Experts Say Use Non-GAAP Measures Carefully

Normalized adjusted EBITDA less capex. Adjusted consolidated segment operating income. Adjusted EBITDA (as adjusted). Even enthusiasts of non-GAAP metrics have to admit that such measures often sound just a wee bit ridiculous.

Non-GAAP metrics, those not addressed in U.S. generally accepted accounting principles, are as controversial as ever. A small number of such measures, like EBITDA and free cash flow, have gained widespread acceptance in the investor community. But regulators often give companies flak for the way they use non-GAAP measures in public filings, press releases and other communications consumed by investors and analysts.

Groupon, the perpetrator of “adjusted consolidated segment operating income” (ASCOI), took heat from the Securities & Exchange Commission in 2012 because the metric excluded online marketing expenses, a critical part of the firm’s business model, from company performance. Groupon eventually dropped the metric from its initial public offering filing, but it absorbed further criticism for its post-IPO use of other non-GAAP measures.

Black Box, a telecommunications company, got some bad press in January 2013, when it included the metric “adjusted EBITDA (as adjusted)” in its quarterly earnings release. The metric subtracted from net income ordinary expenses such as a $2.7 million loss on a joint venture, creating EBITDA (as adjusted), then further excluded stock-based compensation expenses to create the final, rather silly-sounding redundancy. Black Box said the measure demonstrated its ability to service its debt. Others thought it made the company look like well, a black box.

A common opinion is simply that non-GAAP metrics are misleading to shareholders. “They may be perfectly understandable to accountants who know what that company is doing but confusing to others,” says Michele Amato, partner at accounting firm Friedman LLP. Indeed, the SEC has long subjected companies that use non-GAAP metrics to heightened scrutiny, and the chairman of the commission’s new accounting-fraud task force has vowed to keep up the pressure.

But companies that use these black-sheep metrics argue that they often depict financial performance more accurately than GAAP measures and afford investors a window to how management sees things.

Public companies are allowed to disclose non-GAAP metrics in their SEC filings, press releases and earnings calls, subject to certain rules. Under Regulation G, mandated by the Sarbanes-Oxley Act, use of a non-GAAP financial measure must be accompanied by the most directly comparable GAAP measure and a reconciliation of the two metrics.

Everything in Moderation

For her part, Amato says there’s a place for non-GAAP metrics:

 “A very significant variance between GAAP and non-GAAP metrics that management uses as a baseline for internal financial analysis might be of some use,” 

There is nothing wrong with using a non-GAAP metric to provide an additional perspective about something very germane to the company’s performance, like its valuation, credit standing or working-capital management, that can’t be communicated well through GAAP metrics alone, says Robert Rostan, CFO and principal at financial training firm Training the Street.

Original article by Marielle Segarra ad CFO.com

Is the Smartest MD&A the One With the Most Jargon?

“Plain English Works” in MD&A Statements

Those who prepare MDAs don’t have to prove how smart they are by using financial jargon, suggests the SEC’s ex-corporate finance director.

Excessive financial jargon in documents filed with the Securities and Exchange Commission often clouds intended messages, said speakers at an American Institute of Certified Public Accountants conference this week.

The sentiment particularly applies to the Management’s Discussion and Analysis (MD&A) section of quarterly and annual reports and other registration statements, where companies generally discuss their business, uncertainties, and market trends.

“Everyone likes to prove they’re the smartest person in the room because they understand the jargon,” said Brian Lane, partner in the Washington, D.C., office of Gibson Dunn & Crutcher and former SEC director of the division of corporate finance. “Plain English works.”

The best MD&As have “more tables and less jargon,” Lane opined. Tables, he noted, are easier to understand than mounds of text. In the text, companies often include too many comparisons going back several years, which is often unnecessary and even confusing, he said. It’s better to show simple comparisons between this year and last year in both the text and tables, and include information on other years just in tables.

Making sure MD&As are as readable and informative as possible may ward off or lessen the impact of SEC inquiries, Lane added. One key to doing that: in all areas of focus within the section, answer the question “why?” he said.

Actually, having more tables in financial reports is a widening theme. The Financial Accounting Standards Board made a push in that direction this past summer, requesting comments on a proposal calling for nonfinancial companies to disclose expected cash-flow obligations in a table segregated by time of expected maturity.

For one, Katherine Gill-Charest, controller and chief accounting officer at Viacom, should be prepared if the proposal is approved. She already is including more than the usual amount of detailed information in the company’s MD&A statements. To facilitate that, she holds “working meetings” with members of Viacom’s disclosure committee a couple of times a year, instead of having just one formal meeting at reporting time to head off any questions that might arise from the SEC. She also meets with the CFOs of Viacom’s divisions to be aware of pertinent issues in preparing MD&As.

For example, the SEC repeatedly has asked for information on how Viacom plans to fund its $10 billion share-repurchase program. Other questions come when an SEC official hears of a trend during an earnings call that is not included in the MD&A.

Lane supported that use of a firm’s disclosure committee. A good item to discuss with that committee, for example, is “cash runway,” a measure of how long a company’s cash on hand will last, he said. A hoard of $300 million in cash is not actually that much if the company is burning through it at $90 million a quarter.
Knowing what questions the SEC may have raised with competitors is important, too.

 “If I know a peer of mine has gotten reviewed, we will always take a look at the SEC’s comments,” said Gill-Charest, noting that she treats any correspondence between a competitor and the SEC as if it were her own document.

That made sense to Lane:

“You do need to see what competitors and peers are disclosing, because the SEC is going to look at you in that same lens,” he said.

One area where some companies could ease up is their heavy use of forward-looking disclosure statements.

“Projections are not required in [the] MD&A,” said Lane. “You [just] have to talk about known uncertainties and how they could impact the future.”

By Kathy Hoffelder  at CFO.com

FASB vs IASB: Split on Lease Accounting

The US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) failed to reach a consensus for new lease accounting guidance Wednesday but vowed to continue working together in pursuit of consistency.

During two days of meetings at FASB’s headquarters in Norwalk, Conn., the boards failed to reach common answers on key areas of lessee and lessor accounting. In particular, the IASB favored a single approach for lessees for recognition of all leases, while FASB voted for a dual-recognition approach for lessees, depending on the type of lease.

The boards issued a joint statement saying they had agreed on areas such as lease term and short-term leases. The boards also pledged to continue working together on the standard.

“While differences remain, most notably in their preferred approaches to expense recognition, the boards are committed to working together to minimize these differences and to creating greater transparency around lease transactions for the benefit of investors worldwide,” the boards said.

The boards are attempting to create a converged standard that would eliminate a hidden liability for lessees by bringing leases onto corporate balance sheets. But they have struggled to agree on how to do it.

No consensus for lessee accounting

IASB members this week expressed a preference for lessees to account for all leases as the purchase of a right-of-use asset on a financed basis. In this “Type A” approach, a lessee would recognize amortization of the right-of-use asset separately from the interest on the lease liability for all leases.

FASB members preferred a dual-recognition approach for lessees that would use a Type A interest-and-amortization method for leases classified as capital leases under existing guidance, and a “Type B” single, straight-line lease expense for operating leases.

But there may still be a chance for convergence on this issue. FASB Chairman Russell Golden asked the FASB staff to work with the IASB staff to conduct research that would help the boards understand the effects of a possible exception that would permit preparers not to apply the proposed standard’s requirements to leases of small, nonspecialized assets.

The IASB voted for the so-called small-ticket exception, while FASB voted against it. Golden asked for the staff research in hopes that a better understanding of the exception could lead to convergence, which could cause the boards to agree on a preferred method of expense recognition.

FASB member Tom Linsmeier said he would be more inclined to consider the Type A-only approach for lessees if the boards abandon the small-ticket exception.

Sticking point for lessor accounting

On lessor accounting, meanwhile, the boards agreed to keep standards similar to current guidance but couldn’t agree on one important detail. They agreed that lessors should classify their leases as Type A or Type B based on whether the lease is effectively a financing or a sale rather than an operating lease.

But the IASB preferred to make that determination by assessing whether the lessor transfers substantially all the risks and rewards incidental to ownership of the underlying asset.

FASB preferred to make the leases guidance consistent with the requirements for a sale in the soon-to-be-issued revenue recognition standard. FASB’s approach would preclude recognition of selling profit and revenue at lease commencement for any Type A lease that does not transfer control of the underlying asset to the lessee.

The core principle of the new revenue recognition standard will be that revenue should be recognized to depict a transfer of promised goods or services to the customer.

Despite the disagreement on lessor accounting, some IASB members said they could accept the FASB approach, with IASB Chairman Hans Hoogervorst holding a “swing vote” that Golden suggested could move the lessor accounting decision to a converged answer in the future.

Before the boards parted, Golden thanked IASB members and said the boards ought to work together on the definition of a lease, disclosures, and other aspects of the leases proposal.

“We will continue to work together to improve accounting in this area, to continue to meet our objective,” Golden said, “and I hope to continue to minimize any differences.”

The boards have been working since 2006 to come to agreement on a leases standard. Their second exposure draft on the topic, issued in 2013, caused many preparers and some investors to question the benefits of the information—and the costs—the proposal would have generated.

By Ken Tysiac at JofA

11 Issues to be Aware of for Your Next Shareholder Meeting

U.S. public companies are operating in an environment full of both risk and opportunity as they prepare for their annual shareholder meetings.

Cyberthreats, disaster planning, and political and economic unrest are among many factors that make the current climate hazardous for many companies.

Although high values in the stock market indicate an environment that has improved significantly—if slowly—since the lowest depths of the global financial crisis, recent dips in the market indicate that volatility still exists.

Shareholders are likely to be focused on both the risks and the opportunities in upcoming shareholder meetings, according to Wendy Hambleton, CPA, a partner in the corporate governance practice who also heads up the SEC practice at BDO.

“There is still that overriding sense of still coming out of that economic downturn, whatever you want to call the period from 2007 to 2009,” Hambleton said. “I think people are cautious, so they want companies to be cautious and prudent with their funds. I don’t think people are pushing as much for huge growth as they are for measured growth and maybe a little more secure growth.”

Against this backdrop of risks and a desire for secure growth, BDO has compiled a list of issues in a news release that corporate management and boards of directors should be prepared to discuss with shareholders in connection with annual meetings this spring:

- M&A opportunities and takeover defenses. Is management seeking M&A opportunities? Are potential targets properly vetted to prevent buyer’s remorse? And are boards poised to fend off unwanted takeovers and maximize shareholder value if a transaction is accepted?

“We are seeing more M&A activity,” Hambleton said. “A lot of companies have some cash on hand, but I think everyone wants to be cautious to make sure plenty of due diligence is done, that it’s the right transaction, that it makes sense, no one is rushing into deals”

- Spinoff advocacy. Management and the board need to be prepared to respond to well-funded, activist shareholders who have the potential to try to break up companies, according to BDO. This can be a costly exercise, Hambleton said.

“If you’ve got activist shareholders making suggestions and urging the company to take certain actions, that takes a lot of time and in some cases dollars that the company might have wanted to use in an alternative way,” she said.

- Global economic concerns. Investors are concerned about how the crisis in Ukraine and slowing growth in China, Brazil, Japan, and other markets will affect the global economic recovery, according to the news release. Shareholders may ask about how prepared the company is to deal with a serious economic collapse in a certain country or region.

The crisis in Ukraine demonstrates that problems can occur in unexpected places, Hambleton said. And emerging markets pose different political and economic concerns than more mature markets such as the United States, Canada, and Western Europe, according to Hambleton.

“That’s not a reason not to go into those markets,” she said. “It’s just a reason to go in from a measured perspective. And from a shareholder perspective, that’s what people want to see is a measured perspective, that people are thinking about the risks, thinking about the concerns, and then taking a measured response to that.”

- Cybersecurity. Headlines about numerous high-profile breaches are certain to have shareholders’ attention, and companies should be prepared to explain their approach and their defenses. Hambleton notes:

“Companies need to be able to explain to shareholders—without getting into the minutiae of the details and what they do—how they monitor, what kind of controls they have in place,”  

“Have they looked at refreshing their risk management approaches in this area? How often do they do certain types of monitoring activities?”

- Executive compensation. Performance-focused compensation models at public companies have gained favor in the wake of new avenues for shareholder feedback, according to the news release.

Since regulations do not require disclosure of the relationship between pay and company performance, it appears that an emerging consensus is that disclosures should report how the company’s total shareholder returns relate to the CEO’s realizable pay, BDO said. Shareholders will ask more questions when the executives are compensated handsomely while the company struggles, Hambleton said.

- Succession planning. An improving economy may create more opportunities for executives to change jobs. This could cause shareholders to ask whether the board has a succession plan and has identified candidates for CEO and other key positions. Surveys have shown that board members are interested in this issue, Hambleton said.

“If it’s something board members would want to spend time on, you’d think it’s something shareholders care about, too,” she said.

- Accessing public equity markets. In 2013, total U.S. initial public offerings and proceeds raised reached their highest levels since 2000, according to BDO. This may lead shareholders to wonder whether management is considering new securities offerings.

“Certainly, a good IPO market is an opportunity for companies that may be looking at spinning off either their noncore businesses or businesses that maybe would perform better in a separate company rather than as part of the overall conglomeration,” Hambleton said.

- Disaster planning. Events such as Hurricane Sandy in the United States and Typhoon Haiyan in the Philippines have caused tragic losses of human life and disrupted supply chains and operations. Shareholders may want to know if businesses have backup plans that will minimize the effects of such events.

For example, Hurricane Sandy showed that backup servers located far apart on the same coast may be vulnerable to the same storm.

“No one probably envisioned a storm that would start where it did and go all the way and cause so many blackouts that we need to have [servers] on opposite coasts or in the middle of the country or something like that,” Hambleton said.

- New COSO framework. Shareholders may want to know if a company has updated its system of internal control to reflect the guidance in the updated 2013 framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

“I wouldn’t expect there to be significant changes to companies’ assessments,” Hambleton said. “But the new framework does have more particular guidance built into it, so I think some of the controls and the mapping will need to change. There will be some work to do. Hopefully, some enhancement of controls will come out of it.”

- Conflict minerals. New SEC rules require public companies to report to the SEC whether their products contain certain minerals produced in mines in the Democratic Republic of Congo. In some cases, those mines are run by warlords who oppress residents of the region. Although some companies may be behind in gathering information needed to report on these minerals by the May 31 deadline for the 2013 calendar year, Hambleton said shareholders will have a wider perspective.

“They’re going to want to know if [the company is] going to have to report that they use conflict minerals,” she said. “And that gets into the whole question of sustainability and corporate social responsibility with companies.”

- Auditor tenure. Mandatory audit firm rotation no longer is part of the PCAOB’s agenda afterlegislative pushback on the issue, but BDO said management and audit committees should be prepared for shareholders to ask about the length of their auditor’s tenure and their process for hiring their auditors.

“If you’re an audit committee member, you will have heard the discussion, and you need to be prepared to answer the question, what consideration did they give,” Hambleton said. “Not that they should be making a change, but what consideration did they give to it?”

By Ken Tysiac Journal of Accountancy.

 

SEC Comment Letter Watch -- Segment Reporting

Segment reporting is one of the SEC's most common areas of comment. The SEC often asks for specifics of documents that the Chief Operating Decision Maker (CODM) reviews on a regular basis. Companies need to be cautious when answering similar questions since the next request from the SEC might be "please provide us with all regular reports that the CODM review on a regular basis." If the SEC sees something different in those CODM reports from the answer provided previously, that spells trouble. Here is a sample from a letter to Charter Communications:

SEC's question:
We note your response to comment 4. Please provide us additional information about all of the “certain operating metrics”, such as “CPE” and plant maintenance, that management, in particular the CODM, relies on to assess performance and allocate resources.

Describe for us what these non-financial business and operational data represent, at what level of detail does the CODM review them (e.g.KMA or lower), and how the CODM uses them to assess performance and allocate resources.

Company's answer:
Our CEO, as CODM, receives and reviews information at the consolidated level, whether financial or non-financial in nature, and uses that information to assess performance and allocate resources on a consolidated basis. The CEO routinely receives consolidated operating metrics that include customers by product (video, Internet, and phone), sales and disconnects by product, customer net gains, penetration of estimated passings, bundled customer statistics, sales channel performance, call center and truck roll statistics and headcount. In addition, the CEO receives certain statistics related to the quality of physical transactions occurring at a local level, specifically truck roll data and ratios which use the number of customer connections, disconnections and average customers by service to calculate service level ratios. These statistics assist with the review of activity in the field at the local level, but are not the primary data used for resource allocation. Our CEO makes resource allocation decisions to specific operating strategies that impact the performance of the consolidated company. Furthermore, he assesses the performance of the Company on a consolidated level as a result of the implementation of the company-wide operating strategies. The execution of those strategies is carried out by levels below the CODM.

Resources allocated to our strategic initiatives of enhancing the customer experience and increasing customer growth are driven on a consolidated basis by our CODM. One such example would be CPE procurement, which is budgeted based on a certain number of connects and devices per connect, both estimated for the entire company. Consequently, CPE is purchased on a company-wide basis in order to maximize scalability during negotiations with our vendors and to meet estimated connects on a company-wide basis. Plant maintenance is another example. The allocation of corporate resources to plant maintenance is based on the strategy to improve the performance and reliability of the network. Levels below the CODM are then tasked with execution of the strategy and ensuring resources are provided where they are needed. A third example is our strategy of our all-digital network roll-out. Again, the amount of resources required for the all-digital roll-out is based upon an allocation of resources to implement the roll-out company-wide. In executing the all-digital roll-out, managers below the CODM carry out the initiative within our footprint based upon the potential immediate impact on our customers. Other overall resource allocation examples include, but are not limited to, implementation of a back office system to support customer growth or a decision to change the type of modem used, both of which would be on a company-wide basis.

Cleaning Up OCI

Accounting ‘Dumping Ground’ Headed For Clean Up

International accounting rulemakers may focus on cleaning up rules for “other comprehensive income,” a category in a company’s earnings statement that can obscure the true profit and loss picture, the chairman of the International Accounting Standards Board said this week.

The board may restart its efforts to improve financial statement presentation guidance in this area and bring more “discipline” to the way companies decide what is classified as profit and loss or other comprehensive income, IASB Chairman Hans Hoogervorst said in a speech in Tokyo.

More than 100 countries use International Financial Reporting Standards, which are set by the IASB. The U.S. does not use them for domestic companies, but allows foreign companies to file their results with U.S. regulators under these standards. U.S. multinational companies often have to use these standards for foreign subsidiaries.

Other comprehensive income, which includes items initially excluded from net income in a particular accounting period, has gotten a reputation as a sort of dumping ground where companies are allowed store information that would be too damaging to earnings.

For example, he said passing employee benefit expenses through other comprehensive income, rather than earnings, has dis-incentivized companies from dealing with large liabilities head-on.

“In the last decade, some big American car manufacturers and airline companies were brought to their knees by employee benefits that had been building up over the years,” Mr. Hoogervorst explained. Such liabilities may not have been taken as seriously because they were in other comprehensive income, he said.

The other comprehensive income figure is crucial because it can distort common valuation techniques used by investors, such as the price-to-earnings ratio. If the profit and loss statement and earnings are the primary indicators of a company’s performance, they need “to be robust and tinker-free,” Mr. Hoogervorst said.

Mr. Hoogervorst said he’d been approached by Japanese accounting stakeholders about improving and clarifying other rules, as well as differences of opinion from other countries, such as Canada.

In an interview with CFO Journal, Dr. Nigel Sleigh-Johnson, head of financial reporting for the Institute of Chartered Accountants of England and Wales said Thursday, “At the moment there is no clear and consistent basis for,” other comprehensive income.

Accounting rulemakers should try to make it easier for companies to decide what items need to be recognized in profit and what has to go into other comprehensive income, he said.

The U.S. Financial Accounting Standards Board has also been working to clarify rules for other comprehensive income in the past few years and make the rules more transparent to investors.  The board issued new guidance on how companies should present the figures in 2011 and updated accounting standards on items reclassified out of accumulated other comprehensive income last February.

 Article by Emily Chasan, at the Wall Street Journal

Can Companies Smooth-Talk Investors?

Investors Prove Wise at Judging Self-Serving Earnings Explanations

Investors have proven to be sophisticated enough to dismiss implausible explanations from companies of their quarterly earnings results, according to a new study.

For example, a utility company might attribute their lower earnings to “warm weather and higher propane products costs,” while an insurance company might explain a good quarter by touting its “continued efforts on cost containment and operational efficiencies.” Self-serving attributions such as these, which typically blame outside factors for negative developments and claim that their own internal initiatives led to positive results, are a traditional part of corporate earnings reports and press releases. But that doesn’t mean investors generally believe them.

According to a new study in The Accounting Review, a journal of the American Accounting Association, market response to self-serving attributions depends in large part on two key tests of plausibility—how badly the company’s industry peers are doing and what the study calls “commonality,” the extent to which market or industry forces drive a company’s earnings.

The difference proved to be dramatic when those two key tests were applied to the 94 companies in the study, which was conducted by Michael D. Kimbrough of the University of Maryland and Isabel Yanyan Wang of Michigan State University. Firms with average positive earnings surprises who made the highest-plausibility attributions had three-day above-market returns of 4.77 percent on average, whereas those that offered the lowest-plausibility reasons actually averaged a slight decline of 0.79 percent. Meanwhile, among firms with average negative surprises, those with the lowest-plausibility attributions sustained average declines of 5.11 percent, while those with the highest-probability excuses had declines of only 1.42 percent.

“Firms which provide defensive attributions to explain earnings disappointments experience less severe market penalties when 1) more of the their industry peers also release bad news, and 2) their earnings share higher commonality with industry- and market-level earnings,” said the paper. “On the other hand, firms that provide enhancing attributions to explain good earnings news reap greater market rewards when 1) more of their industry peers release bad news, and 2) their earnings shares lower commonality with industry- and market-level earnings.”

 “Collectively, our results suggest that investors neither completely ignore seemingly self-serving attributions nor accept them at face value, but use industry- and firm-specific information to assess their plausibility,” the professors added. “Further analyses reveal that investors’ use of industry peer performance and earnings commonality information appears justified because investors’ perceptions are consistent with the association between the plausibility measures and the ex post actual persistence of earnings surprises.”

In sum, “investors are somewhat sophisticated when interpreting these narrative disclosures,” Kimbrough and Wang wrote:

“Our findings ought to be of value to both investors and corporate leaders,” said Wang in a statement. “Hopefully it will disabuse those executives who are counting on the naiveté of investors to let them get away with empty words or phony excuses in their public communications. For investors, it provides standards they will need to meet to keep up with the investment community at large.”

“The tools needed to apply those standards are certainly available to institutional investors, even though determining commonality is probably beyond the reach of individual stock-pickers,” said Kimbrough. “Still, even they should have the means to stack up the claims of a given company against its industry peers, which can go a long way in assessing the plausibility of the firm's performance narrative.”

The study's findings are based on an analysis of press releases and earnings reports of 94 randomly chosen firms, a roughly equal mix of small, medium and large, over a seven-year period. Sufficient data was obtained for a total of 1,790 firm quarters, 1,023 of which featured self-serving attributions and 767 of which did not. The self-serving classification was assigned to quarters when companies attributed their success in meeting or beating consensus forecasts to internal factors, such as management strategies or introduction of new products, or blamed a negative earnings surprise on external factors, such as bad weather or rising costs or regulatory actions. Firm-years in the self-serving category featured at least one such attribution and an average of three to four in a given earnings press release.

The authors found a significant relationship between the plausibility of self-serving attributions, as determined by industry performance and commonality, and the market-adjusted cumulative return of firms' stocks in the three days centered on earnings announcements. In reaching that conclusion, they controlled for an array of factors likely to affect the market’s response to earnings announcements, including the size of companies, the volatility of their stock, and their book-to-market ratio.

What kind of companies are likely to issue suspect attributions? Preliminary evidence suggests, in the words of the study, “Firms which provide less plausible attributions are larger and have higher likelihood of insider trading around earnings announcements, higher analyst following, higher institutional ownership, higher return volatility, and lower book-to-market ratio. These findings imply that managers with insider trading incentives and those facing greater capital market scrutiny are more likely to offer seemingly self-serving attributions even if they lack plausibility, consistent with the ‘opportunistic behavior’ view of capital markets.”

This view, according to the paper, finds “that capital-market scrutiny combined with the linking of manager compensation with stock prices creates pressure for managers to prop up prices by biasing financial reporting. To the extent capital-market pressure is greater for firms with higher analyst following and/or institutional ownership, the ‘opportunistic behavior’ argument suggests that greater analyst following and/or institutional ownership may increase managers’ tendency to provide implausible attributions to either mitigate market reactions to negative earnings surprises or to increase market rewards to positive surprises.”

Still, given the hazards of implausible attributions, as revealed by the new study, why would managers make them? It’s a matter of what they believe, Wang and Kimbrough wrote. “If managers believe there is a chance that investors might be persuaded by their implausible seemingly self-serving attributions, they are more likely to offer them even if ex post it turns out that investors can see through them.”

This article is by Michael Cohn in Accounting Today. The study, “Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence,” appears in the March/April issue of The Accounting Review, published six times a year by the American Accounting Association.

What have IASB and FASB convergence efforts achieved?

What have IASB and FASB convergence efforts achieved?


Paul Pacter CPA, Ph.D. served as a member of the International Accounting Standards Board (IASB) from July 2010 to December 2012. At the end of his term on the Board, he wrote the following article.

EXECUTIVE SUMMARY

In this opinion piece, former International Accounting Standards Board (IASB) member Paul Pacter describes the accomplishments of the convergence project undertaken in 2002 by the IASB and FASB. He says many standards have converged, and IFRS have been improved as a result of the process.

On a standard-by-standard basis, results of convergence have been mixed, Pacter says. Some standards have been improved. Some have not changed because the boards couldn’t agree on a converged solution. And a few—revenue recognition, leases, and financial instruments—remain under development.

According to Pacter, although progress has been made through convergence, adoption of IFRS for U.S. financial reporting is the ultimate goal. He says adoption is the best approach for any jurisdiction.

For nearly 40 years, the International Accounting Standards Board (IASB) and its predecessor, the International Accounting Standards Committee (IASC), have been working to develop a set of high-quality, understandable, and enforceable International Financial Reporting Standards (IFRS) to serve equity investors, lenders, creditors, and others in globalized capital markets. When the IASB took over from the IASC in 2001, few countries had adopted International Accounting Standards (as IFRS were then called) even for cross-border public sales of securities, let alone for domestic public companies.

That all changed—and quite dramatically—with two events. First, in 2000, the International Organization of Securities Commissions (IOSCO) endorsed IFRS for cross-border securities offerings in the world’s capital markets. Then, in 2002, the European Union made the bold decision to require IFRS for all companies listed on a regulated European stock exchange starting in 2005. Those events started a snowball rolling, to the point where today roughly 100 countries require IFRS or a national word-for-word equivalent for all or most listed companies.

Almost from the outset, a key goal of the IASB and the IFRS Foundation, under which the IASB operates, has been to bring the United States on board. In a plenary address at the World Congress of Accountants in 2002, Paul Volcker, the first chairman of the Foundation’s trustees, said: “I do not think it reasonable today, if it ever was, to take the position that U.S. GAAP should, de facto, be the standards for the entire world. Rather, the International Accounting Standards Board, whose oversight trustees I chair, is now working closely with national standard setters throughout the world to develop common solutions to the accounting challenges of the day. The aim is to find a consensus on clearly defined principles, and I am delighted that the American authorities appear sympathetic to that objective.”

In October 2002, the IASB and FASB signed a memorandum of understanding that has come to be known as the “Norwalk Agreement.” The two boards pledged to use their best efforts to (a) make their existing financial reporting standards “fully compatible as soon as is practicable” and (b) “to coordinate their future work programs to ensure that once achieved, compatibility is maintained.” “Fully compatible” was generally understood to mean that compliance with U.S. GAAP would also result in compliance with IFRS. That is, the standards would be aligned though not identical.

With the Norwalk Agreement, the boards launched a series of both short-term and longer-term convergence projects aimed at eliminating differences in the two sets of standards. The two boards agreed that where either IFRS or U.S. GAAP had the clearly preferable standard, the other board would adopt that standard. And where both boards’ standards needed improvement, the boards would work jointly on an improved standard.

The Norwalk Agreement has been updated several times since 2002, but always with the objective of two sets of standards that were converged in principle if not in words. The IFRS-U.S. GAAP convergence approach has been repeatedly endorsed by global financial leaders such as the G-20 as an important step on the path toward a single set of global accounting standards.

In November 2007 an important milestone was achieved toward use of IFRS in the United States when the SEC eliminated the requirement that a foreign issuer using IFRS must present a reconciliation of IFRS measures of profit or loss and owner’s equity to amounts that would have been reported under U.S. GAAP. In their comment letter on the SEC proposal that led to removal of the reconciliation, FASB and the Financial Accounting Foundation wrote:

Investors would be better served if all U.S. public companies used accounting standards promulgated by a single global standard setter as the basis for preparing their financial reports. This would be best accomplished by moving U.S. public companies to an improved version of International Financial Reporting Standards (IFRS).

So, where are we today after 10 years of convergence work? Some convergence projects have been completed successfully as envisioned—aligned principles even if the words differed. Others have been completed with partial success—some progress toward converged standards, but some differences remain. And some convergence projects either were discontinued or resulted in different IASB and FASB standards because, in the end, the two boards just could not agree. Some convergence projects continue to this day, including such major projects as revenue recognition, leases, and financial instruments.

At this point, it is reasonable to sit back and ask two fundamental questions about each of those convergence projects:

1. Have IFRS and U.S. GAAP been converged?

2. Even if convergence was not successfully achieved, has IFRS been improved?

The accompanying table, “Results of Convergence,” sets out my admittedly subjective views about the success of convergence and the resulting improvements to IFRS for each of the projects listed in the various agreements between the IASB and FASB. As a final thought, I would add that convergence may have been the most realistic way to initiate the use of IFRS in the United States, but such an arrangement is not sustainable in the long term. Rather, the best approach for any jurisdiction is outright adoption of IFRS. As the trustees of the IFRS Foundation said recently in the report of their 2011 Strategy Review:

As the body tasked with achieving a single set of improved and globally accepted high quality accounting standards, the IFRS Foundation must remain committed to the long-term goal of the global adoption of IFRSs as developed by the IASB, in their entirety and without modification. Convergence may be an appropriate short-term strategy for a particular jurisdiction and may facilitate adoption over a transitional period. Convergence, however, is not a substitute for adoption. Adoption mechanisms may differ among countries and may require an appropriate period of time to implement but, whatever the mechanism, it should enable and require relevant entities to state that their financial statements are in full compliance with IFRSs as issued by the IASB.

Adoption is the only way to achieve a single set of global financial reporting standards—an objective that both the IASB and FASB have publicly endorsed on many occasions.

Click here to read "Results of Convergence: A Look at the Outcome of Key Joint IASB/FASB Projects"

Significant vs Material

Often the terms “significant” and “material” are used interchangeably. This can course a lot of confusion. The SEC once took a company to task asking why they used this explanation of a contingency:

“You disclose...that you do not expect the ultimate conclusion of any of the proceedings to which you are a party to have a “significant adverse effect” on your financial statements and you have not disclosed the contingent liabilities associated with these claims either because they cannot be “reasonably” estimated or because such disclosure could be prejudicial to the conduct of the claims. Please revise your future filings...to more clearly confirm that you believe the ultimate conclusion of any of the proceedings to which you are a party will not have a “material” adverse effect to your results of operations, cash flows, or financial position.


Why the distinction between "material" and "significant"? To help with understanding the difference between "significnant" and "material" , the following comes from a paper on the IASB 2008 Annual Improvements Process, Comment Letter Analysis:

Significant vs Material

As mentioned above...some respondents asked for further clarification of the Board’s intentions in changing material to significant.

According to paragraph 30 of the Framework:

“Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.”

“Significant, on the other hand, is not a defined term in IFRSs but is used throughout IFRSs to denote the degree of importance or relevance, eg significant costs (IAS 16) significant increase in turnover rates (IAS 19), significant period of time (IFRS 2).”

“Some respondents questioned whether it is possible to have a material change in the number of employees that is not significant. The staff notes that it is not meaningful to say there is a ‘material’ change in the number of employees in IAS 19 since the standard does not require that number to be disclosed in the financial statements.”

Clear as mud?

Impairment Bucket List

No, it’s not a list of cool impairments that an accountant might calculate in his lifetime, if he or she had the time and luck.

Accounting standard-setters are working on a new method of categorizing impaired financial instruments.

The recent credit crisis has advanced a need for revision of the current model as large financial institutions did not agree with existing standards. Large banks, for example, claim that the existing standards result in a “pro-cyclical” result. That means that when times were good, they accounting rules made things look better, faster. And when times were bad, things looked bas faster. Or went to hell faster, as we saw in 2009/03. The rules also impact other sectors.

Credit Crisis Effects
In 2008, banks were following a system of incurred loss reporting, meaning assets were marked down, or impaired, only once their value had demonstrably fallen. Critics said this caused catastrophic shortcomings in financial early warning systems, meaning banks were unable to build up reserves for expected losses and were woefully unprepared when asset values suddenly went into freefall.

The IASB has developed a more forward-looking set of rules for calculating impairment.

“Three-Bucket Solution”

One approach, and the major one being advocated now, is called the three-bucket approach.

One pre-IFRS problem was earnings management, when banks would set aside provisions with little justification, only to release them in lean years to plump up earnings. Critics said this made it hard for investors to get a handle on banks' true financial positions; from these concerns was born incurred loss reporting.

After the credit crisis, the accounting problem was how to permit the judgment essential for expected loss provisioning without paving the way for a potential return to earnings management.

The three-bucket approach aims to break down assets according to impairments, keeping a tighter rein on provisioning and giving analysts a clearer picture of financial health.

Into bucket one goes 'healthy' assets, those for which banks expect a reasonable return and need only make minimal provisions. Bucket two is reserved for assets with some level of impairment, but which are not completely useless, while bucket three is for assets that are undeniably 'bad'.

Throughout its life, the asset can move between buckets according to macro- and micro-economic triggers, hopefully allowing banks to make exactly the right provision at exactly the right time.

An example might be a bundle of mortgages. The bank grants the mortgages, and works out on the basis of historical data that it is likely to take an 80% return on them. It therefore makes provision for the 20% loss and the mortgage bundle sits in bucket one until a trigger makes re-evaluation necessary.

This trigger could be a macro-economic event such as falling oil prices, a contracting economy or rising unemployment. From this, the bank might deduce that a greater proportion of mortgage holders will struggle to pay and shift the asset bundle into bucket two, requiring higher provisions to be made.

For the mortgages to jump to bucket three, they must be demonstrably impaired, for example when the inhabitants of a town hit by unemployment begin defaulting on their mortgages. This is essentially an incurred loss model and would result in very high or 100% provisioning for the de-valued assets.

Unfinished business
Like all theoretical models, there is much uncertainty to be hammered out. What constitutes a bucket-moving trigger? When an asset is impaired, who decides whether the impairment is expected – therefore already provided for – or unexpected, meaning more cash should be set aside? How will auditors examine such a complicated model and will it really prevent earnings management if banks are determined to do it?

A number of question exist, and will need to be ironed out prior to implementation.

Seven Accounting Changes That Will Affect Your 2010 Annual Report

The following is by Jim Brendel and was originally published in SmartPros.

There are a number of new rules that will have accounting and reporting implications for 2010 year end annual reports. They vary from changing the timing of financial results to adding to overall reporting expense.

Two new Financial Accounting Standards Board updates will have major impacts on accounting for sales contracts that contain multiple deliverables. What’s a multiple deliverable? Say your company sells dishwashers and also provides the installation. Under the old rules, you had to demonstrate objective evidence of “fair value” for each undelivered item in order to recognize revenue for the delivered item. If you could not establish the fair value of the installation, revenue recognition for the dishwasher could be delayed, even though the customer had paid for it.

Under the new revenue recognition rule – ASU 2009-13 – companies don’t need the “objective” proof of each service or good, they can estimate the selling price of the installation and warranty. So in our example, the vendor - say it’s Sears or Appliance Factory - can recognize the revenue of the dishwasher – alone - at the point of sale without waiting a few weeks for the installation guys to do their thing. Then they can recognize the estimated value of the installation after it is complete.

The second major revenue recognition change for 2010 reporting , ASU 2009-14, covers software enabled devices. This has also been referred to as the iPhone rule because of the large effect that it has on Apple Computers’ revenues. Although the iPhone is a piece of hardware, it depends on embedded software for its intended use. Under the old rules, this embedded software caused iPhone sales to be governed by the software revenue recognition rules, which are much more stringent than the rules related to other goods and services. As a result, Apple had to recognize all of the revenue from the sale of an iPhone over two years because it provides software updates over that period. ASU 2009-14 says that the software revenue recognition rules no longer apply to these types of software enabled devices, so they are now governed by ASU 2009-13, like other goods and services. The result of the change? Apple reported a record quarter when it elected to adopt this rule early for its first fiscal quarter 2010. Both of these new standards are effective for fiscal years beginning after June 15, 2010, but can be adopted earlier.

Five Other Changes for 2010 Reporting

Fair value disclosures. Companies will be required to provide additional disclosures about items measured at fair value in the financial statements for their 2010 financial statements. In particular, significant transfers in and out of Level 1 (quoted market price) and Level 2 (valuation based on observable markets) must be disclosed separately, along with the reasons for the changes.

Fair value items classified as Level 3 (valuations based on internal information) will require additional disclosure of purchases and sales during the year. The FASB recently decided not to exempt private companies from these requirements. Investors have said that these new disclosures will give them better insight into the quality of reported earnings, but companies can expect to spend additional time gathering and summarizing all of this information.

Consolidation of variable interest entities. Several changes to the consolidation rules for variable interest entities, also known as special purpose entities, came into effect in 2010. The new rules require a qualitative, rather than a quantitative, analysis to determine the primary beneficiary of a variable interest entity, such as a corporation formed to hold real estate and lease it to an operating company. The primary beneficiary is the company that has the power to direct the activities and obligation to absorb the losses of the variable interest entity, which it will consolidate even though it may own less than a majority of the voting interests.

XBRL. eXtensible Business Reporting Language is a data-tagging technology that standardizes the way that financial statement items are identified, and has been frequently referred to as the next generation of EDGAR. The SEC has required the largest public companies (over $5 billion in market cap) to file financial statements with XBRL tagging since June 2009.

In June 2010, the remaining large public companies (over $700 million in market cap) were first required to provide XBRL tagging in their financial statements. Starting in June 2011, all of the remaining U.S. public companies must file financial information using XBRL.

Companies will likely require outside assistance to match their accounting records with the standard XBRL classifications, and should consider an early start on this project. It can easily cost a small public company from $30,000 to $50,000 to implement.

Non-GAAP financial disclosures. Recent SEC staff interpretations allow more latitude for companies who provide non-GAAP financial disclosures, such as EBITDA, in SEC filings, as well as additional guidance in making those disclosures. These interpretations reduced the constraints on the exclusion of recurring items from the non-GAAP measure, and let companies know that management does not have to use the measure in operating the business in order to disclose it. The new interpretations can be found here. The effect of this change is mainly to provide more flexibility to companies in how they report non-GAAP measures of performance and won’t necessarily add or subtract from earnings statements.

Loss contingencies disclosures. A FASB proposal that would require more disclosures about loss contingencies, such as litigation, has been sent back for more deliberation after concerns were raised that the level of disclosure would put public companies at a disadvantage in the courtroom. However, the SEC is questioning whether companies are adequately complying with the current rule, which requires disclosure of an estimate of the possible loss or range of loss. The SEC believes that in too many cases, no disclosure is made until the case is settled because companies assert that they are not able to make accurate estimates of the potential loss. Companies should expect additional scrutiny of their disclosures in 2010 annual reports.

Developments to Watch in 2011

Short-term borrowing disclosures. In response to concerns about companies window-dressing their balance sheets by paying down lines of credit before year- end, the SEC has proposed rules that would require additional disclosures, such as fluctuating borrowing during the year and a qualitative discussion of the business reasons for the debt. These rules are expected to be finalized in the first quarter of 2011. However, the SEC has reminded companies that they expect to see a thorough discussion of liquidity and capital resources in the management’s discussion and analysis under the existing requirements.

Dodd-Frank Act. The Dodd-Frank Act is considered to be the most extensive overhaul of the U.S. financial system since the 1930s and will require the SEC to write over 100 rules and conduct numerous studies. You can follow the progress of these rules on the SEC's website.

Of particular interest to public companies are the requirements for companies to establish policies to claw back incentive compensation paid to executives in the event of a financial statement restatement and to provide disclosures regarding the ratio of CEO compensation to median employee compensation.

Convergence. While the SEC continues its consideration of whether to adopt international accounting standards (IFRS), the FASB and its international counterpart, the IASB, have their own work plan to complete 11 major projects in 2011 to converge US GAAP and IFRS. Although the effective dates of these standards have not been determined, this level of standard setting activity in such a short time is unprecedented. The two projects that are getting most of the attention are a proposal to replace all industry-specific revenue recognition guidance with one comprehensive standard, and a proposal that would require all lease obligations to be recorded on the balance sheet.

Best of 2010: Accounting

After creating an ambitious agenda for the year, the standard-setters had to play hurry up and wait.

Article by Marie Leone and David M. Katz, CFO.com US

In the realm of accounting, no one moved more rapidly this year than the Financial Accounting Standards Board and the International Accounting Standards Board. The two standard-setting bodies set forth an aggressive agenda that called for a dozen or so new rules to be issued by 2011.

Their aim was to complete their now eight-year-old convergence project and emerge with a single set of global accounting standards. But the effort was ambushed by reality — the global financial crisis and subsequent global recession; heated debates over controversial rulemaking decisions; the early retirement of FASB chairman Robert Herz; and the announced departure of IASB chairman Sir David Tweedie, slated for June 2011. (On December 23, the trustees of the Financial Accounting Foundation announced that Leslie F. Seidman, acting FASB chairman since Herz's retirement, had been named chairman of FASB, effectively immediately.)

Accordingly, the rulemakers slowed down the convergence process in the latter part of 2010, vowing to issue only four newly melded standards at any one time. Still, they hope to finish a number of convergence projects by the end of 2011. That will be a prickly task, since those projects have shaken some fundamental tenets of business. They will, for instance, eliminate the concept of operating leases, rework revenue-recognition rules, do away with last-in-first-out inventory accounting, and expand the reach of fair-value accounting.

Meanwhile, the process of adopting private-company accounting standards ("little GAAP") in the United States began in 2010, and could eventually become the purview of a second standard-setting board. The debate concerning final decisions about little GAAP should come to a head in 2011 — just in time for the Securities and Exchange Commission's decision on whether or not U.S. publicly traded companies should abandon U.S. generally accepted accounting principles in favor of international standards.

"Taking the 'Ease' Out of 'Lease'?"
By doing away with operating leases, new accounting rules could bring billions of dollars back onto balance sheets.
"Shorter Agenda for Convergence"
FASB and the IASB have selected five priority projects to focus on – and hopefully push out by next year.
"One Step Closer to Little GAAP"
A blue-ribbon panel on private-company accounting standards recommends a separate GAAP for private companies.
"Technical Difficulties"
As the pace of accounting-rule changes intensifies, can IT systems keep up?
"A Relentless Pursuit of Global Rules"
Tom Jones, director of Pace University's international accounting center, looks forward to a world without local GAAPs.
"Debunking IFRS Myths"
Experts expose seven misconceptions about international financial reporting standards.
"After Eight Years at FASB, Herz Looks Back"
In an exclusive interview, Robert Herz talks about his legacy as chairman of the Financial Accounting Standards Board.
"One Size Gives Fits to All"
Financial executives say that proposed changes to revenue-recognition rules ignore real-world realities.
"Revenue Rules Could Cause Software Snags"
How much will ERP systems have to be tweaked to comply with FASB's new revenue-recognition rules?
"Without Hoopla, Fair-Value Rule Is Readied"
Among the ripple effects of the global credit crisis is the rewrite of the controversial fair-value accounting rule once known as FAS 157. The revised standard could be in place by the end of the year.

Push Down Accounting

Push down accounting is a method of accounting in which the financial statements of a subsidiary are presented to reflect the costs incurred by the parent company in buying the subsidiary instead of the subsidiary's historical costs. The purchase costs of the parent company are shown in the subsidiary's statements.

Push-down accounting works like this:

Company A buys Company B and borrows to make the acquisition.

Company A pays more than Company B’s book value for the following:

$1,000 Property, plant and equipment and definite lived intangibles
$ 500 Goodwill

Instead of making the entry for the fair market value increments (i.e. excluding book value) to Company A’s books for the purchase, which (simplified) would be--

Dr PP&E $1,000
Dr Goodwill $ 500
Cr Debt $1,500

--Company A makes the above entry in Company B’s legal entity books, instead of its own books.

The entry being made in Company B’s books makes no difference to the consolidated financial statements.

The entry above is generally attributable to the subsidiary, Company B, but was originally, and still likely legally, the parent's entry. U.S. GAAP requires push down accounting.

The Securities and Exchange Commission (SEC) has issued a bulletin stating that debt should be pushed down if "(1) Company B is to assume the debt of Company A either presently or in a planned transaction in the future; (2) the proceeds of a debt or equity offering of Company B will be used to retire all or a part of Company A's debt; or (3) Company B guarantees or pledges its assets as collateral for Company A's debt." "Push Down" Basis of Accounting for Parent Company Debt Related to Subsidiary Acquisition, SEC Staff Accounting Bulletin No. 73 (Dec. 30, 1987).

In situations where a corporation has incurred debt in connection with its acquisition of stock of another corporation and these criteria are not met or where the SEC rules are not applicable to the transaction, push down of debt, while not required, is still an acceptable accounting method.

Some corporations have, as an accounting practice, simply placed Company A's interest expense on B’s books. This is generally not acceptable for tax purposes, although could be acceptable in some circumstances. The rules and related jurisprudence are complex.

One common reason for push down accounting is more for management accounting purposes, since Company B would take deductions from income for depreciation, amortization on the fair market value increments and for interest expense.

Push down accounting may not be acceptable under IFRS on transition. So if a company has pushed down fair market value increments into subsidiaries, because the IFRS 1 business combination exemption is available only for business combinations in which the reporting entity is the acquirer, if the reporting entity is itself a subsidiary and its balance sheet reflects the effects of push down accounting from prior acquisitions, those amounts may have to be reversed upon adoption of IFRS. However, a previous revaluation done for purposes of push down accounting can be used as deemed cost in the case of property, plant and equipment, investment property, and certain intangible assets.

More on this topic later.

Push Down Accounting

The Controller's Roundtable is a web site with a vast array of information, discussions and applications that are of great use to both reporting and operations people.

They recently compiled the results of a discussion group on push down accounting. For those not familiar with this term, when a company completes a share acquisition, they will end up paying more that the acquired company's book value for assets acquired and liabilities assumed.

Companies sometimes “push down” the fair value to the acquired subsidiary. On consolidation, nothing changes. The changes affect internal reporting and segment reporting, where asset values are sometimes used for management accounting purposes in calculating asset and earnings based ratios. The additional depreciation or amortization of hard assets and intangibles would affect the subsidiary's earnings.

On the question of when push down accounting is used, the following was observed from a recent Controller's Roundtable discussion:

- 72% pushed down purchase price allocations (including goodwill, intangibles, and fixed asset fair value changes) to acquired businesses.

- 22% said they generally push down the purchase price allocations in most cases, but this could change depending on whether it's a foreign or domestic acquisition.

Check out the Controllers Roundtable.

Got Goodwill? Part 14: Rio Tinto Impairs $8 Billion

Rio Tinto has reported an asset impairment charge of $8.4 billion, mostly attributed to a write-down of its aluminum business, which recorded a $7.9 billion write down.

The aluminum division reported earnings of $1.18 billion, reduced from $2.8 billion as a result of higher costs and adverse exchange rate movements.

Corporate earnings were a record of $10.3 billion, up 38 per cent from the 2007 at $7.4 billion.

The company is now focusing on paying down its $40 billion debt from its $42.5 billion takeover of Alcan in 2007. The company previously stated that the debt dragging on the company. "We are comfortable ... with our financial position, we are confident that our debt position is manageable," they previously stated. "We have $9 billion of debt which is due for repayment in October 2009, we don't see any need to issue equity to meet that. In fact, we currently have available unused credit facilities of almost $7 billion."

Today Rio announced that Chinalco will inject equity totaling $US19.5 billion.

Malcolm McKay

Got Goodwill? Part 10: Time Warner in the Impairment Hall of Fame

Boom times generate cash. Cash generates mergers and acquisitions. Mergers and acquisitions generate goodwill.

Recent market crashes have caused companies and their auditors to look closely at the value of goodwill and intangibles.

Recent additions to the “Impairment Hall of Fame” (see earlier posts for previous additions):

Sprint Nextel $29 billion (in 2007)
Time Warner $25 billion
Regions Financial $6 billion
Alcatel $5 billion (Euro $3.91 billion)
BHP $3.36 billion
Supervalu $3.3 billion
Motorola $3.5 billion (including tax valuation charges)
Bank of America $2.3 billion
Sovereign Bancorp $1.6 billion
Marathon Oil $1.4 billion
United Rentals $1.1 billion
OfficeMax $1 billion
Sandisk $1 billion
Dow $978 million (restructuring, goodwill impairment and other matters)
Capital One $811 million
Colonial Bancorp $575 million
Citigroup $563 million
UPS $548 million
Nalco $544 million
GMAC $455 million
International Paper $438 million (possibly an additional $1.3 Billion)
Yahoo!$488 million
Synovus $463 million
Micron $463 million
Mylan $385 million
Cytec Industries $358 million
Zions Bancorp $350 million
Quantum $350 million
Chemtura $320 million
Applied Micro Circuits $264 million
The South Financial $237 million
Fairchild $203 million
Western Digital $200 million
Webster Financial $189 million
Comsys (up to) $175 million
Piper Jaffray $140 million
First State Bancorporation $127 million
Colonial Properties $116 million
Sara Lee $100 million
Central Pacific Financial $94 million
H.B. Fuller $86 million
Convergys $61 million
Diebold $46 million

Goodwill is an intangible asset that represents value in a combined post-merger company due to factors other than customers, brands, trade marks, technology and other intangible assets that accounting rules require companies to recognize. According to the Economist, goodwill and other intangibles recoded by S&P 500 companies totals $2.6 trillion, or 10% of their total assets.

Most investors consider goodwill impairment to be old news at the time it is announced. Share values are often not impacted by announcements of goodwill impairment. This is generally thought to be because either: a) markets have already priced impairment into share prices, or b) since share prices are ultimately a factor of the discounted value of future cash flows from operations, that impairments do not affect cash flows and accordingly do not impact share prices. Analysts ignore impairments and other unusual earnings line items when normalizing historical numbers to forecast future earnings. An exception to this is when investors are surprised by the impairment news—if the markets had no reason to believe that a company was underperforming and the bad news was not anticipated.

Time Warner’s market capitalization was about 60-70% of its book value—a sure sign of goodwill impairment. Its market capitalization was less than its total goodwill of over $40 billion—the goodwill on the financials was worth more than Time Warner as a whole.

Is this an acknowledgement by Time Warner that it previously overpaid for acquisitions?. Perhaps based on today’s depressed market they overpaid, but they didn’t buy in this market and might no have paid the same if they bought today. But acquisitions are always supported by due diligence and forward-looking valuations. Goodwill impairment calculations are backward-looking and hindsight is always 20/20.

Around 200 U.S. of the largest companies have market cap less than their goodwill and intangibles according to Bloomberg., which states that combined, these companies had goodwill and intangibles of over $808 billion. And about $400 billion of this is goodwill.

Watch for more impairments.

Got Goodwill? Part 9 Impairment Hall of Fame (continued)

Recently anounced goodwill impairment charges:

Valero Energy Corp. $4.1 billion

Flextronics $5.9 billion

B/E Aerospace, Inc $300 million

U.S. Airways $622-million

Boston Scientific Corp. $2.7 billion

Colonial BancGroup $575 million

Banner Corp., $71.1 million

Quantum Corp. $350 million

Applied Micro Circuits $264 million

Lattice Semiconductor $225 million

These are in addition to the previous charges announced as noted here.

Got Goodwill? Part 8: Symantec has $7 Billion Impairment Virus

Security software maker Symantec Corp. took a $7 billion goodwill impairment charge in its December 2008 third quarter results. Symantec kept $5-billlion of goodwill on its books. About $8-billion of their goodwill before the write-down came from their acquisition of Veritas for $13.5-billion in 2004.

They completed an interim impairment analysis, meaning that they checked for impairment before being required to do so by their internal policy on testing impairment.

Symantec stated” The GAAP net loss for the third quarter of fiscal year 2009 includes a non-cash goodwill impairment charge of approximately $7 billion. Based on a combination of factors, including the current economic environment and a decline in our market capitalization, we concluded that there were sufficient indicators to require us to perform an interim goodwill impairment analysis. We have not completed the goodwill impairment analysis and expect to finalize it during the fourth quarter of fiscal year 2009. We may make an adjustment to this charge when the goodwill impairment analysis is completed.”

Got Goodwill? - Part 7 - Latest Impairment: Celestica

Celestica announced its Q4 earnings this week and disclosed that it has written off all of its remaining goodwill. Their explanation from their financial statement notes is set out below. It’s interesting from the perspective of how they describe the mechanics of the write-down:

We are required to evaluate goodwill annually or whenever events or changes in circumstances indicate that we may not recover the carrying amount. Absent any triggering events during the year, we conduct our goodwill assessment in the fourth quarter of the year to correspond with our planning cycle. We test impairment, using the two-step method, at the reporting unit level by comparing the reporting unit’s carrying amount to its fair value. To the extent a reporting unit’s carrying amount exceeds its fair value, we may have an impairment of goodwill. All of our goodwill is allocated to our Asia reporting unit.

During the fourth quarter of 2008, we performed our annual goodwill impairment assessment. Our goodwill balance prior to the impairment charge was $850.5 and was established primarily as a result of an acquisition in 2001. We completed our step one analysis using a combination of valuation approaches including a market capitalization approach, multiples approach and discounted cash flow. The market capitalization approach uses our publicly traded stock price to determine fair value. The multiples approach uses comparable market multiples to arrive at a fair value and the discounted cash flow method uses revenue and expense projections and risk-adjusted discount rates. The process of determining fair value is subjective and requires management to exercise a significant amount of judgment in determining future growth rates, discount and tax rates and other factors. The current economic environment has impacted our ability to forecast future demand and has in turn resulted in our use of higher discount rates, reflecting the risk and uncertainty in current markets. The results of our step one analysis indicated potential impairment in our Asia reporting unit, which was corroborated by a combination of factors including a significant and sustained decline in our market capitalization, which is significantly below our book value, and the deteriorating macro environment, which has resulted in a decline in expected future demand. We therefore performed the second step of the goodwill impairment assessment to quantify the amount of impairment. This involved calculating the implied fair value of goodwill, determined in a manner similar to a purchase price allocation, and comparing the residual amount to the carrying amount of goodwill. Based on our analysis incorporating the declining market capitalization in 2008, as well as the significant end market deterioration and economic uncertainties impacting expected future demand, we concluded that the entire goodwill balance of $850.5 was impaired. The goodwill impairment charge is non-cash in nature and does not affect our liquidity, cash flows from operating activities, or our compliance with debt covenants. The goodwill impairment charge is not deductible for income tax purposes and, therefore, we have not recorded a corresponding tax benefit in 2008.

Cablevision Accounting Error Case Provides SEC Insights

The recently settled SEC/Cablevision action provides a couple of insights into the SEC's practices. One insight is how the SEC settles actions involving financial statement errors that companies voluntarily bring to the SEC's attention. Another is what the SEC considers a material misstatement--in this case, 3.8% of after tax earnings. Another insight might be how easy it was for the officers of Cablevisions's subsidiary to misstate the financials.

Three former employees of Cablevision Systems Inc. were fined a total of $60,000 as a result of accounting irregularites from 2000-2003. The employees did not admit or deny wrongdoing. The three officials were the president, executive vice president and senior vice president of a subsidiary. They were dismissed in 2004, when Cablevision discovered the errors.

Cablevision is a diversified entertainment and telecommunications company with a market cap of approximately $8 billion and 2007 annual revenues of $6.5 billion.

As a result of the an income smoothing scheme the SEC's order stated that Cablevision’s financial statements for years 2000 through 2003 were materially inaccurate. The total after-tax errors were:

$15 million understatement 2000 (3.8% of earnings)
$25 million overstatement in 2001 (1.5% of earnings)
$8 million overstatement in 2002 (4.9% of earnings)
$8 million overstatement in 2003 (5.1% of earnings)

From 1999 through 2003, Cablelevision recognized certain costs as current expenses when, in fact, the costs should not have been recognized in those periods. These improper "prepays" resulted from fake invoices generated to accrue expenses earlier than when they in fact should have been. The result was that Cablevision overstated expenses in earlier periods, and understated them in later periods. This practice is generally known as "income smoothing".

In addition, from 2000 through 2003, Cablevision’s cable distribution business improperly recognized payments known as launch and marketing support paid to Cablevision by television program vendors for advertising and marketing campaigns to attract viewers to the vendors’ programs. This scheme caused Cablevision to reduce expenses in the periods in which launch support was improperly recognized and increase expenses in the periods when the launch support should have been recognized.

Improper Prepays
Cablevision’s accounting department, however, had little direct knowledge of the type of details discussed below at a business unit level. Internal accounting procedures merely called for recognition of expenses and requests for payment of expenses to be reported to the accounting department on a standardized "authorization for payment" form ("APF"), signed by the appropriate level business unit manager, with evidence of the expense, such as an invoice, attached. These controls, however, were not sufficient to prevent the manipulation of expense recognition that occurred.

Cablevision employees and managers for years were able to defeat Cablevision’s internal accounting controls using methods that were neither particularly devious nor sophisticated. For example, some employees submitted counterfeit invoices to Cablevision’s accounting department that were of noticeably poor quality, and were different in appearance from legitimate invoices. Certain Cablevision employees also asked vendors to submit false, vague or misdated invoices for services not yet provided. These invoices were used to trigger the inappropriate patments. In addition, Cablevision checks were sometimes sent to the business unit from which a counterfeit or false invoice originated, ostensibly for delivery to the vendor by an employee of the business unit. This deficient practice permitted the business unit to hold payment until the anticipated services were actually rendered.

Improper Launch Support Recognition
Beginning in the middle to late 1990s, television program vendors began providing lump-sum launch support payments to Cablevision in connection with multi-year contracts with Cablevision to carry their programs. Contract provisions concerning launch support payments were generally understood to require Cablevision to use the funds for advertising and marketing campaigns to attract viewers to the vendors’ programs. Contracts providing for large up-front payments of launch support to Cablevision were not uncommon. These contracts sometimes also required that the launch support be refunded by Cablevision if, among other things, it dropped the program.

In some cases during the relevant period, Cablevision properly recognized nonrefundable launch support as a reduction of expenses ratably over the life of the contract with the vendor and recognized refundable launch support ratably over the life of the refund period. In fact, in 2002, Cablevision publicly stated that this was how it accounted for launch support. From 2000 through the third quarter of 2003, however, Cablevision improperly accelerated the recognition of launch support received from several program vendors, rather than recognizing it ratably over the life of the contract or the refund period. This early recognition ran contrary to its general practice and its 2002 public statement, and violated GAAP’s matching principle.

For example, after the first two years of an eight-year contract, Cablevision changed its recognition for $15 million of launch support from recognition ratably over the life of the contract to immediate recognition of the remaining balance. Under the circumstances, however, Cablevision should have accounted for launch support payments ratably over the life of the contract where, as here, the contract term was fixed and there was no obligation to refund launch support. Another example involved a contract with a launch support refund period. After the first eight months of a 24 month refund period, Cablevision changed its recognition of $5 million in launch support from recognition ratably over the life of the refund period to immediate recognition of the remaining balance. Under the circumstances, however, Cablevision should have accounted for launch support ratably over the refund period specified in the contracts.

Cablevision also improperly recognized launch support early by treating a 2002 seven-year agreement to carry certain programs as if it were two agreements – one of three years, and another of seven years. As two separate agreements, Cablevision recognized $48 million in launch support over the ‘three year’ agreement ($16 million per year), and recognized $16 million in launch support over the ‘seven year’ agreement ($2 million per year). Under GAAP, however, the two agreements should have been treated as one agreement, with the result that the total $64 million in launch support should have been recognized ratably over seven years, i.e., approximately $9.14 million per year. The purported two agreements were negotiated simultaneously and dated only five days apart, and the ‘seven year’ agreement also amended the terms of the ‘three year’ agreement. Cablevision employees improperly cast the single deal as two agreements to achieve early recognition of the launch support payments.