A Year’s Account Of Fair Value, AS2, Errors

Disclosure took center stage in modern accounting last year, as regulators and investors pushed for more details about all sorts of costs—and for assurances that companies have proper, effective internal controls to make such disclosures. From Sarbanes-Oxley and Section 404 to pensions, taxes, and fair-value accounting, companies had a barrage of new standards come at them; 2007 promises to be a year of learning how to implement it all. A few of the topics certain to loom large are listed below.

Internal Control Over Financial Reporting

As the fifth anniversary of SOX approaches, Section 404’s requirement for companies to report on the effectiveness of their internal controls over financial reporting remains the sharpest thorn in the side of Corporate America. But regulators have heard the complaints that costs now far outweigh any benefits and have promised relief.

Most significantly, the balance of power over the internal control reporting process promises to swing away from auditors and towards managements in the coming year. The Securities and Exchange Commission has issued guidance telling companies how to conduct their assessments of internal controls, giving much more explicit instruction than the audit rules companies have been forced to rely on so far. Meanwhile, the Public Company Accounting Oversight Board is working on new standards and rules that promise to curb excessive auditing.

Regulators hope that their new direction will blunt any action from Congress to intervene and fix the 404 problem. “We have been directed … in a very public way to fix whatever is wrong to this point through regulatory changes,” PCAOB Chairman Mark Olson said. “We’ve done that to the best of our ability [with the newly proposed rules] … The next move will be up to Congress.”

The new rules instruct management to assess the controls that matter most to the accuracy of financial reporting. Likewise, they direct auditors to focus first on top-level controls, then use a risk-based approach to determine where they should step up auditing and testing; they also instruct the auditor to issue one opinion, not two, on the effectiveness of controls. Corporate America still must wait through several months of comment, debate, and revision for the proposed guidance, and regulators say the rules likely won’t become fully effective until 2008.

Nevertheless, regulators say the market can glean much now from the rules to improve the overall reporting and auditing process, especially since the audit rules in particular reflect guidance the PCAOB already has issued calling for a top-down, risk-based audit. “We hope to encourage auditors to adopt and use the provisions of the standard as soon as they are available to them,” said Tom Ray, chief auditor for the PCAOB.

Fair Value

The transition from historical-cost accounting to fair-value accounting took another leap in 2006 when the Financial Accounting Standards Board issued Financial Accounting Standard No. 157, Fair Value Measurements, to establish clear guidelines for how companies should measure fair value in instances where accounting literature has required it.

The market seems to agree that a certain dose of fair value in financial statements is useful because the figures are more timely and more relevant. The conversation gets dicey, however, when it turns to valuation of assets for which no liquid market exists—like stock options, for example. FASB’s controversial requirement that companies expense a fair value for stock options remains a sore spot for many businesses, because there’s disagreement over what value is “fair” since the options are not freely traded.

FASB established a definition for fair value that focuses on the assumptions “market participants” would have about value, not necessarily just the parties that might be involved in a given transaction. It creates a hierarchy that gives highest priority to quoted prices for liquid assets in the market and lowest priority to data that is unavailable to the market, such as a company’s own private information.

Under new rules for measuring fair value, preparers and auditors are required to apply much more judgment and make many more estimates. That’s what causes a lot of discomfort in the move toward fair value accounting.

Sherman

“The good news is that old figures are irrelevant,” says David Sherman, an accounting professor at Northeastern University. "The bad news is that it’s based on a lot of estimates and judgments, and that means it’s a very manageable number. That’s going to be the biggest issue. There’s more room to manage earnings today than ever before, and one of the reasons is fair value.”

Pensions

Although 2006 brought a significant change in the way companies are required to account for their defined-benefit plans, observers say the bigger changes are still ahead.

FASB finished what it promised was only the first, short-term phase of revising pension accounting with FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. Most significantly, the statement requires companies to move the status of their plans out of the footnotes and onto the face of the balance sheet, to give investors a better view of whether a company’s plan is underfunded, which has become increasingly common in recent years.

“More changes are coming down the line,” Sherman says. “The second part is going to affect earnings more directly.”

Jacobson

The second phase will likely address the smoothing mechanisms companies use to make their plans’ balances appear relatively stable; without those, companies would need to disclose plan balances subject to “the extreme volatility that could be caused by interest rates and the stock market going up and down,” says Jan Jacobson, director of retirement policy for the American Benefits Council.

Heaped on to new disclosure rules, Congress also passed the Pension Protection Act, which generally requires companies to get more cash behind the benefit plans that they’ve promised to their employees. The intention is to protect retirement-plan beneficiaries and the federal bailout fund, the Pension Benefit Guaranty Corp., from the kind of full-fledged failure that occurs when a company with an underfunded plan closes its doors.

SAB 108

Companies should look hard at the one-time opportunity provided by the SEC to clean up old, accumulating errors in their financial statements that might otherwise lead to restatements.

The SEC issued Staff Accounting Bulletin No. 108 last September instructing companies to apply two different error-correction methods simultaneously to clear up mistakes that have been lingering and accumulating in some companies’ financial statements for years. The bulletin instructs companies to cease picking between the two methods—known as the “rollover” approach and the “iron curtain” approach—as has been commonly done, but instead to use both methods at once.

Timing is critical, as the bulletin gives only a first-quarter 2007 pass on restatements. If companies don’t seize the opportunity to apply the correction methods in the first quarter of 2007, any corrections in future periods can only be achieved with a restatement.

“If you don’t catch the problem before the end of the first quarter of 2007 you lose the opportunity to use the transitional relief,” says Robert Dow, a partner with the law firm Arnall, Golden & Gregory. “This puts a premium on cleaning the skeletons out of the closet during the upcoming 10-K season.”

FIN 48

With the current reporting season, companies will be required to show on their financial statements where they have taken tax positions that ultimately may not be recognized by tax authorities.

FASB issued Financial Interpretation No. 48 to share its views on how companies should comply with FAS 109, Accounting for Income Taxes. FIN 48 says companies should only report tax positions in their financial statements that are “more likely than not” to be upheld by tax authorities as the company reports it and defends any scrutiny or challenge by tax auditors.

In cases where a company is less than 100 percent certain a particular position will survive the tax reporting and auditing process, it is required to say in percentage terms how certain it is about the particular position and to book a tax asset in proportion to their certainty. For example, if a company is only 75 percent certain it will win a particular research and development credit, it can book only 75 percent of the tax benefit it might win until its position is endorsed by tax authorities.

FASB says the policy makes a company’s tax circumstances more transparent to investors. Opponents say it simply gives tax auditors a roadmap to challenge a company’s tax returns.

“If a company has taken an aggressive position for instance to note file income tax returns in a particular state, this has to be analyzed under FIN 48,” Dow says. “This will become a major project for large, complex, multi-state companies. It also could lead to embarrassing disclosure.”