Fair Value Options; Fighting Complexity; More

A speech by a staffer at the Securities and Exchange Commission has set off a cascade of warnings to auditors to watch for “valuation manipulation,” as a new standard allowing more discretionary use of fair value accounting takes effect.

Joe Kroeker, deputy chief accountant for the SEC, told a recent New York conference on principles-based accounting that the SEC staff is already alert to the reporting games that some preparers are playing, or may be planning to play, thanks to the newly adopted Financial Accounting Standard No. 159, Fair Value Option.

FAS 159 gives companies the discretion to pick and choose which financial assets and liabilities they will retain on the books at historical cost, or revalue using fair value measures. It is intended to create the effect of hedge accounting, ensuring any derivatives and their underlying assets can be valued using the same measurement methods, so they better relate to one another.

During the initial transition, however, regulators now openly worry that companies will take the opportunity to grease earnings rather that focus on alignment of accounting methods—which ostensibly is FAS 159’s primary goal. In his address discussing obstacles to a more principles-based approach to accounting rules, Kroeker said the SEC staff still struggles with accountants who want to engineer transactions to achieve a particular reporting outcome.

“As a very recent example, the SEC staff has become aware that certain parties have identified a series of transactions that might be described by them as an opportunity in adopting the [Financial Accounting Standards Board]’s recently released fair value option standard,” he said. “Some might suggest that an entity should elect the fair value option for certain existing investment assets where the carrying amount is less than fair value. This would provide for the ability to, in effect, write down the value of the asset without a charge to the income statement.”

Even further, Kroeker said at least a few accounting minds are concocting plans to sell an asset after it has been revalued without recognizing a loss, and then repurchase it. Recent reports suggest the investment banking sector is flush with activity around the idea, with bankers seeing the new accounting rule as a way to restructure bond portfolios without showing any hit to earnings.

“Unfortunately, in this case, the ‘opportunity’ appears to be one that could confuse investors rather than provide more meaningful information to investors,” Kroeker said in his speech. “Engaging in this type of activity does not appear to promote the objective of the accounting standard. Accordingly, you can expect the SEC staff to continue to have an interest in such activities.”

The Center for Audit Quality at the American Institute of Certified Public Accountants issued an alert to its members last week warning auditors to be on the lookout for dubious use of the fair value option.

“Although FAS 159 allows for early adoption of the fair value option to held-to-maturity and available-for-sale investment securities held as of the early adoption date, including those securities in unrecognized loss positions (underwater securities), auditors should exercise appropriate professional skepticism and be alert for circumstances in which an entity propose to adopt FAS 159 in a manner that is contrary to the principles and objectives outlined in the standard,” CAQ writes in its alert.

FEI Outlines Path To Cut Accounting Complexity

Adding its voice to the chorus calling for less complex accounting standards, Financial Executives International has issued a four-part plan for how it can be achieved, calling for an end to detailed rules, the reform of class-action provisions, a new framework for making rules and giving regulatory guidance, and a committee to study complexity further.

The FEI says FASB and the Securities and Exchange Commission should call a halt to detailed rules by issuing no new accounting standard and shifting more attention to FASB’s conceptual framework project, the goal of which is to establish a new process by which accounting rules are developed. The objective, according to the FEI, is to look holistically at an accounting and disclosure model with an eye toward usefulness and understandability.

Turner

Lynn Turner, former chief accountant for the SEC and managing director of research for Glass, Lewis & Co., says he’s concerned a moratorium on new standards would inhibit improvement of generally accepted problem areas in the accounting rules. “This would mean no fixing of broken standards such as Financial Accounting Statement No. 13 on leasing, or phase two of the project on pensions, or enhanced disclosures of key performance indicators,” he says.

Grace Hinchman, senior vice president at the FEI, counters that the FEI is calling for a stop only to brand new initiatives. “We’re talking about new accounting standards, not going back and reviewing and fixing or improving current standards,” she says. “We’re saying the foundation for accounting standards is not built. By continuing to issue new standards on a faulty foundation, eventually it’s going to implode.”

Hinchman

Hinchman says the FEI is concerned that FASB isn’t devoting enough time to the conceptual framework project because it is working on too many other issues simultaneously. “They say they’re working on it as they can get to it,” she said. “How fast would it be done if they were focusing more on it?”

The FEI isn’t the first to call attention to the problem. Even SEC and FASB leaders have bemoaned complicated accounting rules and proposed a task force be formed to help determine a path out of the maze. The FEI would welcome such a committee as well.

“Investors, capital markets, and preparers aren’t being served,” Hinchman says. “The auditors and standard setters are increasingly frustrated. Right now the identified participants [in a prospective task force on complexity] are waiting to see who’s going to flip the switch to get a group together and get it started. No one stakeholder should have a predominant role in this discussion.”

Research Firm Ranks Top 100 In Accounting, Governance

An independent research and rating service has named what it regards as the top 100 U.S. public companies in accounting and governance excellence, even establishing a link between governance and accounting practices and market returns.

Audit Integrity routinely provides its subscribers with reports on the best and worst of public companies based on its proprietary rating system. The firm’s most recent report is a list of what it regards as the top 100 public companies in terms of transparency in financial reporting and alignment of management with the interests of corporate stakeholders.

The firm identifies high levels of corporate integrity with fewer incidents of litigations, financial restatements, compliance issues, and related negative events. James Kaplan, chairman and founder of Audit Integrity, says the listing even demonstrates a pattern of greater returns for companies that adhere to principles of corporate integrity.

The firm said its listing of the top 100 companies in corporate integrity coincides with an average 33.4 percent return during 2006, compared with an overall market return of less than half that level. “Investors respond positively to trustworthy, transparent management and negatively to scandals and risky behavior,” Kaplan said in a statement.

The top-ranked companies included the Washington Post and Alliance Bernstein Holdings in the large-cap sector, Baldor Electric and Kelly Services in the midcap sector, and Dollar Financial and CDI Corp. among small caps.

Jack Zwingli, CEO of Audit Integrity, tells Compliance Week the ranking looks at a broad range of financial and nonfinancial measures of risk to reach a conclusion about governance. “With financial data, we look to determine the transparency and reliability of the numbers,” he says. “We look at significant changes or variances that we have found to be linked to aggressive accounting behavior. The best companies showing fewer red flags or areas of concern, indicated greater transparency.”

Zwingli

As for nonfinancial information, the analysis looks at areas such as compensation, insider trading and high-risk events like late filings or executive turnover, Zwingli says. “The link between risky behavior and negative outcomes like litigation and financial restatements is very clear, and the best companies avoid the type of behavior that leads to these problems,” he says.

Zwingli says the firm’s findings support other research that has shown companies with corporate integrity consistently outperform the market. “One clear reason for that is that the best companies do not suffer from earnings surprises, which occur more frequently with companies actively managing their numbers,” he says.