Category: Accounting

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Hello Ms. Schapiro

SEC Seal.gifThe Senate on Thursday confirmed President Barack Obama’s nomination of Mary Schapiro as Chair of the Securities and Exchange Commission. In Ms. Schapiro’s written answers to questions posed by Senator Carl Levin, she indicates a refreshingly sharp break with many policies of her predecessor, Chris Cox.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International Accounting. Ms. Schapiro, unlike Mr. Cox: (a) does not believe that the International Accounting Standards Board meets US legal criteria and is not prepared to delegate authority to it; and (b) believes that US authorities must oversee foreign auditing firms auditing financial statements of companies with securities listed in the US.

3. Internal Controls. Ms. Schapiro, unlike Mr. Cox, would enforce laws requiring internal controls as to small and large public companies alike.

4. Accounting. Ms. Schapiro also believes in: (a) maintaining the independence of the US accounting standard setter, the Financial Accounting Standards Board; (b) cracking down against abuses of off-balance sheet accounting; and (c) continuing the requirement that stock options be accounted for as compensation expense.

5. Regulatory Scope. Ms. Schapiro favors: (a) regulating hedge funds; (b) strengthening capital requirements for securities brokers; and (c) strengthening regulation of rating agencies.

So far so great.

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Satyam Fraud’s Systemic Regulatory Implications

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From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.

But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).

Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.

Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)

Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.

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Spreading Blame in Ponzi Scheme

When word of Bernard Madoff’s alleged $50 billion Ponzi scheme broke last Friday, my systemic worry was whether the fund was audited by a prominent auditing firm. Public revelation of an auditor’s involvement in such a fraud would almost certainly destroy it. Cf. Arthur Andersen amid Enron (2002).

If one of the four very largest auditing firms (Deloitte, Ernst, KPMG or PWC) were involved, the world would face an additional crisis by reducing from 4 to 3 the number of auditing firms capable of auditing most global companies. Indeed, such added crisis could occur if one of the next three largest firms (BDO Seidman, Grant Thornton or McGladrey Pullen) were implicated in such a fraud.

Fortunately, Madoff’s vehicle was not audited by one of those 7 firms (it was apparently audited by a storefront neighborhood accountant). Yet there is continuing fallout from this fraud that, some assert, does implicate one of the large 7 firms. In a putative class action lawsuit filed yesterday, New York Law School is suing investment advisor, Ezra Merkin, and his outside auditor, BDO Seidman.

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KPMG-BCE: Auditor Conflict in Huge LBO Deal?

Green Eyeshade.jpg As one of the largest leveraged-buy out deals in history verges on collapse, much attention is being paid to a central condition in the agreement, the target’s solvency; little attention has been given to conflicts of interest facing the firm, KPMG, deciding whether the condition is met.

The deal is a $28 billion LBO for BCE, Canada’s largest telecom firm. A principal lender in the proposed deal is Citigroup, the struggling commercial bank. BCE has made clear it wants the deal to close as scheduled on December 11; Citigroup, like other lenders amid the current financial crisis, may prefer that it does not.

The agreement contains a condition to the lenders’ obligation to close that BCE shall have obtained an opinion from KPMG, or another public accounting firm, attesting to the solvency of the post-LBO company. This may be difficult to deliver, given the considerable debt being used in the LBO and terrible market and economic conditions.

Trouble is, KPMG is the outside auditor for both BCE and Citigroup, presenting it with a potential conflict of interest. One arm of KPMG may wish to bless the deal, to promote favorable relations with BCE, while another may wish to scotch it, to promote favorable relations with Citigroup.

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SEC Schizophrenic on Global Accounting

SEC Seal.gifWith surprising absence of fanfare, the Securities and Exchange Commission released over the weekend a 165-page document outlining its delayed and long-awaited proposals for how the US might switch from using its own generally accepted accounting principles to new international financial reporting standards. The release bears a schizophrenic quality. It offers one unsurprising and one surprising proposal.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion contemplates allowing selected US issuers voluntarily to make the switch as early as the year after next—2010. This radical proposal would be limited to US issuers whose industry uses IFRS as the basis of financial reporting more than any other set of standards. The release struggles to explain why this special approach for such issuers overcomes the many obstacles facing other US issuers.

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Rescue Plan Relies on Accounting Finesse

Green Eyeshade.jpg Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.

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The Craziest Claims Yet about the Credit Crisis

The credit crisis has provided ample opportunities for foolishness. Certainly California Republican Darrell Issa’s claim that the House bill would have been a “coffin on top of Reagan’s coffin” was an oddly necrophilic bunkmate to President Bush’s penetrating insight that “this sucker’s going down.”

But the prize for crazy claims about the credit crisis must go to former Dallas Fed President Bob McTeer, whose Monday post on the New York Times’ Economix blog claims that: (i) Wall Street banks were the real victims of the crisis; (ii) the real villains were minorities; and (iii) the only thing needed to fix the crisis is to change accounting rules.

I kid you not.

Let’s consider each in turn.

1. Banks are Victims

“[A]ll the focus on C.E.O. salary caps,” he writes “implied that the holders of illiquid mortgage-backed securities were the villains in this drama rather than the victims. They didn’t package the securities, or sell them; they bought them as an investment.”

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More on Accounting as Policy Lever

Debate intensifies on the topic of my Monday post: accounting as a policy tool. (David Zaring captures divergent views.) The intensity shows in today’s NYT column by Floyd Norris, a columnist noted for accounting acumen. I usually agree with Mr. Norris, but have quibbles with today’s column, excerpts of which follow (emphases added):

banks and legislators are pushing for a change in accounting rules to end mark-to-market accounting for financial assets. They are sure that market values are too low, so why not just assume they are really higher? That illogic has caught on [as (1) both of this week’s intervention bills encourage the SEC to consider suspending those rules, in a] push for bad accounting [and (2) the SEC this week issued a statement giving issuers considerable flexibility in measuring fair value amid distressed market conditions].

The American Bankers Association concluded that [the SEC] had slapped down auditors who were forcing banks to unreasonably reduce the value of assets no one was buying. . . . Auditors cringed, awaiting appeals of clients to let them value assets as they please. [Still, the SEC statement] could persuade Congress not to make things worse, and not really give the banks new permission to fudge their books.

It is possible, perhaps probable, that many mortgage securities are undervalued now, amid [prevailing] uncertainty and fear . . . [Pending legislation] calls for the government to buy securities from banks for more than current market value but less than the government hopes they will be worth someday. Whether it will succeed depends in part on whether banks conclude that other banks are solvent after the money arrives and the dodgy securities depart. . . .

Quibbles:

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