August 6, 2002
Even After Enron Change Comes Slowly, If At All
Brady Willett

President Bush wants CEOs behind bars, Harvey Pitt wants CEOs to swear that their financial numbers are accurate, and the investing public wants desperately to believe that no more Enron-type blow-ups are lurking.  What no one seems to want is a clear and honest set of financial numbers.

Stock Options
To begin with, the notion that a handful of companies have ‘voluntarily’ come forward to begin expensing stock options is repugnant.  To be sure, if the markets were not falling and investors were not acquiring new prescriptions that permit them to read footnotes, very few companies would be coming forward to expense stock options.

That said, those companies that have come forward and announced they will expense stock options appear to be doing so for two distinct reasons:

1) They never abused stock options (GE, GM, KO).
2) They believe that shareholders will be more ‘confident’ if they expense options ‘voluntarily’ rather than by  force (if the FASB announces options have to be expensed those companies that have already said they are going to expense options could do better (stock price) than those who have not).

Whats Next
The FASB will meet today to discuss stock options. Although it is unlikely that the FASB will respond to investor outcry surrounding stock options, it is possible that they will propose a transition period for moving stock options from the footnotes to the income statement.  If the FASB does propose such a transition period they would then likely spend the next couple of years or decades fiddling with FAS 132 and/or asking companies if they really want to expense options or not (like the opinion of companies matters).

Additionally, the NYSE and Nasdaq have both agreed to make stock options shareholder approved. Exactly when this will take place has yet to be decided.

What To Watch For
Before options are approved by shareholders watch for companies quickly adopting long-term option plans. Moreover, be mindful that the NYSE is trying to make options approved by shareholders, “with the exception of employment-inducement options, plans at companies acquired through merger, employee stock ownership programs and certain tax-qualified plans, such as a 401(k).” (Reuters)   In other words, unless new accounting regulations force companies to expense stock options do not expect all companies to stop recklessly issuing stock options because of the move to shareholder approved plans.

Additionally, investors should be aware that corporate buy backs are linked to stock options issuance. For certain, many companies readily admit that buybacks are intended to stave of the dilutive impact of stock options issuance (buy backs, which are undertaken using cash, are not recorded as an expense either).  As such, the goal for shareholders should not be to simply gain control of options issuance, but to acquire control of buybacks as well.

SPEs and OTC Derivatives
Special Purpose Entities (SPEs) give companies the ability (under GAAP) to hide debt, lower taxes, and inflate earnings.  And while the vast majority of SPEs are ‘legitimate’, the fact remains that most companies do not disclose their SPE activities (and/or off balance sheet financing).

Since Enron’s blatant abuse of SPEs led to it’s blow-up Harvey Pitt has promised changes.  However, to date all that has occurred is that the amount of outsider capital that must be invested in an SPE has risen from 3% to 10% (this essentially means that the sponsor company of the SPE is now only able to hide up to 90% of the SPEs debt as opposed to 97%).  This may be about to change:

“On September 30, 2002, the FASB will hold a public roundtable discussion to obtain information from and views of interested individuals and organizations about its June 28, 2002 Exposure Draft of a proposed Interpretation, Consolidation of Certain Special-Purpose Entities. (PDF File)”  Roundtable

The FASB’s upcoming discussions on SPEs is noteworthy. However, the most definitive language from the FASB’s Exposure draft still leaves room for corporate maneuvering. Moreover, there is no guarantee that current proposals will not become watered down or even more confusing once companies begin battling with the FASB on September 30.

 “The primary beneficiary would be required to include the assets, liabilities, and results of the activities of the SPE in its consolidated financial statements.” FASB.

With this in mind, the FASB’s attempt to expose SPEs to shareholders is a poor one at that, especially given how long it has been coming.

The SPE Saga
“In 1982, the FASB undertook a project on consolidation. One of my sons who was born that year has since graduated from high school. In the meantime, investors are still waiting for an answer, especially for structures, such as special purpose entities (SPEs) that have been specifically designed with the aid of the accounting profession to reduce transparency to investors. If we in the public sector and investors are to look first to the private sector we should have the right to expect timely resolution of important issues.”
Lynn E. Turner,  Chief Accountant U.S. Securities & Exchange Commission, May 31, 2001

To be blunt, it is baffling that the FASB and SEC cannot get all liabilities held within SPEs to show up on all sponsors (companies) balance sheets. Moreover, what is even more laughable is that following Enron the SEC and FASB, which are supposedly looking out for investor interests, have not ferociously tackled the SPE issue and forced an immediate remedy.  This just in: EVERY INVESTOR WANTS CORPORATE AMERICA TO SHOW ALL SPE AND OBSF DATA ON CONSOLIDATED BALANCE SHEETS! 

“There is no comprehensive FASB standard on SPE accounting.  Most of the guidelines for this accounting lies in various EITF guidelines.  The EITF guidelines are not standards, but they have a significant impact since auditing firms often insist that these guidelines be followed by their clients.  The clients such as General Electric, General Motors, and other large financing companies often play a key role in setting EITF guidelines…”

As Trinity’s Mr. Jensen notes, the 11 member Emerging Issue Task Force (EITF) is headed by people from J.P. Morgan, Citigroup, General Electric, General Motors, and others. Question: is the opinion of any of these companies relevant when it comes to adopting standards for hiding debt?  If allegations against Citigroup and J.P. Morgan are true (with regards to Enron) does anyone believe that these companies should play any part in setting the standards which will be used to police their activities?

The conspiracy angle does not end with SPEs:
“The model for the ‘Derivatives Implementation Group’ is the Emerging Issues Task Force (EITF)”

Quite frankly, and thanks largely to the DIG, the FASB had a tremendously difficult time implementing FAS 133 (Accounting for Derivative Instruments and Hedging Activities): what started out as a simple idea (recording the market value of derivatives on the balance sheet), has turned into a complex 800+ page document that gives companies countless loopholes in which they do not have to record the market value of derivatives each quarter (if used for ‘hedging’ and other variants).

The member list for the DIG? A collection of accountants and ‘experts’ from the likes of Goldman Sachs and J.P. Morgan.

Note to FASB: how about throwing one investor into your groups that argues regardless of how companies and accountants feel about matters rules are rules.

OTC Derivatives
The logic with this unregulated market seems to be that all dealers and brokers are in perfectly hedge positions all the time and no one is ever going to get hurt. If so, this would be the first perfectly safe and free market ever created.  I have my doubts…

Corporations have fought tooth and nail to keep stock options off their income statements. How hard will they fight to ensure that they don’t have to disclose the holdings within their OTC books?

*Rumor has it that J.P. Morgan sees no need to divulge what they are doing with OTC derivatives. As such, JPM will likely head a new special FASB task force to look into the matter more thoroughly.  Don’t worry investors - nothing to see here.

August 14, 2002 – ‘Certification’

CEOs have signed off on financial documents for years. However, supposedly come August 14 when CEOs sign financial documents it will mean they will be liable for the accuracy of the numbers. If only it were this simple (as it should be)...

“In 1980, the Commission amended Form 10-K to require that this report be signed on behalf of a company by the company's principal executive officer or officers, its principal financial officer, its controller or principal accounting officer and by at least the majority of the board of directors”

What is not being talked about is that the SEC has been battling for more than 20-years to make executives accountable for the numbers they produce and that the SEC has failed. Why did the SEC fail?  Because they treat companies as ‘partners’ when structuring regulations not the enemy (which most clearly are).

In our 1998 release proposing reform of the Securities Act offering process, we proposed revisions to the signature sections of all registration statements and periodic reports filed under the Exchange Act to mandate that the persons required to sign those documents certify that they had read them and that they knew of no untrue statement of a material fact or omission of a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading...We received several comments on these proposals. While some commenters supported the proposed certification requirement, a larger number opposed it, primarily as it related to directors. In addition, many commenters opposed an expansion of the signature requirements for Exchange Act reports. Generally, these commenters asserted that the requirements would impose unreasonable administrative burdens and expose corporate officers to increased liability.”

Is it ‘unreasonable’ to assume that CEOs verify financial documents line by line before they sign off? Is it not necessary to make corporate officers liable if they fail to inform investors of fraud within the documents they signed?  Apparently the SEC did not recognize back in 1998 that commenters (companies) did not want ‘increased liability’ because many knew they were breaking the law.  Does the SEC recognize this truism today? No.

We propose to require a company's principal executive officer and principal financial officer to certify that, to their knowledge, the information in the company's quarterly and annual reports is true in all important respects and that the reports contain all information about the company of which they are aware that they believe is important to a reasonable investor.”

As per the SEC language on certification, CEOs and CFOs are only certifying documents ‘to their knowlegde’.  What the SEC fails to understand that for CEOs and CFOs ignorance is bliss.

- GE, Coca-Cola and others should not be applauded for changing the method by which they account for stock options. These companies and others did so because they read the writing on the wall.

- August 14 is a meaningless date. Tough language is still needed so that CEOs begin to earn their huge salaries by approving every single line within financial documents.  When the numbers are fraudulent someone needs to go to jail immediately: ignorance should not be a defense.

- There is still no progress from either the SEC or FASB on special purpose entities. However, they have been looking into the matter since 1982 (keep your fingers crossed).  By contrast, OTC derivatives will probably remain completely unregulated and not talked about by the media unless there is a series of massive blow-ups.

In sum, is it time for the investor to begin trusting corporations again? No.  Is it time for investors to believe that President Bush, Harvey Pitt, and the FASB are attacking companies to increase clarity in financial reports? No.  Rather, it is time for investors to worry that since Enron and Worldcom imploded nothing has really changed: the tough regulatory changes that are needed to ensure companies report clear and honest financial results under simple GAAP have not yet arrived, and cannot be seen coming on the horizon.

If the markets stop falling investors will believe that the needed changes to accounting laws have been implemented, politicians will slacken their tough rhetoric, and the SEC will fall asleep again.  That is, of course, until the next unexpected blow-up arrives and wakes everyone up.

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