Accounting Issues and Credit Analysis

Since the Securities Acts of 1933 and 1934, public companies in the United States have been required to provide the public with audited financial statements. The "Big Four" of the auding industry include Deloitte & Touché, PriceWaterhouseCoopers (PWC), Ernst & Young and KPMG,

who combined control most of the market for auditing public companies in the United States, Canada, the United Kingdom and Europe. Other major auditing firms include BDO International, RSM International, Grant Thornton International, Moore’s Rowland International, Horvath International and Baker Tilly International.
A successful Credit Analyst must have a very good understanding of the fundamentals of accounting principles.
FASB Statements
Statement of Financial Accounting Standards No. 107 (SFAS 107), Disclosures about Fair Value of Financial Instruments
Statement of Financial Accounting Standards No. 133 (SFAS 133 / June 1998), Accounting for Derivative Instruments and Hedging Activities, subsequently amended by SFAS No. 137 and SFAS No. 138, requires that derivatives be recorded on balance sheet at fair value.

Changes in the fair value of derivatives will either be recognized in earnings as offsets to the changes in fair value of related hedged assets, liabilities and firm commitments or, for forecasted transactions, deferred and recorded as a component of accumulated other comprehensive income until the hedged transactions occur and are recognized in earnings. The ineffective portion of a hedging derivative's change in fair value will be immediately recognized in earnings.

Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities No. 140, A Replacement of FASB Statement No. 125 (SFAS 140 / September 2000) clarifies the financial-components approach, which specifies the "control" of the assets, with regard to accounting for securitizations and other transfers of financial assets and collateral.

Statement of Financial Accounting Standards No. 141 (SFAS 141 / July 2001; supersedes APB Opinion No. 16), Business Combinations, requires that all business combinations initiated after June 30, 2001, be accounted for under the purchase method. The statement also clarifies the treatment of intangible assets as they are a part of acquisition of new businesses. The purchase method recognizes all intangible assets acquired in a business combination and SFAS also attempts to categorize them separately from goodwill for reporting purposes.
Statement of Financial Accounting Standards No. 142 (SFAS 142 / October 2001), Goodwill and Other Intangible Assets, eliminates amortization of goodwill from business combinations completed after June 30, 2001, and requires that goodwill and other intangible assets be tested for impairment on a quarterly and / or on an annual basis by utilizing a by applying a fair-value-based test using discounted estimated future net cash flows. Impairment exists when the carrying amount of the goodwill exceeds its implied fair value. If impairment exists then the company must recognize impairment losses as a charge to noninterest expense (unless related to discontinued operations) and an adjustment to the carrying value of the goodwill asset.

Acquisitions of Certain Financial Institutions—an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9; No. 147 (SFAS 147 / October 2002), provides guidance on the application of the purchase method of accounting applied to all acquisitions of financial institutions.
Statement of Financial Accounting Standards No. 149 (SFAS 149 / April 2003), Amendment of Statement 133 on Derivative Instruments and Hedging Activities, amends and clarifies financial accounting and reporting for derivative instruments and for hedging activities. This statement was effective for contracts entered into or modified after June 30, 2003.

Statement of Financial Accounting Standards No. 150 (SFAS 150 / May 2003), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which simply establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity.
FASB Interpretation No. 39 (FIN 39), Offsetting of Amounts Related to Certain Contracts.
FASB Interpretation No. 45 (FIN 45 / November 2002), Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, requires a guarantor to recognize a liability, at the inception of the guarantee, for the fair value of obligations it has undertaken in issuing the guarantee and also requires more detailed disclosures with respect to the guarantees.
FASB Interpretation No. 46 (FIN 46 / January 2003), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. In December 2003, FASB issued Revised Interpretation No. 46 (FIN 46R), which replaced FIN 46. FIN 46R corrected guidelines for the implementation of the consolidation of Variable Interest Entities (VIEs) such as asset-backed commercial paper conduits. The FASB permitted nonregistered investment companies, to defer consolidation of VIEs with which they are involved until the proposed Statement of Position on the clarification of the scope of the Investment Company Audit Guide is finalized.

In July 2004, the FASB voted to review the issue of U.S. corporate overseas profit tax liability. Presently, U.S. corporations do not have to pay taxes on income earned by a foreign domiciled subsidiary if it is reinvested outside the United States. Any tax liability is deferred until the income is realized by the parent through a sale of the subsidiary or in the form as a dividend paid to the parent (as the shareholder of the subsidiary). Thus, U.S. corporations either do not maintain deferred tax liability accounts or maintain only token accounts as if the income earned overseas will never be repatriated ("remitted"). FASB is presently examining how such a tax liability may be estimated and how much should by set aside as a reserve. Presently, the tax rate on corporate earnings is 35% however (hence, why the income is not repatriated in the first place), there is pending legislation in the U.S. to lower the corporate rate to 5.25%.IAS (International Accounting Standards) and National GAAP (Generally Accepted Accounting Principles)
In the United States, domestic U.S. domiciled corporations that are listed on an equity exchange must issue financial statements utilizing GAAP guidelines and FASB rulings. Foreign domiciled corporations listed on a U.S. equity exchange use U.S. GAAP or IAS or their national GAAP. If the statements are not U.S. GAAP, then a note reconciling income statement and balance sheet items to US GAAP is required by regulation of the U.S. Securities and Exchange Commission.

In the United Kingdom, domestic U.K. listed companies must follow U.K. GAAP. Foreign domiciled U.K. listed companies may follow IAS or U.S. or U.K. GAAP. Foreign companies that follow other national GAAP may be required to provide a reconciliation to U.K. GAAP.
In Canada, all Canadian domiciled and all foreign domiciled corporations listed on a Canadian exchange must issue financial statements utilizing Canadian GAAP guidelines, with the exception of the Montreal Stock Exchange which allows foreign companies to issue financial statements that utilize IAS or U.S., U.K., or Australian GAAP (with prior permission of the Exchange) and with a reconciliation to Canadian GAAP.
(Australia) Australian Accounting Standards Board   (Will adopt IASB standards January 2005 with regard to for-profit corporations)
(Canada) Accounting Standards Board
(France) Conseil national de la comptabilité
(Germany) DRSCR / Deutsches Rechnungslegungs Standards Committee e.V
(Japan) Accounting Standards Board of Japan (ASBJ)
(New Zealand) Financial Reporting Standards Board (FRSB)
(United Kingdom) Accounting Standards Board
(United States) Financial Accounting Standards Board (FASB)
International Accounting Standards Board (IASB)
International Accounting Standards Board (IASB) regulations are supposed to adopt by January 1, 2005 as the European Union will require all listed companies, including banks, to prepare consolidated financial statements in accordance with the International Financial Reporting Standards (IFRS). This means that companies must reclassify items that it recognized under previous GAAP as one type of asset, liability or component of equity that are a different type of asset, liability or component of equity under IFRS.
IASB (International Accounting Standards Board) has the sole responsibility for setting IAS (International Accounting Standards).
IASCF (International Accounting Standards Committee Foundation) is the parent organization of the IASB.
IAS (International Accounting Standards) are the pronouncements that specify the actual definitions and transaction / event recognition criteria for assets, liabilities, income and expenses and what comprises a balance sheet; an income statement; a statement of changes in equity; a cash flow statement; and notes, comprising a summary of significant accounting policies and other explanatory notes, and how they should reflect the financial position, financial performance and cash flows of an entity. The IASs were issued by the Board of the International Accounting Standards Committee (IASC) between 1973 and 2001.
IFRS (International Financial Reporting Standards) are also the pronouncements that specify the actual definitions and transaction / event recognition criteria for assets, liabilities, income and expenses and what comprises a balance sheet; an income statement; a statement of changes in equity; a cash flow statement; and notes, comprising a summary of significant accounting policies and other explanatory notes, and how they should reflect the financial position, financial performance and cash flows of an entity and have been issued since April 2001 by the IASB (International Accounting Standards Board). As of January 2005, companies will have to prepare financial statements in accordance with IFRSs (ISFRs include the previously issued IASs).
IFRIC (International Financial Reporting Interpretations Committee) issues Interpretations of International Accounting Standards (reviews of accounting issues do not have the same status as an IAS).
IAS 32 Financial Instruments: Disclosure and Presentation
IAS 36 Impairment of Assets
IAS 38 Intangible Assets
IAS 39 Financial Instruments: Recognition and Measurement, Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk, which would require a mark-to-market treatment rather than leaving the item on balance sheet at cost. Thus, the account category "Assets (held for sale)" would require that the assets be presented at fair market value; all derivative contracts on both the asset side and liability side of the balance sheet be presented at fair market value (net of all realized and unrealized gains and losses); trading assets (held in a portfolio) would be presented at fair market value; Assets (Investments, held to maturity), receivables (loans) would be presented at amortized cost. Fair value accounting also differs from GAAP, such that fair value requires that assets and liabilities be marked-to-market. In GAAP, some items are marked-to-market and some are at historical cost. In November 2004, the European Commission voted to adopt a less stringent version of IAS 39 (also less stringent than U.S. FASB guidelines).
IFRS 3 Business Combinations (supersedes IAS 22), requires (with some exceptions) all business combinations to be accounted for by applying the purchase method.
IFRS ED 5 Insurance Contracts; as of December 31, 2006, requires an insurer to disclose the fair value of its assets and insurance liabilities.

In November 2004, FASB indicated that it had brought its inventory treatment guidelines in line with IAS guidelines. As of January 2006, U.S. companies will be required to expense abnormal or unusual costs that affect inventory (spoilage, excessive idle plant, and freight costs) during the period that they were incurred (and not capitalized over time).

Expensing Employee Stock Options
A Stock Option gives the recipient the right to buy or sell the shares of the stock at a set price (regardless of the market price at the time of exercising the option) on or during a certain period of time. The granting of stock options was very prevalent during the mid to late 1990s in the United States. These options made some employees of a company wealthy and the company granting the options received favorable tax treatment: the option compensated the employee; however the company did not have to treat the grant as an expense.
The FASB has proposed that options classified as "equity" (not as cash). In addition, the proposal is retroactive so that in addition to new grants, unvested options granted in prior years will have to be expensed. This means that many companies will report lower profits than were publicly reported in the past. This treatment will become effective in mid-2005. The FASB is proposing that the charge against earnings be based on the value of the option at the time issuance regardless of what the actual value turns out to be at a later date, thus there would no further adjustment to the value. There would be an actual charge recorded on the Income Statement at the date of the granting of the options to the respective employee(s) with the value derived based on a fair estimate of the option at the date of exercise.
The opposing viewpoint is that the actual value of an option is the difference between the strike price and the actual price when the option is exercised. Thus, the value of the option can only be determined in the future once it is finally exercised. The proper accounting treatment then under this scenario is to treat the option as a mark-to-market liability that is adjusted periodically during the vesting period depending on the value of the underlying stock on a given date.
In order to value an option most companies rely upon the Black-Scholes model, however the formula does not entirely reflect the true value of an option. A more recent competing method of valuation is the Binomial model (lattice model), which allows for a range of values based on assumptions about future conditions (interest rates, stock volatility).
Related to this issue, the FASB has also indicated that companies must disclose how much they spend to buyback equity shares on the open market in order that the exercise of employee options will not dilute the holdings and per-share earnings of other investors.

Pension Fund Requirements and Postretirement Health Care Requirements
These are two of the fastest rising costs for U.S. companies.
Many companies are facing large pension fund shortfalls due to the fact that the assets in the funds have not performed as anticipated and companies are starting to feel the beginning of the wave of baby boomers retiring. Thus, many of these plans are under funded. Pension fund defined benefit contribution cash requirements are not clearly stated on financial statements as to the source of the funds and how much is required. In addition, companies receive a tax deduction when a contribution is made to the fund, although they are legally required to make a minimum contribution.
If a pension fund fails and comes under the administration and coverage of the Pension Benefit Guaranty Corporation, then the bulk of the asset distribution goes to the older retirees with any balance allocated toward active employees. The PBGC basic insurance coverage of pension benefits is approximately $45,000 per annum.
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In addition to pension obligations, many companies also have obligations related to retiree healthcare and insurance coverage. Many companies have not set aside adequate reserves for this expense (separate from pension obligations) and tend to cover any shortfall from operating income. Under revised accounting guidelines (commencing in 2004), nonpension retiree benefit obligations must now be clearly footnoted and presented in quarterly and annual statements. These figures are affected by proper actuarial discounting, the level of present interest rates (that inflate and deflate the size of the obligations), and amendments to the benefit plan (such as higher prescription drug co-payment requirement by retirees). These liabilities are growing fast, however accounting rules also allow a company to carry only an accrued amount on its books. In addition, reserve accounts set up to cover this liability, and contributions to the reserve, do not receive favorable tax treatment similar to pension plans.
With regard to retiree healthcare costs, some companies will be able to take advantage of the recent revision in Medicare program guidelines that created a prescription drug benefit (starting 2006). Unfortunately for retirees the Medicare plan is less comprehensive than employer plans. Many state and municipal governments, and unionized companies, probably will not drop retiree coverage. The Medicare revision includes a subsidy payable to corporations who continue to maintain retiree healthcare coverage.
Pension benefit and post retirement medical benefit obligations and related costs are calculated using actuarial guidelines within the framework of Statement of Financial Accounting Standards No. 87, Employer's Accounting for Pensions (SFAS 87) and Statement of Financial Accounting Standards No. 106, Employer's Accounting for Postretirement Benefit Other than Pension (SFAS 106).

Sarbanes-Oxley Corporate Reform Law (2002)
 Created the PCAOB (Public Company Accounting Oversight Board), a non-profit corporation formed to oversee the audit of public companies that are subject to the securities laws, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors.
 requires senior executives of public companies to endorse the accuracy of the publicly released financial statements.
 Mandates that companies must collect and maintain financial data regardless if it is n the form of an E-mail message or a printed receipt.
 Auditors must report to independent non-executive board directors rather than to the management of the company.
 Prohibits accounting firms from continuing to offer legal services to public companies that they also audit.
 Any foreign company that has a U.S. listing will be required to comply.
 prohibits public companies from making new loans to senior officers
As of November 15, 2004, as per Section 404, public companies will have to begin to evaluate and publicly report the effectiveness of internal controls over financial reporting and then independent auditors will either have to coo borate or disagree with managements statements (404 Reports)

Eighth Company Law Directive

The Eighth Company Law Directive includes guidelines for the oversight of auditors in Europe (the legislation is still waiting for final approval).
Executive Compensation
Publicly traded companies required to file SEC quarterly and annual forms must include summaries of compensation paid to senior management. However, deferred income is not included in this summary and is only minimally summarized in footnotes. As deferred income increases, the future recipient earns interest on the balance. The only indication in the footnotes is the difference between the interest rate that the executive is earning on the deferred income (which is not disclosed) with the prevailing market interest rate, which tends to be above prevailing market interest rates. Similarly, supplemental retirement plans for senior executives, which can be quite substantial, are also not disclosed in the SEC forms.
Freddie Mac (Federal Home Loan Mortgage Corp. / FHLMC) & Fannie Mae (Federal National Mortgage Corp. / FNMA)

Freddie Mac use to be audited by Arthur Andersen until their demise following the Enron scandal. The successor auditor, Price Waterhouse, after review indicated a different interpretation of the income received from some of the derivative instruments that FHLMC had entered into compared to the interpretation that Arthur Andersen had held. Price Waterhouse insisted that some of the derivative contracts be reclassified from a hedge to an asset. Thus, income earned on an asset has to recognize during the same period of the asset's purchase as opposed to a hedge, which would allow the income to be recognized over the life of the contract. The reclassification of the derivative instruments to assets resulted in Freddie Mac having to restate its earnings for 2000, 2001 and 2002, calling into question the accuracy of the financial statements of one of the largest financial institutions in the world, and indirectly raising the same concern of Fannie Mae (FNMA). Freddie Mac was required to execute a consent order with the OFHEO (Office of Federal Housing Enterprise Oversight), and pay a $125 million fine. Both FNMA and the FHLMC are exempt from the disclosing certain financial information under the terms of the 1933 and 1934 Securities Acts. In addition, both entities have regulatory capital requirements below those set for banks and they are both highly leveraged.

In December 2004, Fannie Mae (Federal National Mortgage Corporation / FNMA) issued $5.0 billion in private placement preferred stock in order to improve its capitalization. The decision came after the SEC had indicated that Fannie Mae must restate its earnings for the fiscal years of 2001 through 2004. resulting in a situation that would result in the company actually being below its minimum capital level. In addition, as of mid-2005, Fannie Mae's regulator (the Office of Federal Housing Enterprise Oversight) has indicated that it will mandate that Fannie further increase its regulatory capital by an additional 30%.
Write-down Reversals

Annually, all types of companies take a one-time, special charge to earnings on the income statement to offset accounts receivables that potentially may not be collected, or cover tax liabilities, employee severance expenses, closing of subsidiary operations, lease terminations or for the potential write-off of old inventory. It is anticipated that a company can competently measure accurately the amount of the charge and the certainty that it will be incurred. However, it is possible to liquidate inventory at an amount greater than zero and it is possible to collect on an account that was written off as uncollectible. Thus, this provides the company an opportunity to reverse the charge in a later accounting period and add to the bottom-line earnings during that quarter or fiscal year. Under FASB rules and SEC Regulation S-K the company must disclose the nature of the charge reversal if it is "material". However, the FASB guidelines allow a company to make its own decision as to what "material" means. The SEC guidelines mandate that the disclosure be included in the financial statements filed with the SEC; however a company is not required to disclose a charge reversal benefit to net income in a quarterly earnings release to the public.