Safehaven | Whats New with the Accounting Shell Game? More Shells

March 14, 2006

Whats New with the Accounting Shell Game? More Shells
by Willett / Alway

Following the collapse of Enron, Worldcom and others, regulators were temporarily given the power to dramatically improve US accounting standards. To be sure, and as the passing of the Sarbanes-Oxley Act of 2002 will attest, restoring investor confidence became a top priority of politicians and Wall Street. Regulators could, and did, pass tough regulations with little resistance.

But while Sarbanes-Oxley succeeded in expanding financial practice and corporate governance regulations, its focus was not on overhauling accounting. Rather, the task of cleaning up accounting standards was largely left to the SEC and FASB. Unfortunately, instead of welcomed changes following Enron, investors got new SEC Chairman Harvey Pitt. Mr. Pitt's first, and perhaps only notable item of business, was to force CEOs and financial chiefs to swear "to the best of my knowledge" that their financial statements were accurate. Apparently the groundbreaking Securities Act of 1933 and the Securities Exchange Act of 1934 left out the part about CEOs not lying to investors.

Suffice to say, more than 4-years after Enron - and with the trials of Skilling and Lay finally starting - accounting restatements continue to balloon higher each year, and the SEC has yet to prosecute a major case of 'certification' fraud (a recent study by Glass, Lewis and Co. tallied 1,295 restatements in 2005, or more than triple the amount the year S-O was passed). Along with ballooning restatements new and much needed accounting standards on goodwill stress tests and pension accounting are still in limbo, and no one has the temerity to seriously tackle derivatives transparency. In Buffett's case with Gen Re, 22,477 derivatives contracts have been unwound at a loss of $404 million, and yet 741 contracts remain. Given that Buffett was optimistic about a quick and relatively painless exit from Gen Re's derivatives business nearly 4-years ago, the Gen Re example is proof that not only can derivative businesses not be properly accounted for (how can the cost of unwinding a 100-year contract be properly accounted for?), but also that the world's smartest investor can be duped. The Gen Re situation also goes to show that certain derivatives positions are probably being overstated by numerous companies. With the threat of straying off topic, no regulator cares.

"A given [derivatives] contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences - and I'm personally familiar with several that were huge - tend to be tilted in a direction favoring higher earnings at each firm. It's a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable." -- Warren Buffett. March 1, 2006

So, more than 4-years after Enron, blatant earnings manipulation (i.e. pension assumptions) persists, massive goodwill writedowns continue to shock, and the derivatives mystery grows more ominous and opaque. On the plus side, stock options are being expensed.

Will Things Ever Really Change?

As a quick example of how the accounting regulators have dropped the ball in recent years consider General Electric. In 1999 GE produced a 10K that was 80-pages long and jam packed with excessively elaborate financial schemes. Today GE produces a 232 page 10K, or 2.9 times longer than that produced in 1999. In the case of off balance sheet consolidation the schemes may be more transparent in some respects, but they are nonetheless trapped inside a growing labyrinth of accounting change and revision. Then there is Intel - whose management has spent as much effort resisting accounting changes as focusing on competitor AMD - whose 10K climbed to an astonishing 282 pages this year (fiscal 2005). Up until 2001 Intel's 10K never went into triple digits, but after Enron, S-O, 'certification', etc., the company has left double digits behind for good.

Realizing that accounting changes take an extremely long time to come to bear and that companies simply find new loopholes before the old ones close, what can the SEC do? Perhaps in order to keep the average investor interested the SEC could start by limiting corporations to a 100-page 10K limit?

But alas, if pressured to reduce the length of financial reports some corporations would simply reduce their font size to obfuscate, and then - sooner or later - instead of policing companies and crafting new accounting policies, the SEC would waste decades contemplating new font standards. How much money does the accounting/business lobby have to attack a new 12-point font standard suggested by the SEC?

If this situation sounds ridiculous, don't worry, the whole accounting system in America is. But fear not, although Fannie missed a regulatory filing deadline for the second year in a row, the company is making "substantial progress"! Maybe next year the company will file some audited financial results. And don't worry about the next Enron. After it arrives and investor sentiment implodes another Pitt will come along asking CEOs to certify that they are really, really telling the truth.

As for American investors plowing their hard earned dollars into US equities and awaiting a new 'principles ' based accounting system, how many do you suppose sat down to read Intel's 282 page 10K thriller this year? Our guess is not many. Rather, Americans may own the stocks (most do silently through funds), but they are not interested in reading novels on the many companies they have a stake in. And with Wall Street and the media concerned with EPS and stock price momentum, it makes you wonder if anyone really is. We know that Buffett is because he is honest enough to admit that he doesn't understand certain things. Moreover, he advocates that change is required now, not tomorrow.

"Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered - and improved - the reliability of New Orleans' levees was before Katrina." -- Buffett

Brady Willett & Todd Alway
BWillett@fallstreet.com
www.wallstreetwishlist.com