Category Archives: The Accounting Standard Setting Process

This is an article in the Financial Times dated 11/22. It discusses the effect of Nestle shifting from one method of revenue recognition to another. This example shows how companies have different ways of reporting and the effects/ repercussions of shifting from one method to another.
“Some SFr16bn ($16.1bn) of turnover will vanish from Nestlé’s top line when the world’s biggest food group changes the way it reports revenues on January 1 next year. But the move, which brings it into line with the rest of the industry on accounting for promotional discounts, would have the benefit of boosting Nestlé’s emerging market exposure from about 35 per cent to about 40 per cent, said Jamie Isenwater, analyst at Deutsche Bank.
The reporting shift will put the proportion of Nestlé’s revenues from emerging markets level with that of Danone, the French dairy products group, although still below Unilever’s 50 per cent. Nestlé has been an outlier among peers by reporting revenues without deducting promotional discounts. This means, for example, a two-for-one deal on Kit Kats is reported on the top line as two packs even though the second one generates no revenues.
From January these promotional discounts will be subtracted from the proceeds of sales. The move will reduce Nestlé’s reported sales, which came in at SFr108bn last year, by about 15 per cent, the company said. Mr Isenwater said: “So the purely mathematical impact is that developed market sales fall by SFr16bn and those in emerging markets don’t change.”
In a statement, Nestlé said the changes would “reduce reported sales by about 15 per cent as expenses such as discounts … and promotions for retailers will in future be deducted from proceeds of sales”. It added: “The change will, however, have no impact on absolute net profit, earnings per share, cash flows or items on the Group’s balance sheet.”

A company’s future depends not only on the revenue generated but also on the investor psychology. If investors keep faith in the company, its chances of survival are high. This relation between the investor psyche and a company’s future makes most companies paint a picture-perfect future! However, the auditor steps in as a guardian and ensures that a true picture is projected.

MD & A may not always be the best indicator of the “real” deal.In the Pan Am case, Pan Am MD & A looks highly optimistic  and uses positive indicators like “strong revenue and passenger traffic” and costs due to” efforts to improve” to describe the road-map. However, the auditor report draws a a grim picture with doubts about the going concern capability of the airline company. Similarly, Trinsic speaks of an optimistic future where they “anticipate” and “expect” higher revenue.

In most cases to boost investor morale, the company makes efforts to negate the effect of the auditor’s report. To justify the report, it may resort to use of English language, attribute losses to global events and “positive” efforts by the company to improve service. Few such examples are, use of positive words like “high”, “better” and “strong”, changes attributed to world currencies against US dollar etc.

Moral of the story: As an investor you may want to look beyond the silver lining, into the thunder and lightning!

In her article ” The Going-Concern Assumption Revisited: Assessing a Company’s Future Viability”, the author Elizabeth K.Venuti explains the reasons why auditors report auditee as going concern even though there are some risks that the auditee might go bankrupt in the coming year.

One of the main reasons behind the fact some auditors are reluctant to disclose any negative information is the “self-fulfilling prophesy” according to Professor Venuti. This concept states that auditors believe that reporting any problems or failures about the company will influence investors’ decisions and therefore impact the company.

Hence, the auditors refrains themselves to comply and express their own opinions. Moreover, the auditors are sometimes reluctant to highlight any issues regarding the auditee due to the fact that they got paid by the auditee and they do not want to lose the business relationship on the long term.

In my opinion, SAS-59 is very effective because it allows the public and investors to know the real situation of the company. The problem comes from auditors who do not act as “referees” and comply with the SAS-59. If every auditors would be assessing fairly every auditee, there would be no problems regarding the solvability of companies. Hence, it will bring more discipline to managers’ behavior and less companies will go out of business.

There’s nothing intrinsic about the way Trinsic, Inc. is reporting its financial status.  Formally known as Z-Tel Technologies, Trinsic is a telecommunications company (powered by Cisco) designed to meet personal consumers’ and business’ tele-tech needs.  Whether it’s voice-activated calling, messaging features or the web, Trinsic aims to meet communication needs fast and efficiently.  In a prospering industry with technology depreciating by the millisecond, one could imagine this is not an easy feat.

Trinsic reports, “The Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern.”  As accounting aficionados, you and I understand that if a company has a “going concern” that is a good thing even it’s not so intuitive for Joe Shmo, yet because such lingo is standard for every company it should be counted as a clear and fair message for readers.  However, “anticipate,” “estimate,” “expect,” and “projects” signify forward-looking statements. These statements are not guarantees and are extremely vulnerable to risks. While this is a clear tactic not to scare shareholders, one must wonder whom exactly they are leading on and when will one call their bluff?

Who is responsible to make sure financial status reports are truthful, clear and timely?  While many agencies are able to crack the “financial whip”, the SEC is has the most authority.  One might wonder if the SEC adopted the FDA standards on “natural” or “organic” foods– looks nice on the label and probably has some truth.

Are management memos and auditor statements too PR and not enough promise?  Who exactly is getting hurt in the process?  Is all fair in language and accounting? I’ll open that up to you readers!

Auditor: “Um, I highly doubt you’ll be able to continue operations for the next year”

CEO: “Ah come on, we’re laying off some people, moving to cheaper rent, it’s going to all work itself out!”

Stock Market: “I think I’m going to go with the auditor on this one…”

Receiving an auditor’s report expressing doubt for going concern is something every company dreads (although it shouldn’t come as a surprise); however, it appears that despite evaluations alluding to upcoming failure, companies still seem to look on the bright side and point out the opportunity which still lies ahead. Similar to the PanAm case we recently looked at, Trinsic, an IP telephony firm, agree to the fact that their business is in trouble, but also discuss new steps they have taken to revive their business and move forward. Unfortunately, these improvements are just projections (using words such as “expect” or “anticipate”) and at least for the time being cannot be taken too seriously.

I find it interesting that companies go to such lengths to try and salvage investors since realistically, once someone sees that that their firm may not be able to sustain itself over the next 365 days, I doubt they will keep their money and trust with them (or most likely withdraw their stock and perhaps wait to see how these forecasts pan out).  Although an incorrect going concern evaluation of a company can lead to severe complications, I definitely support the principle, for I would imagine that auditors would prefer not to express a doubt for going concern unless there was a very good reason for it (they’d also be losing a client) and I’d therefore take such a statement quite seriously and ignore the company’s words of encouragement.

So as an investor in Trinsic, while I appreciate the uplifting words, I’m going to say no thanks!

 In the year 2001 and 2002, many of publicly traded companies in the United States filed for bankruptcy. It was not so unexpected because of the national recession, but the auditors’ failure to warn the investing public of the financial distress and impending failure of their clients through modification of the audit report in accordance with SAS 59 was surprising. SAS 59 requires an auditor to evaluate conditions or events discovered during the engagement that raise questions about the validity of the going-concern assumption. An auditor should consider whether certain conditions or events discovered during the course of the audit contradict the going-concern assumption.

 Then why some auditors fail to issue a going-concern opinion? First of all, auditors fear that a going-concern opinion can hasten the demise of an already troubled company. It can reduce a loan officer’s willingness to grant a line of credit to a troubled company. Second, auditors have little independence. Since the management determines the auditor’s tenure and remuneration, auditors have to listen to the management. Third, and most critical, reason may be the fundamental misunderstanding of the assumption itself. Because the assumption is not cleary defined anywhere in the official pronouncements, there are wide-ranging interpretations.

 I believe that some changes to the process of the going-concern assumption are needed. It seems like that SAS 59 is not very effective and useful. Then why not modify it? The accounting standards bodies should make the standard clear so that there be no misunderstanding, and the auditors should have the right and power to give their actual opinions to the public. In that way, the information will be more effective and useful, and therefore, satisfying public expectations.

SAS59, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, requires the auditor to include a separate paragraph in the audit report if the auditor discovers questionable validity of the entity’s going concern assumption.

What does this mean?  Should the auditor raise questions about an entity’s future and ability to continue its business, the auditor must say so in the audit report.  This opinion would help point out potential issues about the entity to investors and other financial users of the report.

However, it seems the auditors are hesitant to include this opinion even if they suspect something wrong.  One reason is that this negative opinion would make it even harder for a struggling entity to obtain new loans.  Another reason is the fear of losing the client along with its auditing fees.  Management can easily shop for a new auditor to get better opinions.  The last reason is the lack of specifics that define SAS59.  It is not clearly defined under GAAP.

I believe that auditors know what to look out for, but remain hesitant due to the first two reasons.  They can possibly send the entity into quicker bankruptcy with a negative opinion.  In addition, the auditors may be under direct orders from their own management to not be as tough as needed.  If possible, reporting conservatively is better than pointing out a negative and not giving the entity a chance to dig itself out of the hole.  This really makes it tough for auditors to perform their duties.

 One of the first things that came to mind when I read the article was that why has there been dominance by the Big 4 in the industry for so long and why have other so called second tier firms not been able to move to the next level and join the Big 4. The Big 4 must be doing something right to maintain their position in the market, for so long. Yes the rankings do change, but only within the Big 4. It is EY leading the race in audit and advisory as per revenues or number or accounts one year or it is KPMG or PwC or Deloitte another year. The competition has not really moved outside the realm of these giants. Is there too little choice then for public companies when it comes to picking an auditor? Do you think that the bigger public companies are actually complaining? Surprisingly they are not. In a report published by the Government Accountability Office (GAO) in 2003, many of these firms do not look beyond the Big 4 to provide them various services. It is also surprising that not many of the public companies that require the services of these giants are actually complaining about lack of choice.

So what makes the Big 4, the Big 4? The differentiating factor according to me lies in the attitude of the top leadership, the values of these respective firms, and the hunger that these companies share, that keeps them at the top of their game. Their firm belief and clarity on what they stand for is what drives their working. They share a common hunger and passion to expand. Their internal foundation is so strong that the quality of the work they deliver is incomparable to any of the smaller firms. Every piece of work that is sent to the ‘client’ undergoes multiple rounds of reviews and checks and a very serious effort is made to deliver the best possible report or in Big 4 terms- a ‘Deliverable’. Yes there have been lapses in the past with Enron, WorldCom etc but the number of these lapses have been so few and sporadic.

So now what about the tier 2 firms and smaller firms? Looks like they will have to keep working harder and take a more aggressive approach to getting new accounts or be satisfied in ruling their own space, because lets face it…the Big 4 are here to stay!

In wake of sub prime crisis, we have been continuously reading – “Asset Backed Commercial Paper’s are still shrinking..; Interest rates on ABCP’s are rising ; FED provides auction window to banks for their ABCP’s.. etc etc but what are really Asset Backed Commercial Paper’s.

So here’s the fundamentals on ABCP: Commercial Papers are generally short term unsecured commercial debt securities issued at high interest rates. However, if the same instrument is backed by a steady flow of income from an existing ‘asset’ it makes the product more secure and provide an avenue to the issuer raise debt at lower cost.

The ABCP’s are primarily issued by organizations to release their locked ‘receivables’. For example, if a company has provided a short term loan, it can protect itself by setting up a conduit (a special purpose vehicle). This SPV will purchase the receivable and issue an ‘asset backed commercial paper’ to investors (who purchase at market determined interest rate). Thus, in bargain the originator, receives the loaned amount (from SPV) and passes the default on to the conduit. Though, it seems like just another form of ABS and or a CDO except the duration is for very short period, hence comparatively safer. Till the obligor is paying their obligation (i.e., principal and interest), investors are safe. If the obligor defaults, the conduit may default as well.

Once ABCP market was higher than $1.3trillion, now due to market collapse and rising interest rates, investor have been reluctant to invest in the product. As of 20 March data, the ABCP market has shrunk to about $800million. Almost 40% from its peak.

Lucy sets the ball.

Charlie Brown goes to kick the ball.

Lucy snags the ball away.

“Oh, good grief!”

Does this remind us of Wall St. vs. Main St.?

As long as there is a “Lucy” to present an opportunity, there will always be a “Charlie Brown” to fall for it. Similarly, there will always be increasingly complex derivatives and people to invest in the derivatives. It’s only human nature.

Humans learn from time to time, however, just when we do, something new comes along to deceive us. Nowadays, investment banks are hiring lawyers for the sole purpose of drafting ever-complex financial derivatives.

What’s the problem? Well, how do you value a contract that the salesperson doesn’t even understand? And if the goal is profit, where’s the incentive to be truthful? This poses a tremendous problem when recording long-term assets. Sure more regulation would be nice, but how likely is this going to happen?

At least conservative buy-side analysts are on our side, right? Good grief.