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 & Touche Tohmatsu, PriceWaterhouseCoopers (PWC), Ernst & Youg 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 Seidman International, RSM International, Grant Thornton International, Moores Rowland International, Horwath International, Rothstein Kass & Co., Eisner, Goldstein Golub Kessler, and Baker Tilly International.

A successful Credit Analyst must have a very good understanding of the fundamentals of accounting principles. Please see  Basic 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, whcih 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 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 defrred 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%.

In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140." SFAS No. 155 permits companies to elect, on a transaction-by-transaction basis, to apply a fair value measurement to hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation under SFAS No. 133.

In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets--an amendment of FASB Statement No. 140." SFAS No. 156, consistent with SFAS No. 140, requires that all separately recognized servicing assets and liabilities be initially measured at fair value. For subsequent measurements, SFAS No. 156 permits companies to choose between using an amortization method or a fair value measurement method for reporting purposes.

In April 2006, the FASB issued FASB Staff Position ("FSP") FIN No. 46 (R)-6, "Determining the Variability to Be Considered in Applying Interpretation No. 46 (R)." This FSP addresses how a reporting enterprise should determine the variability to be considered in applying FIN No. 46 (R). The variability that is considered in applying FIN No. 46 (R) affects the determination of: (a) whether the entity is a variable interest entity, (b) which interests are variable interests in the entity, and (c) which party, if any, is the primary beneficiary of the VIE. FSP FIN No. 46 (R)-6 states that the design of the entity shall be considered in the determination of variable interests.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”), which applies to all tax positions accounted for under SFAS 109. A “tax position” includes current or future reductions in taxable income reported or expected to be reported on a tax return. FIN 48 supplements SFAS 109 by defining the confidence level that a tax position must meet in order to be recognized in the financial statements. The interpretation requires that the tax effects of a position be recognized only if it is “more-likely-than-not” (i.e., greater than 50% likelihood) to be sustained based solely on its technical merits as of the reporting date. In making this assessment, a company must assume that the taxing authorities will examine the position. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

On September 15, 2006, the FASB issued SFAS 157, Fair Value Measurements, which defines fair value, establishes a new framework for measuring that value and expands disclosures about fair value measurements. The standard applied prospectively to new fair value measurements performed after January 1, 2008, for measurements of the fair values of financial instruments and recurring fair value measurements of non-financial assets and liabilities; on January 1, 2009, the standard applies to all remaining fair value measurements, including non-recurring valuations of non-financial assets and liabilities such as those used in measuring impairments of goodwill, other intangible assets and other long-lived assets. It also applies to fair value measurements of non-financial assets acquired and liabilities assumed in business combinations consummated after January 1, 2009.

SFAS No. 157 requires companies to disclose the fair value of its financial instruments according to a fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets carried at fair value will be classified and disclosed in one of the three categories in accordance with the hierarchy. The three levels of the fair value hierarchy are:

Level 1: Quoted market prices for identical assets or liabilities in active markets.

Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: Unobservable inputs that are not corroborated by market data.

Additionally, companies are required to provide enhanced disclosure information regarding the activities of those financial instruments classified within the level 3 category, including a rollforward analysis of fair value balance sheet amounts for each major category of assets and liabilities and disclosure of the unrealized gains and losses for level 3 positions held at the reporting date.

On December 4, 2007, the FASB issued SFAS 141(R), Business Combinations, which is revises the accounting for business acquisitions both during the period of the acquisition and in subsequent periods. Some of the more significant revisions in the accounting for acquisitions include:

In-process research and development (IPR&D) will be accounted for as an asset, with the cost recognized as the research and development is realized or abandoned. IPR&D is presently expensed at the time of the acquisition.

Contingent consideration will generally be recorded at fair value with subsequent adjustments recognized in operations. Contingent consideration is presently accounted for as an adjustment of purchase price.

Decreases in valuation allowances on acquired deferred tax assets will be recognized in operations. Such changes previously were considered to be subsequent changes in consideration and were recorded as decreases in goodwill.

Transaction costs will generally be expensed. Certain such costs are presently treated as costs of the acquisition.

In December 2008, the FASB issued FASB Staff Position (FSP) FAS 141(R)-a, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies, a proposed FSP which would amend the accounting in SFAS 141(R) for assets and liabilities arising from contingencies in a business combination. The proposed FSP would require that pre-acquisition contingencies be recognized at fair value, if fair value can be reasonably determined. If fair value cannot be reasonably determined, the proposed FSP requires measurement based on the best estimate in accordance with SFAS 5, Accounting for Contingencies.

on December 4, 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51, which revises the accounting and reporting related to noncontrolling interests on consolidated financial statements.

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 financail 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   www.aasb.com.au/   (Will adopt IASB standards January 2005 with regard to for-profit corporations)

(Canada) Accounting Standards Board   www.acsbcanada.org/

(France) Conseil national de la comptabilité   www.finances.gouv.fr/CNCompta/

(Germany) DRSCR / Deutsches Rechnungslegungs Standards Committee e.V   www.standardsetter.de/drsc/news/news.php

(Japan) Accounting Standards Board of Japan (ASBJ)   www.asb.or.jp/

(New Zealand) Financial Reporting Standards Board (FRSB)   www.icanz.co.nz/StaticContent/AGS/frsb_wp.cfm

(United Kingdom) Accounting Standards Board   www.asb.org.uk/

(United States) Financial Accounting Standards Board (FASB)   www.fasb.org/

International Accounting Standards Board (IASB)   www.iasb.org/

International Accounting Standards Board (IASB) regulations were adopted on January 1, 2005 by the European Union, which requires all publicly traded / listed companies, including banks, to prepare consolidated financial statements in accordance with the International Financial Reporting Standards (IFRS). This meant that companies had to reclassify items that it recognised 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 Acccounting 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.

Convergence

The difference between U.S. GAAP and non-GAAP rules is sometimes illustrated by the listing of Daimler-Benz on the New York Stock Exchange in 1993 (the first German corporation to list on the NYSE). Under German accounting guidelines, Daimler-Benz indicated a half-year profit of DM168MM. Under U.S. GAAP guidelines the company indicated a loss of DM949MM.

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).

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 maodel), 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 earmings of other investors.

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 underfunded. 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.

Please see:   www.pbgc.gov/news/press_releases/2004/pr05_14.htm#chart.

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 benfit 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), amendments to the benefit plan (such as higher prescription drug copayment 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 similare to pension plans.

With regard to retiree healthcare costs, some companies will be able to take advantage of the recent revision in Meidcare 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, probaly 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 continuiung 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 cooborate or disagree with managements statements (404 Reports)

Companies in the U.S. have complained about the SarbOx requirements but as far as investors and credit analysts are concerned the regulations provide better information and less adjustments for write-offs.

Foreign equivalent (near equivalent) of Sarbanes Oxley internal controls regarding public company management and audits.

Austria - Code of Corporate Governance (2006)

France - Financial Security Law of 2003

Germany - German Company Law (amended 2002); German Corporate Governance Code (Cromme Code; 2006)

Norway - Code of Practice for Corporate Governance (2006)

Singapore - Code of Corporate Governance (published by the Ministry of Finance; 2005)

Switzerland - Swiss Code of Best Practice for Corporate Governance

United Kingdom - Combined Code on Corporate Governance

Eighth EU Company Law Directive

The Eighth Company Law Directive includes guidelines for the oversight of auditors in Europe. The revisions are designed to bring some harmonization to the disparate statutory auditing and financial disclosure requirements for public companies in Europe. There are also relevant portions of the body of European Union (EU) law (acquis communautaire, consisting of legislation, secondary legislation / regulations / directives and case law) concerning corporate accounting, primarily Chapter 6 (Company Law), Chapter 4 (Free Movement of Capital) and Chapter 9 (Financial Services). One of the main insitutuions of the EU is the the Court of Auditors. In addition, one of the standing committees within the EU Parliament is the Committee on Economic and Monetary Affairs (ECON). One of ECON’s responsibilities is the regulation and supervision of financial services, institutions and markets including financial reporting, auditing, accounting rules, corporate governance and other company law matters specifically concerning financial services.
eur-lex.europa.eu/LexUriServ/site/en/oj/2006/l_157/l_15720060609en00870107.pdf

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 receipient 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 tend to be above prevailing market interest rates. Similarly, supplimental retirement plans for senior executives, which can be quite substantial, are also not disclosed in the SEC forms.

Write-down Reversals

Annually, all types of companies take a one-ime, 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 uncollectable. Thus, this provides the company an opportunity to reverse the charge in a later accounting period and add to the botton-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.