Take Me To Your Ledger

Plus, good news for a hybrid tax shelter; why Americans don't invest abroad; NYSE wins a battle on Nasdaq's own turf; and more.

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Take Me To Your Ledger

The key to catching accounting improprieties may lie in your computer–via automated auditing processes called “auditbots.”

“The ERP [enterprise resource planning] systems put in place at many companies have made it possible for outside auditors to embed software in the systems to audit transactions,” says Robert Jensen, an accounting professor at Trinity University in San Antonio.

He says that automating the audit process could free up auditors to look for other problems beyond routine transactions, like under-the-table dealing. The auditbots would also be able to audit every transaction instead of just sampling them, thereby eliminating sampling error. “It would limit some of the suspicion that auditors aren’t doing a good job,” explains Jensen.

Auditbots are starting up at AT&T and HCA Healthcare, and about 15 other companies are experimenting with the technique, says Rutgers University accounting professor Miklos Vasarhelyi. The biggest hurdle so far is how to make the systems secure, even to the companies where they are installed. “It’s coming,” says Vasarhelyi. “It’s just a matter of when.” – Joseph McCafferty

Metrics

Down to the Core

It’s not just the recession that’s taking a bite out of earnings. The entire S&P 500, as well as the 10,000-plus companies included in Standard & Poor’s Compustat database, are slated for an earnings slim-down this summer, at least by S&P’s calculation.

Blame a new metric known as “core operating earnings.” The measure, which S&P analysts, among others, will factor into their debt and equity ratings, adjusts traditional GAAP net income by excluding such items as pension gains, gains or losses from asset sales, and goodwill write-offs, and including such items as restructuring charges and employee stock-option grant expenses.

“Popular replacements have come to be used instead of GAAP numbers,” says David Blitzer, chief investment strategist at S&P. Blitzer cites operating earnings, pro forma, and what he calls “EBBS” (everything but the bad stuff) as some of the substitutes companies use.

S&P president Leo O’Neill says the measure “will help restore investor confidence in the data used to make investment decisions.” While many laud the intent of the effort, few believe it’s the magic number investors have been seeking. “The spirit of what they’re attempting to do is commendable,” says Brooktrout Inc. CFO Bob Leahy, “but it’s essentially creating an S&P version of pro forma.” He says that Brooktrout, a Needham, Mass.-based telecom equipment supplier, reports GAAP results only.

Other CFOs who use pro forma in their reporting are skeptical about whether “core earnings” will appeal to investors. “I believe the right approach is to put out all the information investors will be interested in and let them build their own models,” says Jeff Naylor, CFO of Big Lots Inc., a $3.4 billion Columbus, Ohio, discount retailer. He doesn’t include annual stock-option expense in his version of pro forma, and he says he doesn’t agree with the S&P including it in its new measure.

Analysts, too, are doubtful that the new numbers will have much impact. “They’re making a good theoretical case, but I’m not sure it will change a whole lot,” says Jack Ciesielski, publisher of Analyst’s Accounting Observer newsletter and an adviser on the S&P project. “Most of what moves Wall Street is not trailing earnings, it’s forecasted earnings, and a lot of the things they’re including aren’t in forecasted earnings, because they’re not forecastable.” –Alix Nyberg

Just Kicking Back

Russian, Asian, and U.S. companies are the most likely to pay bribes when looking for business in developing countries, according to a survey by Transparency International.

The average closing cycle is 6 business days, says a recent poll by Hyperion; 50% of firms had a reporting cycle of 11 days or more. Lightbridge CFO Harlan Plumley wants to communicate more with shareholders. Investor Relations

Investor Relations

Too Much Is Never Enough

Eager to soothe jittery investors, companies bulked up their annual reports this year with additional disclosures. Now, many CFOs are looking beyond the annual report for additional ways to convince shareholders that their accounting practices are on the up and up. General Electric, for example, issued a 21-slide PowerPoint guide to its wordy annual report. It also instituted quarterly earnings calls for the first time in its history.

Companies are discovering the virtue of more-frequent communications. Lightbridge Inc., a Burlington, Mass.-based telecom-services provider, simplified its annual report but is supplementing it with quarterly fact sheets. “Rather than the once-a-year, glossy publication, we can communicate five times a year with investors,” explains CFO Harlan Plumley. And it’s cheaper to boot.

Software provider Comshare Inc. has been gradually boosting the amount of information in its 10Qs for about six quarters, says CFO Brian Jarzynski. “We have added some supplemental schedules that break out our revenues on a more specific basis,” he says.

Jarzynski, a former auditor with Ernst & Young, says that although Enron heightened investor demands for disclosure, “some of this was coming anyway.” Comshare recently expanded its discussion of how it recognizes revenue–a key accounting issue for software companies. In fact, Jarzynski expects regulation to call for more industry-specific disclosures in the future. New rules, he says, may ultimately reduce accounting technique explanations in management’s discussion and analysis. Although SAB 101 revenue-recognition rules already address many issues specific to software companies like his, he speculates that “software companies will be required over time to have a specific chart of accounts, and we will have recommendations for disclosure that are very industry specific.” Industry-specific guidelines will make the rules simpler, he says. “They will get rid of the gray and make things more black and white.” –Tim Reason

Hiring Squeeze

The cost to a company of losing a failed senior executive can total as much as $4.7 million, says RHR International.

Health Care

“Unprecedented” Hikes Expected for 2003

Brace yourself for the next great health-care price hike. As companies begin to negotiate health-plan rates for 2003, they are finding that health maintenance organizations (HMOs) and other insurers are insisting on massive rate hikes for next year.

In fact, the California Public Employees’ Retirement System (Calpers), the largest employee health-care purchaser in California, has already agreed to a health-care package that includes a 25.1 percent increase for HMOs. “The marketplace is extremely difficult,” says Clark McKinley, a Calpers spokesman.

Last year, when HMOs proposed high premium increases, Calpers rejected them all and asked for new bids. It later managed to keep premium increases to 13.2 percent. “We didn’t get a sense that we could do that this year,” says McKinley. This year, plans weren’t prepared to take losses to get the sizable Calpers business.

Other health-care purchasers are seeing similar increases. Data from Hewitt Associates Inc. indicates that initial HMO rate increases for 2003 are averaging a gruesome 22 percent, compared with an average premium increase of 15.3 percent this year. “It’s bad,” says Jim Winkler, a health-care consultant at Hewitt. “And with no end in sight, it’s going to get worse before it gets better.” Winkler attributes the higher premiums to the economy, which has increased the ranks of the uninsured; still-higher drug costs; consolidation among providers; and an emphasis on earnings by Wall Street.

He expects companies to get more aggressive in passing costs on to employees. For example, the number of companies with a $15 co-pay for office visits more than doubled, from 11 percent in 2001 to 24 percent in 2002.

And as Calpers’s experience shows, health-plan providers are no longer willing to come down on price to get large contracts from big companies. “The days of [health plans] going for market share are over,” says Winkler. “Big companies can no longer pound their shoe on the table.” – J.McC.

Debt and Taxes

Good News for Coco Buffs

Who dares, wins. Companies issuing contingent convertible bonds–or “cocos”–over the past two years took a risk that the very tax benefits that made these debt instruments so attractive might prompt the Internal Revenue Service to outlaw them. Instead, in a June ruling so favorable it surprised even coco developers, the IRS gave the hybrid securities its unconditional blessing.

Historically, the tax code has allowed companies to deduct only the stated interest rate of a convertible bond–which is low because investors reap a second payout when the bond converts to equity. The IRS excludes convertibles from other types of contingent debt, for which a much higher “comparable yield” can be deducted.

That exclusion was circumvented by coco developers like Merrill Lynch, which tacked on extra contingencies–such as additional interest payments triggered by certain price movements of the underlying stock–to traditional convertibles. Although these new contingencies can be “relatively insignificant in amount or in likelihood of occurrence,” says the IRS, the agency ruled that they changed the bond enough to let it qualify for the larger deduction.

“I wasn’t expecting this [ruling],” says Dan Zucker, a partner at law firm McDermott, Will & Emery, which has advised on the issuance of cocos. “I was surprised not only that [the IRS] said something about it, but that what they said was so favorable.” In fact, the IRS also invited public comment on whether the comparable-yield calculation should also be allowed for straight convertible bonds.

Until that happens, newly approved cocos could be destined to completely replace less tax-friendly convertible bonds. But, notes Zucker, cocos don’t typically sell for a premium over convertibles. That means issuing companies must eat the risk of the added contingencies. In a down market, that’s already come back to bite some companies.

There’s another drawback to cocos: while issuing companies can deduct more interest than they pay, coco holders must also book an equal amount of phantom income and pay taxes on it. Fortunately, that phantom income is not a problem for the primary purchasers of cocos–tax-
exempt institutional investors, as well as those that use the mark-to-market method of accounting. –T.R.

Seen, But Not Heard

According to the NIRI, 25% of companies are planning a Webcast of their 2002 annual meeting. Of those, only 10% plan to accept E-mail questions from “virtual attendees.

International Markets

Why Americans Stay Home
It’s a problem that has baffled financiers for decades: Why don’t U.S. investors buy shares in companies overseas? As things stand, Americans hold only 9 percent of equity investments in foreign companies, and yet foreign stocks represent 51 percent of the world market.

Nobody knows why this home bias exists. “It could be lack of familiarity with overseas markets, language and cultural issues, or barriers to international investment–it’s unclear,” observes James Wardlaw, a managing director at Merrill Lynch.

A new research report released earlier this year could shed some light. “Corporate Governance and the Home Bias,” by Lee Pinkowitz and Rohan Williamson, both of Georgetown University, and René Stulz of The Ohio State University, shows that Americans aren’t nearly as biased as they seem. In fact, their findings suggest that, au contraire, foreign markets are keeping U.S. investors at bay.

The key to their conclusion is the presence of “controlling shareholders”–investors who own big chunks of a company’s shares that they won’t sell unless they’re paid compensation for their loss of control. These shareholders limit the number of shares available for trading.

While the U.S. equity market accounts for 49 percent of the value of the world market, it makes up almost 60 percent of the world’s free-floating shares. “Taking into account the role of controlling shareholders has the effect of reducing (but not eliminating) the home bias of U.S. investors,” notes the report.

On average, say the authors, 32 percent of shares worldwide are unavailable for trading. The country-by-country differences are vast. The United States has the lowest fraction of closely held shares–7.9 percent. -Justin Wood

Floating Away

Total amount of closely held shares limits U.S. ownership.

Country
% of market cap closely held
% of U.S. investor portfolio
% of world market
Brazil
67.13
0.24
1.12
Canada
48.82
0.54
2.49
China
68.74
0.02
0.91
France
37.98
0.65
2.96
Germany
44.74
0.49
3.62
Hong Kong
42.73
0.21
1.81
Italy
37.54
0.32
1.51
Japan
38.38
1.04
9.72
Netherlands
33.74
0.81
2.05
Switzerland
25.73
0.4
7 2.53
UK
9.93
1.66
8.76
U.S.
7.94
91.29
49.6

Source: Pinkowitz, Stulz, and Williamson

Absence-related benefits cost employers an average of 14.6% of payroll in 2000, according to a survey by Mercer and Marsh. Capital Markets

Capital Markets

Trading Spaces
Big and boring is in, fast and furious is out. Just look at the two largest stock exchanges. Only two years ago, some considered Nasdaq poised to take over as the premier ex-change. Now, even the stock market’s name is used to mean going down-hill, as in “the team ‘Nasdaqed’ and missed the playoffs.”

Nowhere is this more noticeable than in the initial public offering market. Through April, the NYSE had 16 of the 24 major IPOs this year. It was the first time in 10 years that the Big Board listed more new companies than did its rival. It’s true that the companies currently going public tend to fit the typical characteristics of the NYSE–bigger and more stable. However, the dot-com bust and the telecom flameout have left a bad impression in the minds of many.

“There’s a perception that the Nasdaq is more volatile,” says Carlton Crenshaw, CFO of Fairfax, Va.-based Anteon International Corp. When Anteon went public in March, it chose the NYSE. “It brings some credibility to the companies listed there,” says Crenshaw. As a defense company in the IT space, he says the company has peers on both exchanges and could have picked either one. Crenshaw adds that he had previously been CFO of two Nasdaq-listed companies, and “I was not happy there.” The reason, he says, is that during secondary offerings, arbitrageurs were able to manipulate the price of the stock, a problem that Nasdaq has since addressed.

In an effort to restore investor confidence, Nasdaq is making additional rule changes to crack down on unethical behavior. It will call for companies to hold shareholder votes for all stock-option plans for company officers and board directors, and has also threatened to delist companies that provide false information.

Some companies continue to believe in Nasdaq. Circle Group Internet Inc., a Mundelein, Ill.-based IT consulting firm, began trading on the Nasdaq OTC in June. “We’re a small company, so we still think Nasdaq is the right exchange for us,” says CFO Arthur Tanner.

Tanner doesn’t expect Nasdaq to be downcast for long. “It’s still a very sexy exchange. Investors will [keep looking] there for growth opportunities.” –J.McC.

Fess Up
The Federal Energy Regulatory Commission has reportedly asked 150 power companies to submit statements on whether or not they conducted “wash trades.”

Debt Market

Buffett’s New Custom Convertibles
Warren Buffett’s Berkshire Hathaway turned some heads in late May when it completed the first-ever issue of negative-coupon convertibles. But other market-watchers were left scratching theirs.

The Omaha-based conglomerate issued $400 million in Squarz, a vehicle created by sole underwriter Goldman, Sachs & Co. The convertible bond consists of a Berkshire senior note due in 2007 and a warrant to purchase Berkshire stock at a premium. The notes will pay holders a 3 percent coupon, but require 3.75 percent installment payments on the warrants. Hence the negative coupon.

“We’ve seen zero percent yield, so I guess negative coupon was the next logical trail to blaze,” says Robert Willens of Lehman Brothers. “And who better to do it?” he adds. Willens says that the issue, while small, has tax advantages for Berkshire. The company gets to deduct the 3 percent interest it pays to bondholders, while the 3.75 percent it collects is not taxable. There’s another advantage as well. “It certainly sends a message that you are bullish about your stock,” says Willens. “It means that you expect the stock to trade through the strike price.”

In fact, the issue created quite a buzz on Wall Street. “The main reason for the unusual structure was to attract attention,” says Whitney Tilson, managing partner at Tilson Capital Partners LLC, in New York. “Buffett wants to remind Wall Street that he is looking for private companies to buy.”

In fact, during a conference call, Buffett, who normally keeps a low profile, admitted that raising awareness about the company’s interest in acquisitions was an objective. “If doing this deal causes one or two people…to think of Berkshire when it comes time to sell their business, then [the offering] will have more than accomplished its purpose,” he said.

The Oracle of Omaha, famous for keep-it-simple investing, puzzled some with the deal. “It’s a bit of a surprise coming from Berkshire,” says Ravi Arcot, director of Kynex Inc., a convertible-bond research firm in Fair Lawn, N.J. “It makes sense for them, though,” he adds. “Effectively, they get a very low cost of capital. But we’re not convinced it makes sense for investors.” – J.McC.

45% of consumers say that service is more important than price, according to a recent survey by Marketing Metrics.

SEC Enforcement

Don’t Ask, Don’t Tell
Companies trying to learn lessons from the current spate of Securities and Exchange Commission accounting probes may have a difficult time doing so, because most enforcement cases are settled with no admission or denial of wrongdoing.

“Companies and individuals will often settle even when a case is extremely defensible,” says David A. Zisser, an attorney with Berliner, Zisser, Walter & Gallegos PC, a Denver-based firm. Xerox, for example, agreed in April to restate its earnings, make changes to its board of directors, and pay the largest financial fraud penalty ever against a public company–$10 million–but never admitted to doing anything wrong.

While settling is convenient for executives who want to avoid a drawn-out legal battle, some say the information the SEC publishes subsequent to the case often squelches details of other charges that were negotiated away in reaching a settlement.

“You have people who read the limited facts and don’t really see all the violations that occurred,” says Gary Illiano, a former SEC enforcement official and now regional director for Grant Thornton LLP. “The fact that someone gets sanctioned for not updating [a registration form] may be completely incidental to the real case, which may have been much more serious.”

Illiano says the lack of a clear precedent makes it more difficult for the accounting firm to rein in potentially abusive accounting practices. “People will come to us with issues,” he notes, “and we’ll say, ‘Be careful, the SEC is going to come after you on that,’ and they’ll say, ‘No they won’t, we read the [litigation] release.'”

Others argue that the litigation releases, administrative proceedings, and complaints that the SEC typically publishes are enough to keep companies out of trouble. “Litigation releases don’t really have any legal precedent, but they do articulate the com-mission’s current thinking,” says R. Steven Aronica, the director of forensic accounting at Milberg Weiss Bershad Heinz Lerach. “When the SEC publishes [them], you can feel confident that the best and brightest have weighed in on the matter and are in agreement.”

The SEC contends it is continually increasing disclosure, recently linking its detailed court complaints to the litigation releases posted on its Web site, for example.

Still, don’t expect to get the full story through official channels. Microsoft settled initial allegations of keeping cookie-jar reserves on the relatively benign charge of failing to keep accurate records, meaning that the precise actions that attracted the SEC’s attention are likely to remain shrouded. –A.N.

Ethics

Do the Right Thing

Benchmarking database users have achieved 69% faster growth and 45% greater productivity than non-users, according to PwC.

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