About six months ago, CSK Auto announced that they were investigating inventory and vendor allowance problems and issued the now-traditional non-reliance 8-K filing.

Yesterday, they released the preliminary results of their investigation. An excerpt from their most recent press release filed with yesterday's 8-K:

"Based on preliminary results of the investigation, the Company previously announced probable maximum estimated overstatements relative to its previously filed October 31, 2005 balance sheet of approximately $70 million in inventory and $12 million in vendor allowances. As previously reported, the Company also identified an estimated overstatement of between $3 million and $7 million of store surplus fixtures and supplies. In addition, it is expected that the restatement will result in material changes that both increase and decrease previously reported results of operations for the periods that will be restated. At this time, no facts have been developed that would indicate that any of the foregoing items would have a material adverse effect on historical revenues or cash flows or on the Company's ongoing or future business operations."

The company has yet to file financials for its 2006 operations. The problems noted above go back to 2003; the previously filed financials haven't been restated yet either, but they're pending. The company's president and its CFO, "as well as several other individuals in the Company's finance organization are no longer employed by the Company."

The item is a curiosity because none of these issues mentioned are at the cutting edge of accounting theory. We're talking about accounting for inventory, what to do with credits given by suppliers, and how to account for store fixtures - not exactly on the same level as accounting for fair values of derivative instruments. It's basic blocking and tackling for retailers. And it demonstrates the need for assessing controls involving basic blocking and tackling. The firm identified the issues in its first Section 404 review last year.

A study done by Bloomberg News on the price effects of backdating probes shows that the investigations have "cost investors $7.9 billion in market value." The article goes on to state the underperformance of the companies compared to their peers and/or the S&P 500 index. Maybe that shouldn't surprise anyone by this time; late in the article, there's an admission that "the market has a tendency to overshoot on fear." At least when you're talking about Apple, which has gone up 37% since dropping by 6% on the day its backdating probe was announced.

The article talks about the market costs of the options probes - but those change from day to day, and the memory of Wall Street is a funny thing. For instance, the article also notes that the impact on stocks at the time of the announcement has diminished: it's dropped in more recent announcements. The article mentions that the "average one-day loss for the first 30 companies to disclose investigations, from March 14 to May 25, was 2.9 percent, or 2.8 percentage points worse than their peers. The last 30 disclosures as of Aug. 31 prompted an average decline of 1 percent, trailing peers by 1.2 percentage points."

Chalk up market effects to evidence about poor controls, poor corporate governance, expected management distractions, or any combination of the above. Market effects might also include anticipated cash costs - but those are so fuzzy to predict, it's hard to believe they'd be currently well-incorporated into stock prices. And they're likely to be "sticky:" they're not likely to be incurred all at once. But incurred they shall be, and the markets might find more to dislike as they're more visibly quantified.

Some possible cash costs that the markets might not yet have fully digested (because they're still pretty much unknown):

Taxes. Finding out that options may not have been validly issued could negate past cash savings on income taxes. Filing amended past tax returns with evaporating deductions could lead to big cash payments - and it's nigh well impossible to guess how much from published financial statements.

Auditing costs. It's not clear how far back misstated financials will have to be restated, but for now, it's reasonable to expect that all material misstatements will be restated. The Commission has effectively warned companies to be very careful about making assumptions about how far back they need to go in restating, in this letter from Chief Accountant Conrad Hewitt issued last week:

"...The staff understands that errors related to the issues addressed in this letter may affect several years of filings, and that companies may believe that amending all of the affected filings is unnecessary. Companies that propose to correct material errors without amending all previously filed reports should contact the staff of the Division of Corporation Finance. No amendment of previously filed reports is necessary to correct prior financial statements for immaterial errors."

If it isn't immaterial, don't expect not to restate... get it? That's the message, it seems.

When the market gets hold of increases in audit fees for the examinations, there's bound to be the cost-versus-benefit kinds of stories in the media, apart from the "shareholder pocketbook" stories like this one. It'll be easy to put down the cost of the auditors: after all, they're part of the cost of restating financials that today's investors might rarely read. Maybe, maybe not. If a management team is still in place at a firm where the company engaged in option skullduggery ten years ago, that would seem to be information that a current investor would still be interested in knowing. Even if there's a complete turnover in the executive suite, today's investors would probably be interested in knowing about the extent of past transgressions: corporate cultures don't necessarily change in the space of ten years.

When it comes to restatements going back longer than just a few years, this is pretty much uncharted territory - it just hasn't been prevalent, at least to my memory. To get today's figures cleaned up, it might be necessary to dive into financials of ten years ago. The options problems being investigated involve plenty of specific documents that may no longer exist, and contacts with people who may have departed the companies - or even this world - long ago. Yet the current financials could still carry an impact from the proper accounting being applied ten years ago - and it isn't going to be cheap or easy to find out what that impact is. Do shareholders deserve to know? Yes. Should they complain about the cost? No. If something unfavorable to shareholders has occurred in a company in which they invest, they'd be foolish not to want to know. That's what the audit function is supposed to provide the shareholders, so they shouldn't have a problem with audit fee increases due to this activity. (If there's a problem with audit fees at all, it should be that they didn't reflect this kind of work ten years ago.)

The new executive comp disclosures, effective for the proxies of the next wave of calendar year end filers, promise to bring some much-needed clarity to the subject so near and dear to the financial journalist community. And there are a few subtleties to them to which the press hasn't devoted much attention.

On Monday, John White, the SEC's Director of the Division of Corporation Finance delivered a speech to the "Practising Law Institute Fourth Annual Directors' Institute on Corporate Governance" on the new disclosures, shedding light on on some aspects of the disclosures that will impact managers and directors - in more ways than just the recitation of a comp figure, with the attendant "Holy Cow!" exclamation by proxy readers.

One change brought by the standard has to do with the new "Compensation Disclosure & Analysis" to be found in the proxy and 10-K. This replaces the old "Board Compensation Committee Report on Executive Compensation" with a "principles-based" disclosure about compensation. (White elaborated on the "principles-based" disclosures in a prior speech this month.) While the format itself will be different, it will also be a corporate disclosure - not a statement by the board's compensation committee. As a corporate disclosure, it will be subject to the CEO/CFO certifications that have brought changes in the "tone at the top," according to Chairman Cox. That increases the pressure on firms to actually produce robust, non-evasive disclosures - or face the stiff consequences of failure to fulfill SarbOx Section 302 obligations.

Another aspect of the new comp rules that don't get much airplay: the effect they'll have on directors. According to White, "Director compensation for the last fiscal year will now be required to be disclosed in a new Director Compensation Table (along with related narrative), which will be similar in format to the Summary Compensation Table that is the primary vehicle for disclosing the amounts of your executives' compensation. As with executives, companies will be required to disclose one total number for a director's compensation, which will include the dollar value of option grants to directors and perquisites, among other compensation."

As the H-P soap opera shows, there are all kinds of, shall we say, "interactions," among board members - and managers, too. The degree to which any interactions in any dysfunctional board might be affected by compensation should be clearer starting next year. It'll provide a rich arsenal of ammunition for the corporate activists.

A couple of news articles about a few denizens of the Enron era surfaced in the past week. You might not remember the name Jamie Olis like you'd remember Ken Lay, but he was a tax accountant with Dynegy who helped arrange that firm's "Project Alpha" to inflate revenues and cash flows using swaps, SPEs and secret side agreements. After the investigation, Olis received a lot of attention for the harshness of his sentence: 24 years. That sentence was tossed out last year in the U.S. Court of Appeals, for being unreasonable. He's been resentenced (by the same judge who sentenced him the first time, Judge Sim Lake) to a six year sentence. Lake also managed the Lay and Skilling trials.

Speaking of Skilling - he's in the news again. Sadly, this time for being ticketed for the misdemeanor of public intoxication as his sentencing date looms on October 23. Meanwhile, fellow Enron perpetrator Andrew Fastow promotes a button-down, nice guy image of a helpful community volunteer as his sentencing date approaches.

SEC Chairman Christopher Cox testified last Tuesday on the impact of the Sarbanes-Oxley Act before the U.S. House Committee on Financial Services. The testimony got little mention in the press, and what mention it did receive focused on Cox's remarks about the costs of Section 404 examinations. (This article, for instance.)

True enough. His testimony did include a recap of the SEC's efforts to effectively neuter Section 404 for small companies (those with a market cap under $75 million), including their most recent proposal to extend the date by which a firm's auditor must attest on internal controls to the first annual report filed for a fiscal year ending on or after December 15, 2008.

It's hard to accept the reasoning in that action, and it's hard to believe that the implementation of the evaluation of internal controls has been so problematic in small companies. They certainly can't be as complex as their grown-up brethren; the issue is probably that they simply don't have adequate controls and auditors must extend their testing further in expressing an opinion on the financial statements as a whole.

Back to the Cox testimony. What's been under-reported: Cox offered an understated rebuttal to those carping critics citing the recent large IPO listings in foreign markets as evidence that SOX 404 requirements have made American capital markets "non-competitive". (Never mind that investment banking fees can be twice as high in the U.S. compared to Europe.) He commented that some of the same countries enticing firms to list on their home exchanges as a way of avoiding SOX are, in fact, adopting some of its provisions. Some examples:

"Governments in the major markets around the world have established independent auditor oversight bodies like the PCAOB. For example, the European Union recently adopted a directive requiring all EU member states to create an auditor oversight body..."

"Other major capital markets have also recognized the conflicts of interest that some non-audit services create, and the need to place restrictions on these services to improve audit quality. The European Union, the United Kingdom, France, Hong Kong, China, Japan, Australia, Canada, and Mexico have all passed reforms requiring mandatory audit partner rotation, although they vary regarding the details about how this rotation works."

"The United Kingdom, Hong Kong, Australia, Canada, and Mexico have all introduced reforms since 2002 requiring that all members of the audit committee be independent of management."

"A number of countries have even adopted requirements similar to the first half of the controversial Section 404 of the Sarbanes-Oxley Act, which requires management to do its own assessment of internal controls. Several countries, including the United Kingdom, Australia, and Hong Kong, have adopted a comply-or-explain approach to a management assessment. Japan, France, and Canada all now have legislation or regulations requiring a management assessment of internal controls."

Cox also defended the effect that the Act has had on the "tone at the top," saying that the Act's requirements for CEO and CFO certification of the financial statements has stopped corporate buck-passing. He testified that the Act has improved the audit process and improved audit committees.

He also testified that while "[w]e have also become convinced that there are no irreparable problems with Section 404 implementation," the SEC would work with the Public Company Accounting Oversight Board to mitigate the implementation issues that have caused small companies to gag at the prospect of implementing internal control reviews. Cox addressed the next SEC inspections of the PCAOB, hinting that they'll focus on whether the PCAOB is looking for auditor effectiveness in carrying out their inspections of public accounting firm audits of public companies. The SEC's concern is that audits are being done without wasted time and effort:

"We anticipate that the SEC staff's next inspection of the PCAOB will focus on the PCAOB's own inspection program for registered audit firms. In particular, the staff will likely focus on the PCAOB's inspections of audits under PCAOB Auditing Standard No. 2.

This authority to inspect the PCAOB is an important aspect of the Commission's general oversight under Section 107(a) of the Sarbanes-Oxley Act. By focusing our next inspection of the PCAOB on its largest program area — inspections of registered public accounting firms under Sarbanes-Oxley 404 and Auditing Standard 2 — we hope to achieve greater compliance with the Commission's and the PCAOB's own guidance that these audits be risk-based and cost-effective."

In short, carrying out the task of auditing public companies in accordance with the standards set by the PCAOB won't be good enough - they have to be efficiently done as well. Considering that the vast initial job of documenting control systems and getting them in order is now out of the way - at least, for firms above the $75 million market cap threshold - it's reasonable to expect that auditors are moving along the learning curve. We'll see when the PCAOB completes its inspections.

No sense wasting more pixels on the H-P mess, even though I'm kind of thankful that it came along. Now there's a diffferent monotone drone in the news to replace backdating stories.

You just can't top the H-P story for sheer boardroom weirdness, though, even though the backdating stories suggest that there wasn't the most rigor being applied to compensation issues. Even dead guys could get backdated options. (If you don't think that spying on board members and trying to plant moles in newsrooms is weird, try out the story on Patricia Dunn being voted into the Bay Area Business Hall of Fame for leadership.)

You can argue about effective boards, sloppy boards, selfish boards, and good boards. One question is worth asking: why bother with boards anyway? How did the board system come about? Is it relevant today?

(Do boards care about accounting? Never mind.)

Back to the point. Justin Fox poses the questions above (but not the one about accounting) in his thoughtful article "Who Needs A Board Of Directors, Anyway?" in his blog Fortune magazine blog. It's a good read: I enjoyed his brief history of the board structure. And though we're stuck with it (didn't mean to spoil the ending for you, but you probably guessed it anyway), it's good to know how we got to where we are. And check out Justin's own blog at by Justin Fox. As he puts it, it's shameless self-promotion of his forthcoming book, "The Myth of the Rational Investor." But if it's by Justin, it ought to be worth reading.

Nearly a year ago, there was a fairly wide SEC investigation going on in Puerto Rico: a group of major financial institutions appeared to be constructing a daisy-chain of transactions with each other. It wasn't the sort of thing that was clear from the financial statements; the SEC must have spent a lot of time at ground level, because they announced yesterday that one of the firms involved, Doral Financial, settled fraud charges for $25 million.

What did the Commission find? According to their complaint, they charge that Doral "overstated income by approximately $921 million or 100 percent on a pre-tax, cumulative basis between 2000 and 2004," which enabled the firm "to report an apparent 28-quarter streak of "record earnings" and facilitated the placement of over $1 billion of debt and equity."

In connection with the securitization of mortgage loans it had originated over the period, Doral had to estimate a fair value for interest-only (IO) strip securities it retained from the securitizations. The estimated values for these IOs were improperly calculated and resulted in the overstatement of the retained interests as well as the gains recorded on the sale of the loans. Worse: it was known within the company that the methodology used in calculating the estimated fair values was wrong - but they were used anyway.

In addition, Doral sold about $3.9 billion in mortgages to FirstBank Puerto Rico between 2000 and 2004, on which it improperly recognized gains on the sales - improperly recognized, because the sales inclueded "oral agreements or understandings between Doral Financial's former treasurer and former director emeritus and FirstBank senior management providing recourse beyond the limited recourse established in the written contracts." Doral, in effect, still had skin in the game for the mortgages "sold," so they weren't genuine sales.

What else? Doral "managed earnings through a series of contemporaneous purchase and sale transactions with other Puerto Rican financial institutions totaling approximately $846.9 million. These involved the generally contemporaneous purchase and sale of mortgage loans from and to local financial institutions where the amounts purchased and sold, and other terms of the transactions, were similar. Doral Financial entered into approximately $200.1 million worth of these transactions during the fourth quarter of 2004 with one Puerto Rican financial institution and approximately $646.8 million worth during 2000 and 2001 with other local financial institutions." Another way of putting it: the company structured transactions with other institutions in order to present a specific amount of income in a certain accounting period, apparently with no real substance other than for making the earnings look good.

Interesting to note that the other financial institutions are not mentioned in the complaint, but it's implied that their earnings are also "managed" by the same transactions. Maybe those firms are what the SEC is referring to in the last line of its litigation release: "The Commission's investigation is continuing."


There's a bit of an unsettling coincidence in the timing of the Commission's Doral release. Many of Doral's transgresssions relate to its estimation of the fair value of the interests it retained in the securitizations of loans: their modeling was unrealistic, they knew it, and it provided them with an intended result. (As did their "contemporaneous purchases and sales.") It's an unpleasant reminder that fair value reporting, while useful, can be pushed and pulled and massaged into whatever management wants in the absence of visible market prices - and the absence of sturdy disclosures about derivations of fair values doesn't help users. The coincidence: the Commission released this example of fair value problems the same week the FASB releases its new standard on fair value reporting, which should set the table for an expansion of fair value reporting in future accounting standards. Cue the theme from the Twilight Zone, please.

Just released yesterday: a letter from new Chief Accountant Conrad Hewitt (his first public missive) to representatives of the financial preparer and auditor communities.

The letter summarizes relevant issues for preparers and auditors to consider in evaluating whether or not an option "mis-pricing" event has occurred. It's just in time before the 2006 audit season gets going; given the attention raised by the press on the issue, and the impetus provided by the PCAOB, auditors will be spending more time than usual on "old-time" options this year. Why does it matter, if the options grants pre-date the financial statements being reported upon? Because it's possible that if the correct accounting treatment had been used, the effects could still have a lingering compensation effect on current year financial statements. Or, perhaps there could have been a material effect on the financial statements of several years ago which are still presented in the comparative package.

The Hewitt letter draws on the observations made by the SEC staff in its investigations to date. Will it launch hundreds of restatements or catch-up adjustments? That's going to depend on how well auditors match up circumstances they find with the "fact patterns" presented in the letter. We'll have to see what they find in the first place, but it should be an interesting fourth quarter. Even if no widespread problems are uncovered.

Yesterday, the FASB issued its oft-delayed Statement No. 157 - Fair Value Measurements.

It's not a standard that will shake things up all on its own - but you can expect that it will affect standards that are yet to arrive. Statement 157 lays down a single concept of what constitutes fair value for assets or liabilities and specifies broader disclosures designed to make estimated fair values more believable to users.

And you can also expect that there will be tons of requests for narrow interpretations of the standard before it becomes effective in years beginning after November 15, 2007.

SEC Chairman Christopher Cox delivered introductory remarks to the 30th Annual Southwest Regional Enforcement Conference last Thursday. Not your typical crowd of accounting wonks; it's made up of law enforcement types for state securities regulators and the U.S. attorney general's office.

So, Chairman Cox didn't focus on say, pension rate assumptions or volatility estimates for option compensation calculations. He did, however, mention backdating because of the extraordinary focus on the subject by regulators and the press. Below, his comments:

"By the time we brought our first major case, in late July against Brocade Communications Systems, we had been on the job for some time. Brocade was the first public step, but the SEC's investigation has been underway for years.

And its geographic footprint is broad. We have many cases here in this region. It covers many industries. As some of the investigations conclude, the American public will get a fuller sense of the picture.

But just as important is making sure that everyone understands our rules, so that the line between observance and transgression is a bright one that everyone can see.

So just a few weeks ago, on July 26, when we adopted new rules on executive compensation, we issued guidance to management and directors on what exactly is expected of them.

And we will soon issue further accounting guidance that will help honest companies to avoid any problems with the law."

It'll be a lot more interesting to see how that "further accounting guidance" affects the companies having the problems with the law.