Broc Romanek is Editor of CorporateAffairs.tv, TheCorporateCounsel.net, CompensationStandards.com & DealLawyers.com. He also serves as Editor for these print newsletters: Deal Lawyers; Compensation Standards & the Corporate Governance Advisor. He is Commissioner of TheCorporateCounsel.net's "Blue Justice League" & curator of its "Deal Cube Museum."
According to footnote disclosure in the equity plan compensation table of its proxy statement, Delta Airlines has relied on the financial distress exception to the NYSE’s shareholder approval rules – and the NYSE staff has accepted the company’s application of the exception. [Here is how the process works: the NYSE’s rule allows for exceptions in the case of financial distress – the NYSE staff reviews each fact pattern to be sure that the company is properly applying the rule. The NYSE doesn’t technically grant the exception.]
Delta adopted two broad-based plans at the end of 2004, with a total of 62 million shares reserved – and these plans create potential dilution of 44% (and now the total potential dilution of all Delta’s plans are over 80%! Note that Delta has three shareholder proposals related to compensation on their ballot).
According to a report from IRRC, the use of the financial distress exception is rare and must be based on audit committee documentation and other factors. Here is the disclosure in footnote 2 of Delta’s table:
“During the December 2004 quarter, we adopted, as part of the Shared Reward program, broad-based pilot and non-pilot stock option plans due to the substantial contributions made by employees to our out-of-court restructuring efforts. We did not seek shareowner approval to adopt these plans because the Audit Committee of our Board of Directors determined that the delay necessary in obtaining such approval would seriously jeopardize our financial viability. The NYSE accepted our reliance on this exception to its shareowner approval policy. A total of 62,340,000 shares of Common Stock may be issued under these plans.”
More Practice Pointers on CompensationStandards.com
New practice pointers continue to be added to CompensationStandards.com – yesterday, I added nearly ten from Towers Perrin and Mercer Consulting, among others. I also added Professor David Yermack’s latest version of his much-talked about airplane perks paper – this one includes a section indicating that a company’s decision to begin disclosing the aircraft perk is highly correlated with shareholder lawsuits for securities fraud. See the updated paper in the “Airplane Use” Practice Area.
We have a lot of momentum for our October 31st “2nd Annual Executive Compensation Conference,” with Stanford Directors’ College and Harvard Law School’s Program on Corporate Governance colloborating with us – and John Reed and other current/former CEOs joining us to speak on responsible compensation practices. More details to come in the next few weeks – but you might want to get a jump on reserving a room at the Chicago Hyatt Regency since last year’s hotel was sold out early (don’t forget to mention the NASPP when you book a room to get the group rate).
What Happens If You Flunk Your 404 Exam?
There are so many good law firm memos on TheCorporateCounsel.net that I am always trying to figure out a better way to highlight them. One idea is to occasionally include them in my blog. Here is a Foley Lardner memo that emanated from a panel discussion – which included NYSE and Nasdaq representatives – that addressed what companies should do if they have internal control problems. It is “short but sweet” and in our “Internal Controls” Practice Area. Law firm memos on the new SEC and PCAOB internal controls guidance also are now posted there (scroll to bottom).
Early yesterday, I updated my blog about the PCAOB’s guidance on their internal-controls requirements – see both the PCAOB’s new FAQs 38-55 and the Board’s policy statement.
Meanwhile at the SEC, the Commission itself issued a statement – plus the Corp Fin staff also issued its own statement on management’s 404 report.
How Is Your Board Deciding to Implement Option Expensing?
As should be evident by now, under the FASB’s 123(R) standard, each company has some flexibility about how to implement option expensing – and the decision about how to do so should have quite an impact on the company’s bottom line. As the numerous NASPP webcasts on this topic – as well as the other resources on the NASPP’s site – make clear, this decision is one that requires some board attention. Learn more in this interview with Mike Melbinger on the Board’s Decisions for Stock Expensing.
SEC Filings Don’t Tell the Whole Pension Story
Today’s Washington Post carries an interesting column by Allan Sloan about the discrepancies between pension valuations disclosed in SEC filings by distressed companies compared to the amounts that the Pension Benefit Guaranty Corporation derives when it terminates the plans of those companies.
On an unrelated note, the SEC Staff released a scathing report yesterday on pension consultants and conflicts of interest.
Is Cisco Kidding?
Last week, I blogged about Cisco’s attempt to create employee stock options that are market traded. Here is some commentary on this idea from Ron Fink’s CFO Blog (not that I agree with Ron, just noting other’s views):
“Cisco’s latest idea for reducing the reported cost of employee stock option grants sounds as if it depends on a poorly performing derivative instrument (see B5 of the WSJ for a better description). How else describe a security that institutional investors could buy but not sell, making them wait as long as five years to convert it to common stock?
Yes, the price of the derivative may suffer as a result of these limitations. And in doing so, that could conceivably establish a market value for the underlying securities—the option grants—that is lower than what might be recorded under the option pricing models that are acceptable to the FASB.
But if the security is such a lousy deal, why would anyone buy it? And if it’s not so lousy, wouldn’t the resulting dilution to EPS offset the benefits?
It seems to me that Silicon Valley’s time and efforts would be better spent on producing new technology instead of methods of limiting the impact of an accounting rule. After all, investors may simply ignore the hit to earnings and focus on cash flow instead. Or is that what really concerns the tech lobby?”
Lot of members asking how to find the SEC Staff’s comment letters on the SEC’s site. Here is some insight from Brink Dickerson: Comment letters are starting to appear in the SEC’s EDGAR database. They are assigned one of two form types, “upload” for letters generated by the SEC staff, and “corresp” for letters generated by filers. As with other filings, they are indexed by filer name, so the primary way to access the letters is to search for the filer and then look for the form type. To search across filers, go to the EDGAR archives – which is within the “Search for Company Filings” area on the main EDGAR page – and search for “form-type=” either “upload” or “corresp.”
So far the selection is not that large, with twenty-four examples – but it should grow at the rate of roughly 300 letters per month. Further, except in a few cases, the letters available so far are either just the correspondence or just from the SEC – but not both.
And here is some further insight from Howard Dicker: Here is a list of all SEC comment letters and responses that the SEC has posted on EDGAR so far.
Note that SEC staff comments have a “Form Type” of “UPLOAD” – and company responses have a “Form Type” of “CORRESP.” Most comment letters posted so far (at least those that do not relate to ’40 Act or asset-backed issuers) appear to pertain to comments on changes in accountants disclosed on Form 8-K (Item 4.01). My cursory review also indicates that the Staff issued the comment letters regarding this item within a few days of the company filing a Form 8-K.
From the most recent draft of the SEC’s EDGAR filer manual, cover letters that include responses will also be posted on the SEC’s site – but no cover letters are uploaded yet (perhaps because when the SEC staff asks a company to respond to comments, they ask that the company respond as “correspondence”).
The Art of the Private Equity Deal
Lately, there are articles written almost daily about how private equity funds are primary players in today’s M&A – such as this article from Thursday’s WSJ about how “Private-Equity Players Turn to Bigger Prey.”
Stay tuned for the DealLawyers.com webcast – “The Art of the Private Equity Deal” – set for June 14th, during which three of the top outside counsel doing private equity deals and the general counsel at a large private equity fund will discuss the latest strategies (as well as the fundamentals) implicated in doing deals with funds. Try a no-risk trial to DealLawyers.com today – get access to this webcast and many more resources on the site for only $195 per year.
PCAOB Releases Internal Controls Guidance
Today, the PCAOB released guidance to help companies and their auditors comply with internal-controls requirements. The staff guidance, in question-and-answer form, is accompanied by a policy statement that may have more of an impact. The guidance addresses some stumbling blocks for companies, including the scope of internal-controls reviews – and the policy statement aims to put technical guidance in context and reiterate the need for auditors to use a flexible, risk-based approach, avoiding a one-size-fits-all model.
In addition, the SEC Staff released this statement on internal controls. More on all this manana…
As noted in this article, there is some controversy over companies that have accelerated the vesting of their underwater options in an effort to create higher earnings after they are forced to implement the FASB’s 123(R) standard.
On the NASPP site, there is a Bear Stearns report that has a chart of 102 companies – all of which have a market cap over $600 million – that have accelerated vesting of their underwater options. The chart includes numerous details about each company’s situation. Bear Stearns predicts more companies will be taking such action – and estimates that over $1 billion of option expense for future periods has been avoided by these companies. The NASPP site has other resources on accelerated option activity as well, including a June 9th webcast – “Q&A on FAS 123(R)” – during which Paula Todd of Towers Perrin and Reginald Oakley of the FASB are bound to answer questions on this technique.
Cisco Exploring Market-Traded Employee Options
Yesterday, both the NY Times and WSJ reported that Cisco Systems is considering the use of market-traded employee options as a possible solution to the huge option expense it will soon incur under the FASB’s new 123(R) standard. Here is the NY Times piece:
“Adding a new twist to the continuing fight over the expensing of employee stock options, Cisco Systems is seeking regulatory approval for a novel financial instrument that could allow the company to assign a lower value to the stock options than under current valuation models.
A lower value for the options, which under new accounting rules will have to be recorded as expenses on Cisco’s books starting this July, would reduce the impact expensing will have on Cisco’s profits and could lead other companies to adopt something similar. The company said that if it employed a traditional valuation standard like the Black-Scholes model for expensing its stock options, its reported profits would fall by roughly 20 percent.
Options give employees the right to buy stock for as long as 10 years at a price set when the option is issued, and thus can become very valuable if the stock rises over that period.
Cisco’s proposal is to create a market by selling new securities based on the employee options. By doing so, the company potentially could be changing the terms of the debate on expensing stock options. But details of the securities Cisco decides to sell, and the way it markets them, could prove crucial in determining how the approach works in practice.
The issue is important for Cisco because it grants options to all employees and because it will be one of the first companies to come under the new accounting rule that requires options to be expensed. That rule, adopted by the Financial Accounting Standards Board after a long and bitter debate, goes into effect on June 15 for fiscal years beginning after that date. Cisco’s fiscal year begins July 31.
In its last fiscal year, Cisco granted 188 million options to employees. It disclosed that had it been forced to take the value of options as an expense, its net income would have fallen by 28 percent, to $3.2 billion.
The securities would be sold only to institutional investors. Cisco would sell new securities when it issued options to employees, and would then use them to value those options on its books.”
A New Twist on the Quiet Period
Apparently, Led Zeppelin guitarist Jimmy Page entertained the NYSE with the band’s “Whole Lotta Love” at the opening bell Wednesday to kick off Warner Music Group Corp.’s IPO – but a few weeks earlier, one of the bands under contract to Warner had threatened to disturb Warner’s quiet period by trying to get out of its contract.
On May 3rd, the WSJ reported that Linkin Park wanted to end its contract with Warner because it was unhappy with the financial implications of the company’s IPO. Since Linkin Park is responsible for 10% of Warner’s sales, the mere threat by them to leave could have caused a problem in the quiet period – particularly since management was unable to publicly respond due to the quiet period’s restrictions. But it looks like Warner was able to get its IPO off the ground. That’s a new one for me, a client trying to get out of its contract – or renegotiate – and using the quiet period for leverage.
On the heels of yesterday’s farewell party for outgoing SEC Enforcement Director Stephen Cutler, Deputy Director Linda Chatman Thomsen has been promoted to take his place. Linda’s roots at the SEC stretch back to 1995, when she joined the Staff as a litigator and she rose through the ranks until becoming Deputy in 2002.
Delaware Supreme Court Limits California’s Long Arms
Thanks to John Jenkins of Calfee Halter for this analysis: With its recent decision in VantagePoint Venture Partners v. Examen, the Delaware Supreme Court soundly rejected California’s controversial efforts to apply its corporate statute to the internal affairs of foreign corporations with substantial ties to the Golden State. This case involved a claim that Section 2115 of the California Corporations Code governed the question of whether a separate class vote by the holders of preferred shares was required to authorize a merger transaction involving a Delaware corporation.
Traditionally, the so-called “internal affairs doctrine” has held that relationships between a corporation and its stockholders are governed by the laws of the state of its incorporation. Section 2115 of the California Corporations Code represents a departure from that traditional approach. That statute purports to apply to corporations that, although they may be incorporated elsewhere, have substantial business activities in California and substantial ownership by California residents.
Section 2115 is sweeping in its scope. As the Delaware Supreme Court noted: “if Section 2115 applies, California law is deemed to control the following: the annual election of directors; removal of directors without cause; removal of directors by court proceedings; the filing of director vacancies where less than a majority in office are elected by shareholders; the director’s standard of care; the liability of directors for unlawful distributions; indemnification of directors, officers, and others; limitations on corporate distributions in cash or property; the liability of shareholders who receive unlawful distributions; the requirement for annual shareholders’ meetings and remedies for the same if not timely held; shareholder’s entitlement to cumulative voting; the conditions when a supermajority vote is required; limitations on the sale of assets; limitations on mergers; limitations on conversions; requirements on conversions; the limitations and conditions for reorganization (including the requirement for class voting); dissenter’s rights; records and reports; actions by the Attorney General and inspection rights.”
Section 2115 would have subjected the merger at issue in this case to a separate class vote by the holders of the company’s preferred stock, notwithstanding the fact that the certificate of designation called for the preferred to vote on an as-converted basis with the common as a single class.
The Delaware Supreme Court rejected the plaintiff’s efforts to invoke Section 2115, holding instead that the internal affairs of a Delaware corporation remain a matter of Delaware law. In so doing, the court reviewed a wide variety of federal, Delaware and California decisions involving the internal affairs doctrine – and concluded that it had no doubt that the California courts would also apply Delaware law under the circumstances of this case. The court opinion and several law firm memos on this case is up in our “California Corporations” Practice Area.
Transcript of Reg FD Webcast is Up!
We have posted the transcript of our popular webcast: “The Latest Regulation FD Practices.”
For Photo Lovers Only
This Flickr Blog contains some very cool photos – new ones added daily. And this Mars Rover Blog has nice photos of Mars – ever wonder what Mars looks like?
Several members recently have inquired as to whether Nasdaq was seeking to delist companies that had filed disclaimed internal control opinions. [A “disclaimed opinion” is an attestation that essentially provides no opinion; compared to an adverse attestation which lists one or more material weaknesses.]
Although I am uncertain as to whether Nasdaq is taking this position across the board, it does appear that it is sending delisting letters to some companies on the basis that their 10-Ks are incomplete due to disclaimed 404 opinions. In fact, one of these companies, Advanced Energy, has put out a press release indicating that it intends to fight Nasdaq over this issue through the Nasdaq’s hearing process.
Disney Dissidents Sue the Company and the Board
Roy Disney and Stanley Gold are at it again. The dissidents of Walt Disney sued the company Monday in Delaware Chancery court, alleging that the directors made false statements to shareholders about the search for a successor to CEO Michael Eisner. In light of this allegedly bad disclosure, they seek to void the election of the Disney directors, force another election and disclose the board to disclose all the details regarding how they selected a new chief executive.
As you might recall, Disney and Gold withheld their support from Disney’s board at the company’s shareholder meeting earlier this year. The lawsuit asserts they would have run an alternate slate of directors if they had known that the company and a majority of the board members “did not intend to stand by their public statements about engaging in a bona fide CEO selection process.” And the complaint outlines a pattern of action taken by the Disney board during its CEO selection process that Gold and Disney claim shows the company never seriously considered anyone but the insider that was tapped as the successor, Robert Iger. Here are the letters that Gold and Disney have written to the board over the years.
Setting aside the fact that I have never seen extensive disclosure about CEO succession – as this process is often conducted in the dark – this lawsuit is consider a longshot by experts as explained in this article for more “legal” reasons.
Learn more about CEO succession in our upcoming June 8th webcast – “Managing D&O Departures and Arrivals” – which I just lengthed by 15 minutes because it became obvious that the expert panel has so much interesting ground to cover during a prep call we held yesterday. I also recently added an expert on D&O background verification to the panel. In addition, I just posted a new survey on director recruitment and background verification – check it out!
Throw Your Name in the Hat: PCAOB’s Standing Advisory Board
It’s that time of year when the PCAOB is soliciting names for their standing advisory board. The advisory board consists of 30 members with expertise in a variety of fields, including accounting, auditing, corporate finance, corporate governance, and investing in public companies. Two years ago, the first members were selected to serve staggered two- and three-year terms (but going forward, all terms will be two-years) – the PCAOB is seeking nominations to fill the 14 slots that are now open. Self-nominations are welcome!
According to this press release, it looks like the SEC is ready to start posting their comment letters – as well as responses – commencing this Thursday, May 12th.
Starting that date, Corp Fin and IM will begin the process of publicly releasing letters relating to disclosure filings made after August 1, 2004, with some of the oldest eligible filings going up first – and as it continues, letters will be released no earlier than 45 days after the review of the disclosure filing is complete.
The comment letters and filer responses will be on EDGAR. As I understand it, you would go to a specific company’s information on EDGAR, and there will be a notation to access the Staff comment letter and one to access the company’s response.
In this Sunday NY Times interview, Jack Welch waxes poetic on serving as a CEO in today’s environment. Here is a question he fielded on serving as a director today:
“Q. These days, directors are personally liable if they make the wrong decision. Has that changed the dynamics of the boardroom?
A. I’m not in boardrooms, but I think it has to have. What we ask is, “What is the role of a director?” We’re picking them for their judgment, their character, their ability to see around corners, to sense whether the strategy is right. But they can’t do that by looking at the books. They can only do that by walking the company. They have to get out and meet people at all levels, and get a feel for what it feels like out there. Are they hearing the same things out there that they’re hearing in the boardroom? Then they have to support the C.E.O. The company has to win. If they don’t have confidence in the C.E.O., they’ve got to make the change. But being timid and being afraid is not what we’re looking for in directors.”
Corporate governance is such a tricky thing. I believe outside directors should conduct plant tours and walk the floors when they can in an effort to boost morale and get a feel for the company.
But realistically they don’t have the time to do this sufficiently to get a complete picture (unless it’s a real small business) – and more importantly, you don’t want outside directors to be interacting with employees and confusing them by giving them directives that are contrary to what their managers instruct. Leave the managing to the managers; it’s not the board’s job to get involved with daily operations.
What I think Mr. Welch is referring to is for boards to gauge employee morale as part of a CEO’s evaluation – which could also include feedback from customers and suppliers (ie. a 360 degree evaluation). Related information can be found in our “Board Access” Practice Area.
The Need for Broad Employee Equity Ownership
There is a lot of concern about the future of ESPPs and other broad-based plans in the wake of option expensing. Learn more in this interview with Corey Rosen on the Need for Broad Employee Equity Ownership. There is more information on the NASPP website – and this topic will be covered during the NASPP’s 13th Annual Conference.
Stars Come Out to Blog
As noted in this Washington Post article, Arianna Huffington has gathered a few hundred of her closest acquaintances to start their own blog city, HuffingtonPost.com. It will be interesting to see where this all goes; my favorite blogs so far are from John Cusack who went to Hunter Thompson’s memorial service and Mark Cuban on the new Enron movie which has gotten rave reviews (need to scroll down a few days in Mark’s blog). I have high hopes for Larry David’s blog, but his initial entry is not so good – even Larry’s wife has a blog…
“I’m sure you saw the latest example of executive excess highlighted in today’s Wall Street Journal . In her article, “Some Visiting CEOs Get Paid to Stay in Residences They Own,” Joann Lublin identifies several chief executives who are reimbursed for staying in their own second homes when traveling on company business.
While this practice doesn’t knock the personal use of corporate aircraft off its perch as the most notorious executive perk, it comes pretty close. Although I can understand the rationale for the payments (the company would incur a hotel expense anyway when the executive was in town), the optics make it an investor relations nightmare.
The article goes on to point out that, until this year, most companies had not previously disclosed these arrangements. [You can see representative proxy disclosures for Time Warner, Disney and Viacom linked from Mark’s blog.]
Apparently, the SEC’s recent admonishments about full disclosure and “best practices” led the companies to include the information as part of their perquisites disclosure. Interestingly, while Time Warner and Disney describe the arrangements, they both go on to expressly state that the amounts are not included in the “Other Annual Compensation” column of the Summary Compensation Table (Viacom included reimbursed amounts in the column).
Not surprisingly, investor group representatives are outraged, with one calling the practice “ridiculous.” I suspect that we haven’t heard the last of this issue.”
The Latest on the SEC’s XBRL Pilot Project
As noted in this recent press release, the SEC continues to encourage participation in its XBRL pilot program. Here are some related remarks by Peter Derby, Chairman Donaldson’s Managing Executive for Operations & Management, before the 11th XBRL International Conference on the topic.
The SEC’s XBRL voluntary filing program received a little help from the US members of XBRL International with this special web page; among the available resources are FAQs, tutorials, an email discussion group, guidelines, and a list of the companies that are voluntarily submitting XBRL documents to EDGAR (five so far). The site also includes links to US GAAP taxonomies, sample XBRL instance documents, and technical background information. Thanks to Allyson Weaver of Electronic Filing Services for pointing this out!
Bullet’s Fever – Happens to Me Every Year!
Moved to the DC area in the late ’70s and became a lifelong Washington Bullets fan after they won a world championship on the backs of Wes Unseld, Elvin Hayes and the gang. Little did I know they wouldn’t win another playoff series for a quarter century – until this weekend! Now I got Bullet’s Fever! DC residents will know this Nils Lofgren song from 1977:
For those of you not interested in b-ball, you can read about “Lawyerpalooza” instead…
The SEC just posted this speech by SEC Commissioner Harvey Goldschmid that was given a few weeks back before the Council of Institutional Investors. A short-timer, due to depart the SEC soon and return to teaching at Columbia University, Commissioner Goldschmid outlines critical issues that he views the SEC as facing over the next year. In his speech, the Commissioner pleads to keep the shareholder access concept alive, which is likely to come in the form of the majority vote movement afoot at the state level. He also pleads that the SEC remain an independent institution, immune from the pressures of partisan politics.
SEC’s Section 16 Amicus Brief
In the ongoing Dreiling v. American Express Travel Related Services case, the SEC has filed this amicus brief in which the SEC urged that it acted within its authority in adopting Rule 16b-3(d) (which exempts certain grants, awards, and other acquisitions of an issuer’s securities by its officers and directors from the short-swing recovery provision in Section 16(b)) – and that, to the extent a person is a director by having “deputized” someone to be a director on its behalf (and is thereby subject to Section 16) exemptive Rule 16b-3(d) also applies to that person – but for that rule to apply, the board approving the transaction must be aware that the deputizing person is a director. Overall, it is important that the SEC acknowledges the possible availability of Rule 16b-3 in deputization situations.
As reflected in this letter from SEC Commissioners Atkins and Glassman to the US Senate Committee Chair on Appropriations, tense relations among the Commissioners continue to fester. The letter starts by stating:
“In voting on whether to send the attached Staff Report on the Exemptive Rule Amendments of 2004: The Independent Chair Condition as required by Consolidated Appropriations Act, 2005, we dissented. We do not believe that the staff report adequately responds to the questions directly posed in the Act. Unfortunately, we were not given at any point in the process an opportunity to provide constructive input on what we would consider a responsive report.”
In my many years following the SEC, I have never seen such disharmony at the SEC’s highest level; if anything, relations among the Commissioners typically were so good that Commission meetings were quite routine and bordered on monotonous. I can’t imagine what closed Commission meetings are like these days! By the way, the Commissioners have not moved to Station Place yet – which is what the new HQ is being called – so they are still on the 6th floor of 450 5th St.
Conflicts of Interest and Dicey Engagements
We have posted the transcript for the DealLawyers.com webcast: “Conflicts of Interest and Dicey Engagements.” I found this to be a fascinating program and some members have pointed out the timeliness of the program in light of the Goldman Sachs conflicts controversy surrounding the NYSE/Archipelago transaction. It was interesting to note this piece in the New York Times last Sunday that even challenged the “back-up” fairness opinions given by others because of ties they had to Goldman.
SEC Guidance May Change How Companies Gauge Accounting Errors
As reflected in my notes from PLI’s “SEC Speaks,” SEC Deputy Chief Accountant Scott Taub talked about a potential summer project that could change how companies determine when accounting errors are large enough to warrant adjusting the company’s books. This project is interesting because it bears on the ongoing “materiality” debate.
Yesterday, the WSJ ran this article on the topic – below is an excerpt:
“Companies currently may choose between two different methods, a process the SEC accountants hope to standardize by calling for companies to use both methods, booking an error if either method shows it to be substantial. The idea was recommended in an academic paper to be published this summer.
Although the shift would require companies to revisit previously issued financial results, SEC accountants are expected to allow companies to use a one-time “catch-up” for past errors rather than roil markets with restatements.
The shift could be difficult and even “ugly,” cautioned Scott Taub, SEC deputy chief accountant, but SEC accountants won’t recommend”grandfather” treatment for companies that would protect them from having to correct prior problems found to be material under a two-pronged approach. Taub’s comments were made at an “SEC Speaks” conference last month at which he gave the usual disclaimer that he was speaking for himself, not the SEC.
Companies can’t ignore “material” errors large enough to matter to investors, typically those exceeding 5% of net income. While companies must consider quantitative and qualitative factors, they have a choice of two methods to quantify if errors are big enough to be material.
Since results can vary depending on which method is used, companies are supposed to pick one approach and stick with it. Companies rarely – if ever – divulge which method they use, which critics say gives executives too much leeway to engineer results.
A 2000 panel on audit effectiveness recommended regulators settle on one method to avoid confusion. Yet the choice isn’t clear-cut since there are instances where one method would indicate an error is material while the other method wouldn’t.
The cumulative or “iron curtain” approach compares the total amount of a misstatement at the end of the current period to net income, while the current-period or “rollover” approach compares the amount of misstatement added in the current period to net income. The “rollover” method, thought to be more prevalent, recognizes that prior errors may be offset or reversed in the current quarter or year while the “iron curtain” approach doesn’t allow that.
Under the “iron curtain” method, a company that overstated inventory by $100 million in 2003 and by $150 million in 2004 would tally a $150 million error in 2004. Under the rollover method, the company would calculate it at $50 million. The $100 million difference could make the mistake material under one method but not the other.
Auditors may be influenced by which method is used. Academic researchers questioned hundreds of accountants at Big Four firms and found just 23% would ignore an error that is relatively large under the iron curtain method while 70% would do so when the rollover method showed the effect was near zero.”
