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Getting Dumped

Why Big Four auditors are dumping some small clients; quiet periods could get a little noisier; the manufacturing sector gets a boost; stock-option expensing goes back on the shelf; questioning the accuracy of credit ratings; more.
CFO Staff, CFO Magazine
December 1, 2004

Some companies are feeling like they've just been through a difficult divorce. That's because Big Four auditors have dropped them — in some cases after years of service.

In the first nine months of 2004, Big Four accounting firms resigned from 157 accounts. While some of those resignations followed unclean opinions, others reflect a move away from smaller clients that are perceived as riskier bets in today's regulatory climate. Not only are some small-caps struggling to implement appropriate internal controls, but they also generate less fee revenue. And with the Big Four stretched thin thanks to Sarbanes-Oxley internal-controls work, they appear to have decided it's better to trim their client lists.

Last July, Ernst & Young LLP ended its relationship with Redhook Ale Brewery, a $39 million Seattle-based company, after auditing the books for its 23-year history. Redhook CFO David Mickelson says the audit committee was anticipating a fee hike and had considered a change anyway. "It was kind of like when you're thinking about breaking up with your girlfriend and she does it first," he says. The timing could not have been worse, however. The company, in the final months of a distribution contract with Anheuser-Busch, had just received a going-concern opinion. Mickelson feared the resignation would make the situation look even worse. (The contract was subsequently renewed.) Together with the audit committee, he pushed to have Seattle-based Moss Adams LLP in place to handle the third-quarter filings.

Michael Perry, finance chief at Vitria, a $66 million software and services business, was less prepared when Ernst & Young resigned from its account in August. "I was stunned," says the CFO. "I thought I had an excellent relationship with the firm." Vitria quickly launched a search for a new auditor and signed with BDO Seidman LLP.

"It's very clear that there's a trend toward bigger firms resigning from small accounts," says Mark Cheffers, CEO of AuditAnalytics.com, which tracks auditor changes. Ernst & Young, however, denies that it is targeting small companies. "Along with other members of the accounting profession, we constantly reexamine our client relationships...we have resigned from a range of clients, both big and small," said the company in a statement.

Mickelson, for one, is happy with the attention of his new auditors: "Having firms competing for our business really made us feel better." —Kate O'Sullivan


Unsettling

In the past few years, the Securities and Exchange Commission has launched hundreds of cases against executives in the financial-services industry, but few of them have resulted in courtroom battles. Instead, the accused usually agrees to pay a hefty fine and is barred from the industry for a certain period, without admitting or denying guilt.

Two former executives of the PIMCO mutual-fund group, however, intend to test the merits of a quick settlement. Stephen Treadway and Kenneth Corba are asking the SEC to prove its charges in federal court. The two are accused of allowing a client to use PIMCO funds to engage in market timing. "[Corba] is confident he will prevail," says his attorney, Jim Rehnquist, a partner at Goodwin Procter LLP in Boston.

The fact that they are proceeding means they must feel they have a good shot at winning, says Thomas Frongillo, an attorney at Mintz Levin. But the move is risky. If they are found liable, Treadway and Corba will likely face stiffer penalties than if they settled. The SEC may have even more to lose in the case. "The SEC has been very successful at resolving cases short of litigating," says Frongillo. If the defendants win, he says, the SEC will have a much harder time pursuing similar cases. —Joseph McCafferty


Who's Got It Made?

The congressional authors of the American Job Creation Act of 2004 wanted to give a tax break to the struggling manufacturing sector in the United States. But by the time the bill was signed by the President on October 22, the definition of manufacturing had been expanded to include nearly everything.

The act eliminates the extraterritorial income (ETI) exclusion , a subsidy for U.S. exporters that has been called illegal by the World Trade Organization. It replaces the exclusion with a tax deduction on net income derived from the sale, exchange, rental, lease, or licensing of "qualifying production property." As long as the property was "manufactured, produced, grown, or extracted by the taxpayer in whole or significant part within the United States," a company can claim the tax break. The deductions are expected to yield $76.5 billion in tax savings over 10 years for qualifying companies, which include such "manufacturers" as coffee roasters, meat packers, and even publishers.

So what qualifies as qualified production property? What doesn't. Included in the roundup are makers of all "tangible personal property"; computer software; water, natural gas, or electricity; sound recordings, film, videotape, and live or taped television programming (except pornography); agricultural products; construction services; and architecture and engineering services performed for construction projects in the United States.


For 2005 and 2006, the tax break will be 3 percent of the net income generated by "qualified production activities." It rises to 6 percent in 2007 and 9 percent in 2010. Total deductions cannot exceed 50 percent of a taxpayer's total W-2 payroll, which covers the "Job" part of the act's title.

Tax experts expect that everyone that doesn't already fit the definition will try to. "The incentive is to make as much of your business process as possible fall within what is considered manufacturing or production, as opposed to services," says Hank Gutman, a principal at KPMG LLP. While the law goes to great lengths to clear up ambiguities, Gutman says there are still many gray areas. One example is the vague phrase "in whole or significant part."

The Treasury has a lot of parsing to do before anybody can claim a penny in tax deductions. Thankfully, the act's authors created a 618-page "explainer," which offers helpful interpretations of their intent when drafting the act.

Mel Schwarz, director of legislative affairs at Grant Thornton LLP, says that interpreting the rule will be "challenging. This is unquestionably going to be very confusing." —Kris Frieswick


Credit Ratings Get Poor Ratings

Finance executives have always had a love-hate relationship with credit-rating agencies (CRAs). But according to a recent survey by the Association for Financial Professionals (AFP), it's more hate than love these days.

The study, released in October, finds that 34 percent of corporate practitioners believe the ratings on their debt are inaccurate, up from 29 percent who thought so when the survey was conducted two years earlier. And 41 percent do not believe the ratings reflect changes in creditworthiness in a timely fashion.

"Confidence in the credit-rating process continues to be low among financial professionals," says Jim Kaitz, president of the AFP. "Despite the news headlines about financial scandals and hearings in Congress, the situation has not improved." The CRAs have been criticized for missing corporate scams at companies like Enron and WorldCom.

For their part, the ratings agencies say they have nothing to hide. "We are always looking for ways to make the rating process more transparent," says Rebecca Hill, vice president of communications at Standard & Poor's. She says the firm is willing to talk to issuers about its ratings and criteria. "As always, we welcome constructive feedback. It's not uncommon for issuers to disagree with our ratings opinions."

But it is not just the downgraded that are skeptical. The study finds that among recently upgraded companies, 36 percent still say the ratings are inaccurate.

Sarbanes-Oxley requires the Securities and Exchange Commission to study CRAs. The commission launched a preliminary report in January 2003, but it has yet to issue any proposals that would change how CRAs are regulated. —J.McC.


Make Some Noise

The so-called quiet period prior to the public sale of securities could get a little louder. The Securities and Exchange Commission is proposing to lift some restrictions on companies' pre-IPO communications.

Under a 1933 law, during the period surrounding an initial public offering the company may publicly discuss only information that appears in the prospectus. But the SEC is suggesting that first-time filers be allowed to continue to publish routine business information, such as press releases about new contracts. They could also be permitted to give media interviews.

The proposal would clear up confusion surrounding the IPO process, says John M. Clapp, a securities lawyer and partner with Squire, Sanders & Dempsey LLP in New York. "It's really a gray area right now as to what you can say and what you can't," he contends. In August, for example, Internet search firm Google Inc. faced a possible delay in its highly anticipated IPO after an interview with executives was published in Playboy during Google's quiet period. The IPO ended up going through as scheduled, after the SEC mandated that the company attach the interview to its prospectus. Customer relationship management applications firm Salesforce.com, however, had no such luck: comments by CEO Marc Benioff — including an interview with the New York Times — delayed the company's IPO.

The possibility of such a penalty has forced most executives to remain tight-lipped before going public. David Johnson, CFO of Color Kinetics, a Boston-based manufacturer of high-tech lighting systems that went public last summer, says the company strictly monitored all communications with the outside world. "I don't think it serves any purpose to have companies going through this process totally closemouthed," he says.

David Arkowitz, finance chief at drug developer Idenix Pharmaceuticals, a July entrant to the public market, agrees. "For small companies, it's important to drive awareness and understanding of the company, and we were precluded from doing that," he says.

Although the SEC's proposal looks promising for companies hoping to increase information flow to potential investors, there is a question of whether businesses will be held liable for the accuracy of any information they publish or share outside the scope of the prospectus. A high degree of liability might mean the quiet period will change very little, says Clapp.


The SEC will solicit comments on the issue until February. —K.O'S.


FASB's Last Stand

Risking sudden death in overtime for its most controversial issue, the Financial Accounting Standards Board has agreed to delay by six months the implementation of a rule that would require companies to expense stock options.

Public firms wouldn't begin recording options against income until after June 15, 2005 — later than the originally proposed December 15, 2004, deadline, but not the 12-month delay some hoped for. The move came after strong lobbying by Securities and Exchange Commission staff, companies, and auditors that requested preparers be given more time to focus on internal controls.

The delay was cheered by technology companies, as it gives them more time to mount an offensive to try to dilute or kill FASB's rule through congressional support. Recently, half the members of the Senate wrote to SEC chairman William Donaldson, asking him to delay any new expensing standard for further field-testing of option-valuation models. Some are beginning to doubt that FASB's standard will see the light of day. "I believe the chances are a lot less than 50 percent," notes Robert Willens, Lehman Brothers's tax and accounting analyst.

"It's possible that we could see the legislation effort preclude expensing entirely, or some kind of [debilitating] compromise," agrees Dennis R. Beresford, University of Georgia accounting professor and former FASB chairman. "I hope that's not the case."

Opponents are expected to look for opportunities to pass anti-expensing legislation in November's lame-duck session or in the new Congress next year. Rick White, chairman of the technology-lobbying group International Employee Stock Options Coalition, says they will "push forward."

FASB board member Michael Crooch says he is focused on issuing a final statement in late December. "I'm pleased that it's coming to an end and we can get this out and move onto other issues," he says. —Craig Schneider

Through the Years
FASB's long battle over expensing.
June 1993 First proposal to expense stock options issued.
May 1994 Senate urges FASB to drop the proposal.
October 1995 Statement 123 issued; does not include expensing.
March 2003 Second project launched to consider expensing options.
July 2004 House passes bill requiring expensing for top 5 executives.
October 2004 FASB delays implementation of Statement 123R.
December 2004 FASB's final standard is expected to include expensing.
June 2005 Companies expected to begin expensing stock options.
Source: FASB



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