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KBL Public Company Report Third Quarter 2009

KBL Public Company Report Third Quarter 2009

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A Brief Look At the 114 Portfolio Companies That First Reported Material Weaknesses in Internal Control Pursuant to Sarbanes-Oxley
FASB Issues Statements 166 and 167 on Securitizations and SPEs
FASB Issues SFAS 165 on Subsequent Events

A Brief Look At the 114 Portfolio Companies That First Reported Material Weaknesses in Internal Control Pursuant to Sarbanes-Oxley

A significant piece of research in the analysis of reactions to the Sarbanes-Oxley Act of 2002 (SOX) was “Section 404 of the Sarbanes-Oxley Act: Did the Stock Market Anticipate It?,” in which Kanalis Ockree and James Martin analyzed the first 114 publicly traded companies that disclosed material weaknesses in internal control between January 1, 2005 and May 31, 2005. Of the original 114 companies reporting material weaknesses, 31 (27%) were no longer publicly traded three years later.

The research findings in this analysis of a portfolio of companies that first reported material weaknesses in internal control pursuant to SOX are noteworthy and robust:

When compared to all publicly traded companies, the portfolio companies had a marked increase in merger and acquisition activity or were delisted from the stock market. Potential reasons for this increased mortality include the desire to eliminate SOX-related disclosures required of publicly traded companies, corporate acquisition opportunity, or general business failure.
Analysts commonly rely on the Beta coefficient of a company’s stock as an indicator of its risk relative to other investment opportunities. Risk, as measured by the average Beta coefficient of stocks in the portfolio, was above average at the time the initial material weaknesses were disclosed. During periods following this reporting, this average Beta coefficient continued to increase for those companies that did not delist or that were not acquired by another company
The stock of the companies in the research portfolio was more likely to be held by institutional shareholders than that of the average publicly traded company. Taking into consideration the higher Beta coefficient of the portfolio stocks, this finding is consistent with prior research linking institutional shareholders to greater appetites for risk.
The market return on stocks in the portfolio was dramatically below a Russell 2000 benchmark for the approximately three year period following an announcement of the material weakness. This is despite the higher risk associated with the material weakness portfolio.
An analysis of the purchases and sales of company stock by the 10 largest insiders following an announcement of material weakness found that insiders were more likely to be sellers than buyers when compared to the market in general. In addition, within the portfolio, the average stock sale was 8.6 times the size of the average stock purchase, as to a ratio of 1.7 times in the market in general.
It is anticipated that management changes, particularly changes in the CEO, may follow disclosure of material weaknesses. The CEO rate turnover following the announcement of the material weakness was found to be higher than average. Compared to historical levels, observed portfolio CEO annual turnover rates were 1.4 to 2.1 times higher than historic benchmarks.
Given that CFOs are most likely to be responsible for the maintenance of adequate internal control procedures, it was anticipated that CFO changes may follow disclosure of material weaknesses. Like the observed CEO turnover rates, CFO turnover rates were also found to be higher than average following the disclosure of material weakness when compared to industry benchmarks.
The analysis of portfolio companies in years following disclosure of a material weakness found a dramatic increase in the percentage of companies changing auditors in the first year after disclosure. In the second year following disclosure, however, portfolio companies were much less likely to change external auditors than the market in general.
The earliest companies reporting material weaknesses made substantial strides in improving internal control. The percentage of portfolio companies reporting material weaknesses in internal control dropped to 19% in the second year and 17% in the third year of reporting. Although still higher than the market in general, this improvement was significant.

FASB Issues Statements 166 and 167 on Securitizations and SPEs

On June 12, 2009, the Financial Accounting Standards Board (FASB or the Board) announced the issuance of Statement of Financial Accounting Standards (SFAS) No. 166, Accounting for Transfers of Financial Assets, and SFAS 167, Amendments to FASB Interpretation No. 46(R), which change the way entities account for securitizations and special-purpose entities. Both SFAS 166 and SFAS 167 will impact financial institution balance sheets beginning in 2010.

FASB revised these statements at the request of the Securities and Exchange Commission (SEC), investors and The President’s Working Group on Financial Markets. Below is a summary of each of these standards.

Please note that the summary below is intended as general information and should not be relied upon as being definitive.

SFAS 166, Accounting for Transfers of Financial Assets

SFAS 166 revises SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets.

Qualifying special-purpose entities (QSPEs), which generally are off-balance sheet entities, are exempt from consolidation prior to the issuance of this standard. Under the new standard, the concept of QSPEs is eliminated. Many QSPEs that currently are off balance sheet will become subject to the revised guidance for consolidations of variable interest entities.

The Board issued SFAS 166 to address: (1) practices that have developed since the issuance of SFAS 140 that are not consistent with the original intent and key requirements of SFAS 140; and (2) concerns of financial statement users that many of the financial assets (and related obligations) that have been derecognized should continue to be reported in the financial statements of transferors.

Objective

The objective of SFAS 166 is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement in transferred financial assets.

Scope

SFAS 166 has the same scope as SFAS 140, thus applies to all entities.

SFAS 166 Changes to Current Practice

Current practices impacted by FASB’s issuance of SFAS 166 include the following:

Removes the concept of a QSPE from SFAS 140 and removes the exception from applying FASB Interpretation No. 46(R) (FIN 46(R)), Consolidation of Variable Interest Entities, to QSPEs.
Clarifies the objective of paragraph 9 of SFAS 140, which is to determine whether a transferor and all of the entities included in the transferor’s financial statements being presented have surrendered control over transferred financial assets.
Defines the term participating interest to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale.
Removes special provisions for guaranteed mortgage securitizations in SFAS 140 and SFAS 65, Accounting for Certain Mortgage Banking Activities, to require those securitizations to be treated the same as any other transfer of financial assets within the scope of SFAS 140, as amended by SFAS 166.
Requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale.
Requires enhanced disclosures to provide financial statement users with greater transparency about transfers of financial assets and a transferor’s continuing involvement with transferred financial assets.

Effective Date

SFAS 166 must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. SFAS 166 must be applied to transfers occurring on or after the effective date.

Additionally, on and after the effective date, the concept of a QSPE is no longer relevant for accounting purposes. Therefore, formerly QSPEs (as defined under previous accounting standards) should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance. If the evaluation on the effective date results in consolidation, the reporting entity should apply the transition guidance provided in the pronouncement that requires consolidation.

Additionally, the disclosure provisions of SFAS166 should be applied to transfers that occurred both before and after the effective date of this Statement.

Convergence

In the short term, this new standard improves convergence with International Financial Reporting Standards (IFRS) by eliminating the concept of a QSPE, which does not exist in IFRS, and by limiting the portions of financial assets that are eligible for derecognition. This standard also incorporates certain of the disclosures currently required by IFRS 7, Financial Instruments: Disclosures.

SFAS167, Amendments to FASB Interpretation No. 46(R)

SFAS 167 is a revision to FIN 46(R) and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance.

The Board issued SFAS 167 to address: (1) the effects on certain provisions of FIN 46(R) as a result of the elimination of the QSPE concept in SFAS 166; and (2) constituent concerns about the application of certain key provisions of FIN 46(R), including those in which the accounting and disclosures under FIN 46(R) do not always provide timely and useful information about an enterprise’s involvement in a variable interest entity (VIE).

Objective

The objective of SFAS 167 is to amend certain requirements of FIN 46(R), to improve financial reporting by enterprises involved with VIEs and to provide more relevant and reliable information to users of financial statements.

Scope

SFAS 167 retains the scope of FIN 46(R) with the addition of entities previously considered QSPEs, as the concept of these entities was eliminated in SFAS 166.

SFAS 167 Changes to Current Practice

FASB’s issuance of SFAS 167 amends FIN 46(R) as follows:

Requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE.
Requires ongoing reassessments of whether an enterprise is the primary beneficiary of a VIE.
Eliminates the quantitative approach previously required for determining the primary beneficiary of a VIE, which was based on determining which enterprise absorbs the majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both.
Amends certain guidance in FIN 46(R) for determining whether an entity is a VIE. It is possible that application of this revised guidance will change an enterprise’s assessment of which entities with which it is involved are VIEs
Adds an additional reconsideration event for determining whether an entity is a VIE when any changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance.
Eliminates the exception that existed under FIN 46(R) where a troubled debt restructuring as defined in paragraph 2 of SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings was not an event that required reconsideration of whether an entity is a VIE and whether an enterprise is the primary beneficiary of a VIE.
Requires enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a VIE

Effective Date

SFAS 167 shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited.

Convergence

Although SFAS 167 was not developed as part of a joint project with the International Accounting Standards Board (IASB), the FASB and IASB continue to work together to issue guidance that yields similar consolidation and disclosure results for special-purpose entities. SFAS 167 addresses the potential impacts on the provisions and application of FIN 46(R) as a result of the elimination of the QSPE concept in SFAS 166. FASB states that ultimately, the two Boards will seek to issue a converged standard that addresses consolidation of all entities

FASB Issues SFAS 165 on Subsequent Events

On May 28, 2009 the Financial Accounting Standards Board (FASB) announced the issuance of Statement of Financial Accounting Standards No. 165, Subsequent Events (SFAS 165). SFAS 165 should not result in significant changes in the subsequent events that an entity reports. Rather, SFAS 165 introduces the concept of financial statements being available to be issued. Financial statements are considered available to be issued when they are complete in a form and format that complies with generally accepted accounting principles (GAAP) and all approvals necessary for issuance have been obtained.

Please note that the summary below is intended as general information and should not be relied upon as being definitive.

Objective

The objective of SFAS 165 is to establish general standards for the accounting and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, SFAS 165 sets forth:

1. The period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements.

2. The circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements.

3. The disclosures that an entity should make about events or transactions that occurred after the balance sheet date

Scope

SFAS 165 shall be applied to the accounting for and disclosure of subsequent events not addressed in other applicable GAAP for interim and annual financial statements.

Recognition

An entity shall recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. SFAS 165 provides examples of recognized subsequent events.

An entity shall not recognize subsequent events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after the balance sheet date but before financial statements are issued or are available to be issued. SFAS 165 provides examples of nonrecognized subsequent events.

Disclosure

An entity shall disclose the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued or the date the financial statements were available to be issued.

Some nonrecognized subsequent events may be of such a nature that they must be disclosed to keep the financial statements from being misleading. In such cases, an entity shall disclose: 1) the nature of the event and 2) an estimate of its financial effect, or a statement that such an estimate cannot be made.

Effective Date

SFAS 165 is effective for interim or annual financial periods ending after June 15, 2009 with prospective application.


Any tax advice in this communication is not intended or written by KBL, LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer, or (ii) promoting, marketing, or recommending to another party any matters addressed herein. With this alert, KBL, LLP is not rendering any specific advice to the reader.

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