New Financial Reporting Committee faces uphill slog

Strategic Finance, August, 2007 by Stephen Barlas

One can only hope that Securities & Exchange Commission (SEC) Chairman Chris Cox's new SEC Advisory Committee on Improvements to Financial Reporting is a little more successful than his last advisory committee. That would be the one that made recommendations on how to make Section 404 of the Sarbanes-Oxley Act easier for small businesses to comply with. Cox has essentially ignored most of the key recommendations that committee made in 2006. Robert C. Pozen, chairman of MFS Investment Management in Boston and former vice chairman of Fidelity Investments, will chair the new committee. When he appeared with Cox for the announcement of the committee's formation, Pozen presented the typical boilerplate statement: "In addressing the complexity of the current system, our advisory committee will focus not only on offering better guidance to preparers of financial reports, but also on providing more user-friendly disclosures to meet the different needs of various types of investors." Pozen's committee will make its recommendations a few months before the next presidential election. At minimum, this will be just a few months before Cox's retirement. At maximum, it will be at a time when a Democrat may be about to move into the White House. All told, the chances for Pozen's committee to make its weight felt lie somewhere between slim and none.

Democratic Effort on Stock Option Taxation Likely

There is very likely to be a tax bill coming out of Congress this year, and taxes paid by private equity executives are already high on the "hit list" of both Republicans and Democrats. Changes to the alternative minimum tax are also in the offing. But those are individual tax issues. In the corporate area, don't be surprised to see changes to the IRS code relating to corporate stock option deductions. At Senate hearings in June, Sen. Carl Levin (D.-Mich.), chairman of the Homeland Security and Governmental Affairs Committee, said companies may be underpaying taxes by as much as $15 billion a year because, based on IRS data, corporations took deductions on their tax returns for stock option compensation expenses that were $43 billion greater than the stock option expenses shown on their financial statements for the same year. He acknowledged that the lower corporate tax bills were totally legal. In making the argument for remedial legislation, which went nowhere when he introduced it in past, Republican-controlled Congresses, Levin resorted to the same battle cry other Democrats have been issuing, saying, "The book-tax difference is fueling an ever-deepening chasm between executive pay and the pay of average workers."

What's likely to propel the Levin legislation forward in this Democrat-controlled Congress--where the tax gap is an increasingly large issue--is the added dimension of at least one questionable implementation of Statement of Financial Accounting Standards (SFAS) No. 123R, "Share-Based Payment," which came into play for the first time for 2006 financial statements. Some investor groups are already complaining that some stock option valuation methods--the "Employee Stock Option Appreciation Rights" (ESOARS) used by Zions Bancorporation, for example--result in a downward-biased valuation that underreports to investors the true costs of a company's stock option awards. The Council of Institutional Investors and the CFA Institute Centre for Financial Market Integrity (an organization representing 90,000 investment professionals in 134 countries) recently met with staff of the SEC's Office of the Chief Accountant (OCA) and requested that the OCA prohibit Zions and all other public companies from using Zions' ESOARS to value stock option awards under Statement 123R unless and until the fundamental failings of the product have been remedied.

Notching Allowed Under Final SEC Rule

The SEC reversed itself on a controversial issue when it issued the final rule on the Credit Rating Agency Reform on June 18. Back in February, in its proposed rule, the SEC had banned "notching," the process where a credit rating agency such as Moody's or S&P downgrades a collateralized debt obligation because another company such as Fitch's had rated components of the CDO. Moody's and S&P objected to that proposal. In the final rule, the SEC allows notching as one of four practices by which a credit rating agency may treat unrated assets underlying a structured product when determining a credit rating for the structured product.

STEPHEN BARLAS, EDITOR