January 2006 Newsletter

Conflicting Definitions of Net Worth

During September 2005 the Court of Appeals at Houston (14th District) issued its opinion regarding net worth in the context of supersedeas bonds (Ramco v. Anglo Dutch, No 14-04-00433-CV). The court adopted the GAAP definition of net worth; the difference between assets and liabilities as reflected on audited balance sheets. The opinion points to substantial differences in the measurement of net worth for supersedeas bonds versus the measurement for solvency purposes.

Within the opinion, reference to federal courts using the same definition of net worth does not include cases involving solvency which in our opinion should be consistent with net worth. Clearly courts use the "fair value" or fair market value of assets to measure solvency. For example, within the Texas Business & Commerce Code: "§ 24.003. INSOLVENCY. (a) A debtor is insolvent if the sum of the debtor's debts is greater than all of the debtor's assets at a fair valuation." Moreover, solvency for bankruptcy purposes is defined in the same manner (11 U.S.C. §101 (32)(A)).

From an accounting perspective, GAAP financial statements do not attempt to value fixed asset or real property (including oil & gas properties at issue in the cited case) at their fair market value on the balance sheet. Instead GAAP balance sheets use historical cost that may bear little relation to the fair market value of an asset.

The situation exists that on the one hand, for the purpose of solvency, inquiry is at the fair market value level and on the other hand, for bonding purposes, inquiry occurs at the GAAP level. When assets have a fair market value in excess of their historical GAAP value, this inquiry at the GAAP level can be irrelevant to the amount of the bond and alleged financial hardship on the obligor because the assets have fair market value in excess of their carrying values for financial statement purposes.

Debt Recharacterization

More frequently, we observe fact issues about whether an account on the books of a company is debt or equity. This makes a difference when one assesses solvency because a liability that is recharacterized as equity can change insolvency to solvency.

Factors identified by the Fifth Circuit in its analysis of debt versus equity (Estate of Mixon v. United States, 464 F.2d 394 et seq. (5th Cir. 1972)) are:

1) the names given to the certificates evidencing the indebtedness;

2) the presence or absence of a fixed maturity date;

3) the source of payments;

4) the right to enforce payment of principal and interest;

5) participation in management flowing as a result;

6) the status of the contribution in relation to regular corporate creditors;

7) the intent of the parties;

8) "thin" or adequate capitalization;

9) identity of interest between creditor and stockholder;

10) source of interest payments;

11) the ability of the corporation to obtain loans from outside lending institutions;

12) the extent to which the advance was used to acquire capital assets; and

13) the failure of the debtor to repay on the due date or to seek a postponement.

While some distinguish this case being a "tax" case, the court's analysis from an economic and accounting perspective is relevant to any situation.

New Fraud Guidance for Compilations and Reviews

The American Institute of Certified Public Accountants (AICPA) amended statement on standards for accounting and review services (SSARS) no. 1, Compilation and Review of Financial Statements by issuing SSARS no. 12, Omnibus Statement on Standards for Accounting and Review Services. SSARS 12 makes specific changes related to an accountant's consideration of fraud and illegal acts in compilation and review engagements.

As discussed in the January 2005 edition of the Journal of Accountancy, this standard does not require a CPA to assess the risk of fraud or to plan a compilation or review specifically to discover fraud. However, CPAs are required to inform the client if incorrect, incomplete or otherwise unsatisfactory information comes to their attention during the engagement. Additionally, for review engagements, as included in SSARS 10, CPAs must make specific inquiries and obtain specific written representations from management about fraud.

According to the article, in compilation engagements, the top three causes of malpractice claims from 1994 - 2000 were: errors on financial statements (33%), failure to detect defalcation (25%) and engagement scope dispute (18%).

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