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Auction-Rate Securities: Hold That Gavel
The securities--long-term bonds that act like short-term debt--have often helped treasurers squeeze out added return on corporate cash balances. But a bevy of woes is making it tougher to embrace the cash-management tool.
Marie Leone,
April 25, 2005

Earlier this month, software supplier Comverse Technology Inc. changed the classification of nearly $2 billion worth of auction-rate securities to short-term investments. Previously, the bonds had been slotted as cash or cash equivalents, the more common accounting treatment.

Following the same trend, clothing retailer Abercrombie & Fitch Co., Lawson Software Inc., and bookseller Borders Group Inc. retagged $465 million, $354 million, and $118 million worth of ARS, respectively. So did the tiny search engine company GuruNet Corp., which moved its $1 million investment in the bonds into the short-term-investments column.


Since December, when Ernst & Young first began advising clients to make the change, scores of CFOs have altered the accounting treatment for ARS. The new interpretation of two accounting standards is now endorsed by the Financial Accounting Standards Board, the Securities and Exchange Commission, and the Public Company Accounting Oversight Board, as well as all the Big Four auditors. (The reinterpreted standards are FAS No. 95, Statement of Cash Flows, and FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.)

A current SEC probe of the auctions, in which investigators are reportedly looking into alleged "bid rigging" within the ARS market, doesn't appear to involve accounting treatment of the securities. But the investigation led some audit clients to reevaluate their investments and later question the accounting treatment, according to an audit manager who preferred not to be identified. After taking another look at the accounting rules, each of the Big Four concluded that a wholesale reinterpretation of the standards was needed, and the audit firms passed the word to their clients.

The accounting change might turn out be the latest crimp in corporate treasurers' use of what's long been seen as an effective cash-management tool. The securities are long-term municipal and corporate bonds (usually with 20-year to 30-year maturities) that are priced and traded like short-term debt.

The reason for the resemblance to short-term debt is that ARS interest rates are reset through a Dutch auction. In a Dutch auction, what sets the price is the bid with the lowest yield that would enable all the bonds in a single block to be sold. (A block of bonds is usually worth at least $200,000.) Generally, the auctions are held every 7, 28, or 30 days, which gives finance executives a chance to liquidate their holdings when they need cash.

The allure of the high-quality bonds — they're often rated AAA — is that they offer a slightly higher-yielding alternative to money-market accounts, commercial paper, and other liquid investments. "The spreads on auction-rate bonds were always a little higher [than other cash-management options], say 4 to 10 basis points, because of the complexity of the product," notes Jim Anderson, chief investment officer of SVB Asset Management, which manages fixed-income portfolios for corporations.

Corporate bond investors represent roughly half of the $200 billion ARS market, with the remainder consisting of individual investors, notes Lance Pan, director of credit research at Capital Advisors Group (CAG), which manages $5.5 billion worth of corporate cash assets.

Most corporate ARS investors revealed the accounting change in their first-quarter regulatory filings. Many companies also noted that the adjustments were immaterial and therefore have no adverse affect on the company's financial performance. Some experts say, however, that the impact of the reclassification may have hidden consequences that CFOs have yet to discover, including market-liquidity problems and debt covenant-defaults.

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