SAB 108: K-Swiss Cleans House

From AAO Weblog

In its 10-K filed last Thursday, sneaker maker K-Swiss presented its clean-up adjustment of payroll withholding taxes:

“In 2006, we determined that there was an underpayment of payroll withholdings in a foreign jurisdiction from January 1, 1993 through December 31, 2006. With the assistance of our tax advisors, we estimated underpayment of withholdings of approximately $5,131,000 and related interest of approximately $5,974,000, totaling $11,105,000.”

All told, the company adjusted its retained earnings balance for a net amount of $7.9 million – which would be a pretty sizable chunk of its $76.9 million in 2006 earnings. That is, a sizable chunk, if Staff Accounting 108 didn’t give companies the chance to catch up adjustments through retained earnings. Instead of making such housecleanings visible through a charge on the income statement, SAB 108 forces investors to look through the notes or the equity section of the balance sheet to find them.

Yes, those amounts didn’t all relate to 2006, as defenders of the approach might say. Then again, they didn’t relate to activity for 2006 in retained earnings, either. When you’ve got charges relating to the wrong periods, it’s best to restate in order to present the best picture of what really happened in the company. If the SEC isn’t going to require firms to do that, at least they should have required them to make the cleanup visible in the income statement – something to point investors to the discussion of the cleanup.

It’s an interesting little case. The errors were discovered in 2006, according to the disclosure – but they went all the way back to 1993. For the period 1993 to 2001, the cumulative errors amounted to 3.59% of the net income for the period – a pretty significant error, and you have to wonder how much any one year could have been affected in that nine-year stretch. Between 2002 and 2005, the errors never mattered to net income by more than 2.16%.

The errors weren’t found until 2006, according to the filing. But the consequences live on. The total aftertax recognition of the payroll tax adjustments was $10.982 million; assuming a 35% tax rate, the gross under-withholding would be $16.985 million. According to the filing, the penalties in that particular jurisdiction can run from zero to 300% of the taxes owed – so there could still be a large tax bill down the road, maybe as much as $50 million. For perspective, that’s about two-thirds of the company’s net income for 2006. Little mistakes over time can really add up.

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