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By Reva B. Steinberg and
Dorothy E. Walker

Each year the AICPA sponsors the National Conference on Current SEC Developments. The program provides a forum for auditors and registrants to discuss accounting and auditing issues while interacting with the Securities and Exchange Commission (SEC or commission) staff. The 24th annual conference was held on December 10 and 11, 1996, and included speeches by an SEC commissioner and its chairman, as well as presentations by senior SEC staff, senior officials of the Financial Accounting Standards Board (FASB) and other professionals. A central theme of many presentations was the current challenge faced by registrants and their auditors to provide meaningful and accurate financial information in today's changing marketplace.

SEC Chairman Arthur Levitt

Chairman Levitt discussed the role of accountants in the coming millennium: "to act as an independent check on the natural inclination of companies and governments to show themselves in the best possible light." Two of the ways accountants provide this reality check are by setting high quality accounting standards and by independently and impartially auditing financial statements. Chairman Levitt expressed continued support for keeping the standard setting process in the private sector. He is concerned, however, about auditing firms becoming too focused on consulting and other services, at the expense of the audit function. Auditors must continue to make the necessary investments to assure that audit quality is not compromised; auditing must not become a loss leader for consulting firms.

The SEC's Chief Accountant

Michael Sutton addressed five "dangerous ideas" held by some accountants and why these notions must be viewed with skepticism:

1. "The matching principle should take precedence in shaping financial statements," and "... current period losses can create assets." Although companies would not incur costs without expecting future benefits, it is difficult for investors to understand why things like advertising (normally associated with ongoing operations) or start-up costs represent assets. Matching and loss deferrals have the potential to undermine the integrity of the balance sheet and the quality of earnings.

2. "Intangible assets have indefinite lives." The International Accounting Standards Committee currently is considering an approach that would establish no upper limit on the amortization period for certain intangible assets. Instead, companies would continually be required to test such assets for impairment. Mr. Sutton questions whether such an impairment standard successfully could be developed. He believes that the large number of sudden and major goodwill write-offs indicates that amortization periods of 25 to 40 years currently used by many companies may be too long.

3. "Good disclosure can cure bad accounting." No amount of supplemental disclosure can justify the use of unacceptable accounting principles.

4. "Accounting drives business decisions." From time to time the SEC staff hears that it will be impossible to consummate a particular transaction if a particular accounting treatment is not allowed. The accounting tail should not be wagging the business dog.

5. "Auditors have closed the expectation gap." Even the new auditing standard on fraud cannot be expected to totally close the gap. Auditors should speak up not only when things are wrong, but when they are not quite right.

Mr. Sutton concluded by saying, "sometimes the biggest challenge posed by 'dangerous ideas' is recognizing them...."

SEC Enforcement Issues

Detection of financial fraud is a commission priority. Liability for fraud evolves in several ways. First, companies may be liable for fraud, false filings, including financial statements and Management's Discussion and Analysis ("MD&A"), inadequate internal controls, and maintaining false books and records. Second, officers may be liable for fraud or other violations of the securities laws, aiding and abetting a company's violations, causing a violation of securities laws, falsifying books and records, and lying to auditors. Last, whenever the staff discovers financial fraud by a registrant, it also examines the role of the independent auditor.

The Division of Enforcement issued 74 Accounting and Auditing Enforcement Releases in 1996 through November.

Revenue recognition is a frequent problem. Some examples: A sale is not a sale without the customer's acceptance of the product. A bill and hold sale qualifies for revenue recognition only in unique and controlled circumstances. A transaction does not qualify as a sale if the seller has a "continuing involvement" or if the sale is subject to a significant future contingency, often manifested in "side letter" agreements. Improper use of percentage of completion method of accounting for long term contracts results in premature recognition of

Delayed recognition of losses also continues to occur. The reserve for losses on accounts receivable must be adequate to cover probable losses; inventory obsolescence needs to be monitored and recorded on a timely basis. Impairment in value can be a concern for equity investments, fixed assets, and real estate. Capitalization of certain costs, such as research and development that should be expensed, or soft costs, such as advertising and pre-opening that may be capitalized only in limited circumstances, can result in improper deferral of current period expenses.

The division is also bringing cases for Foreign Corrupt Practices Act violations, nonexistent inventories and receivables, unrecorded liabilities, lack of appropriate disclosure in MD&A, and false confirmations, as well as audits not performed in accordance with generally accepted auditing standards. Division speakers alerted auditors that more companies are using transactions with foreign entities to facilitate fraudulent financial reporting and to make transactions more difficult to audit.

The staff also devoted considerable time voicing concerns that auditing firms are becoming more focused on providing consulting and other services at the expense of the audit function. In this regard, echoing Chairman Levitt's concerns, Bill McLucas, director of the division, spoke pointedly about what he called "the seduction of the profession."

Current Accounting Projects--
Office of the Chief Accountant

The SEC staff, as usual, covered a wide variety of topics in their prepared remarks and the question-and-answer sessions.

Stock-Based Compensation (SFAS No. 123). Registrants were reminded that the fair value approach is not optional for transactions with other than employees. SFAS No. 123 does not answer the question of whether independent contractors should be considered employees. Until further guidance is provided, the SEC staff will be dealing with the facts and circumstances of each specific case.

Business Combinations. The SEC staff continues to deal with numerous questions concerning the proper accounting for business combinations. With few exceptions, they would require registrants to use purchase accounting unless all of the criteria for pooling-of-interests accounting are met. Exceptions related to certain requirements (e.g., autonomy of the combining entities, no planned transactions, or changes in equity interests) are being considered only on a case-by-case basis. They also discussed valuation of securities issued to effect a purchase. Discounts from quoted market price are acceptable only if there is verifiable objective evidence to support such value. Factors to consider include the period of restriction, if any; the potential for exercise of piggyback rights; large block factors; illiquidity of the market; volatility of stock price; and time value.

Rule 3-05. The commission recently adopted amendments to Rule 3-05 of Regulation S-X to streamline the requirements for financial statements of businesses acquired or to be acquired. The amendments eliminate the requirements to provide financial statements for businesses falling below the 20% significance level, and require one, two, or three years of audited financial statements for acquisitions at the 20%, 40%, and 50% significance level, respectively. The thresholds were formerly 10%, 20%, and 40%. The new rules also allow a registered offering without the financial statements of a business acquired or likely to be acquired until 75 days after the acquisition, unless the acquiree is significant at the 50% level.

Pro Forma Financial Information. The staff reminded registrants that the application of the pro forma rules in Article 11 of Regulation S-X is very mechanical. Allowable adjustments and form of presentation as laid out in the rules are strictly interpreted by the staff.

Derivatives and Hedging. The staff stressed concerns that registrants are not providing adequate, meaningful disclosure about how and why they are using derivatives, and the methods used to account for them. In January 1996, the SEC issued a proposed rule that would require, among other things, disclosures of qualitative and quantitative information about market risk inherent in derivative financial instruments, other financial instruments, and derivative commodity instruments. Although the final rule on quantitative disclosures is not expected to be effective for 1996 annual reports, the staff expects registrants to comply with the interpretive guidance in the proposing release. This guidance is a reminder of what registrants should already be disclosing in their filings. It reminds registrants that when providing disclosure about items such as financial instruments, commodity positions, firm commitments, and other anticipated transactions, the disclosure must include information about derivatives that materially affects those reported items. For example, registrants should disclose the effect of derivatives on interest rates and the reporting characteristics of debt obligations.

Plain English. The Staff Task Force on Disclosure Simplification has recommended requiring "plain English" disclosure to improve readability of the prospectus and other documents. According to the task force, issuers, underwriters, and their attorneys often draft documents filled with jargon and overinclusive disclosures, making it difficult for readers to distinguish material information from boilerplate. The Division of Corporation Finance has created a pilot program and is working with volunteer registrants on techniques for designing and drafting plain English documents. Participants in the pilot program will receive expedited reviews.

Prefiling Conferences. The staff, as always, encourages registrants to request prefiling conferences to discuss potentially controversial issues with the staff. Such conferences can often save a registrant time in the registration process.

Financial Accounting Standards Board

James Leisenring, vice chairman of the FASB, discussed the status of various current projects, in particular the derivatives and hedging project. He indicated that there is support for measuring all derivatives at fair value, but continued controversy over whether changes should be recognized as a separate component of equity or in the income statement. The project is a priority and the FASB hopes to have the issues resolved by June 1997. Mr. Leisenring also discussed some new projects; the FASB has decided to readdress accounting for business combinations and stock compensation issues not addressed by SFAS No. 123.

The Private Securities Litigation Reform Act of 1995--One Year Later

This law, among other things, codifies professional auditing standards relating to illegal acts, related party transactions, and going concern issues. Further, it requires auditors to report, in a timely manner, certain uncorrected "illegal acts" to a registrant's board of directors and to provide information regarding the illegal act to the SEC if the registrant's board of directors fails to do so. The SEC has proposed rules providing implementation guidance for the reporting requirements of the new law. Reports would be received by the Office of the Chief Accountant. The report would be in writing and identify the registrant and the auditor, state the date the auditor made its report to the board, and provide a summary of the report describing the act and the potential impact of that act on the registrant's financial statements.

The proposed rule provides that the reports of both the board and the auditor would be nonpublic and exempt from disclosure under the Freedom of Information Act to the same extent as the SEC's investigative records. *

Notes: 1. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for speeches made by its employees. Accordingly, the presentations reflect the views of the speakers and do not necessarily reflect the views of the commission or other staff members.

2. On January 31, 1997, the SEC issued Release Nos. 34-38223 and 33-7386: Final Rule to Require Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Qualitative and Quantitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments, effective for fiscal periods ending after June 15, 1997.

Reva B. Steinberg, CPA, is the director of accounting research and Dorothy E. Walker, CPA, is a senior manager at Ten Eyck Associates, Inc., a technical and litigation consulting firm with offices in King of Prussia, Pennsylvania and Washington, D.C.

Gary Illiano
Grant Thornton LLP

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