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By Roy Van Brunt and
Reva B. Steinberg

The American Institute of Certified Public Accountants (AICPA) held its 25th National Conference on Current SEC Developments on December 9 and 10, 1997. 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 conference included speeches by an SEC commissioner, as well as presentations by senior SEC staff, senior officials of the Financial Accounting Standards Board (FASB), and other professionals. This year's sold-out event was simulcast not only to a nearby hotel, but also to AICPA offices in New Jersey and even to London.

Auditor Independence

Virtually every speaker touched on the subject of independence in some way. Both Commissioner Isaac Hunt, the keynote speaker, and Chief Accountant Michael Sutton stressed that independence is the cornerstone of the disclosure process upon which investors have continued and will continue to rely in making investment decisions and that auditor independence is essential in maintaining investor confidence in capital markets.

Speakers kept returning to two major issues affecting auditor independence: big firm mega-mergers and the expansion of nonaudit services--which are seen by some to create unacceptable conflicts or mutuality of interest. Commissioner Hunt noted that after the latest mergers, two of the "Big Four" will audit 63% of public companies in the U.S. and a large percentage of public companies in the United Kingdom. He is concerned that the mergers will have an impact on both the fact and appearance of independence. As to auditors performing consulting and other nonaudit services for their audit clients, Commissioner Hunt is troubled about auditor reliance on consulting fees and other business relationships. He does not anticipate rules restricting services in any way, just rules taking the position that such services impair independence.

Hoping to alleviate some of these emerging independence concerns, the SEC worked with the AICPA to create the new Independence Standards Board (ISB). The SEC expects to issue a release early in 1998 that will recognize this board as the professional body responsible for setting independence standards for public company auditors. This release will be much like the SEC's release ASR 150 which recognized the Accounting Principles Board and Financial Accounting Standards Board. The SEC will then cede its day-to-day standard setting role in the independence area to the ISB. This standard setting process is clearly in an early stage, but one that bears watching. The initial ISB activity will focus on a "white paper," prepared at its request by the AICPA. This paper envisions a plan under which the ISB would establish a set of core principles and publish guidelines under which those principles could be attained. Individual accounting firms would then design and implement their own codes to assure the independence of their members.

Commissioner Hunt cautioned that broad standards envisioned by the white paper do not address what he believes are the core issues, and "if the ISB efforts prove unable to effectively regulate this area, the SEC will re-assume its authority." Michael Sutton commented that "all agree" with the paper's assertion that auditor independence is an important issue, and that "most would agree with framing the discussion within the context of the changing business and professional environment." It is also clear, he said, that "we all could, and should, learn more," and that research is needed to identify the independence issues that affect investor confidence. He believes that other views will need to be solicited, considered, aired, and discussed, and that this process will take time.

Michael Sutton; William McLucas, Director of the Division of Enforcement; and Robert Bayless, Chief Accountant, Division of Corporation Finance, all expressed additional concerns about how often accountants fail to bring their expertise and independent judgment to bear on issues, but rather bow to pressure from clients, firms, and employers. In some instances, positions taken by accountants or auditors appear to be so far outside the parameters of professional standards, that the staff can only suspect that the auditors' independence has simply eroded.

Mr. Sutton spoke about the importance of the role of an effective Emerging Issues Task Force (EITF)--one that deals with current issues in "candor, objectivity, and technical competence." In his view the EITF works best when it is relatively free from outside pressure and when its members are able to express and argue for their views separate from firm and client-generated pressures. He expressed frustration with instances in which he perceived that certain issues were being kept "off the table" because of such pressures. He is puzzled with issue summaries that propose "alternatives" which clearly ignore existing generally accepted accounting principles (GAAP) or the advice of FASB.

Mr. McLucas expressed concerns about the continuing contentiousness between business and the FASB. He believes the FASB is "besieged" with client advocacy. He also is concerned with megamergers and the balance of power between the consulting and auditing arms of the largest firms.

Mr. Bayless talked about "managing earnings" and "materiality." He discussed what the staff sees as a growing number of cases in which clear violations of accounting and/or disclosure rules are contained in filings, but about which registrants and their accountants, when asked, express little concern because of supposed "immateriality." He and Corporate Finance Director Brian Lane, both expressed the view that such acceptance of plainly wrong procedures or methods is disturbing and cannot be condoned. In a world in which P-E ratios have grown exponentially, and in which a company's failure to achieve an earnings level forecast can and does have a significant impact on stock prices, stretching to achieve a specific number is becoming commonplace, even if the stretch employs unacceptable accounting that is not "materially wrong."

Ordinarily, violations of GAAP would be considered immaterial if developing information necessary to apply GAAP would not meet a cost/benefit test. Mr. Bayless is disturbed when independent accountants and registrants defend violations of GAAP as not material when a registrant has obviously spent a lot of money in order to generate accounting entries that violate GAAP. If the accounting departure is immaterial, why spend so much time and effort to do it? He provided an example of a company that devoted substantial resources to capturing data to improperly capitalize certain period costs. He also talked about managing earnings in the other direction by improperly recording liabilities. Restructuring charges is a particularly abused area, according to Mr. Bayless

Accountants' Refusal to
Re-Issue Audit Report

Accounting firms sometimes refuse to re-issue their reports on the audits of financial statements that have been included previously in SEC filings. For example, an accountant whose report on an acquired business was included in a registrant's form 8-K may later decline to permit that report to be included in the registrant's subsequent registration statement. Or, an accountant may decline to reissue a report on the registrant's financial statements after the registrant has engaged a different auditor. The staff is not in a position to evaluate the reasons for the accountant's refusal to re-issue a report and will not intervene in disputes between registrants and their auditors. Moreover, the staff will not waive the requirements for the audit report or the accountant's consent to be named as an expert in filings. A registrant that is unable to obtain either re-issuance of an audit report or a new audit by a different firm may be precluded from raising capital in a public offering.

When a registrant engages an auditor, it should consider the need for the accountant to re-issue its audit report in future periods. The registrant should consider addressing in the audit engagement letter its expectations regarding the use of the audit report in filings to be made under either the Exchange Act or the Securities Act and the circumstances under which the accountant may decline to permit its use.

International Accounting Standards

Commissioner Hunt and Michael Sutton both commented on progress in the area of international harmonization of accounting standards and the development of a core body of standards. The commission's acceptance of those core standards in securities offerings by foreign registrants is not a foregone conclusion. It is predicated on the notion that that body of standards developed will be comprehensive, of high quality, and capable of being rigorously interpreted and applied.

SEC Enforcement Issues

Detection of financial fraud is a commission priority. The expanding use of the Internet has raised some issues for the staff, e.g., jurisdictional and international. But according to Special Counsel for Internet Projects John R. Stark, the Internet, for the most part, is merely a new medium for the "same old nefarious, cunning, and shifty bad guys" with the same old swindles. The staff is seeing problems in the offer and sale of bogus investments, market manipulations, online trading facilities, spamming, unregistered investment advisors and investment newsletters, and off-shore broker-dealers and other financial service entities.

The staff, however, is not seeking any new laws, regulations, or rules. The staff is using surveillance (which in some ways the Internet has made easier), self-policing (there are more complaints: the complaints are often well-researched and communicated to the staff through the Internet), investigation and prosecution, education (the SEC's website has information, alerts, and checklists), and liaison with other law enforcement authorities. And since the perpetrators still need to get to the money somehow, the staff has been able to find them so far by following the money.

The Division of Enforcement issued 106 Accounting and Auditing Enforcement Releases in the first nine months of 1997. The releases involved market manipulation, misapplication of accounting for a purchased business, statements in management's discussion and analysis, improper revenue recognition, inflating assets, faulty interim financial statements, municipal securities transactions, falsification of confirmations, foreign investigations, violations of the Foreign Corrupt Practices Act, and Rule 102(e) proceedings against accountants.

Current Accounting Projects--
Office of the Chief Accountant and Division of Corporation Finance

The SEC staff, as usual, covered a wide variety of topics in their prepared remarks and the question-and-answer sessions. Copies of speeches are available on the SEC's website at www.sec.gov.

Stock-Based Compensation (SFAS No. 123). Companies that continue to follow the accounting provisions of APB No. 25, Accounting for Stock Issued to Employees, for stock-based compensation must include in notes to the financial statements certain pro forma data to disclose the effects had the accounting provisions of SFAS No. 123 been applied. The staff has challenged the view of some registrants that the fair value of those options, revealed through the required pro forma earnings disclosure and related assumptions, is not material to investors. The keen interest of investors in stock compensation as demonstrated by continuing press coverage and the related party nature of stock plans create a presumption that the disclosures ordinarily will be considered material to readers of the financial statements if stock compensation is a significant component of compensation arrangements.

In addition, the staff has questioned values assigned to nonemployee stock options and warrants and the misuse of option pricing models. They have also challenged values attributed to stock and stock options issued to employees shortly before an IPO.

Business Combinations. The SEC staff continues to raise numerous questions about accounting for business combinations. Deputy Chief Accountant Jane Adams expressed her view that APB 16 is a "quagmire" that absorbs too many resources of the staff, practitioners, and businesses. For example, the speakers at this conference spent a good deal of time on rather technical questions dealing with issues such as when "tainted" treasury shares prohibit pooling of interests accounting.

Year 2000 Issues. The staff is very serious about requiring companies to discuss the implications of the "Year 2000" issue in their MD&A. Disclosures should be made when the cost of addressing the issue is material to future operating results or financial condition. Further, disclosure is required if the costs or consequences of incomplete or untimely resolution of the issue represent a known material event or uncertainty that is reasonably likely to affect a registrant's future financial results or to cause its reported financial information not to be necessarily indicative of future operating results or financial condition. Given the widespread knowledge about the year 2000 issue and the fact that businesses are operationally interdependent, it seems likely that the year 2000 issue is a trend, demand, commitment, event, or uncertainty for almost all registrants. Registrants are advised against narrowly construing the MD&A requirements in connection with this issue.

Derivatives and Hedging. The SEC recently adopted amendments to Regulation S-K and S-X to clarify and expand requirements for disclosures about derivatives and market risks inherent in derivatives and other financial instruments. The release covers derivative financial instruments as defined in SFAS No. 119 (including futures, forwards, swaps, and options) and derivative commodity instruments that are permitted by contract or business custom to be settled in cash or with another financial instrument (e.g., commodity futures or commodity forwards). In general, the release requires enhanced descriptions of accounting policies for derivatives in the notes to the financial statements, including a description of i) each method used to account for derivatives, ii) the criteria to be met for the accounting method used, and iii) other disclosures that will assist investors in understanding how derivatives impact the financial statements. The release also requires quantitative and qualitative disclosures about market risk inherent in derivatives and other financial instruments outside the financial statements. Finally the release reminds registrants to supplement existing disclosures about financial instruments, commodity positions, firm commitments, and other anticipated transactions with related disclosures about derivatives.

The effective dates for the quantitative and qualitative disclosures about market risk are phased in over the next few years. For registrants with market capitalization in excess of $2.5 billion, the rules become effective for filings that include audited financial statements for fiscal years ending after June 15, 1997. For other registrants, the rules become effective one year later. Accounting policy disclosures should be included in reports filed with the commission that include financial statements for periods ended after June 15, 1997.

Based on reviews of registrants' filings that have attempted to implement the guidance, there is still a lot of misunderstanding. Errors found in those filings included a) failure to present information by risk category, rather than by financial instrument, b) failure to cross-reference information in various places in a filing, c) presentation of forward looking information in the notes to the financial statements (in which case the registrant does not have the benefit of the safe harbor rules), and d) failure to provide the context necessary to understand the disclosures. The staff expects to issue a large number of comment letters, but generally will be lenient in resolving these points. Disclosures made in good faith will ordinarily not need to be restated, but additional disclosures may have to be provided in interim financial statements.

Disclosures About Segments (SFAS No. 131). Companies that expect a material future change in their segment financial information are encouraged to apply the provisions of Staff Accounting Bulletin No. 74, including a) a discussion of the standard and its requirements and b) the impact on their current segment groupings.

Plain English. According to the Staff Task Force on Disclosure Simplification, issuers, underwriters, and their attorneys often draft documents filled with jargon and over-inclusive disclosures making it difficult for readers to distinguish material information from "boilerplate." Under a pilot program, the Division of Corporation Finance has processed approximately 80 "plain English" filings. These filings have had an average turnaround of approximately 10 days. The staff anticipates that the commission will adopt rules in early 1998 (with a phase-in period) that will require plain English disclosures in the forepart of SEC filings. At this point, the staff is encouraging the use of "plain English" in financial statements. Briefly, the suggestion is that filers use everyday terms in shorter sentences.

Pre-Filing Conferences. The staff, as always, encourages registrants to request pre-filing conferences to discuss potentially controversial issues. 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.

Other Sessions

Other sessions provided updates on issues in international reporting, technology, AICPA accounting and auditing developments affecting public registrants and their auditors, and new assurance service opportunities for public accountants. *

Roy Van Brunt, CPA, is a director and Reva B. Steinberg, CPA, the director of accounting research for Ten Eyck Associates, Inc., a technical and litigation consulting firm with offices in King of Prussia, Pa. and Washington, D.C.

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

Gary Illiano
Grant Thornton LLP

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