What's on the horizon from the SEC
1998 AICPA National Conference
Learn by Interacting
Each December the AICPA sponsors a national conference to spotlight matters of topical importance to the accounting profession, registrants, and the SEC. The program features both lecture-type presentations by commissioners, key SEC staff members, and other regulators and extensive question-and-answer sessions at which panelists respond to questions posed by attendees. The two-day conference provides an excellent forum for gaining a better understanding of currently controversial matters and allows for interacting with the SEC staff. The AICPA held its 26th annual conference December 89, 1998, in Washington, D.C., and, due to its growing popularity, the conference was simulcast to several other venues in Washington, to Jersey City, N.J., and to London, England.
As in recent years, the actual texts of many of the speeches are available on the SEC's website, www.sec.gov. Particularly on technical topics, the remarks of the speakers often take on an almost mythically authoritative tone in later years. As a result, many corporate accounting and reporting officers archive these speeches for future reference.
By Roy T. Van Brunt and Dorothy E. Walker
This year's AICPA National Conference on SEC Current Developments featured a keynote address by SEC Chair Arthur Levitt on "A Partnership for the Public Trust." His remarks generally mirrored those that he made at New York University in September (reprinted in full in the December 1998 The CPA Journal), and urged an increase in both vigilance and skepticism on the part of practicing professionals if credible financial reporting is to be maintained. While Levitt is supportive of the accounting profession, he used this opportunity to restate his apparently growing concern about the direction of the relationship between accountants and the companies whose financial statements they audit. He strongly voiced a call to partnership between preparers, regulators, analysts, and auditors to assure the continued vitality of financial reporting.
Earnings management and the resulting erosion of quality financial reporting is certainly not a new topic, but it is obvious from Levitt's remarks, and those of the other senior staff members that followed him over the two days, that the SEC staff will be increasingly skeptical of financial reporting practices that result in either marshalling resources in good times, or avoiding losses in bad times. He was blunt in his assessment that a motivation to satisfy Wall Street expectations may too frequently be overriding common sense business practices. He believes that the SEC staff's review of filings too often indicates that "the pressure has become all too hard to resist."
Recognizing income from partially shipped orders and extending fiscal years "beyond 365 days" were specifically mentioned as examples of recent staff experience. Taking big bath restructuring charges (as a way to avoid recording expenses in later periods) was another. Finally, and perhaps most significantly, tweaking purchase accounting by writing off in-process research and development expenses (IPR&D)--a practice that in form follows and is required by established GAAP--has been found recently by the staff to have become prevalent and extreme, bordering on abusive.
Both Levitt and Lynn Turner, the commission's newly appointed chief accountant, spoke to the extreme inappropriateness of the amounts of IPR&D that recently have been written off by some registrants--sometimes in excess of the actual cost of the acquisition itself. The effect of such accounting is, of course, to minimize or even eliminate the amount of goodwill that results from the purchase--goodwill that would otherwise be charged against earnings in future periods. In the case of technology companies (the principal users of this accounting), the goodwill would likely have a very short life, and, therefore, recording the immediate write-off at acquisition has a significant impact on the immediately following years' financial statements and earnings per share.
With respect to all of these topics, Levitt, in broader perspective, expressed continuing concerns for the vitality of the independence of auditors and for their growing tendency, in his eyes, to live "in the gray areas" that jeopardize the public trust. To illustrate, Levitt mentioned the accounting firms' revenue that is being generated by "other than traditional services." One of these services has occasionally been providing the fair market appraisal of the amount of IPR&D. When such appraisals later serve as the basis for accounting entries, the objectivity of the firm in auditing such accounting write-offs can be questioned rather easily.
Levitt also took the time, once again, to mention a series of initiatives and high-level panels he has prodded the profession and others to establish. Specifically, he commended the Public Oversight Board of the SECPS for forming a committee to review the manner in which audits are now being conducted and to assess the impact of current trends on the public interest. He also indicated that the New York Stock Exchange and NASDAQ are sponsoring a committee to develop recommendations to strengthen the role of audit committees.
And, in a perhaps easily overlooked closing statement, he expressed some concern about the quality of audit work performed by foreign affiliates of major U.S. accounting firms, suggesting that the foreign firms are "practicing accounting techniques that simply don't measure up." Such shortfalls threaten the international harmonization effort that has significant SEC input and interest.
The Ninth Wave
Lynn Turner is the first SEC chief accountant to bring such a diverse background to the position: He has been an SEC staff member (a professional accounting fellow from 1989 to 1991), a major firm audit partner, and a chief financial officer of a public company. Through this experience, he is positioned to understand both sides on virtually every issue. His remarks to the conference included both compliments and criticisms of what he has found to be good and bad about the financial reporting process.
Like Levitt, Turner encouraged the profession's leaders to "stand tall in the saddle" against arguments from clients to use acceptable but inappropriate accounting in order to help reach earnings estimates. He urged true professionals to be less accommodating, to speak out on issues that will advance the needs of investors, and to have a vision of the future that is not distorted by today's realities and pressures.
He announced a recent agreement by the Big Five accounting firms to require timely interim reviews as a precondition for accepting new public clients. While this falls short of a universal requirement for quarterly reviews of all their clients, it does represent a significant starting point toward that ultimate objective.
On the critical end, Turner mentioned that he had noticed several instances in which unacceptable accounting had been agreed to by an auditor, ostensibly on the grounds that doing so would not create an aggregate material error. As mentioned at last year's conference, such decisions are being targeted by SEC staff. Turner and the rest of the Office of the Chief Accountant and the Division of Corporation Finance staffs do not believe that a waived entry list containing individually material items that offset is appropriate. Waiving such entries allows the individual professional to decide whether the violation of a standard is egregious and does not ensure that established standards are followed. As such, it is an act that diminishes professionalism.
Turner closed his remarks with an inspirational allusion to the ninth wave--the power of the sea and the wind working together to create a unique force. Catching such a wave requires timing, but results in unparalleled success. He sees such a wave forming in this, the edge of the technological millennium, and he encouraged the accounting profession to seize
Professional Fellows' Topics
The professional fellows working in the Office of the Chief Accountant--the several accounting fellows and one academic fellow--addressed a wide array of more technical subjects, providing illustrations of the views taken by the staff on a wide range of issues.
Bob Uhl spoke on the initial measurement of interest providing credit enhancements in a securitization (SFAS 125), practices regarding loan loss allowances, and accounting for trading assets (SFAS 115). The second topic, generically associated with earnings management concerns, was helpful in assessing how the staff is treating and commenting on the adequacy or inadequacy of lenders' reserves. Coming so shortly after the staff had forced a highly public restatement of such reserves in a major financial institution, his remarks should be read and studied by financial officers and auditors alike.
Jeff Jones addressed modification of employee stock awards (EITF 90-9), the impairment of abandoned assets (a narrow example of applying SFAS 121), and push down accounting (SAB Topic 5J). He closed with an ASR 146-related topic on tainted treasury shares in a pooling and a Year 2000 software revenue recognition issue.
Eric Casey discussed treasury stock acquisitions (including a specific SAB 96 problem of one registrant), covered a leveraged recapitalization of a division of an entity (EITF 94-2 vs. EITF 88-16), and closed with a discussion of operating lease accruals. Pascal Desroches, the accounting fellow who deals principally with financial instrument issues, addressed debt instruments with embedded written options, accounting and reporting for trust preferred securities, held-to-maturity securities under SFAS 115, and hedging intercompany derivative contracts. Paul Kepple covered nonmonetary exchange transactions, the valuation of assumed obligations, contractual asset dispositions in a pooling-of-interests, and Internet "loss" arrangements--specifically, whether an up-front payment covering assumed losses meets the definition of an asset. The staff's view, not surprisingly, is that it does not.
Academic Fellow Joe Godwin presented an analysis of registrant compliance with the market risk disclosure rules that were adopted in January 1997, as well as plans on amending those rules in light of the subsequent issuance of SFAS 133. The full text of the fellows' comments can be found at www.sec.gov/news/spchindx.htm.
Newly appointed Enforcement Director Richard Walker and Enforcement Chief Accountant Walter Schuetze addressed the concerns of that division. Schuetze told the attendees, colorfully, that "reserves are like crabgrass--they are everywhere," and the accounting that has developed for them in practice is fundamentally flawed because such reserves do not meet the conceptual definition of a liability. Schuetze is not theoretically happy with capitalizing goodwill upon acquisition of a business, although his views here apparently ran somewhat afoul of some other senior staffers' concerns that many of the immediate IPR&D write-offs are inappropriate.
Walker expressed his extemporaneous concerns that accounting fraud was, in his view, on the rise. Of the approximately 500 companies that have been named in enforcement proceedings over the past three years, nearly 60% were involved in accounting deficiency-related allegations. He explained the process used by the division to recommend enforcement actions--determining who is responsible for the fraud and who actually carried it out. He pointed out that these individuals may or may not be the same people. He expressed the SEC's view of the new 102(e) rules, stressing that the staff sees them as a tool to help it discipline professionals and not as a punitive device.
Walker briefly called attention to two current enforcement proceedings involving what the staff deemed inappropriate consulting engagements for audit clients. Both of these matters are, at this writing, unresolved.
Corporation Finance Concerns
The senior accountants from the Division of Corporation Finance (DCF) shared a panel and provided still more details about the earnings management and IPR&D write-off issues that were mentioned earlier. Craig Olinger, the deputy chief accountant of the division, elaborated on the former point and expressed DCF's view that inventory write-offs should not be considered part of restructuring reserves and are more properly reported in operations.
Christine Davine, closely involved in most of the division's discussions with registrants on the IPR&D issue, professed being "passionate" on the subject. She indicated that the staff's position is to be skeptical about the assumptions used to support the write-offs and said that registrants could expect reviews in which the fundamental methodology would be challenged. The division believes that sufficient competent audit evidence includes, for example, the packets of information distributed to directors for meetings at which the purchase was discussed and approved. The division therefore believes the accounting for the transaction should reflect the facts discussed with directors in securing the decision to buy. Apparently, this has not frequently enough been the case.
Joel Levine spoke on the amortization of goodwill. He communicated the standards used by DCF: that the use of a period in excess of 10 years in service industries was inappropriate, as would be periods of over 25 years for physician management practices and more than five to seven years for technology registrants. Ken Marceron elaborated on the division's position with respect to loan loss reserving in financial institutions. He stressed that the staff was not proposing to substitute its judgment for that of management with respect to adequacy but rather that the staff believes there should be a transparency of disclosure between MD&A and the financial statements. The disclosure should be sufficiently detailed such that a reader or investor can relate to the position of management and see the risks that justify maintaining reserve levels in the face of declining losses actually being experienced. He said the staff expects to see prudent and conservative reserves--but not excessive ones. Maintaining artificially high reserve levels affords the opportunity to manage earnings (by dribbling them out) in times of unfavorable economic activity. He mentioned the need set forth in Financial Reporting Release 27 for a systematic methodology, applied consistently, in determining the appropriateness of reserve levels.
Corporation Finance Director Brian Lane took the opportunity to briefly explain some of the significant changes that are being studied with respect to the registration and reporting process, including the "aircraft carrier" release that was recently distributed for comment. In view of the fact that the current disclosure system was constructed in a paper-intensive, nontechnological age 65 years ago, it is in significant need of tune-up and repair.
Lane said that the staff considers the prospectus to now be "but one note in a symphony" and that accordingly, the significance attached to it, as compared to the myriad of other available information, is perhaps out-of-date. He is striving to create a "file-and-go" system, rather than the "go-and-file" sequence that exists today.
Lane indicated that he believes the recent push toward "plain English" disclosures is working, and that simpler and more readily understandable disclosures are being filed and used by investors. He said that to the extent filings currently under review lack disclosures with respect to Y2K readiness, the staff will ask for them.
Other Regulators and Standards Setters
Speaking for the Financial Accounting Standards Board, the ever-popular Vice Chair James Leisenring summarized current FASB projects. Both he and the luncheon speaker, FASB Chair Ed Jenkins, indicated that FASB expects to surface an exposure document on its business combinations project sometime in the second quarter of 1999. Leisenring referred to the "glacial speed" of the consolidation project but hoped that an exposure document on the policy section of this project might see the light of day in the first quarter, as would an interpretive document with respect to stock compensation issues.
The Independence Standards Board's (ISB) projects were summarized by Executive Director Arthur Siegel. The board continues to grapple with conceptual issues, but has several task forces working on topical concerns such as spousal relationships and clients hiring former employees of the audit firm. The ISB recently approved and released a requirement that there be an expanded degree of specific communication between the auditor and the audit committee in which the firm specifically addresses its belief that it is independent and focuses the attention of the committee on the factors that influence that decision.
David Kaplan, chair of the Accounting Standards Executive Committee (AcSEC), summarized the committee's recent activity. AcSEC recently published for public comment Life and Health Insurance Entities, a proposed audit and accounting guide which would supersede the AICPA industry audit guide, Audits of Stock Life Insurance Companies. Kaplan also noted that his committee recently issued an exposure draft of a completely revised audit and accounting guide, Audits of Investment Companies. The proposed guide is intended to address how to enhance the usefulness of investment company financial statements to their users. Among other things, it will provide new guidance on accounting for offering costs, amortization of premium or discount on bonds, liabilities for excess expense plans, and reporting complex capital structures. He also noted that AcSEC issued SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, and SOP 98-5, Reporting on the Costs of Start-up Activities, this past year. The latter requires that the costs of start-up activities and organization costs be expensed as incurred.
Noreen McPartland, a FASB practice fellow, summarized the year's activity on the EITF and elaborated briefly on the nine consensuses that were reached in 1998 and the 19 issues which were still pending.
Vice Chair James Gerson addressed the accomplishments of the Auditing Standards Board (ASB) during 1998. He noted that the ASB had reached the decision that if an auditor finds a deficiency in planning for Y2K problems, such a finding would not reach the level of a reportable condition. However, the ASB believes that absent such plans the auditor should reflect on the implications of that fact on going concern reporting responsibilities and act accordingly.
Finally, there was a highly informative panel in which participants from industry (Loretta Cangelosi from Pfizer, and Mark Lynch from MicroStrategy) discussed compliance from the large company and small company perspectives.
The SEC's Agenda
This year's conference made it clear that under the present leadership of Chair Levitt and Chief Accountant Turner, the SEC's accounting staff will be proactive in 1999, particularly in areas related to earnings management. Comment process correspondence can be expected to center on questioning reserve accounting, particularly those restructuring type reserves that appear to have been used for purposes of either supplementing faltering earnings or "saving them for a rainy day." It is also likely that companies with write-offs of IPR&D, taken at the time of acquisition, will find themselves under some scrutiny and asked to justify their accounting. *
Roy T. Van Brunt, CPA, is a director and Dorothy E. Walker, CPA, a senior manager, at Ten Eyck Associates, Inc., a technical and litigation consulting firm with offices in Washington, D.C., and King of Prussia, Pa.
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