1999 AICPA National Conference on SEC Developments

By Reva Steinberg and Roy Van Brunt

In Brief

A Chance to Get Up Close and Personal

Each year, the AICPA sponsors its National Conference on SEC Developments, where SEC staff are available to discuss current accounting and auditing issues with interested professionals. The conference, which most recently drew almost 2,000 attendees to Washington, D.C., December 7­8, 1999, has become the AICPA's single largest regular conference.

Although a wide variety of topics were discussed at the most recent conference, a common thread running through many presentations was the need for transparent, high-quality financial reporting, especially in the area of revenue recognition. The SEC's concerns about earnings management, fraud, and independence issues were discussed by the speakers, which included SEC Commissioner Isaac C. Hunt, SEC Chief Accountant Lynn E. Turner, and Division of Enforcement Director Richard H. Walker. Although these and other speakers made the SEC's concerns clear, the tone was cooperative rather than confrontational, perhaps indicating that the SEC feels the profession is responding to its concerns.

The National Conference on SEC Developments is sponsored by the AICPA each December. The program provides a forum for auditors and registrants to discuss accounting and auditing issues and to interact with SEC staff. The 27th annual conference, which drew almost 2,000 attendees, was held December 7­8, 1999, in Washington D.C. Due to its growing popularity, the program was simulcast to several locations in Washington, New York, Toronto, and London, and it has become the AICPA's single largest annual conference.

SEC Commissioner Isaac C. Hunt gave the opening address; presentations followed by SEC Chief Accountant Lynn E. Turner, other SEC staff members, FASB officials, representatives of the AICPA senior technical committees, and other professionals, along with several question-and-answer sessions. Although a wide variety of topics were discussed, a common thread running through many presentations was the need for more transparent, high-quality financial reporting, especially in the area of revenue recognition. Earnings management concerns still predominate staff attention, but, in general, there was a more cooperative tone from the staff and less confrontation than has been evident in recent years. The full text of many of the speeches is available from the SEC website (http://www.sec.gov).

Internal Controls

Commissioner Hunt reminded his audience that accounting professionals bear a heavy burden in assuring investor confidence, preventing financial fraud, and generally supporting a fair and efficient marketplace. While he believes our capital markets are some of the most liquid in the world, he remains concerned about the reliability and integrity of financial statements filed with the SEC, especially revenue recognition abuse. Several of his remarks focused on two recently issued staff accounting bulletins: SAB 100, Restructuring and Impairment Charges, and SAB 101, Revenue Recognition in Financial Statements. He urged attendees to go beyond mere adoption of the guidance in the SABs and step up their practices by increased attention to internal controls. This renewed focus on internal controls will assure compliance with both GAAP and the Foreign Corrupt Practices Act and protect against unscrupulous employees, detect problems before they can cause harm, and prevent misleading financial statements. Effective internal control is contingent upon many elements, including support at the top of the organization, effective structure commensurate with the risks of the organization, effective delegation, periodic monitoring, and enforcement.

High Quality Audits

SEC Chief Accountant Lynn E. Turner stressed the importance of high quality audits "because it is the auditor--not the attorney, not the underwriter--to whom the public looks to assure the credibility of the financial statements that are so important to many investment decisions." He listed 11 items that contribute to such audits:

* An objective, independent perspective based on integrity and ethics beyond reproach
* A "spine"
* Quality professional staff
* Continuous training focused on the skills necessary to complete a successful audit
* The availability of and capability to use up-to-date technologies
* Current knowledge of the client's business and any risks associated with it
* An effective quality assurance program
* Auditing standards with sufficiently detailed audit procedures and the guidance necessary to produce audits that will assure the public's confidence in the numbers
* A process that advises clients on improving the quality of their financial reporting processes, procedures, and products
* A sufficiently robust audit methodology and process
* A compensation program that rewards or penalizes audit professionals based on the critical success factors for a successful audit.

The Accounting Standards-Setting Process

Deputy Chief Accountant Jane Adams strongly urged registrants to become more personally active both in the standards-setting process and, more significantly, in bringing developing matters to the attention of standards setters before they result in significant accounting and reporting diversity. She is troubled by the recent decline in accounting firms' and individual filers' participation in the process, and she expressed the staff's view that timely identification and resolution of issues before diversity in practice develops is the most equitable and effective approach to standards setting. She also pointed out that the staff's resolution of issues in a one-off manner precludes other interested parties from contributing their insights and perspective.

SEC Enforcement Issues

Enforcement Division Director Richard H. Walker warned that combating fraud remains a No. 1 priority. Although he has seen evidence that members of the accounting profession are addressing concerns highlighted in prior years, there are indicators that financial fraud is still all too common. During the year ended September 30, 1999, the division brought approximately 90 financial statement and reporting actions covering a broad spectrum of conduct, from multifaceted pervasive frauds to more subtle instances of earnings management and four violations of auditor independence rules. This represents an increase of 15% over the number of cases brought in 1998. Thirty-two of the 90 cases involve improper revenue recognition, and an increasing number of cases involve criminal charges. Walker warned that the division is turning the "numbers game" into a game of Monopoly--cook the books and go directly to jail without passing go. Walker enumerated several important messages revealed by the cases, the foremost of which is that intentional misstatements by management will attract the closest scrutiny.

John R. Stark, chief of the Office of Internet Enforcement, noted that the division has zero tolerance for lying, cheating, and stealing on the Internet. More than 100 Internet fraud cases have been instituted since 1995, but for the most part, the Internet is merely a new medium for the same old swindles such as "pump and dump" and "cybersmears" by short-sellers. Vigilance, education, and self-policing are the division's chief weapons. He elaborated on a newly developed technique he termed "sweeps," which maximizes a nip it in the bud approach to enforcement. The staff actively monitors chat rooms and other Internet areas where many of these frauds originate and acts quickly, where possible, to destroy frauds before they involve a substantial number of victims. In its first such sweep, last September, the staff announced the filing of 30 enforcement actions against 68 individuals; sweep activity is expected to continue this year. Stark also commented on the helpful number of referrals being made to the division via e-mail with respect to bogus or questionable securities offerings.

The Independence Standards Board

Arthur Siegel, executive director of the Independence Standards Board (ISB), gave an update on his organization's activities. The ISB was jointly created by the AICPA and the SEC in 1997 in an attempt to address the ever-increasing complexity of auditor independence issues through SEC oversight rather than direct rule writing. ISB Standard No. 1, Independence Discussions with Audit Committees, was approved this year and is effective for audits of companies with fiscal years ending after July 15, 1999. It requires an auditor, at least annually, to 1) disclose, in writing, all relationships between the auditor and the company that in the auditor's professional judgment may reasonably be thought to bear on independence; 2) confirm, in writing, that it is independent; and 3) discuss the auditor's independence with the audit committee.

The ISB has several other projects on the horizon. The principal one is to develop a conceptual framework for a wide range of principle-based independence standards that are "comprehensible, comprehensive, and implementable." Other projects deal with the independence implications of audits of mutual funds and related entities, family relationships, alternative practice structures, and appraisal and valuation services.

The SEC Practice Section

Michael A. Conway, partner of KPMG LLP and chair of the AICPA's SEC Practice Section (SECPS), gave an update on the section's activities. Formed in 1977 on a voluntary basis, the SECPS now has more than 1,300 members that audit approximately 94% of public registrants. Conway's remarks centered around three new or revised membership requirements:

1) independence and quality controls,
2) concurring partner review for SEC engagements, and
3) international associates of member firms.

The new independence and quality control requirements are aimed at heightening auditors' awareness of independence issues. Each SECPS member firm will be required to establish independence policies, make those policies available to each professional, provide independence training, and maintain an up-to-date database of restricted entities. The revised requirements for concurring reviewers provide for a cooling-off period, under which an engagement partner may not serve as a concurring partner for at least two annual audits after her last year as lead engagement partner. There also are additional procedural and documentation requirements for concurring reviews. Under the new international membership requirement, member firms associated with international firms must adopt certain policies and procedures to address items such as familiarity with U.S. auditing, accounting, financial reporting, and independence standards.

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 particularly in the question-and-answer sessions. Michael McAlevey, deputy director of the Division of Corporation Finance, commented that the staff would focus on getting back to basics in the new millennium. David Martin was named the new director (succeeding Brian Lane) and assumed his position in early January. The division is concentrating on earnings management, revenue recognition, plain English, management's discussion and analysis, pro forma financial presentations, alternative measures of performance, financial statement captioning, loan loss reserves, segment disclosure, and auditor independence.

Revenue Recognition. Several speakers, including Commissioner Hunt, discussed the recently issued SAB 101, which focuses primarily on revenue recognition. It was issued just before the conference, in response to the September 1998 speech by SEC Chair Arthur Levitt, "The Numbers Game," and to the increased number of recent enforcement cases arising from entities recognizing revenue too early. SAB 101 does not change GAAP, but it does provide guidance for improving financial reporting by reiterating the basic criteria a registrant must meet before recording revenue. Under the guidance in SAB 101, revenue should not be recognized unless--

* persuasive evidence of an arrangement exists
* delivery has occurred or the services have been rendered
* the seller's price to the buyer is fixed or determinable
* collectability is reasonably assured.

The pressure to show increased revenues has focused attention on the geography of revenues and expenses in the income statement. The staff addressed a number of issues relating to gross vs. net presentation of revenues. Generally, if a company performs as an agent or broker (e.g., sells travel services over the Internet) without assuming the risks and rewards of ownership of the goods, sales should be reported on a net basis as a fee or commission. Another area of concern is barter transactions (e.g., reciprocal banner advertising on Internet sites). The SEC has requested the Emerging Issues Task Force (EITF) to address whether an entity should report advertising revenues and advertising expense for these transactions or net them in some fashion.

Yet another area of concern is revenue recognition related to the receipt of up-front fees. The SEC staff cautioned that recognizing revenue for up-front nonrefundable cash payments may not be appropriate in many instances, such as those in which the earnings process is incomplete or the registrant has continuing involvement in the arrangement (e.g., membership fees to purchase, for a specified period of time, retail items at a discount).

Segment Reporting. FASB Statement 131, Disclosures About Segments of an Enterprise and Related Information, requires that a public company report financial and descriptive information about its reportable operating segments. Operating segments are components of a company for which separate financial information is available that is evaluated regularly by the chief operating decision maker (CODM) in deciding how to allocate resources and in assessing performance. The staff has noted some problems with segment disclosures and will comment when it finds inconsistencies between disclosure in the text filings and segment disclosures in financial statements.

The staff will look at information provided to the CODM, because some companies assert that the CODM receives detailed information about business components but doesn't use it. If the CODM receives reports of a component's operating results on a quarterly or more frequent basis, the staff may challenge a determination that the component is not a segment. The staff will also consider the existence of managers for each segment and the information provided to the board of directors to determine the existence of separate segments. There was a suggestion that staff attention be focused on large public companies whose disclosures have indicated that they are single-segment operations.

Derivatives and Hedging Transactions. FASB Statement 133, Accounting for Derivative Instruments and Hedging Activities, establishes comprehensive accounting and reporting rules for derivative instruments and hedging activities, effective for years beginning after June 15, 2000. The staff has identified some problems in the way a few early adopters are applying the rules. These compliance issues fall within three categories:

1) the need for contemporaneous formal documentation,
2) the requirement for specific designation of cash flow hedges, and
3) the requirement to describe how an entity will assess hedge effectiveness. Failure to comply with these requirements, in some cases, has resulted in a request for restatement.

Acquired In-Process Research and Development. Randy Larson, KPMG partner and chair of the AICPA's committee on accounting, valuing, and auditing of in-process research and development (IPR&D), reported that this is a topic of continuing SEC staff scrutiny. In a business combination, the cost of the acquired company is allocated to assets acquired and liabilities assumed based on fair values. Costs allocated to assets used in research and development activities are immediately charged to income if the activities have no alternative future use to the buyer.

Because there has been a dramatic increase in the size and frequency of IPR&D write-offs, with some as high as 95­100% of the acquisition cost, the staff is focusing on valuation methodology and assumptions. The staff has challenged the reasonableness of assumptions applied to determine fair value and is also concerned that

1) the value of future development efforts has inappropriately been included in IPR&D,
2) core technology's contribution to IPR&D has been either ignored or undervalued, and
3) entities are applying too narrow a definition of alternative future use.
The EITF expects to publish best practices in identifying, valuing, and auditing IPR&D, and the SEC staff may adopt these best practices through a staff accounting bulletin requiring public registrants to follow the guidance. By raising a nonauthoritative effort to a recognized level of GAAP, this approach would be innovative.

The SEC staff recommends that, in the period of acquisition, the MD&A disclose key valuation assumptions such as revenue and related growth rates, anticipated margins, discount rate, and effect of any cost savings or synergies. In periods following acquisition, the MD&A should disclose the status of projects, a comparison of actual results to assumptions previously disclosed, and an explanation of how failure to achieve results will affect return on investment, results of operations, and financial condition.

Business Combinations. Several speakers touched on other issues related to business combinations. One discussed the determination of the accounting acquirer in a purchase business combination involving the exchange of shares to existing debt holders. In determining the accounting acquirer, the staff initially looks to the former common stockholder interest that retains or receives a larger portion of the voting rights in the combined enterprise. Where debt holders receive common stock in the combined enterprise in exchange for their interests, the staff believes that registrants and their independent auditors should consider whether those debt holders should be viewed as common shareholders for the purposes of determining the accounting acquirer.

The staff also discussed a registrant-specific question of internal acquisition costs in a purchase business combination. Under APB Opinion No. 16, Business Combinations, the cost of an acquired company should include all the direct costs of acquisition. All indirect and general expenses related to the acquisition should be deducted as incurred. For example, a registrant capitalized certain internal management bonuses linked directly to business combination transactions. The management bonuses were only payable for successful closing of acquisitions and only to employees directly involved in the acquisition efforts. The staff objected to the registrant's conclusion that these internal acquisition costs should be capitalized. The staff interprets APB Opinion No. 16 literally and believes all internal costs associated with a business combination should be expensed as incurred, even if those costs are incremental, nonrecurring, and directly associated with the business combination.

Other Sessions

Other sessions provided updates on the status of various current FASB and EITF developments and AICPA accounting and auditing developments affecting public registrants and their auditors. One session was "Fraudulent Financial Reporting, 1987­1997: An Analysis of U.S. Public Companies--COSO Findings." On the second day of the conference, attendees could attend sessions working with audit committees or international reporting issues. Given the pending SEC rule proposals and recommendations of the Blue Ribbon Committee, it is expected that the profession will see significant developments in the area of audit committees as it moves into the next millennium. *

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

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