Current SEC Developments

By Joseph Graziano, Ann McIntosh, and Helen Bachman

In Brief

Getting It Right the First Time

The topics that the SEC staff addressed at the December 2001 AICPA Conference on Current SEC Developments included advancing the interests of investors and year-end reporting matters. The staff emphasized the importance of clear and transparent disclosures in the financial statements and management’s discussion and analysis. The staff also announced that it will no longer make professional accounting fellows’ speeches available on the SEC website. Staff speeches on the topics discussed at the conference are similarly not available, with the exception of comments by the SEC chief accountant and the director and chief accountant of the Division of Enforcement.

The primary role of the SEC is to protect the interests of investors. Management, auditors, and audit committees help ensure that a company’s financial reporting is of the highest quality. Unfortunately, recent events pose a serious threat to the confidence the public has in the financial reporting system.

The Interests of Investors

Robert K. Herdman, the new chief accountant of the SEC’s Office of the Chief Accountant, discussed his three-point plan to advance the interests of investors:

To get it right the first time, the staff encourages registrants to preclear unusual or complex accounting issues. This preclearance process enables a registrant to discuss an anticipated transaction, a planned transaction, or other accounting matter with the staff before filing its financial statements with the SEC. The process can avoid second-guessing or restatement at a later date.

The chief accountant or a deputy will be involved early in the preclearance process. The SEC will promptly notify the registrant of the staff assigned to the submission, make some initial inquiries, and inform the registrant if a face-to-face meeting is called for. In some situations, face-to-face meetings help resolve issues more expeditiously by eliminating the time-consuming process of repeatedly requesting additional information and waiting for a response.

Herdman said that the staff would approach submissions with an open mind: The staff is willing to consider all accounting methods permissible under GAAP as long as investors are adequately protected. If the staff addresses an issue that it thinks may apply to many registrants, it will refer that issue to FASB’s Emerging Issues Task Force (EITF). This approach would ensure due process and make the issue and its resolution more easily retrievable.

Preclearance process. For the preclearance process to be most efficient, the registrant should provide a clear and comprehensive submission that follows the SEC’s revised protocol, available at The submission should include the following:

Before submitting the matter to the SEC for preclearance, registrants should discuss the issue with their auditors, including a representative of the auditor’s national office. In addition, registrants should include the views of their audit committee.

Standards Setting

The second part of Chief Accountant Herdman’s plan aims to improve the effectiveness of the standards-setting process. He believes accounting standards should be balanced, avoid complexity, and include implementation guidance sufficient to ensure they will be applied consistently. In addition, he said, the timetable to complete an accounting standard needs to be shortened.

For the past several years, the SEC staff has expressed its views on accounting matters in speeches that registrants and their auditors have subsequently referred to in resolving transactions with similar fact patterns. The speeches had effectively become rule-making by analogy. However, referring to speeches for accounting guidance is neither efficient nor effective, because the speeches are not easily retrievable and are sometimes outdated.

Therefore, the staff announced that it would no longer express its views on specific accounting fact patterns in speeches. The SEC has reviewed all speeches prior to December 6, 2001, to determine whether they should be removed from the SEC website. Speeches that have been superseded or affirmed by GAAP have been totally removed. The website now contains excerpts of staff speeches that address matters with broad applicability currently under consideration by FASB or that the staff plans to refer to the EITF. The website will also continue to post speeches on matters related to pooling-of-interests accounting under APB Opinion 16, Business Combinations, and certain other business combination issues. The staff will remove views on pooling-of-interests accounting when the transition period for SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets, has ended. Views on the remaining matters will be removed once they are resolved by the FASB or EITF.

Views on the following topics will be retained on the website:

The staff is also updating Staff Accounting Bulletins (SAB) to reflect subsequent authoritative guidance issued by FASB and the AICPA.

Financial Reporting and Disclosure

The last part of the chief accountant’s plan focuses on modernizing financial reporting and disclosure. The following proposals are under consideration:

Enforcement Matters

The Division of Enforcement staff explained its focus on real-time enforcement, a process designed to respond quickly, effectively, and efficiently to enforcement matters. Real-time enforcement encompasses the following:

Enforcement trends. The current market volatility has made the division more likely to focus on quarterly reporting problems, even if they are resolved at year-end. The division has seen increases in several areas:

The single largest problem in the enforcement area continues to be revenue recognition, including bill-and-hold transactions and transactions in which one party is economically dependent on the other. The staff identified the following common indicators of financial reporting failures:

Once a company starts smoothing its earnings using one of these techniques, increasing expectations make it difficult to stop. Smoothing may keep the company from addressing real operating problems and can result in a loss of credibility when the misstatements are uncovered. To avoid such problems, the staff advised maintaining strong internal controls and applying common sense to filings. When in doubt, companies should contact the Office of the Chief Accountant for preclearance.

Year-End Financial Reporting Matters

Impairment and restructuring. In light of the economic downturn and the aftermath of September 11, the SEC staff reminds registrants of the accounting and reporting requirements for impairments and restructurings. The staff has been concerned about whether impairment or restructuring charges are recognized in the appropriate period; whether the company’s recent disclosures are sufficient for investors to understand the events, trends, and uncertainties that precipitated such charges; and whether such charges and disclosures are consistent with other information (e.g., information provided to customers and suppliers). Registrants should expect the staff to review recent press releases, analysts’ reports, and prior quarters’ financial statements (including MD&A) and to ask for additional information supporting such charges.

When adopting SFAS 142, an entity may record a transitional goodwill impairment loss even if no loss would be recognized under SFAS 121 because of the change in the testing model. The SFAS 121 test requires a triggering event and starts with a recoverability test based on undiscounted cash flows rather than a mandatory annual test based on the fair value of a reporting unit and the resulting implied fair value of goodwill. Before adopting SFAS 142, however, a company that anticipates recording a large transitional impairment loss, especially one due to the economic downturn or the aftermath of September 11, should consider whether a triggering event that would require an SFAS 121 test has occurred.

The SEC staff expects SAB 74 disclosures of an anticipated transitional goodwill impairment loss to include a discussion of why there is no impairment loss under the current impairment approach.

The staff noted that it intends to eliminate the disclosure requirements of SAB Topic 5.CC on impairments after all registrants have adopted SFASs 142 and 144.

Debt and equity securities, other-than-temporary declines in value. The staff reminded registrants of the need to write down the cost basis of held-to-maturity and available-for-sale securities to fair value and include the amount of the write-down in earnings if the decline in price is other than temporary (SFAS 115). SAB 59, Accounting for Noncurrent Marketable Equity Securities, provides guidance in evaluating whether a security’s recent decline in value is other than temporary, and states that other than temporary does not mean “permanent.” Declines caused by general market conditions or by information pertaining to an industry or company “require further investigation by management.” SAB 59 also provides that “acting on the premise that a write-down may be required, management should consider all available evidence to evaluate the realizable value of its investment.” SAS 92 (AU Section 300) identifies factors that indicate a decline in value is other than temporary.

The staff expects registrants to use a systematic methodology to analyze whether their marketable securities have experienced an other-than-temporary decline. Furthermore, registrants should have objective evidence to support a realizable value that exceeds the current market price. For example, the issuer’s financial performance, the issuer’s near-term prospects, the issuer’s economic environment, and the registrant’s investment intent could provide supporting evidence.

SAB 59 provides the following examples of the factors that, individually or in combination, indicate a decline is other than temporary and that a write-down of the carrying value is required:

The staff also reminds auditors to closely examine the documentation of management’s determinations of other-than-temporary declines in market values.

Purchased or retained beneficial interests. EITF 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets,” requires the holder of a beneficial interest to estimate the cash flows that a market participant would use to value it. If the fair value of the beneficial interest is less than its carrying amount and estimated cash flows have decreased from the last revised estimate, then an other-than-temporary impairment has occurred.

Servicing rights. Paragraph 63 of SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, provides guidance for recognizing the impairment of servicing assets. Such assets should be stratified by the predominant risk characteristics of the underlying financial assets. Impairment, the excess of the carrying value of a stratum over its fair value, should be recognized as a valuation allowance for that stratum. Strata should be consistent from period to period unless the risk characteristics of the underlying financial assets have changed. Changes should be treated as changes in accounting estimates.

Lease residuals. Sales-type and direct financing lessors should review estimated residual values at least annually and recognize a loss for the reduction in the net investment in a lease if a decline is determined to be other than temporary.

Segment Reporting

The staff continues to see problems with, and will continue to focus on, the identification of reportable segments and segment disclosures. In addition to the financial statement disclosures required by SFAS 131, Disclosures about Segments of an Enterprise and Related Information, Regulation S-K requires certain segment information to be disclosed in Item 101, Description of Business, and discussed in Item 303, MD&A, to the extent that a discussion of a segment is necessary to the understanding of a registrant’s business.

SFAS 131 defines an operating segment as a business component of an entity for which discrete financial information is available and regularly reviewed for operational purposes. An equity method investee can be an operating segment.

The SEC staff believes that some registrants define operating segments too broadly. The staff assumes that chief operating decision-makers use all financial information they receive to allocate resources and assess operating results. Accordingly, a registrant should evaluate whether each report provided to the chief operating decision-maker represents an operating segment and then consider if the operating segments meet the aggregation criteria of paragraph 17 of SFAS 131. According to the SEC staff, the most frequent error registrants make is overlooking the requirement that the operating segments have similar economic characteristics. The staff believes the operating segments should be so similar that they have, for example, similar average gross margins.

The staff reviews analysts’ reports, management’s interviews with the press, public disclosures, marketing materials, registrants’ websites, and other public information to determine if they are consistent with segment disclosures. The staff sometimes asks for all internal reports and asks how decisions are made about divisions if the chief operating decision-maker does not see the information. If the information reveals additional segments (e.g., because the registrant failed to meet the aggregation requirement that operating segments have similar economic characteristics), the staff will require the registrant to amend its filing.

SFAS 131 requires registrants to disclose certain information by geographic location; that is, the country of domicile and each foreign country from which they receive material revenues. The staff reminded registrants that even if they determine segments geographically, they are required to report by-country information.

Changes in reportable segments. If disclosures in the financial statements are presented on the basis of new reportable segments, segment disclosures for all periods presented should be restated, if practicable. For example, in a registration statement or proxy, if interim financial statements reflect new reportable segments, annual audited statements should be restated. If the annual statements are incorporated by reference into a registration statement, revised annual financial statements reflecting the new segments can be filed on Form 8-K and incorporated by reference. The registrant would not have to amend the prior-year Form 10-K.

If changes in a company’s organizational structure change its reportable segments, its financial statements for such periods should include disclosures based on the new reportable segments.

If a registrant files a Form S-3, incorporating by reference the most recent Form 10-K and 10-Q, and changes its segment reporting structure after such period, the registrant will have to determine if this represents a fundamental change, which would require restated segment information prior to the effective date of the Form S-3. The SEC staff indicated it would not expect such a change after the most recent balance sheet date presented to constitute a fundamental change.

Revenue Recognition

Revenue recognition was again highlighted. The SEC staff discussed several EITF Issues on the recognition and characterization of revenues as well as the accounting for certain revenue arrangements and disclosures about revenues.

Up-front nonrefundable fees. An up-front fee applies to any payment received before a contract is complete. SAB 101, Revenue Recognition in Financial Statements, and “SAB 101: Frequently Asked Questions and Answers” significantly restrict the recognition of revenue upon receipt of an up-front nonrefundable fee. The SEC has said that the buyer’s perspective is important in determining whether revenue should be recognized up front.

When evaluating whether a nonrefundable up-front fee should be recognized as revenue, registrants should consider the following questions:

A “no” to any of the above questions indicates that the registrant may have to defer the up-front fee.

Accounting for a nonrefundable up-front fee for a license arrangement. A registrant should defer the entire amount of a nonrefundable up-front fee for a license arrangement if either of the following apply:

Nevertheless, if the ongoing obligation is not necessary for the license to have value but is not inconsequential, at least some of the nonrefundable up-front fee should be deferred. In addition, revenue should be deferred if the customer has made a nonrefundable up-front payment but has not received anything of value (e.g., if the product is in development).

Example. Is it appropriate for an entity to factor in breakage when it evaluates whether revenue should be recognized on a nonrefundable up-front fee? Assume that a company offers a suite of 100 products. A customer pays an up-front fee for any five of the products offered, and the products will be delivered over time. Historically, most customers take delivery of only four of the five products. Can the company factor in the number of customers that will not take the fifth product in its determination of revenue recognition as products are delivered? Assuming the company has substantial statistical information and the products have not changed over time, the staff would not object if the registrant recognized revenue with an estimate of breakage (i.e., the number of customers not expected to take delivery of all products). Revenue would be allocated over the four products and recognized upon delivery, assuming all other criteria for revenue recognition have been met.

Fixed and determinable fees. One requirement for revenue recognition is that the fee is fixed and determinable. The following are examples of transactions in which the fee would not be considered fixed and determinable:

Registrants should consider the specific facts and circumstances of each transaction when the fee is not fixed and determinable. The following recognition models were discussed:

The SEC staff said that the level of control by the seller is important in determining the method to recognize revenues for these transactions. They also said that a price protection clause that is not within the control of the company is an indication that the fee may not be fixed and determinable. It is comparable to a consignment sale. An analogy to SFAS 48 may be appropriate in that historical experience for a volume of relatively homogeneous transactions, among other factors, would be needed to conclude that the price is fixed and determinable.

Bill-and-hold transactions. The criteria for recognizing revenue on bill-and-hold transactions are included in SAB 101. The following are common issues encountered for bill-and-hold transactions:

Arrangements with milestone payments. Each research and development arrangement is unique; therefore, an entity should consider the specific facts and circumstances before selecting a method to recognize revenue. Similar arrangements should be accounted for similarly. A method that recognizes all revenue up front is not acceptable. Conversely, deferring all revenue may also not be acceptable. The following are two methods the SEC staff discussed for recognizing revenue from research and development arrangements that include milestone payments:

Changes in estimates should be accounted for using a prospective or, preferably, a cumulative catch-up method in accordance with APB Opinion 20, Accounting Changes.

Filing Issues

Initial public offerings: carve-out financial statements. An entity may decide to raise capital by carving out certain operations and placing them in a new entity that it intends to take public. There is some question as to whether the financial statements that will be included in the initial public offering should reflect the contributed assets, results of operations, and cash flows of the new entity or should reflect the historical operations of the assets transferred and the assets not transferred.

The SEC staff has indicated that historical carve-out financial statements should represent the track record of management and the evolution of the business over time. SAB Topic 1.B.1 states that historical financial statements of a registrant should reflect all of the costs of doing business. Carve-out financial statements should include all relevant activities that have been part of the history of the business and that are expected to occur again in the future.

Financial statements of businesses acquired or to be acquired. Rule 3-05 of Regulation S-X requires a registrant to include in its filings the audited financial statements of businesses acquired or to be acquired, depending on the significance of the acquired entity. The SEC staff will not accept alternative significance tests in lieu of the significance tests specified in Rule 3-05. Although the staff is unlikely to waive the requirement to include all audited periods in a filing, they may grant relief regarding the number of periods to be included in situations involving undue cost or difficulty.

A registrant that is unable to file the required financial statements in a Form 8-K will not be eligible to use Forms S-2 and S-3. In addition, a registrant will not be able to proceed with any 1933 Act registration statements until it files audited financial statements that include the postacquisition operating results for the periods required by Form 8-K.

Disclosures. The staff said that disclosures in financial statements and MD&A should include information investors need to know, and be clear and transparent. Investors should be able to understand the financial statements, the accounting policies, and the risks that the company is exposed to.

Registrants should disclose accounting principles and methods that are—

When there is diversity in an accounting practice, the staff expects registrants to—

The staff also reminded registrants that investors need to understand the company’s current risk management policy, current exposures, and the results of past risk management activities.

Revenue Recognition

In the SEC staff’s view, investors need to know what a registrant does to generate revenue, the terms and conditions that govern when the registrant is entitled to revenue, when revenue is recognized, and when cash is realized. The staff expects such information to be evident from registrants’ disclosures about revenues in the description of business, MD&A, and the footnotes to the financial statements, as appropriate. Information about revenue disclosures is contained in Regulations S-B, S-K, and S-X; the Codification of Financial Reporting Policies; and the Corporation Finance: Current Accounting and Disclosure Issues posting on the SEC website.

A registrant’s description of its business should include basic descriptions of revenue-generating activities, customary contract terms and practices, and specific uncertainties inherent in business activities. MD&A should discuss how recent changes affect the results of operations and cash flows, as well as changes in the magnitude of uncertainties. The description of the accounting policy and other financial statement disclosures about revenues should include the following:

Management’s Discussion and Analysis

The SEC staff believes there should be a renewed focus on MD&A in the current environment. A registrant should disclose reasonably likely effects of known events, demands, commitments, trends, and uncertainties. The staff reminded registrants that MD&A is meant to give investors an opportunity to look at the company through the eyes of management. At the conference, the staff highlighted some of the disclosures they expect to see in MD&A. A registrant may want to refer to Item 303 of Regulations S-K and S-B, the interpretive guidance in section 501 of the Codification of Financial Reporting Policies, and Corporation Finance: Current Accounting and Disclosure Issues on the SEC website for additional information on MD&A.

Disclosures in the current environment. The disclosures in MD&A should take into consideration the effects of the economic downturn and the aftermath of the September 11, 2001, attacks. Registrants may want to discuss the following topics:

The staff thinks that now is a good time for registrants to take a fresh look at liquidity disclosures. Registrants should focus on the actual and expected impact of the economic downturn and determine whether there has been or will be an impact on raising capital. If so, management should address these liquidity

Research and development. The staff expects registrants to disclose the following information about research and development expenditures in MD&A:

Derivatives. Registrants are reminded to discuss the impact derivatives may have on earnings volatility as a result of partially ineffective hedging strategies, economic hedges, and changes in risk management policy; and on equity volatility as a result of cash flow hedges.

Impairment and restructuring costs. According to the SEC staff, MD&A disclosures should include a discussion of material impairment charges recorded, including the reasons and measurement methodology for the impairment loss. In the event a company has material unrecognized impairment losses for marketable securities, or assesses assets for impairment without recording a loss, the company should ensure that MD&A disclosures are sufficient to give the investor an appropriate understanding of the current status of the business. Any significant uncertainties or market conditions that could adversely affect the company and eventually lead to an impairment should be discussed.

For restructuring costs, SAB 100, “Restructuring and Impairment Charges,” reminds registrants of MD&A disclosure requirements before, during, and after the period in which exit costs and liabilities are recorded in accordance with GAAP. Events giving rise to an exit plan or impairment often meet the requirements for disclosure in MD&A before liabilities can be recognized in the financial statements. The expected effects of the plan and subsequent changes to the liability should be quantified and disclosed. The SEC staff suggests that quantitative disclosures of the components of exit and termination charges be presented in tabular form.

Joseph Graziano, CPA is a partner and Ann McIntosh, CPA, and
Helen Bachman, CPA, are senior managers in the national professional standards group, all of Grant Thornton LLP.

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