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AICPA’s SEC Conference Grapples
with Building Public Trust
Thomas R. Weirich and Robert W. Rouse
SEC officials made a bid for greater cooperation from financial managers and
independent auditors—to build public trust in the financial markets. Conferencegoers also got to listen to the SEC’s thinking on a variety of other issues. © 1999 John
Wiley & Sons, Inc.
H
istory repeats! The American Institute of Ceritified Public Accountants
(AICPA’s) Twenty-Sixth Annual SEC Developments Conference was
held to another overflowing crowd on December 8 and 9, 1998 in Washington,
D.C. The conference provides the opportunities to hear representatives of the
Securities and Exchange Commission (SEC), the Financial Accounting Standards
Board (FASB), and other standards setters involved in the promulgation of
generally accepted accounting principles (GAAP) and generally accepted auditing
standards (GAAS), as well as representatives of the newly created Independence
Standards Board.
Although there was no announced theme, the focus of many comments was
one of building a partnership for public trust in the capital markets. Specific
topics that highlighted the conference again were earnings management and
auditor independence. This article will review the highlights of the speeches
from the conference.
CHAIRMAN LEVITT’S COMMENTS
Thomas R. Weirich, Ph.D., CPA, is
Arthur Andersen Professor at Central
Michigan University. He has served
as academic fellow at the SEC, and
faculty in residence with Arthur
Andersen’s Business Fraud and
Investigative Services practice.
Robert W. Rouse, Ph.D., CPA, is a
professor at the College of
Charleston. He served as an
academic fellow in the Office of the
Chief Accountant at the SEC. He
is a member of the SEC Regulations Committee of the AICPA.
Arthur Levitt, chairman of the U.S. Securities & Exchange Commission,
was the first to focus on this partnership for the public trust. He began his
remarks by recognizing the perseverance of the third SEC chairman, James
Landis, in his solicitation of the accounting profession’s help in enacting the
federal securities legislation in the early thirties. Landis commented to the
accounting profession, “We need you as you need us.” Over the years the
accounting profession and the Commission have supported one another in
creating the most efficient and effective capital markets in the world.
Chairman Levitt once again requested the support of the accounting
profession to work as a team with the Commission on three issues that are
CCC 1044-8136/99/1003081-08
© 1999 John Wiley & Sons, Inc.
81
Thomas R. Weirich and Robert W. Rouse
Mr. Levitt further stated
that the auditing
profession needs to keep
pace with the rapidly
changing environment in
order to maintain the
public trust in the capital
markets.
critical to the health of the capital markets and the integrity of the financial
reporting system: (1) avoidance of the temptation to sacrifice sound financial
reporting practices for the expectations of Wall Street; (2) maintaining of the
highest quality accounting and auditing standards in an increasingly global and
technology driven marketplace; and (3) upholding of independence, objectivity,
and professionalism within the accounting profession.
He then addressed the following topics: earnings management, honoring
the public trust, and the demand for strong accounting standards. With regards
to earnings management, the chairman stated that he is concerned that registrants’
desires to meet Wall Street’s earnings expectations may be overriding
commonsense business practices. As a result, he reported a fear of erosion in the
quality of financial reporting. The problem, he stated did not develop overnight. A cultural change in the financial community may be needed to change
registrants’ objective of earnings management.
The chairman also announced a coordinated plan to address the issue
of earnings management. Various committees and task forces have been
established to address these concerns. He complimented the leadership of
the AICPA and was pleased with the creation of a task force of auditors,
industry accountants, appraisers, and standard setters that will address the
issue of “in-process research and development.” Also, he noted that the
New York Stock Exchange and the National Association of Securities
Dealers have created a blue-ribbon committee to develop recommendations
to strengthen the role of audit committees.
Mr. Levitt further stated that the auditing profession needs to keep pace
with the rapidly changing environment in order to maintain the public trust in
the capital markets. Advancements in technology and globalization have changed
the ways that business is conducted. The chairman then questioned the
effectiveness of the audit process under the current audit risk model and
concluded his remarks by addressing the international efforts to reduce disparities
in reporting and disclosure requirements. The newly proposed global accounting
standards must meet the fundamental test of providing transparency,
comparability, and full disclosure that is currently demanded by SEC.
COMMENTS FROM THE OFFICE OF THE CHIEF
ACCOUNTANT
Lynn Turner, newly appointed chief accountant of the Commission,
elaborated upon Chairman’s Levitt’s remarks concerning a partnership of
representatives of financial management, business executives, public accountants,
attorneys, and others to protect and enhance the transparency in financial
reporting in order to protect the investor. He thanked those in government,
members of financial management, and auditors who have diligently worked to
maintain this partnership of cooperation.
Mr. Turner then provided his thoughts of a vision for the accounting
profession for the 21st century, which focused on leadership and professionalism.
He expressed the need for increasing the level of professionalism in public
accounting and financial management. After citing such business articles as
“Pick a Number, Any Number,” and “Accounting Abracadabra,” Mr. Turner
reported that the investing public expects high quality in financial reporting.
There is a current need for leadership to take financial reporting and the
82
The Journal of Corporate Accounting and Finance/Spring 1999
AICPA’s SEC Conference Grapples with Building Public Trust
auditing profession into the 21st century. This leadership should demonstrate
the willingness to present new ways to have more effective audits, to improve the
financial reporting model, to meet the needs of globalization of the capital
markets, to protect the private standard-setting process, and to incorporate the
changes in information technology.
Mr. Turner’s remarks then addressed audit effectiveness. He questioned
whether the audit process has kept pace with the revolutionary changes in
information technology within the business community. Another concern was
that the current audit staff may not have an adequate understanding and
knowledge of auditing procedures and business operations sufficient to conduct
an effective audit of a complex business. At the request of Mr. Turner, the Public
Oversight Board has established a committee with the charge to investigate the
effectiveness of audits given the current audit risk model. A report from this
committee is expected later this year.
He concluded his remarks by expressing the importance of the profession
to continue to demonstrate to the public its capability and desire to remain an
effective self-regulated organization. Additionally, he commented that the
profession needs to support the private standard-setting process and to contribute
to the future evolution of both international accounting and auditing standards.
Jane Adams, deputy chief accountant of the Commission, also focused on
Chairman’s Levitts’s remarks when she addressed the earnings management
issues. As a result of the Commission’s concerns related to earnings management,
the SEC staff will be shortly issuing three new Staff Accounting Bulletins
(SABs). These bulletins will provide insight in interpreting and applying
existing standards. The three forthcoming SABs will address the following
areas: restructuring charges and impairments of assets, revenue recognition,
and materiality.
Restructuring Charges and Asset Impairment
Recognition of
restructuring charges has
long been a concern of the
Commission for years.
Recognition of restructuring charges has long been a concern of the
Commission for years. The Emerging Issues Task Force (EITF) issued two
consensuses, EITF 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in
a Restructuring), and EITF 95-3, Recognition of Liabilities in Connection with a
Purchase Business Combination. However, Ms. Adams stated that these two
consensuses have not resolved the reporting problems. She reported that the
consensuses were developed with the objective of identifying the circumstances
in which the actions of management create a liability that should be recorded on
the commitment date. The consensuses have focused specifically on criteria of
the essential characteristics of a liability—that is, does management have little
or no discretion to avoid a future sacrifice?
In evaluating a number of restructuring accruals, Ms. Adams identified the
following observed deficiencies relating to the recognition of a liability:
•
•
•
The exit plan lacked sufficient specificity of the actions to be taken.
The exit plan was significantly modified as it was being implemented,
which may suggest that the exit plan may not have existed.
The exit plan would not be completed in the near term, which provides
management with much discretion.
The Journal of Corporate Accounting and Finance/Spring 1999
83
Thomas R. Weirich and Robert W. Rouse
•
Ms. Adams also
commented on the fact
that the staff has objected
to the accrual of costs in
certain circumstances in
which the staff concluded
that the costs either did
not represent the exiting
of an activity or the costs
benefited future
operations.
Costs could not be reasonably estimated, which is a requirement for
accruing a liability.
Ms. Adams also commented on the fact that the staff has objected to the
accrual of costs in certain circumstances in which the staff concluded that the
costs either did not represent the exiting of an activity or the costs benefited
future operations. An additional observation was that bad accounting was often
accompanied by inadequate disclosure. There are certain required disclosures
that must be made in the year that the liability is recognized and in subsequent
periods when such costs are paid.
A second issue in the accounting for restructuring costs is the impact of
FASB No. 121, Accounting for the Impairment of Long-Lived Assets and for LongLived Assets to Be Disposed of. The issue is which impairment model is applicable
when the commitment date for an exit plan also requires an impairment
evaluation prior to the ability to remove the related assets from operations? The
staff has concluded that the recognition of an impairment charge is not a
substitute for choosing an appropriate initial useful life and salvage value
followed by an adjustment.
Revenue Recognition
Ms. Adams then addressed the proposed SAB dealing with revenue
recognition with particular emphasis on the effect of refundability in the
earnings process and the role of probability in determining when revenue
should be recognized. She stated that existing guidance provided by FASB
Concept Statement No. 5, Recognition and Measurement in Financial Statements
of Business Enterprises, is very broad. This statement reports that revenue is
recognized when it is realized or realizable and it is earned.
Areas where the staff has concerns have been the recognition of revenue in the
health care industry and memberships at golf courses. Such registrants have
recorded initial membership or initiation fees as revenue. The staff concluded that
the receipt of the fee was not a discrete earnings event, but rather the purchase of
ongoing rights or services. Therefore, the registrant should recognize a liability, not
revenue, for this initiation or membership fee. In a related issue, the staff concluded
that the activation fee for cellular telephone service should not be recognized as
revenue because the collection of the fee is not a discrete earnings event.
Materiality
Ms. Adams concluded her comments by addressing materiality. Although
there are various definitions of materiality, each definition incorporates the
basic concept adopted by the courts and the Commission. An item is considered
material if there is a substantial likelihood that a reasonable investor would
consider it important in making a decision. Additionally, the issue of materiality
involves an evaluation of both quantitative and qualitative characteristics.
The staff will consider other factors in addition to quantitative characteristics
when evaluating materiality. Examples of qualitative factors include situations
in which a conscious decision was made not to follow GAAP, in which factors
were involved in an erroneous accounting transaction that leads to a change in
the trends of earnings, or in which the factors were a part of a plan to smooth
earnings from period to period
84
The Journal of Corporate Accounting and Finance/Spring 1999
AICPA’s SEC Conference Grapples with Building Public Trust
The final issue commented
on by Mr. Kepple was
Internet loss
arrangements. He
reported that a trend is
developing whereby
companies are entering
into arrangements that
initially appear to be loss
contracts, but after close
inspection are not.
Professional Accounting Fellows’ Comments
Continuing the tradition at the conference, the professional accounting fellows
(PAFs) within the Office of the Chief Accountant summarized specific concerns
that the Office has confronted during the past year. The issues were very complex,
fact-specific, and covered a variety of unique situations. Although selected topics
are reviewed, the full text of the speeches can be obtained from the SEC Web site.
Paul Kepple (PAF) addressed the following issues: nonmonetary exchange
transactions, a purchase business combination valuation issue, a pooling matter,
and an issue that related to immediate expense recognition of prepaid costs. As
to the first issue, Mr. Kepple informed the audience that SEC staff had submitted
a letter to the EITF that outlined the scope of a project that will attempt to
address a number of nonmonetary exchange issues in order to develop a
cohesive model for nonmonetary exchange transactions.
Concerning the business combination valuation issue, the staff objected to
the following conclusions of a registrant. Target Co. provided satellite services
and was owned 100 percent by a foreign government. In a privatization
agreement, NEWCO (the registrant) acquired 100 percent of Target. However,
the registrant was required to provide the government free access to 7 percent
of Target’s available capacity. As a result of this agreement, NEWCO provided
no accounting for the reserve capacity obligation and recorded only 93 percent
of the fair value of the satellites at acquisition of Target.
The staff disagreed with the treatment since NEWCO maintained all the
risks and rewards to ownership of the satellites. It also had the right to sell any
of the reserve capacity not used by the government. The staff concluded that
since NEWCO owned 100 percent of the satellites, it must record the full 100
percent fair value of such satellites.
Mr. Kepple also discussed an issue of whether a contractual asset disposition
would prevent the use of the pooling-of-interests method. The staff concluded
that the registrant should not be able to accomplish through a contractual
provision what it is not permitted to do in a pooling transaction.
The final issue commented on by Mr. Kepple was Internet loss arrangements.
He reported that a trend is developing whereby companies are entering into
arrangements that initially appear to be loss contracts, but after close inspection
are not. For example, an Internet service provider attempted to recognize a onetime nonrecurring loss as a result of entering into an agreement with an Internet
access company. The service company paid a fixed cash payment to the access
company and recorded a loss based on the expected unrecovered costs over the
estimated incremental advertising revenues. The staff disagreed and concluded
that amounts paid to maintain and increase user traffic on the system should be
capitalized and amortized over the period the access is received. This prepayment
is no different than other prepayments for future services.
Robert Uhl’s (PAF) comments centered on (1) the initial measurement of
interests providing credit enhancement in a securitization, (2) allowance for
loan losses, and (3) accounting for trade credits. The staff has raised a significant
number of questions regarding financial institutions’ allowances for loan losses.
He reported that the staff will challenge those allowances that appear too low or
excessive, or are inconsistent with the discloses in filings with the Commission.
Jeffery Jones (PAF) addressed issues relating to (1) certain modifications of
employee stock awards, (2) impairment of nonproductive assets, (3) push
The Journal of Corporate Accounting and Finance/Spring 1999
85
Thomas R. Weirich and Robert W. Rouse
Current business practices
demand that software be
Y2K compliant before
licensing or that the
vendor provide some
assurance.
down accounting, and (4) software revenue recognition. Mr. Jones reported
that there has been significant attention given to the Year 2000 (Y2K) Software
Issue. Current business practices demand that software be Y2K compliant
before licensing or that the vendor provide some assurance. Should revenue be
recognized when the customers’ rights are covered by “bug fixing” unspecified
upgrade rights under support arrangements, or when a specified upgrade/
enhancement is specified? In an Interpretative Release for Year 2000 issues the
staff has stated that “if a vendor licenses a product that is not Year 2000
compliant and commits to deliver a Year 2000–compliant version, the revenue
from the transaction should be allocated to the various elements—the software
and the upgrade.”
Eric Casey (PAF) focused on (1) tainted treasury stock, (2) new basis
relating to leveraged recapitalization, and (3) the accrual of a loss by a lessee
related to an operating lease. Paul Desroches’ (PAF) comments addressed (1)
structured debt instrument with embedded written options, (2) trust-issued
preferred securities, (3) held-to-maturity securities under FASB Statement No.
115, and (4) hedging with intercompany derivative transactions. Donald Gannon
concluded the PAF presentations with a discussion of issues relating to (1) the
Euro as a reporting currency, (2) business combinations, and (3) the recognition
of goodwill and negative goodwill under the International Accounting Standards.
COMMENTS FROM THE DIVISION OF ENFORCEMENT
Walter Schuetze, chief accountant of the Enforcement Division, who
returned to the Commission to assume the position, reported that there was
nothing new under the sun on the accounting side within the Division. There
were only so many ways that one can cook the books. As usual, his speech,
entitled, “Enforcement Issues: Good News/Bad News, Brillo Pads, Miracle-Gro,
and Roundup,” was very interesting—and addressed a myriad of issues.
The good news involved the discussion of statistical information related to
the accounting enforcement cases. In 1997 the Commission completed
approximately 100 accounting enforcement cases. Since there are some 16,000
public companies filing with the Commission, an 0.6 percent enforcement case
rate may initially indicate that most registrants are conforming to the SEC rules.
However, Mr. Schuetze tempered the good news with the bad news when he
concluded that the statistics might not be correct.
He briefly highlighted a July 1998 Business Week article that reported on a
survey of chief financial officers (CFOs) and focused on one question, which
reported that 67 percent of the CFOs responding had been asked to “misrepresent
results.” Eighteen percent of those that were asked actually did misrepresent
results. Mr. Schuetze inferred these statistics to the population of the 16,000
issuer/registrants. Applying the 67 percent statistic to the population, in
approximately 11,000 cases (16,000 x .67), CFOs would be requested by other
executives within the organization to “misrepresent results.” Approximately
2000 cases (11,000 x .18) may exist where CFOs actually gave into the request—
a very alarming statistic indeed!
Mr. Schuetze then reflected on another troublesome development he
noticed from reading the newspapers. Some registrants are turning to “forensic”
auditors from other firms rather than to their own auditors when questions arise
about the registrant’s financial statements. As reported by Mr. Schuetze, these
86
The Journal of Corporate Accounting and Finance/Spring 1999
AICPA’s SEC Conference Grapples with Building Public Trust
forensic auditors bring in their Brillo pads and “scrub” the financial statements—
resulting in restatements the size of an elephant! Therefore, the question is:
Which firm did the real audit? He questioned the original auditing firm’s
objectivity and skepticism, which may be impaired or dulled by relationships
between the auditors and their clients at picnics, golf outings, or other sporting
events. The issue of fraternization between the auditors and their clients is a
major concern of the Commission.
Mr. Schuetze concluded by addressing issues that the Enforcement Division
worked on last year. The issues could be categorized as “pedestrian issues.” He cited
several independence issues in which the auditor promoted the stock of a client and
engagements in which audit and tax partners and staff owned client securities.
Premature revenue recognition and the use of reserves are of concern to the
Enforcement Division. Mr. Schuetze cited cases involving the recognition of
revenue when an undisclosed right of return exists, recognizing consigned
goods as sold, recording revenue on goods shipped to company warehouses,
and recognizing revenue in advance of the customer’s acceptance of the
product.
As to the issue of reserves, Mr. Schuetze reported that some registrants
“bleed” into income without adequate disclosure of “reserves” that were
established in business combinations or restructurings. He stated that reserves,
like tax liability cushions, deferred tax asset cushions, inventory reserves, bad
debt reserves, merger reserves, and restructuring reserves, were like crab grass—
they were everywhere! He believed that some companies kept Miracle-Gro in
the garage and periodically irrigated their crab grass general reserve accounts.
Although the Division of Enforcement squirts Roundup on a registrant’s
financial statements, the crabgrass keeps reemerging. Mr. Schuetze concluded
that these reserves are like a chocolate chip cookie jar into which management
can not resist putting their hands when their earnings need a “sugar high.”
OTHER COMMENTS
The staff of the Division of
Corporation Finance
reported that earnings
management and
restructuring charges will
be major areas of
emphasis in their review
of filings with the
Commission.
The staff of the Division of Corporation Finance reported that earnings
management and restructuring charges will be major areas of emphasis in their
review of filings with the Commission. The review of recent filings provided the
following examples of earnings management:
•
•
•
•
•
•
Excessive accruals or manipulation of accruals for loan losses and
restructuring charges
Excessive valuations of purchased in-process research and development
Improper write-downs of assets that continue to be used in operations
Unreasonable lives for depreciation and amortization
Improper recognition of future operating losses, or deferral of current
operating losses
Front-end recognition of revenue
Other issues of concern include business combinations, exchange
transactions, amortization of intangible assets, and textual disclosures in
Management Discussion & Analysis (MD&A). Other speakers at the conference
presented issues relating to Internet issues and disclosures in cyberspace, new
audit and attest standards, and issues relating to international accounting.
The Journal of Corporate Accounting and Finance/Spring 1999
87
Thomas R. Weirich and Robert W. Rouse
SEC SEEKS GREATER COOPERATION
As in previous SEC Developments Conferences, this year’s conference
provided the unique opportunity to learn of the current issues facing the
profession. However, at this conference, the Commission requested greater
cooperation from financial managers and independent auditors to enhance the
public trust in the financial markets. Some of these issues will mostly likely be
addressed at next year’s conference scheduled for December 7 and 8, 1999. ♦
88
The Journal of Corporate Accounting and Finance/Spring 1999
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