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U.S. Securities and Exchange Commission

Office of the Chief Accountant:
Letter: 2000 Audit Risk Alert to the American Institute of Certified Public Accountants

October 13, 2000

Ms. Arleen Thomas
Vice President - Professional Standards and Services
American Institute of Certified Public Accountants
1211 Avenue of the Americas
New York, NY 10036-8775

Dear Ms. Thomas:

As in prior years, the staff understands that the American Institute of Certified Public Accountants (AICPA) will be publishing a general audit risk alert as well as audit risk alerts applicable to specific industries. These publications are useful in that they advise financial statement preparers and auditors of timely and topical issues that should be considered in the preparation and audit of financial statements. We encourage the profession to continue to enlist members with the necessary expertise to develop, review, and disseminate this type of timely guidance.

The staff believes it is helpful to inform preparers and auditors of financial statements of the topics and issues on which we have recently been focusing our attention and resources. In that regard, the staff hopes that the following information will provide members of the profession with useful guidance in assisting them with the preparation and audit of financial statements included in filings with the United States Securities and Exchange Commission (the SEC or the Commission).

High Quality Financial Accounting and Reporting

Today, nearly seventy years after the SEC was created, our overriding objective continues to be the protection of investors through the fair and orderly operation of the capital markets. The financial reporting system in the United States, which has been established and maintained through the collective efforts of both the private and public sectors, has been designed to satisfy this overriding objective. High quality, transparent financial reporting, which is based upon full and fair disclosure, promotes honest and efficient capital markets and is an indispensable component of the United States financial reporting system.

In preparing and auditing financial statements in conformity with generally accepted accounting principles (GAAP) and in accordance with generally accepted auditing standards (GAAS) in the United States, certain qualitative aspects of accounting information are critical to achieving the ultimate goal of high quality, transparent financial reporting. These aspects include: (1) relevance, which encompasses the concepts of predictive value, feedback value, and timeliness; (2) comparability and consistency; and (3) reliability, which encompasses the notions of verifiability, neutrality, and representational faithfulness. Information that is relevant, comparable, and reliable enhances its usefulness in the decision-making processes of investors. These overriding principles are discussed in more detail in Statement of Financial Accounting Concepts (SFAC) No. 2, Qualitative Characteristics of Accounting Information, promulgated by the Financial Accounting Standards Board (FASB). All individuals that play a role in the United States financial reporting system, including preparers and auditors of financial statements, accounting and auditing standards-setters, and regulators, should always bear these fundamental principles in mind when performing their duties and functions.

Following are some of the staff's observations on several significant accounting and disclosure issues that we have recently been addressing.

Advertising Costs

In Accounting and Auditing Enforcement Release (AAER) No. 1257, In the Matter of America Online, Inc., the Commission alleged that the registrant capitalized certain of its advertising costs that should have been expensed as they were incurred. As further discussed in AAER No. 1257, the essential requirements of Statement of Position (SOP) No. 93-7, Reporting on Advertising Costs, should be met to support capitalization of advertising costs. SOP No. 93-7 permits capitalization of direct response advertising only when persuasive historical evidence exists that allows the entity to reliably predict future net revenues that will be obtained, and it specifies that the realizability of the amounts reported as assets must be evaluated at each balance sheet date on a cost-pool-by-cost-pool basis. In AAER No. 1257, the Commission found that the registrant did not meet the essential requirements of SOP No. 93-7 because its unstable business environment precluded reliable forecasts of future net revenues. Moreover, the registrant did not assess recoverability of the capitalized cost on a cost-pool-by-cost-pool basis. The registrant's business was characterized by the following factors:

1. The company was operating in an emerging business sector characterized by rapid technological change;
2. The company's business model was evolving;
3. Extraordinarily rapid growth in the company's customer base caused significant changes to its customer demographics;
4. The company's customer retention rates were unpredictable;
5. The company's product pricing was subject to potential change;
6. The company could not reliably predict future costs of obtaining revenues;
7. The company's competition was increasing;
8. The company was experiencing negative cash flow from operations and working capital deficiencies.

Further, the registrant disclosed in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of its filings the unstable nature of its operating environment, including several of the above-mentioned factors. Such factors were materially inconsistent with the registrant's presumed ability to predict probable future benefits associated with capitalized direct-response advertising costs.

Registrants and their auditors should ensure that the criteria in SOP No. 93-7 are met prior to the capitalization of direct-response advertising costs. The Division of Corporation Finance has issued interpretive guidance on SOP No. 93-7, which is included on the SEC web site at http://www.sec.gov/divisions/corpfin/guidance/cfactfaq.htm#seci.

Registrants and their auditors are also reminded of the disclosures required by SOP No. 93-7. SOP No. 93-7 requires that companies disclose the accounting policy for reporting advertising costs, indicating whether such costs are expensed as incurred or the first time the advertising takes place. The notes to the financial statements also should disclose the accounting policy for direct-response advertising, if any, a description of the direct-response advertising reported as assets, the amount of advertising reported as assets in each balance sheet presented, and the amortization period. Disclosure of the total amount charged to advertising expense for each income statement presented and separate disclosure of any amounts representing a write-down to net realizable value also are required.

Income Statement Classification

The appropriate classification of amounts within the income statement or balance sheet can be as important as the appropriate measurement or recognition of such amounts. Recently, financial statement users have placed greater importance and reliance on individual income statement captions and subtotals such as revenues, gross profit, marketing expense, research and development expense, and operating income. SEC registrants should apply the guidance provided in SEC Regulation S-X regarding classification of amounts in financial statements. In addition, auditors should perform audit procedures necessary to satisfy themselves that all such classifications are materially correct.

Several recent consensuses of the FASB's Emerging Issues Task Force (EITF) provide guidance on classification of certain revenue and expense items. Such consensuses include: Issue Numbers 99-17, Accounting for Advertising Barter Transactions; 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent; 00-10, Accounting for Shipping and Handling Fees and Costs; and 00-14, Accounting for Coupons, Rebates, and Discounts; all of which were added to the EITF's agenda pursuant to a letter dated October 18, 1999 from the SEC's Office of the Chief Accountant. Each of these consensuses are to be applied no later than in the December 31, 2000 financial statements for calendar year-end companies. Companies and their auditors should ensure that all necessary reclassifications, pursuant to these consensuses, are reflected in the financial statements for all periods affected.

We have noted improper classification of financial statement line items in the income statement, especially in the line items of revenues, cost of sales, and marketing expense. For example, we have seen items that would seem to be inventoriable costs pursuant to Accounting Research Bulletin (ARB) No. 43, Restatement and Revision of Accounting Research Bulletins, being reported inappropriately as marketing expense instead of as cost of sales. Other examples of inappropriate classification include improperly reflecting interest or investment income as product or service revenue. We also note that gains and losses on disposals of assets should be reported and disclosed separately in the financial statements, consistent with SEC Staff Accounting Bulletin (SAB) No. 101 and SAB Topic 5B, and in MD&A.

We have noted the presentation of separate line items within the income statement for the apparent purpose of emphasizing that a particular expense did not involve a cash outlay in the reporting period. For example, we have seen the separate presentation of non-cash stock compensation expense within the income statement, when such expense would more appropriately be classified in the income statement line items to which the expense relates. We believe that type of information (emphasizing the non-cash nature of these assets) is most effectively presented within the statement of cash flows. Registrants and their auditors should ensure that the manner of presentation is not misleading and that the presentation provides full information about the appropriate classification of the separately reported non-cash item. Presentations of gross margin that do not reflect the deduction of all sales discounts and costs of revenues are not appropriate, pursuant to Article 5-03 of Regulation S-X.

Disclosures of the Impact of Recently Issued Accounting Standards

As discussed in SAB Topic 11M (SAB No. 74), and AU section 9410, Item 3, The Impact on an Auditor's Report of an FASB Statement Prior to the Statement's Effective Date, filings with the SEC that include financial statements for a period ending after the issuance of an accounting standard but before the required date of adoption of that accounting standard should include disclosure of the impact that the recently issued accounting standard will have on the financial position and results of operations of the registrant when such standard is adopted in a future period. The following disclosures should be considered by registrants:

  • A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier;
  • A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined;
  • A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless unknown or not reasonably estimable. In that case, a statement to that effect may be made;
  • Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the new standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.).

For purposes of applying SAB Topic 11M, we believe that new accounting standards encompass the multiple sources which comprise GAAP, as contemplated in the GAAP hierarchy in Statement on Auditing Standards (SAS) No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor's Report. In this regard, we will expect calendar-year-end registrants to discuss, in their third quarter filings on Form 10-Q, the impact that FASB Statement (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, and SAB No. 101 are expected to have on their financial position and results of operations, unless the impact is unknown or not reasonably estimable, in which case disclosure to that effect would be required. However, based on the fact that SFAS No. 133 was issued in June 1998 and its effective date was delayed one year, we would expect that most calendar year-end companies would have quantified the expected impact, or range of expected impact, of adoption by the filing date of their Form 10-Q for the third quarter of 2000.

In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which supersedes SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Registrants and their auditors should be aware that, although SFAS No. 140 is effective for transfers occurring after March 31, 2001, its disclosure requirements relating to securitization transactions and collateral are effective for fiscal years ending after December 15, 2000.

Business Combinations - Intangible Assets

Accounting Principles Board (APB) Opinion No. 16, Business Combinations, requires that allidentifiable intangibles be assigned a fair value in the purchase price allocation of a purchase business combination. This would include intangibles such as patents, intellectual property, customer lists, and favorable leases. APB Opinion No. 17, Intangible Assets, requires that the recorded costs of the intangible assets acquired, including goodwill, be systematically amortized to income over the periods benefited.

The global economy has changed dramatically since 1970 when APB Opinion No. 17 was issued. High technology and a variety of service related businesses have become much more significant components of the economy. Communications that forty years ago were done through the "town" operator and eight party lines have been replaced with digital, fiber, and wireless systems. Many homes today have telephone and cable systems that give providers of media and communication services access to a mobile population. Customers differentiate based on the value added by a product or service. Manufacturing has become increasingly technology-driven as competitive pressures in the marketplace require successful companies to reduce costs. Brand and customer loyalty are the focus of every CEO. Products that are at the top of a market one year may be obsolete the next. And in an age of electronic communications, intangible assets may very well represent the majority of the value of a company.

Companies are required to consider the various factors described in paragraph 27 of APB Opinion No. 17 in determining the useful lives of intangible assets, including goodwill. As a result of our changing economy and business environment, the use of a forty-year life is no longer appropriate for many industries and companies. In addition to the factors in APB Opinion No. 17, other factors that we have considered in determining useful lives for intangible assets include:

  • The significance of competition in the industry, the ability of competitors to negatively affect the profitability of the acquired business, and the barriers to market entry;
  • The current or expected future levels of industry consolidation;
  • The impact of potential or expected changes in technology on product margins and life cycles and the importance of technological innovation to the product's future success and profitability;
  • Legislative action that results in an uncertain or changing regulatory environment;
  • Uncertain continuity of revenues dependent upon retention of key employees;
  • The "churn" rate of customers;
  • The mobility of customer and employee bases; and,
  • The relative infancy of an industry, or the company's experience in an industry.

As in the past, a registrant's sole or main support for its goodwill life should not be that it conforms with its peer companies. SAB No. 99 notes that industry practice that is not in conformity with GAAP is inappropriate. Companies should perform an analysis of the factors and assumptions, as discussed above, that are to be used in determining the appropriate useful lives of intangibles in each specific acquisition. In addition, companies should consider the unique attributes of each asset in determining the useful life for each asset. In other words, it is not appropriate to assume that assets with similar uses necessarily have the same useful life. For example, assets based on customer contracts (e.g., subscriber assets) may have different lives from one group to the next depending on the unique factors impacting their useful life as described above.

In certain circumstances, the revenue stream associated with an intangible asset, such as customer accounts, may suggest that the straight-line method of amortization is inappropriate. For example, if the revenue stream associated with the intangible asset results in a large portion of the total revenues expected from the acquired customer accounts being earned in the early years of the customer relationship then decline rapidly in the latter stages of the asset's useful life, an accelerated method of amortization would be more appropriate.

The analysis of the useful life should be adequately documented when the asset is acquired and amortization begins. A company should continually evaluate the periods of goodwill and other intangible asset amortization, including considering the impact of changes in the factors noted above, to determine whether subsequent events and circumstances warrant revised estimates of useful lives or salvage values.

A company and its independent auditors should also ensure that they consider the relevant accounting literature for recognition of intangible assets and the related amortization and impairment guidance found in APB Opinion No. 17; APB Opinion No. 20, Accounting Changes; and SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of; as well as the related disclosure requirements. We noted in SAB No. 100 that GAAP requires registrants to continually evaluate the appropriateness of useful lives assigned to long-lived assets, including identifiable intangible assets and goodwill. We do not view the recognition of an impairment charge to be an acceptable substitute for choosing the appropriate initial amortization or depreciation period or subsequently adjusting this period as company or industry conditions change.

In addition, we have noted instances where registrants have not separately identified intangible assets or have represented that they could not separately value them, instead recording goodwill for the entire excess purchase price in a purchase business combination. The staff has been highly skeptical of a registrant's claim that a valuation of separately identified intangibles is not possible when it appears the intangible assets exist and are valued in other merger transactions.

Employee Pension and Other Postretirement Plan Disclosures

In recent years, two significant trends have developed that could have an impact on the pension obligations of reporting companies. First of all, dramatic changes in the market value of assets held by pension plans to fund related pension obligations could have a material impact on a company's pension expense and cash flows, now and into the future by way of amortization of excess cumulative deferred gains and losses on pension assets. Secondly, many companies have recently converted their traditional defined benefit pension plans to cash balance plans. In certain circumstances, the cash balance plan provides lower post-employment pension benefits to employees, which could result in less pension expense being recorded by an employer sponsoring such a plan. Furthermore, the cash requirements for a company with a cash balance pension plan may be materially different than the requirements for a company with a traditional defined benefit plan. We believe that such events, like any other event giving rise to a material impact on current or future results of operations and cash flows, should be discussed in MD&A pursuant to Item 303 of Regulation S-K and Financial Reporting Codification (FRC) section 501.

FRC section 501 requires that registrants disclose, in MD&A, known trends or uncertainties that the registrant reasonably expects will have a material impact on its income, liquidity, or capital resources. FRC section 501 also notes that MD&A "shall focus specifically on material events...known to management that would cause reported financial information not to be necessarily indicative of future operating results or future financial condition." As a result, if a company has made a significant change to its pension plan, such as a conversion from a defined benefit to a cash balance pension plan, and such change has had or is reasonably likely to have a material impact on the company's liquidity, capital resources, or results of operations, the company should discuss the change and the related impact in its MD&A. Furthermore, if activity within the existing plan, such as earnings or returns on invested plan assets, has a material impact on the company's liquidity, capital resources, or results of operations, that activity should also be disclosed in MD&A. Where related disclosures are missing or inadequate, registrants will be asked to amend their filings to include the appropriate disclosures.

Registrants are further reminded of the need to continually monitor the key assumptions used in measuring pension benefit obligations, returns on plan assets, and periodic service cost. SFAS No. 87, Employers' Accounting for Pensions, indicates that each assumption used shall reflect the best estimate solely with respect to that individual assumption on the applicable measurement date.

Registrants are also reminded of the need to monitor the assumptions used in measuring other postretirement benefit obligations, returns on related other postretirement plan assets, and service cost. Principal actuarial assumptions include discount rates, participation rates, factors affecting the amount and timing of future benefit payments, which for postretirement health care benefits include per capita claims cost by age, health care cost trend rates, and Medicare reimbursement rates, and the probability of payment. The staff is particularly concerned about registrants monitoring their assumptions of health care cost trend rates, given the recent increases in health care costs in the United States. Consistent with SFAS No. 87, SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, requires that each assumption used reflect the best estimate solely with respect to that individual assumption on the applicable measurement date.

Segment Disclosures

In our December 22, 1999 letter to the AICPA, available at http://www.aicpa.org/members/div/auditstd/secchief.htm, we noted concerns related to the proper implementation of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. We continue to see troubling examples of registrants inappropriately applying the provisions of this standard. SFAS No. 131 requires that companies disclose business segment data on the same basis as that data is used by management in evaluating performance and making decisions about allocating resources to the different segments.

The Auditing Standards Board (ASB) issued guidance in AU Section 326, Evidential Matter, which requires, among other things, that auditors "review corroborating evidence, such as information that the chief operating decision maker uses to assess performance and allocate resources, material presented to the board of directors, minutes from the meetings of the board of directors, and information that management provides in the MD&A, to financial analysts and in the Chairman's letter to shareholders, for consistency with financial statement disclosures."

Since the effective date of SFAS No. 131, we have seen instances in which the MD&A disclosures or press releases of registrants describe business segments that differ from the business segments identified and disclosed in the footnotes to the financial statements. Additionally, during routine reviews of filings including segment disclosures, the SEC staff commonly requests registrants to provide copies of the reports or other materials supplied to the "chief operating decision maker" of the company to see if the segment information included in these reports and other information correlates with the segment information disclosed in the external financial statements. We have also reviewed analysts' reports, interviews by management with the press, and other public information to evaluate the consistency between the manner in which the company is portrayed in these other forums and in the financial statements. When the segment disclosures in the financial statements do not reflect a consistent identification of the company's segments as evidenced in the internal reports and materials used by the chief operating decision maker and in other public disclosures by the company, we have requested registrants to amend their financial statements and may do so in the future.

SAB No. 99 highlights some of the SEC staff's views regarding the significance of segment information to the financial statements taken as whole. SAB No. 99 points out that the effects of a misstatement on segment information, and the relative importance of information about the affected segment to the financial statements taken as a whole, should be considered in assessing the materiality of a misstatement. The need to consider such information is cited in AU Section 326.33 as well as in the enforcement action outlined in AAER No. 1140, In the Matter of W.R. Grace & Co. AU Section 326.33 specifically notes, "situations may arise in practice where the auditor will conclude that a matter relating to segment information is qualitatively material even though, in his or her judgment, it is quantitatively immaterial to the financial statements taken as a whole." We would expect all registrants and their auditors to take such considerations into account when assessing the materiality of any misstatements identified during the course of the audit.

In another enforcement action, AAER No. 1061, In the Matter of Sony Corp. and Sumio Sano, the Commission stated that "[t]he issuer's legal obligation extends not only to accurate quantitative reporting of the required items in its financial statements, but also to other information, qualitative as well as quantitative, needed to enable investors to make informed decisions. Such information, particularly the information embodied in the issuer's MD&A discussion, is of critical importance to market professionals and individual investors alike." Furthermore, in AAER No. 1061, the Commission reiterated an earlier MD&A release, Financial Reporting Release (FRR) No. 36 dated May 18, 1989, that in the absence of MD&A, "a company's financial statements and accompanying footnotes may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance." The Commission further cited the earlier MD&A release in AAER No. 1061, stating "MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short and long-term analysis of the business of the company."

Allowances for Loan Losses

In its reviews of registrant filings, the Division of Corporation Finance has noted certain omissions in registrants' accounting policy disclosures related to allowances for loan losses. APB Opinion No. 22, Disclosure of Accounting Policies, requires entities to include, as an integral part of the financial statements, a description of all significant accounting policies. The Division of Corporation Finance's Current Accounting and Disclosure Issues outline, available at http://www.sec.gov//divisions/corpfin/acctdisc.htm, provides information about allowance for loan loss disclosures that registrants should provide in their filings with the Commission. Registrants should provide a complete description of their accounting policy for the allowance for loan losses, specifically describing how they determine the amount of each element of the allowance. Registrants should describe their loan loss allowance accounting policies in sufficient detail to explain and describe the systematic analysis and procedural discipline, as required by FRR No. 28, applied in determining the allowance for loan losses.

In reviews by Federal banking regulatory agencies' examiners of workpapers of audits of insured depository institutions, the examiners place particular emphasis on reviewing the auditors' evaluation of an institution's internal controls and the extent and severity of any internal control weaknesses (including reportable conditions and material weaknesses) identified by the auditors. The Federal banking regulators have recently emphasized the need for appropriate internal controls related to the accounting for and financial reporting of a number of risk-based activities within financial institutions, including lending and the related allowance for loan losses. The SEC staff shares these concerns.

An institution's internal accounting controls for loan loss allowances should ensure compliance with the authoritative accounting guidance contained in accounting and auditing pronouncements, including SFAS No. 5, Accounting for Contingencies, SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and EITF Topic No. D-80, Application of FASB Statements 5 and 114 to a Loan Portfolio. As Topic No. D-80 states, the concept in GAAP is that impairment of receivables should be recognized when, based on all available information, it is probable that a loss has been incurred based on past events and conditions existing at the balance sheet date. Accordingly, internal accounting controls should ensure timely and accurate reporting for financial reporting purposes, in accordance with GAAP, including reporting of losses and changes in the credit quality of the loan portfolio in the periods those changes occur, and should ensure proper preparation and maintenance of documentation to support loan loss allowances, in accordance with FRR No. 28.

In addition, over the past two years, the Federal banking agencies have issued guidance reminding insured institutions about the importance of establishing and maintaining effective internal controls over securitization activity, sub-prime lending, and high loan-to-value residential real estate lending.

Revenue Recognition

SAB No. 101

In December 1999, we issued SAB No. 101. SAB No. 101, as amended, is effective for calendar year-end registrants for their December 31, 2000 year-end financial statements. As provided in SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, all interim periods of fiscal 2000 should be restated upon adoption of SAB No. 101 to reflect its provisions.

In October 2000, in response to questions that had been received from registrants, public accountants, and others, the staff issued responses to frequently asked questions (FAQ) regarding accounting standards related to revenue recognition and SAB No. 101. The FAQ was developed with the assistance of working groups from the accounting firms and industry. The FAQ is available on the SEC web site at http://www.sec.gov/info/accountants/sab101faq.htm. We encourage preparers and auditors to review the FAQ document as they consider the guidance in SAB No. 101.

Questionable Revenue Recognition Practices

We continue to encounter instances of questionable and inappropriate revenue recognition practices. Significant issues that we have dealt with recently include:

  • Complex arrangements that provide for separate, multiple deliverables (e.g., multiple products and/or services), at different points in time, during the contract term.
  • Nonmonetary (e.g., barter) transactions where fair values are not readily determinable with a sufficient degree of reliability (see AAER No. 1229, SEC v. Itex Corporation, et al.).

We have requested that the EITF address certain of these issues to clarify the application of GAAP in these transactions. However, we generally believe that the existing accounting literature provides analogous guidance for a number of these issues, including: SOP No. 97-2, Software Revenue Recognition; APB Opinion No. 29, Accounting for Nonmonetary Transactions; SOP No. 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts (paragraphs 58-60); SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises; and SFAC No. 6, Elements of Financial Statements. Further, we believe companies should be careful not to overlook the guidance in SFAS No. 125, paragraph 16, as it applies to the derecognition of liabilities, including performance and refund obligations to customers.

Revenue Recognition When Right of Return Exists

We have identified increased instances of registrants not properly applying SFAS No. 48, Revenue Recognition When Right of Return Exists. Prior to recognizing revenue on product sales when the buyer is given the right to return the product, SFAS No. 48 requires, among other criteria, that the amount of future returns can be reasonably estimated. If this criterion is not met, no revenue may be recognized until the criterion is met or the refund right expires, whichever occurs first. The ability to make reasonable estimates of returns may be impaired when sellers have little or no visibility into sales channels or products are subject to rapid technological change. In addition, newly formed or "start-up" companies, especially those in new or emerging business sectors, or those using new distribution channels or marketing techniques, may lack sufficient historical data on which to base estimates of returns. Furthermore, SAB No. 101 identifies a number of additional factors that should be considered in determining whether reasonable and reliable estimates of the amount of future returns may be made.

SFAS No. 48 also requires that the buyer either has paid or is obligated to pay the seller in order to recognize revenue at the time of sale, if a buyer's right of return exists. When equipment is sold on an installed basis, arrangements frequently include a retainage that the customer is not obligated to pay until and unless installation is complete. Registrants that enter into these types of arrangements should carefully evaluate whether their customer is obligated to pay the retainage prior to the registrant's recognition of the retainage as revenue.

Finally, if all of the criteria of paragraph 6 of SFAS No. 48 are met to recognize revenue at the time of sale, paragraph 7 of SFAS No. 48 requires that both sales and costs of sales reported in the income statement be reduced to reflect estimated returns. Merely deferring a profit margin on the sale is not appropriate. If a registrant has failed to comply with GAAP, the registrant should correct the error in the manner set forth in APB Opinion No. 20 and SFAS No. 16, Prior Period Adjustments.

MD&A Disclosures

MD&A requires a discussion of liquidity, capital resources, results of operations and other information necessary to an understanding of a registrant's financial condition, changes in financial condition and results of operations. The Commission stated in FRR No. 36 that MD&A should "give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant's financial condition and results of operations, with a particular emphasis on the registrant's prospects for the future." SAB No. 101 provides several examples of revenue transactions or events that the staff has asked registrants to disclose and discuss in MD&A in accordance with FRR No. 36, and registrants should refer to the guidance therein. Material, one time gains that impact current earnings and affect earnings trends should also be separately disclosed in MD&A.

Income Tax Shelters

We have noted an increasing use by registrants of tax strategies for certain investments that result in these registrants not recognizing either current or deferred federal income taxes. Some of these registrants are relying on the criteria in paragraph 33 of SFAS No. 109, Accounting for Income Taxes, which states that, "the tax law provides a means by which the reported amount of that investment can be recovered tax free and the enterprise expects that it will ultimately use that means," as a basis for not recognizing deferred tax liabilities. Registrants must meet the requirements of paragraph 33 of SFAS No. 109 to justify non-recognition of the associated deferred tax liabilities. Furthermore, registrants should make all of the required disclosures under paragraph 44 of SFAS No. 109.

Stock Compensation


In March 2000, the FASB issued Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation. FIN No. 44, which is an interpretation of APB Opinion No. 25, Accounting for Stock Issued to Employees, provides, in paragraph 39, that "if the exercise price of a fixed stock option award is reduced, the award shall be accounted for as variable from the date of the modification to the date the award is exercised, is forfeited, or expires unexercised." We understand that certain registrants have attempted to synthetically, or indirectly, reduce the exercise price of an option award by means other than those specifically contemplated in FIN No. 44. The FASB staff recently addressed such a situation in EITF Topic No. D-91, Application of APB Opinion No. 25, Accounting for Stock Issued to Employees, and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, to an Indirect Repricing of a Stock Option.

FIN No. 44 indicates that any modification or sequence of actions by a grantor to directly or effectively (i.e., indirectly) reduce the exercise price of an option award causes variable accounting for the repriced or replacement award for the remainder of the award's life. Consistent with this guidance, registrants should account for stock option awards, the terms of which have been modified in a manner that appears to result in a direct or indirect repricing of the awards, using variable plan accounting.

Equity Instruments Issued to Other Than Employees

We continue to see numerous transactions involving the issuance, by registrants, of equity instruments to non-employees, which, in some cases, are also registrants, where the underlying economic purpose of the arrangements is not entirely clear. These arrangements use various equity instruments with differing terms and performance commitments by the counterparty. Issuers of these equity instruments should carefully consider the guidance provided in EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, for guidance as to the appropriate measurement date for the fair value of these equity instruments. Issuers that grant unvested equity instruments should comply with the SEC staff announcement in EITF Topic No. D-90, Grantor Balance Sheet Presentation of Unvested, Forfeitable Equity Instruments Granted to a Non-Employee. Registrants that receive equity instruments in these transactions should follow the accounting and disclosure guidance provided in EITF Issue No. 00-8, Accounting by a Grantee for an Equity Instrument to be Received in Conjunction with Providing Goods or Services, and currently being considered in EITF Issue No. 00-18, Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees. If service revenue recognized or to be recognized is materially attributable to equity instruments received by a registrant and measured prior to rendering the services, disclosure about actual or possible changes in the value of the equity instruments may be material to an investor's assessment of the registrant's results of operations and liquidity.

The staff has noted that some valuations of equity instruments issued to other than employees do not appear reasonable. In one instance, the grantor placed a value on the equity instruments issued, while the recipient stated that the instruments could not be valued. Furthermore, the staff has reviewed valuations of equity instruments that are based on unreasonable or unrealistic assumptions, such as the volatility of the NASDAQ 100 index in the valuation of warrants issued by an Internet start-up company. Auditors should carefully review and perform appropriate audit tests with respect to the values assigned to equity instruments issued in these transactions. Such tests should include procedures to determine that the assumptions and valuation methodology used will result in valuations that are realistic given the specific facts and circumstances of a transaction.

We also have noted certain arrangements in which equity instruments are granted by registrants to current or future customers, the terms of which require these customers to purchase goods or services from the registrant in order to vest in the equity instruments. We have seen differing income statement classifications for the fair value of the equity instruments granted, measured pursuant to the guidance in EITF Issue No. 96-18, for similar transactions. For example, some registrants classify the related expense as a reduction of revenues, while others have classified the expense as cost of sales, sales and marketing, or other expenses. EITF Issue No. 96-18 requires companies to recognize the fair value of the equity instruments "in the same period(s) and in the same manner (that is, capitalize versus expense) as if the enterprise had paid cash for the goods or services or used cash rebates as a sales discount instead of paying with or using equity instruments." Further, EITF Issue No. 00-14 indicates that "the reduction in or refund of the selling price of the product or service resulting from any cash sales incentive should be classified as a reduction of revenue." Based on the above, we believe that the fair value of equity instruments granted under these arrangements must be classified in the income statement by the grantor as a reduction of revenue.

Accounting for Convertible Securities With Beneficial Conversion Features

EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, provides guidance on accounting for convertible debt and preferred stock issued with beneficial conversion features. We frequently encounter issues related to determining whether a convertible debt security or preferred stock has a beneficial conversion feature when there is not yet a public market for the common shares.

This topic was discussed at the Twenty-Seventh Annual AICPA National Conference on SEC Developments in December 1999 in a speech by an SEC staff member, available on the SEC web site at http://www.sec.gov/news/speech/speecharchive/1999/spch332.htm. Generally, we believe this issue to be a valuation issue similar to the issue of cheap stock and have approached it in a similar manner. In the evaluation of the fair value of its stock, the registrant should consider the proximity of the issuance of stock to an initial public offering, intervening events, transfer restrictions and exercise dates, profitability and financial condition of the company, and historical cash transactions involving stock with similar terms and restrictions. We consider the sufficiency of objective, verifiable evidence as the best support for the determination of fair value. On the issue of cheap stock, we have advised registrants that we believe stock, options, or warrants issued to employees, consultants, directors, or others providing services to the issuer within one year prior to the filing of an initial registration statement at a price (or exercise price) below the offering price should be presumed to be compensatory.

We follow a similar approach for convertible securities with embedded beneficial conversion features. Convertible securities issued within a year prior to the filing of an initial registration statement with a conversion price below the initial offering price generally are deemed to contain an embedded beneficial conversion feature unless the registrant provides sufficient, objective, and verifiable evidence that the conversion price represented fair value at the issuance or commitment date. As part of this process, registrants and their auditors should consider any valuations that an underwriter has discussed with senior management or the board of directors. In instances where the security contains an embedded beneficial conversion feature, the beneficially convertible security should be accounted for pursuant to the guidance in EITF Issue No. 98-5.

Documentation and Disclosure Related to Derivative Instruments and Hedging Activities

SFAS No. 133, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities (collectively, SFAS No. 133), provides accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 is effective for all fiscal quarters for all fiscal years beginning after June 15, 2000.

One of the fundamental requirements of SFAS No. 133 is that formal documentation be prepared contemporaneously with the designation of a hedging relationship. In addition, upon initial adoption of SFAS No. 133, all hedging relationships must be redesignated anew and documented pursuant to the requirements of the standard. In the speech mentioned above, the SEC staff member addressed our views on registrants' compliance with SFAS No. 133's requirements for contemporaneous formal documentation of hedging relationships, specific identification of hedged transactions, and the method of assessing hedge effectiveness.

We expect registrants to provide all of the SFAS No. 133 required disclosures, including both qualitative and quantitative disclosures. During recent filing reviews, the staff of the Division of Corporation Finance has noted that in some instances, registrants have not provided certain required quantitative disclosures, such as those about hedge ineffectiveness. In some cases, the registrants have informed us that there was no hedge ineffectiveness, or the amount of hedge ineffectiveness was not material for disclosure. Depending on the particular facts and circumstances, registrants and their auditors may be requested to provide documentation in support of these determinations. Assuming the amount of hedge ineffectiveness was properly determined in accordance with SFAS No. 133, registrants should include statements to that effect (i.e., hedge ineffectiveness was immaterial) in their filings to better inform investors about the impact of hedge effectiveness on the financial results of the company. We are also asking registrants to disclose where on the income statement (i.e., on which line item(s)) they are recording hedge ineffectiveness. Additionally, we have requested that registrants provide disclosure, even if immaterial, of the amount of gains or losses reclassified into earnings as a result of the discontinuance of cash flow hedges because it was probable that the original forecasted transactions will not occur. Such disclosure provides useful information to investors about an entity's pattern of discontinuing cash flow hedges because the forecasted transactions are no longer probable of occurrence.

Although not required by SFAS No. 133, we encourage registrants to disclose the fair value of the derivatives recorded on the balance sheet at the end of the reporting period and to state where on the balance sheet they are recorded. Even though an entity discloses that it records its derivative instruments at fair value on the balance sheet, it may not be obvious to readers of financial statements what amounts of the derivative instruments are recorded as assets, what amounts are recorded as liabilities, and what line items on the balance sheet are affected. We believe that such disclosures will help investors and other readers of financial statements gain a better understanding of a registrant's use of derivative instruments. Additionally, registrants and their auditors are reminded that registrants should not net or offset derivative instrument assets and liabilities on the balance sheet unless they have met the conditions in FIN No. 39, Offsetting of Amounts Related to Certain Contracts.

Financial Instrument and Derivative Contract Terms

Financial statement preparers and their auditors are reminded of the need to understand and evaluate the provisions of all financial instrument contracts and other potential derivative contracts in order to properly classify and value these contracts in conformity with GAAP. This need to understand and evaluate contract provisions will increase with the adoption of SFAS No. 133, as amended, and recent guidance issued by the EITF.

Initial application of SFAS No. 133 requires the recognition of all freestanding derivative instruments in the statement of financial position at fair value. Additionally, other contracts will need to be examined to determine if embedded derivative instruments exist that require separation pursuant to the standard. The analysis of contract terms will require an in-depth and thorough analysis.

In addition, as a result of two recent EITF consensuses, Issue No. 00-7, Application of Issue No. 96-13, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock," to Equity Derivative Transactions That Contain Provisions That Require Net Cash Settlement If Certain Events Occur, and Issue No. 00-19, Determination of Whether Share Settlement Is within the Control of the Issuer for Purposes of Applying EITF Issue No. 96-13, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock", it may be necessary for financial statement preparers and their auditors to carefully review equity derivative contracts to determine if equity classification will still be appropriate upon the effective date of the consensuses. The consensus in Issue No. 00-7 requires that contracts that include any provision triggered by an event beyond the company's control that could require net-cash settlement by the company must be classified as an asset or a liability. Similarly, for public companies, Issue No. 00-7 requires contracts with any provision triggered by an event beyond the company's control that could require physical settlement by a cash payment to the counterparty in exchange for the company's shares to be classified as temporary equity (assuming no contract provision could impose net-cash settlement on the company, in which case the contract would be classified as an asset or a liability).

During the process of examining the specific contract terms and the legal or regulatory impediments a company could encounter in trying to execute a net-share or physical settlement provision, financial statement preparers and their auditors must also consider the specific conditions to be met in the consensus reached in Issue No. 00-19.

Transition guidance for these consensuses is designed to allow companies time to evaluate and possibly restructure existing contracts prior to the June 30, 2001 implementation date. Financial statement preparers and their auditors should refer to the above referenced EITF Issues for further guidance on equity derivative contracts.

Equity Method of Accounting for Investments in Common Stock

APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, requires that an investment in the common stock of an unconsolidated subsidiary be accounted for using the equity method if the investor has significant influence over the investee's operating and financial policies. Under APB Opinion No. 18, an investor that owns 20% or more of the voting stock of an investee is presumed to have the ability to exercise significant influence over the investee. We would consider an investor's historical choice not to influence, and its current and future intent not to influence, the investee as being irrelevant where an investor is presumed to have the ability to exercise significant influence over the investee. We have also seen fact patterns which indicate that significant influence existed even though the investor held less than 20% of an investee's voting stock, such as greater than 20% representation by an investor on the investee's board of directors. As noted in APB Opinion No. 18, determining the ability of an investor to exercise significant influence is not always clear and applying judgment, considering all of the relevant facts and circumstances, is necessary to assess the status of each investment. This issue was discussed in a speech by an SEC staff member at the Twenty-Seventh Annual AICPA National Conference on SEC Developments in December 1999, which is available on the SEC web site at http://www.sec.gov/news/speech/speecharchive/1999/spch330.htm.

Accounting Changes

Registrants and their auditors are reminded of the guidance provided in SAB Topic 5F (SAB No. 32). If a registrant is required to adopt an accounting principle by means of restatement of prior periods' financial statements, but the registrant determines that the accounting change does not have a material effect on prior periods' financial statements and thus chooses not to restate such financial statements, the cumulative effect of the change should be included in the statement of income for the period in which the change is made. However, if the cumulative effect is material to current operations or to the trend of the reported results of operations (refer to SAB No. 99 for discussion of the SEC staff's views regarding materiality), then the individual income statements of the earlier years should be retroactively adjusted.

Registrants and their independent auditors are also reminded of the guidance in paragraph 29 of APB Opinion No. 20. Paragraph 29 of APB Opinion No. 20 provides a special exemption for retroactively applying accounting changes in financial statements first issued in obtaining additional equity capital from investors, effecting a business combination, or registering securities. In this regard, APB Opinion No. 20 notes that this exemption is available only once for changes made at the time a company's financial statements are first used for any of these purposes, and it is not available to companies whose securities currently are widely held. Furthermore, paragraph 30 of APB Opinion No. 20 requires that a company disclose the nature of the change in accounting principle and the justification for it in financial statements issued under the circumstances described in paragraph 29. AU Section 420, Consistency of Application of Generally Accepted Accounting Principles, requires the recognition of a change in accounting principle, including those made pursuant to paragraph 29 of APB Opinion No. 20, in the auditors' report through the addition of an explanatory paragraph.

Paragraph 33 of APB Opinion No. 20 requires that the effect of a change in estimate that affects future periods, such as a change in service lives of depreciable assets, on income before extraordinary items, net income and related per share amounts of the current period be disclosed. Changes in accounting estimates for other significant items, such as estimates of loss accruals, could affect future periods and likewise should be disclosed in accordance with APB Opinion No. 20. Registrants also should include a robust discussion of material changes in accounting estimates in MD&A. Such disclosure should not merely reiterate the related disclosure included in the footnotes to the financial statements, but should be a transparent, plain English discussion of the changes and their effect on the trends and operations of the registrant.

Foreign Currency Transactions

In recent press releases and earnings reports, the staff has noted that several registrants with significant foreign currency transactions cite the exchange rate of the euro to the U.S. dollar as a reason for lower than expected operating results. Registrants and their independent auditors are reminded of the requirement in paragraph 32 of SFAS No. 52, Foreign Currency Translation, to disclose a foreign currency rate change that occurs after the date of the financial statements, and its affects on unsettled balances pertaining to foreign currency transactions, if significant. Furthermore, registrants are required to describe in MD&A any known trends or uncertainties that have had or the registrant reasonably expects to have on net sales or revenues or income from continuing operations, which would include a discussion of the effect of foreign currency rate changes (see AAER No. 363, In the Matter of Caterpillar Inc., in which the Commission took enforcement action for inadequate MD&A disclosures).

MD&A Disclosures

As previously discussed, in FRR No. 36 the Commission clearly stated that the purpose of MD&A is "to give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant's financial condition and results of operations, with particular emphasis on the registrant's prospectus for the future (emphasis added)." Registrants are urged to review this guidance, including the examples set forth in that release. Too often, companies merely repeat, in MD&A, the amounts or disclosures included in the financial statements, or merely recalculate new amounts from those provided in the financial statements. These practices fall short of providing investors with the required disclosures. MD&A discussions should clearly explain, in plain English, the known trends, demands, events, commitments and uncertainties that are reasonably likely to materially affect a registrant's liquidity, capital resources, and results of operations. In making these disclosures, it is important that the reasons for the trends, demands, events, commitments, and uncertainties are discussed, in addition to quantifying the related effects.

A number of current developments have occurred in the economy and business environment that are likely to affect registrants and require disclosure in MD&A, if applicable. Some of these developments include:

  • Increasing prices for oil and gas which may materially affect costs in current or future periods;
  • Increasing interest rates;
  • Acquisitions by companies of their own stock, which may materially impact trends in earnings per share, and, if financed by incurring debt, may affect companies' liquidity, financial condition, and current and future operations due to increased borrowing costs;
  • Changes in the value of the euro and U.S. dollar which, as previously discussed, may impact companies with significant foreign operations;
  • Market changes which, as previously discussed, may affect pension assets and related returns thereon;
  • Changes in trends of revenue growth (see also the discussion regarding revenue recognition above);
  • Acquisitions of businesses resulting in new segments; and,
  • Participation in highly leveraged transactions (see FRC section 501.06.b.).

International Accounting Issues

We have noted a number of situations involving purported reconciling items that appear to be the result of non-compliance with home country accounting standards (including International Accounting Standards) and not the result of a difference between those standards and United States GAAP. As such, there should not be a reconciling item. In many of these situations, the registrant asserted that the application of the relevant standards was insignificant or immaterial; however, they were significant enough to be identified as a reconciling item for purposes of the United States GAAP reconciliation. We believe that this reasoning is not persuasive. The reconciliation to United States GAAP cannot be used in lieu of full compliance with the accounting standards applied to prepare the primary financial statements.

We also have noted the inappropriate application of the consolidation and equity methods of accounting by foreign registrants, which have resulted in the restatement of previously issued financial statements, including:

  • Use of the cost method for subsidiaries and investees erroneously characterized as "immaterial";
  • Use of the investee's local GAAP financial statements in applying the equity method;
  • Excessive time lags between the financial statements of the investor and investee in applying the equity method (i.e., the investee's financial statements lag one year behind the registrant's);
  • Lack of analysis of certain consolidation guidance under United States GAAP, including EITF Issue No. 96-16, Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights, and EITF Issue No. 97-2, Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements;
  • Lack of, or incorrect analysis of, the significant influence criteria of APB Opinion No. 18 and FIN No. 35, Criteria for Applying the Equity Method of Accounting for Investments in Common Stock; and,
  • Difficulty in obtaining complete summarized data under Rule 4-08(g) of Regulation S-X, and difficulty obtaining Regulation S-X, Rule 3-09 financial statements on an appropriate basis.

We discussed these and other international accounting issues in speeches at the Twenty-Seventh Annual AICPA National Conference on SEC Developments in December 1999, and at the European FASB-SEC Financial Reporting Conference in Frankfurt, Germany in March 2000 (available at http://www.sec.gov/news/speech/speecharchive/1999/spch338.htm, and http://www.sec.gov/news/speeches/spch359.htm), and in the document International Financial Reporting and Disclosure Issues prepared by staff members in the Division of Corporation Finance, which is available on the SEC web site at http://www.sec.gov/divisions/corpfin/internatl/issues0700.htm.

Effective Auditing

The public accounting profession has a unique role and franchise in our capital markets, and in the financial accounting system in the United States. It is the independent auditor that the public looks to in order to provide an unbiased opinion on and assure the credibility of the financial statements that are essential to many investment decisions. Therefore, to ensure the efficient operation of our capital markets, investors must have confidence in the integrity of our financial reporting system and in the effectiveness of financial statement audits by independent accountants. Following are some of our observations on several significant issues related to high quality, effective financial statement audits.

Panel on Audit Effectiveness

On August 31, 2000, the Panel on Audit Effectiveness issued its final report and recommendations. The Panel's examination was a comprehensive, independent, in-depth analysis to date into the way audits are performed. It was a study of not only the effectiveness of audits, but also the environment in which audit firms operate, the factors that drive their business, their operational management, the types of services they perform as well as the system of self regulation and governance that exists today. We believe that the recommendations included in the final report, if appropriately implemented, will go a long way toward improving the conduct of audits. The staff believes that it is important that the Public Oversight Board ensure, on behalf of the public, that the recommendations included in the final report are successfully implemented in full, on a timely basis.

Non-Standard Journal Entries

In its final report, the Panel on Audit Effectiveness found that financial statement misstatements are often perpetrated by using non-standard entries to record fictitious transactions or other events and circumstances, particularly near the end of the reporting period. The Panel's quasi-peer review disclosed that in about 15% of the engagements reviewed, auditors did not have an adequate understanding of the client's system for preparing, processing, and approving non-standard entries. Furthermore, the Panel found that auditors did not perform procedures to identify and review non-standard entries in about 31% of the engagements reviewed. Given the Panel's findings, the staff believes auditors should review non-standard journal entries to identify those entries that should be subject to further detail testing.

Auditing Loss Accruals

On December 9, 1999, we sent a letter to the ASB reiterating our request for more in-depth guidance in auditing standards and other ASB literature on auditing loss accruals. We believe that more detailed guidance is essential.

A review of enforcement cases, as well as restatements of financial statements filed with the Commission, indicates that some corrections in the financial statements related to liabilities such as contingent liabilities, restructuring accruals, and other types of loss accruals, are not the result of system-based errors. Rather, these corrections are due to adjustments originally made by, or under the supervision of, senior financial reporting personnel. In these situations, we have seen the following audit deficiencies:

1. Concluding that because the loss accrual balance in the current period is the same, or nearly the same, as in the prior period, no further audit work was required to be performed,
2. Not clearly understanding the activity in the loss accrual account and the impact on the financial statements,
3. A lack of understanding of the basis for the accrual and the necessary supporting evidence,
4. Testing the loss accrual balance through poorly designed or implemented analytical procedures,
5. Applying analytical procedures to subjective audit areas incapable of being audited through analytical procedures,
6. Only testing a loss accrual to ensure that the balance is not understated,
7. Failure to evaluate the impact of missing disclosures that are mandated by GAAP,
8. A lack of testing of the proper classification of costs, and
9. Failure to recognize that assets, such as inventory, for which a write down at a previous year end established a new cost basis, as noted in ARB No. 43 and SAB No. 100, were improperly adjusted upward through the adjustment of loss accruals.

Consequently, we believe that it is important for auditors to:

1. Carefully consider all the risk factors set forth in SAS No. 82, Consideration of Fraud in a Financial Statement Audit, and consider how, for a particular client, the existing risk factors should be assessed and related to the specific determination of the nature, timing and extent of the audit tests;
2. In light of the business, industry, and control risks affecting the company, as well as the subjective nature of the particular types of estimates being examined, consider the type of sufficient, verifiable, objective evidence that is required to support the account balances. SAB No. 100 discusses the need for appropriate documentation as well as internal accounting controls; and,
3. Test not only the ending balances, but also the propriety and classification of activity in the accounts during the periods presented. The testing should not be limited to merely determining if the liability is understated, but rather whether it is properly stated such that the financial statements are fairly presented in all material respects.

The staff appreciates the judgment involved in estimating and auditing certain liabilities, and that a range of probable losses may exist. However, we have challenged loss accruals that are either materially understated or overstated, including when understated or excess liabilities are used to manage earnings.

Registrants and their independent auditors are also reminded of the accounting and financial statement disclosure requirements of SFAS No. 5. If no accrual is made for a loss contingency, or if an exposure to loss exists in excess of the amount accrued, paragraph 10 of SFAS No. 5 requires that disclosure of a contingency be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. Furthermore, paragraph 14 of SFAS No. 5 prohibits the accrual of losses for "general or unspecified business risks."

Audit Documentation

Through the staff's oversight of the peer review program of the AICPA's SEC Practice Section (SECPS) and in a 1996 letter from the SEC Chief Accountant to the Public Oversight Board, we have noted recurring comments by peer reviewers related to the lack of sufficient audit documentation in the working papers. This issue was also identified through the quasi-peer review process in the final report of the Panel on Audit Effectiveness.

AU section 339, Working Papers, requires that auditors prepare and maintain working papers. It is the documentation contained in working papers that constitutes the principal record of the work performed by the auditor and of the conclusions that the auditor has reached. Therefore, the failure to prepare and maintain appropriate audit working papers to support the auditors' opinion would constitute a violation of GAAS.

Analysis of AAERs

Two studies have been performed on the SEC's AAERs within the past year. The Panel on Audit Effectiveness conducted a study with the objective of obtaining additional insights regarding the characteristics that were present in the AAERs as well as insights regarding the auditors' work that resulted in detected or undetected material misstatements (refer to its analysis, included at Appendix F in The Panel on Audit Effectiveness, Report and Recommendations, August 31, 2000, available at http://www.pobauditpanel.org/). The second study, entitled Fraud-Related SEC Enforcement Actions Against Auditors: 1987-1997 - August 2000, identified the settings in which auditors were sanctioned by the SEC, as well as the alleged deficiencies in the audit process that caused auditors to be sanctioned.

In planning and performing financial statement audits for the upcoming year-end, we encourage registrants and their auditors to consider the findings of these studies and their implications for the conduct of the audits. Findings of these studies included some of the following common themes:

  • Inappropriately interpreting or applying requirements of GAAP;
  • Over-reliance on management representations as audit evidence;
  • Over-reliance on internal controls, and inadequate substantive procedures;
  • Management override of internal controls;
  • Use of information technology to facilitate frauds that are material to the financial statements;
  • Use of non-standard journal entries;
  • Changes in the entity's business that should have triggered changes to the auditor's inherent risk assessment;
  • A lack of professional skepticism by the auditors; and,
  • Lack of recognition/disclosure of key related parties.

Revenue Recognition

Year-End Cutoff Testing

A study published in March 1999 entitled Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S. Public Companies (the COSO Report) notes that over half the frauds in the study involved overstating revenues by recording revenues prematurely or fictitiously. Many of the revenue frauds involved improper cutoff as of the end of the respective period. The other studies of the Commission's AAERs, as previously discussed, identified inadequate cutoff tests as a problem in a number of the SEC's enforcement actions against auditors. We believe it is critical that auditors conduct appropriate period-end cutoff audit procedures, even when a majority of the fieldwork is conducted at interim or preliminary dates. This is particularly important for audits of businesses that experience a high level of sales transactions or individually significant sales transactions near the end of the financial reporting period. In its report and recommendations, the Panel on Audit Effectiveness recommended that audit firms: "test the cut-off of revenue when inherent or control risks over such transactions are other than low, and specifically when there is a high level of sales transactions or individually significant sales transactions near the end of the reporting period. Cut-off tests should be more extensive than tests of only a few transactions before and after the close of the period. Cut-off testing often should require the auditor's physical presence at the entity's location(s) at period end." The staff strongly endorses this recommendation. Testing of a few transactions before and after year end may very well be insufficient to provide a reasonable basis for the auditors' report.

Side Agreements

Another common problem noted in the COSO Report, as well as in other recent studies, was the existence of "side agreements" that altered the terms of a sales arrangement. Because side agreements often include unilateral cancellation, termination, or other privileges for the customer to void the transaction, they pose a significant risk to proper revenue recognition. As stated in SAB No. 101, companies should have effective internal controls to ensure that any agreements or alterations to sales contracts that are evidenced by side agreements are given proper accounting recognition. Auditors should perform procedures, including confirmation of the terms of significant contracts, that would assist them in detecting side agreements.

Confirmation of Complex Transactions

We believe that the AICPA has provided excellent guidance in the document entitled Audit Issues in Revenue Recognition, which was issued in early 1999. Auditors should consider this guidance when auditing revenue. This document provides guidance on confirming the substantive terms of complex transactions, which has been summarized as follows.

In some entities, the nature of the business is such that the majority of revenues are comprised of complex, large, and/or non-recurring transactions evidenced by individual contracts. Auditors should read and understand the terms of these contracts, since the terms could have a significant impact on the appropriate accounting treatment for the transactions. For these types of transactions, auditors should confirm directly with the customer all significant contract terms which could have an impact on the accounting for the contracts, such as payment terms, right-of-return and refund privileges, customer acceptance criteria, termination provisions, or bill and hold arrangements. Auditors also should confirm with the customer whether significant unfulfilled vendor obligations exist, or the existence of any oral or written agreements outside of the contract that may alter the written provisions of the contract.

Auditing Derivatives and Hedging Activities

SFAS No. 133, and the associated implementation guidance provided by the FASB staff based on its discussions with the FASB's Derivatives Implementation Group, have required entities to significantly change the way they document, account for, and report derivative instruments and hedging activities. As auditors design and implement audit procedures for derivatives and hedging transactions, they should gather sufficient, objective, and verifiable evidential matter to test the audited entity's compliance with the provisions of SFAS No. 133. In particular, auditors should gather evidential matter to determine whether:

  • Upon adoption of SFAS No. 133, the audited entity's management has, in accordance with the standard, recognized all derivative instruments at fair value in the statement of financial position and designated anew and documented all hedging relationships; and
  • Management has documented, at the inception of a hedging relationship and with sufficient specificity to ensure consistent application, the method it will use to assess hedge effectiveness.

Auditors also should gather objective, verifiable evidential matter to support management's expectation at the inception of the hedge that the hedging relationship will be highly effective and should test management's on-going periodic assessment of hedge effectiveness, including its calculations and reporting of hedge ineffectiveness.

Auditing Fair Values of Financial Instruments

As part of the audit of a company's financial statements, an auditor should test management's assertions and gather sufficient supporting evidential matter about fair values of financial instruments. Such testing applies to both the fair values of financial instruments recorded in the basic financial statements, such as derivative instruments within the scope of SFAS No. 133, and to those disclosed in the notes to the financial statements, as required by SFAS No. 107, Disclosures about Fair Value of Financial Instruments. Registrants must have documented evidence to support an assertion that the fair value of a financial instrument, such as trade accounts receivable, approximates the carrying amount if no fair value disclosure of the financial instrument is made. In addition, in instances where it is not practicable to estimate the fair value of a financial instrument, the disclosures required by paragraph 14 SFAS No. 107 should be made. The staff has noted with concern the lack of sufficient, objective, verifiable evidence supporting registrants' SFAS No. 107 disclosures, and a lack of appropriate testing of these disclosures by auditors. The staff reminds auditors that footnote disclosures must also be subjected to sufficient audit procedures in order for the auditor to issue a "clean" opinion.

Financial instruments may be valued by the entity through use of internally or externally developed valuation models. As described in SAS No. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, auditors should obtain evidence supporting the fair value recorded or disclosed by their clients by performing procedures such as: (1) assessing the reasonableness and appropriateness of the model being utilized for the specific financial instrument, (2) independently verifying the underlying assumptions (for example, interest rates, volatility factors, discount rates, foreign currency exchange rates, and expected future cash flows) through reference to external sources, (3) independently recalculating the fair value, and (4) comparing the fair value and assumptions used in calculating the fair value with subsequent or recent transactions.

Given the complexity of many financial instruments, and the continuous introduction of new instruments in the marketplace, testing management's assertions about fair value of financial instruments is important. Independent quoted market prices provide the most reliable measure of fair value and are generally considered sufficient evidence of the fair value of a financial instrument. If independent quoted market prices are not available, an entity may obtain estimates of fair value from broker-dealers or other third-party sources. In auditing such fair value estimates, an auditor should obtain an understanding of how the estimate was developed and whether it is necessary to obtain additional estimates. For example, additional estimates may be appropriate if the third party fair value estimate was developed from bid/ask quotes that were received from the audited entity or if the third party pricing source has a relationship with the audited entity (such as being the entity that originally sold the financial instrument to the audited entity).

In auditing fair value estimates, auditors should consider the guidance in Independence Standards Board Interpretation (ISB) No. 99-1, FAS 133 Assistance. For fair value estimates obtained from third-party sources, auditors should consider the applicability of the guidance in SAS No. 73, Using the Work of a Specialist, or SAS No. 70, Reports on the Processing of Transactions by Service Organizations. In addition, if the determination of fair value requires the use of estimates, auditors should consider the guidance in SAS No. 57, Auditing Accounting Estimates.

Internal Controls

Section 13(b)(2)(B) of the Securities Exchange Act of 1934 requires every issuer which has a class of securities registered pursuant to section 12 of the Act to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: (1) transactions are executed in accordance with management's general or specific authorization; (2) transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP, and to maintain accountability for assets; (3) access to assets is permitted only in accordance with management's general or specific authorization; and (4) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. SAB Nos. 99, 100, and 101 further discuss the importance of internal controls for purposes of providing reasonable assurance that certain transactions are accounted for in accordance with GAAP. Registrants must comply with both GAAP and section 13 of the Securities Exchange Act of 1934. Auditors must design appropriate audit procedures in response to an assessed level of control risk as determined based on an understanding of the internal controls in place during the period under audit.

The report and recommendations of the Panel on Audit Effectiveness stated that audit committees should devote additional time and attention to discussions of internal control with management as well as the independent auditors. Specifically, the Panel recommended that audit committees, "obtain a written report from management on the effectiveness of internal control over financial reporting." The staff strongly supports this recommendation and encourages audit committees to adopt it immediately.

Other Information in Documents Containing Audited Financial Statements

We have seen inconsistencies between information included in the audited financial statements and information included in other sections of documents filed with the Commission. Auditors are reminded that AU section 550, Other Information in Documents Containing Audited Financial Statements, requires an auditor to read the other information in a document containing audited financial statements and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the audited financial statements.

Restated Financial Statements

The staff has recently noted instances in which independent auditors have issued audit reports on financial statements that include restated financial information, but have omitted from their audit report an explanatory paragraph describing the restatement. We believe that, in accordance with AU Section 420, changes in accounting principle that have a material effect on the financial statements, including the correction of an error in application of a principle, require recognition in the independent auditor's report through the addition of an explanatory paragraph that follows the opinion paragraph. Such explanatory paragraph should identify the nature of the change and refer the reader to the note in the financial statements that provides a detailed discussion of the change in accordance with AU Section 508.16, Reports on Audited Financial Statements-Lack of Consistency.

Inquiries of Management

Management Representations

SAS No. 85, Management Representations, requires that the independent auditor obtain written representations from management as part of an audit of financial statements. During an audit, management makes many representations to the auditor, both oral and written, in response to specific inquiries or through the financial statements. Such representations are part of the evidential matter the independent auditor obtains. However, such representations are not a substitute for the application of those auditing procedures necessary to afford the auditors a reasonable basis for their opinion.

As provided in SAS No. 85, we believe that auditors should adequately corroborate specific management representations as well as responses to inquiries of management through substantive auditing procedures. Management representations should not be a substitute for appropriate auditing procedures. In addition, written representations should confirm explicit or implicit representations given to the auditor and reduce the possibility of misunderstandings concerning the matters that are the subject of representations.

Auditors' Response to Management Inquiries

As previously noted, the Panel on Audit Effectiveness recently completed a study of AAERs and found numerous instances where the auditors' substantive procedures apparently were not adequate to detect material misstatements, including auditors' over-reliance on management representations (refer to Appendix F of the Panel's report and recommendations).

Specific examples of areas where the staff has noted that appropriate substantive procedures were not performed to support management representations and responses to inquiries of management include: follow-up on confirmation exceptions; testing sales and inventory cutoff; testing asset and liability valuations; agreeing or reconciling financial statements to the accounting records; corroborating representations made related to unusual fluctuations noted when performing analytical procedures; and verifying the existence of off-site assets.

Interim Reviews Performed to Comply with the New Audit Committee Rules

Audit committees play a critical role in the financial reporting system by overseeing and monitoring management's and the independent auditors' participation in the financial reporting process. Accordingly, the Commission adopted a rule entitled "Audit Committee Disclosure" to improve disclosure relating to the functioning of corporate audit committees and to enhance the reliability and credibility of financial statements of public companies. The new rule was based in large measure on recommendations made by the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. The rule became effective on January 31, 2000. A copy of the final rule is available on the SEC's website at http://www.sec.gov/rules/final/34-42266.htm.

Companies are under increasing pressure to meet financial analysts' expectations, and that pressure can be even more acute in the context of quarterly earnings. We believe that the participation of auditors in the financial reporting process at interim dates will help to counter-balance that pressure and impose increased discipline on the process of preparing interim financial information. Auditor involvement in the financial reporting process earlier in the year should facilitate timely identification and resolution of significant and sensitive issues and result in fewer year-end adjustments, which should reduce the cost of annual audits.

Accordingly, the Commission adopted revisions to Rule 10-01(d) of Regulation S-X and Item 310(b) of Regulation S-B to require that a company's interim financial statements be reviewed by an independent public accountant prior to filing its Form 10-Q or 10-QSB with the Commission. Under the rule, a company's quarterly financial statements must be reviewed by independent auditors using professional standards and procedures for conducting such reviews, as established by GAAS, as may be modified or supplemented by the Commission. Currently, that means that the review should follow all of the procedures required by SAS No. 71, Interim Financial Information.

Paragraph 10 of SAS No. 71 sets forth the presumption that an audit provides the basis for a sufficient knowledge of internal control to perform a review of interim financial statements. Consequently, an accountant who is not the auditor for the registrant's most recent annual financial statements must obtain a sufficient level of knowledge of the registrant's internal controls required to perform the review.

Auditors are reminded that the Commission's rule requires that a complete SAS No. 71 review be performed prior to the filing of the quarterly report. We would consider a registrant's filing deficient if the registrant failed to obtain the required review prior to the filing of the Form 10-Q or 10-QSB. In our view, failure to obtain the required review is a material matter that should be disclosed by the registrant in that filing. In addition, an amended filing should be made if the interim review is obtained subsequent to the original filing.

Practitioners also should be aware that the rule does not require that an auditor issue a review report and does not require the company to file a review report unless the filing with the SEC specifically states that a review has been performed. If, in any filing, the company states that interim financial statements have been reviewed by an independent public accountant, a report of the accountant must be filed with the interim financial statements.

The AICPA's Professional Issues Task Force recently issued a Practice Alert (see Practice Alert No. 00-4) which is intended to provide auditors with information that may help them improve the efficiency and effectiveness of their quarterly reviews of public-company financial statements. We would encourage auditors to read and utilize the guidance provided in this Practice Alert. Furthermore, registrants and their auditors are reminded of the requirement in paragraph 31 of APB Opinion No. 28, Interim Financial Reporting, that extraordinary, unusual, or infrequently occurring items recognized in the fourth quarter must be disclosed in a note to the annual financial statements.

Section 10A of the Securities Exchange Act of 1934

The Private Securities Litigation Reform Act of 1995, among other things, amended the Securities Exchange Act of 1934 (the Exchange Act) to add Section 10A. This section requires that each audit under the Exchange Act include procedures regarding the detection of illegal acts, the identification of related party transactions, and an evaluation of the issuer's ability to continue as a going concern. Section 10A also codified certain then-existing professional auditing standards regarding the detection of illegal acts by issuers and imposed expanded obligations on auditors to report in a timely manner to management any information indicating that an illegal act has, or may have, occurred. The auditor must ensure that the audit committee or board of directors is adequately informed with respect to an illegal act, as broadly defined by Section 10A, unless the illegal act is clearly inconsequential.

In addition, Section 10A requires the issuer to notify the Commission within one business day after the board of directors of the issuer is informed by its auditor that the auditor reasonably expects to resign the audit engagement or to modify its audit report due to an illegal act that has a material effect on the issuer's financial statements for which appropriate remedial action has not been taken by senior management and the board of directors. If the issuer does not notify the Commission within that period, then the auditor, within the next business day, must provide a copy of the "illegal acts report" that it gave to the board (or documentation of any oral report) directly to the Commission. Section 10A provides for cease and desist and civil money penalties to be imposed against auditors who willfully fail to provide the required reports.

We encourage all auditors to review Section 10A and Rule 10A-1 and, when confronted with the proper circumstances, to provide the appropriate notice and reports.


In response to the staff's request, the Executive Committee of the SECPS took action in early 2000 to adopt membership requirements that specify quality controls necessary to ensure the independence of audit firms with respect to their public audit clients. This is an important initial step in addressing issues that ultimately could threaten to undermine public confidence in the integrity of audited financial statements.

Nearly a year ago, we expressed concern to the SECPS, in a letter that the Office of the Chief Accountant sent to the Executive Committee of the SECPS, that firms, practicing before the Commission, may lack sufficient worldwide quality controls to assure the independence of the firm, its partners, and professional staff under the applicable Commission and professional rules. In the time since that letter, we have identified additional, troubling examples that may suggest not only a lack of sufficient global safeguards, but also a systematic failure by partners and other professionals within certain firms to adhere to existing SEC, AICPA, and state regulations as well as their own firm's existing controls. For example, we have identified instances in which auditing firms have provided prohibited legal, bookkeeping, and executive search services, as well as services under contingent fee arrangements.

Auditing firms with public company audit clients must ensure that adequate quality control systems and procedures are in place to make certain that they are in compliance with all of the independence rules of the SEC and the profession. The internal controls for firms set forth in the aforementioned letter include:

  • Establishment of written independence policies and procedures,
  • The requirement for firms to automate their conflicts verification processes,
  • Establishment of firm-wide on-going training programs,
  • Strengthening of internal inspection and testing programs,
  • Creation of disciplinary mechanisms for independence violations,
  • The need for a more responsive professional quality control standards setting process, and
  • The requirement for senior management supervision of the independence process.

Communications With Audit Committees

Auditors are reminded of the requirements of ISB Standard No. 1, Independence Discussions with Audit Committees, to disclose to the audit committee matters that could reasonably be expected to affect their independence. This standard can be downloaded from the ISB's web site at http://www.cpaindependence.org/. Furthermore, the SEC recently adopted rules requiring registrants to disclose whether the audit committee has received the ISB-required communications from the external auditors (this rule can be accessed from our web site at http://www.sec.gov/rules/final/34-42266.htm). In a letter to the SECPS, ISB Chairman William Allen clarified the use of the auditor's judgment under this standard by stating "[I]n asking itself whether a fact or relationship is material in this setting the auditor may not rely on its professional judgment that such fact or relationship does not constitute an impairment of independence. Rather the auditor is to ask, in its informed good faith view, whether the members of the audit committee who represent reasonable investors, would regard the fact in question as bearing upon the board's judgment of auditor independence." We believe that Chairman Allen's interpretation of ISB Standard No. 1 is appropriate.

In connection with an auditor's ISB-mandated discussion, audit committee members are encouraged to request details of any matters that may affect the auditor's independence as well as the role and status of any individual at the audit firm whose independence may be in question. The audit committee should inquire whether the external auditors have reasonable quality control procedures to ensure compliance by the accounting firm with all independence requirements.

We encourage audit committees to consider the final report of the Panel on Audit Effectiveness which recommended that audit committees consider ten factors in assessing whether non-audit services provided by independent auditors impair an auditor's independence or facilitate the performance of the audit, improve the company's financial reporting process, or are otherwise in the public interest. These factors to consider are as follows:

1. Whether the service is being performed principally for the audit committee;
2. The effects of the service, if any, on audit effectiveness or on the quality and timeliness of the entity's financial reporting process;
3. Whether the service would be performed by specialists (e.g., technology specialists) who ordinarily also provide recurring audit support;
4. Whether the service would be performed by audit personnel, and if so, whether it will enhance their knowledge of the entity's business and operations;
5. Whether the role of those performing the service would be inconsistent with the auditors' role (e.g., a role where neutrality, impartiality and auditor skepticism are likely to be subverted);
6. Whether the audit firm personnel would be assuming a management role or creating a mutuality of interests with management;
7. Whether the auditors, in effect, would be "auditing their own numbers";
8. Whether the project must be started and completed very quickly;
9. Whether the audit firm has unique expertise in the service; and,
10. The size of the fee(s) for the non-audit service(s).

The Panel also recommended that "audit committees pre-approve non-audit services that exceed a threshold determined by the committee" and "when audit committees determine whether to approve specific non-audit services they consider the factors listed above."

International Auditing Issues

The Commission recently adopted final rules regarding international disclosure standards (see http://www.sec.gov/rules/final/34-41936.htm). In the release adopting the final rules, the Commission noted that commentators asked if the statement in the Item 8 instructions and in the General Instructions to Form 20-F, that financial statements must be audited in accordance with United States GAAS, was intended to change the staff's practice of accepting auditor's reports that state that the audit was conducted in accordance with local auditing standards that are "substantially similar" or "similar in all material respects" to United States GAAS. As one commenter noted, that practice was adopted to accommodate audit report styles in different jurisdictions that differ from the audit report wording specified by United States GAAS.

However, that practice was not intended to relieve the auditor of the responsibility to perform all auditing procedures necessary under United States GAAS. We do not intend to change our practice of accepting wording variations in audit reports to comply with local reporting formats. In all other respects, however, in order to avoid ambiguity, the auditor's report should indicate that the audit was performed in accordance with United States GAAS. Furthermore, the financial statements included in the filing must be audited in accordance with U.S. GAAS, and the auditor must comply with the U.S. auditing and Commission standards for auditor independence. It should be further noted that Article 2 of Regulation S-X contains requirements for qualifications and reports of accountants.

As always, registrants and their auditors are encouraged to submit to the SEC's Office of the Chief Accountant, on a prefiling basis, accounting, financial reporting, and auditing questions, especially those involving unusual, complex, or innovative transactions for which no clear authoritative guidance exists. The protocol for preparing and submitting such issues to the Office of the Chief Accountant is included on the SEC's web site at http://www.sec.gov/info/accountants/acproreg.htm.

We appreciate the AICPA's continued efforts to alert its members to the current challenges facing preparers and auditors of financial statements, and we are available to discuss these issues at your convenience.

If you have any questions regarding this letter, please contact Eric Jacobsen, Dominick Ragone, Andrew Hubacker or me at (202) 942-4400.


Lynn E. Turner
Chief Accountant

cc:    Mr. George Dietz
Senior Manager, Accounting and Auditing Publications
American Institute of Certified Public Accountants
Harborside Financial Center
201 Plaza Three
Jersey City, NJ 07311-3881
  Mr. Robert Durak
Technical Manager, Accounting and Auditing Publications
American Institute of Certified Public Accountants
Harborside Financial Center
201 Plaza Three
Jersey City, NJ 07311-3881
  Mr. James Gerson
Chair, Auditing Standards Board
c/o PricewaterhouseCoopers LL
500 Campus Drive, Box 805
Florham Park, NJ 07932


Modified: 10/28/2003