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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Financial Reporting Issues in 2001

Remarks by

Robert A. Bayless

Chief Accountant, Division of Corporation Finance
U.S. Securities & Exchange Commission

At "The SEC Speaks in 2001"
Sponsored by The Practicing Law Institute
Washington, D.C.

March 2, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Bayless and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Today I want to focus on accounting and disclosure issues that are sure to capture the attention of investors this year, and may provide grist for comment by SEC staff as well. First, let me alert you that a company's Annual Report stands a better chance of being selected for review this year, compared to last year. This is because the Commission's resources have been absorbed during the last two years by the hot IPO market, leaving little time for more random selection of Annual Reports and other filings by continuing registrants.

In the Commission's fiscal year ended September 30, 2000, we reviewed over 1,300 initial Securities Act offerings and over 1,000 initial Exchange Act registrations. That's a 40% increase over the number of similar filings in 1999, which itself was a significant increase over the prior year. As a result, we reviewed only about 1,100 Annual Reports on Form 10-K. That meant you had roughly a one-in-fifteen chance of being reviewed last year. We would like companies to have a one-in-four chance of a review. So if initial registrations return to historical levels in the current year as expected, you may be hearing from us.

And what you may hear from us about is segment disclosure. Let me warn you that our patience with deficient segment disclosure has been exhausted. Expect the staff to request an amendment, rather than suggest compliance in future filings, if components regularly reviewed by the chief operating decision maker are not presented separately. Aggregation of segments must be limited to the strict conditions enumerated in Statement No. 131. Expect the staff to review the company's web site, financial analysts' reports, and other public documents to assess whether the segments included in the footnote appear reasonably disaggregated. In some circumstances, we could assess compliance by requesting a copy of all the reports made available to the chief operating decision maker in a particular quarter. Expect the staff to require strict compliance with all parts of the standard, including disclosure of revenues for each group of similar products or services, and meaningful reconciliation of segment items with the financial statements. If segment measurement methods change, expect us to challenge a claim that recasting of prior years is not practicable.

Another area for special focus is market risk disclosure. Financial volatility has become a permanent feature of the environment. Whether or not a registrant uses derivatives, its investors need to understand how it is reasonably likely to be affected by changes in interest rates, currency exchange rates, equity prices, or commodity prices. What market risks may affect the company and how are they managed? Companies need to be explicit about their policies and the intended effects of their hedging activities. Describe the extent to which derivatives alter the magnitude, or perhaps even the direction, of exposure relative to a "pure play" on the basic risk in the industry. How much is an investment in a natural gas company like an investment in natural gas? Describe the company's vulnerability to large swings in risk factors, including potential illiquidity, given the rights of counterparties to demand settlement before volatility returns to "normal" levels. Some companies with brilliant hedging programs have gone bankrupt over night because the cash needed to keep their hedges rolling during a market hiccup wasn't there. Disclosure responsive to Item 305 of Regulation S-K need not be obscure or voluminous in order to be accurate and informative.

Given the current set of economic forecasts, disclosure about credit risk also will be read closely by investors and the SEC staff. Who are the registrant's counterparties giving rise to credit risk? Are there concentrations of credit risk exposures with respect to individual parties, industry groups, geographical areas, income classes or other groups that may be similarly affected by environmental factors? What changes in the environment, or in the company's credit terms, customer profile, or policies or procedures, may affect loss experience? Expect the staff to look for the financial statement disclosures specified by Statement No. 114, as amended by Statement No. 118, concerning the loan loss allowance, and for disclosures specified by Statement No. 107, as amended by Statement No. 133, for concentrations of credit risk.

Throughout 2001, the staff expects also that a large number of companies will find the need to make the impairment assessments of long-lived assets called for by Statement No. 121. These assessments are necessary whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Likewise, companies will need to evaluate whether, pursuant to Statement No. 115 and Staff Accounting Bulletin No. 59, a loss must be recognized in income, rather than accumulated in "other comprehensive income," due to an "other-than-temporary" decline in the value of a debt or equity security classified as available-for-sale or accounted for at cost.

Don't take any shortcuts in your assessment or measurement of impairment losses. The staff may ask for your analysis supplementally. As with many accounting standards, there is a degree of subjectivity and judgment involved in recognizing impairment losses. While the staff can be expected to give management the benefit of the doubt with respect to its determination of loss timing and measurement, the staff will be wary of accounting that seems manipulative or assumptions that are not credible. To avoid a lengthy comment process, companies should assure that disclosure about management's assessment of the timing of loss recognition and its measurement is clear and complete.

No accountant from the SEC can speak for long without raising the warning flag about revenue recognition issues. SAB 101 pulled together a broad range of accounting guidance applicable to revenue recognition. While SAB 101 does not create new GAAP, it does provide guidance intended to narrow practice to a single preferred approach where several interpretations may have existed before.

SAB 101 identifies four essential criteria that should be met before product revenue can be recognized. The criterion I want to emphasize today is that delivery must occur. Delivery must be demonstrated by the customer taking title and assuming the risks and rewards of ownership. This precludes revenue recognition in consignment transactions, layaway sales, and almost every bill-and-hold arrangement you can think of. The SAB also discusses other conditions that should be met before management can conclude that delivery of a product or service has occurred for purposes of revenue recognition. Specifically, a seller must substantially fulfill the terms specified in the sales agreement. Revenue should not be recognized if there is uncertainty about whether customer acceptance has occurred.

Of course, these criteria raise tough questions. When has substantial performance occurred? When are the customer acceptance provisions satisfied? And how do you determine whether you are accounting for a contract consisting of a single element, precluding revenue recognition until everything discussed in the contract has been performed, or a contract consisting of many elements for which some revenue can be recognized as each element is delivered. Companies and their auditors should be sensitive to these questions, and develop conclusions reasonably using the guidance in SAB 101 and consensus that have emerged from the EITF.

SAB 101 also discussed revenue recognition for nonrefundable payments. Even if the cash is in your pocket and you will never have to give it back, its not revenue for accounting purposes until the earnings process is complete. The SAB emphasizes that the earnings process isn't complete if anything that remains undelivered or unperformed is essential to the item for which the upfront payment was ostensibly received. SAB 101 discusses a number of examples of nonrefundable upfront payments, such as membership fees, activation fees, set-up fees, contract signing fees, and access fees. In these arrangements, the upfront payments shouldn't be recognized as revenue, because the contract deliverable of value to the customer is a service to be delivered in the future, over a period of time. Getting ready to deliver a service is not the earnings process.

Sometimes service providers receive advance payments that remain refundable to the customer even after the service has been rendered. As a general principle, the SAB advises that amounts received should be accounted for as deposits until the customer's right to refund is extinguished. But the staff indicated that it would not object to analogies to the method of accounting for product sales with rights of return in limited circumstances that are outlined in the bulletin. Subject to those strict conditions, registrants may recognize revenue on large pools of homogeneous contracts, adjusted for estimated refunds, as services are performed. Where those conditions are not met, payments should be accounted for as liabilities until they are no longer refundable upon demand.

Some issues that emerged from the dot.com era have no effect on net income or equity. Instead, they involve classifications within the balance sheet and income statement. While some general guidance was offered in SAB 101, registrants should look to conclusions reached at recent EITF meetings about these issues. What payments received from customers are not revenues because the registrant was acting more like an agent than a principal? Where should shipping, handling, and fulfillment fees and costs be classified? Are rebates and coupons reductions of sales revenue, or are they marketing costs? How should you classify net losses for premiums given to customers for free or below cost to induce them to enter into other lucrative arrangements. Don't forget that the answers to these questions, which were raised in the dot.com environment, have ramifications for large numbers of traditional businesses as well.

There is no shortage of issues to think about when you prepare your disclosure documents this year. Perhaps the most overwhelming will be compliance with Statement No. 133, concerning derivatives and hedging activities. The focus of staff reviews in this area will be on disclosure. You stand a better chance of avoiding staff comments in this area if you are strictly and completely compliant with the disclosure requirements of that standard, as well as the disclosure requirements of Statement No. 140, regarding securitized financial assets and retained interests in securitized financial assets.

As a general theme, you can expect that the SEC staff will be broadly directed toward obtaining disclosure about issues of importance to "value investing." After all, most of us learned a healthy lesson during the last year: not all stock price declines are simply buying opportunities. Wiser now, investors want to know more about the business fundamentals. This is a perfect time to take a fresh look at your MD&A and Description of Business. Rather than recite amounts and changes apparent on the face of the financial statements, discuss the underlying causes and their relationship to the long-term value of the business.

Speaking of value, intangible assets are very important in this economy. Wide variations between a company's stock price and its underlying book value per share frequently are attributed to the failure of the current accounting model to recognize a company's internally generated intangibles. Despite the importance that investors evidently place on those intangibles, a FASB Business Reporting Project Steering Committee observed that filings by public companies generally lacked meaningful and useful disclosures about intangible assets.

The staff can be expected to comment on that deficiency, soliciting better disclosure about intangibles outside of financial statements, and in the MD&A and Description of Business. Those disclosure requirements are not bound by the recognition and measurement rules of generally accepted accounting principles that treat intangible assets differently than tangible assets. If intangible assets are important to the business, registrants should identify them and explain what management does to develop, protect and exploit them. Operational, non-financial, measures can be very effective in explaining to investors the value of a company's intangibles.

Better disclosure and reliable financial statements are our common goals. I hope my remarks have given you some useful ideas that will help you achieve those goals. I look forward to hearing your comments and questions later in this session.