Speech by SEC Staff:
Current Accounting Projects
Jane B. Adams
Deputy Chief Accountant,
U.S. Securities & Exchange Commission
27th Annual National AICPA Conference on Current SEC Developments
December 8, 1999
As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author, and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.
Good morning. It's a pleasure to be here and have the opportunity to speak again at this conference.
The remarks that I have prepared cover a few types of issues. First, I would like to challenge you to think broadly about the benefits and burdens of broad-based constituency involvement in the standards-setting process. Then, I would like to highlight some accounting issues we have seen in the last year. My remarks have two purposes: to convey information about specific issues and to illustrate some of the problems we have seen with issue identification.
Participatory Standards Setting
The standards-setting process in the U.S. has, for the last 60 years, been a partnership of the public sector, including the SEC, and the private sector not just the accounting profession, that is, preparers and auditors (although the profession is central), but financial statement users of many kinds. The partnership that has evolved brings to the process the talents and fresh experiences that are critical to establishing standards that are relevant and operational. A successful partnership draws on and depends on the resources from all constituencies affected directly or indirectly by financial reporting. As you all know, the demand on resources is no small matter.
Over the last ten years, we have seen the resources allocated to standards setting by companies and accounting firms decrease. The demands, however, are no less; in fact, they clearly are increasing. Not only is input requested in response to exposure drafts of the FASB and AcSEC, but also preparation for and participation on bodies such as the EITF, the derivatives implementation group, and various AICPA task forces (such as the group working to develop best practices guidance for in-process research and development or those working on clarifying recognition and measurement issues associated with loan loss allowances) have demanded substantial time commitments. Additionally, the growing importance of international standards setting has and will impose increasing demands. We hear that the crafting of comment letters is something that frequently happens on Saturdays or Sundays, with time during the workweek spent on less "discretionary" activities. We also know that these demands often are being made on the same individuals or groups of people. Their commitment to the standards-setting process is to be praised and encouraged.
The development of relevant standards by the private sector, however, relies on timely input into the process: not simply in reactive modes (that is, in response to others' proposed solutions), but in timely identification of issues or areas in which practice is diverging. With the elimination of standing industry committees at the AICPA, the need for communication, identification, and resolution is perhaps, at least in the short term, even more challenging.
The identification of emerging or established divergent practices often doesn't seem to be difficult. For example, auditing firms frequently specialize in particular industries. One indicator of diversity is when the auditing firm finds itself in the Division of Corporation Finance defending different accounting or financial statement presentations for the same transaction on different clients. As you might recognize, this is not a desirable position for a firm or its clients to be in.
Diversity in practice within an industry may not be the only indicator of the need for timely resolution. Circumstances also may arise in which accounting standards are applied differently based on industry practice. As you know, SAB 991 contains guidance that discusses industry accounting practices that have evolved but are inconsistent with authoritative accounting literature. As the SAB reminds us, an argument that a practice is common to a particular industry, or that it is a long-standing industry practice, is not a persuasive argument; authoritative literature takes precedence over industry practice if that practice is contrary to GAAP. Clearly, investors and the capital markets are best served by transparent financial reporting that ensures that similar transactions and events are accounted for and presented similarly.
Two years ago at this conference, Mike Sutton spoke about issues affecting the continued success of the EITF in performing its role as an effective interpretative body. The first issue he mentioned was that "troublesome issues are best dealt with if they are recognized and brought to the table at the earliest point possible. Failure to do so tends to encourage diversity in practice and makes it more likely that bad practice will take root."2
I would like to identify for you some areas in which the SEC staff (the staff) has seen emerging diversity in practice or questionable application of GAAP and, perhaps as troubling, where we have not seen these areas raised to the EITF or surfaced in other forums that could ensure their timely resolution.
AICPA Statement of Position 98-1
The requirements of AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1), were effective for financial statements beginning after December 15, 1998 and apply to costs incurred after the effective date, even for projects in process. The accounting in the SOP is not elective. Expenditures on software that will be used internally must be capitalized once a project has moved beyond the preliminary project stage. We agree that judgment is necessary to determine when the preliminary project stage has been completed; however, that assessment must be made. If costs that otherwise would qualify for capitalization are expensed on the basis of immateriality, the staff would expect that policy, if appropriate, to be applied consistently, disclosed, and not used to manage earnings.
Let us look at an example arising in the Internet industry. Costs of developing a website, including the costs of developing services that are offered to visitors (chat rooms, search engines, e-mail, calendars, and so forth), are significant for many Internet businesses and are being incurred by many if not most companies across all industries. SOP 98-1, paragraph 15 states that "If software is used by the vendor in providing the service but the customer does not acquire the software or the future right to use it, the software is covered by this SOP." The Chief Accountant recently sent a letter to the EITF identifying areas of diverging practices in the Internet industry. This letter noted the staff view that a large portion of website development costs should be accounted for in accordance with SOP 98-1, as software developed for internal use. We understand, however, that some companies are not following the requirements of SOP 98-1 for these costs.
Let me add that during the development of SOP 98-1, some questioned the wisdom of capitalizing software development costs. However, an answer was reached after significant comment and debate that requires capitalization when certain conditions have been met. That is the standard that enterprises must apply faithfully, auditors must hold companies to, and the SEC must and will enforce.
FASB Statement No. 131
FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (Statement 131), became effective for fiscal years beginning after December 15, 1997. To achieve its objective of improving the information provided to users of financial statements about a company's operating segments, the standard requires, generally, that the financial information that is used internally for evaluating segment performance and deciding how to allocate resources to segments be the basis for external segment reporting. As you have heard from Melanie Dolan, our reviews of filings have found segment reporting that does not comply with the requirements of Statement 131. Packages of discrete financial information provided to and regularly reviewed by the chief operating decision maker seem to be ignored when determining operating segments for financial reporting purposes. As has been emphasized for the previous two years, the staff is committed to ensuring the quality implementation of Statement 131. To that end, when necessary and appropriate, we have required and will continue to require restatements.
Gross vs. Net Income Statement Presentation and the Accounting for Barter Advertising Transactions
With the emergence of Internet companies as a significant part of the economy and for which investment decisions have been based on revenues rather than earnings, income statement classification and presentation has become a critical area. The staff is seeing a number of accounting issues for which the underlying objective seems to be the grossing up of the income statement. For example, we have seen a number of transactions where one party, acting as an agent, and paid on a commission basis, records the transaction as if it had provided that service as a principal. In other words, the enterprise was grossing up its revenue and expenses for selling a third party good or service. Thus, the revenue that is recorded may be multiples higher than the revenue that would be recorded on a net fee basis. Barter transactions also are pretty hot. For example, two Internet companies agree to provide banner advertisements on each other's websites, and record the arrangements as revenue and marketing expense.
The significant pressure to report larger revenues raises questions as to the quality of the information being provided. In the case of barter advertising, how has the value transferred or received been established? What evidence supported that amount? Was the amount recorded in the financial statements based on reliable and verifiable valuations? Did it meet a reality check that that amount could have been realized in a cash transaction? The EITF currently is addressing the accounting for barter advertising transactions3 and is seeking to develop clear tests that must be met to satisfy the threshold imposed by APB 294 as to when fair value is determinable. However, a troubling aspect for the staff is how did this issue get so far? APB 29 addresses nonmonetary exchanges, and EITF 93-115 provides analogous guidance for barter credits. Yet, practice clearly is diverse (or worse not in compliance with GAAP). What happened that the process was not used to identify and address this diversity? How do we ensure that issues are raised on a timely basis?
Within the Internet industry the use of equity-based awards to fund expenditures has become increasingly prevalent, as often is the case with companies in their start-up phase. For most of these companies, cash is not an available alternative to entice new business relationships, alliances, or supplier agreements. In addition to accounting issues for the equity issuer, another area in which we have seen some troubling accounting practices emerge relates to the accounting by the recipients of the equity-based consideration.
Generally, the recipient's accounting for equity consideration received is fair value. We understand that some recipients of equity-based consideration, particularly equity of private companies, may be ascribing little or no value to such consideration, even though the fair value of the consideration may be substantially higher. This treatment initially will understate the revenue that should be recognized by the recipients for providing the products or services for which they are being compensated. If the level of ownership is such that the use of the equity method is appropriate, it also may understate the subsequent equity method loss recognition. This treatment is compounded further if at some time in the future, the company that issued the equity is successful at going public. At that point, the recipient records a large "gain" either through application of Statement 1156 to the now-marketable equity security that it holds, or the appropriate or inappropriate application of SAB 51,7 depending on the size of the equity holding. Another variant emerges when some of the companies that receive these shares recognize the gain from the appreciated value as part of revenues, even though the products or services in many cases were delivered some time previously.
Another aspect of this equity-based compensation issue is the determination of the measurement date in the circumstances in which a performance commitment has not been attained. The staff is receiving questions on this issue and the application of EITF 96-188 from the expense side, but we remember that accounting is a double-edged sword. In this case, the question is: where is the credit issue? Why haven't the questions related to the recipient's revenue recognition also been raised?
Income Statement Classification
Recent press articles about certain companies have identified what, at face value, appears to involve the understatement of cost of sales. Items that would seem to be inventoriable costs or costs more typically included in cost of sales, such as warehousing costs, are instead being reported as SG&A. What is the basis for these different treatments? Are there particular nuances in the arrangements that are believed to influence the answer? Isn't the best way to have this issue resolved one that involves an open, consultative forum?
The staff also is aware of diversity in practice regarding the classification of gains and losses on the disposition of businesses: apparently some are classifying these as operating income and others as nonoperating income. There also are issues regarding the classification within operating income of gains and losses from the disposition of assets.9 Until the diversity in classification is addressed, the staff has been requesting that gains or losses arising from disposition of businesses that are classified in operating income as well as from dispositions of long-lived assets be reported as a component of "other general expenses" pursuant to Regulation S-X, Article 5-03 (b) (6), with any material item stated separately.10
In an effort to achieve some comprehensiveness though perhaps pulling back in some of the detail let me enumerate a handful of other areas in which we believe there is diversity in practice or potential noncompliance with GAAP:
1.SAB 51 realization of gain: Upon completion of IPOs of previously consolidated or equity method investees that have had no history of profitable operations or operating cash flows, SAB 51 requires an assessment as to realizability of any gain that would be recognized. It states that in circumstances that include cases where the subsidiary is a "newly-formed, nonoperating entity; a research and development, start-up or development stage company; an entity whose ability to continue in existence is in question,"11 then the realization of gain is not assured and that amount should be taken directly to equity. Is this provision being followed?
2.Application of the equity method of accounting to limited liability corporations: Which guidance should investors in LLCs look to? Should they follow APB 1812 with its 20 percent threshold presumption for significant influence, or should they follow the guidance for limited partnerships with the lower 3 to 5 percent threshold?13
3.Applicability of EITF 95-19:14 There is diversity in practice as to whether or how this guidance about identifying the measurement date of securities issued in a business combination applies to reverse mergers, when nonmarketable securities of a public or nonpublic company are issued, or when marketable securities of a third party are issued as the consideration to effect the combination. In addition, the staff recently sent another issue relating to EITF 95-19 to the EITF that asks for clarification on how the consideration should be measured when a formula can or does result in a change. Why did it take four years to identify that diversity in practice existed?
4.Intercompany derivative contracts: In December 1998,15 the staff advised registrants that, under GAAP, an intercompany derivative designated as a hedging instrument should be supported by documentation, prepared contemporaneously, which demonstrates that the notional amount, duration, interest rate risk, currency risk, commodity risk, and other risks associated with such intercompany derivative contracts have been laid off to unrelated third parties. The staff indicated that for hedging instruments designated after January 1, 1999, the staff expects registrants to comply with GAAP. The staff has become aware that, in some instances, practice may continue to diverge from GAAP.
I mentioned the issue of structured transactions last year. Of course we realize that a portion of our economy is directed toward the structuring of transactions to obtain a particular accounting treatment perceived as being more favorable than other alternatives. Often these transactions deal with areas in the accounting literature where fairly bright lines have developed. Leasing transactions under Statement 1316 and its progeny are an easy illustration. Often as soon as a new structure "makes it through" or "doesn't get challenged" by the staff, the next generation appears. Whatever the evolution, the staff often is in the position of calling "out of bounds" for those iterative transactions that have crossed the line. These areas are the core of many of the staff's speeches, which often end with "and the staff requested that the registrant restate its financial statements." For example, Pascal Desroches discussed in his speech yesterday the way in which the consensus in EITF 98-5,17 which limits the amount of discount assigned to beneficial conversion features (that is, the discount is limited to the amount of proceeds received), has been inappropriately applied.
Dominick Ragone will be discussing some of the problematic transactions that have been proposed for qualifying special purpose entities (QSPEs), such as engaging in reinsurance operations or writing financial guarantees.
Another transaction that we have seen had as its objective avoiding loss recognition on an equity method investment that was expected to be unprofitable in the early years, but highly profitable later on that is, parking losses. In one case, the seller/transferor in a transaction wrote a deep-in-the-money put contract to the purchaser of the equity method investment. This allowed the transferor to skirt Statement 125's18 prohibition of sales treatment when a transaction includes a purchased option or a forward contract with the purchaser/transferee to repurchase the securities. Because that contract technically did not provide the transferor with the contractual right to reacquire the securities, the transferor reasoned that it did not retain effective control over the investment. The staff disagreed, reasoning that because the put held by the purchaser/transferee was so deep in the money, the purchaser/transferee was effectively compelled to put the investment back to the transferor, and therefore the transferor held the right to reacquire the investment.
Having told you some tales of problematic behavior, I would like to come back to the broader issue that I wanted to raise with the participants at this conference supporting the standards-setting process, which includes interpretations at the EITF. It requires your support, and, I acknowledge and accept, our support. Of the issues that were raised with the EITF during 1999, at least one-third of those issues were brought to the EITF directly by the staff. In terms of another handful of issues brought to the EITF in 1999, we were involved in encouraging (sometimes more strongly than other times) their being raised in that forum. Issue submissions to the EITF are anonymous, in case that is somehow preventing folks from surfacing troublesome, questionable, or diverse practice.
Timely identification and resolution of issues before diversity in practice develops is the most equitable and effective approach we all can take. In addition, it avoids having answers to issues communicated via restatements. Having the issue resolved in a one-off manner based on a particular registrant transaction addressed by the staff cannot be the best solution. Having the staff resolve issues in a one-off manner precludes other interested parties from contributing their insights and perspective. As I indicated in my speech to this group last year: "In order for the process to work, preparers and practitioners must bring these issues to our attention, the DIG's or the EITF's, as early as possible. If that doesn't happen and the issue is identified in the course of a review or in some other manner and the staff is asked to resolve the issue, the staff will resolve it."19 Today, though, I want to beseech you to help to ensure that the quality of financial reporting is not allowed to deteriorate through diverse, opaque, or inappropriate accounting practices. I would like to solicit your support for those who are spending their Saturdays and Sundays reading exposure drafts and EITF issues papers and ask you to help them by bringing problems when there is smoke, and not waiting until there is a forest fire to be put out.
The Public Oversight Board's Panel on Audit Effectiveness also has as one of its established objectives to identify solutions to this problem. The Panel is expected to consider the roles of various players in this process: the AICPA, the firms, the EITF, and the SEC. However, before bringing forth recommendations, it is necessary that they identify the impediments to timely identification of financial reporting problems. We look forward to the results of their efforts.
That concludes my prepared remarks.
1Staff Accounting Bulletin No. 99 (SAB 99) expresses the views of the staff on issues relating to materiality.
2Speech by Michael H. Sutton, Twenty-Fifth Annual National Conference on Current SEC Developments, December 9, 1997
3EITF Issue No. 99-17, Accounting for Advertising Barter Transactions.
4APB Opinion No. 29, Accounting for Nonmonetary Transactions (APB 29).
5EITF Issue No. 93-11, Accounting for Barter Transactions Involving Barter Credits (EITF 93-11).
6FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (Statement 115).
7Staff Accounting Bulletin No. 51, Accounting for Sales of Stock by a Subsidiary (SAB 51).
8EITF 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 (EITF 96-18).
9FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, states in paragraph 18 that:
"An entity that holds assets to be disposed of that are accounted for in accordance with paragraphs 15-17 of this Statement shall report gains or losses resulting from the application of those paragraphs as a component of income from continuing operations before income taxes for entities presenting an income statement and in the statement of activities of a not-for-profit organization. Although entities are not required to report a subtotal such as income from operations,' entities that present such a subtotal must include the gains or losses resulting from the application of paragraphs 15-17 in that subtotal."
10Staff Accounting Bulletin No. 101, footnote 50.
12APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (APB 18).
13EITF Topic D-46, Accounting for Limited Partnership Investments.
14 EITF Issue No. 95-19, Determination of the Measurement Date for the Market Price of Securities Issued in a Purchase Business Combination (EITF 95-19).
15Speech by Pascal Desroches, Twenty-Sixth Annual National Conference on Current SEC Developments, December 9, 1998.
16FASB Statement No. 13, Accounting for Leases (Statement 13).
17EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios (EITF 98-5).
18FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (Statement 125).
19Speech by Jane B. Adams, Twenty-Sixth Annual National Conference on Current SEC Developments, December 9, 1998.