Letter From the Chief Accountant:
Audit Risk Alert
May 12, 2017
December 22, 1999
Mr. Thomas Ray
Director, Audit and Attest Standards
American Institute of Certified Public Accountants
1211 Avenue of the Americas
New York, NY 10036-8775
Dear Mr. Ray:
The AICPA has published a general audit risk alert as well as specific industry audit risk alerts. These publications are useful in that they advise preparers and auditors of financial statements 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 Securities and Exchange Commission (SEC) staff believes it is useful to make preparers and auditors of financial statements aware of the topics that the SEC staff has been working and focusing on. In that regard, we hope the following information will provide your members with guidance they will consider useful in the preparation of future filings with the SEC.
High Quality Financial Reporting
One of the reasons cited that has contributed to U.S. capital markets being the best in the world is the high quality and integrity of the financial reporting system in the United States. This financial reporting system, which has been established through the combined efforts of both the public and private sectors, is designed to provide investors with comparable, consistent, and transparent information necessary to make informed investment decisions. High quality financial reporting serves as the foundation and source of information for our entire disclosure system. A key attribute of our financial reporting system is transparency, which is the complete reporting and disclosure of transactions such that the financial statements reflect the underlying results of the business in conformity with generally accepted accounting principals (GAAP).
Globalization of business and capital markets, technology enhancements that make it possible for significant currency flows across borders at the push of a button, the growth in the volume and magnitude of investments in the capital markets, the current price-earnings ratios, and the market's reaction when "surprises" occur with respect to expected earnings, as well as other factors, have increased the need for greater transparency for investors in the capital markets. The SEC staff believes that the qualitative characteristics of accounting information, such as those set forth in the FASB's Concepts Statements (SFAC),1 provide the best basis for a discussion of the quality and transparency of a company's financial reporting. These characteristics include factors such as relevance and reliability, as well as verifiability, neutrality, comparability, consistency, timeliness and representational faithfulness (the degree to which the accounting actually represents the transaction or event).
The Auditing Standards Board has approved an amendment to Statement on Auditing Standards No. 61, Communication with Audit Committees (SAS 61), in response to the recommendations of the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. As amended, SAS 61 will require the independent public accountant to have a discussion with the audit committee regarding the auditor's judgment about the quality, not just acceptability, of the entity's financial reporting. The amendment notes the following examples of items that could impact the quality of financial reporting:
- Selection of new or changes to accounting policies
- Estimates, judgments, and uncertainties
- Unusual transactions
- Accounting policies relating to significant financial statement items, including the timing of transactions and the period in which they are recorded
The SEC staff also has noted that some believe that conservatism is a characteristic that should be discussed. However, in SFAC 2 the FASB noted:
"Since a preference that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets introduces a bias into financial reporting, conservatism tends to conflict with significant qualitative factors such as representational faithfulness, neutrality, and comparability (including consistency)...Conservatism in financial reporting should no longer connote deliberate, consistent understatement of net assets and profits...The Board emphasizes that any attempt to understate results consistently is likely to raise questions about the reliability and integrity of the information about those results and will probably be self-defeating in the long run."2
Accordingly, the consistent understating of results (i.e., conservatism) or overly optimistic estimates of realization (i.e., lack of conservatism or aggressiveness) are inconsistent with the characteristics of quality financial reporting needed for transparent reporting in today's markets. As some have noted, an analogy can be made to the game of golf. One desires to hit the ball down the middle of the fairway to get the best result and longest drive. While staying in the fairway is acceptable, the quality of the drive is determined by how close to the middle one gets. The staff believes that it is important for financial management and auditors to communicate with the audit committee whether, and where, the ball is on the fairway.
In December 1999, the Commission approved new listing requirements of the New York Stock Exchange and National Association of Security Dealers (see www.sec.gov/rules/sro.shtml) and adopted Regulation S-K item 306 regarding disclosures by audit committees (see www.sec.gov/rules/final.shtml).
Auditors have a unique role and franchise. They are the only professionals that a registrant is required to retain. The United States Supreme Court has stated the importance of that role as follows:
By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as the investing public. This public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust (emphasis added). U.S. v. Arthur Young & Co., 465 U.S. 805, 817-818.
If auditors do not meet the expectations of the investing public and the public loses its confidence in the role performed by the CPA as an objective and independent third party, there will be irreparable harm done to the value of that role. Accordingly, the SEC staff reiterates the need for auditors to maintain their integrity, objectivity, and independence, and when necessary to make the tough calls on the tough issues. In making these calls, auditors should keep foremost in mind that the investing public is their client. Would that client find their decision appropriate and in the interest of the stakeholders?
The ultimate responsibility for the selection and engagement of an independent auditor rests with the registrant. Accordingly, we encourage the audit committee and financial management of each registrant to have a robust discussion with the auditor of the items set forth in Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees. Management and the audit committee should inquire as to whether the firm, its partners, and its employees have complied with the firm's, the profession's, and the SEC's independence rules with respect to the audit of the company's financial statements.
We also encourage each registrant's audit committee and financial management to inquire as to the types of quality controls an audit firm has, both in the U.S. and in its international affiliates where audit work is performed for the registrant. Recent press articles have cited registrants who have had to replace their auditor due to the auditors lack of compliance with the independence rules. Some of these situations have arisen as a result of a lack of high quality internal controls. In a letter to the AICPA's SEC Practice Section Executive Committee (SECPS) dated December 9, 1999, the SEC staff requested that the SECPS modify its membership rules. The modifications were requested to ensure that firms have effective systems of internal controls that ensure compliance by the firm, its partners, and professional staff, with the firm's, the profession's, and the SEC's independence rules. The internal controls set forth in the letter include:
- Establishment of written independence policies and procedures,
- Require firms to automate conflicts verification process,
- Establishment of firm-wide on-going training programs,
- Strengthening of internal inspection and testing programs,
- Creation of disciplinary mechanism for independence violations,
- Need for more responsive professional quality control standard setting process, and
- Require senior management supervision of independence process.
During the past year, the SEC staff expressed its view that an auditor lacks independence if it provides legal services, either in the U.S. or internationally, to an audit client. An attorney acts in an advocacy role for the client, a role that is inconsistent with the role of an independent, objective auditor. Additionally, the Commission recently took enforcement action where the audit firm lacked independence due to a firm member's provision of legal services to an audit client.3
Section 10A of the Securities Exchange Act of 1934
The Private Securities Litigation Reform Act of 1995 (the Reform Act), 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 act4 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 uncorrected illegal act that has a material effect on the issuer's financial statements. 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.
To implement the Section 10A reporting requirements, the Commission adopted Exchange Act Rule 10A-1, 17 CFR 240.10A-1. This rule states, among other things, that the required communications should be sent to the Commission's Office of the Chief Accountant. It also indicates that these communications will receive the same exemption from disclosure under the Freedom of Information Act as the Commission's investigative records.
Congress clearly intended that Section 10A should result in the Commission receiving an early warning from auditors about their clients' illegal activities. Despite this intention, the Commission has received very few Section 10A reports. The General Accounting Office, at the request of Congressman John Dingell, currently is investigating why such a relatively small number of reports have been submitted to the Commission. The Commission encourages all auditors to review Section 10A and Rule 10A-1 and, when confronted with the proper circumstances, to provide the appropriate notice and reports.
Issuance of Financial Statements
Rule 10b-5 under the Exchange Act and General Instruction C(2) to Form 10-K specify that financial statements must be free of material error as of the date they are filed with the Commission. For example, assume a registrant widely distributes financial statements, but before filing them with the Commission, the registrant or its auditor become aware of an event or transaction that existed at the date of the financial statements, and the causes those financial statements to be materially misleading. If a registrant does not make corrections to the financial statements so that they are free of material misstatement or omissions when they are filed with the Commission, the registrant knowingly will be filing a false and misleading document. In addition, registrants are reminded of their responsibility to, at a minimum, disclose subsequent events,5 while independent auditors are reminded of their responsibility to assess subsequent events6 and evaluate the impact of the events or transactions on their audit report.7
A registrant and its independent auditor have responsibilities with regard to post-balance-sheet-date subsequent events, as well as the application of authoritative literature applicable to such events.8 Referring to Statement on Auditing Standards No. 1, Subsequent Events (SAS 1 or AU 560), paragraph 3, states:
"The first type [of subsequent event] consists of those events that provide additional evidence with respect to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements. All information that becomes available prior to the issuance of the financial statements should be used by management in its evaluation of the conditions on which the estimates were based. The financial statements should be adjusted for any changes in estimates resulting from the use of such evidence."
Generally, the staff believes that financial statements are "issued" as of the date they are distributed for general use and reliance in a form and format that complies with GAAP and with an audit report which indicates that the auditors have complied with generally accepted auditing standards (GAAS) in completing their audit. This would generally be the earlier of when the annual or quarterly financial statements are widely distributed to all shareholders and other financial statement users or filed with the Commission. Issuance of an earnings release does not constitute issuance of financial statements because the earnings release would not be in a form and format that complies with GAAP and GAAS.
International accounting and reporting issues were discussed in detail at the 1999 Twenty-Seventh Annual AICPA National Conference on Current SEC Developments. See speeches given at the conference by Craig C. Olinger and Donald J. Gannon at www.sec.gov/news/speech/speecharchive/1999/spch338.htm for background and guidance on these matters, including:
Staff Accounting Bulletins
The SEC staff recently issued Staff Accounting Bulletin (SAB) No. 99 to address the application of "materiality" thresholds to the preparation and audit of financial statements, SAB 100 to address matters related to restructuring and impairment charges, and SAB 101 to address matters related to revenue recognition issues. Registrants will be expected to follow the guidance provided in those documents. The SABs are available through the Commission's website: www.sec.gov.
- Revisions to Form 20-F and Reference to U.S. GAAS in Audit Reports
- Audit Opinion Qualifications
- Compliance With International Accounting Standards
- U.S. GAAP Reconciliations
In early 1999, the AICPA issued a booklet entitled Audit Issues in Revenue Recognition that summarizes the significant accounting and auditing guidance on revenue recognition. This is a useful tool in assessing and auditing revenue recognition issues, and we recommend that CFOs, controllers, and auditors of public companies read it. The publication sets forth useful guidance for auditors that, if followed, may identify revenue that has been improperly recognized.
Year-End Cutoff Testing
A study published in March 1999 entitled Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S. Public Companies 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 SEC staff believes that auditors need to conduct appropriate period-end cutoff procedures. 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 addition, for significant and unusual revenue transactions, especially those at or near the end of a quarterly or year-end reporting period, the auditor should consider confirming9 all significant terms of the transaction rather than just the outstanding account receivable balance.
Another common problem noted in the March 1999 study was "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, "side agreements" pose a significant risk to proper revenue recognition. As stated in SAB 101, companies should create sufficient 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 confirmation10 of the terms of significant contracts, that would assist them in detecting "side agreements."
Questionable Revenue Recognition Practices
The SEC staff continues to encounter cases of questionable and inappropriate revenue recognition practices. Significant issues that the staff has dealt with recently include:
- Complex arrangements that provide for multiple different 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.11
The SEC staff has requested that the EITF address certain of these issues to clarify the application of GAAP in these transactions. However, the SEC staff generally believes that appropriate requirements already exist in the accounting literature to address many of these issues. Specifically, SOP 97-2, Software Revenue Recognition, Accounting Principles Board Opinion No. 29, Accounting for Nonmonetary Transactions, SOP 81-1, Accounting for Performance of Construction/Production Contracts (paragraphs 58-60), and Concepts Statements No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, and No. 6, Elements of Financial Statements, provide guidance on these issues. Further, the staff believes companies should be careful not to overlook the guidance in FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, paragraph 16, as it applies to the derecognition of liabilities, including performance and refund obligations to customers.
Income Statement Classification
The staff believes that appropriate classification of amounts within the income statement or balance sheet is as important as the appropriate measurement or recognition of such amounts. The staff reminds registrants that they should apply strictly the guidance provided in Regulation S-X regarding classification of amounts. In addition, auditors should ensure that all such classifications are materially correct.
Recently the SEC staff has noted improper classification of items in the income statement, especially in the lines of cost of sales and marketing expense. For example, items that would seem to be inventoriable costs or costs that should be more typically included in cost of sales, such as warehousing costs or certain fulfillment costs, are instead being reported inappropriately as marketing expense. The staff also notes that gains and losses on disposal of assets should be reported and disclosed in accordance with SAB 101 and SAB Topic 5B.
Internet Related Issues
The SEC staff recently dealt with a number of issues that commonly arise in companies that do business on the Internet. Some of these issues have arisen due to the new business models used in Internet operations. However, the SEC staff notes that other issues are substantially the same as similar issues faced by traditional (i.e., non-Internet) companies. As a general rule, the SEC staff believes that Internet companies engaging in transactions that are similar to transactions entered into by traditional companies should follow the already-established accounting models for those transactions.
A number of accounting issues related to Internet activities are currently being considered by the EITF, and others will likely be considered in the future. Many of the issues that we have seen and that are likely to be addressed by the EITF are in the following areas:
- Barter transactions in which two companies trade advertising space on each other's websites.
- Accounting for the costs of website development.
- Accounting for the issuance of complex equity instruments in exchange for products, services, or contractual rights, and assessing the impairment of such rights.
Some of the significant accounting issues that arise in Internet companies concern classification of items within the income statement (e.g., gross vs. net presentation of revenue and expenses). While misclassifications may not affect net income, they nevertheless may be material to the financial statements taken as a whole. This is especially true in Internet operations, for which the revenue line item often is viewed by investors as the most significant measurement. For this reason, auditors should be especially cognizant of misclassifications that would result in increased revenues and expenses when auditing the financial statements of companies that do business on the Internet. SEC staff views on gross vs. net presentation are set forth in SAB 101.
Useful Lives of Intangible Assets
Accounting Principles Board Opinion No. 16, Business Combinations, (APB 16) requires that all intangibles be identified and 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, an engineering workforce, favorable contracts, etc. Accounting Principles Board Opinion No. 17, Intangible Assets, (APB 17) 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 17 was issued. High technology and a variety of service related businesses have become much more significant components of the economy. Communications that 40 years ago were done through the "town" operator and eight party lines have been replaced with digital, fiber, and wireless systems. Most 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 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 APB 17, paragraph 27, in determining the useful lives of intangible assets, including goodwill. As a result of our changing economy and business environment, the use of a 40-year life will no longer be appropriate for many companies. In addition to the factors in APB 17, other factors that the staff believes are relevant 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.
- The relative infancy of an industry.
The SEC staff will challenge a registrant that merely conforms its goodwill life to its peer companies.12 Companies should perform an analysis of the factors and assumptions as discussed above that are to be used in determining the appropriate useful life of goodwill in each specific acquisition. This analysis 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.
Fair Value of Financial Instruments
FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, (Statement 107) generally requires all entities to disclose the fair value of financial instruments for which it is practicable to estimate fair value. Paragraph 5 of Statement 107 defines the fair value of a financial instrument to be the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Paragraph 13 of Statement 107 provides that disclosures are not required for trade receivables and payables when their carrying amount approximates fair value.
The staff believes that a registrant must have documented evidence to support an assertion that the fair value of trade accounts receivable approximates carrying amount in order to avoid making the disclosure of fair value. In instances where it is not practicable to estimate the fair value of a financial instrument, paragraph 14 of Statement 107 requires disclosure of:
- Information pertinent to estimating the fair value of that financial instrument or class of financial instruments, such as the carrying amount, effective interest rate, and maturity; and
- The reasons why it is not practicable to estimate fair value.
As part of the audit of the financial statements, auditors have a responsibility to audit the assertions made in the footnotes to the financial statements. As part of that process, auditors are required to review and adequately test objective verifiable evidence supporting assertions about the fair value of financial instruments in the footnotes to the financial statements. For example, auditors should review and adequately test a registrant's documentation supporting the assertion that the carrying amount of certain receivables approximates fair value.
In December 1999, the AICPA's SEC Regulations Committee and its Task Force on Business Combinations issued two whitepapers, "Elements of a Systematic Pattern of Treasury Share Acquisitions" and "Pooling of Interests: Alterations of Equity Interests (47c) and Asset Dispositions (48c)." The whitepapers are available on the AICPA website (www.aicpa.org). These papers identify and discuss best practices related to the application of the criteria established in APB 16, paragraphs 47c, 47d, and 48c, relative to pooling-of-interests accounting. Those paragraphs address the alteration of equity interests, treasury share repurchase, and planned asset disposition criteria, respectively, that must be met, among others, in order to account for a business combination using the pooling-of-interests method.
The SEC staff believes that registrants and their independent accountants should consider the best practices in the whitepapers in determining whether the criteria in APB 16, paragraphs 47c, 47d, and 48c have been met. In this regard, the SEC staff considers the whitepapers to be an accumulation of existing accounting practices and interpretations which do not establish any new standards and do not diverge from GAAP. The SEC staff believes that the guidance recommended in the whitepapers generally is consistent with conclusions previously expressed by the staff. A registrant and its independent auditor should be prepared to justify a conclusion that differs from the whitepapers' guidance.
In-Process Research and Development
The staff continues to monitor the accounting for acquired in-process research and development for compliance with GAAP. The staff notes that commonly requested disclosures include:
- specific nature and fair value of each significant in-process research and development project acquired;
- completeness, complexity, and uniqueness of the projects at acquisition date;
- nature, timing and estimated costs of the efforts necessary to complete the projects and the anticipated completion dates;
- risks and uncertainties associated with completing development on schedule, and consequences if it is not completed timely;
- appraisal method used to value projects;
- significant appraisal assumptions, such as:
- period in which material net cash inflows from significant projects are expected to commence,
- material anticipated changes from historical pricing, margins, and expense levels,
- the risk adjusted discount rate applied to the project's cash flows, and
- in periods after a significant write-off, the status of efforts to complete the projects and the impact of any delays on expected investment return, results of operations and financial condition.
The staff continues to review registrants' compliance with Emerging Issues Task Force (EITF) Issues No. 94-3 and 95-3. In addition, the SEC staff issued two Accounting and Auditing Enforcement Releases during 1999 that specifically address the issue of inappropriately recognizing liabilities for restructuring charges and another issue involving the subsequent inappropriate reversal of those types of liabilities into income. AAER No. 114013 details a scenario in which the Commission alleged that a registrant had inappropriately deferred some portion of better than expected earnings in order to establish a general loss accrual, which was then used in later periods to enhance
earnings shortfalls and smooth earnings trends. AAER No. 112614 describes a similar alleged abuse, except that the loss accruals were established as part of the accounting for purchase business combinations and later used to absorb costs that should have been expensed in the current period.
As further discussed in the above AAERs, as well as in SAB 100, restructuring charges and other loss accruals must be supported under GAAP at the time established. Such liabilities should be analyzed at each balance sheet date and adjusted as required by GAAP. Any need to adjust the accrued liabilities should be completed on a timely basis and should be adjusted against only the financial statement line item through which the accrued liabilities were originally recorded. Amortizing immaterial amounts of the accrued liabilities into income after concluding that no basis exists for ongoing accrual, rather than reversing the entire accrual, would be indicative of inappropriate earnings management. Similarly, maintaining an unsupported restructuring liability or other loss accrual and offsetting or reducing it in a later period for a change in an unrelated item would be inappropriate and not in conformity with GAAP.
A review of enforcement cases, as well as required restatements of financial statements in filings with the Commission, indicate that corrections in the financial statements related to liabilities such as contingent liabilities, restructuring accruals, and other types of loss accruals, are often not the result of system based errors. Rather the corrections are due to adjustments originally made by or under the supervision of senior financial reporting personnel. In these situations, the SEC staff has seen the following ineffective audit techniques used:
|1.||The loss accrual balance in the current period is the same, or nearly the same, as in the prior period, and it was noted that, due to this fact, 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 audit client.|
|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 testing through analytical procedures.|
|6.||Only testing a loss accrual to ensure that the balance is not understated.|
|7.||A lack of testing of completeness of all disclosures mandated by GAAP.|
|8.||A lack of testing of the proper classification of costs.|
|9.||Testing that failed to identify the fact that assets such as inventory, for which a writedown at year-end establishes a new cost basis, as noted in ARB 43 and SAB 100, cannot be subsequently adjusted upward through the adjustment of "reserves."|
Auditors are reminded that audit procedures and techniques must be appropriately tailored to ensure that any contingent liability, restructuring accrual, or other loss accrual balance, and related activity, is adequately supported and disclosed. The staff believes it is important that auditors:
- Carefully consider all the risk factors set forth in Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit, and how for a particular client, existing risk factors should be assessed and related to the specific determination of the nature, timing, and extent of the audit tests.
- 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 verifiable, objective evidence that would be required to support the account balances. The SEC reminds auditors that SAB 100 discusses the need for appropriate documentation as well as adequate internal accounting controls.
- Test not only 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 SEC staff acknowledges the judgment involved in reporting certain liabilities and that a range of possible or probable losses may exist. But the SEC staff has, and will continue to challenge loss accruals that are either materially understated or overstated, including when understated or excess liabilities are used to manage earnings.
Oil and Gas Acquisition Issues
Accounting and reporting issues related to purchase business combinations in the oil and gas industry were discussed at the 1999 Twenty-Seventh Annual AICPA National Conference on Current SEC Developments. See the speech given at the conference by Eric G. Jacobsen at www.sec.gov/news/speech/speecharchive/1999/spch331.htm.
Disclosure of Loss Contingencies
The SEC staff reminds companies and their auditors of the disclosures required by FASB Statement No. 5, Accounting for Contingencies. The standard requires that companies disclose the nature of an accrual made for an estimated loss from a loss contingency. If no accrual is made or if an exposure to loss exists in excess of the amount accrued, the company is required to disclose the contingency when it is other than remote (that is, reasonably possible) that a loss or an additional loss may have been incurred. The disclosure should include the nature of the contingency and an estimate of the possible loss or range of loss or state that such an estimate cannot be made.
The staff notes that AU Section 431, Adequacy of Disclosure in Financial Statements, requires an auditor to express a qualified or an adverse opinion if disclosures required by GAAP are omitted from the financial statements.
General "loss accruals and reserves" are prohibited by GAAP. Paragraph 14 of Statement 5 states:
"Some enterprises have in the past accrued so called reserves for general contingencies.' General or unspecified business risks do not meet the condition for accrual in paragraph 8, and no accrual for loss should be made."
Employee Pension Plans - Management's Discussion and Analysis
Recently a number of companies have made substantial changes to their employee pension plans. These changes could be expected to have a material impact on the results of operations and cash flows of those companies. Similarly, as a result of dramatic increases in stock prices, many companies have experienced a material impact on their results of operations due to the recognition of income associated with their pension plans. The staff believes that such events should be discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) pursuant to Item 303 of Regulation S-K and Financial Reporting Codification (FRC) section 501.
FRC 501 requires that registrants disclose known trends or uncertainties that the registrant reasonably expects will have a material impact on income, liquidity, or capital resources. It 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 change in its pension plan, or activity in the plan itself such as gains or losses on investments are reasonably likely to have a material impact on financial condition, liquidity, or results of operations of the company, then that information should be disclosed in MD&A. For example, if as a result of a change in the type of plan used, or significant gains on investments, a material reduction in cash payments to the plan and plan expense (or increase in plan income) was reasonably likely to occur, then that information should be disclosed as required by FRC 501.
FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, requires that companies disclose segment data based on how management evaluates performance and makes decisions about allocating resources to segments. The Auditing Standards Board issued AU Section 326, Evidential Matter, requiring, 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."
Recently, the staff has seen cases where the MD&A or press releases describe business segments that differ from the presentation of the segment information included in the financial statements. When reviewing segment information as part of the normal review and comment process, the staff commonly requests registrants to provide copies of the reports or other materials supplied to the "chief operating decision maker" of the company. If the segment information provided in the financial statements does not reflect a similar breakdown of the company's segments as is evident in the internal reports and materials, the staff will request registrants to amend the financial statements.
SAB 99 highlights some of the SEC staff's views regarding the significance of segment information to the financial statements taken as whole. That document 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 also cited in a recent enforcement action (see AAER No. 1140) and in AU Section 326.33, which specifically notes that "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." The SEC staff expects that all registrants and their auditors will take such considerations into account when assessing the materiality of any misstatements identified during the course of the audit.
It should also be noted that in another recent enforcement action15 involving segment disclosures 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." In addition, the Commission reiterated an earlier MD&A release (Financial Reporting Release No. 36 dated May 18, 1989) which stated 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 the instant case, stating that "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."
Consolidation of Special Purpose Entities and Formal Documentation Upon Adoption of Statement 133
Accounting and reporting issues related to special purpose entities and formal documentation requirements upon adoption of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, (Statement 133) were discussed at the 1999 Twenty-Seventh Annual AICPA National Conference on Current SEC Developments. See speeches given at the conference by Dominick J. Ragone III and Pascal Desroches.
The SEC staff has observed a number of registrants securitizing assets such as credit card receivables, commercial loans, automotive receivables, residential mortgages, home equity loans, and student loans. The SEC staff expects registrants engaging in securitizations to have adequate systems and internal controls in place to ensure that the valuation of any retained interest and gain or loss arising from securitizations is accounted for in conformity with GAAP. Preparers and auditors need to ensure that valuations are based on assumptions and evidence that is verifiable, supportable, and adequately documented.
Other Hedge Accounting Issues
Macro hedging and hedging with intercompany derivatives are issues that have received attention in the past year. Statement 133's provisions with regard to hedging with intercompany derivatives are outlined in Derivatives Implementation Group (DIG) Issue E3, Hedging--General: Hedging with Intercompany Derivatives. For companies that have not yet adopted Statement 133, guidance related to hedge accounting includes FASB Statement No. 80, Accounting for Futures Contracts,(Statement 80) and EITF Topic D-64, Accounting for Derivatives Used to Hedge Interest Rate Risk, (Topic D-64).
The SEC staff reminds companies that under Statement 80 (and as outlined in Topic D-64), hedge accounting is not permitted for macro hedges. Under Statement 80, hedge criteria include (1) designation of a derivative instrument to an individual item or group of essentially similar items; (2) the probability of a high correlation of changes in (a) the market value of the futures contract(s) and (b) the fair value of, or interest income or expense associated with, the hedged item(s); and (3) enterprise risk reduction.
Hedging With Intercompany Derivatives
Fundamental to Statement 80's enterprise risk reduction model is that the derivative hedging instrument be transacted with an unrelated third party. The SEC staff has advised registrants that for any intercompany derivative instrument designated as a hedging instrument after January 1, 1999, there must exist 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. For intercompany derivative contracts designated after January 1, 1999 that do not meet these requirements, a registrant should eliminate their impact in preparing consolidated financial statements in accordance with ARB No. 51, Consolidated Financial Statements. Additionally, these intercompany derivative contracts do not qualify as hedging instruments in the consolidated financial statements.
Loan Loss Allowances and Effective Internal Controls
One of the specific concerns recently expressed by the banking regulators is the need for appropriate underwriting standards and internal controls related to the accounting for and financial reporting of the allowance for loan losses. An institution's internal accounting controls for loan loss allowances should assure compliance with the authoritative accounting guidance contained in accounting and auditing pronouncements, including FASB Statements No. 5, Accounting for Contingencies, and No. 114, Accounting by Creditors for Impairment of a Loan, and the recent FASB Staff Viewpoints article included in EITF Topic D-80. The accounting controls should ensure timely and accurate reporting for financial reporting purposes, including for losses and changes in the credit quality of the loan portfolio in conformity with GAAP.
In the course of reviewing registrant filings in the past year, the staff noted certain instances in which creditors did not appear to have adequate controls in place to assure that loan loss allowances and provisions were determined and reported in conformity with GAAP. In some cases, institutions did not have adequate documentation and clear, concise internal communication of their policies and procedures related to loan loss allowances. As an example, we noted instances where there was a distinct disconnect between an institution's credit administration function and its financial reporting group in the accounting for loan loss allowances.
The SEC staff and the Federal banking agencies have agreed that institutions should follow GAAP in recording their allowances for loan losses. In addition, the SEC staff has been reminding institutions that they should provide appropriate disclosures of loan loss allowances in their financial reports to ensure transparency of the information to readers of those reports. In January 1999, the SEC staff issued a letter which outlines commonly requested disclosures for provisions for loan losses and loan loss allowances. The letter is available on the SEC website at www.sec.gov/divisions/corpfin/guidance/banklla.txt.
The SEC staff reminds companies that where statistical data, quantitative analysis, or disclosures in a registrant filing appear to be inconsistent with loan loss provisions or allowances, the SEC staff will ask the company to explain those inconsistencies. For example, data commonly used to evaluate the appropriateness of the loan loss allowance may indicate an inconsistency between the accounting for the allowance and the disclosure of material risks in the portfolio for which the allowance was maintained. In such a case, the SEC staff may issue comments on the filing relating to the loan loss allowance. Additionally, disclosures in the filing should be consistent with the documentation supporting the loan loss allowance. The SEC staff questions allowances that appear too low, as well as those that appear too high, as compared to the disclosures made and the supporting documentation.
Protocol for Registrant Submissions to the Office of the Chief Accountant
The SEC has recently implemented new policies and procedures designed to make the pre-filing process more effective and more efficient. These policies are available on the SEC website at www.sec.gov/info/accountants/acproreg.htm.
* * * * *I appreciate the AICPA's continued efforts to alert its members to the challenges facing preparers and auditors of financial statements today, and I am available to discuss these issues at your convenience.
If you have any questions regarding this letter, please contact Dominick Ragone, Mike Kigin or myself at (202) 942-4400.
Lynn E. Turner
|cc:||Arleen Thomas, Vice President, Professional Standards and Services, AICPA|
|Deborah Lambert, Chair, Auditing Standards Board|
|Amy Ripepi, Chair, SEC Regulations Committee|
|1||See FASB Statement of Concepts No. 2 (SFAC 2), Qualitative Characteristics of Accounting Information.|
|2||Ibid., paragraphs 92, 93 and 96.|
|3||AAERs No. 1134 and 1135, In the Matter of Charles E. Falk, CPA and In the Matter of Moore Stephens, P.C. et al, (May 19, 1999). See also AAER No. 312, In the Matter of Samuel George Greenspan, CPA, (August 26, 1991).|
|4||Section 10A(f) defines the term "illegal act" to mean "an act or omission that violates any law, or any rule or regulation having the force of law."|
|5||See AU 560 paragraphs 5 and 8.|
|6||See AU 560 and AU 561, Subsequent Discovery of Facts Existing at Date of Report.|
|7||See AU 530, Dating of the Independent Auditor's Report and AU 560, paragraph 9.|
|8||For example see EITF Issue No. 95-18, Accounting and Reporting for a Discontinued Business Segment When the Measurement Date Occurs after the Balance Sheet Date but before Issuance of Financial Statements and EITF Issue No. 99-11, Subsequent Events Caused by Year 2000.|
|9||Confirmation of accounts receivable is a generally accepted auditing procedure. As such, there is a presumption that an independent auditor will confirm accounts receivable during an audit, and where the auditor does not confirm accounts receivable the auditor must document how he or she overcame the presumption. Refer to SAS 67, The Confirmation Process, for additional guidance (AU 330).|
|10||See AU 330 paragraph 25.|
|11||See various enforcement cases involving barter transactions, including: AAERs No. 1175, 1169, 1186, and 1168, In the matter of Itex Corp., et al, (September 9, 1999), In The Matter C.E.C. Industries, et al., (September 9, 1999), In The Matter of Harold Ickovics, et al., (September 9, 1999), and In The Matter of Mar-Jeanne Tendler et al. (September 9, 1999), respectively.|
|12||See also SAB 99 regarding industry practice that is inconsistent with GAAP.|
|13||AAER No. 1140, In the Matter of W.R. Grace & Co., (June 30, 1999).|
|14||AAER No. 1126, In the Matter of Terex Corporation, KCS Industries, L.P., f/k/a KCS Industries, Inc. and Randolph W. Lenz, (April 20, 1999).|
|15||AAER No. 1061, In the Matter of Sony Corp. and Sumio Sano, (August 5, 1998).|