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Speech by SEC Staff:
Remarks Before the 2004 AICPA National Conference on Current SEC and PCAOB Developments


Russell P. Hodge

Professional Accounting Fellow
Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 6, 2004

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the SEC staff.


It’s a pleasure to be here. The two topics I will discuss today include customer acquisition and related costs and the concept of materiality.

I will start with customer acquisition costs.

Customer Acquisition and Related Costs

At last year’s conference I talked about the accounting for costs of revenue transactions in the context of arrangements under the newly issued EITF Issue 00-21.1 The SEC staff continues to receive a number of cost related questions, including those that are in the context of revenue arrangements in general. Many of these questions involve cost related issues that have been around for some time. For example, the SEC staff continues to address issues related to accounting for customer or contract acquisition costs, such as sales commissions, origination and installation costs. There are only a few industries and situations where specific guidance is provided, so the frequency of these questions is of no real surprise.

We continue to receive questions about whether certain costs can be capitalized. In order to avoid misunderstandings, I want to point out that I am focusing now on whether it is “acceptable” to capitalize costs, not whether such capitalization should be required or even preferable. It continues to be true that expensing customer or contract acquisition costs is almost always acceptable. Now back to the capitalization questions: It is important to remember that before any of these costs can be capitalized on the balance sheet, they must first result in something that meets the definition of an asset.2 And by the way, “Deferred Costs” in and of itself is not an asset. In determining whether an asset can be recorded, it’s also important to remember that GAAP prohibits certain items from being recognized. For example, paragraph 10 of Statement 1423 indicates that, generally, costs of internally developed intangible assets should be expensed as incurred. Although many of these types of costs fall into this category, there are a few exceptions. SAB Topic 134 provides some limited guidance in this area indicating that registrants can elect to capitalize certain of these costs by analogy to Statement 915 and Technical Bulletin 90-16. However, it is important to remember that costs eligible for capitalization must have been incurred in connection with specific customer contracts.

Once capitalization is considered appropriate and an election to capitalize is made, measurement of the asset is fairly straightforward. That is, based on the costs that are incurred.

In terms of attribution and impairment, I think it is usually helpful to start with the question: What is the asset? Determining the nature of the asset may provide useful insight into the accounting models that may be appropriate to follow. For example, most of these types of costs would appear to relate to customer and contract related intangible assets. As you know, Statements 142 and 1447 provide attribution and impairment guidance for intangible assets. Historically, I know we haven’t thought of these costs as intangible assets, but I think it is fair to say the issuance of Statements 1418 and 142 has broadened the thinking about intangible assets.

The main takeaway here is that once you determine cost capitalization is appropriate why wouldn’t the day two accounting that follows be consistent with similar assets?

Moving on to materiality…


As Scott Taub mentioned in a recent speech at the Financial Reporting Conference9 at USC last May, the SEC staff is thinking about materiality again. One of the concerns that he mentioned was the iron curtain versus rollover issue. I would like to spend the next few minutes discussing this longstanding debate.

A materiality evaluation generally begins with quantifying the effects of misstatements in the financial statements. The main subject of the “iron curtain” versus “rollover” debate is how the effects of prior period misstatements are considered in this initial step of the materiality analysis. I should be clear, that the iron curtain versus rollover issue only concerns the exercise of quantifying the effects of misstatements. It only represents a part of the quantitative analysis. For example, a quantitative analysis would also include assessing quantitative thresholds that are considered material in relation to the financial statements and would generally be affected by and be performed in concert with the qualitative analysis.

The best way to illustrate the iron curtain versus rollover issue is through a simple example.

Assume that a registrant has a recurring late cut-off error related to revenue recognition at both the beginning and end of the current period of $120 and $100, respectively.

The rollover method has an income statement bias because it considers the reversing effects of the prior period misstatement. As a result, the quantitative analysis under the rollover method would indicate an error of $20 of understated revenue for the current period. On the other hand, the iron curtain method has a balance sheet bias that focuses on the impact of correcting the end of period balance sheet. The iron curtain approach would result in evaluating materiality based on the effect of correcting the $100 misstatement at the end of the current period.

From this example, it is easy to see the impact that the method used can have on materiality determinations – an understatement of $20 versus an overstatement of $100. Notwithstanding the disparate results that can occur, both methods are commonly used in practice, and the choice of method can significantly affect whether errors are deemed material. A recent study10 by Nelson, Smith and Palmrose (the “Nelson study”) analyzed the effect of the method or approach used on auditors’ materiality assessments. The Nelson study’s conclusion indicated that there is a “robust effect” of the materiality approach used on auditors’ proposed adjustment decisions. It found that, holding constant all other information relevant in a materiality assessment; auditors in the study were more likely to require adjustment under the materiality approach that provided the higher quantitative misstatement.

Given the diversity that exists in current practice, it is apparent that neither the auditing nor accounting standards have adequately addressed the issue. SAS 4711 and SAB Topic 1:M12 both highlight the issue but only offer limited guidance on when prior period misstatements should be considered.13

I think it is important to understand how the evolution of materiality assessments compares to the evolution of our accounting standards. Our accounting standards continue to evolve from a time when the income statement and the matching principle were considered king. Modern day standard setting continues to move more and more towards a balance sheet world where the focus is on element definitions such as assets and liabilities. As a result, it is easy to see why the rollover approach, with its income statement focus, has historically been intuitive to many accountants.

One of the more common weaknesses of the rollover approach relates to the accumulation of misstatements on the balance sheet over multiple periods, which is sometimes rationalized because the incremental amount in any period is quantitatively small from an income statement perspective and the cumulative balance remains quantitatively small compared to balance sheet captions. This situation often leads to some bad accounting. For example, we’ve seen several instances recently where management and the auditors have agreed to “freeze” an unnecessary reserve on the balance sheet indefinitely because correcting it in any given period would likely be material to the income statement. I find it interesting that, in many cases, these accumulated misstatements are suddenly considered material when the entity is acquired or when there is a change in management or independent auditor.

Unfortunately, the potential result of years of use of the rollover approach is that there may be balance sheets out there today that are littered with assets and liabilities that simply don’t exist. If that is the case, I think it is fair to say that it would be a disservice to the investing public to allow this practice to continue. The SEC staff believes that more guidance may be needed in this area. We have given a considerable amount of thought to this issue over the last six months. While, we haven’t completed our analysis, we hope to do so in the near future.

In the meantime, I thought I would at least offer my perspectives on the issue.

Some believe a practical solution to the problem would be to mandate the use of the iron curtain method. This method would clearly address the accumulation of misstatements in the balance sheet. However, the iron curtain approach can completely ignore certain misstatements in the income statement. For instance, in my cut-off example, if there was no error in the end of current period balance sheet, the iron curtain method would ignore the fact that revenue for the current period is understated due to the prior period cut-off error.

In my view, methods of quantifying misstatements in financial statements that primarily focus on one financial statement (for example, the balance sheet or income statement) appear incomplete. Management certifications and audit opinions do, after all, cover all of the financial statements. I believe we should consider whether a dual test approach that requires that a misstatement be immaterial from both a rollover and iron curtain perspective would be more appropriate. The practical application of the dual test approach would result in evaluating each misstatement based on the approach that yields the greater misstatement. This would also be the approach used when evaluating aggregate misstatements. In my example, the evaluation of the cut-off error would be based on the iron curtain result because it yields the greater misstatement (i.e., $100). An approach that focuses on all of the financial statements, including both the balance sheet and income statement, should result in more effective and consistent materiality assessments by both registrants and auditors.

I recognize that assessing materiality is not an exact science and I am, by no means, attempting to minimize the importance of qualitative considerations in materiality assessments. Registrants must consider both quantitative and qualitative factors when assessing materiality. SAB Topic 1:M makes it clear that exclusive reliance on a percentage or numerical threshold has no basis in the accounting literature. That is, quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. For example, judging from my own experience as an auditor, the consideration of certain qualitative factors, such as increased risk of fraud, should lower the quantitative thresholds that are considered material.

With that said, the SEC staff does not believe it is appropriate for so much diversity to exist in practice for something that should be as simple and straightforward as quantifying the effects of objectively determined misstatements.14 That is, shouldn’t the starting point in a materiality analysis be the same?
The iron curtain versus rollover analysis brings up a related issue with respect to the correction of errors – what to do in situations where uncorrected misstatements that were considered immaterial in prior periods have, for whatever reason, become material to the current period financial statements. This may occur, for example, as a result of a misstatement that has accumulated over several reporting periods that eventually reaches the point of being material. Some believe that because the misstatement remains immaterial to prior periods, registrants should correct the misstatement in the current period and provide adequate disclosure of the nature and effect on the current period financial statements. However, the SEC staff believes that, if the reversing or carryover effects of a prior period misstatement is material to the current period financial statements, the correction of the prior period misstatement should be reported as a prior period adjustment in accordance with APB 2015 (that is, the financial statements of prior periods should be retroactively restated).16
As I mentioned, we are still thinking about ways to resolve these issues, some of which have troubled accountants for years. In terms of timing, we hope to be in a position to offer some interpretive guidance in this area in the near future. We understand that there will be some difficult issues to deal with – such as transition for example. And we are thinking about how transition could best be accomplished if a change were required. However, difficult transition issues should not be used as an excuse for not improving financial reporting in this area. As we continue to study this issue, we welcome your input.

Thank you for your time.

1 EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables

2 Financial Accounting Standards Board (“FASB”), Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, paragraph 25.

3 FASB, Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets

4 Staff Accounting Bulletin, Topic 13, Revenue Recognition

5 SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases

6 FASB Technical Bulletin No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts

7 SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets

8 SFAS No. 141, Business Combinations

9 May 27, 2004 Remarks at the University of Southern California, Leventhal School of Accounting, by Scott A. Taub, Deputy Chief Accountant, Office of the Chief Accountant, United States Securities and Exchange Commission.

10 “The Effect of Quantitative Materiality Approach on Auditors’ Adjustment Decisions” by Mark W. Nelson, Steven D. Smith and Zoe-Vonna Palmrose (Publication of the study is forthcoming in The Accounting Review)

11 Statement on Auditing Standards (“SAS”) No. 47, Audit Risk and Materiality in Conducting an Audit

12 Staff Accounting Bulletin Topic 1:M, Materiality

13 SAS 47 refers to the issue as an accounting issue and, as a result, does not address the question.

14 I recognize the difficulty and judgment that may be required to measure the current period effects of prior period misstatements that involve certain subjective accounting estimates. This is only referring to the process of quantifying the effects of prior period misstatements after they have already been determined to exist.

15 APB Opinion No. 20, Accounting Changes.

16 This is consistent with the SEC staff’s conclusion in Staff Accounting Bulletin Topic 5:F, Accounting Changes not Retroactively Applied Due to Immateriality.



Modified: 12/06/2004