Speech by SEC Staff:
Remarks at the 2003 Thirty-First AICPA National Conference on Current SEC Developments
D. Douglas Alkema
Professional Accounting Fellow
Current Accounting Projects
Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 11, 2003
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 to speak to you this morning. I have four rather unrelated topics that I'd like to cover today. They include: revenue recognition, equity method investments, other-than-temporary impairments and a policy matter.
Revenue Recognition Service Contracts
At last year's conference we discussed the application of SOP 81-11 to service contracts and the SEC staff's position that footnote 12 of that Statement specifically scopes out most service transactions. We further stated that we had only seen a limited number of fact patterns in this area and asked for registrants to come talk to us about their accounting for certain long-term service arrangements.
It's a year later and some registrants have taken us up on our request and as a result, we've had the opportunity to address the accounting for a number of service transactions. We continue to believe that a cost-to-cost approach to revenue recognition is generally not appropriate outside the scope of SOP 81-1 since it rarely gives a good estimate of proportional performance. However, this doesn't necessarily mean that the completed contract method of accounting is the most appropriate method either.
In general, the staff has not objected to a revenue recognition model for service contracts that recognizes revenue as the service is performed using a proportional performance model as contemplated under SAB 1013. While this type of model would generally be an output-based approach, the staff has accepted an input-based approach where the input measures were deemed to be a reasonable surrogate for output measures.
In one fact pattern considered, the registrant engaged in a specialized consulting practice that did not provide for any interim deliverables or milestones but rather essentially functioned as a time and materials type contract. The customer received the benefit of the work performed throughout the contract term and was obligated to pay for all services once performed. The registrant recognized revenue at its standard hourly rates based on hours worked by its employees. Setup costs for these arrangements were immaterial and the registrant expensed all contract fulfillment costs as incurred.
The registrant believed, and the staff concurred, that using a revenue recognition model based on hours worked, an input measure, was consistent with the proportional revenue recognition concepts in SAB 101.
In summary, long-term service contracts are not substantially different from other revenue arrangements. In determining whether delivery has occurred, registrants should pay careful attention to the terms of the arrangement, specifically the rights and obligations of the service provider and the customer. Provided all other revenue recognition criteria have been met, the revenue recognition method selected should reflect the pattern in which the obligations to the customer are fulfilled.
I'd like to start by trying to clear up some of the confusion that seems to exist as to what the SEC staff's views are on this subject. Notwithstanding rumors to the contrary, the SEC staff does not conclude on an other-than-temporary impairment issue by using a bright line or even a rule of thumb. Rather, the determination of whether a decline is other than temporary must be made using all evidence that's available to the investor, including: the severity and duration of the decline as well as the investor's ability and intent to hold an investment for a reasonable period of time sufficient for a forecasted recovery. In this regard, the staff's analysis is not different from what is currently proposed in EITF Issue 03-014.
Issue 03-01 requires disclosures addressing impairments in a qualitative and quantitative manner. The consensus requires the securities to be segregated by Statement 115 classifications and also by length of decline those with declines of less than a year and those in excess of a year. Remember that SAB 595 states that management should perform this analysis "acting on the premise that a write-down may be required." Registrants should not infer that securities with declines of less than one year are not other-than-temporarily impaired (that is, it's not a safe harbor), nor should they infer that those with declines of greater than a year are automatically impaired. Rather, an other-than-temporary decline could occur within a very short period or, if the facts and circumstances support it, a decline in excess of a year might still be temporary.
One example of a decline in the market price of a security in excess of a year that might be deemed temporary is a treasury security for which management has both the ability and intent to hold the security until recovery, which may or may not be until maturity. In these situations, an investor's ability and intent is a critical factor in determining whether an other-than-temporary impairment should be recognized. While the staff recognizes that unforeseen factors might cause an investor to subsequently deviate from its assertions regarding intent or ability, a pattern of selling investments prior to the forecasted market price recovery would call into question the investor's future assertions related to its intent and ability to hold investments until recovery.
Since the typical equity security doesn't have a contractual cash flow at maturity on which to rely, an investor's ability and intent to hold an equity security for a reasonable period of time should be analyzed differently than a typical debt security. The ability to hold an equity security indefinitely would not, by itself, allow an investor to avoid an other-than-temporary impairment.
As a practical matter there are limitations on the period of time that management can incorporate into its forecast of market price recoveries. As the forecasted market price recovery period lengthens, the uncertainties inherent in management's estimate increase, which impact the reliability of that estimate. Market price recoveries that cannot reasonably be expected to occur within an acceptable forecast period should not be included in the assessment of recoverability.
As it relates to disclosures, the staff would expect to see disclosures in Management's Discussion and Analysis (MD&A) that, based on materiality, would extend beyond those required by Issue 03-01. Some of the important MD&A disclosures would include:
- The amount of the charge;
- A more specific discussion of the underlying reasons for the charge and its timing;
- An identification of which segment the charge relates to if it is not included in the segment's profit or loss measure under Statement 1316;
- As necessary, the risk and uncertainties regarding future declines; and
- The estimated effects that material declines would have on the registrant's liquidity.
The staff appreciates that the assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment. These factors only serve to stress the importance of transparent disclosure as well as employing a systematic and rational methodology that includes documentation of all of the factors considered by management in reaching its conclusions regarding other-than-temporary impairments.
Equity Method Investments
Now I'd like to move on to Opinion 187 and some equity method of accounting issues. The first deals with the application of purchase accounting to an equity method investment. Prior to the adoption of Statement 1428, registrants might not have strictly adhered to the equity method purchase price allocation requirements of Opinion 18 since all acquired intangible assets including goodwill had a maximum amortization period of 40 years. Due in part to the similarities in the various amortization periods, in many of these cases the staff may not have objected to a registrant's conclusions that their financial statements were prepared in accordance with generally accepted accounting principles in all material respects.
However, paragraph 40 of Statement 142 makes it clear that equity method goodwill should no longer be amortized but rather should continue to be tested for impairment in accordance with paragraph 19(h)9 of Opinion 18. As a result, we encourage registrants to take a close look at equity method investments made after Statements 14110 and 142 to ensure that the purchase price allocation appropriately reflects stepped-up values for tangible assets, identifiable intangible assets and goodwill.
The second issue I'd like to discuss is which investments should be included in the scope of the equity method vs. the cost method or Statement 11511. Of course, now, investors will first have to consider whether the investee is a variable interest entity that would need to be consolidated under Interpretation 4612. But assuming that consolidation is not appropriate, the staff has seen structures designed to avoid the application of the equity method and the associated start up losses that may result. In particular, the investor hopes to avoid the application of the equity method through one of two means: (1) Having significant influence over the financial and operating policies of the investee through a means other than a vote attributable to common stock; or (2) Not holding an investment in common stock of the investee.
The SEC staff has previously stated that the determination of whether an investor has significant influence over an investee should not be limited to the voting powers conveyed by the voting common stock but rather should consider all means through which the investor might influence the financial and operating policies of the investee, however obtained. Examples of these circumstances would include: contractual board representation, veto rights, or voting rights conveyed by a security other than voting common stock.
The EITF is attempting to address the scope of the equity method in Issue 02-1413 by defining what types of investments constitute a residual interest in an investee. Pending resolution of this issue by the EITF, the SEC staff will continue to require the application of the equity method in situations that are perceived to be abusive where investors have significant influence over the investee and hold securities that are functioning as "in-substance" common stock regardless of whether such securities have a liquidation preference to any existing common. In making this determination, we would consider a number of factors, including:
- The capitalization structure of the investee For instance, is there a substantive amount of capital contributed from common stock investors? To the extent that no common capital exists or exists only in the form of founders' shares, the liquidation preference of the preferred held by the investor may not be substantive.
- The characteristics of the security For instance, is the substance of the arrangement between the investor and the investee more of a creditor relationship? This might be the case with securities that qualify as debt under Statement 115. Or is it a shareholder relationship where the return to the investor is expected to be some variable amount based on the underlying performance of the investee? This might be the case with certain non-redeemable convertible equity instruments.
Obviously, this is an area that will require judgment on the part of the investor, but expect the staff to question transactions where the form of the arrangement is a structured transaction designed to avoid loss recognition, while substantively the investor is functioning as a voting common stock holder.
EITF Transition Policy
In previous conferences, we have stated that we would encourage registrants and auditors to consult with the Office of the Chief Accountant on difficult and emerging accounting issues. In some cases, the parties involved will agree that the issue warrants consideration and deliberation in a broader forum most often the EITF. The EITF typically addresses accounting issues within the framework of existing authoritative literature to reduce diversity in practice.
In situations where a registrant has an issue that has been accepted by the EITF's Agenda Committee, the staff will not typically impose its views on the registrant's accounting but rather would wait for the EITF process to culminate. However, this doesn't mean that if the EITF has agreed to take on a practice issue that any accounting positions taken on that issue are acceptable. If the staff believes that the registrant's accounting would not be an acceptable view, whether or not it is explicitly documented in the EITF issue summary, the registrant can expect us to continue to pursue the matter even though the topic is currently being deliberated by the EITF.
In certain cases however, rather than interpreting higher level literature, the FASB may ask for the EITF's assistance in addressing a practice issue with a goal of proposing an amendment to higher level accounting literature. In these cases, we will continue to enforce the accounting literature as it is currently written without regard to the current deliberations until such time as the literature in question is amended. This is similar to what happens when the FASB proposes a change to its own literature. As everyone knows, we neither require nor accept accounting based on proposed standards if such accounting conflicts with current literature.
1 AICPA Statement of Position 81-1, Accounting for Performance of Construction/Production Contracts
2 Footnote 1, This statement is not intended to apply to "service transactions" as defined in the FASB's October 23, 1978 Invitation to Comment, Accounting for Certain Service Transactions. However, it applies to separate contracts to provide services essential to the construction or production of tangible property, such as design, engineering, procurement, and construction management.
3 Staff Accounting Bulletin No. 101, Revenue Recognition
4 EITF Issue No. 03-01, Other-Than-Temporary Impairments
5 Staff Accounting Bulletin No. 59, Noncurrent Marketable Equity Securities
6 Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information
7 APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock
8 Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets
9 Paragraph 19 (h), A loss in value in an investment which is other than a temporary decline should be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capcity which would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors to be evaluated.
10 Statement of Financial Accounting Standards No. 141, Business Combinations
11 Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities
12 FASB Interpretation No. 46, Consolidation of Variable Interest Entities An Interpretation of ARB No. 51
13 EITF Issue No. 02-14, Whether the Equity Method of Accounting Applies When an Investor Does Not Have an Investment in Voting Stock of an Investee but Exercises Significant Influence through Other Means