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U.S. Securities and Exchange Commission

Speech by SEC Staff:
How the Division of Corporation Finance Influences Accounting Practices
and Financial Reporting Standards

Remarks by

Robert A. Bayless

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

To Technical Session of the 30th Annual Convention
National Association of Black Accountants

Washington, DC

July 19, 2000

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

My topic this morning is the role of the SEC in the process of setting accounting standards. But, in particular, I want to talk about how accountants in the Division of Corporation Finance affect the way accounting is practiced, the way financial information is presented and analyzed, and sometimes even the way a public companyís stock is priced.

Let me preface my remarks by reminding you that the Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Accordingly, my remarks are solely my own views and do not necessarily reflect the views of the Commission or my colleagues on the Commissionís staff.

Some who analyze the impact of the SEC on accounting consider only the Commissionís statutory authority and its relationship with the Financial Accounting Standards Board. Certainly, from a statutory point of view, the SECís role in the process of setting accounting standards is central and decisive. The Securities Act of 1933 and the Exchange Act of 1934 established the authority of the Commission to prescribe, among other things, the form in which financial information is presented in registration statements and periodic reports, the methods to be followed in the preparation of accounts, and the definition of accounting terms.

Despite that authority, the Commission generally has not dictated accounting rules beyond a few provisions in Regulation S-X governing the form and content of financial statements. Instead, practically since its inception, the Commission has used its authority over financial reporting to encourage and support the development of accounting standards by the private sector.

When the Financial Accounting Standards Board was established in 1972, the Commission endorsed its structure and its processes of deliberation and public comment as consistent with the public interest. In order for the Commission to look to the FASB for accounting standards, the Commission must be satisfied that FASB operates in the public interest. That assurance comes from the oversight of FASB by the Office of the Chief Accountant.

But the Commissionís oversight is neither a rubber stamp of FASB decisions nor a dictation of the substance of its standards. Rather, the Commissionís staff closely monitors FASBís projects, attends FASB meetings and hearings, meets with the FASB staff to discuss issues, and reviews comment letters received by the FASB about its projects. Throughout this process, the Commissionís staff evaluate whether the FASB is operating in an open, fair, and impartial manner, whether it is addressing issues that are relevant to registrants and investors, and whether its decisions ultimately lead to standards that are within the range of acceptable alternatives that serve the public interest and protect investors.

As important as the SECís oversight relationship with the FASB is, I would submit that this role is not the avenue by which the Commission exerts its greatest influence over the current practice of accounting. Even if you expand your view to consider the results of the SECís Division of Enforcement, you will fail to comprehend fully the Commissionís immediate and pervasive impact on contemporary financial reporting. Of course, the mere mention of the Division of Enforcement serves as a powerful deterrent to financial reporting fraud. SEC Enforcement is the muscle behind many Commission initiatives. But, the Accounting and Auditing Enforcement Releases that report SEC enforcement actions generally represent only the most obviously fraudulent examples of the financial reporting problems we see. They comprise only a small portion of the financial reporting problems discovered in filings with the Commission.

What is commonly overlooked by casual observers, and academics as well, is that most financial reporting problems are handled by the Commissionís full disclosure program, which is administered by the Division of Corporation Finance. The Divisionís review and comment process is less visible to the general public than the activities of the Division of Enforcement or the Chief Accountant of the Commission. But, as I will describe, the review and comment process in the Division of Corporation Finance unearths a surprising number of accounting errors, disclosure deficiencies, and tortured interpretations of GAAP in filings with the Commission.

Only the most egregious and obvious of these accounting errors lead to action by the Division of Enforcement. In the overwhelming majority of cases, the registrant restates its financial statements quietly after a challenge by the Division of Corporation Finance. Although further action by the Division of Enforcement may be considered, most often the staff decides that the investment of additional time and resources into the investigation and litigation of the accounting error is unlikely to accomplish significantly more than the comment process achieved already with the registrantís restatement of its financial statements. But the accounting issues underlying the restatement of financial statements in these situations are usually no less important than those that have served as the basis for more dramatic enforcement actions.

If you have practiced accounting in real time and in complex economic environments -- if you have prepared or audited financial statements of innovative or aggressive companies -- if you are a financial sleuth who has dug through annual and quarterly reports, proxy materials, press releases and financial analystsí reports of public companies -- if you have done any of these things, then you know that the accounting standards published by the FASB are only the visible portion of the proverbial iceberg. The greater body of accounting practice lies beneath opaque waters.

It is the Commissionís review and comment process that probes below that surface, looks behind those antiseptic-looking descriptions of accounting policies in footnote one of the financial statements, and digs deep into the way public companies actually apply the accounting rules to specific transactions. It is precisely at this point of implementation -- where the rubber hits the road -- that a good accounting standard can dissolve into meaningless, or even abusive, accounting practice.

At the Commission, more than 100 accountants in the Division of Corporation Finance are putting current financial reporting practices under the microscope every day. I believe it is the Divisionís review program -- the staffís actual or potential challenge to a registrantís accounting practices -- that most significantly impacts contemporary U.S. accounting standards. It is this vigorous review and comment program, which is absent outside the United States, that makes U.S. accounting standards preeminent and worthy of investor confidence around the world.

Let me describe the Commissionís review and comment process in more detail. The objective of the Division of Corporation Finance in the last several years has been to review every initial public offering and a significant sample of annual reports and other filings by other public companies. In the governmentís fiscal year ended September 30, 1999, the staff reviewed over 1,000 IPOs and almost 700 initial Exchange Act registrations. In addition, the staff reviewed over 2,300 annual reports on Form 10-K.

The purpose of a Division review is to assess compliance with the Commissionís disclosure rules, including compliance with GAAP. The staff issues letters of comment to the registrants. Those letters often recommend additional disclosure in the filing, or request supplemental explanation about a transaction or an accounting method. Comments may be triggered by the absence or incompleteness of a prescribed disclosure, or by the inconsistency of a disclosure with other facts reported in the filing or known by the reviewer.

Division reviews are far short of an audit or an investigation, because they are based almost entirely on a reading of the registrantís public filings with the Commission. Nevertheless, Division reviews of IPOs frequently result in changes to financial statements and related disclosure before the registration statement is declared effective. Also, every year, a surprising number of public companies restate financial statements previously published in their annual reports as a result of issues surfaced in staff reviews.

To give you a snapshot of how the review and comment process affects financial reporting, let me describe the results of the Earnings Management Task Force. The Division formed that special task force of accountants to conduct reviews of filings in 1999 under the umbrella of Chairman Levittís Earnings Management Initiative. A primary objective of the reviews was to elicit improved disclosure in financial statements and Managementís Discussion and Analysis about charges involving asset impairments, restructuring charges, purchased in-process research and development, and similar items. The task force also examined filings for indicia of earnings management and other abuses involving revenue recognition, unreasonable valuations of purchased in-process R&D, and manipulation of loss allowances and estimated liabilities.

In response to the Divisionís focused attention in this area, more than 50 companies revised their financial statements or earnings releases to adjust downward the amounts allocated to purchased R&D, requiring the reinstatement of goodwill and other assets in an aggregate amount exceeding $5 billion. The task force can also be credited with more than 40 other cases in which financial statements were revised to correct the timing of recognition for revenues or restructuring costs. Let me point out that only a small fraction of these restatements were taken up by the Division of Enforcement for further inquiry or action.

The Divisionís Task Force was challenging companiesí implementation of long established accounting standards, such as Financial Accounting Standard No. 2, Accounting for Research and Development Costs, and FAS No. 5, Accounting for Contingencies. Even such seemingly simple standards as those have spawned a myriad of interpretations and applications that would astonish the uninitiated.

Today, many associated with the high tech industry will acknowledge that the quality of accounting for purchased in-process R&D collapsed under the pressure of some dealmakers who thought they could game the accounting literature. Some companies hoped that a purchase business combination could be accounted for almost like a pooling of interests by treating "goodwill" as purchased R&D, which is written off immediately. Higher profits can be reported if goodwill amortization is eliminated in that way. But the Task Force challenged many unbelievably high valuations assigned to purchased R&D projects. Although these projects were depicted for accounting purposes as the predominant asset of the purchased business, we often found that they were not even mentioned in presentations to the acquiring companyís Board of Directors. Corrections to the financial statements were required.

And restructuring charges challenged by the staff sometimes turned out to be Trojan Horses filled with undisclosed losses and bungled projects, smuggled past unwary investors under the camouflage of labels like "unusual" or "isolated." Too often these charges were loaded with write-offs made necessary by managementís prior under-depreciation of assets, and with accruals for ordinary operating costs. Items we found buried in restructuring charges included unfavorable manufacturing variances, bad debt write-offs, reversals of previously recognized but unrealized revenues, and employee bonuses. One of my favorite restructuring charges was the accrual of costs for next yearís advertising program that had been developed because the publicís perception of the companyís trademark needed to be "restructured."

There can be little doubt that the Commissionís review and comment program aimed at these problems produced changes at a number of levels within the standard setting process. Accounting firms re-wrote internal guidance and instituted special training for their audit teams about these subjects. A number of specific implementation questions unearthed in the reviews were submitted for the consideration of various accounting bodies, such as the Emerging Issues Task Force and the Accounting Standards Executive Committee of the AICPA. The SEC staff published informal guidance in speeches and staff accounting bulletins that discussed the results of its reviews. And many of the issues surfaced in these reviews became elements of broader standard setting projects on the FASB agenda.

The earnings management task force is only one example of how the Commissionís review and comment program has provided a dynamic and essential feedback mechanism within the U.S. standard setting process. Between the abstract debate of broad accounting concepts on the one hand, and the relatively slow, necessarily careful, investigation and litigation of fraudulent accounting on the other, lies the huge arena of real business operations and real-time accounting practice. I believe it is the presence of the SEC on this field of action that most shapes financial reporting and accounting standards currently in use. The casualties and compromises on this battlefield provide the framework and inspiration for tomorrowís improvements to accounting and reporting standards.

I know this audience takes the practice of accounting seriously. Perhaps you can imagine yourself taking on a new role overseeing and improving accounting practices. Let me take this opportunity to invite you to join us and participate from this side of the Commissionís review and comment process. Sit at the table with the registrantís lawyers and accountants and witness how companies explain and defend their novel accounting interpretations or their application of old standards to newly emerging business structures. Participate in the resolution of contested accounting issues, and read about the outcome in the newspaper the next morning. If you or someone you know would like to parachute into the front line of the Commissionís oversight of accounting standards as they are really practiced, please give me a call.

Find out about employment opportunities with the Division of Corporation Finance by calling Carol Stacey or Robert Bayless at (202) 942-2850, or by visiting the SEC web site at www.sec.gov/asec/secjobs.htm.