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U.S. Securities and Exchange Commission

Speech by SEC Staff:
The Times, They Are a-Changing

Remarks by

Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

33rd Rocky Mountain Securities Conference
Sponsored by: Continuing Legal Education in Colorado, Inc. and the Central Regional Office of the U.S. Securities and Exchange Commission Denver, Colorado

May 18, 2001

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 the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

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. Turner and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Thank you very much. It's great to be a part of this prestigious program, now more than ever. For, these are changing times, as evidenced by the rapid rise in our markets at the end of the last millennium, and the more recent downturn of the past year. And the predictions by the economists and "market experts" for the future are as numerous and varied as the sands of time.

As many of you know, I believe understanding the history of where we have come from is important in understanding how far we have gone, and what is needed to move ahead. I think it is fitting to quote one of the best-known attorneys, former Securities and Exchange Commission (SEC) Chairman Ray Garrett, who said in a 1975 speech he made entitled "The Accounting Profession and Accounting Principles":

"Accounting and financial reporting can never be a static art. It must be constantly reexamined as the underlying facts and trends change. It takes the best intelligence and labor of all of us to hope to reach wise decisions." (Ray G. Garrett, Chairman of SEC, pg. 15 of speech: The Accounting Profession and Accounting Principles, Oct. 3, 1975)

As we all know, a great deal has changed in our world since 1975, as evidenced by the following ad I recently saw by a law firm in the Wall Street Journal, which said:

"Our lawyers communicate by Cell phone, fax, email, video conference and the occasional telepathic vibe".

Now, it's that telepathic vibe part I really like, and always did suspect was the case with many of my colleagues from the Bar! It is something we always wished for in the auditing profession.

But seriously, in the world of accounting, the more business things have changed, the more accounting things have stayed the same. The profession at times has seemed to be lost in a time warp. All of us in the accounting profession must do a better job of recognizing and reacting to changes while staying true to our number one priority, serving the public who has given us an invaluable and precious, yet fragile franchise. A franchise built on trust. A franchise that will be maintained only if we provide investors high quality and relevant financial information on a timely basis and ensure the credibility of that information with highly effective independent audits on a global basis.

Only then will our markets continue to be the most respected in the world, with the clearest and most transparent financial reporting and integrity. Our financial markets depend on it. Our investors depend on it. We cannot give them less.

To meet the needs of investors in our current environment, financial management and their auditors need to react quickly to the new types of accounting issues they will face in these changing times. For example, the downturn in sales orders and softness in sales channels will raise revenue recognition and inventory valuation and disclosure issues. The changing market and industry conditions have given rise to impairment in the values of investments that have been made in assets and companies. Assumptions used in estimates for such items as sales returns, pension and healthcare costs, no doubt need updating. And rising energy costs are having a significant impact on businesses which no doubt require disclosure to investors.

As a result of these changes, let's focus on a number of topics that seem to be of interest to investors and are often a focus of analysts and the press in their coverage of companies. Many of these are also the focus of the SEC staff as they review filings.

Revenue Recognition - SAB 101

A good starting point is revenue recognition. This is an issue that surfaces in approximately half of our enforcement cases and according to research sponsored by The Committee of Sponsoring Organizations (COSO), Financial Executives International (FEI) and the SEC staff is the largest single issue involved in restatements of financial statements. Restatements for improper revenue recognition also result in larger drops in market capitalization than any other type of restatements.

Accordingly, the staff provided a compendium of existing Generally Accepted Accounting Principles (GAAP) on revenue recognition by issuing Staff Accounting Bulletin (SAB) 101 in December 1999. The 52 footnotes in the SAB provide an excellent frame of reference to the various original publications from which the guidance in the SAB is drawn.

SAB 101 provides a basic framework for analyzing revenue recognition by focusing on four simple, yet bedrock principles established in GAAP. Those principles state that revenue generally is realized or realizable and earned when all of the following criteria are met:

1. Persuasive evidence of an arrangement exists,

2. Delivery has occurred or services have been rendered,

3. The seller's price to the buyer is fixed or determinable, and,

4. Collectibility is reasonably assured.

Watching and evaluating the effects of the implementation of SAB 101 has been interesting. Initially one might have thought the sky was falling. But despite all of its fanfare, less than 2 in 100 registrants reported in the calendar third quarter of 2000 that they had made or expected, at that time, to make an accounting change under SAB 101. In addition, 6 out of 100 registrants indicated that they were evaluating SAB 101 at that time and were not sure of the impact SAB 101 would have, if any. That left 92 out of every 100 companies that were not impacted by SAB 101 according to their own third quarter disclosures that were reviewed by the auditors.

Based on our review of the disclosures in annual filings of companies that were required to implement SAB 101 in the fourth quarter of 2000, we found that approximately 4 in 100 companies made an accounting change. Of the companies that made an accounting change, approximately 71% of these companies recorded a charge for the cumulative effect of a change in accounting principle, with the average after-tax charge for those companies approximating $14 million, or 0.9% of average revenues and 7.4% of average pretax income of these companies for 2000. I believe the fact that there were relatively few companies who reported an accounting change substantiates that the SAB is consistent with GAAP and existing practice.

Of the remaining 29% of these companies, approximately 20% reported a change in accounting policy for revenue recognition that was expected to have a material effect on the registrants' results of operations only on a prospective basis. For example, some registrants in the telecommunications industry reported that they would be adopting a policy of deferring fees associated with the activation or initiation of certain telecommunications services, while deferring an equal amount of direct, incremental costs. Because an equal amount of revenues and expenses are deferred under such policy, there was no cumulative effect from the change in accounting policy to comply with SAB 101.

The remaining 9% of the companies that made an accounting change retroactively changed certain income statement presentation or classifications. For example, many of these companies changed their policy to present revenues and expenses on a net rather than gross basis.

The primary reasons for changes in companies' revenue recognition policies to conform with the views in SAB 101, as disclosed by these companies, were as follows:

  • Deferral of various up-front or prepaid fees for which no separate earnings process had been completed in exchange for the fee;

  • Deferral of revenue until certain non-perfunctory seller obligations were completed (such as equipment installation);

  • Deferral of revenue on product sales until such products are delivered, and title transfers to the customer, rather than when shipped;

  • Deferral of revenue that is contingent on the occurrence of some future event until the future event occurs (such as the achievement by a lessee of certain minimum sales thresholds);

  • For the mining industry, deferral of revenue until the mined material is sold/shipped as opposed to when extracted (pursuant to ARB 43);

  • Income statement classification issues (primarily gross vs. net income statement classification).

Furthermore, we noted that SAB 101 primarily impacted the manufacturing industry, as approximately 43% of the companies that reported a change in accounting policy in light of SAB 101 were in the manufacturing division of the Standard Industrial Classification codes. Other industries impacted, along with the percentage of the total companies impacted, were as follows:

  • Services, 20%

  • Transportation, Communication, Electric, Gas, & Sanitary Services, 20%

  • Finance, Insurance, & Real Estate, 10%

  • Mining, 3%

  • Retail Trade, 2%

  • Wholesale Trade, 1%

  • Other/Miscellaneous, 1%

Despite this small percentage of registrants impacted by SAB 101, we are concerned that a few companies perhaps knew what the impact of implementing SAB 101 would be as of the end of the third quarter of 2000, but failed to provide a meaningful, transparent disclosure of such in their third quarter filing, as required by SAB 74 and the AICPA's Auditing literature in AU Section 9410, "Adherence to Generally Accepted Accounting Principles: Auditing Interpretations of Section 410, Section 3, The Impact on an Auditor's Report of an FASB Statement Prior to the Statement's Effective Date".  Investors in some of these companies received an unnecessary surprise in the annual financial statements.  We also have identified certain disclosures in annual filings that do not clearly explain the impact of SAB 101, or the reason(s) why a change in accounting policy was necessary. The staff expects to follow up on these disclosures.

Audit Issues Related to Revenue Recognition

A study published in March 1999 entitled Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S. Public Companies (or "COSO Report") notes that over half the frauds in the study involved overstating revenues by recording revenues prematurely or fictitiously. These results are consistent with a study published in the August 2000 report of the Panel on Audit Effectiveness (also known as the "O'Malley Report") entitled, Analysis of SEC Accounting and Auditing Enforcement Releases, which found that approximately 70% of the cases in the study involved overstatement of revenues - again, either premature revenue recognition or fictitious revenue.

Given the results of these studies and the current economic environment where companies are struggling to achieve revenue forecasts, it is critical that auditors conduct adequate and appropriate audit procedures on revenues. After all, the investing public relies on the independent auditors to ensure the integrity and credibility of the numbers.

Many of the frauds in the studies I referenced involved improper revenue cut-off at the end of an accounting period. The O'Malley Report noted that the common methods for manipulating cut-off included recording revenue on shipments by backdating shipping documents and delaying the recognition of returns. It is critical that auditors conduct appropriate period-end cutoff audit procedures, even when a majority of the fieldwork is conducted at interim or preliminary dates. 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 its report and recommendations, the O'Malley Panel recommended that "Cut-off tests should be more extensive than tests of only a few transactions before and after the close of the period. Cut-off testing often should require the auditor's physical presence at the entity's location(s) at period end."

I strongly endorse this recommendation and believe it is required in order for the auditor to obtain sufficient evidential matter to perform an audit that fulfills the requirements of generally accepted auditing standards. Testing of a few transactions before and after year-end will often be insufficient to provide sufficient competent evidential matter for a reasonable basis for the auditor's report. The auditor needs to get out of the audit room when testing cut-off. For example, inventory that is received or shipped by a manufacturer has to pass through the loading dock. By asking questions of and talking to shipping and receiving personnel as well as observing the loading dock, an auditor can obtain information on unusually high levels of shipments and returns, whether inventory is being shipped to off-site storage or locations other than to the customers, backdating of shipping documents, delays in recording returns, and other valuable cut-off information.

In some entities, the nature of the business is such that the majority of revenues are comprised of complex, large, and/or non-recurring transactions evidenced by individual contracts. Auditors should read and understand the terms of these contracts, since the terms could have a significant impact on the appropriate accounting treatment for the transactions. For these types of transactions, auditors should confirm directly with the customer ALL significant contract terms which could have an impact on the accounting for the contracts, such as payment terms, right-of-return and refund privileges, customer acceptance criteria, termination provisions, or bill and hold arrangements.

Auditors also should confirm with the customer whether significant unfulfilled vendor obligations exist, or the existence of any oral or written agreements outside of the contract that may alter the written provisions of the contract. A common problem noted in the COSO and O'Malley reports was the existence of "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, they pose a significant risk to proper revenue recognition. Again, I encourage the auditor to get out of the audit room. The auditor needs to ask questions and talk to the sales and marketing executives and personnel. By doing so, an auditor can obtain information on unusually high levels of sales activity near period-end, oral or written side agreements, consignment sales arrangements, unusual payment terms, collectibility issues due to unusual sales terms, financing arrangements, and other terms and conditions that may be indicative of revenue recognition issues.

Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists, provides a list of conditions, all of which must be met, to recognize revenue at the time of sale when a right of return exists. One of those conditions is the seller's ability to reasonably estimate the amount of future returns. When auditing a company that sells through distribution channels, the auditor needs to determine if the company receives accurate and adequate reporting from its distributors regarding inventory levels in the distribution channels and current sales levels to end users. If the company does not receive this information, the resulting lack of `visibility' into the sales channel may cause an inability to reasonably estimate the amount of future returns. Both SFAS 48 and SAB 101 list factors that may impair the ability to make a reasonable and reliable estimate of returns. I encourage auditors to revisit and familiarize themselves with these factors, and if necessary, make adjustments to their audit procedures.

The AICPA has provided excellent guidance on auditing revenues. Two Practice Alerts have been issued. In early 1999, the AICPA issued the document entitled Audit Issues in Revenue Recognition. I understand they are also in the process of finalizing guidance on auditing revenue transactions in the high technology manufacturing and computer software industries. I encourage auditors to review the AICPA guidance and consider them in determining their audit procedures.

Let me emphasize. Cut-off testing, confirmations, understanding sales terms and arrangements, assessing an entity's ability to estimate returns - all these are not new methods of auditing revenues. This is textbook auditing - or, I suppose, one may even call it "Auditing Revenues 101". If you have not done these procedures, you have not done an audit and you are not in a position to issue an opinion on the financial statements.

Complex Customer Arrangements

For some companies, revenues and growth in revenues sometimes are as important to, or even more important than, earnings in affecting market capitalization. As a result, there is increased focus and attention on how revenue transactions are measured and classified in the financial statements. At the same time, companies are increasingly entering into complex strategic alliances, joint ventures, cross licensing and cross ownership agreements. These arrangements often involve two parties, each providing goods or services to each other, and may also involve the issuance of equity from one party to the other. These arrangements are commonly documented in multiple agreements that are negotiated and entered into contemporaneously. As such, the agreements are complex, and it may be difficult, if not impossible to distinguish and reliably measure the fair values of the separate elements of the contracts.

A simple example of this is a company that issues warrants to a customer at the same time the company and customer enter into a supply arrangement for the company's goods or services. In some instances, the warrants will only become exercisable if the customer makes a certain level of purchases. In others, the warrants are fully vested when issued, but the customer contractually commits to purchase some amount of goods or services from the issuer. The SEC staff has seen these and many other forms of these arrangements.

Companies and auditors must carefully evaluate the substance of these arrangements to determine the proper accounting, even in instances where the accounting literature does not specifically address the accounting for a transaction. Statement on Auditing Standards No. 69 recognizes this, noting that:

"...there sometimes are no established accounting principles for reporting a specific transaction or event. In those instances, it might be possible to report the event or transaction on the basis of its substance by selecting an accounting principle to an analogous transaction or event."

Guidance from the EITF exists for some of these situations, in Issues 96-18, 00-14, and 00-25. The concepts set forth in those EITF consensuses reflect the fact that the substance of these arrangements is that the customer is purchasing equity from the company, in addition to goods or services. Thus, the fair value of the equity issued should be subtracted from the cash received in determining how much revenue to record. Cash proceeds from the sale of equity instruments should not be reported in the income statement, even if the sale of equity is to a customer. Although these concepts are not complex, companies have too often recorded these transactions in a way that inappropriately inflates revenues, attributing the cost of the equity instrument to "sales and marketing expense," rather than reducing revenue to reflect the equity issued.

To illustrate a more complex example, a company may simultaneously negotiate and enter into agreements that provide for:

  • The purchase by the counterparty of services from the company over several years with guaranteed minimums each year,

  • An agreement by the counterparty not to compete with the company in certain lines of business for a period of time,

  • The purchase by the company of a minimum amount of advertising from the counterparty over several years,

  • Each party to have access to the other party's membership list for the purpose of sending targeted advertisements, and

  • An agreement by the counterparty to assist the company in marketing its services to others in the counterparty's industry.

In complex situations like this, the company and its auditor should consider whether it is appropriate to report the related cash flows, revenues and costs on a gross or net basis. The EITF, in Issue 00-25, has recently indicated that in order to report these types of arrangements on a gross basis, the company must receive from its customer a separately identifiable benefit that the company could have obtained from a third party, and there must be sufficient, competent and verifiable evidence of the fair value of the benefit received. When an entity would not have entered into one of the separate contracts without all the contracts being negotiated and agreed to as a "package", it will often be difficult to identify a separable benefit being received and to establish reliable and verifiable fair values for each element of the arrangement. In those instances, the facts and circumstances will often dictate that the cash inflows and outflows be reported as a net revenue or cost amount, in the appropriate periods.

I strongly encourage registrants to consider discussing highly unusual and complex transactions with the staff on a pre-filing basis.

Inventory Writedowns

Now let's switch to the other side of the journal entry for a sale, that is, the inventory account. In recent weeks, we have seen a large number of inventory write-downs reported in the press. These write-downs were both large in dollar amount and large in relation to the overall inventory balance.

Generally accepted accounting principles for accounting for the value of inventory is set forth in Statements 5, 6 and 7 of Chapter 4 of Accounting Research Bulletin (ARB) No. 43. SEC Regulation S-X Article 5-02(6) requires disclosure of the major classes of inventory. SAB 100 provides additional guidance on how to account for and classify write-downs of inventory in the income statement. And finally, the MD&A rules will often require disclosure of what happened in the business that resulted in the reduction in sales value of inventories, as well as the impact of those factors on trends in operating results and liquidity.

Inventory write-downs of the magnitude that have been publicly reported raise a number of questions. Have the write-downs been taken on a timely basis? What changes in the business have occurred that resulted in the write-downs? Were complete and full disclosures made to investors on a timely basis regarding these changes, etc.?

The news reports have also raised questions regarding accountability of management for these adjustments. I believe that is a fair question. From my past experience in business, I know it is important to manage the supply chain from suppliers, through order management, production and manufacturing, on to shipping and right on through to inventory levels at customers or in the distribution channel.

It is reasonable for, and I would encourage investors to ask, whether management identified on a timely basis increases in inventory levels at the customer or in other segments of the marketing channels. If so, then what steps were taken in the order management and manufacturing process to adjust purchases from suppliers? Were the increases in inventory consistent with increases in bookings and sales? If not, why not? Were supply contracts flexible enough to permit changes to order quantities or were there take-or-pay contracts that had negative implications for inventory balances and purchases? Are inventories still on hand after any writeoffs reasonable in light of existing backlog or are they still high in light of historical levels? What was discussed with the external auditors and board of directors regarding these significant changes in inventory and the business?

I suspect the staff will focus on this issue. We certainly do not want another In-Process Research and Development episode. I believe you can expect the staff will be asking many of the above questions as well as (1) what has been the status of the items reported on slow-moving items reports for the past three or four quarters, (2) have parts with no sales in the past few quarters been identified and properly accounted for on a timely basis, (3) do inventory write-downs take into consideration internal reports from marketing and sales with respect to forecasted sales, (4) what information has been obtained or is available regarding inventory levels at customers or in the distribution channel, (5) have these sales reports been consistent with what has been reported to analysts and investors, (6) when and how does the company plan on disposing of parts which have been completely written-off or are considered to be obsolete and (7) when and what communications have there been with suppliers regarding reductions in orders?

Some statements in some press reports seemed to imply some companies might be taking write-downs or write-offs of inventory now, with the belief they may be able to sell the same parts later on at a profit margin. This in not what ARB 43 intended when it stated: "In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained." I believe write-offs of inventory for the purpose of later recognizing a profit margin on the sale of that item is contrary to GAAP, and anyone involved risks dealing directly with the Division of Enforcement as opposed to the Office of the Chief Accountant. The recently issued Accounting and Auditing Enforcement Release No. 1393, In the Matter of Sunbeam Corporation, discusses a classic example of improper accounting for inventories and highlights the ramifications for management.

Finally let me note that some companies are treating these inventory adjustments as "pro forma" adjustments as if they were not expenses. I do believe it is important to disclose changes in estimates of the carrying value of inventory. But at the same time, the inventory being reduced in value was paid for by cash. It is a cash operating expense that has been incurred by the management team and company. As a result, it would behoove investors and their representatives on the Board of Directors to ask the tough questions regarding what happened to the company's and investors' cash.

Pensions and Other Post Retirement Benefits

In recent years, some significant trends have developed that will have a material impact on the pension and other postretirement obligations (OPEBS) and related periodic pension and other postretirement expenses of reporting companies. Such events, like any other event giving rise to a material impact on current or future results of operations and cash flows, should be discussed in registrants' MD&A.

The staff expects that the next annual actuarial valuations will contain assumptions that have been updated to comply with SFAS 87, Employers' Accounting for Pensions, and SFAS 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS 87 indicates that each assumption used shall reflect the best estimate solely with respect to that individual assumption on the applicable measurement date. Companies are also required to monitor the assumptions used in measuring other postretirement benefit obligations, returns on related other postretirement plan assets, and service cost.

Principal actuarial assumptions include:

  • discount rates,

  • participation rates,

  • factors affecting the amount and timing of future benefit payments, which for postretirement health care benefits include per capita claims cost by age,

  • health care cost trend rates,

  • Medicare reimbursement rates, and

  • the probability of payment.

Despite decreases in the rate of growth in such costs during the mid-1990's, recent evidence suggests that health care costs are again on the rise, which will have implications for the U.S. economy as a whole. Health care costs in the United States increased by double-digit percentages throughout the 1980's and early 1990's. (source: "Tracking Health Care Costs; Long-Predicted Upturn Appears", Center for Studying Health System Change). Rising health care costs WILL have a significant impact on companies' other postemployment benefit obligations and related periodic expense. Recent trends in health care costs should result in companies reevaluating in their next actuarial valuation, the assumptions used in measuring OPEB expenses and obligations. Auditors should evaluate and compare the trend rates for health care costs to the company's historical actual as well as projected trend rates, to assess whether they are reasonable. Furthermore, the potential impact of such cost increases on registrants' financial condition, liquidity and results of operations needs to be disclosed in accordance with the rules for MD&A.

Another important consideration is the fact that volatile stock market conditions have caused dramatic changes in the market value of assets held by pension plans to fund related pension obligations, and may very well have a significant impact on a companies' periodic pension expense and cash flows.

In looking at the assumptions used, we note that interest rates have been declining. The SEC staff expects registrants to use discount rates to measure obligations for pension benefits and postretirement benefits other than pensions that reflect the current level of interest rates at the next measurement date. The staff suggests that fixed-income debt securities that receive one of the two highest ratings given by a recognized ratings agency be considered high quality (for example, a fixed-income security that receives a rating of Aa or higher from Moody's would be considered high quality).

Auditing Pension and OPEB Liabilities and Costs

Management typically engages an actuarial specialist to assist in performing the necessary calculations and compiling the required information regarding pension and other postretirement plans, which is reflected in the company's financial statements and related footnotes. The new rules on auditor's independence also touch on this issue. Auditors use the specialist's work as evidential matter in performing substantive audit tests on the information included in the financial statements. As required under GAAS (AU Section 336), when relying on the work of a specialist, the auditor should:

  • Evaluate the professional qualifications of the specialist, in order to determine that the specialist possesses the necessary skill or knowledge in the particular field;

  • Evaluate the relationship of the specialist to the audit client to ensure that there are no circumstances that might impair the specialist's objectivity;

  • Obtain an understanding of the methods and assumptions used by the specialist, and evaluate the reasonableness of such; and,

  • Perform appropriate substantive tests of the source data provided to the specialist by the audit client, upon which the actuarial calculations are based.

Auditors must do more than merely agree the numbers in the actuarial reports to the financial statements and related footnotes. Auditors should evaluate the qualifications of the actuary and rigorously challenge the assumptions and methods used in calculating the numbers included in the financial statements.

Changes in the Numbers

Something that we are seeing with increasing frequency, and is of concern to the staff, is the use of changing estimates to make the numbers. While changes in estimates may be perfectly acceptable when supported by real economic facts, too often today the staff is seeing companies changing estimates when the underlying economics of the business do not support the change, and without any disclosure to investors. As such, investors are unwarily using numbers for investment decisions that lack transparency, consistency and comparability. And there is no way to know that.

I would urge companies and their auditors to carefully review such changes to ensure they are appropriate, timely and adequately supported with sufficient competent evidential matter. In addition, companies and their auditors need to be sure their disclosures fully comply with the requirements of Accounting Principles Board Opinion No. 20, Accounting Changes (APB No. 20), regarding the need to disclose changes in accounting estimates. Paragraph 33 of APB No. 20 specifically requires registrants to disclose the effect on income and per share amounts for a change that affects several future periods. The staff expects strict compliance with the provisions of APB No. 20.

Similarly, as required by Item 303 of Regulation S-K, registrants should also disclose in MD&A changes in accounting estimates that have a material effect on the financial condition or results of operation of the company, or trends in earnings, or would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.

While I am on this topic, I want to emphasize the need to follow SAB No. 100's guidance with respect to accruals for loss contingencies. SAB No. 100 explains that GAAP requires that such accruals for loss contingencies must be reversed when they are no longer supportable. I direct you to SAB No. 32 on this matter as well. We will be looking at loss accruals very carefully for compliance with GAAP.

The audit committee, as well as the auditor and management, plays an important role in ensuring there is no abuse of changes in estimates as an earnings management tool. The best advice I can give audit committees on this topic is to consider the AICPA's guidance for communications with audit committees, particularly as set forth in Statement on Auditing Standards ("SAS") No. 89 on Audit Adjustments and SAS No. 90 on Audit Committee Communications. In addition, in February 2000, the AICPA issued Practice Alert 2000-2, "Quality of Accounting Principles - Guidance for Discussions With Audit Committees."

Be sure you ask:

  • Were there any changes in estimates made, such as: changes in depreciable lives of assets, changes in assumptions used to calculate pension or health care costs, or changes in estimates of loss accruals such as inventory valuation allowances, pending litigation, tax examinations, etc.?

  • How large was the effect of those changes on the results of the company?

  • Are those changes reflected in and consistent with:

    • The company's budget and strategic plans; and

    • Recent business and industry economic factors and developments?

  • Are all such changes in estimates quantified and disclosed in the Company's financial statements and the Management's Discussion and Analysis section of the Annual Report to Stockholders?

Restructuring and Impairment

Let me now address a topic that has been the subject of frequent, if not daily, coverage in the morning newspapers - significant corporate restructuring and impairment charges. Given the amount of press coverage this topic has received, I am certain it will not come as a surprise to anyone that the Division of Corporation Finance and the Office of the Chief Accountant have been addressing these issues with increasing frequency.

Throughout 2001, the staff expects that a large number of companies will continue to find the need to make the impairment assessments of long-lived assets. SFAS 121 establishes the guidance for impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets to be held and used. Paragraph 5 of SFAS 121 provides an illustrative list of examples of events or changes in circumstances that trigger a review of long-lived assets for impairment.

In certain instances, the staff has noted that the triggering event resulting in an impairment charge appears to be a change in senior management. The staff has questioned the timing and appropriateness of impairment charges recorded at the same time as a change in senior management. In particular, the staff has inquired as to the underlying changes in the business and its economics, when those changes occurred, and whether those changes have been appropriately disclosed in MD&A when they occurred, on a timely basis.

The staff has previously told registrants that impairment charges recorded to write-down or eliminate goodwill should generally not be recorded in the period of acquisition, in accordance with APB Opinion No. 17. The rationale for these comments on registrants' filings has been to emphasize that recording an impairment charge to immediately write-down goodwill or identifiable intangible assets recorded in a purchase business combination and thereby minimize the impact of amortization expense on subsequent periods is inappropriate.

The staff continues to believe that a write-down of goodwill or identifiable intangible assets in the period of acquisition should be an infrequent occurrence. However, the staff wants to be very clear that if events occurring subsequent to the acquisition result in impairment, such as changes in economic factors (for example, the bankruptcy of a dot-com company in which a registrant held an investment), an impairment charge should be recorded in the appropriate period.

Registrants and their auditors can expect the staff to challenge not only the amount of the impairment charge, but the timing as well. My suggestion is, that registrants not take any shortcuts in their assessment or measurement of impairment losses. The registrant should perform a thorough review of the business and economic factors indicating an impairment review may be necessary.

In order to assess management's assertions regarding the timing of the impairment charge, the staff has, at times, requested to see the following information:

  • Copies of all analysts' reports that covered both the acquiring company and the acquiree from the date of acquisition through the current date;

  • A copy of the Board package submitted by management for Board approval of the purchase of the acquiree;

  • Copies of all Board packages addressing the acquiree subsequent to the date of acquisition through the current date;

  • Details on revenues from the "Top Ten" customers;

  • The number of employees obtained in the business combination and a monthly analysis of employee attrition classified by employee type on a monthly basis; and,

  • Copies of internal reporting and/or forecasting relating to the acquiree from the date of acquisition through the current date.

As with many accounting standards, a degree of subjectivity and judgment exists when recognizing impairment losses. While the staff has given management the benefit of the doubt with respect to its determination of loss timing and measurement, the staff has been wary of accounting that seems manipulative, assumptions that are not credible and a lack of timely, complete and transparent disclosures of the events leading up to the impairment.

To avoid a lengthy comment process, companies should ensure that the disclosures are complete, timely, and fully consistent with the requirements of SFAS 121, EITF Issue No. 94-3, EITF Issue No. 95-3, and SAB No. 100, as applicable. The staff looks for disclosure in MD&A about evolving trends and uncertainties leading to the write-off. In instances where these disclosures have been deemed to be deficient or inadequate, the staff has required registrants to amend previously filed financial statements to provide supplemental disclosures. To avoid restatements, I recommend that registrants ensure these disclosures are adequate to provide investors and users of the financial statements with sufficient and timely information.

Intangible Assets

As the staff has been reviewing the goodwill impairment charges recorded by certain companies, I have been at times surprised by the number of those companies that have not separately identified intangible assets or have represented that they could not separately value them, instead recording goodwill for the entire excess purchase price in a purchase business combination. APB Opinion No. 16 requires that all identifiable intangibles be 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, and favorable leases to mention just a few.

The staff has, on numerous occasions in the past, emphasized the importance of separately identifying and valuing intangible assets acquired in a purchase business combination. We did so most recently in the Audit Risk Alert letter sent to the AICPA in October 2000. The staff continues to be highly skeptical of registrants' claims that a valuation of separately identified intangibles is not possible when it appears the intangible assets exist and are valued in other merger transactions. In order to evaluate representations made to the staff, registrants should expect that the staff might supplementally request the contemporaneously prepared documentation supporting the allocation of the purchase price in a purchase business combination.

Intangible assets are very important in today's businesses. Wide variations between a company's stock price and its underlying book value per share frequently are attributed to the failure of the current accounting model to recognize a company's internally generated intangibles. Despite the importance that investors evidently place on those intangibles, a FASB Business Reporting Project Steering Committee observed that filings by public companies generally lacked meaningful and useful disclosures about intangible assets.

The staff has commented on that deficiency, soliciting better disclosure about intangibles outside of financial statements, and in the MD&A and Description of Business. Those disclosure requirements are not bound by the recognition and measurement rules of generally accepted accounting principles that treat intangible assets differently than tangible assets. If intangible assets are important to the business, registrants should identify them and explain what management does to develop, protect and exploit them. Operational, non-financial, measures can be very effective in explaining to investors the value of a company's intangibles.

Business Combinations and Intangible Assets Exposure Draft

The emphasis on identifying, valuing, and providing clear and concise disclosure of intangible assets will continue to be a focus of the Division of Corporation Finance and the Office of the Chief Accountant. The business combinations project being considered by the FASB, if adopted as currently drafted, will require the staffs' continued vigilance with respect to intangible assets.

Based on the discussions to date, the FASB would require that an acquired intangible asset be recognized separately from goodwill if it meets the asset recognition criteria set forth in paragraph 63 of FASB Concepts Statement No. 5 -

  • (i.e., it meets the definition of an element of financial statements, it has a relevant attribute measurable with sufficient reliability, information about it is relevant, or capable of making a difference in user decisions, and the information is reliable, or is representationally faithful, verifiable and neutral) -- and it meets either of the following criteria:

  • Control over the future economic benefits of the asset results from contractual or other legal rights (regardless of whether those rights are transferable or separable from other rights and obligations), or

  • The asset is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).

The FASB further indicated that an intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually would meet the proposed criterion if it can be sold, transferred, licensed, rented, or exchanged along with a related contract, asset, or liability.

The FASB has indicated its intent to provide implementation guidance in Appendix A of the final standard about the identification of intangible assets in accordance with the criteria I just mentioned. Given the importance attached to intangible assets in the current economy and given that most respondents to the September 1999 Exposure Draft indicated that they found Appendix A appropriate and useful, I strongly encourage the FASB to pursue its objective in this area. Such implementation guidance should be robust and provide clear and concise direction that will eliminate ambiguity and promote consistency in the recognition of acquired intangible assets separately from goodwill.

Evaluating the Valuation

Whether it is in conjunction with the acquisition of a business, the performance of the impairment test, or the evaluation of recorded intangible assets at transition, in almost every instance, companies will be required to obtain the assistance of a competent and knowledgeable professional to assist in the valuation of these intangible assets. Based on the staff's past experiences with IPR&D, I have concerns about the results of this process due to the lack of any meaningful guidance on valuation models and methodologies used to measure fair value and the auditing of those measurements.

Statements that have been made by well-respected members of industry and the investment banking community have also heightened my concerns. Dennis Powell, the Vice President and Corporate Controller of Cisco Systems, during the Senate Banking Committee hearings on the pooling-of-interests method of accounting, remarked that he learned from his experience on the AICPA committee tasked with developing best practices around valuation of Purchased Research & Development "that there [were] no standards in the valuation community to provide any consistency or reliability around the valuation of these intangibles." To compound this problem, I was made aware of a presentation done by a Morgan Stanley Dean Witter analyst during a conference call on IPR&D in which it was noted that the "auditors questioned nothing." Certainly, the lack of meaningful valuation standards coupled with auditors that are not challenging the underlying assumptions and resulting conclusions is a recipe for disaster.

That is why in November of last year, I wrote to the AICPA encouraging it to take a larger leadership role, by developing detailed, broad-based guidance on valuation models and methodologies used (a) to measure fair value, under the oversight of the FASB, and (b) in auditing fair value estimates.

Various AICPA groups have undertaken projects to provide guidance on estimating fair values and auditing those estimates. I am encouraged by those initiatives but challenge the AICPA to engage in a broader-based effort in this area. In particular, I have been especially encouraged by the AICPA's efforts to develop a technical practice aid on IPR&D. In that project, valuation experts, accounting and auditing specialists, and industry representatives have worked together to develop comprehensive guidance that satisfies the requirements of existing accounting standards while providing meaningful information that is consistent with that recognized and used in the marketplace. That guidance includes the details (including examples) necessary to assist preparers, valuation experts, and auditors in "how to" do it. I encourage the AICPA to complete this project as soon as possible.

Apparently, some valuation firms are already out selling their services to companies to assist them in maximizing the value of intangible assets to be subsumed into goodwill upon transition and therefore not be subject to future amortization. This is of great concern to us on the staff. I want to be very clear right now, the staff will expect that each and every valuation be completed using appropriate assumptions and that the conclusions reached are both reasonable and supportable. The auditors must ensure that they audit the key assumptions for reasonableness and consistency with other information provided to management, the Board of Directors, and that provided to the investing public and to challenge the conclusions reached.

A recent Business Week article stated that "it takes the regulators ages to clamp down on questionable practices, allowing companies to hoodwink investors in the meantime." Let me assure everyone, including preparers, auditors, and users of financial statements, we are aware of this practice and will not go back down the IPR&D path, which was littered with questionable intentions, questionable practices, and poor judgments. When we are graded on our efforts on this initiative, we intend to receive an "A."

The Enhanced Role of Audit Committees

I would like to note a very positive development. And that relates to the elevated role, and perception of that role, of the audit committee, and high-quality standards relating to audit committees that have come out in recent years.

The financial community, consisting of business leaders, leading professionals from the legal and accounting professions, standard setters, and stock exchanges have all pitched in during the past three years to shore up the foundation on which our markets are built, and we see that especially with respect to audit committees.

The first major accomplishment was that of The Blue Ribbon Panel on Improving the Effectiveness of Audit Committees, which issued a report in 1999 with ten outstanding recommendations. With the adoption of the ten recommendations by the stock exchanges, the Commission, and the Auditing Standards Board (ASB), we are starting to see greater oversight of the financial reporting process and external auditors, by audit committees. The Panel's report also listed a number of best practices I would urge each and every audit committee to adopt.

I have been reading many of the proxies being filed this year. I have noted more audit committees meeting four to six times a year and engaging in substantive discussions as opposed to a couple of meetings a year during breakfast. I encourage you to read the audit committee report for Coca Cola that I believe is an excellent example. Coca Cola is a household name and this report has been written so investors in households can understand it. It doesn't read like a report written by a corporate attorney to be read by a plaintiff's attorney. Kudos to Mr. Buffett for that type of plain English report to the company's investors.

A second accomplishment has been the adoption by the Commission and ASB of new standards that require audit committees to have meaningful discussions about the quality of the company's financial reporting, including such sensitive matters as the accounting policies selected, the judgments used to record such items as restructuring charges and write-offs of in-process research and development, and the materiality of unrecorded adjustments. These discussions also lead to discussions covering the interim financial statements. As a result, I now see that issues are being addressed by financial management and auditors on a timely basis. And again, audit committees are becoming more active in their oversight, asking more robust, probing questions on a timely basis.

Proxy Disclosures of Audit vs. Non-Audit Fees

We are following the new proxy disclosures for audit committees and auditor's independence closely for compliance with the new rules. This is important information for investors. I want to make clear that, if companies file a preliminary proxy with incomplete or incorrect information that does not comply with the rule, they can and should expect the staff to request it be amended to comply in full.

The SEC staff has reviewed the filings made by some of the larger registrants. Specifically, the staff looked at the first 563 proxies that were issued by Fortune 1000 companies as of April 30, 2001. The Independence Rule Proxy Disclosure study of Fortune 1000 companies contained in your handout materials is subject to the same disclaimer that applies to everything that I have said here today, and that is,

"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 the author and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission staff."

Let me also add that the 563 companies we looked at were simply the very first of the Fortune 1000 companies to have filed proxies as of April 30, 2001. There was no selectivity on our part, as we looked at all Fortune 1000 filings made as of that date. These filings may or may not be representative of the remaining Fortune 1000 companies or all other companies - but it does yield some preliminary information.

Here are some interesting observations with respect to these disclosures:

  • The range of audit fees was $121,000 to $48,000,000.

  • Overall, the average audit fee across all 563 companies was $2,175,724.

  • The median audit fee was $1,059,000 indicating that there are more companies with audit fees below the average than above the average.

  • On average, every dollar a company pays its independent accountant in audit fees is matched by $2.69 paid for non-audit services. In other words, non-audit fees are, on average, about 2.7 times the amount of the fees for the audit and reviews of the financial statements or 73% of all fees paid to a company's independent accountant. Some have said that we have defined audit fees too narrowly. However, the amount disclosed as audit fees are just that. The fees paid to the auditor for the audit (and reviews) of the financial statements. Nothing more, nothing less. Some would have preferred to have a less transparent number. However, that would have prevented investors from seeing the relationship between the economics of the audit to the audit firm and the economics of all other services rendered.

  • The range of non-audit fees paid to a company's independent auditor per dollar of audit fee is from $0.0 to $32.33.

  • One hundred and twenty six (126) or approximately 22% of the 563 companies acquired IT services related to their financial systems from their independent accountant. The average IT fee paid was $875,788. The range was from $0.0 to $46,800,000. One item of the rule that generated a lot of press was the issue of whether Information Technology, or IT consulting, should be banned. It the end, we did not ban IT consulting, but instead required specific disclosure of IT-related information. The Commission did note in the rule making, consistent with the disclosures being made, that the majority of companies do not buy IT services directly from their auditor. Obviously, the lack of providing IT consulting services to the 78% of companies that do not engage such services from their independent accountant does not appear to impair the auditor's ability to perform a quality audit for those registrants.

  • If we consider the 563 companies by revenue category the minimum percent of audit fees to revenue range from 0.0014% (companies with greater than $30 billion in revenue) to 0.0071% (companies with less than $2 billion in revenue). The maximum audit fee percent of audit fees to revenue range from 0.0380% (companies with greater $20 to $30 billion in revenue) to 0.3842% (companies with $10 - $15 billion in revenue).

  • The average audit fee increases as company revenue increases, but generally at a decreasing rate. For companies in the less than $2.0 billion revenue range, the average audit fee is $765,659 or 0.0473% of revenue. For the $10 to $15 billion dollar companies, the average audit fee was $3,782,633 or 0.0305%. For companies with greater than $30 billion in revenue, the average audit fee was $9,421,665 or 0.0155% of revenue. There is some variation in the middle range of revenues, but the trend is clearly up in dollars and down as a percent of revenue.

One item that has caught my attention with respect to the proxy disclosures is the range of audit fees. Obviously audit fees are greatly influenced by such factors as the size of company, the industries they operate in, the quality of their financial systems and controls and their internal audit function. However, some of the fees at the low ends of the ranges for companies of similar size and in similar industries do raise some questions. I have noted well respected companies, in the same industry, audited by the same auditor and one of the audit fees is just over a third of that for the other company, and the higher fee certainly does not look unusually high to me.

I hope these proxy disclosures do cause audit committees to consider whether they are compensating their auditors sufficiently and fairly to ensure the auditor's are able to provide well trained, highly experienced personnel required to perform the necessary procedures and steps for a high quality audit. In my opinion, this is not a place to shortcut the spending of the company's and investors dollars.

The Important Role of the Chief Financial Officer in Quality and Leadership

The overall quality of financial reporting in the United States is today unquestionably of the highest quality in the World. But the staff of the SEC has recently studied the number of restatements in recent years and found it to be trending upward. Investor's losses have also trended upward and in recent years have topped tens of billions of losses each year, aggregating over $100 billion if you go back approximately a half dozen years.

The good news is that the vast majority of these restatements are identified by the auditors or company and not by the SEC staff. More often than not, we read about them in the morning paper just as you do. That tells us something in the system is working right as the errors are being detected and corrected.

The bad news is that the errors were missed in the first place and required later corrections to the financial statements that had been relied upon by investors. Sometimes the errors have gone undetected for a number of years and detected and corrected only when new management is chosen by the board of directors.

Now some may say that approximately 150 restatements a year and losses of tens of billions of dollars are not significant to a market with 10-12,000 actively trading companies and a market capitalization of around $14-16 trillion on any given day. But if you believe that, then I challenge you to go tell that to the very investors who have worked hard every day to accumulate the savings they have put into the markets. I don't believe they would agree that it is acceptable for financial management to pencil numbers into the financial statements and disclosures that are anything less than clearly transparent and reflect economic reality. In fact, I noted an article today in the New York Times that appropriately stated in discussing the Commission's enforcement action with respect to the Sunbeam matter:

"But its real importance may come from whether it establishes a principle that seems obvious to anyone but an auditor: It is material information for investors if a company is trying to report fraudulent profits, regardless of the amount. An auditor who knowingly allows such profits to be reported has failed in his duty."

And that is why CFOs need to establish themselves as strong leaders on the executive management team. This means they need to have the spine and resolve to "just say no" when the CEOs or others pressure them to manage the numbers, especially when others are having difficulty managing the business. CFOs need to remember the lesson in the article in CFO Magazine titled, "Jailhouse Shock." That article listed 22 CFOs who were serving time or awaiting sentencing. In several cases, the CFO was spending years behind bars and away from family, a career destroyed, and the embarrassing notoriety of being labeled a fraud on the front page of your local, if not national, newspaper. Let me read just a few for you:

CFO Miniscribe - 2 years

CFO California Micro Devices - 2 years, 8 months

CFO Phar-Mor - 2 years, 9 months

CFO Ferrofluidics - 5 years, 3 months

CFO Bernard Food Industries - 6 years

CFO Lumivision - 10 years

CFO Bennett Funding Group - 30 years

And four of the CFOs were waiting for sentencing, facing terms of 5 to 115 years in prison. Remember, investigating and prosecuting financial fraud cases have become a priority at the Commission, with District Attorneys, and other law enforcement agencies. Manipulating the numbers, even when trying to play it as close to the edge as possible, has its price. CFOs need to just say No!

I believe CFOs need to present a clear, transparent financial report that tells the whole story. As Warren Buffett has asked, if you (i.e., the CFO) were investing in this company, has all the information you would want to know been made available to investors in an unbiased fashion? Too often today, we see the numbers being "spun," or important information about key trends or key and critical performance indicators being left out. And let's not forget, quality financial reporting means going beyond those minimum boundaries established by the rules governing financial reporting. The Commission's MD&A rules say it best, your disclosures must enable investors to see the business through the "eyes of management."

I am concerned by recent press reports and disclosures the staff has seen. These reports and disclosures do raise a question about the timeliness of accounting for and disclosure to investors of significant trends within business and industry today. As a result, I recently sent a letter to the eight largest accounting firms that follows up on our Audit Risk Alert Letter of last October. This letter is intended to convey a clear message: a lack of timely, complete, and transparent disclosures will result in amended filings. You may access it on the SEC's website at http://www.sec.gov/info/accountants/staffletters/sampleletter.htm.

Public and Internal Reporting on Internal Controls

CFOs also need to establish formal written policies setting forth not only high quality accounting policies, but also reasonable, effective internal controls that will ensure the financial records reflect all the company's policies, generally accepted accounting principles, and safeguard the company's assets. These policies and control procedures also should ensure that all the information necessary for a complete accounting and disclosure to investors of all relevant information is made on a timely basis.

Financial Executives International has stood for, supported, and recommended for many years the inclusion of management reports on internal controls in annual reports to shareholders. The Panel on Audit Effectiveness also recommended that the audit committee receive an annual report from management on the effectiveness of a company's internal controls. These recommendations clearly establish a "best practice" many companies already practice today. I strongly believe the CEO and CFO should sign off on a report to the investing public that the company's internal controls are operating effectively. This will then complete the package of public reporting by the "three legged stool" upon which quality financial reporting depends -- the auditors, the audit committee, and management. And as the Report of the Committee of Sponsoring Organizations noted, over 80% of financial frauds involve the override of internal controls by the CEO and/or CFO.

Balanced, Unbiased Reports to Investors

Let me also challenge CFOs who handle investor relations and public disclosure functions in a company, to treat all investors in a balanced and fair fashion. Selective disclosure of material information to some, but not all analysts and investors, is in my opinion, indefensible. Would you as a CFO be willing to look at those investors you had not informed about important facts, and tell them you had told others, who in turn had capitalized on that information in the markets? Do you really believe that is ethical and condone such practices? I have yet to see a CFO who is willing to answer this question "yes" in public, and I believe that confirms that selective disclosure is totally improper. I believe it is the lesson we all learned a long time ago; if you weren't willing to tell your mom about what you were up to, you probably shouldn't have been doing it!

Honest and fair dealings with investors and analysts also extends to press releases. "Everything But Bad Stuff" or EBS press releases do not present a complete or transparent picture. Often they appear to be trying to lead investors away from the "real" numbers, from real net income, and from real cash inflows and outflows.

For example, press releases that add back expenses to earnings such as marketing costs, costs to start up new businesses or product lines, and interest, fail to note these are real costs paid for with "real" cash. Investors should ask management if they have also backed out all the non-cash revenues they have reported, or plan on excluding the profits from new businesses and startups once they become profitable!!!

Or what about those who always want to add back just selected "noncash" expenditures such as goodwill amortization. If these people are really so mesmerized by cash flows, how about disclosing to investors the value of stock issued or the amount of cash paid for the investment, the amount of subsequent cash flows generated, and the actual rate of return earned in future years from these investments? Why does that seem to be missing from ongoing press releases? It would seem if these returns were what was originally represented to investors, then companies would be willing to disclose them.

Let me stop for a moment here and note that I met with the Committee on Corporate Reporting of FEI approximately two months ago. During that meeting, I expressed my concerns about EBS Press Releases and asked if the Committee would consider trying to develop some type of guidance to address some of the abuses in press releases. Recently, FEI in a cooperative effort with National Investors Relation Institute released new guidelines. I would like to thank these organizations for their efforts and timely response. I encourage you to access the guidelines at www.fei.org/news/FEI-NIRI-EPRGuidelines-4-26-2001.cfm.

While I believe it is clearly preferable to use GAAP earnings as the basis fro press releases, I would hope every CFO and every investor relations officer, as well as every audit committee, would take to heart those recommendations in the new guidelines that state:

  • "...it is managements' responsibility to prepare earnings press releases with a reasonably balanced perspective of operating performance. Such releases should ordinarily include analysis of operating results and a discussion of both positive and negative factors significantly affecting revenue, profitability and other key financial indicators that measure the health of the enterprise (e.g., debt to equity ratios, etc.)."

  • "The most significant factors affecting the enterprise's results for the period will appear in both the earnings press release as well as Management's Discussion and Analysis filed with the Securities and Exchange Commission."

  • "Earnings press releases should include "reported" results for the period presented under generally accepted accounting principles (GAAP)."

  • "It is important to provide pro forma results in context of their GAAP framework."

  • "Pro forma results should always be accompanied by a clearly described reconciliation to GAAP results."

These recommendations are sound and represent progress in the right direction.

You Can Enhance Disclosures to Your Investors Today

We have heard some say that historical cost-based financial statements and information is no longer relevant and that financial disclosures need to be enhanced. However, Jack Bogle, the well-respected founder of Vanguard, has noted that perhaps it was the market, and not the financial reporting model that was wrong. Unfortunately, those investors that have been reading their quarterly portfolio statements printed at the end of March, 2001, have learned the old fashioned way that historical earnings, not just revenues, real cash inflows and outflows, and the amount of cash left, do count.

However in today's business and economic environment, I do encourage registrants to enhance their disclosures. In the area of encouraging registrants to disclose additional useful information, I find the remarks made by Ray Garrett when he was Chairman of the SEC in a speech he gave in 1975 to be equally instructive today, and I quote him as follows:

"I should point out that in general, we have not found registrants and their accountants and lawyers anxious to develop innovative and experimentive approaches in filings with the Commission. Financial statements and other disclosure documents have been too often approached from the viewpoint of limiting liability rather than providing information. This has led to a desire for rules that can be followed in contrast to statements of objectives to be achieved."

"...As an attorney who has spent many years in private securities practice, I can have sympathy with this tendency while at the same time recognizing its limitations. There is great comfort in a rule. And yet, if we allow ourselves to fall into the trap of trying to write a rule to cover every occasion, we will certainly sweep in many effects we don't want while at the same time failing to foresee many items which should be covered. In the accounting field particularly, recourse to rules leads too often to the triumph of form over substance. The conspicuous failures of accounting in recent years, such as leases and business combinations, are areas which are characterized by an excess of rules and a minimum of reason. I also regret to say that these are also the transactions most characterized by the presence of attorneys, whose task is to document transactions so that they conform to detailed rules and, hence, are eligible to be accounted for in a fashion contrary to their essence. (emphasis added)

"In the final analysis, it seems to me that rules are a necessary part of financial disclosure and that it is only fair to allow people to predict accounting outcomes of transactions at the time they are entered into. On the other hand, it is not reasonable to expect that rules will serve as an immunization against the obligation to reflect reality in financial statements. Rules, therefore, can only be regarded as a minimum. Good information for investors requires good will and good sense as well as good rules." (emphasis added) (Ray Garrett, Chairman of SEC, in speech: The Need for Change in Accounting Policies, 1/6/75)

I could not agree more with former Chairman Garrett's remarks about the need to have good sense and good will - by that I mean, integrity -- toward investors in addition to good rules. It is the sensible, good faith application globally of high quality accounting and auditing rules, that makes all the difference in the world.

In particular, I do believe greater disclosure in a neutral, comparable, consistent fashion of key performance indicators would be helpful and would enhance the quality of information investors receive. These indicators do provide information about value creation in a business. For example, indicators such as manufacturing plant capacity and utilization, backlog, trends in bookings from top ten customers, employee turnover rates, the description, nature and number of patents, and technology licensing information, would all be useful to investors. This information is typically already available, as it is the information management is customarily using to manage their business.

However, one of the Big Five Accounting Firms recently conducted a survey of the retail industry which noted that analysts and investors surveyed indicated non-financial indicators such as corporate strategy, quality of management, brand reputation, customer retention, systems and processes, intellectual capital, research and development, innovation, and social and environmental policies are not adequately reported. But, I wonder who is going to set the standard for reporting on the quality of management? And what would these standards say about Ray Kroc, founder of McDonalds, or Thomas Edison, given they had more than one misstep before becoming successful. I encourage corporate business leaders, investors and public accounting firms to undertake to work together to develop enhanced disclosures that are clearly understandable to investors and disclosed on a comparable, consistent basis. This would include defining the terms used in the disclosures such that they have a clear and transparent meaning to the investors who will read them.

Yet there is nothing today that prevents companies from disclosing additional useful and meaningful information. Indeed, to the extent it is forward looking information, the Commission has already afforded registrants safe harbors that can be utilized.

Protocol for Registrant Submissions

I know I've covered a lot of ground today.

But I'd like to focus your attention on one more matter, and I urge you to listen closely.

I would like to take a minute to discuss an issue that is essential to the operations of the Office of the Chief Accountant. In too many situations today, when accounting firms are providing the staff with an explanation for an accounting or auditor independence position, the firms are citing informal phone calls they, or another firm, had with a staff member years ago about a similar issue confronting a different registrant. Many times there is no written record of either the facts in that earlier case or the staff's position.

To address this problem, when my office published our "Protocol for Registrant Submissions to the Office of the Chief Accountant," which is available on the SEC's website, we stated very clearly:

    "Responses to ... informal telephone inquiries are not binding and can not be relied upon by the registrant as formal positions of the staff.... For both written submissions and oral inquiries, the position of the staff may change in the event that new or additional facts arise."

Under the Protocol, when an issue presented to the staff is resolved, the registrant should send to the staff a letter describing the registrant's understanding of the staff's position. Without that written submission, we cannot be sure that the staff has all the relevant facts or that there truly was a "meeting of the minds" between the staff and the registrant.

From the time the Protocol was first disseminated in November 1999, therefore, it has been very clear that if an answer from the staff is not documented in writing, registrants and accounting firms can not rely on that answer as being the position of the Office of the Chief Accountant, or of any member of the Office.

Also, without a written record, the staff cannot apply prior answers to new situations because we cannot reliably determine if the facts in the prior and current cases are different or what factors might have influenced the staff's earlier decisions.

This problem is especially troublesome in areas, such as auditor independence, where the rules have changed significantly in recent years. No one should assume that informal, verbal positions given on old rules and interpretations that have been amended or rescinded still apply. Even where similar terms are used in the old and new rules, it is necessary to carefully analyze the facts and determine how the new rules, and the reasoning expressed in the adopting release, apply to those facts before anyone should assume they can rely on pre-existing positions of the staff.

I encourage anyone confronted with such a situation to discuss it with my office, so that we can remove any doubts, clear up any existing problems, and move forward under the new rules as efficiently as possible.


That sums up my prepared remarks for today. I think the message I want you to take away with you today, is that everyone associated globally with financial reporting and disclosure to investors has to be ever-vigilant in our number one duty, and that is investor protection. For, especially, in these times of paradigm shifts in technology, linking people all over the world, putting transactions and financial reporting on-line, real time -- it reminds me of the Bob Dylan song, "The Times They Are a-Changing". And he sang those words almost 40 years ago. Now doesn't that make you feel old!

But in truth, over the past 40 years, just as in the early years of the securities markets when the SEC was founded to protect investors, we see how important it is that those involved with financial reporting, just as with management of the business, must adjust to those changes or find themselves in the land of dinosaurs and hot volcano's! And let me tell you, I sure don't want to be the one standing there when that volcano erupts and has a meltdown!

So, I invite you to join with us at the SEC in working toward greater transparency, comparability, and quality in financial reporting and auditing, which serves investors and all those who depend on our companies, well.

Thank you.


Modified: 05/25/2001