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Speech by SEC Staff:
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| 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. |
Introduction
Thank you very much. It's an honor for me to have the opportunity to be part of this panel and speak to you about some of the current issues, or "hot topics," as we like to say, that we are focusing on in the Office of the Chief Accountant today.
Let's start by getting some perspective on where we are today, for so much has happened in the past few years, and especially in the last year, in our markets. The 1990s and first years of the new millennium have tested the fortitude and confidence of investors. We have seen the Nasdaq with a total market capitalization of $386 billion in 1989, less than the market cap for General Electric today, increase by 1248% to $5.2 trillion at the end of 1999. And of course, we have since seen the Nasdaq fall from a high of 5132 on March 10, 2000 to around 2,000, a decline of over 50 percent.
But throughout the trying times of the past year, our investors have remained confident in our markets. Of the $29.2 trillion in market capitalization of the domestic companies listed on the global capital markets, at the end of February, $14 trillion or nearly half was invested in companies listed on the New York Stock Exchange, Nasdaq or the American Stock Exchange (AMEX). That's greater than four times the $3 trillion capitalization of the companies on the Tokyo Exchange, more than five times the $2.4 trillion capitalization for the London Stock Exchange, and more than ten times the $1.2 trillion capitalization for Germany. What a success story for our capital markets, for investors, for the companies they have invested in, and for the employees who work for them.
And why have our markets remained so strong? In large part, due to the confidence investors have in the quality and transparency of audited financial information reported by these companies. But this confidence can only remain if we recognize that, typically, when such significant and rapid changes occur in the markets and the economy, there are new accounting issues that arise that require greater attention and focus.
Last October we highlighted a number of these issues in our annual Audit Risk Alert Letter, which you can view on our website at: http://www.sec.gov/info/accountants/staffletters/audrsk2k.htm. Hopefully, our discussion today will serve to provide preparers and auditors with an update to that letter.
Inventory Writedowns
Let's start with something we have read about in the press lately, and that is the inventory write-downs that have been recorded by some companies. 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 are 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. Staff Accounting Bulletin (SAB) 100 provides additional guidance on how to account for and classify write-downs of inventory in the income statement. And finally, the Management's Discussion and Analysis (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 to ask, 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 seem to imply that 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 is 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 Division of Corporation Finance or the Office of the Chief Accountant.
The Sunbeam Case
The recently issued Accounting and Auditing Enforcement Release No. 1393, In the Matter of Sunbeam Corporation, discusses two classic examples of improper accounting for inventories. In the first instance, we alleged that Sunbeam recorded an excessive restructuring reserve in one year that decreased the value of perfectly good inventory, and when that inventory was sold in the next year at regular prices, Sunbeam recognized inflated profit margins and thus overstated income. In the second instance, the Commission alleged that Sunbeam sold its spare parts inventory to a supplier at the end of the year, but improperly recognized income on the sale. The sale price had no practical relationship to any payment Sunbeam might obtain; by its terms, the contract would terminate in January 1998, absent agreement between the parties on the value of the inventory. Moreover, Sunbeam agreed to pay certain fees to its "customer" and guaranteed a 5% profit on the resale of the inventory. When the auditor reviewed the transaction it took exception, but then allowed recognition of the inflated income by passing its proposed audit adjustment as immaterial.
For those of you interested in further details, following are some of the more salient quotes from the Sunbeam order:
Concluding Comments on Inventory Writedowns
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:
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. For example, a recent report by Towers, Perrin entitled, "2001 Heath Care Cost Survey - Report of Key Findings" identifies that health care costs increased at a rate of 12% in 1993, and then decreased to as little as 2% in 1995. However, in the last three years, they have been increasing to 7%, 12%, and 13% (estimated) in 1999, 2000, and 2001, respectively. Accordingly, the staff would expect registrants to also be adjusting their health care cost rates to reflect these developments. If material, the effect of these adjustments should also be disclosed in MD&A.
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 Generally Accepted Auditing Standards (GAAS) (AU Section 336), when relying on the work of a specialist, the auditor should:
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.
Other Than Temporary Declines
In recent years, the issue of other than temporary declines in security values has not received a great deal of attention due to overall market performance. However, notice needs to be taken of recent events. The Nasdaq has suffered sharp declines, and industries such as telecommunications and technology have been hard hit. Various other market indices have fallen significantly and near term recovery is uncertain. Analysts have lowered earnings expectations in the past couple of months significantly from projections made at the end of 2000. Additionally, newspaper articles and other press reports tell stories of industries and market segments with bleak or clouded futures that appeared bright just a short time ago.
Given these and other events, the staff has reminded registrants that hold marketable debt and equity securities of their need to evaluate these securities, on a periodic basis, for other than temporary declines in value. SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, specifies that "[i]f the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value... and the amount of the write-down shall be included in earnings." This write-down results in a new cost basis for the security, which cannot be recovered if the fair value subsequently increases.
The Commission has issued guidance in evaluating whether a security's recent decline in value is other than temporary. This guidance is found in SAB 59, Accounting for Noncurrent Marketable Equity Securities. The SAB specifies that declines in the value of investments in marketable securities caused by general market conditions or by specific information pertaining to an industry or an individual company, "require further investigation by management." In this regard, SAB 59 states: "[a]cting upon the premise that a write-down may be required, management should consider all available evidence to evaluate the realizable value of its investment." Therefore, in conducting its investigation, management should consider the possibility that each decline may be other than temporary and reach its determination only after consideration of all available evidence relating to the realizable value of the security.
SAB 59 clearly states that other than temporary does not mean permanent. Thus, the point at which management deems the decline to no longer be temporary triggers the obligation to write down the investment. This point may precede a determination that an investment is permanently impaired.
Furthermore, SAB 59 sets forth "... examples of the factors which, individually or in combination, indicate that a decline is other than temporary and that a write-down of the carrying value is required." These factors are (a) the length of the time and the extent to which the market value has been less than cost; (b) the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; or (c) the intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.
In several Accounting and Auditing Enforcement Releases (AAERs) (see, for example, In the Matter of Fleet/Norstar, AAER No. 309, In the Matter of Excel Bancorp, Inc., AAER No. 316; In the Matter of Abington Bancorp, Inc., AAER No. 370, and In the Matter of Presidential Life Corporation, AAER No. 443), the Commission has taken action in instances when other than temporary declines in value were not reported in a timely and appropriate fashion.
In these releases, the Commission noted a registrant's assessment of the realizable value of a marketable security should begin with its contemporaneous market price because that price reflects the market's most recent evaluation of the total mix of available information. These releases also state that objective evidence is required to support a realizable value in excess of a contemporaneous market price. Such information may include the issuer's financial performance (including such factors as earnings trends, dividend payments, asset quality, and specific events), the near term prospects of the issuer, the financial condition and prospects of the issuer's region and industry, and the registrant's investment intent.
Additionally, the releases state that the Commission expects registrants will employ a systematic methodology that includes documentation of the factors considered. Such methodology should ensure that all available evidence concerning declines in market values below cost will be identified and evaluated in a disciplined manner by responsible personnel. Auditors are reminded of the need to closely examine the documentation concerning their clients' determinations of other than temporary declines in market values.
The staff has asked registrants to demonstrate, with objective evidence, why they believe that a write down in realizable value is not required for those securities that have experienced declines in value that appear to be other than temporary.
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 material 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 operations 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:
Segment Disclosures
Let me say a few words about segment disclosures. GAAP is clear and requires specific segment disclosures for those components identified in the reporting packages provided to the chief operating decision maker. Aggregation of segments must be limited to the strict conditions enumerated in SFAS 131, Disclosures about Segments of an Enterprise and Related Information. When segments are not appropriately identified and disclosed, an auditor is required by GAAS to qualify its report and note the deficiency. You may find it helpful to know what the staff's approach has been, and will continue to be, in evaluating whether registrants have complied with SFAS 131.
Expect the staff to review the company's web site, financial analysts' reports, and other public documents to assess whether the segments included in the footnote appear reasonably disaggregated. In some circumstances, we could assess compliance by requesting a copy of the reports made available to the chief operating decision maker in a particular quarter. Expect the staff to require strict compliance with all parts of the standard, including disclosure of revenues for each group of similar products or services, and meaningful reconciliation of segment items with the financial statements. If segment measurement methods change, expect us to challenge a claim that recasting of prior years is not practicable.
Restructuring and Impairment
Let me now address a topic that has been the subject of frequent, if not daily, coverage in the morning press - 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.
In 2001, the staff has seen an increase in companies facing economic difficulties and the need to make the impairment assessments of long-lived assets. FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, 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, Intangible Assets. 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.
It is not unusual for staff in the Division of Corporation Finance and the Office of the Chief Accountant to look at the disclosures made to a company's Board of Directors and Audit Committee regarding these events. Often, the staff will look at information such as the company's budgets, operating cash flow forecasts, strategic business plans, level of revenues from major customers, and analysts' reports and assess whether they are consistent with and support the financial reporting and disclosures to investors. Companies should make sure that the cash flows and assumptions used to record restructuring charges and asset impairments are the same as those used in the company's budgets and strategic plans that have been provided to the Board of Directors by management.
The staff will also consider whether all the disclosures required by SFAS 121, SOP 94-6 on risks and uncertainties, and EITF Consensus Nos. 94-3 and 95-3, and discussed in SAB 100, have been made. For example, do the disclosures set forth an adequate description of the expected impact of a restructuring, the subsequent effect on the business, the number of employees to be laid off, and then, in subsequent periods, the actual numbers of the layoffs that have occurred?
Registrants and their auditors can expect the staff to look closely at 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.
Accounting for Intangible Assets
In recent years, some in the accounting profession have expressed a view that a deficiency in GAAP is that it does not reflect the fair value of all intangibles in the balance sheet. They point to this as being one of a number of reasons for the difference in a company's market value and the values presented in the balance sheet.
However, I must point out to those clamoring for valuation of intangibles, that the profession's track record on accounting for and auditing of such "soft assets" is not a good one and leaves much to be desired by investors. In fact, the May 19, 2001 edition of The Economist, stated:
"The problem with all of this is that nobody inside the accountancy profession has much idea of how to put a numerical value on internally generated intangible assets, at least not while staying true to the principle of reliability. Under the present regime, most intangible assets are recognized in the balance sheet only when one company buys another and has to account for the "goodwill" part of the cost.
Soft measures, if required by the authorities, could end up being used to hoodwink investors. Companies would have an incentive to create flattering statistics. Would auditors, given the task, catch them if the figures were misleading? `Accounting firms have a difficult enough time auditing the hard numbers, let alone the soft ones,' says Arthur Levitt , the SEC 's chairman (from) 1993-2000. Some measures could be used to hype companies, he suggests. Another limitation, says the FASB, is that non-financial measures tend to be peculiar to a single industry or even company, making comparisons hard."
Let me delve into this topic to highlight the challenges and obstacles that confront us and the recommendations for removing impediments to progress.
First of all, we as a profession have not yet established accounting, auditing or valuation standards that result in consistent, comparable valuation and reporting of soft assets to investors. The debacle regarding In-Process Research and Development is one such example. In fact, Dennis Powell, the Vice President and Corporate Controller of Cisco Systems, remarked during the Senate Banking Committee hearings on the pooling-of-interest method of accounting 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." Unfortunately, the only consistency was that the numbers were high and all too often, to quote an industry analyst, "the auditors checked nothing." Finally, the repeated lack of compliance with the provisions of APB Opinion No. 16, Business Combinations, that require the identification and valuation of ALL identifiable intangibles continues to represent a significant problem in practice.
I had hoped that FASB would conduct some indepth field-testing of its proposed standard on accounting for business combinations, such as was done with SFAS 106. Such field testing might flush out the key implementation issues and yield higher quality guidance, as the Accounting Standards Board in the United Kingdom noted they did in their comment letter.
As a result many commenters and the SEC staff had also hoped the FASB would provide greater guidance on how to implement its proposed standard on accounting for business combinations. We had hoped that it would result in enhanced and improved transparency for investors regarding intangible assets. But now, I question whether our goal will be achieved and potential improvements in transparent reporting will be achieved.
For example, the AICPA's Auditing Standards Board's (ASB's) comment letter to the FASB on FASB's business combinations proposal stated:
Yet despite this "swing and a miss," I am hopeful the profession has not struck out. Last November, 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.
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 well documented, and are both reasonable and supportable. I call upon the audit firms who are calling for greater transparency and disclosure of the value of intangibles, to match their spoken words with substance and tangible audit results. They need to start ensuring all intangibles are (1) properly identified, (2) properly valued and (3) are properly accounted for. 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 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 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.
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.
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. In addition, we certainly hope these new disclosures will provide the basis for additional academic research in years to come.
For example:
Here are some interesting observations with respect to these disclosures:
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 auditors 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.
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 earlier this year. 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 the National Investor Relations 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 for 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:
These recommendations are sound and represent progress in the right direction.
Audit Related Matters
I would like to discuss with you some matters relating to the performance of audits and their effectiveness, which is another issue that has received a great deal of attention in the past year, in large part as a result of the work of the O'Malley Panel. We expect to closely monitor the profession as it begins to consider and implement the Panel's more than 200 recommendations.
Non-Standard Journal Entries
In connection with the Panel's study, the Panel analyzed certain SEC AAERs. The Panel reviewed the AAERs to obtain additional insights regarding the characteristics that frequently were present in actual or alleged instances of fraudulent financial reporting and audit failures, as well as insights regarding the auditors' work that either resulted in detecting or not detecting material misstatements. The Panel's analysis, consistent with observations of the SEC staff, indicates that all too often the auditor fails to detect non-standard journal entries that result in material entries in the financial statements that are at variance with GAAP. In addition, the SEC's enforcement cases have also highlighted that auditors often identify improper financial reporting and confront the client with the issue. However, management then provides an explanation that the auditor accepts without obtaining appropriate verifiable evidence.
Given the observations of the Panel and SEC staff, auditors should be aware of these and other techniques to materially misstate financial statements. Generally Accepted Auditing Standards (GAAS) require an auditor to obtain sufficient competent evidential matter to form a basis for his or her conclusions about the fair presentation of the financial statements. For example, the staff expects that in performing appropriate audit procedures, the auditor will gain an understanding of the nature and volume of non-standard journal entries, how non-standard journal entries are processed, what controls exist that are effective in ensuring that non-standard journal entries are properly recorded, and to what extent there is adequate segregation of duties and supervision. The auditor should ensure that sufficient, competent, verifiable evidential matter is obtained to support the auditor's conclusion that the non-standard journal entries selected for testing are properly recorded. Auditors would also be well served to consider the Panel's observations in assessing the risk of material misstatement arising from fraudulent financial reporting in connection with the performance of procedures required by SAS No. 82, Consideration of Fraud in a Financial Statement Audit.
It is of utmost importance to keep in mind that the Statements on Auditing Standards require the auditor to obtain sufficient competent evidential matter. I do not see how an audit can be considered to be a GAAS audit if the auditor has not looked at non-standard journal entries that individually OR in the aggregate, are material to the financial statements.
"Iron Curtains" and "Rollovers"
Let me now turn to a step every auditor performs at the conclusion of each and every audit, the assessment of the materiality of the entries on the score sheet. The pertinent guidance for this assessment is in SAS No. 47, Audit Risk and Materiality in Conducting an Audit, which permits the use of either the "iron-curtain" or "rollover" method in evaluating audit differences.
As you probably know, under the iron curtain method, the auditor compares all misstatements, regardless of the period for which the misstatement relates, against current year results of operations, balance sheet, and cash flows. Under the rollover method, the auditor only compares the misstatements that affect the current year against current year operations. Let me provide an illustration. Assume, for example, that a client's finished goods inventory was overstated by $100 in the year 1999 and no adjustment was made by the client in 1999 to fix the misstatement. Further assume that in the year 2000, the client's inventory is now overstated by $150. For the year 2000 under the iron curtain method, the auditor would record $150 against current year cost of sales. Under the rollover method, only $50 would be recorded against current year cost of sales. As I noted above, SAS No. 47 permits, when appropriately applied, the auditor to use either the iron curtain or rollover method to dispose of audit differences. The staff believes the iron curtain method, which compares all misstatements, regardless of the period for which the misstatement relates, against current year results of operations, balance sheet, and cash flows, is the preferable method for disposing of audit differences and the staff would challenge any change from the iron curtain method to the rollover approach.
The staff believes that the method the auditor chooses to dispose of audit differences should be applied consistently for all accounts and for all audit periods. The staff has taken exception to situations where the audit work papers document the use of the iron curtain method in one year and then a change to the rollover method in the subsequent year when difficult accounting issues arise. Similarly, the staff questions auditors that use the iron curtain method for all but a few specific accounts for which the rollover method is used.
Additionally I should note that both SAB No. 99 and SAB No. 32 provide the appropriate guidance with respect to adjustments that may be immaterial in one period, but are material in a future period.
Required auditor communications with audit committees are set forth in SAS No. 61, Communication With Audit Committees. One such communication requires the auditor to inform the audit committee about uncorrected misstatements aggregated by the auditor during the current engagement that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole. The staff believes that best practices would result in this communication including a discussion of the methodology (iron curtain or rollover) used by the auditor to dispose of audit differences. If the rollover method is used, the auditor should inform the audit committee of any risks associated with the use of that methodology.
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.
Closing
I hope I have presented you with a menu of current topics that have some items that are of interest to you. No doubt in the exciting and changing times we live in today, the menu of topics will be constantly changing. The challenge we all face will be meeting those changes based on thorough, continuous evaluation and improvement with a keen eye towards our ultimate customer -- the investor -- and their protection.
Thank you very much for the opportunity to share my thoughts with you today.
http://www.sec.gov/news/speech/spch498.htm
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