SEC Speech: Current Accounting Projects
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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Current Accounting Projects

Remarks by

Jane B. Adams

Deputy Chief Accountant
Office of the Chief Accountant
U.S. Securities & Exchange Commission

1998 Twenty-Sixth Annual National Conference on Current SEC Developments

December 9, 1998

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This article expresses the authors' views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.


Good morning. It is a pleasure to have the opportunity to address you again this year. It has been quite an eventful year for the Office of the Chief Accountant, and the year ahead looks to be no less challenging.

Earnings Management Initiatives

Chairman Levitt identified a number of earnings management initiatives being undertaken by the financial community in response to his call for actions to assure the continued investor confidence in the financial reporting process. The Commission staff also will be fulfilling several roles in this effort. My comments today will focus on one aspect of the SEC staff efforts in this area--publication of three Staff Accounting Bulletins.

Staff Accounting Bulletins--SABs--provide an important tool for the staff to communicate the factors that the staff has considered to be significant in interpreting and applying existing standards. SAB No. 1 was issued over 20 years ago 1 to disseminate staff positions and to provide a means by which "new or revised interpretations and practices can be quickly and easily communicated to registrants and their advisors."

The staff is currently working on finalizing these SABs to address the following areas: restructuring charges and impairments of assets, revenue recognition, and materiality. In my remarks this morning I would like to provide the context for the SABs by explaining why the staff feels a need to issue them at this time.

Restructuring Charges and Impairments of Assets

EITF Issues No. 94-3 and 95-3

The first SAB I will be focusing on addresses restructuring charges and impairments of assets.

As many of you are aware, the recognition of restructuring charges has been an area of staff concern for a number of years. For example, the Chief Accountant of the Division of Corporation Finance spoke about the problems we were seeing in this area five years ago at this conference. That was followed by the SEC Chief Accountant requesting the EITF to add the issue of restructuring charges to its agenda. After 18 months of discussions, the EITF finalized Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring), in January 1995 and Issue 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination , in July 1995. Sadly, these two consensuses have not been a total fix to the reporting problems. Indeed the staff has noted what appears to be an increasing number of reporting problems--reminiscent of the pre-consensus period.

The consensuses were crafted within the definition of a liability in the FASB Concepts Statements, with the objective of identifying the circumstances in which the actions of management create a liability that should be recognized as of the commitment date. The consensuses focus in particular on certain of the essential characteristics of a liability: does management have little or no discretion to avoid future sacrifice and, in fact, is a future sacrifice present or, instead, is there a benefit to future operations.

"Little or no discretion to avoid" is a high standard, particularly when management is continually preparing and updating plans regarding the operations of a business and, indeed, successful managers are compelled to react flexibly to new information. Issue 94-3 differentiates between the factors to be assessed for involuntary employee termination benefits, for which there must be enough information communicated to employees such that they would be expected to rely on the communication and limit management's future discretion, and other exit costs. Issue 94-3 identifies three conditions 2 which must be met in order for the commitment date for exit activities to have occurred. The commitment date is the date when there is little or no discretion remaining for management to avoid undertaking the exit activities. In addition, the consensus reiterates a requirement of FASB Statement No. 5, Accounting for Contingencies, that the costs must be reasonably estimable in order to be recognized at the commitment date.

In evaluating the large number of restructuring accruals that the staff has seen, and considering the requirements of Issue 94-3, I will frame my observations about the deficiencies we have observed in the context of the characteristics of a liability.

  • A common criticism is that the exit plan lacked sufficient specificity, identifying the actions to be taken at only the most general level such that it provided little ability to use the plan to monitor its status or to determine that items charged against the accrual had been part of the plan. Discretion is considerable when only vague or general planning has occurred.

  • Another criticism is that significant changes were made to the exit plan as it was being implemented. Retention of the discretion to change significant elements of a plan, suggests that an exit plan to which management has committed did not exist nor could the costs to implement the plan be reasonably estimated.

  • Another criticism is that the exit plan would not be completed in the near term, extending perhaps several years prior to completion. The inherent need for management to be able to respond to the dynamic environments in which it operates suggests that the longer it requires to implement an exit strategy, the greater the discretion that has been retained.

  • And, the costs could not be reasonably estimated. In some registrant circumstances, this requirement was just ignored -- with no basis provided for the amounts that were accrued. In others circumstances, the staff has observed that the ability to reasonably estimate the cost associated with exiting a contract diminishes when a company does not have the unilateral ability to do so. Continuing negotiations between the contractual counterparties among several options suggests that management retains certain discretion.

I'd also like to discuss the types of costs that are appropriate to accrue as exit costs under Issue 94-3. Issue 94-3 provides that costs resulting from a plan to exit an activity must have no future economic benefits and meet three distinct conditions. 3 The staff has objected to the accrual of costs pursuant to Issue 94-3 in a number of circumstances in which the staff determined that the costs were not consistent with the conditions described, either because the costs did not represent the exiting of an activity or the costs benefited future operations. For example, the staff objected when one registrant accrued the costs to renegotiate the terms of a royalty agreement as well as the lump-sum payment resulting from the revised terms. Note that the contractual relationship with the counterparty, while changed, was not terminated.

In addition, we have a lengthy list of other items accrued by registrants pursuant to Issue 94-3 that either did not represent the exiting of an activity or that benefited future operations. Some examples include: future payments under research and development contracts, future service contract losses, product rebates, product repurchases, product warranty costs, litigation, manufacturing overhead variances, changes in accounting principles, year 2000 costs, audit and appraisal fees, employee compensation (employees not terminated), executive compensation, and marketing expenses.

One correlation that we have observed is that bad accounting often is accompanied by inadequate disclosure. The consensuses require certain disclosures including, among others, a description of the type and amount of exit costs recognized as liabilities and the classification of those costs in the income statement as well as disclosures about the type and amount of exit costs paid and charged against the liability. We cannot stress too much the importance of ensuring that the required disclosures are being made in the year that the liability is recognized and in subsequent periods when the costs are paid.

Asset Impairment

Another aspect of the accounting for the costs of restructuring that requires careful consideration is the interaction of FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of , and the restructuring consensuses. An entity may have met the commitment date for Issue 94-3, but that does not mean that the impairment model should be the held for disposal model. Statement 121 provides different impairment recognition thresholds depending on whether an asset is to be held and used or is to be abandoned or otherwise disposed of. It provides that an impairment loss shall be recognized for an asset to be held and used only if the sum of the undiscounted expected future cash flows is less than the carrying amount of the asset. An asset is classified as held for disposal only when management having the authority to approve the action has committed to a plan to dispose. In determining whether a disposal plan exists, the staff has looked to analogous guidance in APB Opinion 30, Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions , and in Issue 94-3. The staff believes that a necessary condition of a plan to dispose of assets currently in use is that management have the current ability, that is, the ability today, to remove the asset from operations. When continuation of ongoing operations requires continued use of the assets prior to a future disposition, it is likely that the asset is held for use and not held for disposal.

A question arises as to which impairment model should be applied when the commitment date for an exit plan that also results in an impairment evaluation precedes the ability to remove the related assets from operations. For example, in one circumstance considered by the staff, the registrant planned to close duplicate facilities in 7 to 9 months, with the intervening period spent consolidating the operations. Redundant computer equipment would be abandoned when a site was actually closed, but was required to be used to support ongoing operations in the interim. The staff indicated to the registrant that the recoverability of the cost of the computer equipment should be evaluated in accordance with Statement 121's requirements for assets to be held and used. If the sum of the undiscounted expected future cash flows exceeds the carrying amount of the assets, an impairment loss would not be recognized. However, a review of the useful life and salvage value of the equipment would be expected, with appropriate recognition given to the revised estimates of remaining life and salvage value. The staff does not believe that the recognition of an impairment charge is a substitute for choosing an appropriate initial useful life and salvage value and subsequently adjusting either of those estimates on a timely basis as company or industry conditions change. In fact, the accelerating rate of change, which underlies many of the restructuring activities, should be considered when reviewing asset lives at December 31. Registrants should also remember to include sufficient specific disclosures in the notes to the financial statements about the lives applicable to various asset categories so that investors can assess the reasonableness of those estimates and the quality of earnings.

Revenue Recognition

Another area which the staff plans to address with a SAB is revenue recognition. I will comment on two areas in particular: the effect of refundability on the earnings process and the role of probability in determining when revenue should be recognized.

The guidance on revenue recognition that is provided in the accounting literature generally is very broad. Although some industry-specific standards exist, the basic model for recognizing revenue is provided by the FASB's Concepts Statements. FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises , states that revenue should not be recognized until it is realized or realizable and it is earned.

Within this conceptual framework, two broad models for revenue recognition exist. One focuses on the attainment or fulfillment of some "critical event" while the other recognizes the earnings process on a production or continuous performance basis, such as the percentage of completion model. However, in practice we do not analogize to the percentage of completion model for revenue recognition outside the long-term contracts specifically included in the scope of ARB 45 , Long-term Construction-Type Contracts, and SOP 81-1 , Accounting for Performance of Construction-Type and Certain Production-Type Contracts .

As has been mentioned in speeches in years past, 4 the staff has considered registrant circumstances in the health club industry and more recently in memberships at golf courses in which there is an initial membership or initiation fee that is nonrefundable and additional usage fees assessed each month. The staff expressed its conclusion that the receipt of the initiation fee was not a discrete earnings event; rather, the customer/member was purchasing ongoing rights or services and the health club or golf course should recognize a liability (rather than revenue) for the initiation fee. The evaluation of an asset or collectibility of receipts and the release from obligations to provide services are independent assessments.

In addition, the staff would not consider the activation of cellular telephone service, for example, to be a discrete earnings event. Commonly, there are a variety of cellular telephone service plans. An activation fee may be assessed for basic cellular telephone service contracts for a minimum service period. The activation fee may be reduced, or even eliminated, for contracts that provide a wider range of service features or that are for extended periods of time. The costs incurred by a company to activate the phone service are typically nominal.

In this circumstance, the customer is purchasing ongoing telephone services. The upfront fee and the continuing performance obligation relating to the services to be provided should be assessed as an integral package, and the upfront fees, even if nonrefundable, are earned as goods and services are provided over the term of the arrangement. One of several factors that is important to this decision includes an assessment of whether the amount of the upfront fee is disproportionate to the value of the initial goods or services provided to the customer and the costs incurred by the company at the outset of the arrangement.

This leads to an interesting question as to what contingencies might be present in contracts that would change the staff's answer regarding recognizing the revenue as the goods and services are provided. FASB Statement No. 48, Revenue Recognition When Right of Return Exists, addresses contingencies in circumstances when the customer has the right to return a product. Statement 48 provides for the recognition of product sales even though the product may be returned to the seller for a refund. However, Statement 48 does not apply to "accounting for revenue in service industries if part or all of the service revenue may be returned under cancellation privileges granted to the buyer." 5

The conflict between the "goods" model of Statement 48 and its scope exclusion for services came to light in the staff's consideration of an industry that involves the selling of membership arrangements that provide for 100 percent refund of one's initial membership fee at any time throughout the first year of membership. In some cases the percentage of new memberships refunded in the first year exceeds 50 percent. The staff has discussed the role that assessment of probability, that is, the likelihood of a member requesting a refund, should play in recognizing revenue under this arrangement. Other issues that the staff considered included:

  • whether the price was fixed or determinable. When the fees are fully refundable at any point during the contract, without regard to the extent or value of services received to date, it can be argued that the service fee is not fixed or determinable since, in the example I mentioned, half of the members will pay the full membership price and the other half receive the services for free.

  • how the obligation to refund the membership fees should be measured. That is, whether the obligation to refund the fees should be measured at the full amount of the refund times the number of members, similar to the measurement of deposit liabilities 6 or at the estimated amount of refunds that will be requested by analogy to Statement 48. The staff noted that the obligation to refund 100 percent of the membership fee upon request of the member at any point in the first year was reduced neither by the passage of time nor by the rendering of service. In fact, the obligation to refund the membership fee was eliminated only with the expiration of the option.

  • what impact should different refund policies have on comparability, that is, whether the liabilities of entities offering different refund options should look the same or different. For example, should an entity that offers to refund membership fees on a pro rata basis based on the remaining term of the contract and that records a liability based on the unexpired, unrefunded, remaining term look the same as an entity that offers to refund membership fees in full at any point during the contract term?

  • and finally, what impact should the timing of when the member pays the fee have on revenue recognition. For example, would it be appropriate for an entity to recognize a receivable for a membership fee, accreting an amount over the period of the contract, if the member was not required to pay the fee upfront and instead had the right to decide whether or not to pay the fee at the end of the first year?

Let me link these comments to a recent discussion at the EITF.

  • In the staff's evaluation, EITF Issue 98-9, Accounting for Contingent Rent, presents many of the same questions as to the role of probability in the recognition of contingent rental revenue by the lessor.

Before I shift to a brief discussion on materiality, you may have observed that I have not provided you necessarily with any conclusions on the questions raised. SAB's are not meant to pre-empt standard setting. Rather, SABs provide guidance, identify factors that the staff has considered when it looks at individual registrant fact patterns, and generalize where possible about those conclusions. However, it is the staff's view that any change that would expand the role played by the assessment of probabilities in revenue recognition beyond that which already is provided for explicitly in the authoritative accounting literature should be undertaken by the FASB and provided the full consideration of its due process.


Materiality is an often-defined term. We have definitions in Regulation S-X and other Commission rules. FASB Concept Statement No. 2, Qualitative Characteristics of Accounting Information, has several paragraphs dedicated to the notion of materiality, and the auditing literature also provides guidance in this area. Each of these definitions flows back to the idea developed by the courts and the Commission that an item is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment or voting decision. And making determinations about materiality requires the consideration of both quantitative and qualitative factors.

I'm sure that it does not surprise you that in reviewing registrant issues we often hear the statement that the item being discussed is immaterial to the financial statements and, therefore, the staff should not be concerned about the accounting for that item. To support these statements, registrants and their auditors generally refer to percentage ceilings that have been set to determine whether amounts are material to the financial statements. On too many occasions, however, there appears to be little, if any, consideration of the qualitative aspects of materiality.

In our discussions with registrants, we have indicated that there are many factors in addition to the size of the numbers that may make an item, or the erroneous accounting for an item, material to investors' decision-making processes. A few of the more obvious factors we have discussed are:

  • a conscious decision not to follow GAAP that raises questions about the integrity of senior management or the effectiveness of the entity's internal accounting controls,

  • erroneous accounting that leads to a change in earnings or earnings trends,

  • erroneous accounting that is part of a plan to smooth earnings from period to period, and

  • erroneous accounting that contributes to changing a loss to a gain, or vice versa.

Of course, this is far from being an all-inclusive list, and the factors considered by the staff and the weight given to each factor may vary depending on the transaction or event. But the message we have been giving to registrants is consistent and clear -- simple reliance on a percentage ceiling for evaluating materiality is not sufficient. Management and auditors need to look at each situation from the investor's point of view and decide whether there are implications that might influence that investor's decisions.

Early Identification of Issues

One final point...

We periodically hear comments of frustration about the need to work within the system to resolve issues. It is important to everyone that issues be identified and resolved on a timely basis. In the context of this shared objective, I would like to comment on the emergence within the last year of a number of structured transactions whose apparent purpose is to circumvent or exploit specific accounting requirements. Some of the characteristics common to these transactions are the use of two or more contracts entered into with the same counterparty or intermediary with the objective of having the contracts accounted for separately as opposed to accounted for as a unit. The FASB's Derivatives Implementation Group, or DIG, recently addressed this issue of "Determining Whether Separate Transactions Should be Viewed as a Unit." The EITF also has recently addressed the accounting for a structured transaction in Issue 98-15 , Structured Notes Acquired for a Specified Investment Strategy. .

The staff was particularly troubled by the Issue 98-15 transaction because we understand that accounting firms were precluded from bringing this issue to the EITF's or our attention because of confidentiality agreements signed by the parties involved. In order for the process to work, preparers and practitioners must bring these issues to our attention, the DIG's or the EITF's, as early as possible. If that doesn't happen and the issue is identified in the course of a review or in some other manner and the staff is asked to resolve the issue, the staff will resolve it. Period.

That concludes my prepared remarks.

1November 4, 1975

2 The three conditions specified by Issue 94-3 that are necessary in order for the commitment date to have occurred are:

1. Prior to the date of the financial statements, management having the appropriate level of authority approves and commits the enterprise to an exit plan.
2. The exit plan specifically identifies all significant actions to be taken to complete the exit plan, activities that will not be continued, including the method of disposition and location of those activities, and the expected date of completion.
3. Actions required by the exit plan will begin as soon as possible after the commitment date, and the period of time to complete the exit plan indicates that significant changes to the exit plan are not likely.

3 The three conditions specified by 94-3 that must be met for costs to qualify as exit costs are:

1. The cost is not associated with or does not benefit activities that will be continued.
2. The cost is not associated with or is not incurred to generate revenues after the exit plan's commitment date.
3. The cost meets one of the following criteria:

a) The cost is incremental to other costs incurred by the enterprise in the conduct of its activities prior to the commitment date and will be incurred as a direct result of the exit plan.
(b) The cost represents amounts to be incurred by the enterprise under a contractual obligation that existed prior to the commitment date and will either continue after the exit plan is completed with no economic benefit to the enterprise or be a penalty to cancel the contractual obligation.

4Speech by Jan R. Book, January 12, 1993, AICPA Current SEC Developments Conference; Speech by Cody L. Smith, Jr., December 11, 1996, AICPA Current SEC Developments Conference.

5 Statement 48, paragraph 4.

6 FASB Statement 107, Disclosures About Fair Value of Financial Instruments, paragraph 12.