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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Cookie Jar Reserves

Remarks by

Walter P. Schuetze

Chief Accountant, Division of Enforcement
U.S. Securities and Exchange Commission

at the Nineteenth Annual Ray Garrett, Jr., Corporate and Securities Law Institute
The Corporate Counsel Center of Northwestern University School of Law

April 22, 1999

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

One of the accounting "hot spots" that we are considering this morning is accounting for restructuring charges and restructuring reserves. A better title would be accounting for general reserves, contingency reserves, rainy day reserves, or cookie jar reserves.

Accounting for so-called restructurings has become an art form. Some companies like the idea so much that they establish restructuring reserves every year. Why not? Analysts seem to like the idea of recognizing as a liability today, a budget of expenditures planned for the next year or next several years in down-sizing, right-sizing, or improving operations, and portraying that amount as a special, below-the-line charge in the current period's income statement. This year's earnings are happily reported in press releases as "before charges." CNBC analysts and commentators talk about earnings "before charges." The financial press talks about earnings before "special charges." (Funny, no one talks about earnings before credits--only charges.) It's as if special charges aren't real. Out of sight, out of mind.

The occasion of a merger also spawns the wholesale establishment of restructuring or merger reserves. The ingredients of the merger reserves and merger charges look like the makings of sausage. In the Enforcement Division, I have seen all manner and kind of things that ordinarily would be charged to operating earnings instead being charged "below the line." Write-offs of the carrying amounts of bad receivables. Write-offs of cost of obsolete inventory. Write-downs of plant and equipment costs, which, miraculously at the date of the merger, become nonrecoverable, whereas those same costs were considered recoverable the day before the merger. Write-offs of previously capitalized costs such as goodwill, which all of a sudden are not recoverable because of a merger. Adjustments to bring warranty liabilities up to snuff. Adjustments to bring claim liabilities in line with management's new view of settling or litigating cases. Adjustments to bring environmental liabilities up to snuff or in line with management's new view of the manner in which the company's obligations to comply with the EPA will be satisfied. Recognition of liabilities to pay for future services by investment bankers, accountants, and lawyers. Recognition of liabilities for officers' special bonuses. Recognition of liabilities for moving people. For training people. For training people not yet hired. For retraining people. Recognition of liabilities for moving costs and refurbishing costs. Recognition of liabilities for new software that may be acquired or written, for ultimate sale to others. Or some liabilities that go by the title of "other."

It is no wonder that investors and analysts are complaining about the credibility of the numbers. A bank stock analyst was quoted in the WSJ's "Heard on the Street," on April 1, "The reported profits number is now considered an accounting fiction." Warren Buffett's latest annual report to shareholders of Berkshire Hathaway has several pages of commentary about restructuring and merger reserves. He says, "... many managements purposefully work at manipulating numbers and deceiving investors..." "... when it comes to restructurings and merger accounting." A major investment banking house has concluded that the P/E ratios of stocks and indexes of stocks are understated because of restructuring charges and merger charges being "below the line"; that, for example, the P/E of the S&P 500, instead of being say 31 should really be say 34 or 35 because the special charges are not factored into the earnings part of the calculus.

The cover for these shenanigans is two "consensuses" of the FASB's Emerging Issues Task Force that deal with recognition of liabilities on the occasion of a restructuring or a merger, namely EITF 94-3 and 95-3. Generally, what EITF 94-3 permits is (a) the recognition as a liability today of future expenditures for involuntary termination benefits to be paid to employees and (b) the recognition of a liability today for future expenditures that are directly associated with a plan to exit an activity--provided those expenditures will have no future economic benefit and provided four conditions laid down by the EITF are met. EITF 95-3 expands on 94-3 to say that, in a business combination, expenditures to relocate employees may also be recognized as a liability at the time of the business combination, in addition to the employee termination benefits and exit costs covered by 94-3.

Those two utterances by the Emerging Issues Task Force allow for the recognition of liabilities based on a representation by management that the company will make certain expenditures but before a cash outflow is required pursuant to a law or a contract. In all other cases except in the accounting for pensions and OPEBs, liabilities are not recognized until some event has occurred and a cash outflow therefore is required, either by law or regulation or under an enforceable contract. For example, liabilities to suppliers of goods are not booked by the buyer until the supplier has delivered the goods to the buyer. Liabilities for salaries and wages are not booked until employees have worked and earned their pay. Liabilities for tomorrow's rent and electric are not booked until the premises have been used and the electricity has been used--both events of the tomorrow, not today. There is no liability to pay investment bankers, accountants, or lawyers until they have performed services. But, pursuant to the EITF pronouncements, it's OK to recognize a liability today for severance pay to employees which will be paid to them months or years in the future but only if they stay at their jobs until then. It's OK to recognize a liability today for other so-called "exit costs." It's OK to recognize a liability today for future costs that will have no future economic benefit. But, because the EITF could not define a restructuring, and therefore could not specify its ingredients, those two consensuses are, as a practical matter, largely optional. For example, looking at the Forbes article of March 23, 1998 on "Pick a number, any number," two of the companies interviewed, VF Corporation and Walgreen, said that they do not recognize restructuring charges, whereas many companies do. VF charged the $400MM cost of cutting 2000 job positions and consolidating 17 locations to 5 to current earnings instead of a restructuring charge. Walgreen charged the cost of closing 400 stores over five years to current earnings instead of as a restructuring charges. VF's CFO is quoted as saying, "Restructuring is an invention by Wall Street. It's a term for covering up debits. We don't play that game. It's short-sighted. It delays the inevitable." Jack Ciesielski, a CPA/analyst with R. G. Associates, in the March 29, 1999 The Analyst's Accounting Observer, in footnote 8, says that following the consensuses is optional. Thus, Company A may establish a restructuring reserve and charge selected expenditures to that reserve if it wants to, but Company B need not establish such a reserve and may charge the expenditures to income regular way--even though both may be similarly situated and have the same auditors. Or, both Company A and B may establish reserves for some restructurings but not others. To boot, the numbers ascribed to restructurings and thus included in the reserves cannot be verified by the outside auditor by reference to anything except management's assertion, which is no evidence or verification at all; the numbers are whatever management of the enterprise says they are. Moreover, I have seen the amounts of those initially established reserves arbitrarily increased for good measure. These excessive amounts of reserves then are leeched, undisclosed, into subsequent operating income, at a rate that is under someone's radar screen of materiality.

On the point about the inability to audit the numbers in these reserves, imagine a situation where a new management team comes in after year end and changes dramatically the amounts in various reserves established by previous management. New management issues restated financial statements for the prior periods. The same audit firm reports on both sets of financial statements, without qualification. We also see, quite frequently, where restructuring reserve amounts are retroactively restated downward as a result of piercing, probing comment and inquiry by the Division of Corporation Finance, and the external auditors report without qualification on the financial statements with the reserve at its original amount and at its revised, decreased amount. So much for auditing reserves.

I was Chief Accountant in 1994 when EITF 94-3 was debated by the Emerging Issues Task Force. I pleaded with the EITF not to allow the recognition of liabilities today where there has been no past event, for example, the performance of services by employees or the receipt of goods from suppliers or the receipt of cash in return for issuing a put option, that establishes that the reporting enterprise has an obligation to lay out cash tomorrow. I made a speech about that on November 8, 1994 to the Financial Executives Institute. As I recall, I sent a copy of that speech to EITF members. In that speech, I pointed out the conceptual flaw in the EITF's approach and the practical consequences of that approach. Nine days later, on November 17, 1994, despite my pleas, the Emerging Issues Task Force said OK to the establishment of restructuring reserves.

What has happened since 1994? Well, my instinct in 1994 has been confirmed by practice. What has happened since 1994 is that general reserves, contingency reserves, rainy day reserves, and cookie jar reserves, now are in vogue for those who want to use them. Based on what I see in the Enforcement Division, there apparently is almost no limit to what ingredient may be included in the reserves or the amount ascribed to it. I recently was in a conversation with a prominent Wall Street lawyer whose client established, improperly, a general contingency, rainy day reserve. This lawyer explained his client's rationale for the reserve that was established. I said to the lawyer that his description of his client's rationale was the description of a general contingency reserve, which was outlawed by the FASB in 1975. Whereupon, he called me a pencil pusher and said that all the Fortune 500 companies are doing the same thing his client did.

How does this problem get fixed? The FASB's definition of a liability in its Concepts Statement 6 says, in footnote 22, that "It [a liability] includes equitable and constructive obligations as well as legal obligations." The question is--what constitutes a constructive obligation? Does an announcement by a company that it will lay off 100 or 1000 employees create a liability for termination bonuses that are promised to be paid at termination but only if the employee remains as an employee until terminated by the company? Does a decision by a lessee that it no longer will use leased facilities give rise to a recognizable liability for the lease payments when there was no recognizable liability the day before the decision? The accounting for pensions and OPEBs is based on an idea of a constructive obligation, not on a vested-benefit notion which is more akin to a legal obligation. Are management decisions, which obviously are always reversible, to terminate employees and no longer use facilities sufficient either to permit or require the recognition of liabilities before the obligation to pay cash becomes an obligation enforceable at law? The FASB has been working on such questions in three projects that it has on its agenda, namely, Liabilities and Equity, Obligations Associated with the Retirement of Long-Lived Assets, and Impairment and Asset Disposal Issues. It appears that the questions are very, very difficult. Getting agreement apparently is not easy. The SEC staff has been encouraging the FASB to complete work on these projects. Investors urgently need some guidance that can be applied uniformly by all issuers and their auditors so that investors receive better information and can make more informed decisions.

Meanwhile, however, the Division of Corporation Finance and the Office of the Chief Accountant are taking a close look at restructuring reserves and merger reserves. So is the Division of Enforcement. I am going to take a pencil pusher's attitude as to all such reserves and examine whether all of the ingredients of an issuer's reserve are explicitly permitted by the words in EITF 94-3 and 95-3 and the issuer has explicitly and in detail justified the reserve and the amount thereof and documented that justification.

If you have clients that have established restructuring reserves or merger reserves, I recommend that you and the Audit Committee get for yourselves a copy of EITF 94-3 and 95-3, get your client's CFO and CEO into a conference room, and you and the Audit Committee do your own audit of the restructuring reserves and determine whether what your client has done fits into the authoritative literature.