Speech by SEC Staff:
"Financial Reporting Issues Critical to European SEC Registrants/Users of US GAAP"
by Lynn E. Turner1
Office of the Chief Accountant
At the European FASB-SEC Financial Reporting Conference,
April 8, 1999
Thank you. It’s a pleasure to have this opportunity to discuss some financial reporting issues relating to foreign registrants. Today, I would like to discuss the importance of high quality audits and touch on a couple of audit issues; talk about some recent accounting issues that we have discussed with foreign registrants; discuss some Euro issues; make some remarks about compliance with International Accounting Standards (IASs); and conclude with an update on recent Commission action regarding non-financial statement disclosure requirements.
Let me begin with some remarks about the importance of audits.
It should not surprise anyone here that recent headline reports of accounting failures have led some people to question the thoroughness of audits. I do not need to remind auditors they are the public's watchdog in the financial reporting process. The Commission requires that financial statements be audited because we believe that audits significantly enhance the reliability of the information provided to investors. Fulfilling this expectation must take priority over a desire for cost efficiencies or competitive advantage in the audit process.
Last year, Chairman Levitt asked the accounting profession to undertake a review the way audits are performed and assess the impact of recent changes in audit techniques on the public interest. Never before has a committee comprised of such distinguished individuals, a majority of whom are from outside the auditing profession, undertaken such an important task. This panel, known as the Panel on Audit Effectiveness, is expected to complete its study late this year.
The Panel has begun its work by gathering information about how audits are conducted. I believe their review of the audit process will be the most in-depth review to date of how auditors can best serve to protect the interests of investors. The Commission staff have urged the Panel to seek input from groups such as leading thinkers in the business world, forensic auditors, plaintiffs' bar, academics, and big and small accounting firms to gain differing perspectives on the effectiveness of today’s audits. In addition, the International Organization of Securities Commissions’ has questioned whether the implementation of a risk-based audit model that allows the auditor to de-emphasize or eliminate specific types of audit procedures, such as external confirmations, is in the best interests of investors.
As you may know, auditing and independence standards vary from country to country, sometimes significantly. One issue that some have raised relates to the quality of audits performed by affiliates or offices of the major accounting firms. To address some of the quality issues related to audits performed on an international basis, the American Institute of CPA’s has formed a Task Force that focused on how the quality control systems of U.S. firms can be applied to audits of any financial statements of companies filing with the Commission. This would include audit work performed outside the U.S. for non-U.S. operations of U.S. companies, as well as the audit of foreign companies registered with the SEC.
I’d now like to discuss an issue we’ve seen in many of our European registrants -- qualified audit opinions.
Audit Opinion Qualifications
Recently, the staff has received several requests to accept audit reports that include a qualification because the registrant had deviated from home-country GAAP. This may have been done to facilitate a position taken for tax purposes, to produce an accounting effect similar to that of a particular accounting principle generally accepted in a different country, or for other purposes. In the cases reviewed by the staff, such deviations were not required by home-country law or regulation, although they may have been approved by the home-country regulator at the registrant’s request.
As you may know, the Commission does not accept audit reports that are qualified as to compliance with generally accepted accounting principles. This applies to whatever the primary basis of accounting is -- U.S. GAAP or home country GAAP. Adjustment of the deviation as part of the reconciliation to U.S. GAAP would not cure this deficiency. However, the staff has not objected to an audit report qualification in the limited circumstances where a qualification is unavoidable because compliance with home-country GAAP would violate home-country law or regulatory requirements.
Another issue we’ve recently addressed relating to some of our European registrants relates to auditor independence, specifically, fairness opinions.
Auditor Independence - Fairness Opinions
If an auditor renders an opinion on the value of a company, the adequacy of consideration in a transaction, or the fairness of a transaction (known as a "fairness opinion") that the auditor subsequently will audit, the staff considers the auditor’s independence to be impaired.
Regulations in some countries, including some in Europe, require companies to obtain a report from a chartered accountant regarding the consideration to be exchanged in stock-for-stock mergers or other non-monetary exchange transactions. Generally, the accountant is expected to review the Board of Director’s explanations and justifications of the exchange ratio. The accountant prepares a report addressed to the shareholders of the combining companies, provides assurance of the objectivity of valuation procedures and results, and indicates agreement or disagreement with the selected exchange ratio. Failure to satisfy all legal obligations assumed as part of the appointment may expose the accountant to liability for damages caused to the companies taking part in the merger, their shareholders and third parties. The staff understands that in most countries, management is permitted to engage any duly licensed accountant to perform this service.
In some recent filings, the registrant’s auditor performed this service and rendered what appeared to be a fairness opinion. In these circumstances, the staff considers the auditor’s independence to be impaired. The staff may permit registrants in these circumstances to proceed by either engaging another auditor to reaudit the historical financial statements or terminating the current auditor relationship.
It is important to note that the Commission does not accept compliance with foreign independence rules in lieu of or as a substitute for compliance with U.S. independence rules and regulations.
Let me now turn to some of the accounting issues we’ve seen in recent filings.
Compliance With International Accounting Standards
The staff has become aware of situations where a registrant prepares its financial statements in accordance with home-country GAAP and in its footnotes asserts that the financial statements "comply, in all material respects, with" or "are consistent with" IASs. In some of these situations, the registrant may have applied only certain IASs or omitted certain information without giving any explanation of why the information was excluded. The staff has challenged these assertions and will continue to do so. Where the assertion cannot be sustained, the staff will require either changes to the financial statements to conform with IASs, or removal of the assertion of compliance with IASs.
Let me also point out that in July 1997 the IASC approved IAS 1 (revised 1997), Presentation of Financial Statements (IAS 1), which indicates that enterprises who comply with IASs must disclose that fact. IAS 1 also indicates that financial statements should not be described as complying with IASs unless they comply with all the requirements of each applicable standard and each applicable interpretation of the Standing Interpretations Committee.
Earnings Management Issues
Last year Chairman Levitt identified a number of 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. These issues are not unique to our domestic U.S. registrants. In fact, we’ve seen a number of these issues in recent foreign filings. Today, I’d like to focus on three of them -- restructuring charges, impairment of goodwill and materiality.
As many of you are aware, the recognition of restructuring charges has been an area of concern for the SEC staff for a number of years. After more than a year of discussions, our Emerging Issues Task Force (EITF) issued two consensuses relating to restructuring charges: Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) (EITF 94-3) and Issue 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination (EITF 95-3).
EITF 94-3 generally requires management having sufficient authority to commit the enterprise to adopt a termination or exit plan. It differentiates between the factors to be assessed for involuntary employee termination benefits and other exit costs. EITF 94-3 states that a liability for involuntary employee termination benefits should be accrued when and only when the termination benefit arrangements have been communicated to employees so that the employees could determine the type and amounts of benefits they will receive if they are terminated. EITF 94-3 also identifies specific conditions which must be met in order for the commitment date for exit activities to have occurred and a liability accrued. In this case, it is the communication of the benefit arrangements that is viewed as limiting management’s discretion.
I'd like to spend a few moments discussing the types of costs that are appropriate to accrue as exit costs under EITF 94-3. EITF 94-3 provides that costs resulting from a plan to exit an activity must have no future economic benefits and meet three distinct conditions. These are:
- whether prior to the balance sheet date, the enterprise was committed to the plan;
- whether the plan specifically identified all significant actions to be taken in enough detail to be verified objectively; and
- whether the time frame involved is short enough that significant changes to the plan are unlikely.
The staff has objected to the accrual of costs pursuant to EITF 94-3 in a number of circumstances in which the staff determined that the costs were not consistent with the conditions described above because the costs did not represent either exiting of an activity or the costs benefited future operations.
Since EITF 94-3 was finalized in 1995, we have compiled a long list of items accrued as restructuring charges that either did not represent exiting an activity or that benefited future operations. 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 for employees who were not terminated, executive compensation, and marketing expenses. I would encourage any of you who are dealing with accounting for restructuring costs to review EITF 94-3 carefully.
One problem we’ve seen in foreign filings relates to the disclosure of restructuring charges. The EITF consensuses require certain disclosures, including a description of the type and amount of exit costs accrued 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. I cannot stress enough the importance of ensuring that the required disclosures are made in the year that the liability is recognized as well as and in subsequent periods when the costs are paid out.
I’d now like to turn to the issue of impairment of goodwill.
Impairment of Goodwill
Another aspect of the accounting for restructuring charges that requires careful consideration is the interaction of FASB Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of (Statement 121) and the EITF consensuses that I mentioned earlier. I’d like to focus specifically on the impairment of goodwill as this issue has come up several times in recent reviews of foreign filings.
Statement 121 requires that an impairment loss 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. We recently dealt with an issue where a foreign registrant used a different impairment model. The registrant recorded an impairment charge for the difference between management’s original and current estimate of future net cash flows. The staff does not believe that such a method is acceptable under U.S. GAAP, particularly where significant integration of the acquired businesses contemplated enterprise-wide cost savings, cross selling, and other economies of scale.
Another earnings management issue we’ve seen in recent foreign registrant filings relates to materiality considerations.
We have seen a number of foreign registrants assert that some items may be so insignificant that they are not worth measuring and reporting with exact precision. For example, in one case several majority owned subsidiaries were not consolidated as each one was considered immaterial. In another case several majority owned subsidiaries were incorrectly accounted for using proportionate consolidation as the effect of consolidation was considered immaterial. In our view, it is not appropriate to reach this conclusion without considering the aggregate effect of all the omitted items.
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. 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.
Let me turn now to a couple of new U.S. standards that we’ve had questions about. I will try to give you an overview of their requirements and discuss some implementation issues. The first standard relates to reporting comprehensive income.
Reporting Comprehensive Income
In June 1997, the FASB issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income (Statement 130). Comprehensive income is the name given in U.S. GAAP to all changes in equity other than transactions with owners. It includes net income as well as items recorded directly to equity, for example, exchange gains or losses. Statement 130 is effective for periods beginning after December 15, 1997. Earlier application of the statement is encouraged, but not required. Restatement of comparative financial statements is required.
Statement 130 applies when an enterprise prepares a full set of financial statements (including financial position, results of operations, and cash flows). It requires that comprehensive income be displayed with the same prominence as other financial statements. However, Statement 130 does not mandate a specific format or presentation for comprehensive income. Comprehensive income may be presented in a separate financial statement or as part of the income statement or statement of changes in equity. Statement 130 also permits certain additional required disclosures to be made either in a statement of comprehensive income (or as part of the income statement or statement of changes in equity, as appropriate) or in the notes to the financial statements. These items include the tax effect of comprehensive income items, reclassification adjustments, and accumulated balances for each individual component of comprehensive income.
Statement 130 defines the required presentation as a new basic financial statement, rather than a disclosure. Thus, a statement of comprehensive income or its equivalent would be required for companies filing under either Item 17 or Item 18 of Form 20-F. A foreign filer may present the statement of comprehensive income in any format permitted by Statement 130. It may be prepared using either U.S. GAAP or home-country GAAP amounts. Reconciliation to U.S. GAAP amounts is encouraged but not required.
Another new standard that foreign registrants have had questions on is segment disclosures.
In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (Statement 131). Statement 131 requires that public companies report certain information about operating segments in its financial statements. Statement 131 is effective for periods beginning after December 15, 1997. Earlier application of the statement is encouraged, but not required. In the initial year of application, comparative information for earlier periods should be restated.
Statement 131 requires reported segment information to conform to the information reported by management even if that information is not in conformity with U.S. GAAP. We have been asked what information a foreign registrant should report for segments it identifies under Statement 131. A foreign registrant should present segment information using whatever basis of accounting is used internally, even if that information is not on a home-country GAAP basis. As required by Statement 131, the measurement basis for this data would be disclosed. No reconciliation of this data to U.S. GAAP is required.
We also have been asked questions relating to the reconciliation of segment data. Specifically, should segment data be reconciled to consolidated home-country GAAP or U.S. GAAP financial statements? The segment data reconciliation should be to the consolidated financial statements under home-country GAAP. The reconciling items should be isolated in a separate column and adequately described.
In addition, if the consolidated financial statements are presented in one currency and the internal management statements are developed in a different currency, the segment data should be presented in the same currency that is used in the primary financial statements.
Let me know turn to some issues relating to the Year 2000 bug.
Year 2000 Costs
We've all heard the breakdown scenarios about sudden computer failures and widespread corruption of computer programs that relate to the Year 2000. Preventing any significant disruptions must be a top priority as a Year 2000 breakdown could do incalculable damage to investors' finances, and could undermine their confidence in our entire financial structure. In an effort to ensure that investors are receiving adequate information about the Year 2000 bug, the Commission published interpretive guidance to explain what specific disclosure obligations companies had relating to Year 2000 issues. This interpretation, Disclosures of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, was issued in August 1998. It’s also available on our website (www.sec.gov). I would encourage you to consult it.
Regarding the accounting for costs associated with modifying computer software for the Year 2000 bug, the staff is aware that in some jurisdictions such costs may be capitalized. I’d like to remind you that such costs for U.S. GAAP purposes are required to be expensed in accordance with EITF Issue 96-14, Accounting for the Costs Associated with Modifying Computer Software for the Year 2000. In addition, expected future costs to modify software for the Year 2000 should not be accrued for as a liability.
That concludes my prepared remarks. I would be happy to answer any questions you may have during the Q&A part of our session.
1 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 upon the staff of the Commission.