Speech by SEC Commissioner:
Remarks at the 27th Annual AICPA National Conference on Current SEC Developments
by Commissioner Isaac C. Hunt, Jr.
U.S. Securities & Exchange Commission
December 7, 1999
Good morning, it is a pleasure and an honor to be here to address the accounting professionals who do the important and difficult work representing SEC registered companies. The people in this room bear a heavy burden in assuring investor confidence, preventing financial fraud and generally supporting a fair and efficient marketplace. But, before I begin speaking about what the SEC views as the critical responsibilities shouldered by accounting professionals in this process, I am obligated to give you the usual disclaimer that the views I express here today are my own and do not necessarily reflect the views of the Commission, other Commissioners, or the Commission's staff.
As we prepare to enter the Year 2000, our capital markets are some of the most, if not the most, liquid and efficient in the world. But, I remain concerned that some industry practices may threaten this hard fought success. Specifically, I am concerned with the reliability and integrity of financial statements filed with the Commission. The two issues that I wish to focus attention on today are first, the widely disparate accounting for and disclosure of certain expenses and liabilities commonly reported in connection with restructuring activities and business combinations and second, abuses in the revenue recognition area.
Beyond embracing the guidance provided by the recent Staff Accounting Bulletins ("SABs"), the accounting profession also needs to step up and take responsibility for the changing conditions in the market and continue to improve their practices overall. One way to do this is to focus increased attention in the critical area of internal controls. A commitment to quality and good internal controls at the highest levels of an organization may avoid many financial problems. And that is the best use of a professional's time and talents preventing problems before they occur!
Looking back before the advent of SABs and internal controls, we can judge just how far we have progressed in improving our capital markets and also just how much more capital is at stake. To combat the abuses that brought about the historic market decline in the early part of this century, Congress designed a registration and reporting system to provide investors with material information needed to make informed investment decisions. At the heart of this system is the credibility of disclosure documents filed by public companies.
Despite the tremendous importance of full and open disclosure, the Commission has found that while many registrants do a good job of filing statements, too many do not meet the high quality and integrity envisioned by Congress. This problem has gone far beyond the point of mere sloppiness. Again, while limited, too many filings lack sufficient quality and transparency. The staff has even observed some filings that are downright misleading. This view is supported by the fact that nearly twenty percent of the enforcement cases brought in the last year involve financial fraud reporting. Of that amount, over half are directly related to revenue recognition.
What is so troubling from the Commission's standpoint is that these frauds are conducted by financial professionals accountants, high-level managers and lawyers. In fact, the recent Committee of Sponsoring Organizations ("COSO") Report of the Treadway Commission found that a staggering 83% of fraudulent financial statements involved the complicity of either the CEO or the CFO of the reporting company. This is unfortunate as it ultimately impacts the credibility of the entire profession.
While we recognize that the vast majority of these financial professionals (and certainly the people gathered in this room today!) are committed to sound financial reporting, there remain too many financial professionals who push the envelope too far. This can harm unsuspecting investors. Even if the investors are sophisticated, they may be misled by the absence of transparent vision into the company's filings. As a consequence of this confusion, investors could lose confidence in the reliability of a registrant's financial information and that, in turn, would adversely impact the markets.
Even more troubling, as highlighted in the COSO Report, is the fact that many of these individuals are in a fiduciary position with respect to shareholders. Some of these financial professionals have thoroughly abused the trust placed in them. Moreover, they make the jobs of those who do play by the rules even tougher.
What are we doing about it? Well, besides the well-known enforcement cases, the Commission, the NASD, the New York Stock Exchange and the American Stock Exchange have taken some important steps in returning "quality" to financial reporting.
In the past month, the accounting staff of the Commission has issued two Staff Accounting Bulletins (SABs) SAB 100 on Restructuring and Impairments and SAB 101 on Revenue Recognition. The staff believes that these bulletins will help the industry "tighten up" what we see as sloppy financial reporting by those "playing in the 'gray zone'." These two bulletins are consistent with existing Generally Accepted Accounting Principals ("GAAP"), but at the same time attempt to give clear and consistent guidance that registrants can easily understand.
But before we get into the nuts and bolts of the Commission's recent SABs, the message that I want to send to you today is that CFOs and auditors must focus attention and resources on the critical area of internal accounting controls. In order to assure sound financial reporting and, consequently, a level playing field for all investors, good internal accounting controls are critical. These should form the bedrock on which all financial reporting is based.
Here are three good reasons why you focus on internal controls: (1) to protect yourself against the unscrupulous conduct of employees; (2) to prevent and detect problems before they can hurt the firm; and (3) because poor internal controls can lead to misleading financial statements.
Recent press accounts and enforcement cases have raised questions about financial reporting activities including money laundering, basic account reconciliations, and misappropriation of funds to manage earnings. These cases raise fundamental issues about the adequacy and effectiveness of a firm's internal accounting controls and the quality of work being performed by independent auditors. If the firms had strong internal accounting controls in place, most of these problems would have been avoided.
So, what constitutes effective internal controls? What follows are elements of effective internal accounting controls:
- Support at the top of the organization,
- Reflective of the structure, functions and risks of the organization,
- Delegated effectively,
- Codified in writing,
- Checked periodically, and
I encourage firms and their auditors to put renewed focus and emphasis on the existence and effectiveness of internal controls to assure compliance with both GAAP and the Foreign Corrupt Practices Act.
SAB 100 focuses on restructuring changes, impairments, inventory valuation allowances and liabilities assumed in connection with business purchase combinations. This bulletin expresses the staff's view on how these transactions or the consequence of certain events should be reported in a consistent and comparable manner. This way investors have more complete information about the economics of the particular transaction to assist them in making investment decisions. The staff's view for each of the issues addressed in SAB 100 is that registrants must exercise appropriate judgment in applying GAAP to assure reliability and consistency. Two reasons for this position are as follows:
- The balance sheet amounts must reflect management's best judgment -- i.e., be reliably and appropriately based.
- Financial statement users must be able to rely on the transparency of the reported and disclosed amounts to track the subsequent performance of the investment.
In short, investors should not be put in the position of comparing apples and oranges. There should be comparable financial reporting so that everyone is playing by the same set of rules.
On a separate but somewhat related topic, the Financial Accounting Standards Board ("FASB") recently issued an exposure draft. The FASB project on business combinations observes, among other things:
- Having two different methods of accounting makes it difficult for investors to compare companies when they have used different methods to account for their business combinations.
- Under certain accounting methods, financial statement users cannot tell how much was invested in the transaction, nor can they track the subsequent performance of the investment.
- Business combinations are acquisitions and are best accounted for based on the value of what is given up in exchange, regardless of whether it is cash, other assets, debt, or equity shares.
SAB 101 focuses primarily on revenue recognition. As I mentioned earlier, a very large number of enforcement cases have arisen from firms recognizing revenue too early. Once again, SAB 101 does not depart from GAAP. It merely provides more guidance for accounting professionals to improve their financial reporting. Specifically, SAB 101 spells out the basic criteria that must be met before registrants may record revenue. These criteria reflect the recurring revenue recognition themes found in the existing accounting rules. These criteria are:
- persuasive evidence that an arrangement exists,
- delivery has occurred or services have been rendered,
- the seller's price to the buyer is fixed or determinable, and
- collectibility is reasonably assured.
The SAB provides a number of examples of how the staff applies these criteria to specific fact patterns. Moreover, the SAB addresses the following important income recognition issues:
- Whether income should be presented on a fee or commission basis or at the full transaction amount when the seller is acting as a sales agent or in a similar capacity.
- What disclosure registrants should make about their revenue recognition policies and the impact of events and trends on revenue.
I hope the guidance provided by this SAB will assist registrants in assuring that their revenue reporting practices conform to GAAP.
In conclusion, I wish to stress that with the help of accounting professionals, we have made tremendous strides in improving financial reporting and thus strengthening capital markets. But there is still much work to be done. In this "point and click" world in which we live, the SEC must be able to rely on accounting firms proactively protecting both clients and investors. To accomplish this, CFOs and auditors should continue to focus on good internal controls and follow the guidance set out in the recent SABs. These proactive steps will go a long way in improving accounting industry standards and helping the industry grow to meet the challenges of the new millennium.
Good luck and thank you.