financial watch
SEC Addresses Quality
of Earnings
The Commission is stepping up
enforcement and calling for
companies to police themselves.
n a speech at the NYU Center for Law
and Business, SEC Chairman Arthur
Levitt expanded on a recurring
Commission theme—curbing abusive
“earnings management” practices. Mr.
Levitt cited five examples of “common
accounting gimmicks” that have heightened the SEC’s concerns in this area,
including:
• “Big bath charges”—particularly
overstated restructuring charges
that are later reversed into income
in subsequent periods.
• “Creative acquisition accounting”—
including excessive in-process R&D
charges and recognizing liabilities
for future operating costs in purchase business combinations.
• “Cookie jar reserves”—the use of
unrealistic assumptions to estimate
liabilities for routine accruals (e.g.,
sales returns, loan losses or warranty costs).
• Misuse of the materiality concept—
this means intentionally recording
errors within a defined (and
I
arguably immaterial) percentage
ceiling.
• Improper revenue recognition—recognizing revenue before a sale is
complete, before the product is
delivered to a customer, or at a time
when the customer still has options
to terminate, void or delay the sale.
A Nine-Point Plan
To address these earnings management
problems, Mr. Levitt called for a ninepoint action plan dependent on cooperative public-private sector effort.
1. The SEC staff has been instructed to
require detailed disclosures about the
impact of changes in accounting estimates
(e.g., reconciliations of beginning and
ending balances and activity during the
reporting period in restructuring and
other loss reserves).
2. The SEC is challenging the profession, through the AICPA, to clarify the
rules for auditing acquired in-process
R&D and provide additional guidance on
restructurings, large acquisition write-offs,
and revenue recognition.
3. Mr. Levitt has asked the SEC staff to
focus on materiality and publish guidance
emphasizing the need to consider qualitative, not just quantitative factors.
“Materiality,” he proclaimed, “is not a
bright line cutoff of three or five percent,”
but rather requires consideration of “all
relevant factors that could impact an
investor’s decision.” He cited an example
of a Fortune 500 company that had used a
ceiling of six percent to justify recording
an error in its financial statements.
4. The SEC staff will consider interpretive accounting guidance on the “do’s and
don’ts” of revenue recognition. Mr. Levitt
indicated that the staff also will consider
whether SOP 97-2, Software Revenue
Recognition, can be applied to other
service companies.
5. Mr. Levitt called for FASB to promptly
resolve its projects underway, in hopes
that they will more clearly define when a
liability should be recognized.
6. The SEC’s Divisions of Enforcement
and Corporation Finance have been
instructed to reinforce these initiatives,
by (among other things) targeting reviews
of public companies when they announce
restructuring liabilities, major write-offs
or other practices that “appear to manage
earnings.”
7. Mr. Levitt called for improved outside
auditing, challenging the accounting profession to focus on training and supervision.
8. Mr. Levitt also called for empowerment of audit committees and announced
that the New York Stock Exchange and
the NASD have agreed to sponsor a “blue-
financial watch
ribbon” panel to develop a series of recommendations intended to empower audit
committees and function as the ultimate
“guardian of investor interests and corporate accountability.”
9. Finally, Chairman Levitt challenged
corporate management and Wall Street
to re-examine the current environment,
reminding managers that the integrity of
their financial statements is directly
related to the long-term interest of the
corporation.
Loss Accruals,
Revenue Recognition
Recently, SEC Chief Accountant Lynn
Turner met with several groups from the
accounting and business communities to
discuss the SEC’s concerns (based on
input from financial analysts) about the
quality of earnings. These concerns surround how users of financial statements
perceive loss accruals and revenue recognition, including related disclosures, and
how those perceptions impact the integrity of the financial reporting system. In
this regard, the SEC is taking a proactive
role in reviewing companies that report
“big-bath” charges such as restructuring
charges and one-time write-offs.
Mr. Turner informed representatives of
the Emerging Issues Task Force (EITF)
and Auditing Standards Board of an SEC
staff review of implementation problems
and the adequacy of guidance in the
recording of charges and loss accruals.
Citing recent financial press articles, he
expressed concern that financial analysts
and other users of the financial statements do not fully understand the
accounting for loss accruals, and that such
charges make it more difficult to evaluate
a company’s operating performance.
The SEC’s concerns focus primarily on
the use of reserves and write-downs, and
the subjectivity of the timing and amounts
that could potentially permit a degree of
manipulation of reported results.
The Commission has stepped up
enforcement actions on alleged accounting abuses. In December, it filed a civil
action against one company and instituted public administrative and cease-anddesist proceedings against various
employees, alleging that the company’s
reported quarterly and annual earnings
were manipulated in an effort to smooth
earnings. The company, SEC says,
deferred reporting income by increasing
or establishing non-GAAP reserves for
profit planning purposes, and released
some of the excess reserves to increase
its earnings per share. In one period, the
Commission claims, the company
reversed excess reserves and improperly
netted the excess reserves with other
charges and adjustments, misleadingly
describing the reversal as “a change in
accounting estimate.”
The Commission is considering asking
the EITF to consider providing guidance
on Statement 121 (Accounting for impairment losses) and:
• Better define an exit event under
EITF 94-3, Liability Recognition
for Certain Employee
Termination Benefits and
Other Costs to Exit an Activity
(including Certain Costs
Incurred in a Restructuring).
• Provide additional examples of liabilities that can be recognized and
items that cannot be recognized
under EITF Issues 94-3 and 95-3,
Recognition of Liabilities in
Connection with a Purchase
Business Combination.
• Provide guidance as to what is an
adequately specific plan under EITF
Issues 94-3 and 95-3.
• Consider providing a time-frame for
completing a plan as a means of
reducing or minimizing reversals of
over-accruals.
• Provide more guidance with respect
to disclosures.
financial watch
The SEC staff requested that the ASB
discuss Statement 121 impairments in the
1998 Audit Risk Alerts. The staff also is
troubled by the subsequent disclosures
made about restructuring and impairment
charges, citing the quality of disclosures
made in subsequent periods. Further,
companies may not be providing the information required by Schedule II of
Regulation S-X, Valuation and
Qualifying Accounts, or detailed information in the notes to the financial statements. The staff intends to step up its
review of filings, focusing on subsequent
SEC’s concerns
focus on the use of
reserves and
write-downs, and
the subjectivity of
the timing and
amounts that could
permit manipulation
of reported
results.
period disclosures and information
required by Schedule II, and taking
action against registrants that fail to
make appropriate disclosures,
including amending prior filings.
The SEC also is encouraging independent auditors to sensitize the
audit committees to the issue of
earnings quality so that they are better prepared to scrutinize the company’s financial reporting.
In response to the concerns of
financial analysts about the frequency of SEC’s improper revenue recognition actions, Mr. Turner said SEC
staff is considering the issuance of a
Staff Accounting Bulletin on the subject, and that it intended to seek
input from the EITF before its
issuance. L
ELT thanks Alex Arcady, Ernst &
Young, LLP, New York, for this month’s
column.