Therefore, I am calling for immediate and coordinated action:
technical rule changes . . . to improve the transparency of financial statements; enhanced oversight of the financial reporting process . . . and nothing less than a fundamental cultural change on the part of corporate management as well as the whole financial community. . . .1
THE CHAIRMAN’S SPEECH
With the above announcement in a speech on September 28, 1998, to the New York Uni- versity Center for Law and Business, Arthur Levitt, then chairman of the Securities and Exchange Commission, announced an all-out war on the kinds of accounting and report- ing procedures collectively referred to here as creative accounting practices. During recent years, the SEC has witnessed an increase in what the agency termed “accounting hocus pocus.”2In the chairman’s view, the increased use of accounting gimmickry to sway reported financial results was due to a predilection on the part of the financial mar- kets to punish companies that missed their consensus earnings forecasts. He noted an example of one U.S. company that missed its so-called numbers by one cent and saw its market value decline by more than 6 percent in a single day. In the chairman’s view, cor- porate managements were under extreme pressure to make their numbers and were bow- ing to that pressure, putting the integrity of our financial reporting system at risk.
The chairman noted that accounting principles were not meant to be a straitjacket.
Flexibility is necessary to permit financial reporting to handle differences in business structures and keep pace with business innovations. However, according to the chair- man, companies are using that flexibility to create illusions in their financial reports, illu- sions that are anything but true and fair reporting.
In its regulatory role, the SEC is clearly of preeminent importance to the financial reporting process in the United States. The agency has front-line responsibility to help limit the use of creative accounting practices in financial reports filed with it. Given this responsibility and the new diligence being shown by the SEC to address many of the
creative accounting practices being reported on here, a review of the problems the SEC sees with financial reporting and the new directions it is taking was deemed necessary.
Five Creative Accounting Practices
According to the SEC’s chairman, companies are using or, rather, abusing five account- ing practices to control their reported financial results and position. The first three of these accounting practices, big bath charges, creative acquisition accounting, and cookie jar reserves, were considered together with other forms of earnings management in Chapters 2 and 3. The fourth item, materiality, is used by companies to stretch the flex- ibility found in generally accepted accounting principles as they account for individually immaterial items in a manner that is outside the boundaries of GAAP. Treatment of the topic is provided in Chapter 9. The fifth item, revenue recognition, is studied in Chapter 6, the chapter on recognizing premature or fictitious revenue. Exhibit 4.1 lists the five creative accounting practices with the location of where each topic is afforded primary treatment.
Big Bath Charges
Companies are using large restructuring charges to clean up their balance sheets—thus the term big bath. The temptation is for companies to overstate these charges because investors will look beyond the one-time loss and focus only on future earnings. If some extra cushioning can be built into the charge that is taken, making it overly conservative, then the amount of that extra cushioning is “miraculously reborn as income when esti- mates change or future earnings fall short.”3
The chairman’s position is not opposed to restructuring charges generally. Such strategic actions are part of managing a changing business. Rather, his position is that
Exhibit 4.1 Five Creative Accounting Practices Identified by SEC Chairman
Creative Accounting Practice Location of Primary Treatment
1. Big bath charges Chapter 2
Chapter 3
2. Creative acquisition accounting Chapter 2
Chapter 3
3. Cookie jar reserves Chapter 2
Chapter 3
4. Materiality and errors Chapter 9
5. Revenue recognition Chapter 6
Source: Arthur Levitt, “The Numbers Game,” speech given to the New York University Center for Law and Business.
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such charges should be recorded without including a “flushing [of] all associated costs—
and maybe a little extra—through the financial statements.”4 Creative Acquisition Accounting
The second gimmick used by reporting companies to create financial statement illusions is creative acquisition accounting. As the number of acquisitions, consolidations, and spin-offs have increased in recent years, so has the use of “merger magic.”5In particu- lar, that magic is the creative use of purchased in-process research and development.
Companies are classifying an ever-growing portion of the price paid in an acquisition to purchased in-process R&D, writing it off as a one-time charge and removing any future earnings drag. While not stated, the chairman’s implication is that more of the acquisi- tion price paid should be allocated to goodwill or other intangibles and, where relevant, amortized over future years’ earnings.
Another creative accounting practice used by companies completing acquisitions is to create large liabilities for future operating expenses. These liabilities purportedly repre- sent future costs associated with the recently completed business combination. What they may include, however, is a portion of normal future operating expenses. By charg- ing those to the acquisition, future earnings are boosted.
Cookie Jar Reserves
The third item uses unrealistic assumptions to estimate liabilities. The practice entails reducing earnings during good years by stashing amounts in cookie jars, then reaching into the jars when needed during bad times. The chairman specifically mentioned sales returns, loan losses, and warranty costs.
He gave a specific example of an unusual accounting treatment, recalling a company that took a large one-time charge to “reimburse franchisees for equipment.”6That equip- ment, which appeared to include more than what might be considered equipment, had yet to be purchased. Moreover, the announcement of the equipment charge was done at a time when the company announced that future earnings were expected to grow at 15% per year.
Materiality
The fourth item used by companies to adjust earnings to desired levels is the abuse of the concept of materiality. The chairman noted that materiality helps to build flexibility into financial reporting. Some items may be so insignificant that they are not worth measur- ing and reporting with exact precision. The concept of materiality can be misused by intentionally recording transactions incorrectly within a defined percentage ceiling.
However, because the effect on the bottom line is, supposedly, too small to matter, adjustment of the error is unnecessary. Of course, even immaterial items can add a penny or two to reported earnings per share, keeping them in line with analyst forecasts.
Revenue Recognition
More concerned here about improperly boosting earnings, the chairman identified the fifth method of manipulating income as incorrectly recognizing revenue. Revenue recog-
The SEC Responds
nition was likened to a bottle of fine wine. Just like a bottle of fine wine, where the cork should not be popped before it is ready, revenue should not be recognized until the proper time. He noted that it is improper to recognize 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.”7
Beyond the SEC’s Five Practices
This focus by the SEC on five specific creative accounting practices notwithstanding, we have observed numerous examples of creative accounting practices employed in other areas. For this reason, we discuss creative accounting practices dealing with aggressive capitalization of expenditures and extended amortization periods in Chapter 7 and gen- erally all other misstatements of assets and liabilities in Chapter 8. Because we also felt that financial statement readers can be misled by financial statement classifications, we added topics dealing with the formatting of the income statement in Chapters 9 and 10 and the statement of cash flows in Chapter 11.
THE ACTION PLAN
The SEC chairman noted that U.S. capital market supremacy is based on the reliability and transparency of financial statements. Thus, the problems with financial reporting noted in his speech are a problem for the financial community in this country and not just for the companies involved. Accordingly, he called for immediate and coordinated com- munity action, a cooperative public-private sector effort.
Specifically, the SEC chairman’s action plan is a multipoint program designed for both regulators and the regulated to not only maintain but increase public confidence in financial reporting. His nine-point action plan is divided into four categories:
1. Improving the accounting framework 2. Enhancing outside auditing
3. Strengthening the audit committee process 4. Pursuing cultural change
These categories and the nine action-plan program steps are summarized in Exhibit 4.2 and detailed below.
Improving the Accounting Framework
In this first category of the action plan, he outlined six program steps designed to make financial statements themselves more transparent and reliable. The first is a proposal to require well-detailed disclosures about the impact of changes in accounting assumptions.
This disclosure requirement is proposed as a supplement to the financial statements showing, for account balance changes, the beginning and ending balances and cross- period activity, including adjustments. The direct objective here is to better enable finan-
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The SEC Responds
Exhibit 4.2 SEC Chairman’s Nine-Point Action Plan to Return Reliability and Transparency to Financial Reporting in the United States
Category Action Plan Program Step
Improving the Accounting 1. Better disclosure of impact of changes in
Framework accounting assumptions
2. Clarified accounting rules for purchased in-process research and development, large acquisition write- offs, and restructuring charges
3. Guidance on qualitative factors for determining materiality in accounting measurements 4. Interpretive guidance for revenue recognition 5. Prompt resolution of FASB’s definition of
liabilities
6. Targeted reviews of public companies announcing restructuring liability reserves, major write-offs, or other earnings-management practices
Enhancing Outside 7. Call to auditors to review the way audits are
Auditing performed and determine if changes are needed
Strengthening the Audit 8. Blue-ribbon panel to develop recommendations Committee Process to strengthen audit committees
Pursuing Cultural Change 9. Corporate management and Wall Street to examine reporting environment, to reward open and
transparent reporting and punish creative accounting practices
Source: Derived from Arthur Levitt, “The Numbers Game,” speech given to the New York University Center for Law and Business.
cial statement users to understand the nature and effects of restructuring liabilities and other loss accruals.
The second point is a challenge to the accounting profession to clarify the accounting rules for purchased in-process research and development, large acquisition write-offs, and restructuring charges. In the chairman’s view, there is too much gray area and flex- ibility surrounding the accounting for these items.
In his third point, the chairman addresses his concerns about the misuse of material- ity, which can be used as an excuse to deliberately misstate performance. He noted the example of a company that used a materiality ceiling of 6% of earnings to justify an error. According to the chairman, that is not the manner in which materiality thresholds are to be used. He directed the SEC staff to study the problem and publish guidance that emphasizes the need to consider qualitative, not just quantitative, factors of earnings. In this way, materiality guidelines will consider all relevant factors that should impact an investor’s decision.
In the fourth action point, the SEC staff is directed to consider interpretive account- ing guidance for revenue recognition. The objective here is a clearer insight into what are and what are not proper revenue recognition practices. Acknowledging new, tighter guidance for software revenue recognition, outlined in Chapter 6, the chairman directed the SEC staff to determine whether the software revenue recognition standards can be applied to other service companies.
The fifth point is directed at private sector accounting standard setters, in particular, the Financial Accounting Standards Board (FASB). The chairman encouraged the board to pursue a prompt resolution of ongoing projects to clarify the definition of liabilities.
In particular, the FASB has an ongoing deliberation of issues raised in a 1990 discussion memorandum that focuses on the characteristics of liabilities and equity, Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Charac- teristics of Both.8
The SEC plans to reinforce the regulatory initiatives contained in these accounting- change action steps. In the sixth point of his nine-point program, the chairman indicated that the SEC will formally target reviews of public companies that announce restructur- ing liability reserves, major write-offs, or other practices that appear to manage earnings.
Enhancing Outside Auditing
The seventh point is directed at the auditing profession. In the chairman’s view, auditors are the watchdogs in the financial reporting process. They put the equivalent of a “good housekeeping seal of approval on the information investors receive.”9In this view, the integrity of the information contained in financial reports must take priority over any desire for cost efficiencies or competitive advantage in the audit process. In addition, a high-quality audit requires well-trained auditors who are well supervised. The chairman wondered aloud whether, given the high number of audit failures being observed in recent years, the professionals actually doing the audits were sufficiently trained and supervised. In his words, “We cannot permit thorough audits to be sacrificed for re-engi- neered approaches that are efficient, but less effective.”10To address this potential prob- lem, he ordered all constituencies involved in the audit process to review the ways audits are performed and determine if changes are needed.
Strengthening the Audit Committee Process
Audit committees are subcommittees of corporate boards of directors assigned the responsibility of ensuring that corporate financial reporting is fair and honest and that the audit is conducted in a probing and diligent manner. A good audit committee is a tough- minded group of independent members of the board of directors that have appropriate financial accounting and reporting knowledge. The SEC chairman noted that many audit committee members are not sufficiently independent from management, do not have the requisite financial accounting and reporting knowledge, and do not meet often enough to make a difference in a company’s reporting environment. He contrasted the character and composition of two different audit committees. One committee had little expertise in the basic principles of financial reporting and met only twice per year for 15 minutes
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before a regular board meeting. Every member of the second committee had a financial background, had no personal ties to the chairman or the company, and met monthly to ask tough questions of management and the outside auditors. In the latter case, accord- ing to the chairman, investor interest was better served.
In point 8 of the SEC’s action plan, the chairman announced the formation of a blue- ribbon panel sponsored by the New York Stock Exchange and the National Association of Securities Dealers. The purpose of this panel, the Blue Ribbon Committee on Improv- ing the Effectiveness of Corporate Audit Committees, is to develop a series of recom- mendations intended to empower audit committees to better function as the ultimate guardian of investor interests and corporate accountability.
Pursuing Cultural Change
In the ninth and final point of the action plan, the chairman challenged corporate man- agement and Wall Street to look carefully at the current reporting environment. He reminded managements that the integrity of their financial numbers is directly related to the long-term interests of their corporations. Temptations abound to employ creative accounting practices. However, the rewards are ultimately self-destructive. As to Wall Street, he encouraged market participants to punish firms that rely on deception in finan- cial reporting rather than those that use openness and transparency.
SUBSEQUENT DEVELOPMENTS
Arthur Levitt’s address was a watershed event. It rang a starting bell and announced that the SEC was going after creative accounting practices from several directions in a con- certed way. The financial markets of the United States are the envy of the world, and Levitt was convinced that reporting problems were putting their preeminence at risk. He would not let that happen.
In the time following the SEC chairman’s speech, we have seen numerous develop- ments on many fronts that can be attributed directly to the SEC’s new found diligence.
Accounting Framework
Developments in the SEC’s accounting framework area are summarized in Exhibit 4.3 and detailed below.
Consistent with their accounting directives, the SEC issued three new Staff Account- ing Bulletins (SABs). SAB 99 Materiality, was issued in August 1999.11The bulletin reiterates the SEC’s view that materiality cannot be judged based on quantitative mea- sures alone, but must consider qualitative factors as well. The bulletin also notes that in determining materiality, offsetting misstatements cannot be netted but must be consid- ered separately. Finally, the bulletin states that intentional misstatements of immaterial items are not permitted.
In November 1999, the SEC issued SAB 100 Restructuring and Impairment Charges.12In this bulletin, the SEC expresses its views on the accounting for and dis-
The SEC Responds
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closure of expenses commonly reported in connection with exit activities and business combinations. The bulletin includes exit costs—the costs to exit a business activity, including employee termination benefits and other costs such as lease termination fees and asset disposal costs—within the broader term restructuring charges. Restructuring charges are the costs associated with restructuring activities, including the consolidation and/or relocation of operations or the disposition or abandonment of operations or pro- ductive assets. Generally, the bulletin prohibits the accrual of exit costs prior to the date that a company’s management is committed to an exit plan. Moreover, there must be a detailed budget of the various costs associated with an exit plan strategy. The bulletin concludes with detailed disclosure requirements for exit costs, including adjustments to any previously accrued exit-plan liability.
Also following closely after the chairman’s speech was SAB 101, Revenue Recogni- tion.13SAB 101 notes that accounting rules for revenue recognition are not comprehen- sive but rather a collection of industry and transaction-specific guidelines. The bulletin, however, does not change any of the existing rules on revenue recognition. It clarifies the basic criteria for revenue recognition found in those existing rules and explains how the SEC applies them to other transactions that the existing rules do not specifically address.
Generally, the bulletin takes the newly updated and carefully considered revenue recog- nition requirements for software revenue and applies them to other product and service sales. Using those requirements, the bulletin maintains that before revenue can be rec- ognized, four criteria must be met:
1. There is persuasive evidence of an arrangement 2. Delivery has occurred or services have been rendered
Exhibit 4.3 Summary of Developments in the Accounting Framework since the SEC Chairman’s Speech
SEC issued SAB 99: Materiality.
SEC issued SAB 100: Restructuring and Impairment Charges.
SEC issued SAB 101: Revenue Recognition.
FASB issued SFAS No. 141: Business Combinations.
FASB issued SFAS 142: Goodwill and Other Intangible Assets.
FASB deferred reconsideration of purchased in-process research and development to comprehensive project on R&D.
FASB planned exposure draft and final statement on the definition of liabilities.
SEC filed numerous accounting fraud civil suits.
SEC announced heightened pursuit of criminal prosecutions for accounting fraud.
Sources: Securities and Exchange Commission Internet Web Site, June 2000, and Financial Accounting Standards Board, Status Report, April 17, 2000.