May 2000

Society Committee Responds to SEC Proposale

By Robert N. Waxman, CPA

The NYSSCPA SEC Practice Committee recently submitted comments to the Securities and Exchange Commission in response to the commission's recent initiatives to address what SEC Chair Arthur Levitt has termed "earnings management." This article provides background on the issue and briefly outlines the committee's recommendations to the SEC.

Background

In 1998, the SEC identified six accounting practices used by reporting companies to materially "manage" their earnings. Levitt pointed out that the financial statements of these reporting companies were audited, and the nagging question was, "Where were the auditors?" The six accounting practices were identified as "cookie jar" reserves, big bath charges (restructuring reserves), purchased in-process research and development, overaccruals in purchase method business combinations, "immaterial" errors, and premature revenue recognition.

Since the 1998 kickoff of its initiative to improve accounting, disclosures, and the effectiveness of audits and audit committees, the SEC has issued staff accounting bulletins on materiality (SAB No. 99), restructuring and impairment charges (SAB No. 100), and revenue recognition (SAB Nos. 101 and 101A).

New Item 302(c) of Regulation S-K

As part of this effort, last January, the commission proposed rules that moved certain schedule information (that the SEC currently requires in Rule 12-09 of Regulation S-X) to a new Item 302(c) of Regulation S-K. This information would reconcile changes (from the beginning to the end of the year) in all valuation and loss accrual accounts. These accounts include:

* allowance for doubtful accounts or notes receivables
* allowance for sales returns, discounts, and contractual allowances
* unamortized discount or premium
* excess of estimated costs over revenues on contracts (loss contracts)
* inventory valuation allowance
* valuation allowance for deferred tax assets
* liabilities for exit and employee termination costs related to a restructuring or business combination
* liabilities for costs of discontinued operations
* liabilities for environmental costs
* contingent income and franchise tax liabilities recorded under FASB Statement No. 5
* product warranty liabilities
* probable losses from pending litigation.

New Item 302(d) of Regulation S-K

The proposal also asks for detailed information about changes in long-lived assets and the related accumulated depreciation, depletion, and amortization accounts. The SEC defines long-lived assets as those for which a separate presentation is made in the balance sheet and includes land, buildings, equipment, leaseholds, brand names, noncompete agreements, customer lists, goodwill, and other major tangible or intangible assets. Further, reconciliations must also be given for each allowance account that corresponds with the major asset account.

New Item 8C to Recently Revised Form 20-F

The SEC also proposed that the same 302(c) and 302(d) requirements would be mandatory for all Form 20-F filers.

Society Comments

In its comment letter, the Society's SEC Practice Committee observed that the accounts listed in the proposal included certain valuation and loss accrual accounts that are not needed to meet the SEC's objectives for "transparent" financial statements. Many of the identified accounts are routine and are not considered unusual, nor have these accounts typically been used to "manage" earnings. Further, whether an accrual or provision is or has been managed (or is "too high," "too low," or "just right") cannot be discerned by financial statement users and analysts, so there is no perceived utility for all the information the release asks for.

The committee recommended the following accounts be excluded from the required reconciliations:

* Allowance for doubtful accounts and notes receivable
* Allowance for sales returns, discounts, and contractual allowances
* Unamortized premium or discount (as such valuation account pertains to either an asset or liability)
* Inventory valuation allowance [As the release points out, under GAAP the use of an inventory valuation allowance to reflect a writedown of inventory to the lower of cost or market establishes a new cost basis. Thus, the writedown to market is not through an allowance (valuation) account, and the committee believes that asking for a reconciliation of the valuation allowance is merely a test by the SEC of a registrant's and its auditor's ability to properly apply GAAP. One unanswered question is whether the SEC considers the amount that reduces FIFO to LIFO to be a valuation account and therefore would require a reconciliation.]
* Valuation allowance for deferred tax assets (FASB Statement No. 109 already requires the net change in the valuation allowance.)
* Contingent income and tax liabilities recorded under FASB Statement No. 5
* Product warranty liabilities.

The committee also recommended that the SEC use a percentage test to trigger specific account disclosures. The committee suggested that the disclosures of valuation accounts or loss accruals under 302(c) should only be required when (a) the latest balance sheet amount exceeds either 10 percent of current assets or current liabilities (depending on the valuation accounts classification), or (b) the gross additions or gross credits charged or credited to the statement of operations exceed 10 percent of pretax income or loss.

In addition, the committee suggested that the SEC require disclosures of long-lived assets and allowance accounts under 302(d) only when at both the beginning and end of the latest fiscal year, the total tangible long-lived assets or intangible long-lived assets exceed 20 percent of total assets as shown in the related balance sheet.

The committee's comment letter stated that on the supposition that this information is considered by users and financial analysts to be very important data, all of it should be included in both (a) registration statements and (b) interim financial statements, and not just in annual filings on Form 10-K.

Among its many other comments, the committee recommended that the SEC require no disclosures in interim financial statements concerning changes in property, plant, equipment, and intangible assets, and the related accumulated depreciation, depletion, and amortization. In the committee's view, the SEC proposal did not make the case as to exactly how analysts or others would actually use this data. The committee said that until the SEC establishes the practical usefulness of this information, it should not be required in interim financial statements.

See www.nysscpa.org for the complete draft of the committee's comment letter. *

Robert N. Waxman is chair of the Society's SEC Practice Committee and a consultant to companies on SEC matters.