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SEC Staff Reviews Accounting Projects and Enforcement at Recent Conference

At the AICPA's recent conference on SEC and PCAOB developments, staff members from the Office of the Chief Accountant and the Office of Enforcement outlined their current projects. Among OCA's current projects is the consideration of issuing guidance on the "iron curtain versus rollover" materiality debate about how to consider the effects of prior period misstatements. Enforcement panelists reviewed the kinds of cases they have seen in the past year.

With respect to the iron curtain versus rollover debate, professional accounting fellow Russell Hodge said the staff does not believe it is appropriate for so much diversity to exist in practice for something that should be as straightforward as quantifying the effects of objectively determined misstatements. He suggested that the starting point in a materiality analysis should be the same.

Hodge said the staff has devoted a fair amount of time to this issue over the last six months. The staff has not completed its analysis, but hopes to do so in the near future. If the interpretive guidance suggests a change to current practice, the staff has to consider how to handle difficult transition issues, he noted, but that should not be an excuse for failing to improve financial reporting in this area.

G. Anthony Lopez advised that revenue recognition continues to be a significant area of interest. He issued a reminder that changes in circumstances or contractual provisions have to constantly be considered in determining whether revenue recognition policies are still appropriate. This is an area in which policies may require more frequent updating than others, he said.

Chad Kokenge reviewed the staff's views on the disclosure of modifications to certain equity-based compensation arrangements that may occur prior to FASB's adoption of a new standard. This issue has surfaced as companies prepare to adopt the fair value model for recognizing compensation expense for employee stock options, he explained, and relates to accounting for the acceleration of the vesting of stock options having an exercise price in excess of the current market price, known as "out-of-the-money" options.

Any modifications to accelerate the vesting of out-of-the-money options in anticipation of adopting the new accounting standard must be disclosed, according to Kokenge. He cited Deputy Chief Accountant Scott Taub's remarks about needing to disclose the reasons for transactions that appear to have a significant accounting-related purpose. Kokenge said companies should disclose the reasons for modifying the option terms. The intent may be, in large part, to avoid recognizing an expense in future financial statements, he said, and that reasoning should be disclosed to investors.

Kokenge added that language to the effect that "during fiscal 2004, certain of the company's stock options were modified to accelerate vesting," would not be sufficient. If companies have engaged in this type of transaction or are planning to, Kokenge said they should be prepared to explain those actions in their SEC filings.

Enforcement

Linda Thomsen, the deputy director in the SEC's Division of Enforcement, reported that what she has seen in the past two years has not been encouraging. The SEC has brought over 1,300 enforcement cases in the last two years and has obtained more in disgorgement than during any other two year period in history. Thomsen referred to director Stephen Cutler's speech on December 3 at the general counsel roundtable about the need for an ethical culture at every company.

Thomsen said that the Division will maximize its resources for the greatest impact by focusing on the gatekeepers. During the past two years, the SEC has brought 30 actions involving lawyers. She added that the Division has about two dozen Wells notices outstanding that relate to audits. Obstruction is a very serious charge, Thomsen said. There is no document more dangerous intact than there is shredded, she said.

The Enforcement Division's chief accountant Susan Markel reported that financial fraud continues to be the largest category of enforcement cases, representing 28% of the cases brought. The common fraud schemes include premature revenue recognition, excess reserves used to smooth earnings, improper accounting for vendor rebates and improper capitalized costs.

The new types of cases the staff has seen include certain types of related party transactions, undisclosed compensation, false certifications, missing money, variable length quarters and financial products used to manage earnings. Auditor independence is a critical part of financial reporting, she added, and remains a focus of the SEC's enforcement program. In financial fraud cases, the staff will ask where the accountants and the auditors were.

The basic audit failures seen by the staff include situations where there was a lack of evidence to support conclusions, an over-reliance on management's representations, an improper confirmation process and inadequate testing of internal controls. In cases lacking evidence, Markel said the source of the audit failures ranged from not testing at all to poor execution, ignoring red flags and a lack of documentation.

Markel advised that the PCAOB has not replaced the SEC in auditor enforcement cases. The plan is to coordinate, not to duplicate, she advised. PCAOB enforcement should not be viewed as an alternative, but as an addition, according to Markel.