For release on December 10, 1997 1997 Twenty-Fifth Annual National Conference on Current SEC Developments December 10, 1997 Remarks by Jane B. Adams Deputy Chief Accountant Current Accounting Projects Office of the Chief Accountant U.S. Securities and Exchange Commission (c) Copyright 1997. All rights reserved. As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff. INTRODUCTION Good morning. I am pleased to be speaking to you today, and particularly to be doing so in this capacity. As you may know, I have been the Deputy Chief Accountant in the SEC's Office of the Chief Accountant for a little more than 3 months. Steve Swad, who addressed you last year, was quite thoughtful and generous in the energy he expended to assure a reasonable transition for me. He anticipated a number of my needs, and left a number of useful items behind. Unfortunately, I never did find the speech for today's conference. Today I would like to speak to you about several projects -- some completed, some in process, and some just peeking over the horizon -- that have been or will be receiving our attention and resources. These projects span OCA's three major areas of responsibility: overseeing private sector setting of accounting standards; resolving questions about the interpretation and application of existing GAAP; and making rules to supplement private-sector accounting standards where necessary for investor protection. OVERSIGHT One of the OCA's responsibilities is execution of the Commission's oversight responsibility for private sector standards setting--including FASB, EITF, AcSEC, ASB, and now the ISB. In this capacity, we attend public meetings held by these groups and also meet with representatives of these bodies on a regular basis, trading information on project status and implementation questions. This oversight activity is influenced by our day-to-day experience with current registrant issues. While the Division of Corporation Finance has the direct responsibility for reviewing filings, OCA also spends a substantial amount of time on registrant issues. These may be telephone inquiries, pre-filing submissions, issues identified by Corp Fin in its review of filings, or enforcement cases. OCA becomes involved when issues of accounting policy arise, and the immediate task is to interpret and apply existing GAAP as it relates to a specific registrant issue. But this involvement in registrant matters also shapes our oversight activity, since resolution of registrant reporting issues identifies where existing standards create practice problems. By communicating the types of practice problems that we encounter, we can help standard setters to understand the practical effects of guidance issued through the standard- setting process and where additional guidance is needed. INTERPRETATION AND COMMUNICATION While experience with registrant issues feeds our oversight activities, it often also involves communicating directly with the profession about fact patterns we've considered, and the conclusions we've reached. Clearly, the registrant's financial statements reflect a final decision, and when a restatement is involved, the issues considered -- as well as the end result -- is usually pretty clear. Absent a restatement, the analysis of the issues -- or even the issue's resolution -- may not be clear. So the staff may look for ways to communicate a specific fact pattern and conclusion. This communication can take a number of forms, including Staff Accounting Bulletins, staff announcements at the EITF, participation in meetings with groups like the AICPA SEC Regulations Committee or FEI's Committee on Corporate Reporting, as well as speeches at conferences like this. So, today the staff members bring technical issues to share with you, with the goal of communicating staff positions in recent registrant matters. And if anyone doubts that communication is a significant part of our activities, I invite you to come see the recycling bins in our office -- many trees died on behalf of this conference! The last major type of activity for OCA is rulemaking -- and the market risk disclosure release and new Rule 10-A issued during 1997 are two examples of this type of effort. I'll cover rulemaking issues at the end of my remarks. With this backdrop, I'd like to share with you our progress on several projects, which derive from these main areas of responsibility. The first area where I'd like to comment is... Business Combinations Although this isn't the subject of a specific SEC staff project, it has been -- and continues to be -- an endless source of registrant inquiries. Indeed, one of the first big issues that I had to address was a very basic one -- What is a Business Combination? The issue considered by the staff focused on whether a transaction involving the contribution of two businesses to a newly established company should be accounted for as a business combination. The registrant believed that it should be accounted for as a joint venture since the ownership would be split 50/50 between the two companies. The staff focused on the structure of the transaction itself, with one company transferring all of the assets and operations of one of its divisions in return for a 50% ownership stake in the combined entity, while the other potential "venturer" was a holding company recently formed to consolidate the votes of a number of equity holders. The staff also focused on the scope of APB 16, which is very broad. According to paragraph 1 of APB 16, "A business combination occurs when a corporation and one or more incorporated or unincorporated businesses are brought together into one accounting entity. The single entity carries on the activities of the previously separate, independent enterprises." In the view of the registrant, the ONLY distinguishing feature of a joint venture is joint control. Ultimately, the staff disagreed, noting that APB 18 identifies several common features of joint ventures, including: 1. ownership by a small group of venturers as a separate and specific business for the benefit of the venturers; and 2. direct or indirect participation by each joint venturer in the overall management of the joint venture, so that joint venturers have an interest other than that of a passive investor.[1] As a result of the staff's consideration of this fact pattern, the EITF was asked to add an issue to its agenda regarding when the combination of businesses in a jointly owned entity is a business combination, and when it is a joint venture. While it seems difficult to believe that the only criteria should be 50/50 ownership, there clearly is a need to resolve the apparent overlap between APB 16 and APB 18. The other business combination accounting issue I'd like to cover today is one that Steve touched on last year... Pooling of Interests Criteria: Can Alterations of Equity Interests Be Cured? An issue that the staff addresses repeatedly is whether specific alterations of equity interests were made in contemplation of a business combination. Paragraph 47c of Opinion 16 requires that "none of the combining companies changes the equity interest ... in contemplation of effecting the combination" within two years of initiation of the combination. Any change in equity interests that occurs within two years of initiation of a business combination is presumed to have been made in contemplation of the combination -- just as any acquisition of treasury stock made within two years of initiation is presumed to have been made in contemplation of the transaction. In several recent transactions, the staff has objected to registrants' conclusions that it overcame the presumption that the change was in contemplation of the business combination. As a result, the registrants proposed rescinding the transactions that violated paragraph 47c, which in the cases reviewed were grants of stock options. In evaluating these proposals, the staff has learned that there is diversity in practice in permitting rescissions of such grants as effective "cures" of the alterations. Some practitioners believe that a "no harm/no foul" analysis can be applied so long as an alteration is canceled or rescinded for no consideration and the equity holders are returned to the same equity position held before the alteration. Other practitioners believe that to be an effective cure, rescissions also must occur shortly after an alteration occurs -- usually not more than a few months. Others question whether a cure can be effected at all in circumstances where the equity position in question has value -- for example, an in-the-money option. There does seem to be agreement, however, that application of the "no harm, no foul" approach requires that any such rescission be made for no consideration. The staff has not objected to cures that put the shareholders back in the same position as before the alteration, based on analogies to the guidance in Interpretations 19 and 20 of APB 16 regarding other alterations of equity interests. The staff has taken this position, however, only when no consideration is paid to the counterparty -- otherwise the shareholders would not be restored to their former position. The staff has informed registrants that consideration includes any promise made to counterparties -- either written or unwritten -- to provide any form of additional compensation at the time of the rescission or at any time in the future. The staff is concerned that some rescissions of alterations of equity interests have been effected that do not restore the shareholders to their former positions, as would be the case if the rescissions had been done for consideration. As a result, the staff is reconsidering its views on cures to determine the circumstances and conditions where cures should be permitted. When that process is completed, the staff will determine if there is a need to issue guidance in this area. By the end of this conference you will have heard several staff members discuss issues related to business combinations. Let me move on after noting that I've already joined the ranks of those who view APB 16 and the literature and body of practice that has developed since APB 16 was issued as a quagmire. An incredible amount of resources of preparers, practitioners, standards setters and regulators is consumed daily by APB 16 in what at times seem futile efforts to make sense out of an outdated model that ignores the basic economic values underlying a transaction. Given that many complex business combination questions come down to very basic issues that have been around for years, resolution of the FASB project on business combinations should result in significant improvements in accounting. Best Practices A very common question that we receive is: How an issue can get through interpretive review by the DCF and OCA as fast as possible? Although some may doubt me, the staff is interested in providing timely responses. We recognize that delays can be costly, and that there can be significant pressures on registrants to go effective with their filings as quickly as possible. Given the volume involved and the staff's limited resources, a well-organized and thoughtful approach to issue identification and resolution significantly improves the timeliness of the staff's response. I would like to share with you some tips that can help expedite the process, which is discussed more fully in the recommendations of the AICPA SEC Regulations Committee, in its Summary of Best Practices - Communications with the SEC Staff. These tips will help a registrant to focus the review of a filing, and will help prevent issues arising at the last minute and potentially interfering with an offering's planned timetable: 1. Identify key issues on a pre-filing basis. 2. Prepare a comprehensive submission that identifies the issues and succinctly presents a thorough analysis. 3. Consider obtaining national office input, particularly if a meeting is requested with Commission staff. 4. Present management's understanding of the external auditor's views on the conclusions presented in the submission. 5. Avoid presenting duplicate information in multiple submissions. If resolution of the issue calls for a meeting with the staff, a registrant should present the issue and its position, including the basis in the literature for its position. In addition, a representative from the registrant's audit firm normally attends these meetings to present the views of the audit firm, which may differ from those of the registrant, and the basis for the auditor's conclusions. To the extent that those conclusions apply or affect an audit firm's nation-wide policy, it may be helpful to include a national office representative in the meeting. Let me emphasize: the completeness of the facts presented and a comprehensive analysis of the issue in the first submission can have a significant impact on the speed with which the staff can consider and respond to the issue at hand. THE EMERGING ISSUES TASK FORCE The SEC's oversight of the accounting standards-setting process and the OCA's role in interpreting GAAP converge with the EITF. As Mike Sutton discussed yesterday, participation by the SEC Observer in the EITF process is one of the OCA's more critical responsibilities. The EITF plays a key role in interpreting the literature as new issues arise, hopefully before emerging practices become too diverse or before practices not permitted in the literature become acceptable in the guise of widely recognized or prevalent industry practice." Recently, as the FASB continues its deliberations on the consolidation project, the EITF tackled two issues on the periphery of that broad project. These two issues are EITF Issue No. 96-16, "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights", and No. 97-2, "Application of FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries, and APB Opinion No. 16, Business Combinations, to Physician Practice Management Entities and Certain Other Management Entities with Similar Circumstances and Arrangements." Issue 96-16 -- veto rights -- was an opportunity to resolve a fundamental question and improve practice: when, and if so how, do rights granted to minority shareholders by a majority shareholder affect consolidation of the subsidiary by the majority shareholder? However, Issue 96-16 does not establish a model for determining when control does exist and consolidation is required; 96-16 establishes a model for determining when the presumption that control exists has been overcome. Recently, the EITF agenda committee received a request to consider whether or how the 96-16 model could be applied in circumstances in which less than a majority ownership of voting stock exists, such as in a joint venture or partnership. However, for an investee that is not majority owned there is generally no presumption of control and therefore no presumption of consolidation. In those circumstances, the more appropriate question would seem to be "When is consolidation required for an ownership interest of less than 50 percent?" Once that model has been established, the question addressed by Issue 96-16 may be appropriate. That is, when does the presence of veto rights overcome the presumption of consolidation? EITF Issue 97-2 provides an answer to the first question -- when is consolidation required for less than 50% ownership interest -- in the context of one set of circumstances. The consensus specifies conditions that require consolidation in the absence of majority voting ownership interests, and explains why consolidation would not be appropriate absent those conditions. In addition, Issue 97-2 addresses the second question as to whether the consolidation conclusion would change if the physicians are granted any veto rights. Although Issue 97-2 addresses only physician practice management entities, the SEC Observer has indicated that the conclusions reached in Issue 97-2 as to control, consolidation, and business combination may be applicable to similar arrangements in other industries and that the SEC staff will consider this guidance when assessing the appropriate accounting for those arrangements. Similar arrangements could include those circumstances where one entity had a controlling financial interest in another entity through either a nominee structure or other contractual arrangement. Some examples of similar arrangements identified by the Task Force to which this consensus might apply include R&D arrangements, franchise arrangements, hotel management contracts and service corporations for REITs. These arrangements may involve the transfer of significant rights from the legal owners of an entity to another via contract. Since these structures appear to be similar to those contemplated in Issue 97-2, it may be appropriate to assess whether to consolidate these entities. RULEMAKING In terms of the projects that I inherited from Steve Swad, the market risk disclosure release is a clear winner -- significantly because it's one that is done. Thank you very much Steve. The SEC's Market Risk Disclosure Release (the "Release") is an example of the rulemaking activities the SEC and OCA undertake to supplement private-sector accounting standards. The Release was issued in January 1997, and was designed to provide additional information about market risk sensitive instruments, which investors can use to better understand and evaluate the market risk exposures of a registrant. I won't repeat the detailed requirements of the release; those details were communicated last year at this conference and are available from the Release itself. However, there are two on-going activities that may affect the Release that I would like to share with you. The first is that the staff has been and will continue to review disclosures made by registrants under the new Release. Later this morning, Walter Teets will provide additional detail on preliminary findings from the review to date. Second, the FASB is nearing completion of its standard on hedging and derivatives. As a result, the staff has been receiving frequent inquiries about the impact of that standard on the policy disclosures specified in the Release. Review The Commission indicated in the release adopting the Market Risk Disclosure requirements that these disclosure requirements will be reviewed three years after adoption. As part of that review, we plan to evaluate the disclosures received from the first group of filers and to discuss with various interested market participants the impact and effectiveness of the Release requirements. This disclosure is widely recognized as revolutionary in the sense that it is the first time the Commission has required registrants to disclose a quantitative measure of risk. It may take time for registrants to perfect their disclosures and for investors and analysts to become fully familiar with the new disclosures. Nonetheless, it is our expectation that after a little experience with the disclosures, they will be recognized as a useful tool for both investors and management. How the FASB's derivatives standard will affect the policy disclosure requirements The Commission stated in the Release adopting the market risk disclosure requirements that it will assess the need for all of the enhanced accounting policy disclosures after the FASB completes its standard on derivatives and hedging. Until the FASB completes its project we will not be in a position to identify the disclosure requirements included in the Release that will be outdated or superseded by the new derivatives standard. Some potential candidates for change, however, are obvious. For example, under current generally accepted accounting principles, there are several methods for accounting for derivatives: mark to market through earnings, mark to market and defer the amount until a future period, and accrual accounting. The Release requires registrants to disclose each method used to account for derivatives and the criteria that were met to qualify for the accounting method used. As currently envisioned in the FASB's project, all derivative financial instruments will be recognized and measured at fair value. In addition, there will be uniform requirements for special hedge accounting treatment. In its current form, the project reduces the accounting choices available, thus certain of the Commission's accounting policy disclosures may be unnecessary. Conclusion That concludes my prepared remarks. Thank you for your attention -- it's been a pleasure to be here with you today and I look forward to working with you in the future. _______________________________ [1] See paragraph 3(d) of APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock.