8 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS 1996 Twenty-Fourth Annual National Conference on Current SEC Developments Washington, DC December 10, 1996 DANGEROUS IDEAS Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission Washington, DC __________________________________ The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Sutton and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. “Dangerous Ideas” Introduction Good morning. It is a pleasure to be here with you again and to share some thoughts on accounting and financial reporting. Like most of you, I spent the Thanksgiving holidays with family, and to my good fortune, that included grandchildren. Having small children in our home again reminded us of the dangers all around when toddlers are on the scene. A living room that is perfectly safe in the hands of adults becomes a minefield of sharp-edged coffee tables, naked electric sockets, and windows and doors that open to unexpected perils. Certainly, some of our concern for safety reflects the natural anxiety of grandparents, but some of it is based on the knowledge and experience of past mishaps. When I returned to the office and again took up some of the difficult accounting issues we encounter, it occurred to me that in financial reporting we often encounter ideas -- or proposals -- that to many seem safe in normal day-to-day practice but that, on closer inspection, can pose perils to the credibility of financial reporting and to the interests of investors. In accounting, as in life, what can seem harmless in some circumstances can become hazardous in others. What I plan to do this morning is to explore a few of these “dangerous ideas” as they apply to the world of accounting. Those ideas are as follows: · The matching principle should shape the financial statements. · Intangible assets have indefinite lives. · Good disclosure can cure bad accounting. · Accounting drives business decisions. · Auditors have closed the expectation gap. Matching and Loss Deferrals One of the most common ideas that we encounter is that the matching principle should take precedence in shaping the financial statements. A corollary idea, and one also frequently advanced, is that current period losses can create assets. At first blush, those ideas can be understood. After all, why would a company incur a cost if a future benefit is not expected? A closer look, however, reveals that both of those notions, when and if implemented, have the potential to undermine the integrity of the balance sheet and, therefore, the credibility of a company’s financial reporting. It is hard for investors to understand why things like deferred advertising costs or customer acquisition costs or start-up costs represent assets. When a registrant adopts an accounting policy -- based on matching theory -- that results in the deferral of costs normally associated with ongoing operations, concerns about the quality of the asset created and, therefore, the quality of earnings follow. To appreciate some of the pitfalls associated with matching, let’s look for a minute at an industry where there are specialized accounting practices that rely heavily on that theory -- the public utility industry. Under Financial Accounting Standards Board Statement 71, which addresses the accounting for rate-regulated industries, many costs that would be expensed by non- regulated enterprises are capitalized and carried as “regulatory assets”. This practice -- described as reflecting “the economic effects of the rate-making process” 1-- is an elevation of the matching principle to recognize a specific circumstance in which current period costs can be attributed to future revenues and existing legislation provides a strong expectation of recovery of those costs. It is rare for a company other than a rate-regulated enterprise to have a similar level of assurance about recoverability of current period costs. Indeed, recent trends toward deregulation in the utility industry raise questions about whether companies that are currently rate regulated will be able to recover deferred costs that have long projected recovery periods. But outside of rate- regulated industries, there usually is no direct and traceable linkage between current period expenses and a specific future period revenue, even though it may be possible to associate, at least in part, current period activities with future revenues. Taking the “high road” and recognizing operating costs in income as they are incurred may be painful at first -- like starting a long run at the bottom of a hill -- but companies that select accounting policies that postpone recognizing expenses often lose credibility in their financial reporting. They frequently come under pressure to change and find that explaining why the new policy is preferable -- but that the old policy was acceptable too -- is a difficult task that can strain investor confidence. The reality of this credibility issue was illustrated recently when an analyst, describing a massive write-off of marketing expenses, commented, “The earnings numbers were meaningless -- they were a house of cards.”2 As basic as the deferred cost issue is, it is one that comes up often, and I encourage all of us to look with skepticism at proposals that elevate the matching idea to the point that it overrides the definition of an asset. Intangible Assets Let me turn to the suggestion that intangible assets have indefinite lives. As many of you know, the current International Accounting Standard for business combinations requires goodwill to be amortized over not more than 20 years.3 The International Accounting Standards Committee is now revisiting that standard as part of its core accounting standards project, and the debate has been contentious. In its deliberations, the IASC has moved away from the 20-year maximum life and has taken an approach that would establish no upper limit on the amortization period for intangible assets that are perceived to have indefinite useful lives. Instead, an ongoing impairment test would be required. The effect of such a standard would be to permit companies to not amortize some intangible assets. In my view, amortization is a necessary consequence of the decision to recognize intangibles as long-lived assets. Under our current accounting model, the initial cost of long- lived assets is allocated -- amortized -- over the estimated useful lives of those assets. That principle should be applied to intangible as well as tangible assets. Likewise, it seems that there should be some reasonable limit on the allocation period. Even assets that remain in use for many years -- even the most valuable brand names -- require significant ongoing support to maintain their value, and the distinction between value acquired and value created by subsequent ongoing maintenance blurs quickly. I doubt, for example, that it would be feasible to separate the value -- and the additional life -- created by current expenditures for advertising and other marketing activities from the value originally acquired when trying to decide whether the original cost of a brand name has been impaired. In recent times, we have seen a number of sudden and major goodwill write-offs, and those events have led to questions about the reliability of impairment accounting. In number of cases, despite assigned lives of 25 to 40 years -- the periods over which companies expected to receive superior returns from premium investments -- all of the goodwill was reported to be impaired and written off in a single quarter. The staff’s experiences have led me to question whether an impairment standard could be developed that would be an adequate substitute for systematic amortization. As you may recall, the “indefinite useful life with an impairment test” approach was the accounting model that preceded APB Opinion 16, and it didn’t work very well. The 40-year maximum amortization period required by Opinion 16 was established to assure that the cost of intangible assets would not be spread over extremely long periods, and practice has shown that even a 40-year limit may be too long. Certainly, this is not a new problem, and finding answers will not be easy. Still, I think we have to be careful to avoid repeating old mistakes. Disclosure vs. Accounting Another idea that can be hazardous to sound financial reporting is the suggestion that disclosure can cure bad accounting. Without question, good disclosure is an essential component of effective financial reporting. It’s the flesh on the bones of the balance sheet and income statement; its the words that make the numbers in the financial statements become three dimensional. But disclosures are, in point of fact, the modifiers of the accounting. Good disclosure doesn’t cure bad accounting any more than an adjective or adverb can be used without -- or in place of -- a noun or a verb. In Accounting Series Release 4,4 the Commission recognized the importance of this issue when it concluded that no amount of supplemental disclosure can justify the use of unacceptable accounting principles. Thus, for example, cash basis accounting for cost of goods sold would be viewed as misleading, even if accrual basis amounts were disclosed fully in the footnotes. While using cash basis accounting for cost of goods sold may be an extreme example, there have been a number of cases in which footnote disclosure has been urged as a remedy for something close to cash basis accounting. Remember, for example, that when the FASB proposed using accrual accounting for postretirement benefits, some urged that the pay-as-you-go approach be maintained and that footnote disclosures be improved. You will recall that in Statement 106, the Board concluded that disclosure is no substitute for recognition and that “the usefulness and integrity of financial statements are impaired by each omission of an element that qualifies for recognition.”5 I believe that, with hindsight, almost everyone now agrees with the Board’s decision in that project, and equally interesting, many managers have recognized that the information they obtained about their long-term obligations was of significant value in managing their businesses. Similarly, in Statement 12, the Board prescribed footnote disclosure of the market values of investments in marketable debt securities as a supplement to accounting based on amortized cost.6 Because of continuing concerns about the accounting for those instruments, the Board concluded in Statement 115 that the recognition of market values resulted in more relevant financial statements. Today, this same issue has been raised in the context of the Board’s derivatives and hedging project. Some have suggested that good disclosure, such as the quantitative disclosures in the Commission’s market risks disclosure proposal, would avoid the need to record and measure those instruments in the basic financial statements. Certainly, enhanced quantitative disclosures about market risk will provide important information for financial statement users. But those disclosures have different objectives than the Board’s project to improve the accounting for derivatives. I continue to believe that both improved accounting and improved disclosures are needed, and I encourage the Board to complete its deliberations as soon as practicable. Accounting and Business Decisions We often hear that business decisions are driven by accounting. This idea takes a variety of forms, including suggestions that, if a particular accounting treatment is not allowed, it will be impossible to consummate a particular transaction. Trying to develop accounting rules based on a prediction about how business decisions might be made may be the financial reporting equivalent of “the tail wagging the dog.” While, as accountants, we should be proud of the important role financial reporting plays in business and in our capital markets, we should remember that accounting is and should be a vehicle for effective communication. Accounting should report the facts in the most relevant and reliable way possible, and it should be unbiased. As an example, when the staff is engaged in discussions about the applicability of pooling of interests accounting or other forms of carry-over basis accounting, we often hear that the preferred accounting is critical to the marketability of the stock being sold and, thus, accepting that accounting would encourage capital formation. One submission pleaded that we should “rise above the technical merits” of the accounting analysis and not object to pooling of interests accounting so that the company’s shareholders could realize increased share values. Those arguments, however, have another side. What may be good for selling shareholders in a particular circumstance may not be good for the buying shareholders -- the new investors and shareholders on the other side of the transaction. In other words, a good price for the seller may be a bad price for a buyer. Each day, we, like you, encounter other requests to accept or encourage an accounting treatment that will not deter some form of business or capital market activity that is believed to be highly desirable. We should all see “red flags” flying when we are told that the accounting will make or break a deal -- or create or destroy a particular market. While accounting can be an important factor in some circumstances, we all should recognize that accounting that masks, or fails to capture, meaningful information for the benefit of all investors is not sound. We should all share the goal of enhancing the ability of accounting to express the story of an enterprise’s financial performance in a meaningful, accurate and consistent way. The “Expectation Gap” I will close with a periodically recurring idea -- a hopeful suggestion -- that, finally, auditors have closed the “expectation gap”. The term “expectation gap”, of course, was coined to characterize the difference -- sometimes very significant -- between what the “ordinary person” was thought to perceive an auditor’s role to be and the responsibilities that the profession established for itself. The bigger the difference, the wider the “expectation gap”. Auditors have spent years trying to narrow that gap. The most recent effort is a new auditing standard that specifically requires auditors to assess the risk of material misstatements in financial statements as the result of fraud. This new standard, for the first time, refers to fraud by name instead of by the more euphemistic term “irregularities” and describes over 40 fraud risk factors that the auditor is to consider in planning and performing the audit. Based on our discussions with representatives of the Auditing Standards Board and others, the new standard is expected to improve auditor performance by causing auditors to spend more time looking for and analyzing evidence of fraud as well as providing better documentation of that process. Auditing procedures are expected to be more detailed and deliberate, and auditors are expected to conduct more training for their personnel on how to search for and respond to indications of fraudulent financial reporting. In short, with the adoption of this standard, an auditor should not be able to skip lightly over the issue or to assert that it is not the objective of the audit to discover fraud that is material to the financial statements. But the new fraud standard can’t be expected to completely close the “expectation gap”. In some respects, the expectation gap is like an earthen dam -- it requires constant maintenance. As soon as you plug one hole, another seems to spring up. An expectation that has received considerable attention recently has to do with the auditor’s role in helping the board of directors assess the quality of a company’s financial reporting. One of the observations of the Public Oversight Board’s Advisory Panel on Auditor Independence, which emphasized this point, was that the board of directors “must expect, and the auditor must deliver, candid communication about the appropriateness, not just acceptability, of accounting principles and estimates and the clarity of the related disclosures....”7 As their report notes, current practice appears to focus on whether an accounting principle is “within the range of acceptable practice” rather than whether it is the best practice for the specific circumstances of the registrant. If this distance between “within the range” and “best practice” is not scrutinized, and if efforts are not made to reduce it, I fear that a new gap will develop -- this time a credibility gap. If companies select accounting policies that fall just within the letter of the accounting law, we cannot be surprised when financial reporting appears to fall short of investor expectations. The fact that there is a perceived need for auditor communications with boards of directors about the quality of reporting says a great deal about the complexities of today’s accounting and auditing world, and it says a great deal about the broadening of the corporate governance process. But, investors depend on the expertise and integrity of independent auditors to deal with those issues every day -- and to call problems to the attention of those responsible for policy and oversight. To continue to win the war of the expectation gap, auditors need to speak up -- not just when things are wrong, but also when things aren’t quite right -- to pose difficult questions about the quality of reporting, and to seek full and fair disclosure. Conclusion I will conclude by saying that, sometimes, the biggest challenge posed by “dangerous ideas” is recognizing them, especially when they are presented in a familiar environment and have seemingly worthwhile goals. I hope that, in the next two days, the presentations by our staff -- which inevitably focus on contentious and challenging issues -- will raise our level of awareness about those issues and better prepare all of us for the challenges that lie ahead. Thank you for your attention. _______________________________ 1 Financial Accounting Standards Board, “Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation,” 1982, Summary. 2 Sandberg, Jared, “America Online Plans $385 Million Charge,” Wall Street Journal, October 30, 1996, page A3. 3 International Accounting Standards Committee, “International Accounting Standards IAS 22 (revised 1993), Business Combinations,” paragraph 42. 4 U.S. Securities and Exchange Commission, “Accounting Series Release 4,” April 25, 1938. See Codification of Financial Reporting Policies, Section 101. 5 Financial Accounting Standards Board, “Statement of Financial Accounting Standards No. 106, Employers’ Accounting for Postretirement Benefits Other than Pensions,” 1990, paragraph 164. 6 Financial Accounting Standards Board, “Statement of Financial Accounting Standards No. 12, Accounting for Certain Marketable Securities,” 1975, paragraph 12. 7 Advisory Panel on Auditor Independence of the Public Oversight Board, “Strengthening the Professionalism of the Independent Auditor,” 1994, page 23.