Arthur Levitt addresses "illusions".

Over the summer, the SEC quietly held a series of meetings with members of the FEI, FASB and Big Five firms, among others, prompted by recent accounting problems--many of them widely publicized--at companies such as Livent, Cendant and Sunbeam. Although at the time the SEC would not comment on what transpired, in a September 28 speech at the New York University Center of Law and Business, SEC Chairman Arthur Levitt made it very clear how he felt. In brief, the SEC expects the accounting profession to get out of the "gimmick" business.

This isn't the first time the SEC has traveled this road. Not long ago, Levitt's dissatisfaction with the state of auditor independence led to the creation of the Independence Standards Board to address the issue. No doubt the profession will be taking his new statement very seriously.

Earnings management--the party's over

Levitt blasted a process that has become "a game of nods and winks" among corporate managers, auditors and analysts. Continued Levitt, "In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation.... Integrity may be losing out to illusion." While reiterating his pride in the strength of U.S. capital markets, Levitt stressed that continued good fortune depended on clear, unambiguous financial statements. "If a company fails to provide meaningful disclosure to investors about where it has been, where it is and where it is going, a damaging pattern ensues. The bond between shareholders and the company is shaken ... the trust that is the bedrock of our capital markets is severely tested."

Under a category titled "hocus-pocus," Levitt discussed five key illusions he felt were poisoning the financial reporting process.

"Big bath" charges. Companies may overstate one-time charges associated with restructuring. Such charges help companies clean up their balance sheet--"a big bath." The theory is that Wall Street will ignore a one-time loss and focus on future earnings. Levitt agrees that financial reporting needs to reflect restructuring charges. "But this should not lead to flushing all the associated costs--and maybe a little extra--through the financial statements."

Creative acquisition accounting. Levitt criticized a process he called "merger magic" that occurs when some business acquirers use stock as an acquisition currency. "They classify an ever-growing portion of the acquisition price as `in-process' research and development, so--you guessed it--the amount can be written off in a one-time charge--removing any future earnings drag."

Miscellaneous cookie-jar reserves. Some companies use unrealistic assumptions to estimate liabilities for sales returns, loan losses or warranty costs, for example. "In doing so, they stash accruals in cookie jars during the good times and reach into them when needed in the bad times." Levitt discussed one company that took a large one-time loss to earnings to reimburse franchisees for equipment which had yet to be bought. At the same time, the company announced future earnings would grow by 15% a year.

Materiality. Levitt agreed that some items may be so insignificant they are not worth measuring precisely. "But some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling." According to Levitt, the companies then say the effect on the bottom line is too small to matter. "If that's the case, why do they work so hard to create these errors? Maybe because the effect can matter.... "Missing an earnings projection by a penny, for example, can result in a loss of millions in market capitalization, he pointed out.

Revenue recognition. "Think about a bottle of fine wine," said Levitt. "You wouldn't pop the cork on that bottle before it was ready." However, he said some companies were essentially doing that, recognizing revenue before the sale was complete when the customer still had the option to void or delay the sale.

Call to action

Levitt did not just point out the problems--he outlined solutions. He asked that regulators and standard setters improve the transparency of financial statements and called for nothing less than a "fundamental cultural change on the part of corporate management as well as the whole financial community." Specifically, he introduced a nine-point plan:

* The SEC staff will require well-detailed disclosures about the impact of changes in accounting assumptions. Companies should include a supplement to the financial statement showing beginning and ending balances, for example.

* Through the AICPA, the SEC will challenge the accounting profession to clarify rules for auditing of purchased research and development. The AICPA also should increase guidance on restructurings, large acquisition write-offs and revenue recognition.

* The concept of materiality will no longer be an excuse for deliberate misstatement of performance. Levitt brought up a Fortune 500 company that used a materiality ceiling of 6% of earnings to justify an accounting error. "Materiality is not a `bright-line' cutoff of 3% or 5%. It requires consideration of all relevant factors that could impact an investor's decision."

* SEC staff will immediately consider interpretive guidance on revenue recognition. It will look at software revenue-recognition standards to see if that guidance is applicable to other industries. (See "Recognize the Software, Recognize the Pitfalls," JofA, May98, page 17, and "Software Revenue Recognition Updated" JofA, Nov.97, page 16, for details on recent changes in this area.)

* Standard setters will have to take quick action where current standards are inadequate. The FASB should promptly resolve key projects in process.

* SEC review and enforcement teams will assist in this effort by focusing on companies with red flags that indicate they are managing earnings. Included will be companies with restructuring liability reserves and major write-offs, for example.

* Auditors must rededicate themselves to the reliability of the financial reporting process. "The integrity of that information must take priority over a desire for cost efficiencies.... "Junior auditors must have proper supervision, and corporate audit committees must take responsibility on behalf of their companies.

* The New York Stock Exchange and the National Association of Securities Dealers are sponsoring a blue-ribbon panel to recommend changes for audit committees and "function as the ultimate guardian of investor interests and corporate accountability."

* Corporate management and Wall Street must re-examine the current environment. "While the temptations are great, and the pressures strong, illusions in numbers are only that--ephemeral, and ultimately self-destructive. To Wall Street, I say, look beyond the latest quarter. Punish those who rely on deception, rather than the practice of openness and transparency."

The view from the Institute ...

In a press release dated the same day as Levitt's speech, the AICPA threw itself behind the chairman. "We share Chairman Levitt's commitment to investor protection and will continue to ensure that auditors fulfill their responsibilities." The Institute announced several new initiatives to support the SEC's thrust:

* The Institute is issuing a new publication--a toolkit--containing comprehensive guidance to help all involved in the financial reporting process understand the importance of accurate revenue recognition. It will reinforce best practices and summarize current standards.

* The ASB will examine the audit risk model to see if it needs updating. In fact, the ASB has already moved in that direction with its report, Horizons for the Auditing Standards Board: Strategic Initiatives Toward the Twenty-First Century. (See "New Dawn for Auditing," JofA, May98, page 23, for details on this report.)

* The AICPA will prepare a periodic publication for audit committee members to keep them up to date in accounting, financial disclosure, corporate governance and market regulation.

Much of the AICPA's recent focus has been on expanding the CPA's role into consulting services and assurance services that focus on nonfinancial issues. However, the Institute statement concluded with a renewed commitment to the audit, the most traditional of a CPA's services. "For the past century, the AICPA has provided guidance, standards and tools to assist auditors in that trusted role. We will continue to demand that auditors fulfill their responsibilities. To that end, we support recommendations that will have as their result the protection of investors."

... and others

The profession has not responded widely yet. However, a spokesman for KPMG Peat Marwick said the firm has always been in favor of any movement aimed at strengthening the vitality of U.S. capital markets.

Also, the Journal spoke with John P. McAllister, CPA, PhD, chairman and professor of accounting at the Michael J. Coles College of Business, Kennesaw State University, who did not seem surprised at some of the issues Levitt brought up. "Just look at the sheer size of the purchased R&D being written off--there's definitely a problem." He brought up the WorldCom/MCI merger as an example. McAllister pointed out that, in this $37 billion deal, $7 billion was initially to be written off as purchased R&D. After discussions with the SEC, the amount was reduced to $3.1 billion--a good indication that the SEC is serious about making changes. McAllister also said that in the same deal $26 billion was allocated to goodwill. If this were added to the initial purchased R&D amount, the total would be close to 90% of the purchase price. He said, "Our accounting model dealt well with the assets of the industrial age--land, buildings, equipment. It does not deal nearly so well with the assets critical to today's information-age companies."

The complete text of the Levitt speech is available at www.sec.gov/news/speeches/spch220.txt. The AICPA press release is on its Web site, www.aicpa.org, under the Press Releases/News Alerts link.