Speech by SEC Staff:
Debits and Credits in the New Economy

Remarks by

Robert A. Bayless

Chief Accountant, Division of Corporation Finance
U.S. Securities & Exchange Commission

Meeting of the Silicon Valley Chapter of Financial Executives International
San Jose, California
September 18, 2001

Thank you for inviting me here to Silicon Valley and the heart of the New Economy. Let me remind you at the outset that the SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Accordingly, these remarks are solely my own views, and they do not necessarily reflect the views of anyone else at the Commission.

Whatever view an individual Commissioner or SEC staff member may have about any subject involving the securities markets, it is unlikely that the view was developed without considering its impact on and relationship with the so-called New Economy. People may be quick to point out these days that the New Economy is subject to the same laws of gravity as the old economy. But the New Economy is different from the old economy in many far-reaching ways. And the New Economy is here to stay. Regulators and accounting standard setters are increasingly aware of the financial reporting challenges presented by the New Economy and the new technologies that emanate from it.

I can't forecast how financial accounting will respond to those challenges, but I suspect that it will cast its light over an area wider than today's debits and credits. For example, the Financial Accounting Standards Board recently issued a request for comment on whether it should add to its rule-making agenda major projects to address disclosure about intangibles and common financial performance measures. Many other private organizations and academics have initiated inquiries into similar subjects that inevitably spill outside the traditional financial reporting model.

But radical changes in financial reporting, if they come at all, may be several years away. In the interim, you and I can only continue to work with the existing framework, shifting here and adjusting there, to make it work for complex transactions and business structures that didn't even exist 15 years ago, and for tomorrow's transactions and designs that are incubating today.

As you heard in my introduction, I'm with the Commission's Division of Corporation Finance. We oversee the disclosure in registration statements and periodic reports filed by public companies. Like you, we try to interpret and apply the accounting rules in real time. We share with you the goal of describing to investors the special dynamics, opportunities and risks of each unique company. We understand the challenge of communicating clearly and simply things that are complex or novel, using the financial reporting language that exists today.

With about 100 accountants and 200 lawyers, the Division works hard to carry out its missions of protecting investors and maintaining transparency. But we are outnumbered by the 14,000 or so public companies. That number includes both New Economy and old economy companies that are struggling to explain simply and clearly how their own particular assortment of diverse, global businesses affect consolidated performance and liquidity. And that number includes more than 1,300 foreign private issuers, representing 59 countries, struggling to translate their home country accounting and disclosure practices into information accessible to US investors.

Every year, the Division tries to review all initial registration statements, along with a significant sample of the annual reports. In the government's fiscal year ended September 30, 2000, the staff reviewed over 2,300 initial registrations, and over 1,100 annual reports. This year, with fewer IPO filings, more of our resources are focused on the annual and quarterly reports of public companies.

The purpose of a Division review is to assess compliance with the Commission's disclosure rules, including compliance with GAAP. The staff issues letters that comment on the registrant's filing. The letter may recommend new or clarifying disclosure, or it may request supplemental explanation about a transaction or an accounting method. If controversial issues arise, several letters may be exchanged, and there may be several telephone calls or meetings to sort through the facts and applicable accounting literature.

In conducting our reviews, we recognize that each company's filing is its own experiment in disclosure. Generally, the Division permits, and even encourages, experimentation that is supplemental to the existing disclosure and accounting framework. At the same time, the Division has a duty to ensure that generally accepted or legally prescribed disclosure is not supplanted or buried by unfamiliar and undefined performance measures or other disclosure experiments. Our goal is to maintain balance, accuracy, and some degree of comparability in the disclosure provided by public companies.

This year, much of our focus has been on MD&A and Description of Business. Companies, whether they represent the "new" or the "old" economy, have a special need to write these narrative sections in plain English that investors can understand. Registrants can do without the jargon, the buzz-words, and the metaphysics. Given the current economic uncertainties, investors want answers to some old-fashioned, fundamental questions: What is the business today, and how did it perform this year? Where is the cash, and where are the profits? What drives the value of the company, what risks affect its businesses, and how flexibly can the company respond to change?

We think registrants can best answer these questions if they start with good disclosure responsive to FASB Statement No. 131 about operating segments and major lines of products and services, and then build upon that framework to discuss the important risks affecting those businesses. Because Regulation S-K Items 101 (Description of Business) and 303 (MD&A) build upon segment disclosures, a registrant's comprehensive identification of operating segments and product and service lines is a critical part of every SEC filing.

The staff also has focused on the Statement 131 disclosures because, frankly, we are concerned that too many companies have not responded adequately to Statement 131's mandate to present separately financial information for those business components that are regularly reviewed by the chief operating decision maker. It's difficult to believe that chief operating decision makers review as little disaggregated information as some company's segment disclosure would have us believe.

Another area drawing the staff's attention is disclosure about credit risk exposures. Technology companies may have a particular need to consider carefully what disclosures about credit risk will be material to investors. Some companies stimulated sales by granting long-term or below-market financing to customers, and some of those customers may not be in good financial condition this year. Footnotes to financial statements must include quantitative disclosures about credit risk concentrations as required by GAAP, while MD&A should explain how changes in credit risk affected or may affect operating results and liquidity.

Who are the registrant's counterparties giving rise to credit risk? Are there concentrations of credit risk exposures with respect to individual parties, industry groups, geographical areas, income classes or other counterparty groups? Have there been recent changes in the environment, or in the company's credit terms, customer profile, or policies or procedures, that may affect loss experience? In the past, you probably represented that the fair value of those receivables approximated their carrying value. Perhaps you should test that assertion again.

In current market conditions, you probably need to evaluate whether other financial assets are impaired as well. Statement No. 115 and Staff Accounting Bulletin No. 59 require a loss to be recognized in income due to an "other-than-temporary" decline in the value of a debt or equity security classified as available-for-sale or accounted for at cost. Stock you received from your customers and recognized as revenue two years ago could well be investment loss expense by now.

Of course, some non-financial assets, perhaps even your most valuable asset, may have suffered rapid deterioration in recent months that is not apparent in your financial statements. I'm speaking here of intangible assets. Despite the importance that management and investors appropriately place on unrecognized intangible assets, filings by public companies generally lack meaningful and useful disclosures about those assets.

We believe the requirements of Regulation S-K's Description of Business and MD&A should elicit better disclosure about intangibles than we are getting. Regulation S-K disclosure rules are not bound by the recognition and measurement rules of generally accepted accounting principles. If intangible assets are important to the business, registrants should identify them and explain what management does to develop, protect and exploit them. Operational, non-financial, measures can be very effective in explaining to investors the importance of a company's intangibles. And these measures can help investors anticipate changes in the contribution that those intangibles make to operating results.

The Division's reviews of filings are nothing like an audit or an investigation, because they are based almost entirely on a reading of the registrant's public filings with the Commission. The staff focuses on disclosures in response to Description of Business and MD&A, and in notes to financial statements, because we generally presume that the amounts reported on the face of the financial statements are correct. We expect that deficiencies or confusing disclosure can be corrected with additional disclosure or clarification. But sometimes, comments about disclosure lead to much more contentious issues involving financial statement measurements. Division reviews of initial registration statements result not infrequently in changes to financial statements before the registration statement is declared effective. Also, every year, a surprising number of public companies restate financial statements previously published in their annual or quarterly reports as a result of issues surfaced in staff reviews.

Based on our extensive research, we have found that there are two basic areas of accounting where problems arise in filings by public companies. One area is the debits, and the other area is the credits! But it is the credits - that is, revenues - that have received particular attention recently.

Whether you survey the Commission's enforcement cases or you look at the larger universe of financial statements restated by public companies, problems with revenue recognition turn up as the number one issue. That's why the Commission's staff pulled together for publication as Staff Accounting Bulletin No. 101 a broad range of accounting guidance applicable to revenue recognition.

A staff bulletin is not a rule. The Commission doesn't issue or approve a SAB. A SAB is informal guidance issued by the staff describing how we believe public companies should address particular accounting and disclosure issues based on existing accounting guidance. SABs don't change generally accepted accounting principles. But SABs may result in changes to the accounting practices observed by a few, or even many, public companies. That is because SABs fill in some of the gaps in GAAP with interpretive advice. Where diversity in practice, or conflicting or silent literature, cause confusion in financial reporting, the staff will identify what it believes to be the best practice or most valid interpretation that public companies should follow.

SAB 101 is an example of this. SAB 101 doesn't affect the accounting for revenues from computer software, long-term construction contracts, real estate sales, or the array of other activities addressed by specific authoritative literature. But, the SAB did try to address some other ordinary and recurring revenue-generating activities that were being accounted for in different ways by different companies. SAB 101 provides guidance intended to narrow practices to a single preferred approach where several interpretations may have existed before.

SAB 101 distills from the accounting literature four essential criteria that should be met before product revenue can be recognized. The SAB, and a supplemental Q&A also published by the staff, offer guidance for a number of transactions based on those four requirements. Let me remind you what they are:

• persuasive evidence of an arrangement exists;

• delivery has occurred or services have been rendered;

• the seller's price to the buyer is fixed or determinable; and

• collectibility is reasonably assured.

You wouldn't think there would be much controversy about those criteria, would you?

In some cases, a breach of these basic tenets is widely recognized as wrong and venal. Those situations typically become the subject of an enforcement investigation leading to a Commission order and the finding of a violation of securities laws. Some issues are perennial subjects for enforcement cases: The goods are parked in a warehouse, rather than delivered to a customer. A side agreement allows the customer not to pay unless and until he can resell the goods. The contract, purchase order, or delivery ticket is forged. The books were held open so that a few more sales could be included in the year's revenues.

Other departures from the basic tenets are less apparent. Surely, all of us agree that product delivery must be demonstrated by the customer taking title and assuming the risks and rewards of ownership. The classic textbook example is the different treatment given to sales fob shipping dock, compared to sales fob destination. But some public companies and accounting firms expressed dismay, and then revised the financial statements, because SAB 101 reminded everyone that sales fob destination can't be recognized as revenue before delivery to the destination. The staff is continually surprised by similar discoveries of accounting practices, often never disclosed in notes to financial statements, that have drifted away from the basic tenets of revenue recognition.

Even accounting professors add to the confusion. Many accounting textbooks teach that layaway sales should be accounted for using an installment sales method that recognizes revenue on a pro rata basis - before there is delivery to the customer or transfer of title. But let's face it. Layaway is just another bill-and-hold arrangement. The SAB reminds public companies that just about every bill-and-hold arrangement you can think of doesn't meet the basic criteria for revenue recognition.

The SAB also emphasizes that you haven't delivered until you deliver what you contracted to deliver. In other words, a seller must substantially fulfill all the terms specified in the sales agreement.

• So, if I agreed to deliver a complete computer system, but I've got no CPUs in stock, may I at least recognize some revenue if I deliver the monitor and the printer on the last day of the reporting period?

• What if my contract provides that I will deliver and assemble the computer? May I recognize all the revenue when I drop the unassembled computer off at your house on last day of the reporting period? After all, I'll assemble it next month and I'll accrue a liability now for the cost of labor to do that. Hasn't substantial performance occurred?

• And what if my contract says the sale is contingent on customer acceptance. If title doesn't transfer legally until customer acceptance occurs, can I recognize the sale of the computer anyway as long as I also have an appropriate allowance for estimated customer returns? Should customer acceptance provisions be treated different from, or the same as, more customary rights of return?

Accounting and auditing textbooks don't address these questions, but you and I know that these are a real life issues. SAB 101 offers guidance about these kinds of questions.

SAB 101 also discussed revenue recognition for nonrefundable payments. Companies that have high selling costs or high set-up costs often charge a large upfront fee. For example, many health clubs pay large commissions to the salespeople who get you to sign their 5-year membership contract. These clubs typically require a large nonrefundable initial membership fee at the beginning of the contract, along with smaller monthly payments throughout the membership term. Similarly, some companies offering access to a data base may require a large upfront fee, in addition to monthly fees, because the company will incur most of its costs setting up your access to the data base.

Of course not all companies in these industries demand a large initial payment. Companies with strong balance sheets may price their services at a lower initial fee, but a higher monthly fee. Typically, the present values of the aggregate fees charged by companies over the contract term are similar. But, before SAB 101, some companies thought that revenue recognition should be driven by the timing of the customer's payment.

We found that when one company in an industry pumped up its revenue with big front-end fees, all its competitors had to follow to keep shareholders happy. But investors attracted to companies reporting big profits from immediate recognition of the large upfront fees often found, when new customer sign-ups slowed, that they were stuck with the shares of an uncompetitive company with a poor profit margin on operations. Maybe that explains why, just when you assumed your health club was rolling in cash because it had so many members you couldn't get close to the equipment, the health club went bankrupt!

So SAB 101 says that even if the cash is in your pocket and you will never have to give it back, it's not revenue for accounting purposes until the earnings process is complete. The earnings process isn't selling memberships, and it isn't setting up the data base or installing a customer's connection to the data base. The earnings process is keeping the health club open during the membership period, and keeping the data base accessible to subscribers throughout the contract term. In these arrangements, the upfront payments shouldn't be recognized as revenue, because the contract deliverable of value to the customer is a service to be delivered in the future, over a period of time.

Another area addressed by the SAB is the sale of services where the customer can obtain a refund of its payment even after the service has been satisfactorily delivered. Sales of products with the right of return are governed by FASB Statement No. 48. Statement 48 requires estimating product returns at the point of sale and subtracting the revenues and costs attributed to the expected returns. But Statement 48 says it doesn't apply to services. So what accounting should we apply to services?

For example, a few years ago I paid $36 for a one-year contract with a company that gave advice by telephone for home computer problems. The contract said the fee was guaranteed fully refundable for any reason within one year. I used the service a few times, and it wasn't too bad. But I didn't think it was worth renewing. I was rotten enough to cancel my contract in the 11^th month and get my $36 back. Of course, I didn't return any of the advice I had received. Should that company have been recognizing $3 a month as revenue, or should it have waited to see whether I cancelled?

As a general principle, SAB 101 advises that amounts received should be accounted for as deposits until the customer's right to refund is extinguished. But that is clearly not what companies have been doing. So, the staff indicated that it would not object to analogies to Statement 48 in limited circumstances that are outlined in the bulletin. Subject to those strict conditions, registrants may recognize revenue on large pools of homogeneous contracts, adjusted for estimated refunds, as services are performed. Where those conditions are not met, payments should be accounted for as liabilities until they are no longer refundable upon demand.

There are a surprising number of controversial accounting issues that emerged from the recent dot.com era have no effect on net income or equity. Instead, they involve classifications within the balance sheet and income statement. With no profit to report, revenues and gross margins became critical to investors in the New Economy for their assessment of the feasibility of the company's business plan. Because net income was unaffected, it seems that some auditors must have only shrugged when their client dreamed up funny accounting tricks that blew up revenues and costs equally, or that classified direct product costs as if they were marketing or administrative expenses, or that classified non-operating income as revenue.

Investor interest in proper and consistent classification means that the SEC staff is interested, too. Registrants should comply strictly with Regulation S-X in the form and content of financial statements, and should look to recent conclusions of the EITF on these issues.

For example, EITF 99-19 identifies factors that should lead a company to report as revenues only the net amount retained in a transaction, rather than the gross amount billed to the customer, because the company is acting as an agent or broker, rather than a principal. While the legal questions of whether the company takes title and is obligated to the customer for performance are important, they are not necessarily determinative. For example, if the amount the company earns is always a fixed amount per transaction, or a stated percentage of billings, net presentation is likely to be required.

Some issues not discussed directly in SAB 101 should be considered as well. The EITF addressed in Issue Nos. 00-14 and 00-25 the accounting for discounts, rebates, premiums and other consideration granted to customers, and is presently working on consolidating all of its answers into a single consistently framed consensus. I won't go into the details of those debates, but it is worth standing back and recognizing what the big issue is. Companies are expected to sell goods and services and receive monetary consideration in return. But if a company gives "extra" consideration to its customers, something special is happening and special accounting and auditing issues must be considered.

Consideration given to customers may be in the form of cash, coupons for discounts or rebates, separate goods or services (or "premiums"), or equity securities or other financial instruments. Three basic guidelines are worth remembering in these situations. First, the value of discounts and rebates given to a customer or end-customer should be accounted for as a reduction of the revenue reported on the sale of goods and services to that customer. Second, premiums and financial instruments given to customers and end-customers may require separate accounting for the portion of transaction proceeds and the costs attributable to the premium or financial instrument. You may have created a multiple-element arrangement with the customer, requiring that the four criteria of revenue recognition be considered separately for each element. And finally, if you give your customer your own equity securities, the transaction proceeds attributable to the equity securities is not revenue, it's capital.

Let me wrap up my remarks at this point so that I can respond to your questions. But before I do, I want to mention that we greatly appreciate the comments and suggestions of Financial Executives International whenever the Commission or the FASB proposes new rules that affect FEI's membership. The Commission will only understand how proposed rules may affect investors, registrants, underwriters, brokers, accountants or financial analysts if the members of these groups take the time to tell us what works, what doesn't work, and, very importantly, why. If all of us maintain that dialog, our securities markets will continue to be the greatest, safest, fairest, and most efficient capital markets in the world.