SEC Comments Studied; Ethics Rules Fixed

The Securities and Exchange Commission is taking a keen interest in internal control effectiveness letters, improper use of non-GAAP measures, holes in MD&A, and the ways in which revenue is allocated from complex contracts.

Those are among 10 hot-button issues that prompted SEC remarks on corporate periodic filings, according to a recent analysis of SEC comments from an eight-month period of 2006. The research arm of Financial Executives International zeroed in on 513 comments arising from quarterly and year-end filings to get a sense for where SEC’s gaze most often fell.

Cheryl Graziano, vice president of research and operations for Financial Executives Research Foundation, says the study is meant to give a little more guidance about where regulators have focused their attention as they have reviewed companies’ regular period-ending filings. That may prove helpful to companies as they prepare their own disclosures, she says.

Graziano

“Many of the key areas identified in the report seem to be consistent with other information provided by the SEC,” says Graziano, such as the SEC’s own recent report on corporate financial reporting issues that it considers worthy of close attention.

Graziano, who co-authored the report, titled “Current Financial Reporting Trends: A Qualitative Review of SEC Comment Letters,” says the research doesn’t attempt to rank or quantify SEC comments. Instead, it highlights the recurring themes in SEC comments.

“Many of the comments were specific to a particular company’s facts and circumstances and covered more than one topic,” she says. The report includes specific examples of SEC comments and responses that companies can take into account as they prepare their own year-end and quarterly disclosures into 2007.

In revenue recognition—always a thorny subject for financial reporting executives—the report says the SEC commented repeatedly where it noticed companies did not adequately describe the nature of contracts with multiple elements or how they booked the revenue related to such contracts. In internal control effectiveness letters, the SEC frequently noted where companies omitted important elements or where regulators found inconsistencies between internal control letters, auditors’ letters, and other disclosures in SEC filings.

The report says the SEC frequently pointed out instances where companies included in their financial statements measures that did not adhere to generally accepted accounting principles, or where they failed to reconcile non-GAAP measures. The report also says the SEC often found holes in management discussion and analysis, such as inadequate explanation for changes in financial statements or specific accounting policies, inadequate discussion of specific operational issues, and missing items from the table of contractual obligations.

Other issues of interest to the SEC, based on FEI’s comment analysis, include disclosures surrounding operating segments and their consistency with other disclosures, derivatives, acquisitions, writedowns related to goodwill, and stock option accounting.

Separately, FEI’s research operation also produced a checklist for financial executives to summarize the key provisions of the Pension Protection Act of 2006. The checklist pays closest attention to issues like funding and disclosure that will have the greatest impact on the financial statement of single-employer defined-benefit and defined-contribution retirement plans, Graziano says.

The report also covers some of the most notable changes brought about by the new pension law, Graziano adds, but they are not addressed extensively because they are typically managed by other functional areas in the company.

AICPA, IFAC Issue New Ethics Pronouncements

The American Institute of Certified Public Accountants has finished its revisions to its ethics rules that address independence in delivering forensic accounting services and tax compliance services, but the group’s professional ethics division is still working on how to address revisions surrounding indemnification.

Lisa Snyder, director of the AICPA’s professional ethics division, says the draft revisions to ethics rules that focused on indemnification or limitations on liability generated “a lot of mixed comments.” The Professional Ethics Executive Committee will continue to cull the remarks and determine how the rules ultimately will read, she says.

The ethics committee issued a second draft in September outlining its views on factors that could compromise an auditor’s independence. In addition to addressing items that would compromise independence in tax and forensic services, the draft tackled the burning question of whether an auditor’s independence is compromised if the engagement gives the auditor some measure of indemnity from legal action.

The September draft said that certain types of indemnification and provisions limiting an auditing firm’s liability threaten the auditor’s independence, because they may give an auditor a false sense of security and encourage less thorough auditing. The proposal says the threat can be mitigated, however, if the provisions are contingent on the auditor adhering to professional audit standards.

Based on the new language addressing forensic and tax services, the ethics rules now hold that a forensic accountant would impair independence by acting as an expert witness on behalf of a client and that a tax accountant would impair independence by representing a client in a court proceeding.

Snyder says comments to the proposal ranged from “it’s a contractual agreement, so there’s no independence issue” to “all indemnification clauses should be considered impairment.”

In the committee’s original draft, the proposal held that an auditor’s independence would be impaired if it sought to limit or eliminate liability from a client’s negligence or its own, but not when problems arise from a client’s fraudulent behavior. Snyder said the committee changed that view based on the first round of comment letters and further task-force review.

Based on the new language addressing forensic and tax services, the ethics rules now hold that a forensic accountant would impair independence by acting as an expert witness on behalf of a client and that a tax accountant would impair independence by representing a client in a court proceeding. A tax accountant can still represent a client in an administrative proceeding before a tax authority, such as a hearing or an audit, but if the matter goes to court, the independence line would be crossed.

Separately, the International Federation of Accountants has issued an exposure draft that updates and strengthens the independence requirements contained in its code of ethics for professional accountants. The proposal would modify the ethics code to expand partner rotation requirements, update requirements related to non-assurance services, and extend independence requirements to audits of a wider range of entities.

Snyder says the AICPA and IFAC codes are “substantially consistent,” but based on somewhat different approaches to rulemaking. She says the AICPA’s ethics committee will review IFAC’s proposal to see if any updates to AICPA rules might be warranted.