So You Think You Know the SEC ...

The last year since I left the Securities and Exchange Commission has been a real eye-opener for me in lots of ways.

Among the surprises that I’ve encountered are a number of widely held beliefs about the SEC staff that are simply incorrect. This has been reinforced during the past few months, as I’ve read the preliminary papers published by the subcommittees of the SEC Advisory Committee on Improvements to Financial Reporting (CiFIR), conversed with others at the American Institute of Certified Public Accountants’ SEC and PCAOB Developments Conference, and worked on issues with my clients.

So in the name of improving relationships between Compliance Week readers and the SEC, I present five things you probably believe about the SEC staff that are incorrect. Just to be clear, each of the next five headings is not true, despite popular belief.

The SEC Staff Dislikes All Pro Forma Numbers

Clients often tell me that their Management Discussion and Analysis in their 10-K reports has been less effective in the last few years, because they can no longer include pro forma numbers. When I ask who won’t allow them to present those numbers, I usually get knowing stares or noises of exasperation in return. I’ve learned that those responses mean “The SEC, you dolt!” But, that’s wrong.

The SEC staff will object to pro forma presentations that are used to shift attention away from something the company doesn’t like, or simply to make the company’s financial position and results of operations look better than they actually were. Of course, those are the kinds of abuses that led Congress to mandate new rules regarding pro forma measures in the Sarbanes-Oxley Act. So if your goal in using some measure out of step with Generally Accepted Accounting Principles is to divert attention from the GAAP numbers, because the GAAP numbers are unflattering, uncontrollable, volatile, or whatever, then the SEC will (rightly) object. The SEC’s rules prohibit certain kinds of non-GAAP measures that are thought to have these characteristics.

But neither the SEC’s rules nor the Sarbanes-Oxley Act prohibit non-GAAP measures entirely, and that was by design. The SEC has nothing against the use of pro forma figures that provide more insight into how a company works and how economic events affect the company in different ways. As the SEC noted in a 2001 release: “‘Pro forma’ financial information can serve useful purposes. Public companies may quite appropriately wish to focus investors’ attention on critical components of quarterly or annual financial results to provide a meaningful comparison to results for the same period of prior years or to emphasize the results of core operations. To a large extent, this has been the intended function of disclosures in a company’s Management’s Discussion and Analysis section of its reports.”

The intent of the SEC’s rules is to ensure non-GAAP measures aren’t used in a misleading way, and to ensure that when they are used, they include sufficient information so that investors can understand what additional insight is provided. The rules require that any non-GAAP measure be accompanied by disclosure that explains what the company uses the measure for and what information that measure conveys about the company. I’ve generally found that writing these disclosures is fairly easy for non-GAAP measures meant to provide insight and rather difficult for presentations meant to confuse or misdirect.

So if you have a pro forma presentation that provides added insight, go ahead and include it in your filing, and explain why you consider it so useful. Don’t exclude it simply because you want to avoid the possibility of SEC staff objection, or because your attorney tells you that excluding it is just safer. The purpose of financial reporting is to communicate with investors, and providing them with insightful pro forma measures can be a big part of that.

Creating GAAP via SEC Comments

Over the years, I have heard countless referrals to “speech GAAP,” usually from people who are unhappy with the SEC staff’s view on something. Robert Pozen, chairman of the SEC’s financial reporting committee, recently described it as something that needs to be stopped. It seems to be generally accepted that the SEC staff expects that issuers will “comply” with staff speeches or letters to industry in the same the way they would comply with GAAP. Again, this isn’t correct—or, at least, it isn’t entirely correct.

When a member of the SEC staff publicly discloses a view about a particular subject and describes certain accounting as either required or prohibited, it is because the staff member believes GAAP already requires or prohibits the accounting discussed. The speech is not meant to establish a new requirement, but to describe one that the SEC staff believes already exists. Some readers may think this is a distinction without a difference, but I think this understanding can help issuers in dealing with the SEC.

Part of the reason that so many view the SEC staff as creating GAAP is that comment letters all too often cite a speech or a staff letter as the sole reason for mandating or rejecting a particular accounting method. That shouldn’t happen. Instead, the comment letter should refer to the underlying GAAP literature on which the speech was based, and highlight the speech as an illustration of how the literature should be applied. But the speech itself isn’t enough, and never should be asserted to be enough, to require a particular accounting treatment. The particular accounting in question is either in accordance with GAAP (excluding the speech) or not.

Another part of the reason for this misconception is that issuers, frankly, don’t like to admit they misapplied GAAP. So if the SEC staff has made recent comments about an issue, it is easier to blame the restatement on SEC staff comments rather than admit an accounting error. For example, the spate of lease restatements in 2005 is often blamed on a letter from the SEC’s then-chief accountant that has been characterized as changing the accounting for leases with uneven rents. A quick read of that letter would reveal that all it does is remind people that the correct accounting is clearly described in Paragraph 15 of Financial Accounting Statement No. 13, Accounting for Leases. Nonetheless, those who read the press releases come away believing the SEC staff changed the rules.

This does not mean that SEC staff speeches (or letters, or other expressions of views) regarding accounting can be ignored. It does mean that they should be viewed and read in context of the authoritative literature from which they derive. As Jim Kroeker, current SEC deputy chief accountant, said in a recent speech: “[T]he views of individual staff members … do not set GAAP. Certainly there will be remarks expressing the views of how existing GAAP may be relevant to a given set of facts. If this causes you to take a closer look at existing GAAP and rethink things, or confirms your view of how existing GAAP should be applied, then you have the right mindset. If, on the other hand, you hear a perspective on the accounting for a transaction and believe that we have failed to consider other reasonable conclusions, please come talk to us.”

All Large Errors Are Material

I’ve written about this before, but it bears repeating. Staff Accounting Bulletin No. 99 explains why small errors can nonetheless be material. Before SAB 99, it was becoming common for an issuer to book a non-GAAP entry purposely to improve the numbers and then claim the improper item’s size made it immaterial. SAB 99 stopped this practice by reminding issuers and auditors of qualitative factors that could cause small errors to nonetheless be material.

SAB 99 is silent on whether, and in what cases, a large error could be immaterial. That silence, combined with experiences in working with the SEC staff, have led many to conclude—again incorrectly—that the staff would never accept that a large error was immaterial. While at the SEC, I was involved with several situations where we agreed that a large error was immaterial. In both December 2006 and December 2007, Todd Hardiman, a member of the SEC staff, tried to communicate the staff’s openness on this issue. He wasn’t believed in 2006, but perhaps 2007 will bring a different result.

Remember that the absence of the factors cited in SAB 99 isn’t enough to make a large error immaterial, because those factors were designed to provide insight on when a small error might be material, not the other way around. Factors that might point out that a large error is immaterial are more likely to be specific to the situation in question, and so there isn’t a list of them to consult. But that doesn’t mean they don’t ever exist.

Asking a Question Is Asking for Trouble

My clients commonly have issues that present new and difficult questions about applying accounting principles. Sometimes, the question arises of whether to ask the SEC staff for their views—for example, when the issue presents new questions that are unusual or unique and the company is concerned about the risk of restatement. Or when the issue is similar to one that the SEC staff has addressed in the past and the company believes different accounting is warranted. I have been surprised at how often my clients have been advised against writing to the SEC staff. The explanations for this advice range from, “Waste of time, they’ll never accept your view” to “Ask about one thing, and they’ll just fish for problems elsewhere” to “You don’t want to be branded a troublemaker” to “The chance that they’ll find this if you don’t ask about this is small, so don’t worry about it.” All of this is bad advice.

Foremost, talking to the SEC in advance about an accounting issue might not change the odds that the SEC will agree with your accounting, but it does remove the possibility of restatement for that item. In addition, it allows the conversation to take place with less pressure on everybody, because neither the company nor the auditors are “at risk” for having blessed the accounting treatment in question. Further, it alerts the SEC staff to new issues and gives them a chance to consider them in a setting where they can thoroughly contemplate the issue. As an added bonus, if the issue is truly new and emerging, the SEC staff is more likely to believe it should be settled through the standards-setting process.

As for the downsides that my clients are so often warned about, these concerns are overblown. The SEC staff doesn’t have a “black list” for companies that take up too much of their time. On the contrary, the staff tends to think favorably of companies that are open about the issues they face and the judgments they make. Also, I have found that the SEC staff is more than willing to consider whether accounting they have accepted or required in the past for a particular fact pattern should be applied to similar fact patters. In the past few months, several clients have received favorable responses from the SEC staff in such situations. And as for the SEC staff fishing for issues once the company has opened the door: I can assure Compliance Week readers that the SEC staff is as overworked as anybody else, and they don’t make a habit of expanding the scope of inquiries.

One more reason to be open to discussing things with the SEC staff ahead of time is that whatever trouble might be caused by asking for the staff’s views pales in comparison to the trouble that will arise when the SEC staff asks about the issue during a review by the Division of Corporation Finance. By that time, you and your auditors are on the hook, and while the staff will only be considering what the best accounting is, you will be worried about liability, potential restatement costs, or other issues that can cloud the discussion and make resolution difficult.

If an SEC Comment Suggests You Restate, Just Do It

This is another one I’ve written about before, but I know it keeps happening, and I know that it bothers the SEC staff. Restatements sometimes occur because the company believes it is the quickest path through the comment process, rather than because the issuer actually agrees that it should change its accounting. This is always a bad idea.

Especially early in the review process, SEC comment letters are likely to be focused on gaining understanding of an issue, rather than communicating a conclusion about it. In some instances, the SEC staff doesn’t fully understand the issue. Other times, the company may not completely understand the SEC staff’s views.

Instead of rushing to restate before discussing the issue in full, it’s far better to provide a complete explanation of the facts and the accounting rationale the company used, and to get additional experts or senior SEC personnel involved. Not only will this avoid unnecessary restatements, it will also help ensure that the market only perceives an “SEC staff position” when, in fact, all of the appropriate members of the staff were involved in the issue.

Conclusion

Working with SEC staff is never going to be something that companies relish. But these and other misconceptions about the SEC staff make things more difficult than they need to be. Companies rightly object when the SEC staff seems to assume that company personnel are out to deceive or evade their disclosure responsibilities. Similarly, the SEC staff is troubled that so many believe they employ policies that amount to abuses of power. Give the SEC staff the benefit of the doubt in these areas, and you’ll likely be pleasantly surprised.