Highlights of the 2005 AICPA National Conference on Current SEC and PCAOB Developments

Effective December 1, 2005, significant reforms were made to the rules that govern registered securities offerings under the Securities Act of 1933. Deputy Director Dunn spoke at length describing the changes and their expected impact.

The reforms can be summarized in five general categories: (1) communication prior to and during registration, (2) shelf offerings, (3) prospectus delivery, (4) changes to periodic reporting disclosures, and (5) liability.

One of the objectives of the reform is to provide registrants added flexibility in communication during the registration and offering process. The degree to which the rules have been relaxed varies with the size and reporting history of the company. Large, closely followed, and "seasoned" issuers are granted the greatest flexibility; initial public offerings are granted the least. The relaxed rules allow companies to:

1. Provide information to investors through "free writing prospectuses," allowing regulators to focus on the content of the communication, rather than the method (written or verbal) by which the information is delivered, and
2. Continue to provide the marketplace factual business and financial information during what was previously a quiet period prior to the filing of a registration statement.

The most notable of reforms to the shelf registration process is the creation of a new category of issuer, the "Well Known Seasoned Issuer." These are companies that are large, widely held, and have a public reporting history. This category of issuer can use a new automatic shelf registration; a short form filing that is immediately effective upon filing. This allows securities to be issued without the delay typically experienced between filing and effectiveness.

Physical delivery of the final prospectus is no longer required as long as it is readily accessible by investors.

Annual reports on Form 10-K now require:

1. Disclosure of risk factors (material changes in risk factors must be reported in the Form 10-Q);
2. The cover page of the Form 10-K to indicate whether the registrant is a well known seasoned issuer or a voluntary filer;
3. Well known seasoned issuers and accelerated filers to disclose unresolved material SEC comments that remain outstanding for more than 180 days as of fiscal year end.

The reforms also changed a number of the Securities Act liability provisions. These changes include the following:

1. Section 11 liability for underwriters and issuers in a shelf registration is now determined as of the date of the shelf takedown, rather than upon effectiveness of the registration statement. Section 11 liability for directors, officers who sign the registration statement, and "experts" continues to be determined at the registration statement effective date. If an expert provides a new report or opinion in an Exchange Act report or in connection with the takedown that would require a consent, however, there would be a new effective date for that expert.
2. The liability of security sellers for false and misleading statements (Section 12(a)(2)) is now based solely on information deemed to have been conveyed to the investor before or at the time of the security sale, rather than being based on information in the final prospectus.
3. Section 11 liability now applies to prospectus supplements.

For further reference see:

These can be found on the SEC's Web site at www.sec.gov.

Mr. Levine discussed proposed amendments to the accelerated filer definition and filing deadlines and indicated that the Commission would hold an open meeting to vote on these proposed amendments.

At its December 14, 2005, meeting, the SEC amended the definition of "accelerated filer" by creating a new category, "large accelerated filers," for companies that have an aggregate worldwide market value1 of $700 million or more and meet the other conditions in Exchange Act Rule 12b-2 that apply to accelerated filers (e.g., having previously filed at least one annual report). Accelerated filers other than large accelerated filers are those companies with an aggregate worldwide market value of at least $75 million but less than $700 million.

Also at the meeting, the SEC delayed by one additional year the final phase-in of Form 10-K filing deadlines for "large accelerated filers." Large accelerated filers will continue to be subject to the current 75-day deadline for Form 10-K for an additional year. Beginning with fiscal years ending on or after December 15, 2006, large accelerated filers will become subject to a 60-day deadline for Form 10-K.

Accelerated filers, other than large accelerated filers, will continue to be subject to the current 75-day deadline. The current Form 10-Q deadlines will be maintained for all filers. As such, the deadlines are as follows:

Additionally, the amendments will ease some of the current restrictions on the exit of companies from accelerated filer status. The final rule is available on the SEC's Web site, www.sec.gov.

In connection with the Sarbanes-Oxley Act, the Commission issued final rules in 2003 requiring disclosure about off-balance-sheet arrangements that management believes are reasonably likely to have a material effect on the registrant's financial position, results of operations, and cash flows. The rules include a definition of off-balance-sheet arrangements and require that the related disclosures be presented in a separately captioned section in MD&A.

The Sarbanes-Oxley Act also required the SEC to complete a study of filings by issuers to determine both (1) the extent of off-balance-sheet transactions, including assets, liabilities, leases, losses, and the use of special purpose entities; and (2) whether generally accepted accounting principles result in financial statements that reflect the economics of such off-balance-sheet transactions to investors in a transparent fashion.

The study was completed and submitted to the President of the United States and certain other components of the government in June 2005 (see Heads Up, June 23, 2005). For the study, the SEC staff analyzed data collected from the 2003 Form 10-K filings of a sample of 200 issuers, comprising the 100 largest issuers and 100 randomly selected issuers. At the Conference, Ms. Mincin presented a summary of the proportion of issuers that reported off-balance-sheet arrangements in MD&A:

Ms. Mincin observed that a significant portion of issuers did not have a separately captioned off-balance-sheet arrangement section in MD&A and, for those that did, the data was often incomplete. Specific examples of transactions that were included in other sections of Form 10-K filings but were omitted from the off-balance-sheet arrangement section in MD&A include:

• Equity-linked derivatives,
• Retained interests in securitized assets,
• Interests in variable interest entities, and
• Guarantees.

Ms. Mincin emphasized that disclosures of off-balance-sheet arrangements need to include information necessary for an understanding of the arrangement and its material effects, including:

• Nature and business purpose of the arrangement,
• Importance of the arrangement,
• Financial impact of the arrangement and exposure to risk as a result of the arrangement, and
• Known events, demands, commitments, trends or uncertainties that affect availability or benefit of the arrangement.

Ms. Mincin also suggested the following best practices for disclosure of off-balance-sheet arrangements:

• Include descriptions that specifically address the company's particular circumstances and operations,
• Include cross references that clearly identify specific information in the footnotes and integrate the substance of the footnotes into MD&A, and
• When there are no material transactions that meet the Regulation S-K definition of an off-balance-sheet arrangement, clearly disclose that fact.

Ms. Stokes reminded the audience that all registrants are required to evaluate the effectiveness of disclosure controls and procedures on a quarterly basis in accordance with Item 307 of Regulation S-K in connection with management's certification requirements under Section 302 of the Sarbanes-Oxley Act of 2002. Once a registrant has completed its first annual assessment of the effectiveness of its internal control over financial reporting (ICFR), it is also required to make disclosure on a quarterly basis of material changes in ICFR. The requirements related to management's annual assessment of ICFR are in Item 308 of Regulation S-K and apply to (1) accelerated filers with fiscal years ending on or after November 15, 2004; (2) foreign private issuers who are accelerated filers with fiscal years ending on or after July 15, 2006; and (3) non-accelerated filers (including small businesses) with fiscal years ending on or after July 15, 2007.

In each quarterly filing on Form 10-Q in Item 4, Controls and Procedures, management must clearly state its conclusion as to whether disclosure controls and procedures are either (1) "effective" or (2) "ineffective" as of the end of the respective quarter, without any qualifying or alternative language. The SEC will request that a company amend its filing if it includes qualifying or alternative language in its conclusion on the effectiveness of disclosure controls and procedures. Examples of unacceptable language include phrases such as "effective except for," "effective except as disclosed below," or "adequate."

If, during the quarter, a company has identified the existence of a material weakness in ICFR that is not remediated by the end of the quarter, the registrant should (1) disclose the existence of such material weakness and (2) describe the nature of the material weakness, the impact on financial reporting and the control environment, and management's remediation plan. Ms. Stokes indicated that, while highly unlikely, it is possible that a registrant could conclude that disclosure controls and procedures are effective if a material weakness exists in ICFR. This is due to the substantial overlap between disclosure controls and procedures and ICFR. Ms. Stokes reaffirmed that when a material weakness exists in ICFR, management has a high hurdle to overcome before being able to conclude that disclosure controls and procedures are effective.

However, if management does conclude that disclosure controls and procedures are effective, notwithstanding the existence of a material weakness in ICFR, it is critical that the company clearly disclose the factors that it considered and the basis for reaching this conclusion. Ms. Stokes stated the disclosure should not be "boilerplate"; rather, it should reflect in detail the specific facts considered by the registrant.

Ms. Stokes stated that a material weakness in ICFR does not always exist when previously issued financial statements are restated for the correction of an error(s). A registrant should consider why the restatement was necessary and whether the restatement resulted from a material weakness in underlying controls. However, she acknowledged that a restatement of previously issued financial statements to reflect the correction of an error(s) is indicative of at least a significant deficiency and a "strong indicator" that a material weakness exists, as described in PCAOB Auditing Standard No. 2, An Audit of Internal Control Performed in Conjunction With An Audit of Financial Statements.

In the case of a restatement of previously issued financial statements to reflect the correction of an error(s), Ms. Stokes commented that the SEC's rules do not require a registrant to make a full reassessment of its report on internal control over financial reporting; the rules require the registrant to make only one assessment at its year-end balance sheet date.

Ms. Stokes noted that the registrant would have to address disclosure of the material weakness(es) in its Form 10-K/A in conjunction with its Regulation S-K, Item 307 and 308(c) disclosures. Item 307 disclosures might need to be changed to state that disclosure controls and procedures were not effective and Item 308(c) disclosures might need to be changed to state that a material weakness in internal control over financial reporting was identified subsequent to year end. In accordance with AICPA Codification of Statements of Auditing Standards, AU Section 561, "Subsequent Discovery of Facts Existing at the Date of the Auditor's Report," an auditor would need to issue a revised report on the registrant's internal control over financial reporting for inclusion in the Form 10-K/A. Ms. Stokes observed that, although the registrant is not required to reassess its report on internal control over financial reporting, it may elect to do so since the registrant would likely want an unqualified opinion on management's assessment of internal control over financial reporting from its auditors upon reissuance of the auditor's opinion. This would prompt the registrant to issue a revised management report on internal control over financial reporting.

Ms. Stokes stated that, other than as permitted for certain specialized industries, available quoted market prices are evidence of the fair value of a financial instrument, and that using block discounts to determine fair value is not in accordance with GAAP. Taking a block discount refers to taking a discount from the quoted market price of a financial instrument when an entity's position in a traded security is so large that the entity believes it cannot be absorbed readily by the market (e.g., because the security is thinly traded).

Ms. Stokes referred to a registrant example involving company-issued preferred stock that was convertible into common. In estimating the fair value of its convertible preferred stock, the registrant took a block discount from the quoted market price of its common stock because the preferred stock was convertible into approximately 50 percent of the company's existing outstanding common stock and it believed its shares were thinly traded. The SEC staff objected to the use of the discount and believes that, other than as permitted for certain specialized industries, quoted market prices are generally the best evidence of fair value.

The use of quoted market prices versus block discounts is supported by paragraphs 5 and 58 of FASB Statement No. 107, Disclosures About Fair Value of Financial Instruments, and by paragraph 3(a) of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The prohibition on using block discounts to estimate fair value is supported by paragraph 6 of Statement 107 and footnote 3 of EITF Issue No. 98-5, "Accounting for Convertible Securities With Beneficial Conversion Features or Contingently Adjustable Conversion Ratios."

Ms. Stokes explained that warrants issued to nonemployees differ from employee share options in that they typically do not contain transfer restrictions and are normally subject to immediate exercise. These differences impact how the fair values of warrants granted to nonemployees and share options granted to employees should be estimated when using a Black-Scholes model. She then referred to footnote 7 of SEC Staff Accounting Bulletin No. 107, Share-Based Payment, which states the following, in part:

Accordingly, Ms. Stokes stated that if warrants issued to non-employees are valued using a Black-Scholes model, issuers should use the contractual term in the calculation, not the expected term if it is shorter.

In February, the SEC adopted final rules enabling registrants to voluntarily submit supplemental financial information using the eXtensible Business Reporting Language (XBRL) format in addition to filing its financial information in HTML or ASCII format, as currently required. XBRL is a data tagging language for enhancing financial reporting. Tagging provides greater context to data through standard definitions that turn text-based information, such as the filings currently contained in the Commission's EDGAR system, into documents that can be retrieved, searched, and analyzed through automated means. Data tags describe information such as items included in financial statements. This enables investors and other marketplace participants to analyze data from different sources and allows for the automatic exchange of financial information across various software platforms, including Web services. The SEC will use the tagged data to assist in its review of financial statements and disclosures and provide the ability to screen filings when submitted in order to manage the review process in a risk-based manner.

The SEC encourages, but does not require, registrants to participate in the program. The XBRL documents are furnished, rather than filed, as Exhibit 100 to Exchange Act and Investment Company Act filings. While there is no deadline for XBRL submission, the SEC encourages it either with the official filing or shortly thereafter. Registrants participating in the program are free to stop and start at any time.

Volunteers must provide disclosures about the XBRL documents that (1) include cautionary language that the submission should not be relied upon for investing decisions since the document is furnished to the SEC and not filed and (2) disclose that the information is "unaudited" or "unreviewed." XBRL documents must contain at least one of the following: (1) a complete set of financial statements (footnotes and schedules may be omitted); (2) earnings information from a Form 8-K or Form 6-K; or (3) financial highlights or condensed financial information. Optional content may include audit opinions, interim review reports, reports of management on the financial statements, certifications, and MD&A.

Assurance reporting is not a required part of the XBRL program; however, in May 2005, the PCAOB issued a list of frequently asked questions and answers regarding the application of attest standards, engagement procedures, and engagement reporting. These frequently asked questions can be viewed at the PCAOB's Web site, www.pcaobus.org.

The SEC Advisory Committee on Smaller Public Companies was formed by SEC Chairman William H. Donaldson in December 2004 to examine the impact of the Sarbanes-Oxley Act on smaller public companies and make recommendations to the Commission. The Advisory Committee is composed of four subcommittees that deal with (1) accounting standards, (2) capital formation, (3) corporate governance and disclosure and, (4) internal controls .

Mr. Wander reported key activities of the four subcommittees and highlighted some of the recommendations that may come out of these subcommittees. Information regarding Advisory Committee activities can be found in the Small Business section of the SEC's Web site at www.sec.gov.

A number of countries, led by those in Europe, have mandated the use of International Financial Reporting Standards (IFRS) beginning in 2005. As a result, several hundred foreign private issuers will be adopting IFRS for the first time in their 2005 financial statements to be filed with the SEC next year. The SEC staff has indicated that over the next several months it will be focused on the implementation of IFRS by these foreign private issuers.

To eliminate certain inconsistencies between IFRS and SEC rules and regulations, and to address other issues related to the first-time application of IFRS for foreign private issuers, the Commission issued First-time Application of International Financial Reporting Standards (Release 33-8567, April 12, 2005) (the Rule).

The Rule permits eligible foreign private issuers, for their first year of reporting under IFRS, to file only two years of audited financial statements (versus three, as otherwise required under Regulation S-X) prepared in accordance with IFRS, with appropriate related disclosure. All years presented using IFRS must be reconciled to US GAAP.

This two-year accommodation is available to registrants that adopt IFRS by fiscal year 2007 and applies to all annual reports on Form 20-F and to 1933 and 1934 Act Registration Statements. The two-year accommodation is available for financial statements of the registrant and for the financial statements of other "foreign businesses" included in the registrant's filings (e.g., financial statements of (1) acquired businesses provided under Regulation S-X Rule 3-05, (2) equity method investees under Rule 3-09, (3) guarantors under Rule 3-10, (4) collateral entities under Rule 3-16, and (5) target companies in a business combination filed in a Form F-4, Form S-4, or proxy statement).

A registrant may include "previous" GAAP (i.e., the GAAP used by the issuer immediately prior to the adoption of IFRS) financial information, but is not required to do so. However, if previous GAAP information is included, there must be appropriate cautionary language about the lack of comparability with IFRS; side-by-side presentation with IFRS is prohibited.

"EU GAAP"

The Rule contemplates full compliance with IFRS; it requires an unreserved and explicit statement of compliance and the auditors' report must be unqualified. An exception to full compliance exists for registrants that prepare financial statements in accordance with IFRS, as adopted by the European Union (referred to as "EU GAAP" in the Rule) as long as the financial statements include:

• Audited reconciliations from EU GAAP to IFRS as published by IASB, including any additional required disclosures; and
• Audited reconciliations to US GAAP.

All first-time adopters are required to disclose their transition elections under IFRS 1, First-time Adoption of International Financial Reporting Standards, as well as the initial reconciliation of previous GAAP to IFRS. The staff emphasized that their reviews during the 2005–2006 implementation period would focus on faithful and consistent application of IFRS, and the completeness of the US GAAP reconciliation. The staff emphasized the importance of transparent disclosure of reconciling items — especially in order to help investors understand those reconciling items arising from the transitional exemptions from IFRS allowed under IFRS 1 (e.g., elimination of any foreign currency cumulated translation adjustments) versus ongoing differences between IFRS and US GAAP.

The Rule addresses not only the financial statements, but other disclosures of Form 20-F and other foreign registration statements as well. Selected Financial Data, for example, should reflect data from the financial statements, and accordingly should include:

• Two years of IFRS data (expanding to five years over future periods); and
• Five years of US GAAP (unless a shorter period is already permitted

Selected Financial Data disclosures prepared on a basis of previous GAAP are permitted, but not required. Where issuers elect to include or incorporate previous GAAP financial information they must prominently disclose that the filing contains financial information based on the issuer's previous GAAP, which is not comparable to IFRS. The SEC did not specify particular language to be used as they believe it may vary depending on the use made of the previous GAAP information.

The Rule also allows other disclosures to be based on two years of IFRS data (with disclosure of US GAAP amounts, if material). These include (Item numbers refer to Form 20-F):

.· Description of the Business (Item 4),

• Operating and Financial Review and MD&A (Item 5),
• Market Risk Disclosures (Item 11), and
• Industry Guide Data (previous GAAP or US GAAP for previous years).

Under existing rules, interim financial statements required to be included in Form 20-F registration statements only because they have been published in the home country (see Form 20-F, Item 8.A.5) do not need to be reconciled to US GAAP unless they are prepared on a different basis of accounting than those in the most recent annual financial statements. The Rule provides an accommodation when the change in the basis of accounting is to adopt IFRS. In these cases, a reconciliation from IFRS to US GAAP is not required. The staff noted that registrants need to include appropriate disclosures about the lack of comparability between the most recent annual financial statements prepared on a previous GAAP basis and the interim IFRS financial statements. The Rule also acknowledges that an issuer may be unable to comply fully with IFRS for interim financial information during the transition year and that the issuer should provide appropriate cautionary language in this regard.

When interim financial statements are required in a Form 20-F registration statement effective more than nine months after year end, the rule provides the following four options during the transition year:

• Previous GAAP option — include three years of audited annual previous GAAP and current comparative unaudited interim previous GAAP financial statements, all reconciled to US GAAP;
• IFRS option — two years of audited annual IFRS and current comparative unaudited interim IFRS GAAP financial statements, all reconciled to US GAAP;
• US GAAP condensed option — three years audited previous GAAP financial statements, current comparative unaudited interim IFRS GAAP financial statements, all reconciled to US GAAP and condensed US GAAP balance sheet and income statement for most recent fiscal year and current and comparative interim period;
• Case-by-case option — the staff is open to consultation if registrants believe they are either unable to comply with the other three options and believe that alternative meaningful combinations of previous GAAP, IFRS, and US GAAP could be substituted.

Where a registrant adopted IFRS prior to January 1, 2005, and later adopts the Improvement Project standards, its financial statements for periods prior to adoption of the improved standards may require restatement if reissued. This arises because many of the Improvement Project standards require retrospective application, and Item 5(b)(1)(ii) of Form F-3, Material Changes, states, in part: "include restated financial statements if there has been a change in accounting principles…where such change…requires a material retroactive restatement of the financial statements." While this requirement is articulated in the instructions to Form F-3, the staff indicated that they will be applying it to all registration statements.

A number of IFRS implementation issues were discussed at the May 2005, AICPA International Practices Task Force meeting. Affected registrants and their auditors are advised by the SEC staff to read the highlights of that meeting. Items discussed include:

• Eligibility,
• Registration statements in the transition year,
• Exceptions mandated or permitted by IFRS No. 1,
• EU GAAP matters,
• Other disclosures, and
• Furnished information.

The staff clarified that rules regarding the use of non-GAAP financial measures is not intended to prohibit additional useful captions and subtotals that are consistent with IFRS reporting. The staff cited the presentation of operating results articulated in IAS 1, paragraph BC 13 as an example. The staff will evaluate compliance with IFRS and challenge the purpose and usefulness of unusual/additional measures and presentations that appear to be misleading or inconsistent with IFRS. Where the income statement presentation is considered acceptable under IFRS, additional disclosure under the non-GAAP measures rule generally would not be required.

The staff noted that the new shell company rules (Release No. 33-8587, Use of Form S-8, Form 8-K, and Form 20-F by Shell Companies), also apply to foreign private issuers. Upon completion of a merger or reorganization with an operating company, a foreign private issuer shell company must file a Form 20-F within four business days. This is a significant acceleration of the due date.

The staff clarified that while a foreign private issuer meeting the necessary conditions can be considered a "well known seasoned issuer," a filer utilizing the Multi-Jurisdictional Disclosure System ("MJDS") may not be considered a "well known seasoned issuer."

Mr. Olinger noted that the accelerated filer definition impacts the revised compliance dates for foreign private issuers for internal control reporting under Section 404. Accelerated filers are required to comply with Section 404 for the first fiscal year ending after July 15, 2006. Non-accelerated filers must comply for the first fiscal year ending after July 15, 2007. Mr. Olinger indicated that for December 31 year-end companies, the market capitalization test should be completed as of June 30, with all other tests completed as of December 31.

The staff indicated that because a foreign private issuer is not required to file interim financial statements, management's report on internal control over financial reporting only needs to cover those periods that are filed with the SEC (thus, closing procedures over interim periods not filed with the SEC need not be reported on).

"Bifurcation" of Sarbanes-Oxley 404 Reporting

The SEC staff is still considering whether it would be appropriate for management to conclude, in its assertion on internal control over financial reporting, that the controls surrounding home-country GAAP financial statements were effective, but that the controls surrounding the reconciliation to US GAAP were not effective. The staff is also considering the effect of this situation on the auditor's attestation under PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements.

The staff noted that foreign private issuers currently are subject to the Disclosure Controls and Procedures reporting requirements of Regulation S-K Item 307 and must consider the impact of restatements on previous control effectiveness disclosures. In cases where material weaknesses are found, the staff expects that careful consideration be given to the need for disclosure under Item 15, Controls and Procedures, of Form 20-F.

Mr. Olinger indicated that regardless of whether a registrant applies home-country GAAP or IFRS, it must reconcile the condensed consolidating information required under Article 3-10 of Regulation S-X with US GAAP. He clarified that the reconciliation should be prepared with a level of detail consistent with Item 17 of Form 20-F to aid investors in evaluating the sufficiency of the guarantees.

The SEC staff also believes condensed consolidating cash flow statement data presented under Article 3-10 should not reflect "price-level adjusted" information. The staff will allow registrants to prospectively apply this guidance beginning with fiscal years ending December 31, 2005.

Ms. Koski-Grafer indicated that the International Organization of Securities Commissions (IOSCO) has a project underway to promote consistent application of IFRS across the globe. It involves the creation of a database to which regulators will contribute information on regulatory decisions relating to the interpretation of IFRS.

Participating regulators are expected to use their best efforts to refer to this database when making decisions and to contribute information. Contribution of information is not required, but it is encouraged. Conflicting decisions on the application of IFRS will be referred to the IASB and its interpretation committee. IOSCO anticipates that the database will be operational by the second half of 2006. At this stage it is not intended for the catalogue of decisions to be publicly accessible.

Ms. Koski-Grafer indicated that the Public Interest Oversight Board (PIOB), established in February 2005 by the International Auditing and Assurance Standards Board (IAASB), will oversee the work of the International Federation of Accountants' (IFAC) auditing, ethics, and education standards setting committees and its Member Body Compliance Program. The stated objective of the PIOB is to help ensure that IFAC's standard-setting activities reflect the public interest and are fully transparent to those affected by the standards.

Mr. Niemeier emphasized that the accounting profession is currently in the spotlight and that many outside the profession who were previously unaware of the auditors' role now have awakened to the significance of the profession to the capital markets. He acknowledged that four years ago the profession was in crisis, but that the profession has responded by admitting mistakes and making the changes that the Sarbanes-Oxley Act required it to make. In his view, the increased focus on the profession makes it critical that the profession communicate to the public in a way that helps people to better understand what auditors do and why.

Mr. Niemeier commended the FASB and the SEC for their commitment to reducing the complexity of financial reporting. However, he expressed his view that effecting change will take a collaborative effort from all interested parties. He encouraged everyone involved to contribute.

Mr. Niemeier noted that while professional judgment is at the root of the profession, CPAs have a tendency instead to rely on rules. He stated that "there is a simple truth that there is no rule against doing the right thing," and continued by saying that "often we know what the right thing is" and that we have a professional responsibility to "do the right thing" regardless of what the rules will allow.

Mr. Carmichael focused on three areas: (1) standard setting, (2) internal control over financial reporting, and (3) fraud detection, which are discussed below.

Mr. Carmichael emphasized that the PCAOB has made significant progress, citing increased staffing of highly qualified professionals at the PCAOB and the establishment of solid working relations with the SEC and an effective process whereby the PCAOB can promulgate authoritative guidance through PCAOB Staff Questions and Answers.

Mr. Carmichael stated that the PCAOB is in the process of developing Staff Questions and Answers on the following topics:

• Predecessor and successor auditor situations when an issuer is required to use the retrospective application method of reporting a change in accounting principle or is required to restate financial statements to correct an error and the predecessor auditor is no longer independent of the issuer. The answers will provide a means whereby the successor auditor will be able to report only on the adjustments, presuming the predecessor auditor is willing to reissue its original report.
• Auditing of Statement 123(R) Assumptions — The answers will provide detailed guidance to auditors related to the application of AICPA Statement of Auditing Standards No. 101 (AU Section 328), Auditing Fair Value Measurements and Disclosures, when auditing the assumptions used in fair value measurements required by FASB Statement No. 123 (revised 2004), Share-Based Payment (e.g., volatility and expected term).

Mr. Carmichael stated that the PCAOB, pursuant to Rule 4010, recently issued its "Report on the Initial Implementation of Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements." Under Rule 4010, the PCAOB may publish summaries, compilations, or general reports concerning the results of its various inspections, provided that no such published report may identify the firm or firms to which any quality control criticisms in the report relate. These reports also may include information that was not gathered during the inspection process.

Mr. Carmichael stated that the report includes the following observations in the areas of efficiency and effectiveness, as follows:

In addition to these observations, the report clarifies that the objective of an audit of internal control over financial reporting is to obtain reasonable assurance that no material weaknesses exist. However, when planning the audit, the auditor must consider the fact that deficiencies, either individually or in the aggregate, may represent a material weakness. The standard does not require the auditor to design the audit to identify all deficiencies or significant deficiencies.

Mr. Carmichael stated that the PCAOB is in the process of developing its next 4010 report that will address implementation of AICPA Statement of Auditing Standards No. 99 (AU Section 316), Consideration of Fraud in a Financial Statement Audit. He is concerned that auditors are not taking fraud detection seriously enough in the performance of audits. Although the report is not finalized and therefore subject to change, he stated that the following issues might be addressed:

• Fraud Brainstorming Session — Engagement teams should determine that the right people are involved in the brainstorming sessions.
• Fraud Risk Factors — When risks are identified, it is the expectation of the PCAOB that an appropriate response will be identified and the audit documentation would reflect the fact that the approach has changed in response to the risk.
• Extent of Testing — When the risk of fraud increases, the PCAOB expects that the work performed by the auditor in these areas will increase (e.g., increased sample sizes for confirmations).
• Error Evaluation — Qualitative factors should be considered when evaluating all errors detected during the audit to determine whether the errors are intentional or the result of management bias, specifically when the errors are the result of departures from generally accepted accounting principles.
• Journal Entry Testing — Auditors need to determine that selections are made from a complete population. In addition, journal entries should not be excluded from the sample based on quantitative thresholds alone (e.g., do not exclude all journal entries below an established threshold).
• Senior Management Involvement — The PCAOB expects that senior members of the engagement team will be extensively involved in the fraud consideration process in an audit. He advised the avoidance of the "checklist approach," which results in senior members of the engagement team receiving less information upon which to evaluate decisions.

Christopher Cox, Chairman of the SEC, noted that the SEC has joined with the FASB and the PCAOB in a major effort to make accounting less complex. Mr. Cox, observing that many of the accounting scandals "were made possible in part by the sheer complexity of the rules," fears that "conformity to hundreds of technical rules became not a shield to protect investors, but a sword to be wielded against them."

Robert Herz, Chairman of the FASB, echoed this sentiment, stating that "the detail and volume of accounting, auditing, and reporting guidance now pose a major challenge to maintaining and enhancing the quality and transparency of financial reporting to investors and the capital markets." Mr. Herz also believes that complexity can lead to a "check-the-box, form over substance approach to accounting" that encourages some to structure transactions to achieve a desired accounting outcome contrary to economic substance. Mr. Herz, who views this issue as one of both national and international importance, noted that accounting complexity adds to the costs and effort involved in financial reporting, and reduces the transparency of financial statements to investors and analysts, making it more difficult to perform comprehensive financial analysis. Additionally, an increased number of restatements due to accounting errors have been an unwelcome byproduct of the many detailed rules that are a part of existing accounting literature.

What is the source of complexity? A number of contributing factors were cited by the speakers. Mr. Herz listed the following

• Conflicting perspectives and agendas of participants in the reporting process
• Demands from companies and industry groups for special exceptions and accounting treatments to address their specific business needs;
• An evolutionary approach to standard-setting that can result in non-conceptually based compromises, exceptions, and inconsistencies in standards over time;
• An emphasis on short-term earnings; and
• Creation of anti-abuse rules to curb structured "form over substance transactions."

Scott Taub, Acting Chief Accountant of the SEC, observed that accounting complexity is an unintended consequence of constituent desires to reduce income statement volatility or simplify the accounting for specific types of transactions. To illustrate his point, Mr. Taub discussed the shortcut method of hedge accounting and the optional smoothing mechanisms that registrants choose to make in accounting for their benefit plans.

Some critics assert that fair value accounting adds to complexity. Mr. Taub does not agree. Although he acknowledges that fair value poses measurement challenges, he believes that increased use of fair value actually may reduce complexity in financial reporting, particularly with regard to financial instruments. For example, if all financial instruments were recorded at fair value, there would be no need to assess whether contracts contain embedded derivatives, nor any need for fair value hedge accounting for financial instruments, with its myriad of stringent requirements. He noted also that improvements have occurred within the valuation profession that should help alleviate some of the measurement challenges in the future.

SEC Chairman Cox, FASB Chairman Herz, and SEC Commissioner Atkins suggested that the existence of multiple standard-setters or rule makers adds complexity to accounting literature. Although Messrs. Cox and Herz referred to recognized, established standard-setting bodies, SEC Commissioner Atkins expressed a concern that accounting positions of the SEC staff, even if publicly disseminated (e.g., SAB 1011), inject additional detailed rules into accounting literature, adding to complexity. Mr. Atkins does not object to the SEC staff attempting to explain or apply existing literature to a given fact pattern; however, he believes that "if the SEC feels that everyone should follow a particular approach, the approach should be set forth in a rule or standard that has been subjected to due process of notice and comment."

Finally, Messrs. Cox, Atkins, Herz, and Taub agreed that auditors' and other constituents' reluctance to exercise professional judgment generates additional complexity. How so? Mr. Herz explained that the FASB receives numerous requests from preparers and auditors for detailed rules, bright lines and safe harbors, many of which "stem from a fear of the potential consequences of second-guessing by regulators, enforcers, and the trial bar." Mr. Atkins, concurred, noting that "the possibility of a future challenge by someone exercising 20-20 hindsight makes people reluctant to use their professional judgment."

How can accounting be simplified? There is no easy way to reduce complexity. In Mr. Taub's view, some complexity could be reduced immediately if those involved in financial reporting focused on communication, transparency, and simply telling financial statement readers what is going on and why. To address other entrenched complexities, cooperation of numerous financial reporting stakeholders will be required. SEC Chairman Cox noted that the SEC, the PCAOB, the government, and the accounting profession will need to work together to meet the challenge. As summarized by Mr. Herz, "Principles-based standards…cannot succeed without more principles-based regulatory review and enforcement and without a more principles-based legal framework around financial reporting."

Mr. Herz also announced the FASB's three-pronged effort to reduce complexity:

1. Revisit significant accounting standards whose complexity inhibits relevant and transparent financial reporting;
2. Improve the understandability, consistency, and usability of the accounting literature through

   1. Completing its current project to compile a comprehensive and integrated codification of all existing accounting literature organized by subject matter (i.e., a "one-stop-shopping" source of accounting literature);
   2. Consolidating U.S. accounting standard-setting under the FASB to stem the proliferation of accounting guidance issued from multiple sources; and
   3. Developing new standards more consistent with a "principles-based" or "objectives-oriented" system.
3. Strengthen the FASB's conceptual framework to provide a foundation for the future development of principles-based standards.

Although these are steps in the right direction, Mr. Herz does not believe they alone will achieve the goal of reducing complexity unless the "structural, institutional, cultural, and behavioral" drivers of complexity are addressed.

Many speakers at the Conference expressed optimism that technological advances may help to reduce complexity in financial reporting. Such advances could result from implementation of XBRL.

XBRL is an acronym for eXtensible Business Reporting Language, a technology that provides an identifying electronic "tag" for each data item included in financial information. For example, the net income line item in an income statement would have its own identifying tag. These tags are easily read by computer applications, which can accurately and efficiently analyze that information, thus sparing analysts the effort of manually re-entering and comparing the financial information. Additional information about XBRL can be found at http://www.xbrl.org/home.

SEC Chairman Cox, an ardent proponent of this technology, believes it will do for business reporting what the bar code did for product distribution. In his view, "the interactive data that this initiative will create will lead to vast improvements in the quality, timeliness, and usefulness of information that investors get about the companies they're investing in." Additional XBRL benefits envisioned by Mr. Cox include providing SEC analysts with better fraud detection tools, making it easier and less expensive for preparers and their accountants to comply with SEC reporting requirements, and automating significant portions of the internal control documentation and testing required by the Sarbanes-Oxley Act of 2002. In his remarks, Mr. Taub noted that XBRL or similar interactive data technology could, to a great extent, simplify data analysis by streamlining collection and collation, and by confirming the accuracy of financial information. Messrs. Taub and Herz also can foresee this technology increasing the efficiency with which financial information is distributed to investors and other constituents. Mr. Cox noted that the improvements that will result from XBRL will free accountants to devote more time and energy to the questions of accounting judgment and materiality that are the ultimate determinants of quality.

The SEC has established an XBRL voluntary program that provides registrants with the option of furnishing XBRL information in their periodic filings. The SEC and its staff encourage registrants to participate in the trial and provide feedback to the SEC so it can continue to assess the usefulness of the technology.

In addition to his comments regarding accounting complexity and XBRL, SEC Chairman Cox discussed another issue that he characterized as a "pressing matter" - the lack of competition in the market for audit services for large public companies. Mr. Cox discussed the market share of the four largest firms and stated his belief that such concentration indicates that significant barriers prevent other firms from competing for audits of large public companies. He noted that the SEC needs to review its rules to ensure that they do not discourage competition in this market.

The terms of many share-based compensation arrangements contain clauses providing for acceleration or continued "vesting" in awards after an employee has retired from active service. Statement 123(R) indicates that compensation cost for awards should be recorded over the "requisite service period" (the period over which an employee is required to provide service). Ms. Benedict highlighted that once the employee is eligible to leave employment without losing the award, by definition there is no longer a requisite service period. In other words, when employees are able to continue to vest without providing service (or acceleration of vesting is provided), the stated vesting term is nonsubstantive and should be ignored for purposes of recognizing compensation expense

In practice many companies have adopted an accounting policy under Opinion 25 or Statement 123 (prior to the adoption of Statement 123(R)) of recognizing compensation cost (either in the income statement or in the required pro forma disclosures) over the "nominal" vesting period (four years, in the above example) with acceleration of unrecognized compensation cost, if, and when, an employee elects to retire. Ms. Benedict stated that companies that have followed this approach in the past need not consider their previous accounting conclusion to be an error. Rather, these companies should continue to follow their previous accounting policy for awards granted prior to the adoption of Statement 123(R) (even after the adoption of Statement 123(R)). The Statement 123(R) methodology, outlined by Ms. Benedict, should be applied to all new awards and to previously granted awards modified after adoption of Statement 123(R). Companies in this position should disclose the impact of this change in policy so that investors can compare results of operations pre- and post-adoption of Statement 123(R).

The Effect of Non-Compete Agreements on the Requisite Service Period for Share-Based Payment Awards

Prior to the adoption of Statement 123(R), most companies elected to follow the intrinsic value model provided for in Opinion 25 (generally resulting in little or no compensation expense), and to provide Statement 123 fair value information in the pro forma footnote disclosures only. The adoption of Statement 123(R), therefore, may result in financial statements that are significantly different from periods before adoption. In these circumstances, companies should ensure that their disclosures are detailed enough for users of the financial statements to determine the financial impact of transitioning to Statement 123(R), including the impact in the past, present, and future.

Similarly, Ms. Benedict indicated that compensation cost recognized or disclosed in accordance with Statement 123 and the amount that will be recognized under Statement 123(R) could be different due to (1) refinements of estimates, and/or (2) companies modifying plans or individual outstanding awards. When making such changes, companies need to disclose the effects of these changes and explain the reasons for them. Additionally, she reminded companies of disclosure requirements in Statement 123 when they modify the terms of share-based payment awards before the adoption of Statement 123(R).

Ms. Benedict also reiterated the staff's view (Section H of SAB 107, Opinion 28, and Article 10 of Regulation S-X) that all annual period disclosures of newly adopted accounting standards should be presented in the financial statements of the first interim period in which a new standard is adopted.

Measures that exclude the impact of share-based payment transactions such as "Net Income Before Share-Based Payment Charge" are non-GAAP financial measures as discussed in Regulation G and Item 10(e) of Regulation S-K. FAQ 8, in the related series of frequently asked questions prepared by the SEC staff, clarifies that in order to exclude an amount that is recurring (and to report the non-GAAP measure), a company needs to demonstrate the usefulness of the measure.

A company may only avail itself of FAQ 8 and disclose non-GAAP measures when this hurdle is overcome, and when the measure does not violate any of the other prohibitions. In order to overcome this burden, a company should be able to demonstrate that it utilizes the non-GAAP financial measure to internally evaluate performance.

Many awards with repurchase obligations (cash settlement obligations including put features) will be classified as liabilities under Statement 123(R). However, for some awards with redemption features, a proper analysis under Statement 123(R) might indicate that the award is not a liability. In the latter circumstance, Ms. Benedict reminded participants that the "mezzanine equity" requirements in ASR 268 (as further clarified in Topic D-98) apply to all share-based payment awards. ASR 268 requires classification outside of permanent equity for equity instruments that are redeemable at a fixed or determinable price (including redemption at fair value) on a fixed or determinable date (1) at the option of the holder, or (2) upon the occurrence of an event that is not solely within the control of the issuer. Note that the status section of Topic D-98 has been updated to provide transition guidance for non-liability share-based payment awards with redemption features upon the adoption of Statement 123(R).

Mr. Hardiman stated that the SEC staff frequently encounters mistakes in the accounting for convertible debt, convertible preferred stock, and freestanding warrants to buy the registrant's stock. Why? The complexity in accounting for these instruments lies in part in the difficulty of identifying the appropriate applicable guidance; companies need to consider a plethora of FASB pronouncements, EITF Issues, and SEC guidance and their interaction with one another.

Mr. Hardiman indicated that with respect to embedded conversion options, companies tend to focus on intrinsic value issues (whether embedded conversion options have beneficial conversion features under Issue 98-5 and Issue 00-27) and neglect to consider potential classification issues under Statement 133 and Issue 00-19. That is, companies fail to consider whether the embedded conversion option should be bifurcated and accounted for separately as a derivative liability instrument. The SEC staff suggested that before considering intrinsic value issues, registrants should first determine whether the embedded derivative should be separated from the host contract. This involves determining whether the embedded conversion option should be classified as a liability (e.g., derivative subject to Statement 133) or equity, if it were freestanding.

From the issuer's perspective, a freestanding instrument on an issuer's own stock or a similar option embedded in a debt host would not be considered a derivative under Statement 133 if the instrument is both (1) indexed to its own stock, and (2) classified in stockholders' equity. Issue 00-19 addresses whether an option on an issuer's own stock is considered a liability or equity. Mr. Hardiman indicated that the default classification of a freestanding option and an embedded conversion option is a liability unless the very restrictive and specific requirements for equity classification as stated in Issue 00-19 have been met.

In order to attain equity classification, paragraphs 12–32 of Issue 00-19 specify very stringent criteria (e.g., the issuer must have the ability to settle in unregistered shares) that must be met in addition to the general settlement provisions. Paragraph 4 of Issue 00-19 provides an exception to applying the stringent criteria for equity classification (paragraphs 12–32) only if the contract is a conventional convertible debt instrument in which the holder may realize the value of the conversion option only by exercising the option and receiving the entire proceeds in a fixed number of shares, or the equivalent amount of cash (at the discretion of the issuer). Mr. Hardiman observed that the reference to the discretion of the issuer refers to the form of settlement (i.e., cash or shares), not the number of shares to be issued upon conversion.

In Issue 05-2, the Emerging Issues Task Force further clarified the term "conventional convertible debt" as contemplated in paragraph 4 of Issue 00-19. The Task Force reached a consensus that a conventional convertible debt instrument is an instrument that provides the holder with an option to convert into a fixed number of shares, and the ability to exercise that option is based on the passage of time, or a contingent event.

The SEC staff has encountered numerous instances where the accounting for the conversion option is dependent on the convertible instrument being considered conventional (i.e., if the stringent criteria of paragraphs 12–32 of Issue 00-19 were to be applied, the embedded derivative would fail to attain equity classification) and companies have assumed incorrectly that they have issued conventional convertible debt as contemplated in paragraph 4 of Issue 00-19. What is the most common mistake companies make in this regard? Concluding that convertible debt is conventional when the number of shares the holder can convert into is not fixed. For example, the number of shares is not fixed if it can vary based on a contingent future event, even if the event is under the control of the issuer (see Editor's Note below for an exception provided under Issue 05-2 for standard anti-dilution provisions).

Another common mistake: In order to be considered conventional, the entire proceeds upon exercise of the conversion option should be settled either in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer). Convertible debt that can be settled in a combination of cash and shares is not considered to be conventional convertible debt.

Mr. Hardiman provided the following examples of features in convertible debt agreements that will cause convertible debt to be considered non-conventional:

If a company has determined that its debt does not meet the definition of a conventional convertible debt, it must apply the provisions in paragraphs 12–32 of Issue 00-19 to determine the proper classification of the conversion option. The important point here is that the issuer should determine if there is any possible scenario under which the conversion option can be settled in cash. A low probability cannot alter the conclusion, even if it is remote that the issuer could be required to settle the conversion option in cash. Because the possibility of cash settlement exists, the conversion option should be classified as a liability and bifurcated from the debt host. Conversion options classified as liabilities must be measured at fair value each reporting period

In discussing some of the issues around equity classification under Issue 00-19, Mr. Hardiman also offered some thoughts on Issue 05-4 currently being discussed by the Task Force. The issuer, unless exempt from the provisions of paragraphs 14–18 of Issue 00-19, must be able to settle the instrument in unregistered shares. Because of this requirement, registration rights agreements that include a liquidated damages clause commonly accompany the issuance of equity instruments, stock purchase warrants, and financial instruments that are convertible into the issuer's own shares. Typically, the agreement requires the issuer to use its "best efforts" to register the underlying shares by the end of a specified grace period. If the issuer fails to have the registration declared effective within the grace period (or if effectiveness is not maintained), the issuer is required to pay liquidated damages to the investor each month until the registration is declared effective. The Task Force is discussing whether the registration right with a liquidated damages clause is separate from the related financial instrument (e.g., warrant or conversion option in convertible debt) or, if combined, affects whether the unit can be classified as equity. Currently there is diversity in practice on these issues.

Mr. Hardiman noted that while the Task Force has not reached a consensus, companies must consider carefully the terms of registration-rights agreements, specifically as it relates to the liquated damages penalty. For example, if the liquidated damages clause is not limited to the difference between the fair value of registered and unregistered shares, the SEC staff has concluded that the issuer is effectively compelled to settle in cash in an amount equal to the value of the registered shares. Why? Settlement in unregistered shares and payment of the penalty is an uneconomic alternative in that the combined value exceeds the value of the registered shares. Therefore, if the amount of liquidated damages is not appropriately limited, settlement in cash equal to the value of the registered shares is assumed. Thus, the unit would not be considered to meet the requirements of an equity instrument.

Mr. Hardiman stated that consideration of the paragraph 19 criteria of Issue 00-19 is another area where the SEC staff has noted errors. Registrants have failed to consider all other commitments that may require the issuance of stock during the maximum period of the contract. Paragraph 19 states that in order to assume settlement in shares, a company should have sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative could be outstanding. This analysis should take into account all instruments that can be settled in shares regardless of probability (e.g., employee stock options and other embedded and freestanding instruments).

Some instruments may require settlement in a variable number of shares, and the maximum number of shares is not capped. Because a company is not able to determine that it will have sufficient authorized shares to settle the instrument, share-settlement is not within the control of the company, and, therefore, cannot be classified within equity. In addition, this instrument could cause other instruments to fail the criteria to be considered equity. Why? A possibility exists that the company will have to settle the uncapped instrument first, resulting in a lack of authorized and available shares to settle other contracts in shares.

In his concluding remarks Mr. Hardiman stated that companies should explicitly state in their disclosures the features of alltheir instruments indexed to their own stock with specific disclosure of the accounting analysis of these features.

According to Mr. Levine, the statement of cash flows is receiving increased focus by investors and greater scrutiny in SEC staff reviews. The Division of Corporation Finance continues to address a number of cash flow presentation issues, several of which are discussed below.

Statement 95 does not require separate disclosure of cash flows from discontinued operations; however, if a company chooses to separately disclose those amounts, it must do so consistently for all periods affected.2 In determining whether a company's presentation of cash flows pertaining to discontinued operations is appropriate, the SEC staff makes such assessment with the following basic principle of Statement 95 in mind:

What are some examples of acceptable presentation methods? Cash flows pertaining to discontinued operations should be separately disclosed either (1) within each category of the statement of cash flows, or (2) near the bottom of the statement of cash flows, by category. Alternatively, companies choosing not to separately disclose cash flows pertaining to discontinued operations should present all cash flows (i.e., continuing and discontinued), within each category without differentiation. It would not be appropriate to present cash flows from discontinued operations as a single line item at the bottom of the statement of cash flows or all within operating activities (i.e., aggregating operating, investing, and financing cash flows). Doing so would violate the basic principle of Statement 95 stated above.

Mr. Levine also highlighted the importance of disclosure in the liquidity and capital resources section in the MD&A. Companies should describe how cash flows pertaining to discontinued operations are reported in the statement of cash flows, or if they are not separately disclosed in the statement of cash flows, the amounts should be quantified, by category, in MD&A. Companies also should discuss the impact on future liquidity and capital resources due to the absence of cash flows from discontinued operations.

In many dealer floor plan financing arrangements, the finance entity is a subsidiary of the supplier. In those situations, the dealer reports purchases as increases to inventory and trade loans (a non-cash transaction), with repayments of trade loans presented within operating activities in the statement of cash flows. The end result on the statement of cash flows? A net operating cash inflow in the amount of the dealer's gross profit.

Registrants have run into problems when the financing entity in such an arrangement is not affiliated with the supplier. The SEC staff's view under that circumstance is that the amounts financed are not trade loans; rather, they are third party loans. As such, cash flows related to the amounts borrowed and repaid should be presented as financing activities in the statement of cash flows.

Mr. Levine stated that cash received from insurance settlements should be presented in the statement of cash flows based on the nature of the insurance coverage (i.e., the nature of the loss). It would not be appropriate to classify such proceeds based on how a company plans to spend those proceeds (see paragraph 22(c) of Statement 95).

The following examples were provided by Mr. Levine:

In addition to appropriate presentation in the statement of cash flows, Mr. Levine also reminded registrants to include a discussion of material insurance proceeds in MD&A, including:

• What you received;
• Why you received it;
• What you plan to do with it;
• Where it is classified in the statement of cash flows; and
• The impact on reported earnings.

There are many sources of authoritative literature, often analogized to, that address where items should be presented on the income statement. Mr. Lopez pointed out that Issue 99-19 is the primary authoritative literature that addresses whether revenue should be recognized on a gross or net basis. The guidance and related examples in Issue 99-19 focus on Internet-based companies; however, the scope of Issue 99-19 is not limited to companies that sell products or services over the Internet. Mr. Lopez believes that this frequently leads to an awkward application of Issue 99-19 to non-Internet-based companies, or in some cases, an incorrect conclusion by companies that the guidance does not apply. He also noted that the SEC staff finds it helpful generally to begin its Issue 99-19 analysis by identifying the ultimate customer in the arrangement.

As summarized below, Mr. Lopez discussed the SEC staff's views on how to account for various types of arrangements when the guidance in Issue 99-19 is not applied easily.

Mr. Lopez pointed out that companies often analogize to Issues 99-19, 00-10, 01-14, and/or the AICPA Audit and Accounting Guide, "Audit of Federal Government Contractors," when determining whether research and development costs (and the related reimbursements for those costs) should be presented on a gross or net basis. He did not indicate what the SEC staff believes is the appropriate presentation; however, he did note that the SEC staff has observed instances where companies may in fact be "cherry picking" their presentation depending on whether they are, or expect to be, in net gain or net loss positions. He also reminded companies to treat income statement classification issues consistently and to adequately disclose their classification policy. However, Mr. Lopez cautioned that companies within the scope of the Audit and Accounting Guide must follow its guidance to determine the appropriate income statement presentation.

Mr. Lopez discussed whether deferred revenue that is recognized as part of a business combination in accordance with Issue 01-3 should be presented on a gross or net basis when recognized in the income statement. He believes companies should focus on the nature of each arrangement and should look to the guidance outlined in Concepts Statement 6. For example, under Concepts Statement 6, in order for an item to be considered a component of revenue, it must represent an inflow "from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations." Mr. Lopez provided the following example:

Companies that collect taxes from customers in connection with the sale of a product or service must determine whether those taxes should be presented on a gross or net basis. In making the gross versus net determination, Mr. Lopez believes that companies should consider the types of taxes involved (e.g., excise taxes, sales taxes, etc.) and whether the company is acting in a pass-through capacity or whether it has the primary obligation for remittance of the taxes. He believes that companies should look to the guidance in Issue 01-14. Mr. Lopez provided the following example:

Mr. Lopez discussed how companies should determine whether intangible asset amortization should be presented as part of (1) cost of sales or (2) selling, general, and administrative expense. He believes such a determination generally should be based on the function of the intangible asset. For example, if the intangible asset is a component of the activities that constitute the entity's ongoing major or central operations (that is, a revenue generating activity of the company), generally it should be classified as part of the cost of sales (e.g., amortization of a patent). Any presentation still must comply with the requirements of Rule 5-03 of Regulation S-X and SAB Topic 11.B.

Mr. Lopez emphasized that this issue is particularly important when the sale to the customer, including a reseller, occurs prior to the vendor's year end but the rebate is offered after year-end. He believes that a rebate should be considered "offered" at the date the related revenue is recognized (regardless of when the rebate actually is provided to the customer) if the vendor does not, in substance, control that rebate. Mr. Lopez believes that a vendor would not be in control of the rebate if it is economically compelled to provide that rebate. Judgment is involved in determining whether a vendor is economically compelled. He believes an important factor to consider is the relative size of the customer compared to the vendor that is offering the rebate (e.g., the manufacturer). If the vendor concludes that it is economically compelled to provide the rebate, then it must recognize the sales incentive when the related revenue is recognized.

Software Revenue Recognition

According to Mr. Lopez, the SEC staff recently concluded that an upgrade would be considered "specified" if there is a promise to upgrade, regardless of whether that promise includes or refers to specific features and functionality of the upgrade. If the conclusion is reached that the upgrade right is "specified" and there is not vendor-specific objective evidence of the fair value of the upgrade, then the vendor would have to defer all revenue from the arrangement until the earlier of the point at which (1) such sufficient vendor-specific objective evidence does exist or (2) all elements of the arrangement have been delivered.

Additionally, Mr. Lopez reminded companies that they cannot default to recognizing revenue ratably over the term of the arrangement in situations where there is not vendor-specific objective evidence. The ratable method is appropriate only for those arrangements that are in substance a subscription or for post-contract customer support and services.

The scope of SOP 01-6 includes not only finance companies, but also non-finance companies that engage in transactions that involve lending to or financing the activities of others. Ms. Mincin indicated that these activities include selling goods or services in exchange for trade receivables. Under the guidance in paragraph 8, the SEC staff believes that loans and trade receivables should be accounted for as held for sale if (1) at origination, management intends to sell the loans or receivables or (2) management decides to sell loans or receivables that were not initially classified as held for sale.

What is the financial statement impact of classifying loans or receivables as held for sale? They should be reported separately on the balance sheet at the lower of cost or fair value (individually or in the aggregate). Disclosure should be made explaining how the company determines when to classify a loan or receivable as held for sale and the method used to determine the recorded amount. For the presentation of loans or trade receivables in the statement of cash flows, Ms. Mincin provided the following views:

Retained Interests in Securitized Loans — Cash Flows

Ms. Mincin also shared her views on the classification in the statement of cash flows for retained interests in securitized loans. According to Ms. Mincin, the "receipt" of a retained interest in a securitization does not result in a cash flow to the company. However, the company should consider whether that transaction needs to be disclosed as a noncash investing activity in the statement of cash flows.

Ms. Mincin stated that paragraph 8 of Statement 102 requires principal payments received on retained interests to be recognized as operating cash inflows only when the retained interest is accounted for like a trading security under Statement 115. If the retained interest is not accounted for like a trading security, principal payments received should be presented as investing cash inflows. The result? It is possible to end up with negative operating cash flows from a securitization transaction. Ms. Mincin illustrated this point by way of the following example:

The SEC staff has seen instances where companies have applied the shortcut method without meeting all of the requisite criteria listed in paragraph 68 of Statement 133. Mr. Northan pointed to the guidance in Implementation Issue E4, which states that all shortcut conditions must be met — simply complying with the "spirit" or "principle" of the shortcut method is not acceptable. While a theme of this year's Conference was to look for the principle, he noted that as a practical exception provided in Statement 133, the SEC staff does not believe the shortcut method has an underlying spirit or principle.

One of the criteria for the shortcut method is that the fair value of an interest rate swap at the inception of the hedging relationship must be zero. The SEC staff has seen situations where financing elements have been included in interest rate swaps as adjustments to the "pay" or "receive" legs of the swap. For example, instead of directly paying a broker fee for a certain transaction, the fee may be added to the pay leg of an interest rate swap. Even though no cash may have been exchanged when the swap was entered into, the SEC staff holds the view that these "adjustments" result in the swap having a fair value other than zero at inception. As a result, the hedge would fail to meet the shortcut criteria.

Therefore, what are the consequences for a company that applied the shortcut method without meeting all of the criteria? The SEC staff generally would expect companies to remove the effects of hedge accounting for all periods during which the company relied on the shortcut method, as usually all other general hedge requirements would not have been met for prior periods, such as prospective and retrospective testing of hedge effectiveness. That is, the derivative should be marked to market in the income statement and, for fair value hedges, adjustments to the hedged item reversed.

Implicit Variable Interests

At last year's Conference, the SEC staff indicated that companies should be considering "activities around the entity" when analyzing the consolidation provisions in Interpretation 46(R).5 In March 2005, the FASB issued guidance6 on implicit variable interests indicating that variable interests may encompass implied or indirect interests in an entity. The objective of that guidance is to prevent companies from avoiding the requirements of Interpretation 46(R) simply by entering into arrangements with another holder (related or unrelated) of an interest in the entity, rather than with the entity directly. Mr. Northan stated that identification of implicit variable interests involves judgment based on specific facts and circumstances. In identifying implicit variable interests, preparers should consider the following questions:

• Was the arrangement entered into in contemplation of the entity's formation?
• Was the arrangement entered into contemporaneously with the issuance of a variable interest?
• Why was the arrangement entered into with a variable interest holder instead of with the entity?
• Did the arrangement reference specified assets of the variable interest entity?

EITF Topic D-98 requires redeemable shares to be classified outside of permanent equity and initially recognized at fair value. If redeemable in the current period, the shares should be adjusted to redemption amount at each balance sheet date. If the shares are not redeemable in the current period, but it is probable that they will become redeemable, then the shares should be adjusted to their redemption value using one of the two methods allowed in Topic D-98 (see example below). If it is not probable that the shares will become redeemable, then subsequent adjustment is not necessary until it becomes probable.

The SEC staff has received inquiries on the accounting for preferred securities that include multiple mutually exclusive options exercisable by the holder. For example, consider a security that contains both a conversion option, which is currently exercisable, and a redemption option, which is not currently exercisable but will become exercisable following the passage of a specified period of time. Questions have arisen about the probability of the security ever becoming redeemable because of the likelihood that the holder will exercise the conversion option first. Mr. Northan explained that the exercise of the conversion option is outside of the control of the issuer; therefore, absent any action by the holder, the security will become redeemable upon the passage of time. As a result, the instrument described above would be considered probable of becoming redeemable.

Endnotes

5 - Pursuant to Interpretation 46(R), the holder of a variable interest in a variable interest entity that is considered the primary beneficiary should consolidate the variable interest entity. A variable interest is an interest in an entity that absorbs or receives changes in the value of the entity's net assets.

6 - FSP FIN 46(R)-5.

In a technical accounting issues breakout session, Mr. Oakley discussed the Statement 123(R) Resource Group, which the FASB staff is using to identify Statement 123(R) accounting issues. The Resource Group is a panel of experts (composed of preparers, auditors, and consultants) selected by the FASB staff with the objective of identifying and resolving potential issues. Discussions of this group do not establish GAAP; instead, the FASB staff has used FASB Staff Positions to resolve certain identified issues. Where members of the group reach agreement, the consensus of the group may indicate that the selected issue is addressed sufficiently in the existing Statement 123(R) framework. While the Resource Group's meetings are not public, representatives of the SEC and PCAOB are invited to observe. Mr. Oakley discussed a number of Statement 123(R) implementation issues identified by this group, including the following that resulted in FASB Staff Positions

• FSP FAS 123(R)-1, which defers the requirement of Statement 123(R) to reassess the classification (equity or liability) of an award when the holder's rights are no longer contingent upon his or her being an employee of the entity;
• FSP FAS 123(R)-2, which gives entities a practical accommodation to the application of "grant date" as defined in Statement 123(R); and
• FSP FAS 123(R)-3, which gives entities a simplified method to computing their APIC Pool upon adoption of Statement 123(R).

The Resource Group agreed that the following alternatives are acceptable methods for dealing with the hypothetical balance sheet adjustment under the modified prospective method of adoption:

• Upon adoption, adjust the balance sheet, with a corresponding adjustment to APIC, for the impacts of the pro forma asset(s). As assets are realized or depreciated, the capitalized stock-based compensation expense would be relieved through the income statement.
• Upon adoption, no entries are recorded on the balance sheet. Amounts capitalized in the pro forma balance sheet are recognized as additional expense in the income statement when the related asset is realized or depreciated (as if the opening balance sheet had been adjusted for the pro forma asset). How do you balance the books? A corresponding adjustment to APIC would be recorded when the additional expense is recorded.

Under Statement 123(R), when the exercise of an award results in a tax deduction greater than the compensation cost recognized, the resulting "excess tax benefit" is recorded in APIC. The accumulation of excess tax benefits in APIC builds up what is commonly referred to as an entity's "APIC Pool." Likewise, when the tax deduction is less than the compensation cost recognized, the resulting "tax benefit deficiency" is recorded in APIC. However, recording a tax benefit deficiency directly to equity is only permitted when there is a sufficient APIC Pool to absorb the deficiency; otherwise, the deficiency is recorded in the income statement. The Resource Group discussed the issue of how "excess tax benefits" and "tax benefit deficiencies" should be treated for interim financial reporting purposes.

Resource Group members agreed that an acceptable approach for interim reporting purposes would be to consider the APIC Pool adjustment to be an annual calculation (versus a daily, weekly or quarterly adjustment). Under this approach, an excess "tax benefit deficiency" (and the related charge against income) occurring in one quarter can be offset and reversed in a subsequent quarter (within the same fiscal year) if, in that subsequent quarter, an excess tax benefit arises that is large enough to absorb the previous deficiency.

Mr. Oakley explained that the Resource Group members also concluded that the impact of tax benefit excesses and deficiencies should be accounted for in the interim period in which they occur (that is, they should be treated as discrete items). The effects of expected future excesses and deficiencies should not be anticipated when preparing current period interim or annual financial statements.

During the 2004 Conference, a former Professional Accounting Fellow, Russell Hodge, discussed the two ways in which errors that span more than one period are quantified — the "rollover" approach and the "iron curtain" approach. Not everyone agrees which is the better of the two; both have their respective strengths and weaknesses.

To illustrate the difference between the approaches, Mr. Roberson gave the following example:

Mr. Roberson reiterated that the SEC staff does not believe diversity is appropriate in this area. Further, the staff continues to consider the issue and to evaluate whether and what type of guidance would be appropriate. In light of the perceived weaknesses of both approaches, the staff continues to believe that the better approach may be to quantify the error using both approaches.

As to any guidance to be issued, Mr. Roberson noted that the SEC is cognizant that registrants will need time to digest the new guidance and that some form of implementation guidance would be helpful. Until that time, registrants were encouraged to understand their current approach to quantifying errors. In a decentralized company, are units evaluating errors consistently? Are there errors, "immaterial" under the rollover approach, accumulating on the balance sheet? Ultimately, quantifying errors and evaluating materiality is a registrant's responsibility first (and an auditor responsibility second), as registrants are responsible for preparing the financial statements.

Mr. Roberson also reminded registrants to consider future periods in quantifying errors and in applying the materiality disclaimer found at the end of each FASB standard. Preparers were reminded that a decision to not apply a FASB standard must continually be updated as "the fact that not applying a particular provision in GAAP is immaterial in one period is not a lifetime pass to never apply the provision." He sounded a final word of caution regarding registrants who fail to apply GAAP to "immaterial" items in order to avoid negative financial statement consequences. Mr. Roberson concluded that "not applying the standard [because application] would cause users to view your financial statements differently…by definition, makes the difference material."

An acquisition between parties with a preexisting relationship should be considered a multiple-element transaction, the business combination and the settlement of the preexisting relationship. The latter requires the determination of a gain or loss. The key take-away? A buyer of a target, with which it has a preexisting relationship, cannot "bury" the gain or loss resulting from the implicit settlement of the relationship in goodwill.

Mr. Roberson also indicated that the SEC staff has concluded that this multiple element accounting also applies to less than 100 percent acquisitions. The speech contains an illustration of this situation

Next was the topic of reacquired rights. Issue 04-1 states that an intangible asset should be recorded apart from goodwill when previously granted rights to use the acquirer's intangible assets (e.g., trade names under franchise or rights to technology under a license) are reacquired in a business combination. Valuation and life were noted as the two most common issues addressed by the SEC staff.

• Valuation — Registrants were reminded that the rights need to be valued as if the registrant was buying a right not previously owned. He illustrated the point by citing the acquisition of a previously granted restaurant franchise. Mr. Roberson indicated that the higher price paid for the franchise of a mature restaurant might include values attributable to factors independent of the value of the franchise right — for example customer relationship intangibles, workforce, real estate, etc.
• Life — Mr. Roberson noted that one indication of the life of the right could be the life the acquirer uses for its existing intangible asset. There are differing views as to useful life if the original grant of the asset had been for a limited period of time: over the remainder of the contractual life originally granted or based on the useful life of the license to the acquirer. Mr. Roberson referred the audience to the FASB's exposure draft for the replacement of Statement 141, in which the FASB has proposed that such rights be amortized over the remaining contractual period of the pre-combination contract that granted the rights. He also mentioned the SEC staff's willingness to discuss this accounting issue with registrants.

In a timely message to retailers and other vendors this holiday season, Ms. Schlosser addressed revenue recognition by a vendor on arrangements in which a customer makes a payment in advance of vendor performance (e.g., gift cards and phone cards.) In some cases, the customer does not demand full performance for various reasons. This is referred to frequently as "breakage." The issue is when the vendor can derecognize the deferred revenue liability and recognize revenue in the absence of performance.

Ms. Schlosser reminded the audience that the SEC staff has stated previously that it is appropriate for a vendor to apply the liability derecognition guidance of Statement 140 to these circumstances. However, breakage also can be recognized in earnings prior to being legally released if the vendor can demonstrate that it is remote that the customer will require performance.

The important point is that companies should not recognize breakage as revenue immediately upon the receipt of payment, even if there is historical evidence to suggest that for a certain percentage of transactions, performance will not be required. The SEC staff has objected to a registrant recognizing, based on historical redemption rates, 10 percent of the prepayment as revenue and 90 percent as deferred revenue upon the sale of a gift card, since performance had not yet occurred.

Ms. Schlosser described two acceptable approaches to revenue recognition:

• Specific Identification — Vendors can recognize gift card breakage on a card-by-card basis as the vendor is legally released from its obligation, for example, at redemption or expiration; or at the point redemption becomes remote.
• Homogeneous Pool — Vendors can recognize gift card breakage in proportion to actual redemptions if redemption of a certain amount of homogeneous transactions is remote. Under this approach, the estimated value of gift cards expected to go unused in a homogeneous pool sold over a certain period of time would be recognized as the remaining gift cards are redeemed. The company would need to reasonably and objectively determine both the estimated time period of actual gift card redemption, and the amount of breakage.

Customer-Related Intangible Assets Acquired in a Business Combination

Ms. Schlosser addressed a difficult business combination question: How should the fair value of an acquired intangible asset be estimated when that intangible will not be used to its fullest extent by the acquirer? Consider the following example:

How should Company A estimate the fair value of the relationships? The SEC staff believes the income approach - based on the benefits of incremental sales to those customers - generally is the most appropriate approach. In addition, Ms. Schlosser pointed out that both Statement 1417 and Issue 02-178 state that fair value estimates should incorporate assumptions that marketplace participants would use in estimating fair value. She recommended consultation with the SEC staff in a situation in which a company thinks that an entity-specific valuation is appropriate.

New Basis of Accounting

Ms. Schlosser explained that, with the recent uptick in M&A activity, the number of new basis issues, addressed by the staff, is on the rise. She discussed a few of the issues addressed recently.

Topic D-97 explains that investors that come together to make an investment may be considered to constitute a "collaborative group" — that is, they have worked together to promote and collaborate on both the form and subsequent operations of that entity. The conclusion of whether a group of investors is considered a "collaborative group" could significantly impact whether push-down accounting is required (i.e., whether the company has become substantially wholly owned).

Ms. Schlosser stated that the staff has no "golden rules" in applying Topic D-97. Given that the application of Topic D-97 is highly dependent upon an entity's specific facts and circumstances, she stated that "the totality of all of the factors should be evaluated in concluding whether the investors represent a collaborative group." Some of the questions that the staff may ask in gaining a better understanding of the relationship among the investors, and thus whether a collaborative group exists, are:

• How did the various investors come together to make this investment?
• Hypothetically, if one of the investors would have backed out of the deal, would the deal still have been done?
• How are board seats determined and can the number of seats change over time?
• What is the nature of decisions that require unanimous or majority approval of the investors?
• What evidence supports that sale restrictions are considered reasonable and customary?

SEC staff members also address many questions on when a new basis of accounting should be applied. First, it is important to understand whose accounting is being considered: the accounting for an OLDCO (an existing operating company that underwent a change in ownership) or a NEWCO (a newly formed entity that just acquired an operating company)? Ms. Schlosser explained that SAB 54 and Topic D-97 are applied from the perspective of an OLDCO and, therefore, should not be applied to NEWCOs. Consequently, in transactions that involve a NEWCO, registrants must look to the guidance in Statement 141 and Issue 88-16. Additionally, it is important to understand that the form of the transaction may impact the accounting result, especially in the application of Issue 88-16. Ms. Schlosser provided the following examples:

The moral of the story? In both examples, the role of NEWCO, the amount of debt, and the form of the transactions are crucial in determining the appropriate accounting. Ms. Schlosser encouraged companies and their auditors to continue to consult with the staff in these areas of judgmental accounting.

Statement 123(R) defines volatility as "a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period." However, Statement 123(R) does not specify a method of estimating expected volatility; rather, paragraph A32 of Statement 123(R) provides a list of factors that are required to be considered in estimating expected volatility. Factors to consider include historical volatility and implied volatility. SAB 107 includes the SEC staff's thoughts on determining expected volatility as well as when exclusive reliance on either historical volatility or current implied volatility is appropriate.

The SEC staff acknowledged that in many circumstances companies may conclude that sole reliance on either historical or implied volatility is inappropriate. In those circumstances, all information available to estimate expected volatility should be considered. Companies should keep in mind that the objective is to determine the volatility assumption that marketplace participants would be likely to use in determining an exchange price for an option. Ms. Spivey provided some additional thoughts on implied volatility and historical volatility as a result of questions received after release of the SAB.

Ms. Spivey reiterated that the SEC staff, as stated in SAB 107, will not object to a company exclusively relying on the implied volatility derived from a traded option with a remaining maturity of at least one year, assuming other criteria provided in the SAB are also met (even if the employee option has a longer term than the traded option). In addition, SAB 107 also notes that implied volatility based on a traded option with a remaining maturity of six months or more could be considered as long as a company also considers other relevant information in estimating expected volatility.

Ms. Spivey stated that the SEC staff has become aware of the following two methods of computing historical volatility that would not be considered to be a good faith effort in estimating expected volatility:

1. A method that weighs the most recent periods of historical volatility much more heavily than earlier periods; and
2. A method that relies solely on using the average value of the daily high and low share prices to compute volatility.

Expected Term Assumption

SAB 107 provides a "simplified" method for estimating the expected term for "plain vanilla" options, as those options are described in the Staff Accounting Bulletin. This alternative is available for all public companies. However SAB 107 is silent on whether this guidance applies to nonpublic companies. Ms. Spivey clarified that the SEC staff would not object if a company applied the simplified method in the financial statements for the pre-IPO years included in the initial registration statement filed with the Commission.

Statement 123(R) states that the best evidence of fair value for employee share options is observable market prices of identical or similar instruments in active markets. Since the issuance of SAB 107, the SEC staff has become aware of efforts to design and sell a market instrument for the purpose of providing a value for employee share options. Ms. Spivey stated that they are not currently aware of any such instruments that have been sold in the market for the purpose of valuing employee share options. However, the SEC staff believes it should be possible to design instruments whose transaction prices would be a reasonable estimate of the fair value of underlying employee share options.

Ms. Spivey then discussed two possible approaches to market transactions that might meet the fair value measurement objective in Statement 123(R):

• Design an instrument that would result in a payoff that tracked the payoff on an underlying pool of employee stock options, or
• Structure an arrangement in which a company compensates a market participant to assume the role of the employer and its risks associated with future exercises of options.

Ms. Spivey contrasted the above alternatives to an approach where an instrument is structured to replicate the restrictive terms included in employee share options. In this case, the SEC staff does not believe that the value that a third party investor would assign to an instrument with the same restrictive terms would represent the fair value of the employee share option consistent with the measurement objective of Statement 123(R). That is, it does not seem possible to replicate an employer-employee relationship or the effects of that relationship in a transaction with a third party.

Ms. Spivey stated that the marketing plan for the instrument is an equally important consideration because marketplace participants will need information about the terms of the awards as well as other information that would be useful to appropriately determine a fair value estimate.

"Full, fair, and accurate disclosure is the mantra that we live by," Ms. Stacey said as she challenged companies and their auditors to ensure that their financial statements provide the information that investors need to make informed business decisions. While management remains responsible for its company's financial statements, Ms. Stacey re-emphasized the role played by independent registered auditors in the financial reporting process. By reference to the May 16, 2005 SEC and PCAOB guidance, she reiterated that neither the internal control process nor the independence rules preclude dialogue between a company and its auditor pertaining to new or complex transactions or accounting standards.

Ms. Stacey articulated the following five ways companies and their auditors can ensure that financial statements are complete, accurate, and relevant to users:

Ms. Stacey called for better use of technology in understanding a company and all its available information, including press releases and other periodic filings beyond financial statements. Once this understanding is achieved, the next step involves comparisons of the company with its competitors. Although XBRL is not currently required, Ms. Stacey believes XBRL has the potential to create benefits and cost savings through easier access and analysis of financial information, while concurrently assisting companies in their internal and external financial reporting. Ms. Stacey reminded registrants that they can voluntarily furnish, in an exhibit to an EDGAR filing, supplemental tagged information using XBRL

Ms. Stacey challenged accountants to place a high priority on education. Citing Statement 133 as an example, she encouraged continued training on complex standards that frequently are applied by registrants, in lieu of extensive reliance on subject matter experts.

Ms. Stacey asked preparers to consider how their accounting can be simplified. U.S. GAAP often establishes one clear accounting application, but it does allow certain other optional methods. The use of these optional methods tends to increase complexity. Possible areas that offer immediate opportunity to reduce complexity include:

• Choosing the direct method of cash flow,
• Choosing not to aggregate segments,
• Presenting the income statement by function and nature, and
• Adopting more rigorous other-than-temporary impairment policies.

In addition, Ms. Stacey noted that Statement 133's general preference is for derivative instruments to be reported at fair value, with changes in fair value being recorded though current income. As such, a company can reduce financial reporting complexity by foregoing use of fair value hedging.

Echoing one of the Conference themes, Ms. Stacey took the opportunity to emphasize the criticality of applying judgment by all of those involved in the financial reporting process. Financial statement preparation involves the use of estimates and assumptions, which will only increase if the trend toward fair value measures in financial statements continues to gain momentum. Management should describe to users how they arrived at estimates and assumptions, including events and circumstances that could cause changes in estimates and assumptions. Preparers were reminded to look to the SEC's 2003 MD&A interpretive release for additional guidance regarding disclosures related to management's use of estimates and assumptions.

In addition, she reminded auditors to engage experts and challenge management as deemed appropriate. Regulators and users were urged to be mindful of hindsight and second-guessing, and instead to focus on whether registrants (and auditors) had a reasonable basis for the estimates or assumptions.

Ms. Stacey emphasized that financial reporting is a communication exercise, as opposed to one of compliance. While increased business complexity is a contributing factor, opportunities remain for preparers to reduce the size of their filings. Ms. Stacey, reiterating many of the items included in the 2003 MD&A interpretive release, mentioned prioritizing disclosures for investors, emphasizing in MD&A those issues that keep the CEO "up at night," eliminating redundancies, and communicating in plain English. Lastly, she urged registrants to push back if they receive disclosure requests from the Division of Corporation Finance that the registrants believe are not material or are redundant of other disclosures in the filings.

Ms. Stokes explained that the SEC staff continues to scrutinize registrants' application of Statement 131 in (1) identifying all operating segments9 and (2) appropriate aggregation of those operating segments to arrive at reportable segments.10 She reminded participants that, in addition to meeting all five criteria outlined in paragraph 17 of Statement 131, operating segments must possess similar economic characteristics before they can be aggregated into reportable segments.

Ms. Stokes gave an example of a registrant that aggregated its operating segments into one reportable segment, but the operating segments had gross margins ranging from minus 15 percent to positive 60 percent. While there is no clear guidance on the meaning of "similar economic characteristics," the SEC staff objected to the aggregation because the significantly different gross margins made it difficult to conclude that the segments possessed similar economic characteristics.

Why are segment disclosures so important? In addition to providing investors with a management perspective, Ms. Stokes reminded participants that conclusions over operating segments impact other areas of accounting - for example, goodwill impairment under Statement 142. Remember that, at the date of a business combination, goodwill needs to be allocated to a reporting unit and that goodwill impairment is tested annually at the reporting unit level. Also remember that Statements 141 and 142 define a "reporting unit" as an operating segment or one level below an operating segment.

The consequence? If an enterprise makes an inappropriate conclusion regarding operating segments (e.g., one operating segment should have been two - one large profitable segment and one small unprofitable segment), it will likely inappropriately conclude on its reporting units as well. As a result, the enterprise might not record a goodwill impairment that is otherwise necessary (e.g., the deficiency of book value over fair value of an impaired reporting unit may have been inappropriately masked by the excess of fair value over book value of another reporting unit). Another potential consequence is that the enterprise could incorrectly calculate the amount of the goodwill impairment charge if the fair values of two reporting units are inappropriately combined in the impairment test.

When goodwill is material to an entity's financial position, Ms. Stokes reminded participants that registrants should consider discussing the following in their critical accounting estimates section of their MD&A: the nature of an entity's reporting units, how goodwill was allocated to those reporting units upon acquisition, how and when subsequent changes in the number of reporting units are identified, and the related accounting consequences.