Office of the Chief Accountant:
December 1999 Letter to Auditing Standards Board re: Need for Additional Guidance on Revenue Recognition (Multiple Element Arrangements) and Loss Accruals

December 9, 1999

Ms. Debbie Lambert
Chair
Auditing Standards Board
c/o Johnson Lambert & Co.
7500 Old Georgetown Rd., Suite 700
Bethesda, MD 20814-6133

Dear Ms. Lambert:

The staff of the Securities and Exchange Commission ("SEC") appreciates and supports the Auditing Standards Board's ("ASB") efforts to provide relevant guidance on a variety of issues to enable auditors to fulfill their responsibilities to the public. The ASB's recently issued revenue recognition tool kit is an excellent example of the ASB's efforts to provide practitioners with much needed guidance. We also understand the ASB is developing a much needed revenue audit guide, a project the staff strongly supports.

As part of your efforts in this area, there is one particular revenue recognition issue that we would like you to address. There has been a significant increase during the 90's in companies providing solutions to their customers as opposed to just a product or service. Quite often, revenue generating arrangements today include multiple deliverables such as a package including a technology license, a service and a product. The delivery or performance of the products, services, and/or rights to use assets, occur at different points in time or over different periods of time. As a result of this continuing trend in business practice, we recently sent a letter to the Emerging Issues Task Force ("EITF") requesting that issues dealing with multiple element arrangements be added to the EITF's agenda.

In the absence of specific authoritative literature that addresses the accounting for these types of transactions, we believe that revenue should be allocated to the multiple elements based on the relative fair value of each element. In order to accomplish this allocation, we believe that sufficient verifiable objective evidence of fair value of the elements must exist.

Consequently, we ask that the ASB develop guidance for practitioners on what constitutes sufficient verifiable objective evidence of fair value for purposes of revenue recognition in multiple element arrangements. We suggest that this guidance be included in the revenue recognition audit guide referred to above.

As we have indicated to you previously, we are concerned about the need for more in-depth guidance in auditing standards and other ASB literature on auditing loss accruals (i.e., "reserves"). We believe that timely and more detailed guidance is essential in this critical audit area. This guidance could perhaps mirror the action taken by the ASB in developing the revenue recognition tool kit and the related practice alert and audit guide. At Exhibit A, we have provided details on the types of problems that the SEC staff has seen regarding auditing loss accruals and have, as requested, also provided suggested areas for guidance.

In view of the importance of these issues and the necessity for timely guidance, we encourage the ASB to develop this guidance as quickly as possible. Since it is important that auditors have this guidance as soon as possible, could you please provide me with a copy of your timetable for developing and completing these guides.

Should you have any questions regarding the attached, please contact either Scott Bayless, Eric Jacobsen, or me at (202) 942-4400.

Sincerely,

Lynn E. Turner
Chief Accountant

cc: Amy Ripepi, Chair, SEC Regulations Committee
Timothy Lucas, Technical Director, FASB staff

enclosure: Letter to EITF

EXHIBIT A

A number of accounting standards, including FASB Statement No. 5, Accounting for Contingencies, EITF Consensus 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs incurred in a Restructuring), and 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination, FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, as well as other standards, require significant judgment by both management and the auditor in determining the proper accounting for loss accruals under generally accepted accounting principles.

A review of enforcement cases, as well as required restatements of financial statements in filings with the Commission, indicate that corrections in the financial statements related to liabilities such as contingent liabilities, restructuring accruals and other types of loss accruals, are not the result of system based errors. Rather the corrections are due to adjustments originally made by or under the supervision of senior financial reporting personnel. In these situations, the SEC staff has seen the following unsuccessful audit techniques used:

1. The loss accrual balance in the current period is the same, or nearly the same, as in the prior period, and it was noted that, due to this fact, no further audit work was required to be performed,

2. Not clearly understanding the activity in the loss accrual account and the impact on the audit client,

3. A lack of understanding of the basis for the accrual and the necessary supporting evidence,

4. Testing the loss accrual balance through poorly designed or implemented analytical procedures,

5. Applying analytical procedures to subjective audit areas incapable of testing through analytical procedures,

6. Only testing a loss accrual to ensure that the balance is not understated,

7. Missing disclosures mandated by GAAP,

8. A lack of testing of the proper classification of costs, and

9. Testing that failed to identify the fact that assets such as inventory, for which a writedown at year end establishes a new cost basis, as noted in ARB 43 and SAB 100, cannot be subsequently adjusted upward through the upward adjustment of "reserves."

The 1987-1997 Committee of Sponsoring Organizations ("COSO") Report on Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S. Public Companies, also highlights some ideas that need to be considered. For example, it notes that in over 80% of the enforcement cases examined, a senior member of management was involved with overriding controls. Given this type of statistic and the results the SEC staff has seen from its review of filings, guidance needs to be provided as to:

1. The interaction of Statements on Auditing Standards ("SAS") 82 and the business and audit risks inherent in auditing subjective contingent loss accruals and other types of "reserves." This includes inherent pressures that may give rise to improper "earnings management."

2. Given the fact these account balances usually are not system driven, but rather are based on highly subjective judgments, when is it appropriate to rely upon controls versus robust substantive tests.

3. In light of the nature of the processes and procedures for establishing these account balances by senior management in a company, or perhaps large U.S. or foreign division, what comprises sufficient, verifiable, objective audit evidence for the account balances given. It is important to note that there may not be evidence available from an independent source for at least some of the account balances. Too often we have seen a lack of supporting evidence for restructuring charges and other loss accruals. In some cases, companies and their auditors have not even been able to explain the reason for the establishment of, or basis for continuing, the account balance.

4. Given the involvement of senior management, a process that, in many situations, is "manual" verus system driven, and lacks the typical level of independent third party evidence, what is the appropriate "oversight" role of the audit committee or internal auditors?

The staff believes it is important that auditors:

1. Carefully consider all the risk factors set forth in SAS 82, and how for a particular client, the existing risk factors should be assessed and related to the specific determination of the nature, timing and extent of the audit tests.

2. In light of the business, industry and control risks affecting the company, as well as the subjective nature of the particular types of estimates being examined, consider the type of verifiable, objective evidence that would be required to support the account balances. Please note that SAB 100 discusses the need for appropriate documentation as well as internal accounting controls.

3. Test not only the ending balances, but also the propriety and classification of activity in the accounts during the periods presented. The testing should not be limited to merely determining if the liability is understated, but rather whether it is properly stated such that the financial statements are fairly presented in all material respects. The staff appreciates the judgment involved in reporting for certain liabilities, and that a range of possible or probable losses may exist. But the SEC staff has and will continue to challenge loss accruals that are either materially understated or overstated, including when understated or excess liabilities are used to manage earnings.

http://www.sec.gov/info/accountants/staffletters/asb120999.htm