In May, the Federal Accounting Standards Advisory Board issued two pronouncements dealing with federal agency loans and loan guarantees.

The intention of Statement of Federal Financial Accounting Standards no. 18, Amendments to Accounting Standards for Direct Loans and Loan Guarantees, is to improve financial reporting for subsidy costs and performance of federal credit programs. The new standard, which pertains to loans and guarantees from U.S. agencies such as the Small Business Administration and the Department of Education, applies when a federal agency provides a loan for a student or the SBA guarantees a loan for an individual.

Statement no. 18, which amends Statement no. 2, Accounting for Direct Loans and Loan Guarantees, becomes effective after September 30, 2000. (For the text of the document, see Official Releases, JofA, June00, page 112.)

FASAB’s second issuance, an exposure draft, requires program-by-program reconciliation for major credit programs to help identify each program’s performance. The ED refines Statement no. 18’s mandate for displaying such reconciliation on a reporting entity’s balance sheet. Titled Credit Program Reconciliation and Technical Amendments to Accounting Standards for Direct Loans and Loan Guarantees in SFFAS No. 2 and No. 18, the ED includes questions on which FASAB particularly wants respondent feedback. The comment deadline for the ED is August 10, 2000. Further details are available on the Web site at www.financenet.gov/fasab.htm .

The AICPA governing council last fall named FASAB as the accounting standard-setting body for the federal government, raising it to the level of FASB and GASB (see “AICPA Recognizes FASAB as GAAP Standard Setter,” JofA, Mar.00, page 24).

In March 2000, FASB released an interpretation on several implementation issues related to APB Opinion no. 25 on accounting for stock issued to employees. The guidance defined the term employee for purposes of applying the opinion and clarified accounting for options that have been repriced.

FASB Interpretation no. 44, Accounting for Certain Transactions Involving Stock Compensation, says that when a company directly or indirectly reprices its stock options it changes the terms of its stock compensation plan under the opinion, making it a variable plan. Edmund Jenkins, FASB chairman, said the interpretation brings needed consistency to the reporting of stock option awards and reduces the uncertainty over the appropriate accounting for option plans.

Interpretation no. 44 not only defines employee but also clarifies the criteria for determining whether a plan qualifies as a noncompensatory plan, the accounting consequences of various modifications to the terms of a previously fixed stock option or award and the accounting for an exchange of stock compensation awards in a business combination.

The interpretation says an individual is considered an employee if the company granting the stock options has control sufficient to establish an employer-employee relationship over him or her as defined by case law and IRS regulations.

Jenkins said the questions addressed in Interpretation no. 44 were not new and had been raised at times by preparers and auditors of financial statements since APB Opinion no. 25 was issued in 1972.

Jenkins also said the board based its guidance on the APB opinion and not on the concepts underlying FASB Statement no.123, Accounting for Stock-Based Compensation, issued in October 1995. Under APB Opinion no. 25, fixed option plans—whose terms, including price and number of shares granted, remain the same throughout the life of the plan—have no compensation expense associated with the options when the exercise price is equal to the fair value of the stock at the grant date.

Repricing—why companies do it

According to a knowledgeable industry observer, repricing is a sensitive issue—especially for high-tech companies that experience a lot of volatility in their stock prices.

It is not that those companies automatically have to reprice—it’s just that when the stock value falls, the options are significantly “out of the money” (that is, the option price is below the current price) and the companies are forced to issue options in lieu of cash compensation. In effect, the intrinsic value of an option disappears and a company must reprice to recapture value.

When asked whether more high-tech companies will be repricing, Dennis Powell, CPA, vice-president and corporate controller of Cisco Systems, said, “If a company experiences a decline in the value of its options—and that value is not likely to go up in the foreseeable future—it is going to lose all its employees. This could create a problem for the smaller technology companies.”

An example

Take the case of XYZ Technical Corp., which hired Maria Patton on October 1, 1998. As a hiring bonus, it granted her an option to purchase 5,000 shares of the company’s stock at $25 a share—the closing price of XYZ stock on that date. On October 1, 1999, she was granted an option to purchase another 5,000 shares at $50 per share—the stock’s closing price on that date. By mid-January 2000, the price of XYZ stock had increased to $80 per share. Had she exercised her options at that time, Maria would have experienced a significant financial windfall.

In April 2000, XYZ’s stock price declined to $15 per share. Maria’s options were “out of the money” by $10 and $35 per share, respectively. Since the company’s future prospects were uncertain and her options now worthless, Maria started looking for another job. To persuade her not to leave, XYZ adjusted the price of her two option grants—as well as those of other employees—to $15 per share. Based on the guidance in Interpretation no. 44, XYZ now had a variable stock option plan and must account for it as such on its financial statements.

Impact on high-tech companies

Powell said the FASB position that a company directly or indirectly reprices its stock options when it changes the terms of its plan under Opinion no. 25—making it a variable plan—was an “unfortunate” one.

“A reasonable solution,” added Powell, “would have been to allow one repricing before you had a variable plan—which would have been accepted as a sound compromise.”

What is commonly referred to as the “cash burn” rate could affect the viability of dot-com companies. If they cannot raise additional cash through an offering or some sort of cash infusion from a venture capital company, they have to control compensation—which is probably their largest single cost.

The provisions of Interpretation no. 44 became effective July 1, 2000, and, with some exceptions, will apply prospectively to new stock option awards, exchanges and modifications and changes in status that occur on or after that date.

In April, GASB issued Statement no. 36, Recipient Reporting for Certain Shared Nonexchange Revenues, which alters previous guidance on accounting for certain shared revenues. The new statement amends paragraph 28 of Statement no. 33, Accounting and Financial Reporting for Nonexchange Transactions.

Since GASB issued Statement no. 33 in December 1998, questions have arisen concerning the differences between the provisions of paragraph 28 of Statement no. 33 and the recognition requirements for government-mandated and voluntary nonexchange transactions, examples of which are certain grants and most donations.

The new guidance requires governments that receive shared derived tax revenues (for example, sales and income taxes), or shared imposed nonexchange revenues (for example, property taxes) to account for the sharing either as a voluntary or government-mandated nonexchange transaction, whichever is appropriate. An example of the latter transaction is federal government mandates concerning state and local governments.

Statement no. 36 also changed another aspect of recording shared revenue. Paragraph 28 of Statement no. 33 had said some recipient governments might not be able to obtain or reasonably estimate the accrual information necessary to record a nonexchange transaction and, therefore, should accrue revenue equal to cash received, adjusted for amounts that are attributable to prior periods.

The release of Statement no. 36 removed that requirement, permitting governments now to use any method that provides a reasonable estimate including, but not limited to, cash received.

Statement no. 33 had also required recipients of shared revenues to account for the transaction in a manner different from the provider government’s. Recipient governments were required to record the sharing as if they had imposed the tax (for instance, sales tax), rather than as if they had received a portion of a tax imposed by another government. Thus, in certain situations, the recipient government could have been required to report a receivable and revenue even though the provider government had not recognized a liability and expenditure for the same transaction. For example, a provider government might have collected revenues in one period, and appropriated and remitted them to the recipient government in the subsequent period.

GASB recommends that Statement no. 36 be implemented simultaneously with Statement no. 33, which is mandatory for periods beginning after June 15, 2000. Governments that already have implemented Statement no. 33 should apply the provisions of Statement no. 36 in preparing their next GAAP report.

In June, after numerous business entities reported problems implementing FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities, FASB issued an amendment, FASB Statement no. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, to address those concerns.

The newly issued provisions will ensure companies can more easily implement Statement no. 133. They have until the beginning of their first fiscal year after June 15—which, for many, is January 1, 2001—to do so.

Robert E. Jensen, a professor in the Department of Business Administration at Trinity University in San Antonio, Texas, said, “The amendment is designed to address some of the complexities involved in implementing Statement no. 133.” He noted, for example, that it relaxed restrictions on cross-currency hedges, which Statement no. 133 had effectively prohibited.

In addition, the FASB amendment expanded the normal purchases and normal sales exception, redefined the specific risks that can be hedged and allowed the use of intercompany derivatives as hedging instruments in certain situations.

Kevin Stoklosa, a FASB project manager, explained the reasoning behind the amendment provisions related to hedges of interest rate risk and hedges of foreign-currency-denominated assets and liabilities. “Before the amendment, Statement no. 133 permitted the market interest rate, defined as the risk-free rate plus the credit sector spread, to be designated as the hedged risk in a hedge of interest rate risk.” (The risk-free rate is generally equated with the return on three-month U.S. Treasury obligations; sector spread is the premium borrowers offer lenders, in addition to the risk-free rate, as compensation for the risk associated with their debt instruments.)

“The problem,” Stoklosa continued, “was that the derivatives available for hedging interest rate risk were based on a definition of interest rates that did not include the sector spread.” Therefore, the definition in the amendment now permits the use of a benchmark interest rate that excludes the sector spread. This enables companies to hedge interest rate risk with available derivative products.

In addition, as Jensen observed, the amendment relaxes Statement no. 133’s restrictions on hedging recognized foreign-currency-denominated assets and liabilities. Stoklosa noted that Statement no. 133 prohibits hedging items remeasured with changes in fair value reported in earnings. That notion was extended to hedges of foreign-currency instruments remeasured at current spot exchange rates with the resulting gain or loss reported in earnings. “But,” he said, “a measurement anomaly existed for certain foreign-currency instruments in which remeasurement at spot exchange rates did not represent fair value.”

Stoklosa said earnings volatility resulted when the changes in those foreign-currency items were compared to changes in the derivative hedging instrument, which is required to be measured at fair value. He said such volatility is mitigated by the amendment provisions permitting the recognized items to be designated as hedged items.

The purpose of the amendment project, Stoklosa said, was to address a limited number of issues causing implementation difficulties for a large number of entities. In his view, the amendment has achieved its objective, especially for institutions heavily involved in interest rate derivatives, which are probably the most common type of derivatives in use today.

Other kinds of companies will have fewer, if any, adjustments to make, Jensen said.

SEC Renews Push for More Oversight of Auditors

I n early May, SEC Chairman Arthur Levitt returned to the speaker’s podium at what has become for him a familiar venue—New York University. It was there, in September 1998, that Levitt charged the accounting profession with failing to ensure the independence of auditors. This and related issues are being examined from several perspectives, four of which are discussed elsewhere in this article.

In his recent speech, Levitt reiterated his view that auditors, in their reluctance to displease clients to whom their firms could provide consulting services, have been overlooking flaws, such as earnings misstatements, in those companies’ financial reports to the SEC. “Too many auditors are being judged not just by how well they manage an audit, but by how well they cross-market their firm’s nonaudit services,” he said, citing statistics showing that accounting firms’ consulting revenue has eclipsed their income from auditing services.

Oversight funding questioned

The week before the speech, the SEC practice section of the AICPA division for firms wrote a letter to the Public Oversight Board, an independent body of observers that monitors the profession’s self-regulatory activities. In it, the SECPS said it would discontinue funding of the POB’s review of auditor independence at the eight largest accounting firms until the SECPS, the POB and the SEC all agreed to the scope and nature of the review. The SEC had requested the review after it found PricewaterhouseCoopers auditors had substantially violated rules restricting their investments in the securities of audit clients.

The immediate result was a storm of protest, despite the SECPS’s explanation that the POB’s funding was only temporarily suspended, not terminated. Levitt said the SECPS’s action raised “serious questions as to the profession’s commitment to self-regulation.” Congressman John D. Dingell (D-Mich.), ranking member of the House Commerce Committee, offered Levitt his support in “getting needed reforms in place.”

Soon after the SECPS letter was sent, the AICPA took steps to ensure the POB could continue its work. According to John Hunnicutt, AICPA senior vice president, funding has been fully reinstated. In a related development, Hunnicutt said the POB had received comments from the AICPA board of directors on a draft of a new charter the POB had designed for itself. Following possible modifications by the POB, the AICPA board, which is a signatory of the charter, will review it once more in July.

Meeting a higher standard

In his remarks at NYU, Levitt said that if investors are to have confidence in auditors’ assessments of financial statements, they first must perceive the auditors as independent.

But some think objective criteria must be established to ensure such independence. Professor Rick Antle of Yale University’s School of Management recently analyzed auditor independence issues for the Big Five. “To the extent that the SEC’s allegations are about perceptions,” he said, “the firms can’t be sure they can do anything to respond effectively.”

In 1999, William T. Allen, chairman of the Independence Standards Board, sent the Big Five a questionnaire concerning auditor independence. Antle collaborated with Mayer, Brown & Platt, a Washington, D.C., law firm the Big Five engaged to analyze their responses to the ISB, a body jointly created by the SEC and the SECPS in 1997 to address long-standing auditor independence issues.

Mayer, Brown found the firms’ gross margin for auditing services was larger than that for consulting services, before compensation. This finding, which measured profitability, differed from the statistics Levitt cited, which measured consulting services revenue. Mayer, Brown also reported the firms said that, since assurance services are a consistent source of revenue, they will continue to work on improving audit performance and ensure consulting services do not jeopardize auditor independence and assurance revenue.

A source familiar with the ISB inquiry said it was designed to gather information on auditor independence from the biggest firms because they perform much of the audit work needed by public companies to satisfy SEC reporting requirements. Information on the ISB’s reaction to the firms’ reply, which was submitted in February, is not yet available. The ISB’s Allen could not be reached for comment.

During the months immediately preceding and following the Big Five’s reply to the ISB, they attempted to address charges that pursuit of consulting-related revenue was undermining their auditors’ independence. Each firm moved, in one way or another, toward divesting itself of its consulting division. Despite these planned actions, Levitt said in his address that the spin-offs “must be accomplished without creating conflicts of interest through long-term financial relationships.”

Behind the SEC’s quest

Earlier this year, the SEC conducted a special review of PricewaterhouseCoopers that uncovered more than 8,000 violations of auditor independence rules governing investments by auditors and their relatives in the securities of the companies whose financial statements they audit. As a result of these findings, Levitt asked the other Big Five firms to perform self-assessments of their past compliance with the financial investment rules. Each of the firms agreed to take part in the voluntary review program, which began on June 15, 2000, and is open to all accounting firms that practice before the SEC. ( Click here for additional information. ) Levitt also said the SEC would update the rules to recognize, among other things, increased independent investment by partners’ spouses—a factor complicating the impact of the rules on relatives’ investments.

Further, Levitt called for limits on the kinds of consulting services firms can perform for their audit clients, recommended that a majority of the ISB’s members be drawn from outside the profession and expressed his support for the new POB charter, which would expand its power to issue and enforce auditor independence rules.

But while Levitt pursued his goals, others stood in line for his attention. Members of the House Commerce Committee waited for a response to questions they had addressed to the SEC in April about its research into auditor independence activities. Congressman Tom Bliley (R-Va., chairman of the committee) gave Levitt two weeks to respond. A spokesman for Bliley said the committee is confident the SEC soon will supply any evidence it has of a causal relationship between consulting engagements and audit failures.

Putting the facts in perspective

According to a report published on March 31 by the Public Accounting Report, a newsletter focusing on the profession, Big Five growth in management and consulting services in fiscal year 1999 slowed to its lowest rate in five years. Although some might see this as proof the profession is not overly dependent on consulting revenue, the report attributes the slowdown to a Y2K-related pause in consulting engagements—a trend not expected to continue in 2000.

A study conducted recently by the Financial Executives Institute, an international trade association for senior financial executives, offered another view. According to the FEI, 85% of the more than 200 large companies it surveyed said they buy consulting services from the firms that audit their financial statements.

In a related finding, the Big Five’s responses to the ISB’s questionnaire indicated their assurance revenue grew by almost 10% in 1997 and 15% in 1998, ending a period of stagnation that began in the early 1990s.

Consulting and auditing a good mix?

Phillip Livingston, president of the FEI, said companies responding to the FEI study indicated they are very selective about the consulting work for which they engage their auditors’ firm. For example, although respondents said they wouldn’t employ an audit firm’s consultants to work on an activity or product of theirs the firm audits, such as derivatives, they don’t feel that way about other services, such as systems consulting, which they think the audit firm’s consultants are often best qualified to provide.

According to Livingston, most CFOs would cancel a proposed consulting engagement if even one member of their audit committee had misgivings about its effect on the auditor’s independence. Livingston said the FEI supports companies’ freedom to obtain consulting services from any firm they wish and that he hoped the SEC would, through its rulemaking process, codify best practices for choosing consultants, rather than pursue additional means of oversight. He suggested, as an example of a best practice, that proposed consulting contracts exceeding a certain dollar amount should automatically be referred to the audit committee for approval.

Meanwhile, as the JofA went to press, the Panel on Audit Effectiveness, which the POB convened to assess independence issues, released an exposure draft of a report stating that “both the profession and the quality of its audits are fundamentally sound” and that the POB’s research did not “identify any instances in which providing nonaudit services had a negative effect on audit effectiveness.” The report also said “the profession needs to address vigorously the issue of fraudulent financial reporting.” The panel will hold hearings this month to discuss its findings.

Adding value to the profession

Professor John C. (“Sandy”) Burton of Columbia University’s School of Business told the JofA that, in addition to solving its current problems, the profession also must plan its future boldly. “I advocate the accounting profession’s development of an expanded financial reporting function,” the former SEC chief accountant and member of the Accounting Hall of Fame said. “By that I mean an activity that not only would say whether a company’s financial statements are accurate, but also would assimilate and interpret them,” he said. “If the accounting profession is going to continue to have a significant role, it’s got to be willing to step forward.”

—Robert Tie