Risk & Compliance

SEC Study Endorses Principles-Based Accounting

Approach should provide "more transparent information about a company's financial results and position." Also: Chase and Citigroup settle Enron-rel...
Stephen TaubJuly 29, 2003

The Securities and Exchange Commission has prepared a staff study that supports the adoption of a principles-based accounting system. This approach relies more on broadly applied principles and less on specific, detailed rules.

The SEC staff study, prepared by the Office of the Chief Accountant and the Office of Economic Analysis, was submitted last week to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives. It recommends that new standards should:

  • Be based on an improved and consistently applied conceptual framework.
  • Clearly state the accounting objective of the standard.
  • Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis.
  • Minimize the use of exceptions from the standard.
  • Avoid use of percentage tests — so-called bright lines — that allow financial engineers to achieve technical compliance with the standard while evading its intent.

The study, ordered under the Sarbanes-Oxley act passed last summer, “endorses an approach to setting accounting standards that should result in investors receiving more transparent information about a company’s financial results and position,” said SEC Chairman William Donaldson in a statement.

“Objectives oriented” is the term that the SEC will use for this approach to principles-based standard setting. Standards would clearly establish the objectives and the accounting model for the class of transactions, while also providing management and auditors with a framework that is sufficiently detailed for the standards to be operational, maintains the SEC.

“An objectives-oriented approach should ultimately result in more meaningful and informative financial reporting to investors and also would hold management and auditors responsible for ensuring that financial reporting complies with the objectives of the standards,” adds the commission.

The SEC points out that the Financial Accounting Standards Board has begun the shift to objectives-oriented standard setting and is doing so on a prospective, project-by-project basis. It adds that it expects the FASB will continue to move towards objectives-oriented standard setting on a transitional or evolutionary basis.

(Read more about how U.S. and international standard-setters are trying to get “On the Same Page.”)

Chase and Citigroup Settle Enron-Related Charges

The SEC reports that it has settled charges against J.P. Morgan Chase & Co. and Citigroup Inc. for their roles in Enron Corp.’s “manipulation of its financial statements.”

Each of the financial giants helped Enron mislead its investors by characterizing what were essentially loan proceeds as cash from operating activities, charges the SEC.

The proceeding against Citigroup also resolves other charges, adds the commission, stemming from the assistance Citigroup provided Dynegy Inc. in manipulating that company’s financial statements through similar conduct. Citigroup agreed to pay $120 million under its settlement; $101 million pertains to Citigroup’s Enron-related conduct and $19 million to the Dynegy conduct.

In U.S. District Court in Texas, the commission filed a civil injunctive action against J.P. Morgan Chase, which agreed to pay $135 million as disgorgement, penalty, and interest.

The banks neither admit nor deny the SEC charges under the settlements.

The payments — a total of $236 million in the Enron-related cases, and $19 in the case of Dynegy — will be used to repay the victims of the frauds, said the SEC. The commission brought these actions in coordination with the New York County District Attorney’s Office, which also settled with the banks.

“These two cases serve as yet another reminder that you can’t turn a blind eye to the consequences of your actions,” said Stephen M. Cutler, director of SEC’s Enforcement Division, in a statement. “If you know or have reason to know that you are helping a company mislead its investors, you are in violation of the federal securities laws.”

According to the SEC’s complaint, J.P. Morgan Chase and Citigroup engaged in and helped their clients design complex structured finance transactions. The structural complexity of these transactions had no business purpose, adds the commission, aside from masking the fact that, in substance, they were loans.

By engaging in these actions, Chase and Citigroup helped their clients inflate reported cash flow from operating activities, underreport cash flow from financing activities, and underreport debt, alleges the SEC. “As a result, Enron and Dynegy presented false and misleading pictures of their financial health and results of operations,” it adds.

With respect to Enron, both financial institutions knew that Enron engaged in these transactions specifically to allay investor, analyst, and rating agency concerns about its cash flow from operating activities and outstanding debt, charges the SEC. “Citigroup knew that Dynegy had similar motives for its structured finance transaction,” it adds.

In the 20 months since Enron declared bankruptcy, the SEC has brought six separate actions in connection with Enron. The commission added that its investigations relating to Enron and Dynegy are continuing.


AOL Time Warner has reported that the SEC has made a final determination that its accounting for two advertising deals was incorrect.

In its 10-K filed earlier this year, AOL disclosed that with respect to two related transactions between America Online and Bertelsmann A.G. in 2001, which were worth $400 million, the SEC had expressed a preliminary view to that effect. Management at the media giant added that the SEC recommended the company adjust its accounting.

“Since that time, the SEC staff has reviewed those transactions further, and the Office of the Chief Accountant of the SEC has recently informed the company that it has concluded that the accounting for these transactions is not correct,” noted AOL in a press release.

“Based on their knowledge and understanding of the facts of these transactions, the company and its auditors continue to believe that the accounting for those transactions is appropriate, but it is possible that the company may learn additional information as a result of its own review, discussions with the SEC and/or the SEC’s ongoing investigation that would lead the company to reconsider its views of the accounting for these transactions,” added AOL.

The new determination could lead to another restatement of earnings by the company.

Last October, AOL announced that it would restate revenues downward by $190 million for the eight quarters ended June 30, 2002. The restatement stemmed from advertising and commerce transactions at America Online.

Two months earlier, the company admitted that it may have overstated $49 million in advertising and E-commerce revenues at the America Online unit.

Short Takes

  • The IPO market continues to steadily reawaken along with the rest of the equity markets. This week radio giant Citadel Broadcasting Corp. plans to sell 22 million shares at $17 to $19 a pop, raising about $396 million. The offering is being led by Goldman Sachs & Co. Netgear Inc., whose products enable small businesses and households to share Internet access and information among multiple personal computers, hopes to raise about $77 million by selling 7 million shares at $10 to $12 apiece.

Lately, there have been one or two IPOs each week on average, according to Reuters. Many of these IPOs have soared in the first day of trading, just like in the good ol’ days in the late 1990s. The difference today — according to 123Jump.com analyst John Fitzgibbon, as reported by Reuters — is that “these deals are being offered to investors at a fire-sale price to ensure that the deal gets done, and to give it a good start in the aftermarket.”

  • NL Industries Inc. announced that CFO Robert Hardy will step down but remain as a consultant to the company in the near term. Gregory Swalwell has been named vice president, finance; Robert D. Graham has been appointed vice president, general counsel, and secretary; and Kelly D. Luttmer has been appointed tax director.
  • Philips Electronics’ finance director Jan Hommen has been appointed chairman of the audit committee at Ahold, which is currently embroiled in an accounting scandal.
  • Mellon Financial Corp. filed a shelf registration to sell up to $2 billion in debt securities, common and preferred stock, and other securities. The financial services giant said it plans to use the net proceeds for general corporate purposes, including working capital, capital expenditures, and investments in or loans to subsidiaries. The proceeds may also be used for refinancing debt, including outstanding commercial paper and other short-term indebtedness, if any, redemption or repurchase of shares of outstanding common stock, funding of possible acquisitions, and satisfaction of other obligations.
  • IBM signed a 10-year, $1.1 billion outsourcing deal with Swiss engineering company ABB to manage 90 percent of ABB’s information systems infrastructure operations. As part of the deal, more than 1,200 ABB employees will transfer to IBM.

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