Commission Information:
Letter From the Office of the Chief Accountant Regarding the 1998–1999 Audit Risk Alerts

October 9, 1998

Mr. Thomas Ray
Director, Audit and Attest Standards
American Institute of Certified Public Accountants
1211 Avenue of the Americas
New York, NY 10036-8775

Dear Tom:

The staff of the SEC is pleased to provide the AICPA with comments on potential topics for this year's Audit Risk Alerts. The topics noted below are of concern to the SEC staff and should be given due consideration by auditors of public companies. The 1998/99 General Audit Risk Alert provides an excellent opportunity to highlight these matters to the profession.

One of the reasons US capital markets have been cited as the best in the world is the high quality and integrity of the financial reporting system in the United States. This financial reporting system, which has been established through the combined efforts of both the public and private sector, is designed to provide investors with sufficient and reliable information necessary to make informed investment decisions. High quality financial reporting serves as the foundation and source of information for our entire disclosure system. A general attribute of our financial reporting system is transparency, which is the complete reporting and disclosure of transactions such that the financial statements reflect accurately the underlying results of the business.

Our financial reporting system generally has served our markets well and has minimized the premium charged for capital. However, the staff has noticed recently some trends in financial reporting that, if left unaddressed, may threaten the preeminent position of US markets because they cause investors to question the reliability and transparency of the financial statements of US registrants. These trends range from an inappropriate management of earnings to fraud, and encompass inappropriate application of generally accepted accounting principles ("GAAP"), and aggressive applications of GAAP. These trends have been manifested in a rash of recent highly publicized cases of alleged financial accounting fraud in which corporate financial results may have been misrepresented.

A number of troublesome areas involving the use of inappropriate earnings managment techniques have been highlighted in Chairman Levitt's recent speech on this topic. This speech, which is available at the SEC website (www.sec.gov/news/speech/speecharchive/1998/spch220.txt) notes the action plan the Commission and its staff is taking with respect to its initiative on earnings management. The action plan includes a focus on the part of the staff of the Divisions of Corporation Finance and Enforcement in reviewing the filings of public companies.

Because of these trends, the SEC staff believes that there is a need for greater auditor vigilance. The SEC has highlighted certain issues to focus the attention of management, audit committees and auditors to these issues. The Commission cannot tolerate an erosion of investor confidence, which will inevitably occur if investors believe that the information they receive is a product of manipulation or gimmickry. Manipulated, incomplete, or unreliable information generally is cited as a common problem in weaker financial reporting systems and has contributed to economic problems in other areas of the world, such as Asia and Russia.

Audit Committee Role

Audit committees must play a very important role, along with the Chief Financial Officer ("CFO") and auditor, in achieving high quality internal financial controls and financial reporting by public companies. Recently, the efforts of certain audit committees have been questioned in the press. These cases highlight the need for audit committees to fulfill their responsibility for Board of Directors oversight of the integrity and quality of the accounting process and independence of the auditor. A critical part of this oversight is ongoing and timely communication with both the auditor and CFO so that the audit committee is sufficiently informed about significant internal control and financial reporting matters. Armed with this information, the audit committee must be able and willing to ask the CFO and auditor the necessary tough questions about the selection and application of accounting principles and estimates, the preparation of disclosures, the impact of transactions and relationships on the auditor's independence, internal controls and any other matter significant to the registrant's financial reporting process.

While the audit committee itself plays an important role in achieving high quality and integrity in the financial reporting system, the auditor plays an equally important role in the process. The auditor has an obligation under the literature (AU 380) to communicate with the audit committee or, lacking an audit committee, to those who have the responsibility for oversight of the financial reporting process. In order to ensure that the audit committee receives the information necessary to carry out its responsibilities the auditor must determine that the audit committee is informed as to:

• The initial selection of and changes in significant accounting policies and their application,

• The process used in formulating sensitive accounting estimates,

• Adjustments proposed by the auditor but not recorded by the entity that could cause future financial statements to be materially misstated,

• Disagreements with management and whether or not satisfactorily resolved,

• Cases when management consulted with other accountants about auditing and accounting matters,

• Difficulties encountered in performing the audit, and

• Other information, such as the Management's Discussion & Analysis ("MDA").

The staff believes it would be useful for the 1998/99 General Audit Risk Alert to highlight the importance of these communications, which hopefully go beyond just another "form letter." In addition, the risk alert could note the proposal of the Independence Standards Board for a "robust" discussion of auditor's independence issues, between the audit committee and auditor.

Intentional Immaterial GAAP Violations

The high earnings multiples on which stocks are assessed and traded in today's markets have heightened the importance of reported earnings. Familiar measures of materiality, for example, 5% of pre-tax income, may not be adequate in a marketplace with P/E multiples of 40, where missing the market's expectation of earnings per share by a penny can have significant consequences. In such an environment, management, auditors, and boards of directors should be concerned when known violations of GAAP are present in the financial statements.

The SEC staff believes that auditors must assess the qualitative factors important in determining whether information would be considered material to investors. The use of quantitative factors alone is not sufficient. Percentage tests, such as one based upon the relationship of the item in question to earnings figures, often are not conclusive, sometimes not relevant. Indeed, a trend, such as a trend of earnings for a period of years, may be as important to a question of materiality as a selected percentage. In addition, known errors that have not been recorded based solely on a quantitative materiality factor, especially intentional errors, should be addressed. When qualitative materiality significantly alters the apparent significance of a matter, the pertinent information should be adjusted or disclosed.

When considering issues of materiality, auditors of public companies are expected to consider guidance that is already provided in several important areas including court decisions, Commission rules, regulations and enforcement actions, as well as accounting and auditing literature.

In-Process R&D

The SEC staff has been challenging registrants that have recognized significant in-process R&D ("IPR&D") charges as part of a purchase business combination. The challenges have run to valuation methodologies and value assigned to both core technology (which is capitalized and amortized) versus IPR&D (which is expensed immediately). The SEC staff has issued a letter to the AICPA SEC Regulations Committee (copy attached) requesting assistance in developing best practices in this very judgmental area. The AICPA is in the process of forming a task force to commence working on this project.

In its letter to the AICPA SEC Regulations Committee, the SEC staff emphasized that the allocation of the purchase cost of a business or group of assets can affect current and future reported results significantly. The accounting literature requires that the allocation begin with an analysis to identify all of the tangible and intangible assets acquired. In addition to IPR&D, intangible assets such as rights to existing products, underlying technology, patents, copyrights, brand names, customer lists, marketing channels, and engineering work force may be identified. The fair value of each asset must be estimated. The total purchase cost is allocated based on the relative fair values of the individual assets.

The SEC staff has noted that unreasonable valuations of IPR&D appear to be caused frequently by management's treatment of attributes of capitalized assets as if they were attributes of IPR&D. A common practice problem is the bifurcation of purchased rights to technology into two categories: (a) the immediate value of any presently completed product and (b) the future value of the right to enhance or embellish that product. The latter right was deemed to be IPR&D because that right will be used in research and development. The SEC staff believes that the value of the right to enhance or embellish an existing product, or the right to enhance or embellish an existing technology that has alternative future uses, is not separable from the value of ownership of the intellectual rights to the technology itself. If the technology itself meets the criteria for capitalization, the fair value of that asset necessarily includes the value of the right to enhance or embellish the asset. That fair value includes also the value of the engineering know-how intrinsic in the technology which will serve as a platform for future versions.

SEC staff reviews of filings have noted a number of other problems involving IPR&D. Problems noted include the definition of fair value, purchase price allocations based on appraisals that use an income approach involving forecasted cash flows between IPR&D and other assets, and valuations that employ a "relief from royalty" approach using average industry royalty rates. (This is a hypothetical rate which may not reflect the full value of ownership of a product and all the related intellectual property rights). The SEC deems the relief from royalty approach unacceptable. In addition the staff has questioned purchase price allocation when a valuation model, such as replacement cost and forecasted income, have been used to allocate the purchase price between capitalized R&D, IPR&D, and goodwill.

The SEC staff will continue to apply these views in its review of filings. Restatement of financial statements will be necessary if a registrant's valuation of IPR&D is materially misleading. Revisions to disclosures may also be required to describe in detail the assets acquired, commitments necessary to fund future development efforts, and material assumptions underlying the purchase price allocation.

We recommend the risk alert note the staff's concerns highlighted above. It should also note the various sources of authoritative literature auditors should consider when testing valuations used in preparation of financial statements. This would include the literature on use of a specialist, including how it relates to work performed by specialists in one's own firm. The staff has been concerned that in some registrant filing matters, it does not appear the auditor has adequately tested or challenged the underlying assumptions and data used to develop the valuations. In other instances, it appears auditors may have generated the numbers used in valuations and in the financial statements, and then audited those same numbers, giving rise to a question as to whether the auditors were in fact auditing their own work. This of course would give rise to a question by the staff as to the independence of the auditors.

Asset Impairments

FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of (Statement 121), does not provide sufficient specificity as to a plan of disposal, including a current ability to dispose of the asset. There also is inadequate guidance provided on the impairment of goodwill, which has contributed seemingly to discretionary write-offs. The FASB currently is working on a "repairs and maintenance" project to address certain problematic areas of Statement 121, to reconcile the various impairment/loss recognition models currently in existence, and to provide guidance on the appropriate cash flows to be used in evaluating impairments. These are all areas that the SEC staff believes should be addressed.

In the interim, the SEC staff has provided a letter to the AICPA SEC Regulations Committee (copy attached) relative to requirements of disposal plans. That letter stated that, in the staff's view, a necessary condition to a plan to dispose of assets in use is that management actually have the current ability to remove the assets from operations. For example, the staff believes that a capital replacement plan contemplating the upgrading of machinery and equipment before these assets are fully depreciated over their originally estimated lives would not qualify as a plan of disposal under Statement 121 if the assets cannot be taken out of operations for sale or abandonment prior to installing new machinery and equipment. The operational requirement to continue to use the asset is indicative that the asset is held for use. In this circumstance, management must assess the recoverability of the asset's net carrying amount and reconsider its expected useful life and salvage value in light of the capital replacement plan.

Under Statement 121, a necessary condition to classify an asset as held for disposal is a plan by management to take that action. The staff appreciates that determining whether a plan satisfies that condition can be difficult when managers continuously prepare plans in differing levels and that management's commitment to execute any of its plans is tempered by its responsibility to react flexibly to new information.

When evaluating whether and when a plan to dispose of assets meets the requirements of Statement 121, the SEC staff believes that in addition to having the current ability to remove the assets from operations, registrants should consider analogous criteria in Accounting Principles Board Opinion ("APB") No. 30, Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, and EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Cost to Exit an Activity (including Certain Cost Incurred in a Restructuring). Those standards and consensus require a plan to have the following characteristics:

• Prior to date of the financial statements, management having the appropriate level of authority approves and commits the enterprise to a formal plan of disposal, whether by sale or abandonment,

• The plan specifically identifies all major assets to be disposed of, significant actions to be taken to complete the plan, including the method of disposition and location of those activities, and the expected date of completion,

• There is an active program to find a buyer if disposal is to be by sale,

• Management can estimate proceeds or salvage to be realized by disposal,

• Actions required by the plan will begin as soon as possible after the commitment date, and

• The period of time to complete the plan indicates that significant changes to the plan are not likely.

Auditors should test the data and underlying assumptions used by management in assessing whether an asset impairment has occurred. That testing should consider if the impairment is reasonable in light of previous disclosures by a public company about its business, senior management's presentations to the Board of directors regarding budgets and strategic plans, and ongoing global and industry developments.

The staff also believes that many impairment charges are a result of improper attention to depreciation lives in prior periods. Registrants will be alerted that "overnight" goodwill and asset impairment charges will be challenged vigorously by the staff if, for example, evidence exists that management had known about, or contemplated, disposing of the asset in prior periods and had not properly adjusted the estimated useful life on a timely basis.

Auditors should review the reasonableness of the initial depreciation and amortization periods assigned to tangible and intangible assets. That review should consider all of the relevant factors including global, industry, regulatory and company specific factors. Such factors, including changes in business technologies and strategies need to be carefully assessed at the end of each financial reporting period for the potential impact on the useful lives of assets.

Revenue Recognition

• Market channel stuffing without adequate provisions for sales returns. In some of these instances it appears the company may not have had sufficient visibility into the channel to make reasonable estimates for sales returns pursuant to FASB Statement No. 48, Revenue Recognition When Right of Return Exists.

• Accelerating revenue recognition prior to delivery of the product to the customers site, or prior to completion of the terms of the sales arrangement.

• Recognition of revenue when customers have unilateral cancellation or termination provisions, other than the normal and customary product return provisions, especially in unusual or complex transactions.

• Questionable bill and hold provisions.

• Recognition of upfront fees when other than perfunctory provisions of the sales agreement have yet to be fulfilled.

This observation is supported by the high level of SEC enforcement cases in this area, ongoing problems in the high tech industry, and other high profile cases.

The SEC staff believes that appropriate requirements already exist in the accounting literature and findings of the Commission in previous enforcement cases. Specifically, FASB Statement 48, SOP 97-2, Software Revenue Recognition, Concepts Statements No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, and No. 6, Elements of Financial Statements, and Accounting and Auditing Enforcement Release ("AAER") No. 108 (see discussion of bill and hold arrangements below) provide guidance on revenue recognition. In addition, the recognition and measurement of liabilities associated with refundable fees should be considered by auditors. That is, liabilities should be recognized based on contractual obligations; revenue should not be recognized until it is realized or realizable and earned.

SOP 97-2 most recently addressed the criteria that must be met for revenue to be recognized, and should be considered by others in industries outside of the software industry, particularly if the transaction is complex or unusual. Those criteria are:

a)	persuasive evidence of an arrangement exists
	– customer must have fixed commitment
b)	delivery of the product or service has occurred
	– the risks of ownership must pass to the buyer
	– the seller must not have retained any specific performance obligation
c)	the fee or price to be received is fixed or determinable
	– appropriate recognition should be given to the likelihood of returns
	– the refundability of a fee may indicate that it is not fixed or determinable
d)	collectibility is probable

In addition, if it is a bill and hold arrangement:

– the buyer must request the bill and hold arrangement

– the buyer must have a substantial business purpose for the arrangement

– the goods must be segregated

– the items to be delivered must be complete and capable of being delivered

The ASB has indicated that it will develop a "Tool Kit" (similar to the product developed by the AICPA for the Year 2000 issue) by the end of 1998 summarizing audit guidance in the revenue recognition area. The ASB has also been asked to elevate to authoritative guidance the information contained in Practice Alert No. 95-1 on revenue recognition issues. It would be useful for the risk alert to mention these projects and materials.

Auditors should be well informed of a company's revenue recognition policy for each different type of material sales transaction. Disclosure of these policies should be made in accordance with APB No. 22, Disclosure of Accounting Policies. Auditors should be alert to the possibility of unusual or complex transactions. This may require the auditor to make inquiries of marketing or sales personnel or undertake other alternative auditing procedures. When unusual or complex revenue transactions exist, the firm should ensure that personnel with the appropriate level of expertise are involved with analyzing the appropriate accounting.

Improper Accruals and Estimated Liabilities

The accounting specified by EITF Issue No. 94-3, and Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination, requires management to accrue future costs to exit an activity based on an approved management plan. They do not, however, allow for the creation of general accruals. General accruals cannot be recognized unless the criteria of FASB No. 5, Accounting for Contingencies, are met, i.e., " . . . it must be probable that one or more future events will occur confirming the fact of the loss, and the amount can be reasonably estimated."

The accounting that has resulted from the consensuses to these two issues has proven highly discretionary. The staff has noted a number of circumstances in which costs of future periods have been charged off in the current period prior to the development of a detailed plan. The SEC staff believes that registrants and their auditors have a responsibility to assure the reliability and comparability of the amounts reported pursuant to EITF issues No. 94-3 and 95-3. Auditors should consider whether:

• plan details are sufficiently specific for merger-related, restructuring, or exit costs to qualify for accrual in the current period,

• the activities qualify as exit activities,

• the disclosures specified by EITF consensuses have been provided for each period, and

• accruals that are not used for their original intended purpose are reversed when the relevant information becomes known. The reversal should be classified in the income statement in the same manner as the original provision, with disclosure provided of the amount credited to income and the reason therefor.

It has been noted in some instances that analytics have been the only auditing procedures applied to significant liability accounts established for losses such as restructurings. For example, the staff has noted where balances were compared from one year to another, and as long as the balances did not change, the auditor noted no further work was considered necessary. Often such an audit procedure is inadequate in light of ongoing changes to the company's business plans, strategies and industry conditions. Auditors need to understand what activity has occurred within the account balances, and in instances where no activity has occurred, question if this is appropriate. Too often we have seen instances where the activity in account balances did not receive sufficient scrutiny by the auditors. We have also seen circumstances where the auditors did not adequately understand or test the original plan and assumptions used to record the initial liability. In some cases this has resulted in over-stated liability accounts that are improperly reversed to income at a later date.

There is also a viewpoint among some accountants that a focus of financial reporting is to ensure that liabilities are not understated and therefore, the larger a liability is, the more "conservative" the accounting is. The staff certainly believes liabilities should be recorded pursuant to the authoritative literature, including FASB Statement No. 5, on a timely basis. However, recording a larger than necessary liability, especially when that liability is used later to manage earnings, is not conservative accounting.

S-X Schedules

A reconciliation of valuation allowances and qualifying accounts (allowances for loan losses or bad debts, loss accruals, restructuring or business combination liabilities etc.) currently is required by Regulation S-X [Article 12 of Reg S-X (210.12-09)]. However, this information is not always being provided as required. The staff believes that these schedules provide important information to investors. The staff has seen a number of cases of excessive loss accruals, inappropriate charge-offs of items against liabilities set up for other items, and reversals of excess accruals to boost earnings in selected periods. The lack of information about changes in balances (including the reallocation among accrual balances) hinders analysts in identifying the impact on earnings attributable to reversals.

An auditors opinion is required on the supplemental schedules provided pursuant to Regulation S-X. Auditors should ensure the schedules include the required information. The information in the schedules should also be consistent with that reported in the financial statements and in other data in the Form 10-K.

Segment Information

FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, is effective for periods beginning after December 15, 1997. The new standard requires that companies disclose segment data based on how management makes decisions about allocating resources to segments and measuring their performance. The Auditing Standards Board has issued an interpretation (AU Section 326, Evidential Matter) requiring, among other things, that auditors "review corroborating evidence, such as information that the chief operating decision maker uses to assess performance and allocate resources, material presented to the board of directors, minutes form the meetings of the board of directors, and information that management provides in the MD&A to financial analysts, and in the Chairman's letter to shareholders, for consistency with financial statement disclosures."

In light of recent financial difficulties in a number of foreign markets, it will be critical that the segment disclosures include the appropriate geographical disclosures. In addition, major product line information continues to be a required disclosure pursuant to Regulation S-K, Item 101.

The SEC staff will monitor closely the implementation of Statement 131 and segment information in the financial statements and the MD&A to assess its consistency and completeness. The staff may require additional supplemental information when the segment disclosures do not appear to be consistent with information disclosed elsewhere in the filing or to the public, such as to analysts. Inconsistencies, or perceived failure to provide all necessary operating segments and other information in the financial statements will be challenged.

It should be noted that in a recent enforcement action involving segment disclosures (see AAER Nos. 1061 and 1062) the Commission stated that "The issuer's legal obligation extends not only to accurate quantitative reporting of the required items in its financial statements, but also to other information, qualitative as well as quantitative, needed to enable investors to make informed decisions. Such information, particularly the information embodied in the issuer's MD&A discussion, is of critical importance to market professionals and individual investors alike." In addition, the Commission reiterated an earlier MD&A release (Financial Reporting Release No. 36 dated May 18, 1989) which stated that in the absence of MD&A, "a company's financial statements and accompanying footnotes may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance." The Commission further cited the earlier MD&A release in the instant case, stating that "MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short and long-term analysis of the business of the company." The action was initiated as a result of a substantial "overnight" write-off of goodwill.

Inventory

Both the SEC and FASB staffs believe that the accounting literature requires that a write down of inventory to the lower of cost or market at the close of a fiscal period creates a new cost basis that cannot be subsequently marked up based on changes in underlying facts.

Accounting Research Bulletin No. 43, Chapter 4, Statement 5, specifies that:

"A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical obsolescence, changes in price levels, or other causes, the difference should be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market."

In addition, APB No. 20, Accounting Changes, provides "inventory obsolescence" as one of the items subject to estimation and changes in estimates under the guidance in paragraphs 10-11 and 31-33 of that Opinion.

Risks and Uncertainties

SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties includes disclosure requirements for certain significant estimates and vulnerability due to certain concentrations. Registrants should carefully analyze the need for adequate disclosure of such matters in light of Year 2000 issues and ongoing developments in certain foreign and industry markets. These developments may also impact market risk disclosures pursuant to Regulation S-K, Item 305.

Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisors, Investment companies, and Municipal Securities Issuers

The SEC has published interpretative guidance for public companies, investment advisors, investment companies, and municipal securities issuers. The guidance provides the SEC's guidance based on the federal securities laws and focuses on Managements Discussion and Analysis. The guidance clarifies when Year 2000 disclosures are required, as well as what disclosures are necessary.

Auditors should be aware that the interpretive release discusses certain Year 2000 financial statement considerations. These include the proper accounting for Year 2000 related costs, including the costs of failure to be Year 2000 compliant and losses from breach of contract. The guidance discusses the auditors responsibilities for conducting the audit and notes the applicable guidance in the AICPA publication, The Year 2000 Issue – Current Accounting and Auditing Guidance. The release also notes the responsibilities of registrants and their auditors for disclosing Year 2000 issues in a Form 8-K.

Planning and Supervision

The recent combination of changes in the audit process and high profile financial frauds have raised questions about the efficacy of the audit process. For example, auditors have changed their audit procedures to use a risk assessment model that places increased reliance on analytical procedures, while decreasing the use of substantive audit procedures, such as confirmations with debtors and detailed testing of transactions, account balances, and the activity in those accounts. This restructuring of the audit process has come at a time when the press has reported several frauds involving materially and in some cases hugely misstated financial statements that appear to have gone undetected by auditors.

Use of this audit process involves substantial ongoing assessments of operations and associated risks, and how those risks might impact the reported results. The SEC staff is concerned that many of the individuals performing audit work today may lack the practical business experience necessary to perform these high level assessments, which may have significant detrimental effects on the quality of audits. AICPA Professional Standards require that "work be assigned to personnel having the degree of technical training and proficiency required in the circumstances" (System of Quality Control for a CPA Firm's Practice, section 20.13). The SEC staff believes that in order to comply with this standard it is essential that the firms bring more partner-level and in-depth industry experience to bear at earlier stages of the audit and more frequently during the audit if use of the risk assessment approach is to be effective in protecting investors.

I appreciate the AICPA's continued efforts to alert its members to the challenges facing auditors today, and am available to discuss these issues at your convenience.

Sincerely, Lynn E. Turner Chief Accountant

Enclosures

cc:	Arleen Thomas, Vice President, Professional Standards and Services, AICPA
	Deborah Lambert, Chair, Auditing Standards Board

September 9, 1998

Mr. Robert Herz
Chair, AICPA SEC Regulations Committee
c/o PricewaterhouseCoopers, LLP
101 Hudson Street
Jersey City, NJ 07302

Dear Mr. Herz:

Recently published articles and research indicate that the amounts written off by public companies as acquired in-process research and development ("IPR&D") have increased dramatically both in magnitude and frequency. Prior to the 1990's, large write-offs of IPR&D were rarely reported, even though acquisitions of high technology companies occurred frequently. Although there was no change in the relevant accounting literature, IPR&D write-offs increased significantly in the 1990's. More intense merger activity in the technology sector may explain some of the increase, but abuses in the valuation of IPR&D also are suspected. This trend of larger write-offs could undermine public confidence in financial statements and presents significant challenges for the accounting profession.

The staff's own inquiries into IPR&D write-offs have identified circumstances where many of the facts appear at odds with the fair value assigned to that asset as part of the purchase price allocation. Examples of this include:

• A company acquired a product which it intended to continue to market. An updated version of the product had been released shortly before the acquisition and only a small amount of work towards the next release was completed. However, the vast majority of the purchase price was allocated to IPR&D.

• An appraisal of a company's IPR&D was based on forecasted revenues for the next seven years. The forecast included estimated revenues not only for the existing product and the succeeding version under development at acquisition date, but also estimated revenues for later versions not then under development. The cost and time necessary to develop any future version would be much greater without the "core technology" included in the currently marketed version. Yet the appraisal attributed substantially all revenues from all the future product versions envisioned by the acquiring company to the value of IPR&D.

• An appraisal underlying a write-off of substantially all the purchase price as IPR&D was inconsistent with the business reasons for the acquisition presented to the Board of Directors.

• Valuations developed by two different independent appraisers of the same business combination reached differing conclusions about even the existence of technology that should be capitalized.

• A company allocated nearly all of the purchase price to IPR&D, but the target company had not incurred or disclosed expenditures prior to the acquisition that would indicate any significant research and development effort.

More thorough study of the situations described above confirmed the presence of significant problems in the recognition and valuation of IPR&D. In light of the practice problems we encountered, we encourage the AICPA SEC Regulations Committee to provide its constituency additional guidance concerning IPR&D. A working group comprised of appraisers, auditors, and accountants from industry could be useful in the development of a comprehensive description of best practices in this area. We would be pleased to participate in those efforts, too.

The allocation of the purchase cost of a business or group of assets can affect current and future reported results significantly. The accounting literature requires that the allocation begin with a rigorous analysis to identify all of the tangible and intangible assets acquired. In addition to IPR&D, intangible assets such as rights to existing products, underlying technology, patents, copyrights, brand names, customer lists, marketing channels, and engineering work force may be identified. The fair value of each asset must be estimated. The total purchase cost is allocated based on the relative fair values of the individual assets.

Unique among purchased assets, IPR&D must be written off immediately in certain circumstances. FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, distinguishes between "assets resulting from research and development activities" and "assets to be used in research and development activities." The amount of the purchase price allocated to "assets to be used in R&D activities" must be expensed as IPR&D unless those assets have an alternative future use.

Unreasonable valuations of IPR&D appear to be caused frequently by management's treatment of attributes of capitalized assets as if they were attributes of IPR&D. A common practice problem is the bifurcation of purchased rights to technology into two categories: (a) the immediate value of any presently completed product and (b) the future value of the right to enhance or embellish that product. The latter right was deemed to be IPR&D because that right will be used in research and development.

We believe that the value of the right to enhance or embellish an existing product, or the right to enhance or embellish an existing technology that has alternative future uses, is not separable from the value of ownership of the intellectual rights to the technology itself. If the technology itself meets the criteria for capitalization, the fair value of that asset necessarily includes the value of the right to enhance or embellish the asset. That fair value includes also the value of the engineering know-how intrinsic to the technology which will serve as a platform for future versions.

Our reviews of filings detected a number of other problems involving IPR&D. Additional practice issues and questions which the Committee should consider in its development of guidance for IPR&D include the following:

• APB 16 requires that the allocation of purchase cost be based on "fair value." In some circumstances, some appraisers have defined fair value not as "fair market value" (e.g., the exchange price between a willing buyer and seller), but as "investment value to a particular buyer" (e.g., the value of the assets to the acquiring company). That approach is not defined in the accounting literature and is not appropriate to the extent it varies from "fair value."

• The fair value of IPR&D should be determined separately from all other acquired assets. The fair value of IPR&D relating to an enhancement of an existing technology should not be different, depending on whether or not the acquiror already owns the technology itself. Value flowing from acquired brand names, customer relationships, and engineering and marketing resources should not be attributed to IPR&D. Estimation of the fair value of IPR&D requires consideration of factors specific to that asset, such as its stage of completion at the acquisition date, the complexity of the work completed to date, the difficulty of completing development within a reasonable period of time, technological uncertainties, the costs already incurred, and the projected costs to complete.

• Purchase price allocations may be based on appraisals that use an "income approach" to valuation. In this case, management's estimates of future revenues and costs should be evaluated with skepticism. They warrant particular challenge if the company does not have a record of accurately forecasting the completion dates of its research and development projects and the amount and timing of its future cash flows from new products or releases. Forecasted revenues should be evaluated in light of market conditions, competing technologies, and known or likely development efforts by others.

• The "income approach" typically involves allocation of forecasted cash flows between IPR&D and other assets. Allocations of cash flows among acquired assets should be challenged if they do not give full recognition to the contribution of existing products, core technologies and other acquired assets that must be capitalized. Cash flows attributable to development efforts, including the effort to be completed on the development effort underway, and development of future versions of the product that have not yet been undertaken, should be excluded in the valuation of IPR&D.

• Valuations that employ a "relief from royalty approach" using average industry royalty rates are not appropriate. Royalties are frequently the product of individual negotiations, and the rights and terms of licenses may vary as to exclusivity, manner of use, transferability, and geographical limits. Hypothetical royalty rates may not reflect the full value of ownership of a product and all the related intellectual property rights.

• If an existing product is acquired as part of the acquisition, and continues to be marketed by the purchaser, the fair value of the product should be capitalized. It should not be considered IPR&D, even if the buyer intends to significantly modify or alter the product in the future. (There still could be an IPR&D allocation if in fact, there was an ongoing enhancement to the existing product in process at the acquisition date.) The staff has noted that FASB Statement No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, defines a product enhancement to include "Improvements to an existing product that are intended to extend the life or improve significantly the marketability of the original product. Enhancements normally require a product design and may require a redesign of all or part of the existing product."

• The estimates of future cash flows and allocations of those amounts between IPR&D and other assets may be prepared by management. However, an appraiser is unable to issue a valuation report based on that data unless the appraiser concurs with the reasonableness and appropriateness of the forecast. While the methods, assumptions used and their application are the responsibility of the appraiser, the auditor must make appropriate tests of the forecast data furnished for the appraisal, and evaluate whether the appraisal findings support the assertions in the Company's financial statements. AT 200, Financial Forecasts and Projections, applies to examinations of forecasts and not an audit of financial statements. However, it includes factors including those in AT 200.69 that provide additional guidance that auditors should consider in evaluating revenue and cost projections used to determine the value assigned to IPR&D.

• Of paramount importance is the responsibility of the company and its independent accountant to evaluate the reasonableness of the results of whatever methodology is applied. Is the proportion of total value assigned to IPR&D consistent with the relative amount of attention given that aspect of the acquired assets and assumed liabilities during due diligence? Is the value assigned consistent with the importance attached to that item in presentations to the Board of Directors concerning the potential acquisition? Is the assigned amount disproportionate to the difficulty, cost and time likely to have been necessary to achieve the seller's IPR&D results independently? If the company already owned the core technology, would it be willing to make a separate investment in the amount attributed to the IPR&D?

I hope this letter has been helpful in clarifying our views on IPR&D. You can expect that the staff will continue to apply these views in its review of filings. Restatement of financial statements will be necessary if a registrant's valuation of IPR&D is materially misleading. Revisions to disclosures may also be required to describe accurately the assets acquired, commitments necessary to fund future development efforts, and material assumptions underlying the purchase price allocation.

Efforts by your Committee to develop guidance for practitioners on a timely basis would be very constructive. We look forward to discussing the guidance the Committee could provide. If you have any questions, please call me or Jeff Jones, Paul Kepple or Eric Casey at (202) 942-4400.

Sincerely, Lynn E. Turner Chief Accountant

Enclosures

cc:	Annette Schumacher-Barr, AICPA Timothy Lucas, FASB

April 23, 1998

Mr. Robert Herz
Chair, AICPA SEC Regulations Committee
c/o Coopers & Lybrand, LLP
101 Hudson Street
Jersey City, NJ 07302

Dear Bob,

The staff recently was presented with several questions regarding FASB Statement No."Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" (Statement 121). Your committee may find the staff's views regarding certain of those issues of particular interest. Our analysis of certain provisions of Statement 121 is summarized below.

Statement 121 requires different accounting for assets depending on whether the assets are "to be held and used" or "to be disposed of." If the asset is to be held and used, it is depreciated over its useful life, with management continuously re-evaluating the asset's remaining useful life and its salvage value. An asset to be disposed of by sale or abandonment must be reported at the lower of carrying amount or fair value less cost to sell, and depreciation is suspended during the selling period. As a result of these differences, it is important that registrants evaluate carefully whether a plan of disposal is sufficiently robust to classify an asset as "to be disposed of" and suspend depreciation. Suspending depreciation on an asset that management prematurely classifies as an asset to be disposed of may distort operating results and confuse investors. Conversely, failing to write-down the asset on a timely basis also can result in overstating results of operations.

The staff believes that a necessary condition to a plan to dispose of assets in use is that management actually have the current ability to remove the assets from operations. For example, the staff believes that a capital replacement plan contemplating the upgrading of machinery and equipment before they are fully depreciated over their originally estimated lives would not qualify as a plan of disposal under Statement 121 if the assets cannot be taken out of operations for sale or abandonment prior to installing new machinery and equipment. The operational requirement to continue to use the asset is indicative that the asset is held for use. In this circumstance, management must assess the recoverability of the asset's carrying amount and reconsider its expected useful life and salvage value in light of the capital replacement plan.

Under Statement 121, a necessary condition to classify an asset as held for disposal is a plan by management to take that action. The staff appreciates that determining whether a plan satisfies that condition can be difficult when managers continuously prepare plans in differing levels of detail for several time horizons and frequently revise those plans. In addition, the staff recognizes that management's commitment to execute any of its plans is tempered by its responsibility to react flexibly to new information.

When evaluating whether and when a plan to dispose of assets meets the requirements of Statement 121, the staff believes that in addition to having the current ability to remove the assets from operations registrants should consider analogous criteria in APB Opinion No. 30 and EITF Issue No. 94-3. Those standards require a plan to have the following characteristics:

• Prior to date of the financial statements, management having the appropriate level of authority approves and commits the enterprise to a formal plan of disposal, whether by sale or abandonment,

• The plan specifically identifies all major assets to be disposed of, significant actions to be taken to complete the plan, including the method of disposition and location of those activities, and the expected date of completion,

• There is an active program to find a buyer if disposal is to be by sale,

• Management can estimate proceeds or salvage to be realized by disposal,

• Actions required by the plan will begin as soon as possible after the commitment date, and

• The period of time to complete the plan indicates that significant changes to the plan are not likely.

The FASB has recognized the need for improved standards and guidance, and is considering various aspects of this issue. While the staff will look to the FASB to complete its comprehensive review, in the meantime, I hope this letter has been helpful in clarifying how the staff interprets Statement 121. If you have any questions, please call me or Jeff Jones at (202) 942-4400.

Sincerely, Jane B. Adams Deputy Chief Accountant

Enclosures

cc:	Annette Schumacher-Barr, AICPA

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