VideoMake room, earnings management. Despite recent reports that the Securities and Exchange Commission is intensifying its crackdown on accounting fraud, agency officials are warning that their investigative spotlight may now also be trained on disclosure issues.
In March, Robert Bayless, chief accountant at the SEC's Division of Corporation Finance, predicted that if registration of initial public offerings dropped dramatically -- and they have -- the agency would be able to refocus its enforcement efforts. Companies, he said, ''may be hearing from us. And what they may hear from us about is segment disclosure. Our patience with deficient segment disclosure,'' he added, ''has been exhausted.''
Specifically, the SEC is threatening to focus on compliance with FAS 131, which in 1997 defined how segment data should be reported. Most companies, however, did not have to supply compliant information until 1999, when there were many other demands on the SEC, including innumerable IPO filings. Last year, in fact, the SEC was able to review only about 1,100 annual reports, and there were no announced enforcement actions that cited segment disclosure. This year, however, the SEC expects to more than triple its reviews, with an eye on such violations.
Whether new Commissioner Harvey Pitt has the resources to pursue these investigations remains to be seen. A change in administration has not left the commission in top form. On the same day Bayless made his speech, previous Commissioner Laura Unger admitted that ''we face a staffing crisis.'' What's more, the agency's Director of Enforcement Richard Walker and Chief Accountant Lynn Turner -- both key enforcers of recent Commission crusades against earnings management -- are also stepping down.
Still, finance executives have to take such threats seriously. ''SEC speeches do set standards,'' says Kevin Thompson, CFO of Durham, North Carolina—based Red Hat Inc., who says he scrupulously follows FAS 131, despite his own skepticism. ''FAS 131 had a good theory behind it,'' he says, ''but the rules missed the mark.''
The Unstandard Standard
Scrutinizing segment reporting is not new, of course. FAS 14, the statement that FAS 131 replaced, required that segments be reported on a geographic and industry basis, and was criticized for being too vague and circumventable. Analysts complained that it allowed too many companies to consider themselves single-segment firms. A study by the Financial Accounting Standards Board of almost 7,000 public companies, in fact, found that some 75 percent said they operated in only one industry segment during the 1985—1991 time frame.
In response, FAS 131 was developed to appease ''analysts who wanted to see how the company is managed through the eyes of management,'' says disclosure expert James F. Harrington, a partner with PricewaterhouseCoopers. According to FASB, that meant that companies had to start reporting the same information ''that is used internally for evaluating segment performance and deciding how to allocate resources to segments.''
Now the SEC wants to find out if the internal information being provided by companies is the same as that presented to and acted on by their ''chief operating decision maker,'' says Harrington. But what information is shared with which top decision maker can vary from company to company, and create compliance hassles. ''All of these are very subjective types of rules that are open to interpretation,'' he says.
Take Red Hat, for example. Its board has historically viewed numbers on advertising sales generated by the software firm's Web site. Consequently, even though Web advertising involves only 2 of Red Hat's 650 employees and represents only 2 to 3 percent of the company's revenue, Thompson says, he felt compelled to present it as a segment in the company's fiscal 2001 10-K. ''That's what the rules required, but it doesn't provide any value,'' he says. Thompson adds that he intends to ''stop showing the board those numbers so I don't have to show [Web advertising] as a segment again.''
Complicating matters, of course, is that defining just which information decision makers actually use is tricky in an era of desktop access to enterprise resource planning and other financial systems. ''Given IT today,'' points out Patricia McConnell, senior managing director of Bear, Stearns & Co. in New York, ''you can slice and dice the information a gazillion different ways.''
Consistency is a Virtue
The SEC, notes Harrington, also intends to investigate whether ''companies are aggregating businesses that are not similar or are limiting the amount of information.'' And one test of compliance, according to Bayless, will be whether companies refer to segments consistently in their investor communications.
Achieving such consistency, however, is easier said than done. Just ask San Antonio—based SBC Communications Inc. Ostensibly, its segments are defined as Wireline, Wireless, Directory, International, and Other. But that depends on what page of the annual report you read. The chairman's letter in the annual report, for example, never mentions these five segments, focusing instead on ''growth engines,'' referred to as ''data and broadband,'' ''long distance,'' and ''wireless.'' Only the last of these is later described as a segment.
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