Highlights of the 2003 AICPA National Conference on Current SEC Developments

Mr. Cutler noted various common themes in these actions brought by the Division of Enforcement including the division’s efforts to hold audit firms and audit personnel responsible where there have been audit failures. In the most recent fiscal year the division has charged five audit firms, including three Big 4 firms. An additional 11 Wells calls (communications initiated by the Staff to a prospective defendant’s counsel before enforcement action is recommended) have been made to audit firms on matters that are still pending and have not been brought or resolved. Mr. Cutler believes that the number of cases brought against firms will continue to rise in future years. Other themes noted in these cases were the lack, in certain instances, of good disclosure in various filings, registrants facilitating another company’s reporting violations, the lack of integrity of working papers and other documents maintained by auditors, and increasing penalties and criminal prosecutions.

The relationship between the auditor and audit committee, Mr. Nicolaisen noted, is more critical than ever in this new environment and should be based on an open line of "active, substantive, and brutally honest communication." He stated that the audit committee should be the external auditor’s biggest fan and harshest critic. He also noted that the relationship between management and the audit committee is equally important and that audit committees will require more information than ever before from management to fulfill their fiduciary responsibilities.

Mr. Nicolaisen also touched on the relationship between the SEC, the Public Company Accounting Oversight Board (PCAOB), and the Financial Accounting Standards Board (FASB) and said that he was impressed with what the PCAOB had accomplished in a very short period of time. He stated that the PCAOB would go through growing pains and that the SEC would do its best to ensure that the PCAOB was a success. He also supported the critical role of the FASB as the profession’s primary standards setter but noted that many facets of U.S. generally accepted accounting principles (GAAP) could be improved. Mr. Nicolaisen briefly discussed the Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System released last summer, which encouraged standards that are more objectives-based and less rules-based. He commented that he supported a reordering of the GAAP hierarchy to put the concepts at the top, followed by objectives and principles, supported by detailed guidance or rules.

The Commission, Mr. Nicolaisen said, is developing a roadmap to facilitate the effort of the FASB and International Accounting Standard Board (IASB) to make their existing financial reporting standards compatible. The roadmap would develop steps necessary for statements prepared using International Accounting Standards to be accepted by the Commission. Mr. Nicolaisen also noted that the Staff will continue to monitor the ramifications of the Sarbanes-Oxley rules on small businesses and stated that he understood the increased burden the proposed rules would place on smaller-sized public companies.

Regarding matters of corporate governance, Mr. Dunn addressed the new disclosures required in proxy statements filed after January 2, 2004 regarding the director nomination process and director attendance at annual meetings and spoke briefly on a proposed rule on shareholder director nominees. There are also changes to the listing standards of the NYSE, NASDAQ, and AMEX, which require that equity compensation plans be approved by shareholders and that boards contain a majority of independent directors with a much stricter definition of what constitutes an "independent" director.

In rulemaking, the next focus of the Staff will be to finalize the proposed rule on Form 8-K disclosures (Release No. 33-8106), Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date, which, as proposed, would expand the items required to be reported on for Form 8-K and shorten the deadline for a registrant to file its Form 8-K to within two business days of the event triggering disclosure.

Recent news articles reported that registrants’ responses to SEC comment letters were being made widely available. Mr. Dunn explained that the Freedom of Information Act (FOIA), enacted in 1966, provides that anyone has the right to request access to federal agency records or information. There has been a continuously increasing trend whereby corporations, attorneys, competitors, potential investors, and, now, commercial enterprises are requesting specific information relating to correspondence between the SEC and registrants (i.e., comment letters). Mr. Dunn urged registrants to consult with their SEC attorneys on requesting confidential treatment of such correspondence and other information not required to be filed under the Securities Act or the Exchange Act under Rule 83 of the Commission's Rules of Practice.

With respect to EITF Issue 03-1, the Staff stated that their position, when evaluating other-than-temporary losses, is no different than that proposed in EITF Issue 03-1; however, the Staff would expect to see disclosures in MD&A that go beyond those called for by the EITF.

The Staff believes that the substance of these types of transactions equates to the purchaser obtaining financing from a lender in order to pay amounts due to its vendors. Thus, pursuant to the provisions of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, the purchaser’s original liability to the vendor is extinguished on the date the lender remits cash to the vendor. Pursuant to the provisions of Article 5, the purchaser should derecognize its trade account payable and record a new liability classified on its balance sheet as a borrowing from the lender. Consistent with this classification, the purchaser should then accrete the difference between the initial carrying amount of the borrowing (i.e., the discounted amount of the vendor invoice) and the repayment amount (i.e., the amount owed to the lender) through interest expense using the effective yield method.

Registrants were also reminded that Issue 00-21 emphasizes that leases of assets should be separately accounted for under SFAS No. 13, Accounting for Leases. This would include hardware or equipment that is leased as a part of a software arrangement.

The Staff also discussed the contingent revenue provisions in paragraph 14 of Issue 00-21, which limits the amount of revenue that can be allocated to a delivered item to the noncontingent amount. This can result in little or no revenue being allocated to a delivered item even though it meets the separation criteria and the revenue allocated may actually be less than the cost of the delivered item. The Staff has been asked to consider alternatives in accounting for the resulting loss on the delivered item. The Staff does not believe that the separation criteria of Issue 00-21 are elective and, therefore, must be applied. The Staff discussed several approaches and its views on accounting for the costs of revenue that are incurred in excess of revenues recognized. They focused on the question of whether assets are generated in the revenue arrangement such as consigned inventory, contractually guaranteed reimbursable costs, or an investment in the remainder of the contract. The Staff believes that there may be circumstances where it is appropriate to recognize an asset in connection with a multiple deliverable arrangement with contingent revenues. However, they believe that asset recognition is limited to situations where a loss has been incurred on the delivered item and noted that such cost deferral accounting raises many other questions such as the nature of the costs to be included, amortization, and impairment testing for such assets. Issue 00-21 does not address the accounting for such situations and, therefore, there is very little guidance. The Staff will consider the facts and circumstances in each individual case in evaluating registrants’ accounting.

Issue 95-8 indicates that a contingent consideration arrangement in which the payments are subject to forfeiture if employment terminates is a strong indicator that the arrangement is compensation for postcombination services. Accordingly, when this indicator is present, the Staff believes that overcoming the compensation conclusion is very difficult.

With that said, this is not a bright line test, and the Staff has, in rare situations, agreed with registrants who have suggested that a contingency arrangement that is tied to employment should, nonetheless, be treated as purchase price.

Paragraph 12 of SFAS No. 142, Goodwill and Other Intangible Assets, states, in part, that "the method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used."

The Staff noted that the EITF has formed a working group for EITF Issue No. 03-9, Interaction of Paragraphs 11 & 12 of SFAS 142, "Goodwill and Other Intangible Assets," Regarding Determination of the Useful Life and Amortization of an Intangible Asset.

In certain cases, an intangible asset may be in service, yet, the ability to realize the full value of that asset may be related to certain tangible assets that are to be constructed over time. Some have suggested that it might be appropriate to analogize to SFAS No. 51, Financial Reporting by Cable Television Companies, and to phase in an intangible asset's amortization expense as a related tangible asset is constructed and capacity is increased. However, we have focused on the concept as illustrated in EITF Topic D-21,Phase-in Plans When Two Plants Are Completed at Different Times but Share Common Facilities, with regard to physical tangible assets.

Topic D-21 sets forth an example where two electric generating plants on a common site share certain facilities, such as coal handling equipment. One plant (Unit 1) is completed at the beginning of the year and the other plant (Unit 2) is completed at the end of the year. The coal handling equipment is completed at the beginning of the year and is used by Unit 1 during the year. The Topic indicates that "depreciation for the common facilities should begin at the beginning of the year." In other words, even though the common facilities are not being utilized at full capacity, the company is nonetheless deriving the benefits available from the facilities as a result of having an asset placed into service.

Lastly, the Staff emphasized that SFAS 142 states that to follow a method of consumption other than straight-line, that method must be reliably determinable. Accordingly, the pattern should be based on supportable assumptions. The Staff recognizes that this determination is naturally subject to judgment.

In general, the Staff believes the analysis of a pattern of consumption for a finite-lived intangible asset is not significantly different from that of a physical, tangible asset. The Staff said that it is looking forward to the EITF's continued deliberations and hopes that the guidance put forward will provide clarity to the issue once a consensus, if any, is reached by the EITF.

The Staff stated that recognition of a contingent asset must be supported by evidence sufficient for the auditor to conclude that it is at least probable (in this context, we understand "probable" to mean a 70 percent or greater likelihood of favorable outcome) the deduction will be sustained and/or the temporary difference will exist before an asset and tax provision benefit can be recognized in the registrant’s financial statements. Only then can SFAS No. 109, Accounting for Income Taxes, criteria be applied to evaluate the realization of the recorded asset. SFAS 109 requires that a valuation allowance be established if it is "more likely than not" that a deferred tax benefit will not be realized.

The Staff provided the following example situation to illustrate their view on the criteria necessary for financial statement recognition of a contingent tax asset:

The Staff also discussed various methodologies for recording deferred taxes and tax contingencies associated with temporary differences by comparing the financial reporting bases versus either the probable tax bases or the as-filed tax return bases. The Staff stated that, in its opinion, a registrant should measure temporary income tax differences as the difference between the financial reporting bases and the probable tax bases of assets and liabilities (as consistent with Question 17 of the SFAS 109 Implementation Guide). The consequence of such a conclusion is that it would then be necessary to provide for a contingent income tax liability measured as the difference between the probable tax bases and the as-filed tax bases. If a provision for contingent income tax liabilities is recognized, it should not be included with deferred income tax liabilities or as part of any valuation allowance.

The Staff understands that, despite its preference, most often companies measure temporary differences as the entire difference between the financial reporting and as filed tax bases. In this case, there is no additional contingent tax liability to recognize as it would already be reflected as a reduction of an entity’s net deferred tax assets or an increase in its net deferred tax liability at year end. The two methodologies generally result in the same net tax position (asset or liability) and net tax benefit being recorded during the period.

The Staff also reminded registrants that income tax contingencies generally remain within the scope of SFAS No. 5, Accounting for Contingencies, and to that extent, the existing disclosure requirements of SFAS 5 and the Commission’s disclosure guidance related to MD&A apply.

The Staff has seen investments structured to avoid the application of the equity method (assuming the entity would not be required to be consolidated under FIN No. 46, Consolidation of Variable Interest Entities) and the associated start-up losses that may result. This has been accomplished by giving the investor significant influence over the investee by means other than its interest in common stock. The Staff expressed its view that determining whether an investor has significant influence over the investee should not be limited to the voting power conveyed by the voting common stock, but through a review of all means by which an investor may exert significant influence over the investee such as through board representation or veto power. The Staff noted that pending the resolution of EITF Issue No. 02-14, Whether the Equity Method of Accounting Applies When an Investor Does Not Have an Investment in Voting Stock of an Investee but Exercises Significant Influence through Other Means, the SEC staff will continue to require the application of the equity method in situations that are perceived to be abusive where investors have significant influence over the investee and hold securities that are functioning as "in-substance" common stock, regardless of whether such securities have a liquidation preference to any existing common.

To have a basis for their conclusions on these matters, an evaluation of the effectiveness of disclosure controls and procedures must be undertaken. Examples of these procedures might be the establishment of disclosure committees to determine a company's disclosure obligations and to assist the certifying officers in forming conclusions about the effectiveness of the disclosure controls. A company should maintain evidentiary matter, including documentation to provide reasonable support for its judgments and conclusions. Developing and maintaining such evidential matter is an inherent element of effective disclosure controls.

Changes or improvements to controls may be made as a result of preparing for a company’s first report under Section 404 of the Sarbanes Oxley Act of 2002 (Section 404). Although these changes do not necessarily need to be disclosed under Item 308 of Regulation S-X, the Staff encourages companies to disclose all material changes to controls in advance of the effective date of the rules with respect to Section 404. It is not the SEC’s intent to dissuade companies from making improvements to controls in advance of their first report. However, if a company were to identify a material control weakness, they should carefully consider whether that should be disclosed as well as the changes made in response to that weakness. Subsequent to a company’s first report on Section 404, a company will clearly have to identify and disclose any material changes in the company’s internal controls in each quarterly and annual report.

Small business issuers are exempt from the accelerated filer rules even if they voluntarily file a Form 10-K and Form 10-Q. Companies are no longer small business (SB) eligible if public float or revenues are greater than $25 million at the end of two consecutive years. Once a registrant qualifies as an accelerated filer, it remains one unless it subsequently qualifies as a small business issuer.

For purposes of determining whether an issuer is an accelerated filer, market value is computed using a company’s share price and number of shares at the end of the second fiscal quarter. It must be disclosed on the cover of the Form 10-K by all registrants, not just accelerated filers. Registrants who omit this disclosure must correct their Form 10-K by filing a Form 10-K/A with a new cover page, new signature page, and Section 302 certifications, Items 1 and 2 only.

If financial statements of an acquired company or a target company in a probable acquisition are required to be filed in accordance with Rule 3-05 of Regulation S-X, the age of financial statements is typically as follows:

• Interim financial statements must be as of a date less than 135 days preceding the Form 8-K filing date or the date of effectiveness for a Securities Act registration.
• Third-quarter data must be updated to include audited financial statements of a target’s most recently completed year if the Form 8-K filing date or the registration statement effective date is 90 days or more after the target’s year end (45 days in the case of a registration statement when the registrant is not eligible for the relief provided by Rule 3-01(c) of Regulation S-X).
• However, if the target company is an accelerated filer, these timeframes will be reduced to match their accelerated deadlines.

These rules have transition implications in performing reviews on interim financial statements if the audit firm is not registered with the PCAOB:

• Interim reviews can be done in the short term as long as the audit firm is registered before the next Form 10-Q or Form 10-K is due.
• Audit firms must be registered with the PCAOB in order to commence any significant work regarding the review of interim financial statements for fiscal periods ending after November 30, 2003..
• If the audit firm is not ultimately registered by the time the financial statements in the next Form 10-Q or Form 10-K are reviewed/audited, the issuer will need to engage a PCAOB-registered firm to re-review the prior interim financial statements. (The SEC has stated that it considers interim financial statement reviews to be integral to the audit of annual financial statements; accordingly, an unregistered audit firm cannot perform the interim reviews while a registered firm performs the audit of the annual financial statements.)

These rules also have implications regarding association with other audit firms in SEC filings:

• Financial statements provided under Rule 3-05 of Regulation S-X—Rule 3-05 financial statements (financial statements of companies acquired or to be acquired) are not issuer financial statements, so it is acceptable to have Rule 3-05 financial statements audited by a nonregistered audit firm.
• Financial statements provided under Rule 3-09 of Regulation S-X—The SEC is considering whether Rule 3-09 financial statements, which form the basis of the equity pick-up for a significant equity investee, can be audited by a nonregistered firm. Rule 3-09 financial statements are not issuer financial statements; however, they may have a material bearing on the issuer’s financial statements via the equity pick-up and amounts on the balance sheet. The SEC has indicated that they should be consulted if an issuer has this situation where a nonregistered audit firm is auditing Rule 3-09 financial statements. Note, however, that the Staff, in response to a question from the audience, stated that while the SEC is still debating this issue, the auditor of the Rule 3-09 financial statements would have to be registered if the principal auditor refers to that auditor in the principal auditors’ report.

The foreign private issuer PCAOB registration deadline is April 19, 2004 (a 90-day extension may be considered). Until the registration deadline, foreign private issuers continue to be subject to the existing rules.

Financial statements of a private company used in connection with a reverse merger into a public shell can be audited by a nonregistered firm. However the financial statements become those of the issuer and, therefore, going forward, the registrant’s audit firm has to be registered with PCAOB. Additionally, a company must file Item 4 of Form 8-K in a reverse merger where it has a change in accountants.

Additionally, the Staff does not believe that liquidity discussions have been particularly insightful or forward looking. The Staff believes there has been little attention given to providing a meaningful analysis of historical sources and uses of cash.

To address these shortcomings, the liquidity discussion should explicitly identify cash flow trends and uncertainties, and cash commitments. The Staff stated that the key to an effective liquidity analysis is getting to the underlying drivers of cash flows rather than describing reconciling items on the cash flows statement—in other words, what bills will have to be paid and where will the money come from.

The Staff offered several suggestions on improving the format of MD&A. These suggestions can be summarized as follows:

• Include more "analysis" and less "discussion."
• Executive-level management should participate substantively in the preparation of MD&A so that readers can have a vision of the business through the eyes of management.
• Organize MD&A based on the relative importance of information (i.e., most important information first.) Remember that not all material information is of equal importance.
• Use tables, charts, and graphs to help facilitate an understanding of the underlying data. A picture may be worth a thousand words.
• Eliminate immaterial information.

On December 19, 2003, the SEC released its interpretation, Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations. The full text of the interpretation can be found at http://www.sec.gov/rules/interp/33-8350.htm.

The Staff went on to say that pensions and other postemployment benefits (OPEB) were not originally contemplated in the contractual obligations table but, to the extent a material known funding requirement exists, then disclosure should be provided.

Many registrants stated that the proposed rule on critical accounting policies was too prescriptive; therefore, the Staff is continuing to look at the proposed rule interpretively. However, registrants are currently required to discuss known uncertainties in MD&A. These uncertainties include many of the critical accounting policies that involve significant assumptions and estimates necessary to account for highly uncertain matters. The Staff indicated that it will be scrutinizing the critical accounting policy disclosures made in the upcoming reporting season and will assess the need for additional interpretive guidance, which would be issued after the calendar-year-end annual reports have been filed. The Staff cautioned registrants that it is unlikely that merely copying the significant accounting policy disclosures appearing in the footnotes to the financial statements would provide adequate disclosure for purposes of MD&A.

Whether the company includes the restated financial statements directly in the registration statement or files the Form 8-K, the Staff believes that the financial statements should be accompanied by:

• Management discussion of the Company’s restated results from operations with emphasis on continuing operations
• The circumstances that led to the discontinued operation
• The material terms of the transaction
• The impact on the Company’s operating results and business
• Revenues, costs, and margins from continuing operations, including trends
• Contingencies, commitments, or continuing involvement with the discontinued operation
• Any impact on the Company’s liquidity and capital resources
• The likely effect the discontinued operation will have on the Company's continuing business and financial health

When performing the significance measurements for a completed or probable acquisition under Rule 3-05 of Regulation S-X, a registrant must use the amounts reflected in the restated financial statements once they have been filed.

For purposes of measuring the significance of an equity investee under Rule 3-09 of Regulation S-X, registrants are reminded that this test is performed annually at year-end in connection with the Form 10-K. Accordingly, significance would not be remeasured at the time the restated financials statements are filed.

In filing the next Form 10-K, registrants should be mindful that significance will be measured against amounts that will reflect the effects of the discontinued operations. This may cause a previously insignificant equity method investee to exceed the 20 percent threshold.

Because the PCAOB requires the registration of any firm that plays a significant role in the preparation or furnishing of an audit report for an issuer, there is a potential need for restated financial statements to be reaudited. This occurs when a predecessor auditor is unable to reissue its report and/or perform additional procedures because it has either ceased operations or is not currently registered with the PCAOB.

These structures might be faced with Exchange Act reporting requirements upon deconsolidation. The Staff stated that if a trust preferred security structure meets the definition of a finance subsidiary under S-X Rule 3-10, the narrative disclosures called for under Rule 3-10b would be required in the parent’s financial statements rather than condensed consolidating financial information, and the Staff will accommodate the continued use of Rule 3-10b provided the following additional disclosures are made:

• Whether the structure is consolidated and why
• The impact consolidation has or would have on the parent company’s financial statements.

A finance subsidiary is defined in Rule 3-10 as having no assets, operations, revenues, or cash flows other than those that are directly related to the issuance, administration, and repayment of the registered securities.

The Staff will also accommodate the use of the Exchange Act Rule 12h-5 exemption in circumstances where the trust does not need condensed consolidating financial information under Rule 3-10. Thus, these structures would not be required to file Form 10-K’s or Form 10-Q’s assuming, again, that they meet the definition of a finance subsidiary with no requirement for condensed financial information.

The Staff also provided some items to consider for disclosure in the registrant’s MD&A related to FIN 46 as follows:

• Analysis of the impact that the consolidation has or will have on known trends
• Identification and contextual discussion about uncertainties that result from consolidation and their likely impact
• Whether consolidation creates technical defaults under agreements or other uncertainties (If so, registrants should start analyzing those items.)
• Whether there needs to be a distinction drawn between restricted and unrestricted assets in the liquidity analysis
• For unconsolidated variable interest entities, an analysis of the potential losses of the entity, including:

  • What are the qualitative aspects of the exposure?
  • What are the reasonably likely events that would trigger that exposure?
  • What are the reasonably likely cash requirements of that exposure and the sources of cash available to satisfy these requirements?

In discussing the need to file reports on Form 8-K related to the acquisition or disposition of variable interest entities, the Staff made the following observations:

• A registrant does not have to file a Form 8-K with respect to existing variable interest entity relationships upon the initial adoption of FIN 46.
• If a variable interest entity that is an asset is acquired or disposed, the registrant should consider whether the criteria of Item 2 of Form 8-K have been met.
• If a variable interest entity in the form of an obligation or an executory contract that is consolidated is acquired or disposed, Item 2 of Form 8-K is likely to apply.
• If a variable interest entity in the form of an obligation or an executory contract that is not consolidated is acquired or disposed, Item 2 of Form 8-K is not likely to apply.

The Staff emphasized skepticism relating to the use of disclosures that eliminate recurring items. While such measures are not specifically prohibited, the registrant would need to describe the usefulness of the measure to investors, how the measure is used by management—including the economic substance behind management’s decisions—and give substantive reasons for its use. The discussion should be robust and not boilerplate. (See Q8 and Q9 of the FAQ.)

The segment information called for by SFAS No. 131, Disclosures About Segments of An Enterprise and Related Information, is to be prepared using a "management approach" and is not required to be provided in accordance with the same generally accepted accounting principles used to prepare the consolidated financial statements. Because these segment measures are required to be disclosed by GAAP they a not considered "non-GAAP." The Staff cautioned, however, that registrants should ensure that segment measures used n MD&A mirror the SFAS 131 measures in the footnotes and added that registrants can always provide more analysis within MD&A when using these measures. The Staff also noted that segment measures that are adjusted from the amounts reported to the chief operating decision maker for purposes of allocating resources or assessing segment performance are non-GAAP measures and accordingly, would be subject to the non-GAAP rules. (See Q16-Q21.)

Debt covenants are not non-GAAP measures if they are material to an understanding of liquidity and are used in the appropriate context; the Staff would expect these measures to be fully disclosed. (See Q10.)

If a registrant discloses a non-GAAP performance measure that complies with Item 10 of Regulation S-K, the registrant can also disclose that measure divided by the number of shares outstanding. The Staff emphasized, however, that dividing a prohibited non-GAAP numerator by the number of outstanding shares is not curative—it is still a prohibited measure. (See Q11.)

Disclosure of free cash flow measures may not be prohibited under the non-GAAP rules. The Staff cautioned, however, that registrants must specifically and clearly explain what is included in the measure as the definition can vary among companies, provide a reconciliation, and justify the use of the measure. (See Q13.)

The Staff was asked, "Does presenting revenue percentage increases on a constant currency basis in MD&A, constitute a non-GAAP disclosure requirement for reconciliation?" The Staff referenced Q17 on non-GAAP measures and stated that if the presentation of constant currency basis revenue is part of a larger discussion in MD&A that is intended to show the components of the changes in revenue from period to period (e.g., volume and price), then the Staff considers that to be part of the natural MD&A analysis of explaining trends and changes. However, if the constant currency revenue is presented in isolation without context, then it could be considered a non-GAAP measure.

The Staff noted that analysts’ requests for non-GAAP information do not constitute a reason for inclusion of such information. However, there is nothing that prohibits the company from learning why the measure is significant to analysts and investors and, if appropriate, including the information in the filing.

If the Staff had granted the registrant SLB 2 relief during bankruptcy, the registrant does not need to file missed periodic reports as long as all periods are covered in post-reorganization filings. If the registrant failed to file periodic reports during bankruptcy, whether or not they reported under SLB 2, then upon emergence from bankruptcy the registrant should file within 15 days an Item 3 Form 8-K with an audited emergence balance sheet (whether fresh-start accounting has been applied or not).

If no SLB 2 relief had been granted, the registrant must file all delinquent Forms 10-K/KSB and 10-Q/QSB reports before its emergence from bankruptcy. In lieu of filing all delinquent reports before emergence from bankruptcy, the Staff will consider a request to allow the registrant to file a "comprehensive" Form 10-K/KSB and subsequent Form 10-Q/QSBs. A "comprehensive" Form 10-K/KSB includes all information that would have been included if all delinquent filings had been made; makes full disclosure of any corrections of errors, misstatements or omissions of material facts; complies with all SEC rules and regulations; presents summarized quarter data as required by S-K Item 302(a); and includes a Description of Business and MD&A. A company that files a "comprehensive" 10-K/KSB will not be considered to be a "timely" or "current" filer for purposes of S-2 or S-3 eligibility.

Subsequent to emergence, all Exchange Act reports must be filed timely. Post-reorganization filings under the Securities Act or the Exchange Act must include audited financial statements for all periods required, even if the registrant was in bankruptcy during some of those periods.

The Staff believes that under SFAS No. 142, Goodwill and Other Intangible Assets, identifiable intangible assets having an indefinite life will be rare. Additionally, the Staff stated that annual goodwill impairment testing under SFAS 142 should be at the same date each year and that a change in date would be a change in accounting principle for which a preferability letter would be necessary. The Staff also made reference to EITF Issue D-101, Clarification of Reporting Unit Guidance in Paragraph 30 of SFAS Statement No. 142, and noted that the Staff may challenge the registrant’s determination of reporting units and the allocation of assets and liabilities to those reporting units.

Paragraphs 46-47 of SFAS 142 require disclosure of the method used to determine fair value when a goodwill or intangible asset impairment is recognized. The Staff encouraged enhanced disclosure of fair value determination methodologies in "critical accounting policies," including discussion of the assumptions used.

The Staff also emphasized that registrants should focus on the timing of disclosure as impairments do not happen "overnight," but rather result from known events and uncertainties that must be analyzed in the period in which the event occurs, not just when the charge is taken. If a registrant is testing for impairment, then it likely has an uncertainty that needs to be disclosed regardless of whether the company actually takes a charge.

When impairment has been identified and a write-down is required, the registrant must keep in mind that present market conditions must be considered when assessing fair value, not market conditions that may or are expected to exist in a different environment. Additionally, if the sale occurs in a current market that is depressed, that does not mean it is a distressed sale; in determining the fair value of assets in a depressed market, registrants must analyze the prices that buyers and sellers are paying in that market.

The SEC noted that there are clear guidelines for the separate identification of identifiable intangibles that have and have not been previously separately identified (may have been included with goodwill) in terms of whether they may be included with goodwill. For example, if a company had previously identified a core deposit intangible that was classified on the balance sheet as goodwill, however separate records and amortization schedules were not maintained, the intangible must be reclassed to goodwill. In contrast, if a company accounted for and recorded core deposit intangibles separately from goodwill, they cannot subsequently reclassify the intangibles as goodwill and discontinue amortization. The SEC cited EITF Topic D-100, Clarification of Paragraph 61(b) of SFAS Statement No. 141 and Paragraph 49(b) of SFAS Statement No. 142, for guidance.

The Staff noted registrants must remember that aggregation is a facts and circumstances judgment. The Staff will look very carefully at similar long-term financial performance including both past historical performance and estimated future performance, which must be for a reasonable length of time since the standard requires similar long-term performance; a few years of past and future performance measures would not be considered long-term.

The Staff emphasized that assessing whether operating segments have similar economic characteristics is only one example of factors that should be considered in the aggregation process; other measures may be applicable as well. The Staff indicated that all factors should be considered and that they will look to underlying reasons for differing or similar performance of aggregated segments such as cost structures, markets or customers in the United States or internationally, and variations in products by market.

 SFAS 141 clearly states that mineral and use rights are intangible assets. SFAS 142, excluded from its scope the accounting for oil and gas companies that follow SFAS 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, but it did not scope out the classification aspects of SFAS 142. SFAS 19 does not address classification issues, which is why the Staff believes that SFAS 141 is applicable. Further, the Staff commented that they would adhere to their position, absent an amendment to SFAS 141 and 142 addressing mineral and use rights, until the EITF reaches a consensus on Issue No. 03-0, Whether Mineral Rights are Tangible or Intangible Assets, that mineral and use rights do not need to be classified as intangibles.

D.16.2. Energy Trading Activities (EITF Issue 02-03)

 The SEC Staff reiterated its belief that EITF Issue 02-03, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities, has changed the definition of trading activities as previously defined in EITF Issue No. 98-10, Accounting for Contracts Involved in Energy Trading and Risk Management Activities. EITF Issue 98-10 required registrants to perform an overall assessment in total of their activities to determine whether they were engaged in energy trading activities, unlike EITF Issue 02-03, which requires the registrant to analyze its activities on a contract by contract basis.

D.16.3. Auditor Disagreements

 The SEC reminded auditors that if an auditor and a registrant disagree on an accounting matter, the auditor has a professional responsibility to take a position on an accounting issue. If that accounting matter cannot be resolved and the auditor and/or registrant wishes to consult the SEC on the matter, the Staff would want to know what the auditor’s position is and why it believes it is correct and what the registrant’s position is and why it believes it is correct. If the SEC agrees with the client’s position (i.e., the auditor continues to believe the client’s position is wrong), no one, including the SEC, can force the auditor to sign the opinion. The Staff noted that registrants should not think that the SEC can provide a free appeal to lobby the auditor to sign its opinion if they do not want to and that no one in the SEC has the power to do so.

D.16.4. Stock Options

 The SEC has stated publicly it continues to believe that stock options represent an expense and that fair value is the appropriate measure of that expense.

 The Staff discussed transition issues relating to FIN No. 46, Consolidation of Variable Interest Entities, based on standards-setting activity prior to the Conference; however, after the Conference the FASB issued FIN 46(R), which changed the effective date of the interpretation. The IPTF, the FASB, and the SEC are currently reviewing the impact of the change in the effective date on FPIs. We expect guidance to be forthcoming on the topic.

 With respect to the need for disclosures about the impact of FIN 46, the Staff clearly stated that there are no deferrals of disclosure requirements for FPIs. The SEC reminded FPIs that have selected the reduced disclosure scheme of Form 20-F, Item 17 U.S. GAAP reconciliation that SAB Topic 1D, Foreign Companies, requires registrants to include disclosures in MD&A when adoption of an accounting standard has, or is expected to have, a material impact. In addition, the SEC noted they would expect substantive SAB No. 74, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period, disclosures that discuss the impact of FIN 46 and related discussion in the MD&A section.

E.3.2. Consolidation of Subsidiaries

 Over the past year, the Staff has noted cases where FPIs had not consolidated small subsidiaries but instead reported these entities as investments using the cost method of accounting. The SEC noted that "small" is not necessarily immaterial, particularly if there are a number of such nonconsolidated subsidiaries. The SEC was clear that this practice may result in restatement. In particular, FPIs preparing Item 17 reconciliations should remember that Form 20-F requires them to present information substantially similar to U.S. GAAP, regardless of which primary GAAP they use. Consolidation is a requirement under U.S. GAAP and by not consolidating a subsidiary, an FPI is at risk of not complying with the requirements of Item 17.

 The SEC's view is that FPIs should consolidate all subsidiaries. The only reason for not consolidating would be immateriality. Materiality would be assessed based on the guidance in SAB No. 99, Consideration of Fraud in a Financial Statement Audit, and would include the following assessments:

• Carefully consider whether this is an estimate or a complex accounting judgment - probably not applicable since the SEC considers the literature on consolidated to be clear
• Determine whether nonconsolidation is an inadvertent error or omission. (If the FPI has control of these entities, this criterion would not be applicable.)

 Based on these factors, the Staff stated it would have low tolerance for not consolidating subsidiaries and warned that restatement may result from this type of reporting.

E.3.3. Investment Securities Impairment

 The Staff noted that impairment of investment securities has been a significant problem in many foreign bank and foreign insurance company filings during the last year and reminds registrants that they must employ rigorous processes to assess impairment under US GAAP.

 Auditor qualification issues noted by the Staff during the last year include:

• The auditor was not licensed in the jurisdiction where the report is signed.
• A licensed firm performed the audit but an unlicensed affiliate signed the report.
• The audit was conducted in the U.S. but the report was signed by a nonU.S. firm (both firms were licensed in their respective jurisdictions, but this issue is whether the auditor doing the work is appropriately taking responsibility by signing the auditors’ report).

 Regulation S-X, Article 2 addresses auditor qualifications and requires that auditors must be licensed and in good standing in their place of residence and principal office. While the rule does not state whether the location of the auditor must correspond to the location of the registrant, the Staff evaluates the auditor’s compliance with PCAOB rules (formerly the rules of the AICPA SEC Practice Section (SECPS), which were adopted by the PCAOB on an interim basis) and whether the relationship between the location of the auditor and the location of the registrant makes sense.

 The Staff attributes the variety of practices in the area of auditor qualification to the brevity of the rules. However, to be considered appropriately qualified, an auditor should be able to demonstrate one of the following two criteria:

• An affiliation with a U.S. firm that is registered with the PCAOB and follows Appendix K of the former SECPS rules, or
• Demonstrating to the Office of the Chief Accountant their knowledge and experience in applying U.S. GAAP and GAAS, SEC rules, independence rules, and other relevant practice requirements.

 Auditor qualifications are applicable to all audit reports included in filings with the Commission and not just those related to the financial statements of the registrant issuer. This includes auditors of a subsidiary, auditors of equity investees under Regulation S-X, Rule 3-09, auditors of guarantors under Regulation S-X, Rule 3-10, and acquisition target companies under Regulation S-X, Rule 3-05. However, there have been limited exceptions for an acquired business under Rule 3-05 in circumstances where a non-SECPS auditor of the acquired business will not continue, the registrant’s auditor is assuming future audit responsibility, and the target company’s auditor has not and does not otherwise practice before the Commission. The SEC has granted this exception in the past because the qualification requirements, in some instances, may be too onerous for an audit firm that will not continue serving the SEC registrant.

E.4.2. PCAOB Registration of Foreign Accounting Firms

 Foreign accounting firms that issue reports included in filings with the Commission must register with the PCAOB by the April 19, 2004. When the PCAOB adopted interim quality control standards in April 2003, they added the requirements for SECPS membership, including Appendix K, which deals with the quality-control relationships and the file review procedures required for audits of FPIs.

E.4.3. MJDS Reporting Regime

 The Multijurisdiction Disclosure System (MJDS) is still in place for Canadian issuers, and while there have been discussions to remove this regime, no actions are currently underway or imminently planned to this end. Given the small number of registrants using the MJDS system, the Staff stated that it would make sense to eliminate it.

E.4.4. Auditor Report Issues

 Over the past year there have been developments in the United Kingdom in regard to inclusion in the auditors’ report of language limiting the auditor’s liability to third parties. The issue arose from a court case in Scotland, where the judge allowed a creditors lawsuit to proceed against an auditor even though there was no contract between the auditor and the creditor (though there was knowledge by the auditor that the creditor would receive the financial statements). The judge stated the ruling could have been different had the audit report disclaimed responsibility to third parties. In response, the Institute of Chartered Accountants of England and Wales issued guidance to its members on how to render an audit report that includes language that would limit the duty of care to third parties. A question then arose whether this type of limitation would be acceptable in a filing with the SEC. The Staff indicated that the restrictions in these reports would be inappropriate. The Commission prepared a letter to support its view, which was sent to the Institute of Chartered Accountants of England and Wales. The letter is available on the SEC website.

 Another issue that came up during the past year was whether it is acceptable to use alternatives to the wording required under U.S. GAAS to express uncertainty about a registrant’s ability to continue as a going concern in an auditors’ report (e.g., the use of home country GAAS.) In its consideration of this issue, the SEC made reference to the following guidance:

• Rule 2-02 of Regulation S-X states there must be a clear expression of the auditors opinion
• U.S. Auditing Standard (AU) 341, which deals specifically with reporting in going-concern situations, includes (1) wording to the effect that the auditor must state specifically that "there is substantial doubt about the entity’s ability to continue as a going concern"—the footnote disclosure must use that phrase or a phrase very much like it, and (2) states that when expressing substantial doubt, the likelihood must be unconditional (i.e., the auditor cannot say there may be substantial doubt).

 The Staff believes this guidance to be explicit and that it should be followed for U.S. GAAS purposes.

 Regarding comparative financial statements, the Staff noted that an auditor’s report must cover all periods presented which are required to be audited. If there is a change in auditor, the report of the prior auditor must be filed. The Staff emphasized that the audit report must be reissued by the prior auditor as contemplated under U.S. GAAS, and submitting just a copy of the prior auditor’s report would not be acceptable.

 Regarding the topic of principal, subsidiary, or joint auditors, the Staff presented a number of reminders: (1) To be the principal auditor, the firm must audit the majority of the registrant’s consolidated assets; (2) if the principal auditor places reliance on and refers to the auditor of a subsidiary, an equity investee or a joint auditor, then the registrant must file the reports of those auditors. In addition, the Staff described a recent situation where it was not clear which auditor was taking responsibility for the reconciliation of subsidiary accounts to U.S. GAAP. The IPTF is now looking into ways to more clearly identify the auditor that is assuming responsibility for U.S. GAAP reconciliations.

 With respect to error corrections, the Staff stated that if previously filed financial statements are materially incorrect, the registrant must amend its filings with restated financial statements. This applies to all FPI SEC filings, notwithstanding the fact that home-country GAAP or home-country law may not require restatement. According to the SEC, attorneys have typically concluded that these home-country directives apply in the home-country but not in the United States with respect to filings with the Commission.

The Staff further noted that:

• Registrants should be prepared to demonstrate why the measure qualifies as expressly permitted, since this is defined in the FAQ as something that can be clearly identified from standards-setting guidance, the Staff expects that registrants would be able to produce the related guidance that requires or permits the questioned presentation/disclosure.
• When expressly permitted disclosures are made, registrants are expected to include additional disclosures about the purpose of the measure and why management believes it provides useful information to investors.

The SEC did not intend to prohibit additional captions in income statements that are considered normal in jurisdictions where rules provide for different captions than U.S. GAAP and GAAS reporting. One of the more frequent practice issues was from the U.K. application of Financial Reporting Standard (FRS) No. 3, Reporting Financial Performance. FRS 3 outlines three specific "exceptional items" that are required to be shown separately below the operating income line. FRS 3 provides that other items may be included as exceptional items and presented below the operating income line if, based on management’s judgment, such items meet the definition of an exceptional item provided in FRS 3. The SEC believes that the judgment applied by management in determining what to present as an exceptional item should be discussed within the Critical Accounting Policies section.