Comfort Letter Procedures Relating to Capsule Financial Information Presented In a Registration Statement Prior to the Issuance of the Year-End Financial Statements

Issuers sometimes undertake securities offerings after their year-ends, but before the issuance of their annual audited financial statements. This paper provides a framework for evaluating the types of comfort letter procedures that an independent accountant could perform in connection with information included or incorporated by reference in securities offerings related materials relating to an issuer's fourth quarter when the annual audited financial statements have not been issued.

This paper was developed by, and reflects the views of, a task force of the Center for Public Company Audit Firms' SEC Regulations Committee. It provides knowledgeable individuals with a framework to assess the types of procedures that could be performed, however caution and individual judgment, based on facts and circumstances should be exercised when considering performing procedures on information which is the subject of ongoing audit procedures and/or which is subject to change until the issuance of the annual audited financial statements.

The PCAOB is the regulatory body authorized to establish audit and attestation standards for registered public accounting firms in the preparation and issuance of audit reports as required by the Sarbanes-Oxley Act. This framework has not been approved, disapproved, or otherwise acted upon by the PCAOB or its staff.

Issuers frequently prepare registration statements after year-end but before issuing their year-end financial statements. Those registration statements oftentimes include capsule financial information for the recently completed 4th quarter and fiscal year (e.g., information that is included in an earnings release).

As part of their due diligence procedures, underwriters frequently request accountants to perform procedures with respect to the capsule financial information.

Accountants must exercise caution when considering performing procedures and reporting results that relate to information which is the subject of ongoing audit procedures and/or which is subject to change once the issuer finalizes and issues its year-end financial statements.

Underwriters frequently ask accountants to provide a comfort letter in connection with securities offerings that take place after the issuer's fiscal year-end but prior to the date that the issuer has "issued" its year-end financial statements1.

Registration statements prepared during this timeframe oftentimes include2 capsule financial information for the fourth quarter and/or full year notwithstanding the fact that the year-end financial statements have not been "issued".

A number of questions arise as to what level of comfort the accountant should consider providing (at the request of the underwriter) on the fourth quarter or full year capsule financial data in connection with a registration statement that is declared effective prior to the issuance of the year-end financial statements.

Underwriter requests for comfort on this type of capsule data generally include one or more of the following:

1. Positive assurance that the year-end capsule financial information has been audited (or the year-end financial statements have been audited);
2. Negative assurance that the capsule information for full year or the 4th quarter have been reviewed pursuant to Statement on Auditing Standards No. 100 "Interim Financial Information" (or that the underlying 4th quarter or full year financial statements have been reviewed under SAS 100);
3. Reading unaudited financial information for the 4th quarter and reporting certain changes in specified financial statement elements;
4. Inquiring of company officials as to changes in specified financial statement elements;
5. Agreeing the 4th quarter or full year capsule financial information to the company's accounting records (commonly referred to as "tickmark" comfort).

The purpose of this paper is to explain what types of procedures accountants are generally willing to perform on behalf of and report to underwriters relating to 4th quarter and full year capsule financial information included in a registration statement prior to the time that the year-end financial statements have been issued.

Section 11 of the Securities Act of 1933 (the "Act") provides that underwriters could be liable if any part of a registration statement contains material omissions or misstatements. Specifically, Section 11(a) of the Act provides (in part) that every underwriter with respect to a security may be sued by any person acquiring that security if any part of the registration statement contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.

Section 11(b)(3) of the Act, however, provides that the underwriter would not be liable if he sustains "the burden of proof that (among other things)…:

The standard of reasonableness for purposes of determining what constitutes a reasonable investigation and a reasonable ground for belief under Section 11(b)(3) "…shall be that required of a prudent man in the management of his own property".3 This is commonly referred to as the "due diligence" defense.

Underwriters generally request that accountants issue a comfort letter with respect to certain information included in the registration statement as one of a number of procedures that may be used to establish that an underwriter has conducted a reasonable investigation4.

Statement on Auditing Standards No. 72 "Letters for Underwriters and Certain Other Requesting Parties" (SAS 72/AU 634) provides guidance to accountants for performing and reporting on the results of engagements to issue comfort letters to underwriters. SAS 72 provides for several different types of procedures which an accountant may, at the request of the underwriter, consider5 performing.

There are three key parties involved with a comfort letter to be issued in connection with an underwritten registered offering: the issuer, the underwriter and the accountant.

The issuer is responsible for preparing the registration statement and determining its contents. By including the capsule financial information in the document, the issuer is likely attempting to ensure that investors have the most current information available for purposes of making an investment decision. The information that the issuer determines to present in the registration statement is a key factor in establishing the population of information that the underwriter must consider in designing his "due diligence" procedures.

The underwriter is also striving to ensure that the offering materials contain the appropriate information. However, unlike issuers which are always directly liable for material misstatements or omissions in the registration statement (including the capsule financial information), the underwriter may have the ability to "avoid" liability for a material misstatement or omission in the registration statement (including the capsule financial data) if the underwriter can show that after reasonable investigation, the underwriter had reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.

The accountant's primary role is to audit the annual financial statements included in the registration statement. However, as a service, an accountant may also issue a comfort letter reporting the results of certain procedures (selected by the underwriter as considered necessary in connection with performing his "due diligence").

There is a natural tension that exists when an underwriter asks the accountant to perform procedures on capsule financial information for a period more current than the financial statements included in the registration statement.

The issuer, by not including the year-end financial statements in the registration statement, is acknowledging that the audited financial statements are, in fact, not available.6

The underwriter, however, wants to ensure that the registration statement has the appropriate level of current information while protecting himself from liability.

Accountants want to facilitate, to the extent practical and appropriate, the capital formation process, but are reluctant to perform procedures on capsule financial information and report findings in the context of a comfort letter when the financial statements underlying that data are not yet complete and have not been issued. In fact, oftentimes, the accountant is in the process of performing an audit of the underlying financial statements at the time that the comfort letter is issued, thus putting the accountant in the position of being asked to comment on balances and amounts which are subject to change7 and which are currently being subjected to a higher level8 of professional service.

Reporting the results of procedures on balances and amounts, which are the subject of ongoing, soon to be undertaken or completed auditing procedures, and which are still subject to change, is a risky proposition that the accountant must approach with caution to avoid assuming undue and disproportionate risk.

There are, however, a number of procedures which accountants are generally willing to perform on capsule financial information prior to the date that the year-end financial statements are issued. However, prior to considering any level of comfort on 4th quarter or full fiscal year capsule financial information, the accountant must first consider the issuer's circumstances such as the internal control environment, past history of audit adjustments, open contingencies (including the likelihood of resolution prior to "issuance" of the financial statements) and the nature of the business.

A discussion of the various types of comfort letter procedures on capsule financial information that underwriters may request accountants to perform prior to the date that the year-end financial statements are issued (together with any relevant milestones that must be achieved prior to the accountant being in a position to give the indicated comfort) is presented below:

An accountant cannot give SAS 100 negative assurance on financial information for a company's full fiscal year because SAS 100 only applies to interim financial information as that term is defined in AU 722.02.

Paragraphs 37 and 38 of AU 634 state that accountants can comment, in the form of negative assurance, on unaudited condensed interim information when they have conducted a SAS 100 review, in which case the accountants must (i) state in the comfort letter that the information has not been audited and (ii) disclaim an opinion thereon. Paragraph 39 of AU 634 states that accountants can comment, in the form of negative assurance, on capsule financial information only when they have conducted a SAS 100 review of the financial statements underlying the capsule financial information.9

However, as noted above, management is responsible for evaluating subsequent events until the time that year-end financial statements are issued. Therefore, until the financial statement issuance date, management is not in a position to assert that the financial statements are final. Additionally, until the audit is complete and the financial statements are issued, there may well be adjustments to the balances and amounts included in the capsule financial information and those adjustments may be material.

Even though SAS 72 does not otherwise place specific conditions on giving SAS 100 negative assurance on 4th quarter financial statements or capsule information, the facts that i) financial statement balances and amounts are subject to change and ii) are subject to on-going audit procedures should result in the exercise of extreme caution by the accountant.

Recognizing this, the accountant should wait until audit fieldwork is substantially complete10 and the year-end financial statements are in substantially final form11 before considering providing SAS 100 negative assurance on the 4th quarter financial statements or capsule information. If the accountant is in a position to give this level of comfort, 4th quarter financial statements must be prepared (at an S-X Article 10 level of detail, with all required financial statements and disclosures) and must be attached to the comfort letter if not included in the registration statement (see AU 634.41).

SAS 72 permits an accountant to give negative assurance that he has read the issuer's financial information for October, November and December (for a calendar year end company) and that he is unaware of certain specified changes in financial statement amounts (see paragraphs 4b and 5b of Example A to SAS 72).

Even though SAS 72 does not otherwise place specific conditions on giving negative assurance as to specified changes in financial statement amounts based on reading subsequent financial statements through the end of a fiscal year, the facts that i) the 4th quarter/year-end financial information cannot be finally determined until the year-end financial statements are "issued" and ii) the accountant either has been engaged to perform or is performing an audit on the annual period, indicate that the accountant should exercise extreme caution in providing this level of comfort prior to the completion of the audit.

Recognizing this, the accountant should consider providing negative assurance as to specified changes in financial statement amounts based on reading subsequent financial statements through the end of a fiscal year only after audit fieldwork is substantially complete12 (even if the annual financial statements are not in substantially final form)13. The accountant could however provide negative assurance that he has read financial information for a shorter period within the fourth quarter (e.g., one or two months) even if the audit fieldwork is not substantially complete.

SAS 72 permits an accountant to give negative assurance that he has inquired of company officials and that he is unaware of certain specified changes in financial statement amounts up to a date that is less than 135 days from the end of the most recent period for which the accountant has performed an audit or review (see paragraph 6 of Example A to SAS 72).

Even though SAS 72 does not otherwise place specific conditions on giving negative assurance as to specified changes in financial statement amounts based on inquiries as of or subsequent to the end of a fiscal year, the facts that i) the 4th quarter/year-end financial information cannot be finally determined until the year-end financial statements are "issued" and ii) the accountant either has been engaged to perform or is performing an audit on the annual period, indicate that the accountant should exercise extreme caution in providing this level of comfort prior to the completion of the audit.

Recognizing this, if the cut-off date is year-end, the accountant should make these inquiries only after substantially completing the year-end audit field work (even if financial statements are not in substantially final form)14.

The accountant can consider making these inquiries and reporting the results even if he has not substantially completed the audit or fourth quarter SAS 100 review procedures as long as the cutoff date is not the year-end15 (mindful of the 135 day rule discussed above).

Paragraph 55 of AU 634 permits an accountant to agree certain information relating to an unaudited period to an issuer's accounting records if the accountant has performed an audit of the financial statements for a period including or immediately prior to the unaudited period or if they have otherwise obtained knowledge of the issuer's internal control (as described in AU 634).

Even though SAS 72 does not otherwise place specific conditions on commenting on financial amounts related to the recently completed fiscal year or fourth quarter thereof, the facts that i) the 4th quarter/year-end financial information cannot be finally determined until the year-end financial statements are issued and ii) the accountant either has been engaged to perform or is performing an audit on the annual period, indicates that the accountant should exercise caution in providing this level of comfort prior to the completion of the audit.

Recognizing this, an accountant should agree fourth quarter and full year information to the issuer's accounting records (so-called "tick mark comfort") only after audit fieldwork is substantially complete (even if financial statements are not substantially in substantially final form)16.

Underwriters sometimes request that accountants make a statement in the comfort letter indicating that an audit of the recently ended fiscal year is complete prior to the date that the client has issued the underlying annual financial statements.

The accountants should not comment on the completion (or the status, other than the fact that the audit is pending completion) of the audit prior to the issuance of the underlying financial statements. Even though audit fieldwork may be substantially complete or the date of the audit report has passed, both the company and the auditor are responsible for evaluating post-balance sheet (pre-issuance) subsequent events for their impact on the financial statements and disclosures up to the issuance date. Therefore management cannot assert that the financial statements are complete until the date that the financial statements are issued. Since management is not in a position to represent that the financial statements are complete, the auditor cannot indicate that the audit is complete. Additionally, as noted above, if the audited financial statements were complete (and therefore, by definition, "available"), S-X 3-12(c) would require that they be included in the registration statement.

* * * * * * * * * *