December 1, 2005
December 1, 2005 Prepared by Accounting Staff Members in
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement of any of its employees. This outline was prepared by members of the staff of the Division of Corporation Finance, and does not necessarily reflect the views of the Commission, the Commissioners, or other members of the staff.
I. Recent Rules, Proposed Rules, Interpretive Bulletins, and Other Commission ActivityA. Final Rules Regarding Securities Offering Reform (Updated)On June 29, 2005, the Commission voted to adopt modifications to the registration, communications, and offering processes under the Securities Act of 1933 (see Release No. 33-8591). The principal areas of the release are summarized below. In many cases, the amount of flexibility granted to issuers under the reforms is contingent on the characteristics of the issuer, including the type of issuer, the issuer's reporting history, and the issuer's equity market capitalization or amount of previously registered non-convertible securities, other than common equity. The reforms divide issuers into four categories:
Liberalizing Communications Around the Time of Registered Offerings The rules update and liberalize permitted offering activity and communications to allow more information to reach investors by revising the application of the "gun-jumping" provisions under the Securities Act. The cumulative effects of these rules are:
A number of these new rules include conditions of eligibility. Most of the rules, for example, are not be available to blank check companies, penny stock issuers, or shell companies. The rules address the treatment under the Securities Act of electronic communications, including electronic road shows and information located on or hyperlinked to an issuer's website. The Commission addressed the liability provisions under the Securities Act. In this regard, the Commission:
Improvements to Registration Procedures The rules make improvements to the shelf registration provisions that will modernize the operation of the shelf registration process under the Securities Act. The changes:
The rules also contain procedural changes that allow certain reporting issuers that are current in filing their Exchange Act reports to incorporate by reference previously filed Exchange Act reports and other materials into a Securities Act registration statement on Form S-1 or Form F-1. Prospectus Delivery Reforms The rules change the way in which the final prospectus delivery obligations under the Securities Act are satisfied by creating an "access equals delivery" model for final prospectuses. Under this model, filing a final prospectus with the Commission and complying with other conditions will enable offering participants to conduct securities offerings without printing and actually delivering final prospectuses. A cure provision for inadvertent failures to file is included. In addition, the rules include a separate requirement to notify investors that they purchased securities in a registered offering. Required Disclosure in Exchange Act Reports The rules require issuers to include the following in their Exchange Act periodic reports:
The effective date of the rules is December 1, 2005. • The Commission staff has posted questions and answers regarding the B. Regulatory Relief and Assistance for Hurricane Katrina Victims (New)On September 15, 2005, the Commission issued an order providing emergency regulatory relief to investors, companies, and securities firms affected by Hurricane Katrina (see Release No. 34-52444). To address compliance issues caused by Hurricane Katrina and its aftermath, the order conditionally exempts affected persons from the requirements of the federal securities laws with regard to the following:
In addition, the Commission has directed the staff to take the following positions under the Exchange Act, the Securities Act and the Investment Advisers Act with regard to issues that may arise commonly for companies and other persons attempting to comply with their obligations under the federal securities laws:
Companies and other affected persons may require additional or different assistance in their efforts to comply with the requirements of the federal securities laws. Commission staff will address specific issues, such as difficulty completing audits or complying with the internal control requirements adopted pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, and any disclosure-related issues on a case-by-case basis in light of their fact-specific nature. Any companies, transfer agents, registered investment companies, registered investment advisers, security holders, or other persons requiring additional assistance are encouraged to contact Commission staff for individual relief or interpretive guidance. For this purpose, the Commission has established both telephone and e-mail hotlines to provide immediate responses to questions or to hear from those that want to advise the Commission of their needs:
C. Employee Stock Options (New) 1. Amendment of Compliance Dates for Statement of Financial
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Table of Contents10-Q filings on the following schedule. | ||
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For Fiscal Years Ending On Or After | Form 10-Q Deadline | Form 10-K Deadline |
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December 15, 2003 December 15, 2004 December 15, 2005 December 15, 2006 | 45 days after fiscal quarter end 40 days after fiscal quarter end 40 days after fiscal quarter end 35 days after fiscal quarter end | 75 days after fiscal year end 75 days after fiscal year end 60 days after fiscal year end 60 days after fiscal year end |
The deadlines provide for a scheduled phase-in over a defined period in time, so that all registrants who meet the definition of an accelerated filer have the same reporting deadlines no matter when they became an accelerated filer.
Rule 12b-25 permits registrants an extension of time in which to file their Forms 10-K and 10-Q and still be considered to have filed those reports timely. The new rules do not change the 15 calendar day period (for Form 10-K) and 5 calendar day period (for Form 10-Q) provided for under Rule 12b-25.
Accelerated filers can file their Article 12 financial statement schedules by amendment within 30 days following the due date of their Form 10-K. Consequently, at the end of the phase-in period, accelerated filers will be required to file the schedules within 90 days of the end of the fiscal year.
If an accelerated filer changes its fiscal year end, the transition report deadlines are phased in under the same schedule as quarterly and annual reports on Forms 10-Q and 10-K.
Forms 10-K and 10-Q Disclosures
The new rules require that all Exchange Act registrants filing on Form 10-K include new cover page disclosures in their Forms 10-K for fiscal years ending on or after December 15, 2002. The amended cover page requires the registrant to indicate by check mark either that it is or is not an accelerated filer and to disclose its non-affiliated common equity public float as of the end of the last business day of the registrant’s most recently completed second fiscal quarter. The accelerated filing status disclosure is also required on Form 10-Q.
If a registrant’s cover page to its Form 10-K mistakenly discloses its non-affiliated common equity public float as of the date of filing, rather than as of the last business day of its most recently completed second fiscal quarter, it should file an amended Form 10-K. That amendment should include a corrected cover page, a new signature page, and Exhibit 31, a revised 302 certification required by Item 601 of Regulations S-K and S-B which includes the first 2 certifying statements. Note that both the share price and outstanding share amount must be as of the last business day of the most recently completed second fiscal quarter.
For purposes of completing the cover page to their first Form 10-K, we have advised registrants who complete their IPO after their most recently completed second quarter to compute their common equity public float as of a date within 60 days of filing the report. This method was used prior to the adoption of the new rules. Note that this is only to fulfill the cover page disclosure requirement. It does not mean the issuer uses that common equity public float to determine whether it is an accelerated filer. In this scenario, the registrant would not qualify as an accelerated filer because it was not a public company for 12 months and it had not filed at least one annual report as of its fiscal year-end.
Transactional Filings (Subject to Recent Proposed Revisions)
In addition to accelerating the Form 10-Q filing deadlines, the new rules accelerate the updating requirements of interim financial statements required in registration statements at the time of effectiveness and in proxy statements at the time they are mailed to conform to the accelerated phase-in filing deadlines of Form 10-Q. Therefore, if the registrant meets the definition of an accelerated filer, its interim financial statements must meet the following:
For Fiscal Years Interim Financial Statements
Ending On Or After Cannot be Older Than
December 15, 2003 134 days
December 15, 2004 129 days
December 15, 2005 129 days
December 15, 2006 124 days
An accelerated filer that meets the three tests specified in S-X Rule 3-01(c) must update to include its audited year-end financial statements using the same phase-in schedule for its Form 10-K. Therefore, an accelerated filer meeting the tests must include its audited year-end financial statements according to the following schedule:
For Fiscal Years Audited Year End Financial
Ending On Or After Statements Must be Included by
December 15, 2003 75 days after year-end
December 15, 2004 75 days after year-end
December 15, 2005 60 days after year-end
If the filer does not meet the Rule 3-01(c) tests, it will still be able to delay updating to include its year-end financial statements until 45 days after its year-end. The 45-day period has not changed. Note that, despite the stipulated timeframes, registrants are required to include their year-end audited financial statements in definitive proxy statements and registration statements at the time of effectiveness if they are available.
Financial Statements under S-X Rules 3-05 and 3-09
The requirement for updating interim and fiscal year-end financial statements of an acquired business included in an acquirer’s Form 8-K or in its proxy/registration statement under S-X Rule 3-05 has been accelerated only when the acquired company is itself an accelerated filer. Therefore, an acquirer that is either an accelerated or non-accelerated filer must include the financial statements of the acquired business at least as current as the financial statements required to be filed by the acquired company in its own periodic reports. Accelerated filers still have 75 days from consummation to file 3-05 financial statements on Form 8-K.
Separate financial statements of unconsolidated subsidiaries and 50% or less owned persons required by S-X Rule 3-09 will not be accelerated for inclusion in the parent’s Form 10-K unless both the parent and the subsidiary/investee are accelerated filers.
I. Management’s Report on Internal Control over Financial Reporting and
Certification of Disclosure in Exchange Act Periodic Reports
(Updated)
Section 404 of the Sarbanes-Oxley Act directed the Commission to adopt rules requiring each annual report of a registrant, other than a registered investment company, to contain (1) a statement of management’s responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) management’s assessment, as of the end of the registrant’s most recent fiscal year, of the effectiveness of the registrant’s internal control structure and procedures for financial reporting. Section 404 also requires the registrant’s auditor to attest to, and report on management’s assessment of the effectiveness of the registrant’s internal controls and procedures for financial reporting in accordance with standards established by the Public Company Accounting Oversight Board. The Commission adopted final rules on May 27, 2003, in Release No. 34-47986 concerning management’s report on internal control over financial reporting and certification of disclosures in Exchange Act periodic reports.
The final rules require that management’s annual internal control report include:
- a statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the registrant,
- management’s assessment of the effectiveness of the registrant’s internal control over financial reporting as of the end of the registrant’s most recent fiscal year,
- a statement identifying the framework used by management to evaluate the effectiveness of the registrant’s internal control over financial reporting, and
- a statement that the registered public accounting firm that audited the registrant’s financial statements included in the annual report has issued an attestation report on management’s assessment of the registrant’s internal control over financial reporting.
Under the new rules, a registrant is required to file the registered public accounting firm’s attestation report as part of the annual report. The rules also require that management evaluate any change in the registrant’s internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.
The Commission also adopted amendments to rules and forms under the Securities Exchange Act of 1934 and the Investment Company Act of 1940 to revise the Section 302 certification requirements and to require registrants to provide the certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 as exhibits to certain periodic reports. The amendments permit registrants to furnish rather than file the Section 906 certifications with the Commission. Thus, the certifications will not be subject to liability under Section 18 of the Exchange Act. Moreover, the certifications will not be subject to automatic incorporation by reference into a registrant’s Securities Act registration statements, which are subject to liability under Section 11 of the Securities Act, unless the registrant takes steps to include the certifications in a registration statement.
The compliance schedule for the rules regarding management’s report on internal controls was revised in February 2004 (Release No. 33-8392), revised again on March 2, 2005 (Release No. 33-8545), and on September 21, 2005 (Release No. 33-8618). As a result of Release No. 33-8392, an accelerated filer must begin to comply with the rules regarding management’s report on internal controls for its first fiscal year ending on or after Nov. 15, 2004 (originally June 15, 2004). As a result of Release No. 33-8545, a foreign private issuer that is an accelerated filer must begin to comply with these requirements for its first fiscal year ending on or after July 15, 2006 (originally April 15, 2005). As a result of Release No. 33-8618, a non-accelerated filer (whether a domestic company or a foreign private issuer) must begin to comply with these requirements for its first fiscal year ending on or after July 15, 2007 (originally April 15, 2005). As noted in Section I.D. of this outline, accelerated filer status is determined at the end of a registrant’s fiscal year based on certain conditions, including its non-affiliated common equity public float as of the last business day of its most recently completed second fiscal quarter. Therefore, there may be registrants who are currently non-accelerated filers who become accelerated filers as of the end of their next fiscal year that will not be eligible for further extension under Release No. 33-8545.
The Commission also is soliciting public comment on several questions about the application of the internal control reporting requirements including questions regarding the amount of time and expense that non- accelerated filers have incurred to date to prepare for compliance with the internal control reporting requirements. Comments should have been received by the Commission on or before October 31, 2005. The full text of the release can be found at http://www.sec.gov/rules/final/33-8618.pdf.
The Commission held a public roundtable on April 13, 2005 on Implementation of Internal Control Reporting Provisions, and received extensive feedback. Two messages have been clear from the feedback. First, compliance with Section 404 is producing benefits, including a heightened focus on internal controls at the top levels of public companies. Second, implementation in the first year resulted in significant costs. While a portion of the costs likely reflect start-up expenses from this new requirement, it also appears that some non-trivial costs may have been unnecessary, due to excessive, duplicative or misfocused efforts.
As a result of the concerns expressed, on May 16, 2005 the Commission staff released a Staff Statement on Management's Report on Internal Control Over Financial Reporting to provide additional guidance and clarification of certain issues (see the Staff Statement at http://www,sec.gov/info/accountants/stafficreporting.htm). An overarching principle of this guidance is the responsibility of management to determine the form and level of controls appropriate for each company and to scope their assessment and the testing accordingly. Registered public accounting firms should recognize that there is a zone of reasonable conduct by companies that should be recognized as acceptable in the implementation of Section 404. The SEC staff guidance complements the guidance that the PCAOB provided on the same date with respect to the application of its Auditing Standard No. 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of the Financial Statements.
The staff will continue to monitor the implementation of the internal control reporting requirements. In addition, because of the importance we place on effective and efficient implementation of Section 404, all participants in the process should consider the following broad concepts:
- Both management and external auditors must bring reasoned judgment and a top-down, risk-based approach to the 404 compliance process. A one-size fits all, bottom-up, check-the-box approach that treats all controls equally is less likely to improve internal controls and financial reporting than reasoned, good faith exercise of professional judgment focused on reasonable, as opposed to absolute, assurance.
- The internal control audit should be better integrated with the audit of a company's financial statements. If management and auditors can achieve the goal of integrating the two audits, the Commission expects that both internal and external costs of Section 404 compliance will fall for most companies.
- Internal controls over financial reporting should reflect the nature and size of the company to which they relate. Particular attention should be paid to making sure that implementation of Section 404 is appropriately tailored to the operations of smaller companies. Again, this is an area where reasoned judgment and a risk-based approach must be brought to bear.
- The Commission encourages frequent and frank dialogue among management, auditors and audit committees with the goal of improving internal controls and the financial reports upon which investors rely. Management of all companies - large and small - should not fear that a discussion of internal controls with, or a request for assistance or clarification from, the auditor will, itself, be deemed a deficiency in internal control. Moreover, as long as management determines the accounting to be used and does not rely on the auditor to design or implement the controls, the Commission does not believe that the auditor's providing advice or assistance, in itself, constitutes a violation of our independence rules. Both common sense and sound policy dictate that communications must be ongoing and open in order to create the best environment for producing high quality financial reporting and auditing; communications must not be so restricted or formalized that their value is lost.
In addition, the Commission staff has received specific questions regarding the implementation and interpretation of the rules. For answers to some of the questions most frequently posed, please see Management’s Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Frequently Asked Questions (revised October 6, 2004) at http://www.sec.gov/info/accountants/controlfaq1004.htm and Exemptive Order on Management's Report on Internal Control over Financial Reporting and Related Auditor Report, Frequently Asked Questions (January 21, 2005) at http://www.sec.gov/divisions/corpfin/faq012105.htm. The PCAOB’s Office of Chief Auditor has also issued staff questions and answers related to PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements available at http://www.pcaobus.com/Standards/Staff_Questions_and_Answers/index.asp.
New COSO Guidance on Section 404 Compliance
In adopting its rules with respect to Section 404, the Commission specified that management must base its evaluation of the effectiveness of the company's internal control over financial reporting on a suitable, recognized control framework that is established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment. In its rule-making release on June 5, 2003, the Commission acknowledged that the original COSO (Committee of Sponsoring Organizations of the Treadway Commission) framework satisfies that criteria. The COSO internal control framework has been widely used by management and auditors in fulfilling the requirements of Section 404. However, concerns have been expressed that existing internal control frameworks are not appropriately tailored to a small business control environment and that, as a result, the costs and burdens of internal control assessments may fall disproportionately on smaller businesses. Due to these concerns, SEC staff encouraged COSO to develop guidance on the use of their framework to address the needs of smaller businesses. On October 26, 2005, COSO published for comment new guidance on the use of its framework to address the needs of smaller businesses in fulfilling the requirements of Section 404. COSO's guidance, entitled Guidance for Smaller Public Companies Reporting on Internal Control Over Financial Reporting, is available at www.coso.org. Comments should be directed to COSO through its website by Dec. 31, 2005.
J. Management’s Discussion and Analysis
1. Disclosure in Management’s Discussion and Analysis about Off-
Balance Sheet Arrangements and Aggregate Contractual Obligations
Section 401(a) of the Sarbanes-Oxley Act added Section 13(j) to the Securities Exchange Act of 1934, which required the Commission to adopt final rules by January 26, 2003, to require each annual and quarterly financial report required to be filed with the Commission, to disclose "all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the registrant with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses."
On January 22, 2003, the Commission adopted rule amendments to implement Section 401 of the Sarbanes-Oxley Act (see Release No. 34-47264). The amendments, which are effective, require a registrant to provide an explanation of its off-balance sheet arrangements in a separately captioned subsection of the MD&A section in its disclosure documents. The amendments also require registrants (other than small business issuers) to provide an overview of certain known contractual obligations in a tabular format.
The amendments include a definition of off-balance sheet arrangements that primarily targets the means through which registrants typically structure off-balance sheet transactions or otherwise incur risks of loss that are not fully transparent to investors. The definition of off-balance sheet arrangements employs concepts in accounting literature in order to define the categories of arrangements with precision. Generally, the definition includes the following categories of contractual arrangements:
- certain guarantee contracts,
- retained or contingent interests in assets transferred to an unconsolidated entity,
- derivative instruments that are classified as equity, or
- material variable interests in unconsolidated entities that conduct certain activities.
The amendments require disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. That disclosure threshold is consistent with the existing disclosure threshold under which information that could have a material effect on financial condition, changes in financial condition or results of operations must be included in MD&A.
The amendments require disclosure of the following specified information to the extent necessary to an understanding of off-balance sheet arrangements and their material effects:
- the nature and business purpose of the registrant’s off-balance sheet arrangements,
- the importance to the registrant for liquidity, capital resources, market risk or credit risk support or other benefits,
- the financial impact and exposure to risk, and
- known events, demands, commitments, trends or uncertainties that implicate the registrant’s ability to benefit from its off-balance sheet arrangements.
Consistent with other MD&A requirements, the amendments contain a principles-based requirement that a registrant provide such other information that it believes is necessary for an understanding of its off-balance sheet arrangements and their material effects. In addition, the amendments include a requirement for registrants to disclose, in a tabular format, the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligation, for specified time periods. The categories of contractual obligations to be included in the table are defined by reference to the applicable accounting literature.
2. SEC Staff Report on Off-Balance Sheet Arrangements, Special
Purpose Entities and Related Issues (New)
On June 15, 2005, the SEC staff released a staff report prepared by the Office of the Chief Accountant, the Office of Economic Analysis and the Division of Corporation Finance on off-balance sheet arrangements, special purpose entities and related issues (see the full text of the staff study at www.sec.gov/news/studies/soxoffbalancerpt.pdf.). The report was prepared pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002. As required by that Act, the report was submitted to the President, the Committee on Banking, Housing and Urban Affairs of the Senate, and the Committee on Financial Services of the House of Representatives. The staff report includes an analysis of the filings of issuers as well as an analysis of pertinent U.S. generally accepted accounting principles and Commission disclosure rules. The report describes the staff's study, details its findings, and provides recommendations.
The staff took a broad approach to the scope of the report by including a review of a range of topics with potential off-balance sheet implications, including consolidation issues, transfers of financial assets with continuing involvement, retirement arrangements, contractual obligations, leases, contingent liabilities and derivatives, as well as a discussion of special purpose entities (SPEs).
The report identifies several goals for those involved in the financial reporting community, including efforts to:
- discourage transactions and transaction structures motivated primarily and largely by accounting and reporting considerations, rather than economics;
- expand the use of objectives-oriented standards;
- improve the consistency and relevance of disclosures; and
- focus financial reporting on communication with investors, rather than just compliance with rules.
The report also provides the following staff positions and recommendations regarding certain changes in accounting and reporting requirements, each of which complement one or more of the goals mentioned above:
- The staff recommends the accounting guidance for defined-benefit pension plans and other post-retirement benefit plans be reconsidered. The trusts that administer these plans are currently exempt from consolidation by the issuers that sponsor them, effectively resulting in the netting of assets and liabilities in the balance sheet. In addition, issuers have the option to delay recognition of certain gains and losses related to the retirement obligations and the assets used to fund these obligations.
- The staff recommends that the accounting guidance for leases be reconsidered. The current accounting for leases takes an "all or nothing" approach to recognizing leases on the balance sheet. This results in a clustering of lease arrangements such that their terms approach, but do not cross, the "bright lines" in the accounting guidance that would require a liability to be recognized. As a consequence, arrangements with similar economic outcomes are accounted for very differently.
- The staff recommends the continued exploration of the feasibility of reporting all financial instruments at fair value.
- The staff recommends that the Financial Accounting Standards Board continue its work on the accounting guidance that determines whether an issuer would consolidate other entities-including SPEs-in which the issuer has an ownership or other interest.
- The staff believes that, in general, certain disclosures in the filings of issuers could be better organized and integrated.
3. MD&A Interpretive Release
On December 19, 2003, the Commission issued an interpretive release providing guidance regarding MD&A disclosure in registrants’ disclosure documents. The guidance reminds registrants of existing disclosure requirements and provides additional guidance, designed to elicit more informative and transparent MD&A, that satisfies the principal objectives of MD&A:
- to provide a narrative explanation of a registrant’s financial statements that enables investors to see the registrant through the eyes of management,
- to enhance the overall financial disclosure and provide the context within which financial information should be analyzed, and
- to provide information about the quality of, and potential variability of, a registrant’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
The guidance emphasizes that MD&A should not be merely a recitation of financial statements in narrative form or an otherwise uninformative series of technical responses to MD&A requirements, neither of which provides the important management perspective called for by MD&A. Instead, the release encourages top-level management involvement in the drafting of MD&A, and provides guidance regarding:
- the overall presentation and focus of MD&A (including through executive-level overviews, a focus on the most important information and a reduction of duplicative information),
- emphasis on analysis of financial information,
- known material trends and uncertainties,
- key performance indicators, including non-financial indicators,
- liquidity and capital resources, and
- critical accounting estimates (see also Financial Reporting Release (FRR) No. 60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies (http://www.sec.gov/rules/other/33-8040.htm) and Release No. 34-45907, Proposed Rule: Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies).
The release does not create new legal requirements, nor does it modify existing legal requirements. A copy of the release can be found on the Commission’s Web site at http://www.sec.gov/rules/interp/33-8350.htm under Regulatory Actions / Interpretive Releases.
K. Rule Proposals Related to Proxy Materials
1. Proposals Regarding Security Holder Director Nominations
On October 8, 2003, the Commission voted to propose rule changes that would, under certain circumstances, require registrants to include in their proxy materials security holder nominees for election as director (see Release No. 34-48626). These proposed rules are intended to improve disclosure to security holders to enhance their ability to participate meaningfully in the proxy process for the nomination and election of directors. The proposed rules would not provide security holders with the right to nominate directors where it is prohibited by state law. Instead, the proposed rules are intended to create a mechanism for nominees of long-term security holders, or groups of long-term security holders, with significant holdings to be included in company proxy materials where there are indications that security holders need such access to further an effective proxy process. This mechanism would apply in those instances where evidence suggests that the company has been unresponsive to security holder concerns as they relate to the proxy process. The proposed rules would enable security holders to engage in limited solicitations to form nominating security holder groups and engage in solicitations in support of their nominees without disseminating a proxy statement. The proposed rules also would establish the filing requirements under the Exchange Act for nominating security holders.
2. Proposals Regarding Internet Availability of Proxy Materials
On November 29, 2005, the Commission voted to propose rule changes that would allow companies and other persons to use the Internet to satisfy proxy requirements (See Release No. 34-52926). The proposed rules would amend the proxy rules under the Securities Exchange Act of 1934 to provide an alternative method for issuers and other persons to furnish proxy materials to shareholders by posting them on an Internet Web site and providing shareholders with notice of the availability of the proxy materials. The proposed rules are intended to put into place processes that would provide shareholders with notice of, and access to, proxy materials while taking advantage of technological developments and the growth of the Internet and electronic communications. The proposed amendments also would apply to a soliciting person other than the issuer, which may reduce the costs of engaging in a proxy contest. Comments should be received on or before the 60th day after publication in the Federal Register.
L. Public Release of Comment Letters and Responses (New)
The staff of the Securities and Exchange Commission announced on May 9, 2005 that on May 12, 2005, it would begin the process of publicly releasing comment letters and response letters relating to disclosure filings made after August 1, 2004, and reviewed by the Division of Corporation Finance and the Division of Investment Management. The staff had announced on June 24, 2004 that it would begin releasing comment letters and filer response letters relating to disclosure filings made after August 1, 2004 that were selected for review (see Press Release No. 2004-89 for additional details). The staff is releasing comment letters and response letters relating to reviewed disclosure filings on a filing-by-filing basis through our EDGAR system at www.sec.gov. The process commenced with some of the oldest eligible filings; as it continues, letters will be released no earlier than 45 days after the review of the disclosure filing is complete.
M. Recent Enforcement Actions Involving MD&A (New)
1. Enforcement Action involving The Coca-Cola Company
On April 18, 2005, the Commission announced a settled cease-and-desist proceeding against The Coca-Cola Company relating to its failure to disclose certain quarter-end sales practices used to meet earnings expectations. Coca-Cola also has voluntarily undertaken steps to strengthen its internal disclosure review process to prevent future violations.
The Commission found that, at or near the end of each reporting period between 1997-1999, Coca-Cola employed an undisclosed "channel stuffing" practice in Japan known as "gallon pushing" to record sales in a current period that would have occurred in future periods. Specifically, Coca-Cola offered Japanese bottlers extended credit terms to induce them to purchase quantities of beverage concentrate they otherwise would not have purchased until a later period.
As a result of gallon pushing, from 1997 to 1999 Coca-Cola's Japanese bottlers' concentrate inventory levels increased at more than a five times greater rate than that of finished product sales to retailers. Gallon pushing resulted in Coca-Cola prematurely recording sales that would have occurred in later periods and made it likely that Coca-Cola's bottlers would purchase less concentrate in later periods. This practice contributed approximately $0.01 to $0.02 to Coca-Cola's quarterly EPS and resulted in Coca-Cola meeting as opposed to missing analysts' consensus or modified consensus earnings estimates in 8 out of the 12 quarters from 1997-1999. Despite the impact to current earnings and the likely impact to future earnings, Coca-Cola failed to disclose its gallon pushing practice in its periodic reports. Coca-Cola misled investors by failing to disclose in MD&A the period-end practices that impacted the company's current and future operating results.
Also, Coca-Cola made misstatements in a January 2000 Form 8-K about a subsequent inventory reduction, which continued to conceal the impact of prior end-of-period practices and further misled investors. In that Form 8-K, Coca-Cola disclosed that a worldwide concentrate inventory reduction was planned to occur during the first half of the year 2000. The Form 8-K described the inventory reduction as a joint action between Coca-Cola and its bottlers and that certain bottlers throughout the world, specifically including those in Japan, had indicated that they intended to reduce their inventory levels during the first half of the year 2000, when in fact the bottlers were unaware of the inventory reduction.
As set for the in the Form 8-K, the impact on Coca-Cola's earnings for the first and second quarter of 2000 was estimated to be between $0.11 and $0.13 per share. The Form 8-K, however, did not disclose that more than $0.05 of the estimated earnings impact would be attributable to an anticipated reduction of sales for Japan with a corresponding gross profit impact more than five times greater than that of any other operating division in the world.
Although the Commission did not make findings about Coca-Cola's accounting treatment for its gallon pushing sales, it did find that Coca-Cola's failure to disclose the impact of gallon pushing on current and future earnings, as well as the false statements and omissions within the Form 8-K, violated certain antifraud and periodic reporting requirements of the federal securities laws. See AAER-2232 for more details.
2. Enforcement Actions involving Kmart
On August 23, 2005, the Commission filed charges against two former top Kmart executives for misleading investors about Kmart's financial condition in the months preceding its bankruptcy. The Commission's complaint alleges that the former CEO Charles Conaway and former CFO John McDonald are responsible for materially false and misleading disclosures about the company's liquidity and related matters in the MD&A section of Kmart's Form 10-Q for the third quarter and nine months ended October 31, 2001, and in an earnings conference call with analysts and investors.
The Commission alleges that Conaway and McDonald failed to disclose in MD&A the reasons for a massive inventory overbuy in the summer of 2001 and its impact on the company's liquidity. The MD&A disclosure attributed increases in inventory to "seasonal inventory fluctuations and actions taken to improve our overall in-stock position" where, in reality, a significant portion of the inventory buildup was allegedly caused by the purchase of $850 million of excess inventory. The defendants allegedly dealt with Kmart's liquidity problems by delaying payments owed vendors, thereby effectively borrowing $570 million from them by the end of the third quarter. Kmart filed for bankruptcy on January 22, 2002.
The Commission's complaint seeks as relief permanent injunctions, disgorgement with prejudgment interest, civil penalties and officer and director bars. See AAER-2295 for more details. The Commission’s Kmart investigation is continuing.
N. Recent Enforcement Actions Involving GAAP (New)
1. Enforcement Actions involving Warnaco
On May 11, 2004, the Commission settled enforcement proceedings against The Warnaco Group, Inc., a major apparel manufacturer, its former CEO Linda Wachner, former CFO William Finkelstein, former general counsel Stanley Silverstein, and the company's former audit firm, PwC. Warnaco was charged with securities fraud for issuing a false and misleading press release about its financial results on March 2, 1999, and Finkelstein with aiding and abetting the company's fraud. The Commission also charged Warnaco, Finkelstein, Wachner, and Silverstein for their roles in Warnaco's misleading disclosure in its annual report for 1998. In addition, the Commission charged PwC, Warnaco's audit firm at the time, with aiding and abetting Warnaco's reporting violations in the 1998 annual report.
The Commission found that a March 1999 press release, which reported "record" results for 1998, failed to inform investors that Warnaco had discovered a $145 million inventory overstatement that would require the company to restate and significantly lower its financial results for the prior three years. Instead, Warnaco falsely characterized the inventory restatement as the write-off of deferred start-up costs under a new accounting pronouncement. In fact, the overstatement had been caused by serious defects in Warnaco's inventory accounting and internal control systems and did not involve deferred start-up costs.
A month after issuing the fraudulent press release, Warnaco filed a misleading annual report for 1998. Although the annual report correctly accounted for the $145 million restatement, Warnaco failed to inform investors of the true cause of the restatement, instead claiming that the restatement resulted from the write-off of "start-up related" costs. Warnaco's senior management, Wachner, Finkelstein, and Silverstein, knew or should have known that the restatement resulted from material flaws in the company's cost accounting and internal control systems at one of its divisions. Nevertheless, all three approved the annual report, and Wachner and Finkelstein signed it.
PwC, which audited Warnaco's 1998 financial statements, failed to object to Warnaco's mischaracterization of the inventory overstatement as "start-up related" costs and included the misleading description of the restatement into its audit report.
In addition to agreeing to an injunction against future violations of the federal securities laws, Finkelstein agreed to disgorge his bonus for 1998, including interest, of $189,464 and pay a $75,000 civil penalty, for a total payment of $264,464. He also consented to an order prohibiting him from acting as an officer or director of a public company for four years. Wachner and Silverstein also agreed to disgorge their bonuses for 1998, along with prejudgment interest, of $1,328,444 and $165,772, respectively.
Warnaco was required to hire an independent consultant to perform a complete review of the company's internal controls and policies relating to its inventory systems, internal audit, financial reporting and other accounting functions. Warnaco also agreed to adopt the recommendations of the independent consultant within 180 days.
PwC consented to pay a $2.4 million penalty in the federal court action. The Commission censured PwC under Rule 102(e), after finding that that PwC willfully aided and abetted Warnaco's violation of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1.
See AAERs-2005 through 2007 for more details.
2. Enforcement Actions involving Adelphia Communications
Corporation
On April 25, 2005, the Commission settled a civil enforcement action against Adelphia Communications Corporation, its founder John J. Rigas, and his three sons, Timothy, Michael and James P. Rigas, in one of the most extensive financial frauds at a public company. On April 26, 2005, the Commission also settled proceedings against the company’s auditors Deloitte & Touche (D&T) by censuring D&T for improper professional conduct under Rule 102(e) and fining D&T $25 million. D&T also agreed to pay an additional $25 million into a fund to compensate victims of Adelphia’s fraud. In addition, D&T agreed to substantive undertakings designed to address its audit of high-risk clients.
The Commission’s complaint charged that Adelphia, at the direction of the Rigases, (1) fraudulently excluded $1.6 billion in co-borrowing debt from its consolidated financial statements by shifting the debt to the books of off-balance sheet affiliates, the co-borrowers; (2) falsified operating statistics and inflated earnings to meet Wall Street estimates; and (3) concealed rampant self-dealing by the Rigas family, including the undisclosed use of corporate funds for purchases of Adelphia stock and luxury condominiums, by, among other methods, improperly netting related party payables ($1.348 billion at December 31, 2000) and receivables ($1.351 billion at December 31, 2000).
Under the settlement agreement, the Rigas family members forfeited over $1.5 billion in assets that they derived from the fraud, including the Rigas family's interests in certain cable properties. Upon the completion of forfeiture proceedings, Adelphia will obtain title to those cable properties and, at or around the time of Adelphia's emergence from Chapter 11, will pay $715 million into a victim fund.
The individual Rigas family members were barred for life from acting as officers or directors of a public company. Also under the settlement agreement, Adelphia and the Rigas family members agreed to entry of permanent injunctions enjoining them from the antifraud, periodic reporting, and record keeping and internal control provisions of the federal securities laws.
See AAER-2237 and AAER-2326 for more details.
3. Enforcement Actions involving Dollar General
On April 7, 2005, the Commission settled its enforcement action charging Dollar General Corporation and various former executives with accounting fraud. The Commission’s complaint alleged that, during its fiscal years 1998 through 2001, Dollar General engaged in fraudulent or improper accounting practices in violation of GAAP which ultimately resulted in a restatement of Dollar General's financial statements in January 2002. The restatement reduced the company's pre-tax income by approximately $143 million, or about 30 cents per share, over the restated period.
The complaint alleges that Dollar General's misconduct included: (1) intentionally underreporting at least $10 million in import freight expenses for the Company's fiscal year 1999; (2) engaging in an $11 million sham sale of outdated, essentially worthless, Omron cash registers in the Company's fiscal year 2000 fourth quarter; (3) overstating cash accounts; (4) manipulating the Company's reported earnings through the use of a general reserve or "rainy day" account; (5) failing to maintain accurate books and records and filing inaccurate financial reports with the Commission; and (6) failing to maintain adequate internal accounting controls. The complaint also alleges that some of the fraudulent or improper accounting practices were caused by, or known to, former senior executives and accounting personnel who were motivated to report earnings that met or exceeded analysts' expectations and to maintain employee bonuses. By deferring the freight expenses, Dollar General met certain targets, including an internal target for employee bonuses and analysts' expectations for the company's earnings per share for fiscal year 1999, that it would not have met if it had properly recognized the freight expenses in 1999.
The complaint alleges that Dollar General's accounting staff determined that the company should have recognized $13.4 million in freight expenses in fiscal 1999. Rather than recognizing all the expense in fiscal year 1999, the company recorded freight expenses of $4 million in fiscal year 1999 and recognized the remaining $9.4 million ratably during fiscal year 2000. In an attempt to hide part of the improper deferral from the Company's auditors, accounting staff moved $1.3 million of the $9.4 million to the miscellaneous accrued liabilities account, widely known at Dollar General as the "Rainy Day Fund," and $2.7 million of the $9.4 million to corporate bank clearing accounts.
Dollar General consented to the entry of a final judgment permanently enjoining it from future violations of the antifraud, books and records, internal controls, and periodic reporting provisions of the federal securities laws. In addition, Dollar General agreed to pay $1 in disgorgement and a civil penalty of $10 million. Settlements by three company officers included permanent injunctions, permanent or temporary bars against practicing before the Commission or acting as an officer or director of a public company, and fines and penalties of approximately $1.4 million.
See AAER-2226 for more details. Charges against Dollar General’s former CFO are pending.
4. Enforcement Actions involving Bristol-Myers Squibb Company
On Aug. 4, 2004, the Commission settled its civil enforcement action against Bristol-Myers Squibb Company. BMS agreed to pay $150 million dollars and perform numerous remedial undertakings, including the appointment of an independent adviser to review and monitor its accounting practices, financial reporting and internal controls. The Commission’s complaint alleged that BMS engaged in a fraudulent earnings management scheme that deceived investors about the true performance, profitability and growth trends of the company and its U.S. medicines business. According to the Commission's complaint, BMS inflated its results primarily by (1) stuffing its distribution channels with millions of dollars of excess inventory near the end of each quarter to artificially inflate its financial results and meet its internal targets and the consensus estimate of analysts and (2) improperly recognizing upon shipment revenue from specially incentivized consignment-like sales associated with the channel stuffing.
The complaint alleges that BMS sold excessive amounts of its pharmaceutical products to wholesalers ahead of normal orders and improperly recognized revenue from $1.5 billion of such sales to its two largest wholesalers from the first quarter of 2000 through the fourth quarter of 2001. BMS engaged in this fraudulent scheme to inflate Bristol-Myers' sales and earnings in order to meet or exceed internal sales and earnings targets and analysts' earnings estimates. In addition, when BMS earnings results still fell short of its internal targets and analysts’ estimates, the company used "cookie jar" reserves to further inflate its earnings.
In addition, BMS did not disclose that: (1) it was stuffing its distribution channels with millions of dollars of excess inventory near the end of each quarter to artificially inflate its financial results and meet its internal targets and the consensus estimate of analysts; (2) it stuffed its distribution channel by using financial incentives to wholesalers to induce them to buy excess inventory; (3) it was covering the costs its two largest wholesalers incurred from carrying the excess inventory and guaranteeing those wholesalers a specified return on any excess inventory they agreed to take, until they sold the products; (4) channel-stuffing was causing an unusual buildup in excess inventory; and (5) this unusual buildup in excess inventory posed a material risk to BMS' future sales and earnings.
The Commission’s complaint also alleges that BMS circumvented or failed to maintain a system of internal accounting controls sufficient to prevent material misstatements in its books, records, accounts, and financial statements. Specifically, BMS internal controls over revenue recognition, Medicaid and prime vendor rebate liabilities, divestiture reserves, and other accounting items were inadequate.
On June 28, 2004 the company filed a Form 10-K/A to restate its financial statements for the three years ended December 31, 2001 which reflected the sales as consignment sales. As a result of the restatement for these and various other errors, pre-tax income from continuing operations decreased 31% in 2001, 7% in 2000 and 9% in 1999. See AAER-2075 for more details.
On August 22, 2005, the Commission filed civil fraud charges against two former Bristol-Myers Squibb officers Frederick Schiff, former CFO and Richard Lane, former President of the company's Worldwide Medicine Group for creating a fraudulent earnings management scheme that deceived investors about the true performance, profitability and growth trends of the company and its U.S. medicines business. Those charges are pending. See AAER-2294 for more details.
II. Other Current Accounting and Disclosure Issues
A. Dividend Policy Disclosures
The staff believes that certain disclosures are necessary in registration statements for initial public offerings by new registrants that include statements regarding their intention to pay future dividends. This issue first arose when companies began registering a new type of security called the income deposit security or IDS. Since then, the idea of “promised dividends” has expanded to other offerings including those of common stock. The companies making these types of offerings tend to be low-growth, mature companies with stable cash flows and little technology risk. Most of the offerings indicate that they will pay out cash in excess of operating needs as dividends.
Initial public offerings of master limited partnerships (MLP) should include similar disclosures. In the case of the MLP offerings, the registration statement typically states that the MLP will distribute all available cash flow to unit holders. However, similar to the common stock offerings discussed above, the distributions are generally not guaranteed since the partnership agreement can be modified by the majority of the common unit holders. The current owners (prior to the IPO) will likely still have significant control and the ability to unilaterally modify the partnership agreement.
The staff believes the following disclosures are necessary in registration statements for initial public offerings where the registrant indicates its intention to pay out a significant amount of dividends:
- detailed dividend policy description;
- discussion of material risks and limitations, including:
- the fact that the distribution rate could be changed or eliminated at any time,
- the impact of debt covenants and state laws on proposed dividend policy,
- the risks of paying out all excess cash as dividends on growth, and
- the impact on future debt repayment;
- forward-looking information about cash available for distribution; and
- disclosures supporting whether the registrant would have been able to achieve its distribution policy historically if the new policy had been in place at that time.
The forward-looking information about cash available for distribution should include a reconciliation of expected cash earnings to cash available for distribution. This reconciliation should start with a measure that the registrant considers to be highly correlated to cash. In some situations, it may be appropriate for a registrant to start with a non-GAAP measure such as EBITDA (earnings before interest, taxes, depreciation and amortization), assuming the registrant is able to assert that this measure is highly correlated to cash. Adjusted EBITDA also may be appropriate if calculated consistently with the measure contained in the registrant’s debt covenants and the registrant is able to assert that the measure is highly correlated to cash.
The historical information supporting whether the registrant would have been able to achieve the proposed distribution policy should include a reconciliation of GAAP cash flows from operating activities to cash available for distributions. This reconciliation also should include reconciling items for things such as the additional costs associated with being a public company and adjustments for changes in interest expense expected as a result of the initial public offering or recapitalization transactions occurring concurrently with the initial public offering. Registrants should include detailed disclosures surrounding the assumptions used in deriving these amounts. Additionally, if the registrant would not have been able to pay the dividends at the intended level based on historical amounts, the registrant should clearly disclose why they believes it will be able to pay the dividends going forward.
Registrants also should include detailed disclosures regarding the assumptions used in arriving at the forward-looking information, including the risks and expected outcomes if expected results are not achieved. This disclosure may take the form of a bullet point list of assumptions with discussion of any changes from historical amounts. The registrant should discuss any impact on compliance with debt covenants based on the forward-looking operating results and expected cash flow information. MD&A disclosure also should include the intended dividend policy for the next year and how the registrant expects to fund the distribution.
B. Classification and Measurement of Warrants and Embedded
Conversion Features (New)
EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, contains explicit guidance regarding the classification and measurement of warrants and instruments with embedded conversion features. Before considering the requirements of EITF 00-19, registrants that issue warrants, convertible preferred stock or convertible debt should first determine whether these instruments fall within the scope of FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. If they are excluded from the scope of SFAS 150, registrants must then determine whether the instrument is within the scope of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This issue has been the subject of staff reviews in recent months.
1. Freestanding Instruments - Warrants
Since warrants are freestanding instruments, the warrants should be analyzed to determine whether they meet the definition of a derivative under SFAS 133 (paragraphs 6 -9), and if so, whether they meet the scope exception in paragraph 11 of SFAS 133. If the warrant does not meet the definition of a derivative under SFAS 133, it must be evaluated under paragraphs 12 -32 of EITF 00-19 to determine whether the instrument should be accounted for as a liability or an equity instrument. Registrants should ensure they have appropriately analyzed all warrant and registration rights agreements in considering the appropriate classification and accounting for their warrants.
The two most common reasons that warrants should be accounted for as liabilities are (1) the warrants could be required to be settled in cash if certain events occurred, such as delisting from the registrant’s primary stock exchange, or if a registration statement covering the shares underlying the warrants was not declared effective by a certain date; and (2) the warrants contained registration rights where significant liquidated damages could be required to be paid to the holder of the instrument in the event the issuer fails to register the shares under a preset timeframe, or in some cases, where the registration statement fails to remain effective for a preset time period. The liquidated damages usually are expressed as a percentage of the original amount invested by the holder and may or may not be capped at a certain maximum percentage. The issuer of the warrants must analyze paragraph 16 of EITF 00-19 to determine whether the liquidated damages are meant to compensate the holder for the difference between a registered share and an unregistered share, which may require significant judgment. The EITF is currently deliberating the effect of certain issues related to freestanding warrants; registrants should monitor the progress of the FASB and EITF on these issues (see the deliberations of Issue 05-4).
Note that in analyzing instruments under EITF 00-19, the probability of the event occurring is not a factor. For example, certain warrants can only be settled in cash if the registrant’s stock is delisted from its primary stock exchange. Even if delisting is not considered probable of ever occurring, the warrants would still be classified as a liability under the EITF 00-19 analysis. Similarly, the likelihood that penalties related to the lack of an effective registration statement will occur, or how significant they could become, is not a factor. The registrant is required to determine the maximum penalty that could occur in analyzing this provision under paragraph 16 of EITF 00-19.
2. Embedded Conversion Features – Convertible Debt and Convertible
Preferred Stock
The embedded conversion feature within convertible debt and convertible preferred stock must be assessed under paragraph 12 of SFAS 133 to determine whether the embedded conversion feature should be bifurcated from the host instrument and accounted for as a derivative at fair value with changes in fair value recorded in earnings. If the embedded conversion feature is not required to be bifurcated under SFAS 133, the convertible instrument should be accounted for in accordance with Accounting Principles Board Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants (APB 14). Registrants also should consider Accounting Series Release No. 268, Redeemable Preferred Stocks (ASR 268), and EITF D-98, Classification and Measurement of Redeemable Securities, for the classification and measurement of the instrument, and EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, for consideration of any beneficial conversion feature.
Embedded conversion features that meet the criteria for bifurcation under SFAS 133 may qualify for the paragraph 11(a) scope exception in SFAS 133. In analyzing whether the conversion feature meets the paragraph 11(a) scope exception, one of the things the registrant must determine is whether the conversion feature would be classified within stockholders’ equity. To determine classification, the conversion feature must be analyzed under EITF 00-19. The first step of the EITF 00-19 analysis for these features is to determine whether the host contract is a conventional convertible instrument (paragraph 4 of EITF 00-19 and EITF 05-2,
The Meaning of "Conventional Convertible Debt Instrument" in EITF Issue 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock”.) If the instrument is a conventional convertible instrument, the embedded conversion option would qualify for equity classification under EITF 00-19, qualify for the scope exception in SFAS 133 and not be bifurcated from the host instrument. In that case, the convertible instrument should be accounted for in accordance with APB 14; ASR 268 and EITF Topic D-98 should be considered for the classification and measurement of the instrument; and EITFs 98-5 and 00-27 should be considered for any beneficial conversion feature.
If the instrument does not qualify as conventional convertible, paragraphs 12-32 of EITF 00-19 must be analyzed to determine whether the conversion feature should be accounted for as a liability or equity. If the feature is classified as a liability under EITF 00-19, it would not qualify for the paragraph 11 scope exception in SFAS 133 and therefore the feature would be accounted for as a derivative at fair value, with changes in fair value recorded in earnings. If the feature is classified as equity under EITF 00-19 and meets the other criterion in the SFAS 133 paragraph 11 scope exception, the embedded conversion option is not bifurcated from the host instrument. The registrant should assess whether the convertible preferred stock instrument should be classified in permanent equity or temporary equity by reference to ASR 268 and EITF D-98. Additionally, registrants should assess whether there is a beneficial conversion feature that must be accounted for under EITFs 98-5 and 00-27.
Registrants should ensure that they have properly considered SFAS 133 and EITF 00-19 in accounting for the conversion feature embedded within their convertible debt and convertible preferred stock instruments. The two most common causes of improper accounting stem from the fact that (1) the number of shares issuable upon conversion of the convertible instrument is variable, and there is no cap on the number of shares which could be issued; and (2) the agreements contain registration rights where significant liquidated damages could be required to be paid to the holder of the instrument in the event the issuer fails to register the shares issuable upon conversion under a preset timeframe, or in some cases, where the registration statement fails to remain effective for a preset time period. In the case of (1) above, since there is no explicit limit on the number of shares that are to be delivered upon exercise of the conversion feature, the registrant is not able to assert that it will have sufficient authorized and unissued shares to settle the conversion option. As a result, the conversion feature would be accounted for as a derivative liability, with changes in fair value recorded in earnings each period. Additionally, registrants should note that a variable share settled instrument that results in liability classification may impact the classification of previously issued instruments, as well as instruments issued in the future.
Registrants should ensure they have appropriately analyzed all terms contained in their convertible preferred stock and convertible debt agreements, including any registration rights associated with these agreements, and properly accounted for these instruments under all applicable accounting literature.
C. Statement of Cash Flows
The statement of cash flows is one of the primary statements required with a full set of financial statements. It is relied upon by analysts and investors as much, if not more in some instances, as the statement of net income. The importance of appropriate classification and presentation of items in the consolidated statement of cash flows cannot be overstated. As such, registrants should give significant attention to the preparation of their consolidated statement of cash flows in order to ensure it provides an accurate presentation of their actual cash receipts and cash payments based on activity (operating, investing and financing), which in turn assists the reader in determining the registrant's ability to meet its obligations, pay dividends, generate cash flows sufficient to grow its business, etc. While the staff believes a statement of cash flows using the direct method provides investors with more useful information than the short-cut indirect method, we recognize that most registrants use the indirect method. Therefore, we encourage registrants to put more time and effort into ensuring that the statement of cash flows, and related disclosure in the financial statement footnotes and in MD&A, is meaningful and useful to users of the financial statements.
1. Classification of Cash Receipts from Inventory Sales
Registrants may finance the sale of inventory in various ways, such as on account or with a note or sales-type lease receivable (whether long-or short-term), using various entities in the consolidated group. Paragraph 22a of FASB Statement No. 95, Statement of Cash Flows, states that cash receipts from the sales of goods or services are operating cash flows. Paragraph 22a clarifies that classification as an operating activity is required regardless of whether those cash flows stem from the collection of the receivable from the customer or the sale of the customer receivable to others; regardless of whether those receivables are on account or stem from the issuance of a note; and regardless of whether they are collected in the short-term or the long-term. It is important to note that FASB Statement No. 102, Statement of Cash Flows – Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale (“SFAS 102”), did not change this requirement. SFAS 102 addressed in part whether loans made by financial and similar institutions were sufficiently similar to product inventory of non-financial institutions such that the cash flow effects of those loans should be classified in the statements of cash flows in the same way as the cash flow effects from the sale of inventory, as operating activities. SFAS 102 did not alter the requirement in paragraph 22a of SFAS 95 to classify cash receipts from the sale of inventory as operating activities. As the SFAS 95 basis for conclusions indicates in paragraphs 93 to 96, the FASB considered and rejected classifying any portion of the cash receipts from the sale of inventory as investing activities.
Presenting cash flows between a registrant and its consolidated subsidiaries as an investing cash outflow and an operating cash inflow when there has not been a cash inflow to the registrant on a consolidated basis from the sale of inventory is not in accordance with GAAP. Similarly, presenting cash receipts from receivables generated by the sale of inventory as investing activities in the registrant’s consolidated statements of cash flows is not in accordance with GAAP.
Registrants should ensure that footnote disclosure identifies where the cash flows related to the sale of inventory are classified in the consolidated statements of cash flows and explains the nature of the receivables/notes/loans and where the cash flows from these transactions are classified in the consolidated statements of cash flows. Registrants should also ensure that the line item descriptors on the consolidated statements of cash flows are consistent with those on the consolidated balance sheets and in the financial statement footnotes detailing the components of finance receivables.
2. Classification of Payments Related to Settlement of Pension
Liabilities
SFAS 95 states that cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. Paragraph 23(b) of SFAS 95 states that operating cash outflows includes cash payments made to other suppliers and employees for other goods and services. Contributions to pension plans are reported as operating cash outflows because they relate to employee compensation, an item reported as an expense in the income statement.
Registrants that reorganize in bankruptcy often enter into agreements with the Pension Benefit Guaranty Corporation (PBGC) regarding their liability under employee benefit plans that provide for a settlement of the plan liability through an assumption by the PBGC. The PBGC is a non-profit federally-created corporation that guarantees payment to plan participants of certain pension benefits under defined benefit plans should the plan sponsor be unable to fulfill its obligation. The agreements with the PBGC typically require that payments be made by the registrant at, and/or subsequent to, emergence from bankruptcy for the defined benefit plans that were assumed by the PBGC.
Despite the fact that payments made to the PBGC pursuant to these agreements may continue for several years, the cash outflows should not be classified as financing activities in the statement of cash flows. The form of settlement of the pension liability does not change the substance of the activity for which cash is being paid to any other classification than as an operating activity. In addition, the classification of these payments as an operating activity does not change in the event the registrant is required to apply “fresh start reporting” pursuant to AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code, upon emergence from bankruptcy.
D. Oil and Gas
Staff reviews have uncovered diversity in practice among registrants in the oil and gas industry in several areas. Diversity has been noted in the areas of buy/sell transactions and capitalization of exploratory drilling costs. The accounting for these items is currently being considered by the accounting standard setters. The staff issued letters to registrants in the oil and gas industry in February 2005 requesting additional disclosure in order to provide investors with comparable information in light of the different practices in these areas. See the letter at http://www.sec.gov/divisions/corpfin/guidance/oilgas021105.htm. A brief description of the buy/sell transactions can be found in section II.F.1. of this outline, as the issue may have application outside the oil and gas industry.
The letter also discusses the staff’s consideration of the accounting for a property disposition by a registrant using the full cost method that resulted in a less than 25% alteration of the proved oil and gas reserve quantities within a cost center and whether goodwill should be allocated to the property disposed. Goodwill associated with acquisitions of oil and gas properties that constitute a business is recognized in accordance with FASB Statement No. 141, Business Combinations, but accounted for outside of the full cost rules. Therefore, when dispositions of these properties occur, the goodwill previously recognized does not affect the adjustments contemplated under Rule 4-10(c)(6)(i) of Regulation S-X. Rather, the accounting for the goodwill and any potential impairment should follow the provisions of FASB Statement No. 142, Goodwill and Other Intangible Assets. Registrants should consider whether a property disposition that results in a less than 25% alteration of the proved oil and gas reserve quantities within a given cost center is a trigger that requires goodwill be evaluated for impairment under SFAS 142.
E. Leasing
1. Accounting
There have been a number of restatements for lease accounting in the following areas: (1) the amortization of leasehold improvements by a lessee in an operating lease with lease renewals, (2) the pattern of recognition of rent when the lease term in an operating lease contains a period where there are free or reduced rents (commonly referred to as “rent holidays”), and (3) incentives related to leasehold improvements provided by a landlord/lessor to a tenant/lessee in an operating lease. The Commission’s Office of Chief Accountant recently issued a letter outlining the current GAAP literature that should be looked to in determining the appropriate accounting. See the letter at: http://www.sec.gov/info/accountants/staffletters/cpcaf020705.htm
2. Disclosure
Registrants should review the completeness and accuracy of disclosures concerning both operating and capital lease accounting to address the material terms of and accounting for leases. The disclosure should be concise and to the point. Basic descriptive information about material leases, usual contract terms, and specific provisions in leases relating to rent increases, rent holidays, contingent rents, and leasehold incentives may be best addressed in the description of properties or business section. In addition to the disclosures required by FASB Statement No. 13, Accounting for Leases, and FASB Statement No. 29, Determining Contingent Rentals, and related interpretations, the accounting for leases should be clearly described in the notes to the financia