Training Material
2000 Edition (3.31.00)

Division of Corporation Finance
an Overview

Accounting Disclosure Rules and Practices

Topic Four: Independent Accountants' Involvement
(Article 2 of Regulation S-X)

Table of Contents

I. Qualifications of Accountants

A. Duly registered and in good standing under the laws of his or her place of residence or principal business.

1. Licensure status should be confirmed with appropriate personnel in OCA if the accounting firm is unfamiliar to the staff.

2. SX 2-01 requires that an independent accountant be licensed and in good standing under the laws of the place of the accountants residence or principal office. The rule is silent as to whether or not the accountants state or country of licensure must coincide with the location of the registrants corporate offices or place where the registrant conducts it principal operations.

a) The staff interprets SX 2-01 to require the audit report on a domestic registrants financial statements to be rendered by an auditor licensed in the US. However, the staff has made limited exceptions in the circumstance of a domestic shell company registrant where substantially all operations are foreign, and the audit report is rendered from the location of the principal business.

b) In any event, an auditor whose report is included in a domestic registrants filings should be an expert in US GAAP and US GAAS. In circumstances where the audit report is not rendered in the US, the staff should inquire about the steps the auditor has taken to obtain competency in US GAAP and compliance with US GAAS. Notify DCAO of instances where the audit report on a domestic registrants financial statements was rendered by a non-US auditor.

B. Independent. [FR 602]

1. All independence questions should be referred through DCAO to the Commissions OCA.

2. An accountant is not independent if he or she has any direct, or material indirect, interest in the client. The Commission's rules are more restrictive than AICPA guidelines regarding the association of the accountant's family members and retired partners with the client. The Commission also is more restrictive as to the extent of services (particularly recordkeeping) that may be provided to an audit client.

3. Independence rules also apply to Regulation A and Regulation D filings. [FRC 602.02(a)]

C. Indemnification

Indemnification of parties subject to liability under the U.S. securities laws is considered contrary to public policy. Indemnification also may impair an auditors independence (FRC 602.02.i.i). The staff does not object to a domestic or foreign registrants indemnification of predecessor auditors for costs incurred in successful defense of claims. However the current auditor may not be indemnified under any circumstances. Any auditor indemnification arrangement should be described under ''Experts'' in a registration statement.

D. Principal Auditor

1. A principal auditor must take responsibility for the financial statements of the registrant for each year presented, although that auditor may refer to other auditors whose reports and audits are being relied upon by the principal auditor. The principal auditor is expected to have audited or assumed responsibility for reporting on at least 50% of the assets and revenues of the consolidated entity. If it is impracticable for a principal auditor to assume that extent of responsibility for one or more of the periods presented, the staff will evaluate whether to accept the audit reports as sufficient for reliance in filings with the Commission depending on the facts and circumstances. The staff should encourage registrants that are unable to obtain a report from an auditor assuming that degree of responsibility to consult with the staff well in advance of filing.

2. The staff has not objected to a principal auditor's report solely on the basis that the auditor is taking responsibility for less than 50% of the assets and revenues of the registrant if that report is issued by an auditor required to be designated as the principal auditor because of the laws, regulations, stock exchanges rules, or similar circumstances applicable to the registrant.

E. AICPA SEC Practice Section

Independent accountants are not required to be members of the AICPA or the AICPA SEC Practice Section to practice before the Commission. However, the AICPA requires a member of the AICPA that issues a report on financial statements of a company after it has become subject to the Commission's reporting requirements to be a member of the AICPA SEC Practice Section.

II. Accountant's Report

A. General

1. Basic requirements: dated; signed; indication of City and State where issued; identify the financial statements covered.

2. The report should refer to any supplemental schedules furnished pursuant to SX Article 12 (or a separate report on those schedules may be included with the schedules).

3. The report must contain clear statements as to scope, opinion and any exceptions taken. It must include representations that the audit is conducted in accordance with GAAS and that financial statements are presented in conformity with GAAP. All audits of financial statements filed with the Commission must be conducted in accordance with U.S. GAAS. All financial statements must be prepared in accordance with U.S. GAAP, except as permitted by Item 17 or 18 of Form 20-F.

4. If an audit report required to be filed includes reference to another accountant's report, the separate report of the other accountant must also be included in the filing.

5. Auditors' reports referring to each period for which audited financial statements are required must be included in the filing, except that only audit reports opining on the most recently completed fiscal year are required in an Annual Report to Shareholders. Including only an audit report on the current period precludes the incorporation by reference of those financial statements into the Form 10-K unless the audit reports for previous years are separately included or incorporated by reference from another document. [PR 14a-3]

B. Qualified Reports

The audit report that an independent auditor may be required to issue under GAAS may indicate that either the financial statements or the audit procedures applied do not satisfy the requirements of the form or the Commission's rules. Examples of audit reports that always represent a substantial deficiency in the filing include the following:

1. Scope qualifications [SAB 1E.2]

a) Any qualification with respect to the scope of the audit results in a finding by the staff that the audit of the financial statements required by Commission rules has not been performed.

b) Sometimes an auditor is not present for observation of inventory. In that case, the auditor must be able to satisfy himself or herself through alternative procedures. No language in the report should imply a qualification as to scope or conclusions. [FRC 607.01]

2. Disclaimer of opinion SX Article 2 requires the clear expression of an opinion on the financial statements. A report that states that the auditor is disclaiming an opinion for any reason does not satisfy the requirements of SX Article 2.

3. Qualifications as to accounting principles or disclosures [SAB 1E] Financial statements not in conformity with GAAP are presumed to be inaccurate or misleading, notwithstanding explanatory disclosures in footnotes or in the accountant's report. [FRC 101]

C. Other Report Modifications

1. Emphasis of a matter [AU 508.19] Auditors are permitted, but not required, to include the emphasis of a matter in their reports regarding:

• the entity is a component of a larger entity
• significant related party transactions
• subsequent events
• issues (such as changes in accounting) that affect the comparability of financial statements
• other matters that are of such a character as to warrant emphasis to investors.

The staff should be alert to language in an audit report that emphasizes an uncertainty. That language may be indicative of a scope limitation, or may be presented in a fashion that can confuse readers as to the conclusions reached by the auditor with respect to amounts presented in the financial statements. Audit reports that emphasize or otherwise refer to uncertainties, other than going concern modifications, should be brought to the attention of DCAO.

2. Going concern modifications [AU 341]

a) Going concern modifications are required by GAAS in certain circumstances.

b) Filings that include reports having going concern modifications must also include appropriate and prominent disclosure of the financial difficulties giving rise to that uncertainty. Discussion of a viable plan that has the capability of removing the threat to the continuation of the business must be included. The plan may include a "best efforts" offering so long as the amount of minimum proceeds necessary to remove the threat is disclosed. The plan should enable the issuer to remain viable for at least the 12 months following the date of the financial statements being reported on. If management has no viable plan, the use of going concern financial statements should be questioned. [FRC 607.02]

c) Going concern opinions that do not use the words "substantial doubt" when referencing a going concern matter do not comply with GAAS.

d) Going concern opinions that are phrased as a conditional uncertainty, that is, they indicate that substantial doubt will arise if an event occurs or fails to occur, are not appropriate.

e) A disclaimer of opinion resulting from going concern matters is permitted by SAS 59, but does not comply with the requirements of SX Article 2.

3. Changes in accounting principles

a) A reference in the audit report is required if there has been a change in accounting principles applied that materially affects the comparability of financial statements presented.

b) A registrant filing an initial public offering is permitted a special exemption to retroactively apply a change pursuant to APB 20.29. However, disclosures of the nature of the change and the justification for a change, including an explanation of why the newly adopted accounting principle is preferable, are required by APB 20.17 and .30.

c) Preferability Letters

The presumption that an entity should not, in the absence of the promulgation of a new accounting standard, change an accounting principle may be overcome only if the enterprise justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. [APB 20.16] The registrant is required to file a letter from its independent accountant concurring with its conclusion as to the new method's preferability. [SAB 6G.2.b] In all cases, the staff should evaluate the reasonableness of the new accounting policy and ensure adequate disclosure of its effects. In the absence of authoritative literature providing another basis for evaluating preferability, the registrant's determination should be based on its own particular circumstances and reflect management's business judgment.

(1) Preferability letters must be included in Form 10-Q or Form 10-K as Exhibit 18 and need only be filed once in the first applicable Exchange Act filing following the change. Preferability letters are not required in Securities Act filings. A preferability letter generally is required in Form 10-K only when a change in accounting occurred in the fourth quarter. Even though the independent accountant referred to the change in its audit report as required by GAAS and thus concluded as to the preferability of the change, Regulation S-K requires that a preferability letter be included as an exhibit to the Form 10-K.

(2) The staff has objected to the change from one acceptable method to another acceptable method if the registrant and its independent accountants cannot demonstrate that the new method is preferable. Conforming to industry practice may not justify a change if industry practice is not the preferable method.

(3) Preferability letters are generally not required after a purchase business combination where changes in the acquired entity's accounting are made to conform to those of the acquiring entity.

(4) For a business combination accounted for as a pooling of interests, a preferability letter is required if the registrant issuer changes it accounting principles. A preferability letter is not required when the other combining company changes accounting principles to conform to the registrants accounting.

(5) A preferability letter is required for a change in estimate effected by a change in accounting principle.

(6) No preferability letter is required if the change is in response to newly issued category A or category B GAAP, a SAB, or an EITF Consensus.

(7) GAAP hierarchy for evaluating preferability or resolving conflicts in guidance is as follows [AU 411.10]

NOTE: In addition, the staff would challenge any accounting that differs from an EITF consensus even though it is considered Category C GAAP by the AICPA. The staff believes that EITF consensus issues represent the best thinking on areas for which there are no specific standards.

III. Review and Compilation Reports

A. Review Reports on Interim or Pro Forma Data

1. Prior to filing, interim financial statements included in quarterly reports on Forms 10-Q and 10-QSB must be reviewed by an independent public accountant using professional standards and procedures for conducting such reviews, as established by generally accepted auditing standards, as may be modified or supplemented by the Commission. If, in any filing, the company states that interim financial statements have been reviewed by an independent public accountant, a report of the accountant on the review must be filed with the interim financial statements. Otherwise, the report is not required to be included in Forms 10-Q and 10-QSB.

2. An accountant issuing a review report on interim data is presumed to not have adequate knowledge of the company's accounting and financial reporting policies unless he has also audited the prior fiscal year. [AU 722.09 & SP] Likewise, an accountant issuing a review report on pro forma data should have conducted an audit of a significant portion of the historical data in the pro forma presentation. See also Topic Three, II.E. [SP]

3. Consent to inclusion of the report, in the form discussed in Section 605 of the Codification of Financial Reporting Policies, should be included.

B. Selected Quarterly Financial Data

1. Required for all registrants except foreign private issuers, mutual life insurance companies and small business issuers filing on small business forms. If it is required to be furnished, it must be reviewed by the independent accountant. [SK 302]

2. No reference in the audit report to the quarterly data accompanying the annual financial statements is necessary if the auditor's review conformed with applicable standards and the auditor is not aware that the interim information is materially affected by a departure from GAAP. Otherwise, the auditor must discuss the departures that exist.

3. If a significant charge or credit is reported in a quarter the staff may question whether the adjustment should have been recognized in whole or in part in an earlier quarter. The staff will also consider the need to confirm that (1) the auditor made reasonable inquiry as required by review standards and (2) the auditor has not referred to the interim data because they have concluded that there is no reason to believe that any departure from GAAP related to the adjustment materially affected interim information.

C. Compilation Reports

Compilation reports are not appropriate in any filings, including Regulation A filings, because the association of the accountant provides no basis for reliance. [SP]

IV. Change in Accountants; Disagreements [SK 304]

A. Change in Accountants

1. If a change in accountants occurred within 24 months prior to or in any period subsequent to the date of the most recent financial statements, the registrant should provide required information

• in Form 8-K within 5 business days of the change
• in proxies, even though previously disclosed in Form 8-K
• in registration statements, unless the change was previously disclosed.

2. Disclose:

• whether the accountant resigned, declined to stand for reelection or was discharged, and the date of resignation or discharge;
• whether the decision was recommended or approved by the Board of Directors or committee thereof; and
• whether the accountant had issued a report in the last two fiscal years containing a disclaimer or adverse or qualified opinion.
• whether in connection with audits of the two most recent years through the date of resignation or discharge there were any disagreements with the former accountants on any matter which, if not resolved to the satisfaction of the accountants, would have caused the accountant to make reference in its report to the matter. This includes disagreements which were resolved to the satisfaction of the accountant. The filing should describe the subject matter of any such disagreement.

3. If the registrant amends the Item 4 disclosures for any reason it must also file as Exhibit 16 an updated letter from the auditor addressing the revised disclosures.

B. Unusual Issues Involving Changes in Accountants

1. New accountant hired prior to termination of prior accountant A registrant may engage a new auditor prior to termination of the predecessor accountant who is completing the audit of the current fiscal year. A termination occurs on the date the registrant hires a new accountant. The registrant should file an Item 4 Form 8-K when it formally engages the new auditor. The Item 4 Form 8-K should report the change, identify disagreements or reportable events and include the predecessor auditor's letter. The registrant should file an amendment on Form 8-K within five days after it files the predecessor auditor's final audit report on the registrant's financial statements. The amendment should indicate whether there are any disagreements through that date and include a confirming auditor's letter.

2. Reverse acquisition Unless the same accountant reported on the most recent financial statements of both the registrant and the accounting acquirer, a reverse acquisition always results in a change in accountants. A Form 8-K filed in connection with a reverse acquisition should provide the disclosures required by SK Item 304 under Item 4 of Form 8-K for the change in independent accountants, treating the accountant that no longer will be associated with the registrants financial statements as the predecessor accountant.

3. The disclosures required by Item 304 with respect to any changes in the accounting acquirers auditor which occurred within 24 months prior to, or in any period subsequent to, the date of the acquirers financial statements must be provided in the first filing containing the accounting acquirers financial statements.

V. ''To Be Issued'' Accountants Reports

A. Contingent Upon Future Event or Transaction

If audited financial statements are required in a filing, the audit report should be signed and unrestricted. Generally, the staff should not commence a review of a filing that does not meet that requirement. However, if the entities comprising the registrant will not be legally transferred to the registrant in a reorganization until immediately before effectiveness, the staff has accepted filing of a "draft" report in the form that it will be expressed at effectiveness. In that case, the draft report should be accompanied by a signed preface of the auditor stating that it expects to be in a position to issue the report in the form presented at effectiveness. No registration statement can be declared effective until the preface is removed and the accountant's report finalized. If a filing does not include a currently effective audit report for reasons other than as described here, DCAO should be advised promptly.

B. Contingent Upon Future Underwriting Agreement

If a report is restricted solely to avoid issuing a modified report because of doubt about the registrant's continued existence and the modification would be removed upon receipt of proceeds from offering, the accountant's report should reflect such modification in the registration statement upon effectiveness. [SP]

VI. Other Matters

A. Consents to the Use of Audit Reports

1. Registrants must file a copy of the auditor's consent to the use of its report in any filing under the Securities Act as an exhibit. The primary purpose of obtaining consent is to assure that the auditor is aware of the use of its report and the context in which it is used.

2. A new consent is required:

• whenever any change, other than typographical, is made to the financial statements
• for an amendment if there have been intervening events since the prior filing that are material to the company
• with an amendment if an extended period of time passes since the last filing. An extended time is generally any period which is more than 30 days. Many firms require their clients to obtain a new consent each time an amendment is filed.

3. Exchange Act reports

a) Filing of a consent to the use of an audit report is not required in Exchange Act reports. Ordinarily, an auditor's engagement letter with the registrant will require the registrant to inform the auditor prior to each occasion that the report is filed with the Commission. Audit reports included in Exchange Act filings are required to be signed.

b) An amendment to a previously filed Exchange Act filing may require the reissuance of the auditor's report. In other circumstances, it may be sufficient to include a manually signed report or consent that affirms that the originally filed report applies to the financial statements and/or schedules as revised in the amendment.

4. Waivers [SAB 1A and SAB 1L]

a) In rare circumstances, such as situations involving hostile takeover attempts, a consent may be waived if the registrant applies for a waiver and provides an affidavit complying with Rule 437 of Regulation C.

b) Hostile takeovers A registrant offering its own securities in a hostile exchange offer for a targets stock may seek and not be able to obtain the targets cooperation in providing either its audited financial statements or the target auditors consent to the use of its report in the required registration statement. The acquirer/registrant should use its best efforts to obtain the targets permission and cooperation for the filing or incorporation by reference of the targets financial statements and the target auditors consent to the inclusion of its report on the financial statements. At a minimum, a registrant is expected to write to the target requesting these items and to allow a reasonable amount of time for a response prior to effectiveness of the filing. The target may, however, fail to cooperate with the registrant.

If a registrant uses its best efforts but is unsuccessful in obtaining the targets permission and cooperation for the filing or incorporation by reference of its financial statements and its auditors consent to the inclusion of its report on the financial statements, the registrant may request a waiver of the consent. The affidavit included in the request should document the specific actions taken by the registrant to obtain the cooperation of the other party for the filing as well as the efforts to obtain the auditors consent. Correspondence evidencing the registrants request for these items should accompany the affidavit.

The staff will generally agree to waive the requirement to include or incorporate by reference the target auditors audit report. In that situation, disclosure should be made that, although an audit report was issued on the targets financial statements and is included in the targets filings, the auditor has not permitted use of its report in the registrants registration statement. The auditor should not be named. Any legal or practical implication for shareholders of the registrant and the target resulting from the inability to obtain the cooperation of the target or consent of the targets auditor should be explained. No disclosure in the registration statement should expressly or implicitly disclaim the registrants liability for the targets financial statements. In the event that circumstances change, the registration statement should be amended to include the audited financial statements and the auditors consent required by the form.

5. The consent of the independent accountant is not required for a report on financial statements which is not a part of a 1933 Act registration statement under Rule 412(c) of Regulation C, like superseded financial statements.

The staff has not objected to a modified consent language indicating that the independent accountant's report on financial statements previously filed on Form 10-K and incorporated by reference in Form S-3 is no longer appropriate since restated financial statements have been presented giving effect to a business combination accounted for as a pooling-of-interests. This language is only appropriate where the pooling-of-interest combination is consummated and the financial statements have been restated as a result of the publication of post-combination financial statements. That is, this does not apply to supplemental financial statements.

B. Withdrawal of Audit Report [AU 561 and SP]

When an auditor becomes aware of information in interim periods which relates to financial statements previously reported on and that information would require revision of the financial statements and/or the auditors report , the auditor must notify the Commission (through OCA) that the report must no longer be relied upon. If a registrant publicly discloses that previously filed audited financial statements require adjustment and the auditor has not withdrawn its report, confusion for investors as to the auditors concurrence with the adjustments may result. In this situation, the registrant should clarify in the filing the extent of reliance on the audit report.

C. Accountants Refusals to Re-issue Reports

Some accounting firms have adopted risk management policies that lead them to refuse to reissue their reports on the audits of financial statements that have been included previously in Commission filings. In some cases, accountants whose reports on acquired businesses were included in a registrant's Form 8-K have declined to permit that report to be included in a registrant's subsequent registration statement. In other cases, accountants have declined to reissue their reports on the registrant's financial statements after the registrant engaged a different auditor for subsequent periods. The Commission's staff is not in a position to evaluate the reasons for an accountant's refusal to re-issue its report and will not intervene in disputes between registrants and their auditors. Moreover, the staff will not waive the requirements for the audit report or the accountant's consent to be named as an expert in filings. If a registrant is unable to re-use the previously issued audit report in a current filing, the registrant must engage another accountant to re-audit those financial statements. A registrant that is unable to obtain either re-issuance of an audit report or a new audit by a different firm may be precluded from raising capital in a public offering.

D. Illegal Acts

Section 10A of the Exchange Act requires that auditors report in a timely manner certain uncorrected illegal acts to a registrants board of directors. It further requires the registrant, or the auditor if the registrant fails to do so, to provide information regarding the illegal act to the Chief Accountant of the Commission. Notify DCAO immediately upon any indication from a registrant or its auditor that an illegal act has occurred.

E. Signatures

Wherever a signature is required, typed signatures or duplicated or facsimile versions of the manually signed document may be used. In any of these cases, each signatory must manually sign the document authenticating, acknowledging or otherwise adopting the signature that appears in the filing before or at the time that the filing is made, and the manually signed document must be retained by the filer for five years. A copy of this document must be furnished to the Commission upon request. [ST 302]

F. Selected Financial Data

1. An auditor may be engaged to report on selected financial data using the guidance of SAS 42. Identification of some or all columns of selected financial data as "audited" or other references to the auditor can create the impression that the registrant has so engaged the auditor. If no auditor association with the selected financial data has occurred but an investor could obtain such an impression from the manner of presentation, the staff should recommend revision of that presentation. A statement in a headnote to the data that the amounts presented for the fiscal year are derived from audited financial statements does not create the impression that the information was subject to a SAS 42 examination.

2. If an auditor was engaged to report on the selected financial data, the form of report specified by SAS 42 should be included in the filing and the auditor's consent to the report should make reference to its applicability to the selected financial data.

G. Miscellaneous

1. The financial statements should not appear on the accountants' letterhead, and should not refer in any way to the accountants' report. [TPA 9410.06]

2. The terms "audited" and "certified" have the same meaning in the Commission's regulations. [SAB 1E.1]

3. The accountant's report should not refer to unaudited interim financial statements even where they are presented along side of audited fiscal year data. [AU 504.14] Such data should be clearly labeled as unaudited.

4. Additional disclosures are required if an auditor report of a bankrupt accounting firm is included in a filing. [SAB 1L]