Training Material
2000 Edition (3.31.00)

Division of Corporation Finance
an Overview

Accounting Disclosure Rules and Practices

Topic Seven: Related Party Matters

Table of Contents

I. General Disclosure Requirements
[SX 1-02(u) and FAS 57]

A. Definition of Related Party

• Principal Owners: persons that hold 10% or more of the enterprises securities and their immediate families
• Management: board of directors, executive officers and other persons with policy-making authority.
• Affiliates: a party that directly or indirectly controls, is controlled by or is under common control with the enterprise. [SX 1-02(b)]
• Investees accounted for by the equity method.
• Employee trusts directed by management of the enterprise.
• Entities, the management of which may be controlled or significantly influenced by the enterprise to the extent that it may be prevented from fully pursuing its own separate interests.
• Parties who can influence significantly the enterprise.
• Promoters: persons founding or organizing the entity; persons who receive 10% or more of the stock of the entity in connection with its founding or organization. [SX 1-02(s)]

B. Disclosures

1. All material related party transactions.

a) The significance of an item may be independent of its amount; this is often the case with respect to related party transactions. [SAB 4E]

b) No disclosure is required by FAS 57 for compensation arrangements, expense allowances and other similar items in the ordinary course of business.

2. Nature of relationship.

3. Description of transaction, including all information necessary for an understanding of its effects.

a) If material relative to total notes or accounts receivable, notes or accounts receivable from related parties should be shown separately. [SAB 4E] Dollar amounts of all material related party transactions should be disclosed in the notes.

b) SX 4-08(k) requires the dollar amount of related party transactions be disclosed on the face of the balance sheet, income statement, or statement of cash flows, as appropriate. However, the staff may accept footnote disclosure if, giving consideration to the magnitude and nature of the transaction and the relationship of the parties, prominent display on the face is not warranted.

c) FAS 57 requires that terms and manner of settlement of amounts due to/from related parties be disclosed unless they are otherwise apparent.

4. Transactions should not be represented in the financial statements as equivalent to arms length transactions unless that statement can be substantiated.

5. Forgiveness of debt by a related party typically should be considered a capital transaction. [footnote 1, APB 26.20]

II. Expenses Incurred on Behalf of Registrant

A. Reflect All Costs of Doing Business in the Financial Statements [SAB 1B.1 and 5T]

All costs of doing business, including costs incurred by parent and others, should be reflected in historical financial statements. Allocation of common expenses may be required. Footnote disclosure should include managements assertion that the allocation method is reasonable and managements estimate of what the expenses would have been on a stand-alone basis, if materially different. See also Section IV, ''Components of Larger Entities,'' below.

1. Organizational and offering costs paid for by a related party should be reflected in the financial statements of the registrant where those costs will be directly or indirectly reimbursed. [SAB 5D] In the absence of an obligation or intent to reimburse directly or indirectly, the staff will not insist on inclusion of these amounts in the issuers financial statements.

2. Obligations paid by parent or principal shareholder on behalf of the registrant must be reflected in the registrants financial statements. [SAB 5T]

B. Compensation Arrangements

1. Contributed services

a) Historical financial statements should reflect reasonable compensation levels. Where charges were not made or are unreasonably low, and if material to an understanding of operating results, historical statements should be revised to reflect the value of services rendered as a capital contribution. However, contributed services ordinarily need not be reflected if the entity is in formation or earliest phases of development stage.

b) If historical statements reflect compensation that is not unreasonable, but is materially different from that after the offering, disclosure of the salary commitment should be made and pro forma data for the latest year and interim period may be necessary. [SAB 2C]

2. Employee stock plans and other compensation provided by the parent or promoter should be reflected in registrants financial statements.
[AIN-APB 25,#1]

III. Transfers and Receivables from Shareholders [SAB 5G]

A. Transfer of Nonmonetary Assets

In most circumstances, transfers of nonmonetary assets for stock or other consideration of the registrant prior to an initial public offering are recorded at predecessor cost as determined in accordance with GAAP. Where the registrant gives monetary consideration for property conveyed by promoters, the excess over predecessor cost is treated as a reduction of equity (i.e., a special distribution).

NOTE: The guidance in SAB 5G is not intended to modify the requirements of APB Opinion No. 16. The combination of two or more businesses should be accounted for in accordance with APB Opinion No. 16 and its interpretations and SAB 2A.

B. Receivables

1. Receivables from affiliates which are the equivalent of unpaid subscriptions receivable or capital distributions should be reflected as a deduction from equity. [SAB 4G]

2. Receivables arising in the ordinary course of business and paid in the ordinary business cycle need not be deducted from equity. [SAB 4E]

C. Distributions to Major Shareholders Prior to Offering [SAB 1B(3)]

1. Refer to Topic Three for detailed discussion of pro forma requirements

2. Distributions should be given retroactive effect in latest balance sheet or reflected in pro forma balance sheet along side of historical balance sheet.

3. If the distribution is compensation for prior services or consideration for prior conveyances, only retroactive presentation would be acceptable.

D. Offering Proceeds

1. If a material portion of the proceeds of an offering will be distributed to shareholders, present pro forma EPS for the latest year and interim period giving effect to the number of shares whose proceeds will be used to pay dividends in addition to historical EPS.

2. Even if the distribution is not clearly to be paid from offering proceeds, pro forma EPS is required if distribution exceeds current years earnings

IV. Components of Larger Entities [SAB 1B]

A. Financial Statement Requirements The financial statements of components of larger entities should consider the following:

1. All costs of doing business should be included in registrants financial statements, including expenses incurred on its behalf by its parent or other shareholders.

2. Reasonable method of expense allocation should be applied where specific identification is not practicable; accompanied by footnote explanation, managements assertion that method is reasonable, and disclosure of what expenses would have been on stand-alone basis.

3. If historical cost-sharing is not continued, present pro forma EPS data for latest year and interim period only.

4. Tax expense is presented, preferably, on stand-alone basis in historical financial statements. (Pro forma may be an alternative.)

5. Interest expense associated with debt ''pushed down'' to the registrants books or to be paid with offering proceeds should be reflected in historical statements. Also, parents debt secured by registrants assets should be reflected in registrants financial statements. [SAB 5J] Where other interest expense on intercompany debt is not included, an analysis of intercompany accounts as well as average balances should be provided for each period.

6. Retained earnings should not be separately reported by a non-corporate entity. The residual interest should be presented as a single component, such as ''parents equity in division''.

7. Push-down accounting of the parents basis, including goodwill, if any, should be reflected in the entitys financial statements. This applies even where the parent is an individual or control group of individuals. [SAB 5J]

a) The staff will not object to the application of push down accounting if the parent acquires 80 to 95% of a subsidiary.

b) Push down is required at the 95% and above level, unless the entity has outstanding public debt, and is not permitted if less than 80% of a subsidiary is acquired.

c) If a subsidiary without public debt becomes 95% owned by the parent or public debt is eliminated from a 95%-owned entitys financial statements in a subsequent period, the entitys financial statements must be adjusted at that time to push down the parents basis. Also see EITF No. 90-5 for push down of parents cost in a transfer of an equity interest in one subsidiary to another controlled subsidiary.

B. Statements of Revenues and Direct Expenses

Refer to Topic Two, Section I.A.3 for a discussion of when less than full financial statements are appropriate as well as form and content requirements.

C. Pro Forma Financial Statement Requirements

Refer to Topic Three, Section II.K for guidance on pro forma financial information related to acquisitions of components of larger entities.

V. Research & Development Arrangements [FAS 68]

A presumption exists that the registrant will pay back the funding party (i.e., a liability should be recorded) where 10% or more of the funding party is owned by persons deemed to be related parties of the registrant, or where the funding party has any direct interest in the registrant. The apparent absence of financial ability to pay funding party back does not overcome this presumption. [SAB 5O]

VI. Compensation Issues

A. Stock Compensation

1. Compensatory stock, options or warrants issued to

a) employees are accounted for under APB 25 or FAS 123.

b) non-employees, including consultants, advisory board members or others providing services to the issuer are accounted for under FAS 123. See also EITF No. 96-18.

2. In evaluating whether a stock issuance is in fact a compensation arrangement or only a restructuring of non-employee ownership rights prior to an offering, the staff will evaluate the circumstances of the issuance and the extent of employee participation.

B. Cheap Stock

1. Measurement Under paragraph 10 of APB 25, the fair value of the companys stock on the measurement date must be used to measure compensation. In the evaluation of the fair value of the stock, the registrant should consider the proximity of the issuance to the offering, intervening events, transfer restrictions and exercise dates, and profitability and financial condition of the company. The staff looks to objective evidence as the best support for the determination of market value. Examples of objective evidence include transactions with third parties involving issuances or repurchases of stock for cash (including the offering) and/or appraisals by reputable valuation experts independent of the offering at or near the issue date.

2. Cheap Stock vs Nominal Issuances Issuances for which compensation or other expense has been appropriately recorded under APB 25 or FAS 123 ordinarily would not be considered nominal issuances since consideration received for issuance of shares may include goods or services. However, even if goods or services are received, it may still be necessary to compare the consideration received, as accounted for in the financial statements, to the fair value of the shares issued to determine whether the consideration is nominal. Also, issuances in exchange for assets (e.g., SAB 48 transactions) would not be considered nominal issuances, unless the fair value of the assets is nominal.

3. The staff expects nominal issuances to be limited to certain issuances to investors or promoters. Any issuances considered to be nominal should be brought to the attention of DCAO.

C. Escrowed Shares

The staff views the placement of shares in escrow as a recapitalization by promoters similar to a reverse stock split. The agreement to release the shares upon the achievement of certain criteria is presumed by the staff to be a separate compensatory arrangement between the registrant and the promoters. Accordingly, the fair value of the shares at the time they are released from escrow should be recognized as a charge to income in that period. However, no compensation expense need be recognized for shares released to a person that has had no relationship to the registrant other than as a shareholder (for example, is not an officer, director, employee, consultant or contractor), and that is not expected to have any other relationship to the company in the future.