CHAPTER 14 SEC REPORTING

ANSWERS TO QUESTIONS Q14-1 The basis of the SEC's legal authority to regulate accounting principles stems from the Securities Exchange Act of 1934. In the 1934 Act, the SEC was given the legal responsibility to regulate trades of securities and to determine the types of financial disclosures that a publicly-held company must make. Q14-2 The Securities Act of 1933 regulates the initial registration of securities. The Securities Exchange Act of 1934 regulates the periodic reporting of publicly traded companies. Q14-3 The Division of Corporation Finance receives the registration statements of companies wishing to make public offerings of securities. The Division of Enforcement investigates individuals or firms who may be in violation of a security act. Q14-4 The Foreign Corrupt Practice Act of 1977 requires that companies maintain accurate accounting records and an adequate system of internal control. An adequate system of internal control should contain the following: a. b. c. d. Strong budgetary controls An objective internal audit function that helps develop, document, and then monitor the control system An active audit committee from the company's board of directors A review of the internal control system by the independent auditors

Q14-5 Regulation S-X covers the form and content of financial disclosures; specifically, the form and content of financial statements, schedules, footnotes, reports of accountants, and pro forma disclosures. Items included in Regulation S-K include a description of business, management's discussion and analysis, disagreements with accountants, and required information about new stock issues. Q14-6 The objectives of the integrated disclosure system are to reduce the duplicate disclosures companies were required to make for the annual report and each of the filings to the SEC and to disclose the most important information investors and others need in order to assess a company's financial risk.

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Q14-7 The five classes of information comprising the Basic Information Package (BIP) are as follows: a. Market price of and dividends on common equity and security matters b. Selected financial data c. Management's discussion and analysis of financial condition and results of operation (MDA) d. Audited financial statements and supplementary data e. Other information Q14-8 Two types of public offerings of securities are exempted from the comprehensive registration requirements of the SEC. The first type of offering exempted from the full registration process is a small offering of less than $1.5 million of stock sales during any 12-month period. The second type of offering exempted from the full registration requirements is limited offerings to accredited investors up to $5 million in securities within a 12-month period. Q14-9 A company can use a Form S-1 registration form when the general registration is for a first time offering and no other publicly-traded stock has been issued. A company must use a Form S-3 registration form when the registrant is large and established, possessing stock that has been trading for several years. Q14-10 A customary review is a thorough examination by the SEC and may result in acceptance of the registration or a comment letter from the SEC. A comment letter is issued by the SEC specifying the deficiencies that must be corrected before the securities may be offered for sale. A red herring prospectus is a preliminary prospectus providing information to investors about an upcoming issue. This type of prospectus has a cover printed in red ink indicating it is not an offering statement and the securities being discussed are not yet available for sale. Shelf registration allows large, established companies with other issues of stock already actively traded to file a registration statement with the SEC for a stock issue which may be brought off the shelf and updated within a very short time when the company wants to actually issue the stock. Q14-11 Form 10-K is broken into four parts. Parts I, II, and III contain the Basic Information Package, including the financial statements. Part IV contains additional schedules and exhibits. Form 10-K must be filed with the SEC 90 days after the end of the company's fiscal year-end. Q14-12 Interim reports submitted to the SEC are not required to be audited. The public accountant is expected to review, on an ex post basis, the information provided in the company's Form 10-Qs as part of the annual, year-end audit.

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Q14-13 The types of items reported on in Current events include the following items: a. b. c. d. e. f.

Form

8-K

cover

current

events.

A change in the control of the registrant Acquisition or disposal of major assets Bankruptcy or receivership of the registrant Changes in the registrant's certifying accountants Resignations of one or more of the registrant's directors Any other events deemed to be of material importance to security holders

Q14-14 A proxy is a request by the company, or by a stockholder, for a security holder's vote on a corporate matter. Proxy solicitations must include a full discussion of the matters to be voted on, and must also include the most recent annual shareholders' report if the present management is making the solicitation for a meeting at which directors will be elected. The SEC has established requirements in the following four areas for proposals in opposition to management: eligibility, attendance, timeliness, and rejected proposals. Q14-15 Part I of the Foreign Corrupt Practices Act (FCPA) prohibits individuals associated with United States companies from giving bribes to foreign governmental or political officials for the purpose of securing a contract or otherwise increasing the company's business. Part II of the FCPA requires all public companies, whether operating internationally or not, to keep detailed records that accurately and fairly reflect the company's financial transactions, and to develop and maintain an adequate internal control system. The impact of this act is to require companies to establish and maintain an adequate internal control system, to require public accountants to evaluate the company's internal controls, and to communicate any material weaknesses in those controls to the company's top management and board of directors. Q14-16 The following information must be disclosed in the management discussion and analysis (MDA): Discussion of liquidity, capital resources, and results of operations b. The impact of inflation and changing prices on net sales and income c. Material changes in line items of the consolidated financial statements from prior-period amounts Known material events and uncertainties that may make historical financial information not indicative of future operations or future condition Any other information the company believes necessary for an understanding of its financial condition, changes in financial condition, and results of operations.

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Q14-17* The SEC has taken the lead in requiring the independence of the auditor from the client company and in defining the parameters of the audit function. The SEC insists on strict independence of the auditor as the best protection of the public investors' need for full and fair disclosure of a company's financial position and performance. In addition, the SEC's Division of Enforcement has actively investigated instances of possible false or misleading statements that may have been caused by the failure of generally accepted auditing standards.

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SOLUTIONS TO CASES C14-1 Objectives of Securities Acts [CMA Adapted]

a. Investment practices of the 1920s that contributed to the erosion of the stock market include the following: - The prices of securities were manipulated through the use of "wash sales" or "matched orders." Brokers or dealers engaged in prearranged buy and sell orders that created the impression of activity and drove up prices. When the public began buying, driving prices up even higher, the brokers and dealers would sell, making huge profits before prices fell back to market level. - False or misleading financial statements were issued to lure unwary investors. - The excessive use of credit to finance speculative activities served to undermine the market. There was no limit to the amount of credit or "margin" that a broker could extend to a customer. As a result, a slight decline in market prices often caused overextended customers to sell when margins could not be covered, thus further reducing prices. - Corporate officials and other "insiders" misused information about corporate activities to take advantage of fluctuations in stock prices.

b. 1.

The objectives of the Securities Act of 1933 are to - provide investors with financial and other information concerning the initial offering of securities for sale, thus ensuring full and fair disclosure. Companies were required to file a registration statement and prospectus for review. - prohibit misrepresentation, deceit, and other fraudulent acts and practices in the sale of securities. 2. The objectives of the Securities Exchange Act of 1934 are to - regulate the trading of securities on secondary markets by requiring the registration of securities traded on any national exchange. - create a regulatory agency, the Securities and Exchange Commission, to administer the requirements of both the 1933 and 1934 acts.

c. The

provisions of the Foreign Corrupt Practices Act of 1977 include the requirement for public companies to devise and maintain a system of internal accounting controls to provide reasonable assurance that transactions are properly authorized, recorded, and accounted for.

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C14-2

Roles of SEC and FASB [CMA Adapted]

a. The Securities and Exchange Commission (SEC) was created through the Securities Exchange Act of 1934. As a result of this Act, the SEC has legal authority over accounting practices. The U.S. Congress has given the SEC broad regulatory power to control accounting principles and procedures in order to fulfill its goal of full and fair disclosure. Specific responsibilities of the SEC include: Regulating the sale of securities on secondary markets Regulating the initial offerings and actual sales of stock in interstate commerce Prescribing the forms and reports to be used Prescribing the items or details to be shown in the financial statements and the methods to be followed in preparing the accounts

b. The SEC was created by Congress, and the FASB was created by the private sector; therefore, no direct relationship exists. However, the SEC historically has followed a policy of relying on the private sector to establish financial accounting and reporting standards. The SEC recognized the FASB as authoritative in one of its Accounting Series Releases (ASR 150__Dec. 20, 1973). There has been cooperation between the SEC and FASB, but at times the relations between these bodies have become strained. In cases of unresolved differences, the SEC rules take precedence over FASB rules for the companies within SEC jurisdiction.

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C14-3 a. The

SEC Organization and Responsibilities [CMA Adapted] SEC is an independent federal agency that receives its authority from federal legislation. The Securities Exchange Act of 1934 created the SEC and empowered it to administer compliance with provisions of that Act and the Securities Act of 1933.

b. (1) The SEC supports fair securities markets by regulating brokers, exchanges, and the publicly held companies themselves. The Commission monitors the trading practices and financial condition of brokers. The Commission oversees the activities and trading rules of securities exchanges. Finally, the Commission requires registration and continuing public disclosure of financial and other information by publicly held companies. (2) The SEC fosters shareholders' participation in major corporate decisions by requiring corporate management to keep stockholders informed by various means. Management is required to issue proxy solicitations, file periodic reports with the SEC, hold annual stockholders' meetings, and issue annual reports to stockholders that include audited financial statements.

c. The SEC requires publicly held companies to file audited financial statements and other disclosures in accordance with its regulations. The Commission relies primarily on the integrity and legal responsibility of the reporting entities and the external auditors for the material accuracy and completeness of the filings. The Commission reviews filings on a selective basis in an attempt to discover untrue, incomplete, or misleading information.

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C14-4

Proxy Solicitations [CMA Adapted]

a. The purpose of proxy statements is to provide full and fair disclosure of significant events in order to allow shareholders to exercise a more informed judgment before voting on corporate matters. b. Events or actions for which proxy statements normally are solicited include election of directors, change in corporate charters or by- laws, appointment of auditors, issuance of securities or modification of outstanding securities, or plans to merge, acquire, or dispose of property. c. Conditions that must be met in order to have a shareholder proposal opposition to management incorporated in a proxy statement include: in

Eligibility The proponent must own a security with voting privileges. Attendance The proponent or his designated alternate shall agree to be present at the annual meeting to present the proposal. Timeliness The proposal shall be received at least 90 days in advance of the proxy statement mailing date. Rejected The proposal cannot relate to a similar proposal Proposals that has been rejected within the past 5 years.

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C14-5

Registration Process [CMA Adapted]

a. The Securities Act of 1933 requires a filing by any firm that raises capital in the primary capital market through the initial sale of a new security, whether by a public offering made directly by the firm or through an underwriter. The registration applies only to the specific quantity of the specific security being offered. The Securities Exchange Act of 1934 requires a filing by any firm whose securities are being traded publicly in the secondary capital market. These securities are registered as an entire class with no amount specified. A secondary offering of a firm's securities also requires the filing of a registration statement. b. An objective of the 1933 Act is to provide investors with material information concerning the issuing firm, its management, the securities offered for public sale, and the proposed use of the proceeds from the sale. The SEC does not evaluate the creditworthiness of the firm or attest to the potential of the security as an investment. The 1933 Act is an attempt to ensure that investors are given full and fair disclosure of all pertinent information about the issuing firm, including audited financial statements. c. SEC Publication Explanation

Regulation S-X Instructions as to the form and content of the required financial statements. Regulation S-K Instructions as to the form and content of required disclosures other than the required financial statements (i.e., supplementary financial information, summary financial data, and nonfinancial information). Financial Reporting Releases (formerly Accounting Series Releases) Constitute part of Regulation S-X in the determination of the form and content of the required financial statements.

Staff Accounting Interpretations and practices followed by Bulletins the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws.

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C14-6 Part A a.

Form 10-K [CMA Adapted]

Form 10-K is an This report is phrase in bold the additional be obtained by

annual report companies are required to file with the SEC. required under the Securities and Exchange Act of 1934. The type informs stockholders and other interested persons that information included in a 10-K is public knowledge and can writing to the company.

b.

Possible additional information which might be ascertained from a firm's 10-K and which might not be in the company's annual report: 1. Remuneration of directors and officers 2. 3. 4. 5. 6. Indemnification arrangements for directors and officers Principal holders of equity securities and holdings by directors and officers Interest of management in certain transactions Number of equity security holders Management analysis of material changes in revenue and expense.

c.

Financial information which might be included in a firm's annual report but not required for the 10-K includes: 1. 2. 3. 4. 5. Financial charts (bar graphs, pie charts, etc.) Ratio analysis of operations and financial position Ten-year summary of financial data Market price by quarter for common stock for the current year Analysis of operations and future prospects in president's letter.

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C14-6 Part B

(continued)

Jerford Company must reveal the following information in Form 8-K to the SEC regarding its change in auditors: 1. 2. Date former auditor resigned or was dismissed. A statement whether there were any disagreements with the former auditor on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure during the 24 months before the change. Each disagreement, if any, would have to be fully described whether or not it was resolved to the satisfaction of the former auditor. In addition, those disagreements which would have caused the former auditor to make reference to the subject matter of the disagreement in his report had they not been resolved would have to be identified. 3. A statement whether the former auditor's report on the financial statements was qualified in any way the past two years and the nature of each qualification, if any. A letter from the former auditor as an exhibit with Form 8-K which states whether the former auditor agrees or disagrees (including reason for disagreement) with the facts of the case as presented by the registrant.

4.

The Jerford Company would also have to provide a footnote to its 20X5 financial statements disclosing any disagreements with its former independent auditor during the past 24 months regarding accounting principles, financial statement disclosure, or audit procedure.

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C14-7 a. 1.

Form 8-K [CMA Adapted]

The purpose of Form 8-K, called the Current Report, is to ensure that any significant event affecting a firm's policies or financial position is immediately reported to the SEC. Covering the period since the filing of the latest annual or quarterly report, Form 8-K provides a continuous stream of material information concerning specified events between filings. 2. Form 8-K must be filed with the SEC within 15 days after the occurrence of a reportable event. Violation of the 8-K filing requirement may jeopardize a registrant's status. Form 8-K is a narrative report with sufficient flexibility to permit management to describe any significant events. The first page must contain the standard 8-K heading identifying the reporting corporation, and the body of the report details the specified event or events in accordance with the disclosure requirements outlined in the regulations for each event. The corporation may include any other information, financial or otherwise, it deems appropriate for a complete description of the event. The report must be signed by an officer of the corporation. The inclusion of audited and pro forma financial statements is only required when reporting the acquisition of a business. Financial statements may be included in a Form 8-K in order to clarify the effect of any event on the corporation. In general practice, financial statements are included if an event is deemed to have a material financial impact.

3.

4.

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C14-7

(continued)

b. Six circumstances under which the Securities and Exchange Commission requires the filing of Form 8-K include: - Changes in the control of the registrant - Acquisitions or dispositions of assets - Bankruptcy or receivership - Changes in the registrant's certifying accountants - Resignations of one or more of the registrant's directors - Any other events deemed to be of material importance holders

to

security

c. The role of the SEC is to regulate the issuance and trading of securities. By requiring the disclosure of adequate information, it enables investors to make informed judgments about securities. Form 8-K fosters this purpose by requiring firms to report significant events as they occur to the investing public. d. The purpose of the securities laws is not to have the SEC judge the merits of securities offered for sale. Through its strict disclosure and reporting requirements, the SEC attempts to make certain that the investor has the opportunity to judge the merits of securities on the basis of full disclosure of the pertinent facts. The SEC does have the power to suspend trading in securities of companies that fail to make full and accurate reports; however, these actions are not based on the merits of the securities but on the companies' failures to comply with reporting regulations.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

C14-8

Audit Committees [CMA Adapted]

a. The audit committee acts as an intermediary or communication link between the external auditor and management during the external audit process. In addition, the audit committee reviews the arrangements for the audit, the scope of the audit, the progress and findings of the audit, and any investigative matters related to financial reporting and internal control. b. Duties which may be assigned to the audit committee by the board of directors, other than those associated with the annual audit, may include: - Monitoring the activities of the internal audit staff - Seeing that any recommendations made by the external auditor are acted upon by the internal auditors - Reviewing the design of the company's control systems c. The audit committee should act as an overseer of the company's internal audit staff. The audit committee would be concerned with such matters as the scope of internal audits, the completion of assignments, and discussion of the results of reviews conducted by the internal audit staff. d. Members appointed to serve on the audit committee should be outside board members (independent of management) because the NYSE specifies that members be independent of management. Outside members would be free from bias or conflicts of interest, and outside members would be more objective in settling disputes between management and the external auditor.

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C14-9

Research Related to the SEC can be found at Internet URL:

a. A listing of recent SABs http://www.sec.gov/rules/acctindx.htm.

The statements in Staff Accounting Bulletins are not rules or interpretations of the Commission nor are they published as bearing the Commission's official approval. Rather they reflect the Commission staffs views and provide interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws. The SABs may be very narrowly written to describe the staff view of a particular event or circumstance. The purpose of the SABs is to disseminate staff views on particular matters for guidance in other situations where events and transactions have similar accounting implications.

b. 1.& 2. 1)

Internet URL:

http://www.sec.gov/enforce/abenf.htm

The Division of Enforcement was created in August 1972.

2) In general, the Commission's enforcement staff conducts investigations into possible violations of the federal securities laws. The Commission will prosecute the civil suits in the federal courts as well as conduct administrative proceedings. In civil suits, the Commission seeks injunctions (i.e., an order that prohibits future violations) and will often seek civil money penalties and the disgorgement of illegal profits. In addition, the courts may also bar or suspend individuals from acting as corporate officers or directors. The Commission can bring a variety of administrative proceedings. These proceedings are heard by administrative law judges and the Commission itself. There are many types of proceedings, a few examples include: a cease and desist order, an order to the respondent to disgorge ill-gotten funds, and an order to suspend employment. 3. A listing of recent litigation http://www.sec.gov/enforce/litig.htm. releases can be found at Internet URL:

4. A listing of recent administrative proceedings can be found at Internet URL: http://www.sec.gov/enforce/adm.htm.

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C14-10 a.

Research Related to the EDGAR Database Internet URL: http://www.sec.gov/edgarhp.htm

The above Internet address provides access to the EDGAR database homepage. From the homepage, the user is able to select Search the EDGAR Database, then Select Quick Forms Lookup. The user can then select to search for a company form. Hint: It is easiest to identify a company name prior to performing the search. Then request all forms in the search. The search can provide a list of all forms on EDGAR for the company using the data range of entire database available.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

SOLUTIONS TO EXERCISES E14-1 Organization Structure and Regulatory Authority of the SEC [CMA Adapted] c b b d a d d

1. 2. 3. 4. 5. 6. 7.

E14-2 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Role of SEC in Establishing Disclosure Standards [CMA Adapted] e d a c c e b a c e

E14-3 1. 2. 3.

Registration of New Securities [CMA Adapted] e c b

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E14-4 1. 2. 3. 4. 5. 6. 7. 8.

Reporting Requirements of the SEC [CMA Adapted] a c b e d e b d

E14-5 1. 2. 3. 4. 5. 6. 7.

Corporate Governance [CMA Adapted] a e a b c b e

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E14-6

Application of Securities Act of 1933 [CMA Adapted]

The impact of the registration requirements of the Securities Act of 1933 on each of the proposals is as follows: The offering of the participation units in the citrus groves, although ostensibly the sale of an interest in land, constitutes an offer to sell, or the sale of, securities within the meaning of section 2 of the Securities Act of 1933. Although land itself is not a security, the offering of the land in conjunction with a management contract has been held to constitute the offering of a security. Since interstate commerce and communications are to be used and since there is no apparent transactional exemption available, a registration under the 1933 act is required. Whatever hope there was of an intrastate offering exclusion is dashed by the fact that the units will be offered and sold in two states. The short-term borrowings evidenced by the promissory notes of Various Enterprises are exempt from registration. This exemption from categorization as a security for purposes of registration under the act applies to commercial paper such as notes, drafts, checks, and similar paper arising out of a current transaction that have a maturity not exceeding nine months. In addition, the private placement exemption is applicable. If Various is deemed to be a controlling person insofar as Resistance is concerned, it must register the securities in question before it can legally sell them. The Securities Act of 1933 provides in connection with its definition of the term underwriter, that, the term issuer shall include in addition to an issuer, any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer. Securities Act rule 405(f) further defines the term control. It states that the term control... means the possession, direct or indirect, of the power to direct or cause the direction of the policies of a person, whether through the ownership of voting securities, by contract, or otherwise. It is obvious that control as defined is a question of fact. In general, a controlling person has the power to influence the management and policies of the issuer. If any individual is an officer, director, or member of the executive committee, a low percentage of stock would suffice. Actual or practical control is sufficient and the power to exercise control will also be sufficient even if it is not exercised. Stock ownership is looked to and majority ownership naturally constitutes control. Although ownership of 17 percent of the stock is certainly not conclusive, it is a substantial block of stock and, if any of the above factors is also present, it would be most likely that Various would be a controlling person. Thus, although not the issuer of the stock, it would need to register the securities. This resembles a secondary offering of a large block by the owners of the corporation. This sale through the brokers will in no way insulate the transaction from registration.

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