INTERNATIONAL REPORTING ISSUES IN THE DIVISION OF CORPORATION FINANCE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS TWENTY-FOURTH ANNUAL CONFERENCE ON CURRENT SEC DEVELOPMENTS DECEMBER 11, 1996 WAYNE E. CARNALL ASSOCIATE DIRECTOR - ACCOUNTING OPERATIONS DIVISION OF CORPORATION FINANCE U.S. SECURITIES AND EXCHANGE COMMISSION The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement of its employees. The views expressed in this paper are those of Mr. Carnall and do not necessarily represent the views of the Commission or other members of the staff. INTRODUCTION It is my pleasure to speak at this conference for the fifth consecutive year on international reporting issues in the Division of Corporation Finance. I would like to welcome all of our visitors from foreign countries especially my fellow regulators. The US has had the distinction of being the preeminent market for cross-border offerings for a number of years. We have long ago surpassed the other major capital markets with respect to the number of reporting foreign companies and our lead continues to grow. As of September 30, 1996 there were 843 companies from 47 countries registered with the Commission. New countries represented for the first time include Taiwan and Russia. If anyone doubts the value of the requirement to provide a reconciliation from foreign GAAP to US GAAP, they should consider that these registrants use over 35 different types of generally accepted accounting principles ("GAAP") in filings with the Commission ranging from Argentine GAAP to Zambian GAAP as well as International Accounting Standards. During 1996, 133 foreign companies filed with the Commission for the first time. Through nine months in 1996 over $60 billion in securities were registered exceeding the previous annual high of $49 billion. My remarks today will address four items: 1. concerns regarding filings made under the multijurisdictional disclosure system; 2. our working relationships with foreign regulators and standard setters; 3. selected issues that were addressed by the AICPA International Practices Task Force; and 4. recommendations to consider in preparing filings with the Commission. MULTIJURISDICTIONAL DISCLOSURE SYSTEM In 1991, the Commission established a multijurisdictional disclosure system ("MJDS") with Canada. This system provided Canadian companies that meet certain eligibility requirements special accommodations for listing in the US. As indicated in the adopting release, the Commission's staff would not select MJDS filings for review unless the staff had reason to believe that there is a problem with the filing or offering. 1 Earlier this year, the staff reviewed a number of filings made on Form F-10 to evaluate compliance with respect to the US GAAP information that was provided. The results were disturbing. With only one exception, all the filings selected were significantly deficient. Examples of the deficiencies included the following points: ! Disclosures required by US GAAP and Regulation S-X including information required by SFAS 87 on pensions, SFAS 109 on income taxes, differences in the cash flow statement, etc. were omitted. It was clear from the information provided that such disclosures were applicable to the registrant. ! The annual report that was incorporated by reference into the Form F-10 specified that it complied with Item 17 of Form 20-F as opposed to the required Item 18. ! Differences between US GAAP and Canadian GAAP were not quantified or addressed in the reconciliation. Again, it was apparent from the information disclosed that certain items should have been presented in the reconciliation to US GAAP. ! Several registrants simply ignored the requirement to provide any US GAAP information. The disclosures required by US GAAP were not provided, nor was there any reference to US GAAP and differences compared to Canadian GAAP. The staff expects registrants and their advisors to improve the quality of compliance with respect to US GAAP information in MJDS filings. To evaluate the level of compliance in the future, the staff may look at the US GAAP information contained in certain registration statements filed on MJDS forms. This will not delay processing. If the staff determines that an MJDS registration statement does not contain a reconciliation or that there are obvious significant deficiencies with respect to the information required by US GAAP and Regulation S-X, the staff will take appropriate action. This may include communicating with the registrant and the Canadian regulators regarding the deficiency, or, perhaps, performing a full review of the financial statements once the required information has been provided to determine if there are other significant deficiencies. Many Canadian companies elect to file on MJDS forms to avoid delays attributable to the Commission review process. Non- compliance with the requirements of the form could result in a delay in the offering. The Commission staff and the staff of the Ontario Securities Commission ("OSC") are working together to develop, for an appropriate period of time, a coordinated approach to reviewing the US GAAP information contained in annual reports on Form 40-F. Accordingly, in the future, it is possible that Canadian companies receiving a letter from the OSC may notice that certain comments on US GAAP information have been issued by the staff of the Commission. WORKING WITH FOREIGN REGULATORS AND STANDARD SETTERS International harmonization is not limited to the long term development of common standards; rather, it also includes working with regulators and standard setters in foreign countries to address current issues that affect cross-border offerings. While the staff does not claim to be experts, we have issued comments on compliance with respect to foreign GAAP. In addressing these issues, the staff frequently seeks the advice of regulators and standard setters in the applicable foreign country. I would like to share with you our experiences involving Canada, Mexico and the United Kingdom. CANADA The staff regularly discusses issues with the staff of the OSC. There have been numerous instances in which the staff, after receiving permission from the registrant, discussed issues with the OSC staff that subsequently led to the restatement of the financial statements prepared in accordance with Canadian GAAP. These issues primarily related to disclosure, but several also related to measurement issues. There has only been one company that did not grant permission for the staff to talk to the Canadian regulators. This company subsequently withdrew its registration statement. The excellent working relationship we enjoy with the OSC staff has benefited investors in both Canada and the US by improved disclosure and accounting. In responding to either the OSC or the SEC, registrants should assume that there is a possibility that the information will be shared. Do not tell us one story and the OSC a different story. MEXICO I have met with representatives of the Mexican Accounting Principles Commission over the years to address unique issues that confront Mexican companies in complying with the US GAAP reconciliation requirements. As described in more detail later, during the past year, the AICPA International Practices Task Force was invited to participate in these meetings. Early in the year we met in Houston and during the summer we met in Mexico City. While not all of the issues on our agenda were resolved, both the Mexican accounting profession as well as the AICPA Task Force believe these meetings have been very beneficial and will contribute to improved and more consistent financial reporting by Mexican companies in the future. UNITED KINGDOM The UK Companies Act 1985 ("Act") requires the financial statements to give a true and fair view of the state of affairs (balance sheet) and profit or loss. This provision requires the departure from a specific accounting standard to the extent necessary to give a true and fair view. In such instances, UITF abstract 7: "True and fair view override disclosures" ("UITF 7") requires specific disclosures including why following the prescribed treatment would not give a true and fair view. Based on informal discussions with the staff at the UK Accounting Standards Board, invoking the true and fair override provisions of the Act should be rare. While the UK does not have a regulatory agency similar to the Commission, a Financial Reporting Review Panel ("FRRP") is empowered to consider apparent defects in published accounts and determine the appropriate corrective action. If the staff notes the disclosures required by UITF 7, we will contact the staff of the FRRP to seek their advice as to the appropriateness of departing from the specific accounting standard. In several instances, registrants changed their accounting to comply with the prescribed standard, and they no longer invoked the true and fair override provisions of the Act, after being informed of the staff's intention to review the issue with the FRRP. In addition, on a regular basis, the staff seeks the advice of the staff of the Accounting Standards Board regarding issues involving compliance with UK GAAP. AICPA INTERNATIONAL PRACTICES TASK FORCE The AICPA International Practices Task Force ("Task Force"), of which I am an observer, met several times during the year to discuss unique accounting and reporting issues affecting foreign private issuers and, to a lesser extent, other international issues that effect domestic registrants. As I indicated last year, the Task Force cannot develop accounting standards; rather, its primary purpose is to reduce diversity in practice and improve the accounting and reporting regarding selected unique issues. If there was a recurring area of focus to our meetings this year it was Mexico. As previously indicated, the Task Force met twice with representatives of the Mexican Accounting Principles Commission ("MAPC") and other leaders of the accounting profession in Mexico to discuss a variety of issues that were primarily related to the application of price level accounting to certain US accounting standards. I would like to share with you some of the more interesting issues addressed during the year involving Mexico and other countries. 1. Determining if Mexico is a Highly Inflationary Economy The first issue affects domestic and foreign issuers with subsidiaries or other investments in Mexico. The Task Force reached a unanimous conclusion that since the three year cumulative rate of inflation for the year ended December 31, 1996 will exceed 100%, Mexico should be treated as a highly inflationary economy for purposes of applying SFAS 52. Accordingly, domestic registrants with a calendar year end should consider the US dollar to be the functional currency effective January 1, 1997. 2 Companies with significant operations in Mexico should consider the need to disclose the following in MD&A and/or the financial statements: ! that the functional currency will change from the peso to the US dollar;3 ! the difference in the methodology to calculate the deferred tax balance - i.e., the application of paragraph 9(f) of SFAS 109 4; and ! the implications of the change in functional currency. For example, if the company had a net monetary asset position in pesos, the change could result in foreign exchange losses assuming the peso declines in value compared to the dollar. 2. Consolidation of Foreign Operations The MAPC is currently working on developing a standard that provides guidance on the consolidation of foreign subsidiaries and other operations into financial statements that are price level adjusted for inflation. The methodologies used in practice are diverse, and the differences can have a significant effect on reported results. As the translation of foreign subsidiaries is an integral part of the comprehensive basis of preparing price level adjusted financial statements, adjustments are not made in the reconciliation to US GAAP. Until guidance is issued, registrants should indicate that there is no standard, differences in methodology exist in practice, and clearly describe the method of consolidation that is being utilized. In addition, disaggregated information in the MD&A and/or financial statements may be necessary. For example, to allow comparability among Mexican companies that follow different consolidation policies, companies should consider the need to provide condensed financial information, along with the applicable exchange and inflation rates, for each country in which there are significant foreign operations. There is also diversity in practice on presenting corresponding amounts from the prior year that are attributable to foreign operations. Most Mexican registrants recast prior year amounts by applying the general Mexican inflation index. 5 Some Mexican registrants, however, have developed an alternative methodology in which the amounts reported by the foreign subsidiaries in the prior year are "re-translated" into pesos using the most recent balance sheet exchange rate. The staff and the Task Force concluded that this methodology is inconsistent with Rule 3-20(e) of Regulation S-X. This rule states that the financial statements should be presented using the same reporting currency for all periods. In preparing price level adjusted financial statements, the registrant is defining their reporting currency as pesos of equivalent purchasing power as of the most recent date. This alternative methodology of re-translating prior year balances using the current exchange rate effectively results in changing amounts that were previously reported, and thus, the prior year amounts are not stated in pesos of equivalent purchasing power. This alternative method should not be used in future Commission filings. 3. Pensions There are two related issues involving pensions. First, should the actuarial assumptions be based on real (net of inflation) rates or nominal rates? Second, should the pension liability/asset be considered monetary or non monetary? 6 The MAPC is currently drafting a circular to address these issues that may be useful in determining the accounting under US GAAP. Until a final circular is adopted, for purposes of reconciling to US GAAP, Mexican registrants should either (a) use real rates and treat the pension plan liability/asset as non monetary, or (b) use nominal rates and treat the pension liability/asset as monetary, but defer as part of the actuarial gain/loss a portion of the monetary gain/loss attributable to the difference between the actual rate of inflation and the assumed rate of inflation included in the actuarial assumptions. 4. Deferred Income Taxes Under Mexican GAAP, fixed assets and inventory are recorded at replacement cost. Currently, there is diversity among Mexican registrants on how the use of replacement cost affects the deferred tax calculation. Some companies allocate a portion of the change in the deferred tax balance that is attributable to the use of replacement cost to equity while others include the entire change in the income statement. There is also inconsistency among Mexican registrants as to the methodology of allocating an amount to equity. The staff, the Task Force and representatives of the MAPC have been evaluating this issue for over two years and have not been able to reach a conclusion. This complex issue may simply go away. The MAPC has reconfirmed the issuance of the Fifth Amendment to Bulletin B-10 that would prohibit the use of replacement cost accounting effective January 1, 1997. The Comisión Nacional de Velore ("CNV") currently requires the use of replacement cost accounting and is reviewing the issue with the MAPC. Assuming replacement cost accounting is no longer allowed effective January 1, 1997, the staff will not object to registrants using their existing method for the year ended December 31, 1996 provided appropriate disclosures on the methodology are included in the financial statements. 5. Cash Flow Statement The last issue regarding Mexico that I would like to address relates to the need to reconcile a statement of changes in financial position required by Mexican GAAP to a cash flow statement required by US GAAP. Pursuant to Mexican GAAP, the amount included under financing activity is determined based on debt in constant pesos. To illustrate, assume debt of NP 100 at both the beginning and end of the year and inflation of 50%. In preparing price level adjusted financial statements, debt would be restated as NP 150 at the beginning of the year. Despite the fact that there is no transaction involving cash, the statement of changes in financial position under Mexican GAAP would present this change as a NP 50 "use" in the financing caption and a NP 50 "source" in the operating activity - included in net income as a monetary gain with no adjustment. It would appear that this presentation overstates operating cash flow and gives the incorrect impression that the company is servicing its debt. This issue will be discussed at the Task Force meeting tomorrow. 6. Inflation Indices in Brazil At last years conference, I indicated that the Task Force intended to work with their counterparts in Brazil to try to reduce diversity in practice regarding the selection of the inflation index used in Commission filings. These two groups concluded that the IGP, which differs from the official index, is the appropriate inflation index for preparing price level adjusted financial statements and should be used prospectively by existing registrants effective January 1, 1996. The staff supports the use of one index by all Brazilian registrants in Commission filings. Any comprehensive index that reflects actual inflation which the registrant represents is most appropriate in the circumstances can be used for periods prior to January 1, 1996. Brazilian companies that file with the Commission for the first time and include audited financial statements for periods subsequent to January 1, 1996 should use the IGP index for each period that US GAAP information is presented. The staff will not object to registrants using a different index for periods prior to which US GAAP information is presented provided the registrant represents that is the most appropriate in the circumstances. RECOMMENDATIONS FOR PREPARING FILINGS WITH THE COMMISSION The last topic I would like to present today are 15 recommendations to consider when preparing filings with the Commission. 1. The staff continues to be willing to review draft filings by foreign private issuers on a confidential basis, and we are committed to meeting the registrant's time schedule. The staff has noticed, however, an increasing number of these filings are substantially incomplete when submitted for review. For example, the US GAAP information is excluded, financial information for the most recent year is not provided, footnotes are missing, etc. Reviewing the draft registration statement on a piecemeal basis requires significantly more staff time and can result in the registrant incurring additional time in addressing staff comments that could have been avoided. The more complete the draft registration statement, the more efficient the review process for both the registrant and the staff. Prior to submission, registrants should seek the staff's concurrence that it will review a draft registration statement that is missing significant information. These requests should be addressed to Paul Dudek, Chief of the Office of International Corporate Finance. 2. Item 17/18 of Form 20-F indicate that a quantified reconciliation to US GAAP of an acquired business is only required when the significance level exceeds 30%. The staff has encountered situations in which substantially all of the operations of the ongoing business in an IPO constitute acquired foreign businesses that are significant at a level of less than 30% and whose financial statements are prepared in accordance with a foreign GAAP. In determining the financial statements that should be included in the filing, the registrant relied on Staff Accounting Bulletin No. 80. The staff believes that it is consistent with investor protection and the intent of the accommodation to require a reconciliation to US GAAP of a substantial portion of the acquired businesses in this situation. Registrants in similar situations are encouraged to discuss the specific facts and circumstances with the staff on a prefiling basis to determine which financial statements, if any, should include a reconciliation to US GAAP. 3. Chilean companies are required to distribute 30% of their net income to shareholders unless a majority of shareholders approve the retention of the profits. The amount of retained earnings that is required to be distributed should not be considered permanent equity for purposes of US GAAP. 4. The financial statements of an acquired foreign business by a domestic issuer may be prepared on a basis other than US GAAP provided, if the business exceeds the 30% significance level, a reconciliation to US GAAP is provided under Item 17 of Form 20-F. This accommodation applies to financial statements prepared pursuant to Rule 3-05 of Regulation S-X and does not apply to financial statements of the predecessor which, if the issuer is not a foreign private issuer, must be prepared in accordance with US GAAP. 5. If three years of audited financial statements of an acquired foreign business would be required based on the level of significance, registrants can elect to present only two years if the statements are prepared in accordance with US GAAP as opposed to a foreign GAAP with a reconciliation. In applying this accommodation, the primary financial statements of the registrant must also be prepared in accordance with US GAAP if post acquisition periods are considered in determining the years presented. To illustrate, assume the acquired business prepares its financial statements in accordance with US GAAP and is included in the registrant's financial statements since the date of acquisition for the most recent year. If the registrant prepares its financial statements in accordance with US GAAP, the requirements of Rule 3-05 of Regulation S- X could be satisfied with providing one year of preacquisition financial statements of the acquired business. However, if the registrant prepares its financial statements in accordance with a foreign GAAP with a reconciliation to US GAAP, two years of preacquisition financial statements of the acquired business would be required. 6. Canadian issuers that do not meet the definition of a foreign private issuer may prepare financial statements in accordance with Canadian GAAP provided that a reconciliation prepared in accordance with Item 18 of Form 20-F is provided. Issuers incorporated in countries other than Canada that do not meet the definition of a foreign private issuer are required to prepare financial statements in accordance with US GAAP. 7. In 1996, a law imposing a 10% surtax was established in France. While parliament intended that the tax would be eliminated in 1998 or 1999, this intent does not establish an enactment date under SFAS 109. The staff would expect that deferred tax balances under SFAS 109 would be computed using rates that include the 10% surtax. 8. Foreign registrants with significant subsidiaries that are consolidated under local GAAP, but would be accounted for using the equity method under US GAAP, are encouraged to discuss with the staff the information that should be disclosed in the US GAAP reconciliation. At a minimum, the staff would expect disclosure of the following information: 1) condensed information on the equity investee required by Rule 4-08(g) of Regulation S-X, and 2) a sufficiently detailed reconciliation to allow an investor to reconstruct financial statements prepared in accordance with US GAAP and Regulation S-X. Based on the specific facts and circumstances, the staff may require additional disclosure either in the financial statements or management's discussion and analysis and may require financial statements pursuant to Rule 3-09 of Regulation S-X. 9. In disclosing the policy on depletion of capitalized mining expenditures, many companies simply state that it is on a units of production method over the expected economic life of the mine with a reference to some form of mineral reserves. The staff expects mining companies to provide explicit disclosure of the types of reserves that are included in the base - that is proven and probable reserves. The Commission has indicated in Industry Guide 7 that disclosure of reserve information is limited to proven and probable reserves. As disclosure of possible reserves is prohibited by Commission rule, the staff does not believe that the base of depletion should include such amounts. Excluding possible reserves from the base may result in an item that needs to be addressed in the reconciliation to US GAAP for Canadian and Australian companies as well as companies from other countries. 10. Compilation reports by independent accountants on pro forma information may be included in registration statements used in cross-border offerings pursuant to requirements in the foreign country. While such reports would not normally be allowed in US filings, the staff tries to accommodate foreign issuers that want to use one document in different jurisdictions to the extent consistent with investor protection. The staff will not object to the inclusion of a compilation report provided that the registration statement includes a statement from the independent accountants that addresses the following items: ! the opinion is included solely to comply with the requirements of the particular jurisdiction; ! US GAAS does not provide for an expression of an opinion on a compilation of pro forma financial statements; ! to report in conformity with US GAAS, an examination greater in scope than that performed would be required; and ! no opinion is expressed under US GAAS. The format of these comments in the manner in which the Canadian Institute of Charted Accountants recommends for differences between US and Canadian reporting standards would be acceptable. 7 The registration statement should include a letter from the independent accountants acknowledging the use of the report. 11. The report of the independent accountants from a foreign country should include a statement that the audit was conducted in accordance with US GAAS. A statement in the report that the audit was conducted in accordance with foreign auditing standards that are substantially similar or similar in all material respects to US GAAS is acceptable. In lieu of a specific reference in the auditor's report, the staff has accepted this representation regarding US GAAS in a letter from the independent accountants. Previously, this letter was usually furnished only when specifically requested by the staff in connection with a review of a filing. To ensure that the independent accountant is making an affirmative representation about US GAAS, the staff recommends that this letter be included as an exhibit to the filing. If the audit was conducted in accordance with Canadian GAAS, no reference to US GAAS is required. 12. Financial statements prepared in accordance with Israeli GAAP and presented in constant New Israeli Shekels ("NIS") are adjusted by either (i) the rate of inflation using the consumer price index, or (ii) the devaluation of the NIS to the US dollar ("devaluation method"). The use of the devaluation method effectively results in the company measuring all transactions in US dollars and simply translating the amounts for all periods into NIS at the period end exchange rate. Item 17/18 of Form 20-F states that issuers that prepare their financial statements in a reporting currency that comprehensively includes the effects of price level changes are not required to eliminate its effects in the reconciliation to US GAAP. The staff does not believe that this accommodation applies to the use of the devaluation method. Accordingly, the devaluation method would not be acceptable under US GAAP, and differences should be addressed in the US GAAP reconciliation. 13. A number of foreign companies have obtained a backdoor listing through a reverse acquisition with a US public shell. Notwithstanding the fact that substantially all of the operations are conducted outside of the US, the registrant would not be considered a foreign private issuer. To facilitate the initial filing, the staff will not object if the financial statements included in the 8-K are prepared in accordance with a foreign GAAP provided a reconciliation to US GAAP that complies with Item 18 of Form 20-F is provided. However, the first 10-K and any registration statement should include financial statements prepared in accordance with US GAAP for all periods presented including those prior to the reverse acquisition. Financial statements in a foreign GAAP reconciled to US GAAP would not be acceptable. 14. Several Brazilian companies have expressed interest in preparing US dollar US GAAP financial statements. The amounts presented for non-monetary assets and liabilities as well as total stockholders' equity should not be materially different than if the US dollar had always been used as the reporting currency, and thus the currency for measurement, during the period that the Brazilian economy was hyperinflationary as defined by SFAS 52. It is not acceptable to use price level adjusted financial statements expressed in reais and translate into US dollars. 15. Registrants that prepare financial statements of acquirees and investees using a foreign GAAP are reminded to include as part of the audited financial statements a discussion of differences between the accounting principles used and those required by US GAAP. The amendments to Item 17 and 18 of Form 20-F eliminated the requirement to provide a quantified reconciliation to US GAAP involving financial statements of acquirees and investees that were significant at a level less than 30%. The audited historical financial statements are still required to include a discussion of differences in accounting. CONCLUSION Thank you, and I look forward to working with you in 1997. _______________________________ 1 See Securities Act Release No. 6902. 2 The Chief Accountant of the Commission made an announcement at a recent EITF meeting that confirmed the conclusion by the Task Force. In addition, at the same meeting, the FASB staff provided guidance on determining if an economy is highly inflationary. See EITF D-55. 3 Companies with a reporting currency other than the US dollar would indicate the applicable currency. 4 Prohibits recognition of a deferred tax liability/asset for differences related to assets/liabilities that, under SFAS 52, are remeasured from pesos into US dollars using the historical exchange rates and that result from (1) changes in exchange rates or (2) indexing for tax purposes. 5 This method is consistent with paragraph 34 of International Accounting Standards No. 29 "Financial Reporting in Hyperinflationary Economies." It is the staff's understanding this method is also used by registrants in other countries that prepare price level adjusted financial statements that are filed with the Commission. 6 SFAS 89 indicates that a pension liability is a non monetary item. 7 See AuG-21 "Canada-U.S. reporting differences."