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U.S. Securities and Exchange Commission

Division of Corporation Finance:
Current Accounting and Disclosure Issues

June 30, 2000

Prepared by Accounting Staff Members in the Division of Corporation Finance
U.S. Securities and Exchange Commission
Washington, D.C.

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any of its employees. This outline was prepared by members of the staff of the Division of Corporation Finance, and does not necessarily reflect the views of the Commission, the Commissioners, or other members of the staff.


Recent Financial Reporting and Disclosure Initiatives

  • Initiative to Address Improper Earnings Management
  • Rules Governing Independence of the Accounting Profession
  • New Rules for Audit Committees and Reviews of
    Interim Financial Statements
  • Materiality in the Preparation or Audit of Financial Statements
    (SAB 99)
  • Restructuring Charges, Impairments, and Related Issues (SAB 100)
  • Interpretive Guidance on Revenue Recognition (SAB 101)
  • Proposed Rule for Disclosure about Valuation and Loss Accruals, Long-Lived Assets
  • Proposed Rule for Guarantors and Related Issuers
  • Matters Involving Auditor Independence
  • Recent Enforcement Action -- America Online, Inc.

Other Commission Rules and Proposals Affecting Registration
and Reporting

  • Interpretive Release on the Use of Electronic Media
  • Regulation of Takeovers and Security Holder Communications

Current Accounting and Disclosure Issues

  • Segment Disclosure
  • Issues Associated With SFAS 133, Accounting for Derivative Instruments and Hedging Activities
  • Amortization Periods Selected for Goodwill
  • Accounting for Intangibles Relating to Customer Relationships
  • Purchase Adjustments to Acquired Company's Loss Accruals
  • Allowance for Loan Losses
  • Internal Costs Associated with an Acquisition
  • Redeemable Securities and "Deemed Liquidation Events"
  • Changes in Functional Currency
  • Effects of Changes to Financial Statements Filed with the Commission in an IPO
  • Market Risk Disclosures
  • Revenue and Cost Recognition in Co-Marketing Arrangements
  • Write-Offs of Prepayments for Services, Occupancy or Usage
  • Cost or Equity Method of Accounting
  • Accounting for Extended Warranty Plans
  • SFAS 45 Guidance Limited to Franchise Agreements
  • Disclosures about "Targeted Stock"
  • Gain on Sale or Securitization of Financial Assets
  • Combining Companies in a Pooling of Interests
  • Issues in the Extractive Industry

Internationalization of the Securities Markets

  • Foreign Issuers in the U.S. Market
  • International Accounting Standards
  • International Disclosure Standards – Amendments to Form 20-F

Other Information About the Division of Corporation Finance
and Other Commission Offices and Divisions

  • The SEC Website and Other Information Outlines
  • Corporation Finance Staffing and Phone Numbers
  • Division Employment Opportunities for Accountants

Recent Financial Reporting and Disclosure Initiatives

Initiative to Address Improper Earnings Management

Many in the financial community have expressed concern that market pressures are driving more public companies to use improper earnings management tricks. In remarks made to the NYC Center for Law and Business in September 1998, Chairman Levitt identified several areas where accounting rules have been abused by some companies to manage earnings: "big bath" restructuring charges, "creative" acquisition accounting, miscellaneous "cookie jar" reserves, intentional "immaterial" errors, and manipulative revenue recognition. The Chairman outlined a plan to address the threat to the integrity of financial reporting posed by improper earnings management. The Chairman's speech can be found at www.sec.gov/news/spchindx.htm.

The Division of Corporation Finance established an Earnings Management Task Force that focused staff resources on the review of filings where potential improper earnings management issues could be present. A primary objective of the reviews has been to elicit improved disclosure in financial statements and MD&A about charges involving asset impairments, restructuring charges, purchased in-process research and development, and similar items. Disclosure sought by the staff has included explanation of the types and amounts of restructuring liabilities and valuation reserves, the timing and amount of increases and decreases in these accounts, and the nature and amount of any changes in estimates. The Task Force also examined filings for indicia of earnings management and other accounting abuses involving revenue recognition, unreasonable valuations of purchased in-process research and development, and manipulation of loss allowances and estimated liabilities. Also, as part of its proactive disclosure program, the Division of Corporation Finance sent letters alerting companies, prior to their filing 1998 annual reports, of disclosures that are often needed to give transparency to significant charges. Samples of those letters are available at the SEC web site.

Other actions taken in connection with the Chairman's earnings management initiative include staff interpretive guidance and rule proposals and amendments discussed elsewhere in this outline.

Rules Governing Independence of the Accounting Profession

On June 27, the Commission proposed to modernize the rules for auditor independence primarily in three areas:

  • investments by auditors or their family members in audit clients;
  • employment relationships between auditors or their family members and audit clients; and
  • scope of services provided by the audit firms to their audit clients.

The release articulates four principles by which to measure an auditor's independence. An accountant is not independent when the accountant:

  • has a mutual or conflicting interest with the audit client,
  • audits his or her own work,
  • functions as management or an employee of the audit client, or
  • acts as a advocate for the audit client.

Financial Relationships

The proposed rule would narrow significantly the circle of partners and family members whose investments trigger independence concerns. The proposed rules limit these restrictions to principally those who work on the audit or can influence the audit. Under the proposed rules, the following financial relationships would cause an accountant to be not independent:

  • Any direct investment in an audit client or its affiliates by the firm or "covered persons" (i.e., those involved in the audit or in a position to influence the audit, or their immediate family).
  • Direct investments of more than 5 percent of the equity of an audit client or its affiliates held by firm partners, professional employees and certain of their family members not included above.
  • The firm, any covered person in the firm, or any immediate family member has any material indirect investment in an audit client, including, ownership of more than 5 percent of an entity that owns an interest in an audit client, or ownership of more than 5 percent of an entity of which the audit client owns an interest.

Certain other financial relationships with an audit client also would preclude an accountant from being independent, including:

  • Having loans to or from an audit client except for certain consumer loans, such as mortgages or auto loans;
  • Maintaining savings, checking, brokerage, or similar accounts with the audit client in excess of insured amounts;
  • Maintaining a credit card issued by an audit client with a balance in excess of $10,000;
  • Holding individual insurance policies, and for the firm, professional liability policies backed by the audit client;
  • Investing in an investment company that is in the same investment company complex as the audit client.

The proposed rule also prohibits investments by the audit client in the auditor. It also prohibits an audit client from acting as an underwriter, or engaging in related activities, for the auditor.

There are certain exceptions for financial interests that are acquired through gifts or inheritances that are disposed of in a timely manner.

Employment Relationships

As with financial relationships, the proposed rules would greatly reduce the pool of people within audit firms whose families would be affected by the employment restrictions necessary to maintain independence. The rules also identify the specific positions, namely those in which a person can influence the audit client's financial records, which would impair an auditor's independence if held by a "close family member" of the auditor.

An accountant will not be independent when certain employment relationships exist:

  • a close family member of a covered person is employed by an audit client in an accounting or financial reporting oversight role.
  • a former partner or professional employee is employed by an audit client in an accounting or financial reporting oversight role -- unless the former partner has severed his or her financial ties with the firm.
  • a former employee of an audit client becomes a partner of the accounting firm and participates in the audit of the audit client.

Business Relationships

Consistent with existing rules, independence will be impaired if the accountant or any covered person has a direct or material indirect business relationship with the audit client, other than providing professional services or acting as a consumer in the ordinary course of business.

Non-Audit Services

The proposed rules identify particular non-audit services that are inconsistent with independence under the four basic principles articulated in the rule. Certain services, such as advising on internal accounting controls and risk management, do not impair an auditor's independence. The proposal covers certain aspects of the following types of services, several of which are already precluded under SEC, AICPA, and SECPS membership rules:

  • Bookkeeping or other services related to the audit client's accounting records or financial statements.  When an accounting firm provides bookkeeping services for an audit client, the auditor auditing the client's financial information may be auditing his or her accounting firm's work.
  • Financial information systems design and implementation.  Designing and implementing a hardware or software system used to generate information that is significant to the audit client's financial statements may create a mutual interest between the client and the accountant in the success of that system, supplant a fundamental business function, or result in the accountant auditing his or her own work.
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports where there is a reasonable likelihood that the accountant will audit the results.  Valuing assets and liabilities or opining on the adequacy of consideration in a transaction may create a situation where the auditor reviews his or her own work, including key assumptions or variables that underlie an entry in the financial statements.
  • Actuarial services.  Providing any advisory services involving the determination of policy reserves and related accounts, unless the audit client uses its own actuaries or third party actuaries to provide management with the primary actuarial capabilities, may affect amounts reflected in an audit client's financial statements and may result in an accountant auditing his or her own work.
  • Internal audit outsourcing.  Companies sometimes "outsource" internal audit functions by contracting with an outside source to perform all or part of their audits of internal controls. Since the external auditor generally will rely, at least to some extent, on the internal control system when conducting the audit of the financial statements, the auditor would be relying on a system he or she helped to establish and maintain. There also may well be a mutuality of interest where management and external auditor may become partners in creating an internal control system and share the risk of loss if that system proves to be deficient. This proposal does not include nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function. It also does not include operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements.
  • Management functions.  When the accountant acts, temporarily or permanently, as a director, officer, or employee of an audit client, or an affiliate of the audit client, or performs any decision making, supervisory, or ongoing monitoring functions, the accountant becomes part of the very entity he or she is auditing.
  • Human resources.  Recruiting, advising clients about organizational structure, developing employee evaluation program, or conducting testing of employees may create a mutuality of interest with the audit client in the success of the employees the auditor selected, tested or evaluated.
  • Broker-dealer, investment adviser, or investment banking services.  Serving as a broker-dealer, promoter, underwriter, investment adviser, or analyst of an audit client's securities will create a mutuality of interest with the audit client in enhancing the value of the securities portfolio. In addition, providing advice and recommendation in this realm often places the auditor in the position of promoting the client's securities.
  • Legal services.  A lawyer's core professional obligation is to advance clients' interests. This fundamental obligation is incompatible with the independence required of an auditor.
  • Expert services.  An accountant who renders or supports expert opinions in legal, administrative, or regulatory filings or proceedings creates, at the very least, the appearance that the accountant acts as an advocate.

Contingent Fee Arrangements

The proposed rule reiterates that an accountant cannot provide any service to an audit client that involves a contingent fee. Contingent fees result in the auditor having a mutual interest with the audit client in the outcome of the work performed.

Quality Controls

The rule proposal provides a limited exception for independence failures if certain factors are present:

  • The individual did not know, and was reasonable in not knowing, the circumstances giving rise to his or her violation.
  • The violation was corrected promptly once the violation became apparent.
  • The firm has quality controls in place that provide reasonable assurance that the firm and its employees maintain their independence. For the largest public accounting firms, the basic controls must include, among others, written independence policies and procedures, automated systems to identify financial relationships that may impair independence, training, internal inspection and testing, and a disciplinary mechanism for enforcement.

Proxy Disclosure Requirement

The proposal would require registrants to disclose in their annual proxy statements information relating to services and fees provided by the auditor. Under the proposal, registrants would be required to disclose each professional service provided by the registrant's principal independent public accountant, if the fees exceed $50,000 or 10 percent of the audit fee, whichever is less. The disclosure would also indicate whether a company's audit committee or board of directors considered the effect that the provision of each disclosed service could have on the auditor's independence.

Lastly, if over fifty percent, the registrant would be required to disclose the percentage hours worked on the audit engagement by persons other than the accountant's full time employees. This requirement responds to recent moves by some accounting firms to sell their practices to financial services companies. The partners or employees often become employees of the financial services firm. The remaining accounting firm becomes in essence a "shell" that then leases assets, namely professional auditors, back from those companies to complete audit engagements. The professionals who had previously worked in the firm's audit practice become full-or part-time employees of the financial services company, but work on audit engagements for their former accounting firm, and receive compensation from the financial services firm, and in some situations, from the accounting firm.


The Commission solicits comments on each of the rule proposals. In addition, the Commission solicits comments on a range of alternative approaches regarding non-audit services.

Public Hearings

The comment period will be 75 days and will include public hearings.

New Rules for Audit Committees and Reviews of Interim Financial Statements

On December 15, 1999, the Commission adopted new rules to improve public disclosure about the functioning of corporate audit committees and to enhance the reliability and credibility of financial statements of public companies. The Commission's actions are part of a broader effort by the securities exchanges and the accounting profession to improve the oversight of financial reporting by corporate boards. Proposals for action by each of the different groups were set forth in the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. The Blue Ribbon Committee is a prestigious group of business, accounting, and securities professionals led by John Whitehead and Ira Millstein. The committee's report is available at www.nasd.com. The Commission's new rules coincide with rule changes by the New York Stock Exchange, the American Stock Exchange, and the National Association of Securities Dealers.

In brief, the rules require that:

  • companies' interim financial statements must be reviewed by independent auditors before they are filed on Forms 10-Q or 10-QSB with the Commission;
  • companies, other than small business issuers filing on small business forms, must supplement their annual financial information with disclosures of selected quarterly financial data under Item 302(a) of Regulation S-K;
  • companies must disclose in their proxy statements whether the audit committee reviewed and discussed certain matters specified in the ASB's Statements of Auditing Standards No. 61 (concerning the accounting methods used in the financial statements) and the Independence Standard Board's Standard No. 1 (concerning matters that may affect the auditor's independence) with management and the auditors, and whether it recommended to the Board that the audited financial statements be included in the Annual Report on Form 10-K or 10-KSB for filings with the Commission;
  • companies disclose in their proxy statements whether the audit committee has a written charter, and file a copy of their charter every three years; and
  • companies whose securities are listed on the NYSE or AMEX or are quoted on Nasdaq disclose certain information in their proxy statements about any audit committee member who is not "independent." All companies must disclose, if they have an audit committee, whether the members are "independent." Independence is defined in the listing standards of the NYSE, AMEX and NASD.

Under the new rules, interim auditor reviews must begin with the first fiscal quarter ended after March 15, 2000, and compliance with the other new requirements begin after December 15, 2000. Foreign private issuers are exempt from requirements of the new rules. The new rules include a "safe harbor" for the disclosures.

The Commission's new rules build upon rule changes proposed by the NYSE, the AMEX, and the NASD and approved by the Commission on December 15, 1999, which were also part of the recommendations of the Blue Ribbon Committee. Those rules:

  • define "independence" more rigorously for audit committee members;
  • require audit committees to include at least three members and be comprised solely of "independent" directors who are financially literate;
  • require companies to adopt written charters for their audit committees;
  • give the audit committee the right to hire and terminate the auditors; and
  • require at least one member of the audit committee to have accounting or financial management expertise.

In December 1999, the AICPA's Auditing Standards Board issed Statement of Auditing Standard No. 90 which requires independent auditors to discuss with the audit committee the auditor's judgment about the quality, and not just the acceptability under generally accepted accounting principles, of the company's accounting principles as applied in its financial reporting.

Materiality in the Preparation or Audit of Financial Statements (SAB 99)

On August 12, 1999, the staff published Staff Accounting Bulletin No. 99. That SAB expressed the staff's view that exclusive reliance on certain quantitative benchmarks to assess materiality in preparing or auditing financial statements is inappropriate. The SAB states that the staff has no objection to the use of a percentage threshold as an initial assessment of materiality, but exclusive use of such thresholds has no basis in law or in the accounting literature. The staff stresses that evaluations of materiality require registrants and auditors to consider all of the relevant circumstances, and that there are numerous circumstances in which misstatements below a benchmark percentage threshold could be material. Some of the circumstances listed in the SAB that should be considered are:

  • whether the misstatement masks a change in earnings or other trends,
  • whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise,
  • whether a misstatement changes a loss into income or vice versa,
  • whether the misstatement concerns a segment of the registrant's business that plays a significant role in the registrant's present or future operations or profitability,
  • whether the misstatement affects compliance with loan covenants or other contractual requirements,
  • whether the misstatement has the effect of increasing management's compensation.

The SAB observes that managers should not direct or acquiesce to immaterial misstatements in the financial statements for the purpose of managing earnings. The SAB indicates that investors generally would consider significant an ongoing practice to over- or under-state earnings up to an amount just short of some percentage threshold in order to manage earnings.

The SAB also notes that even though a misstatement of an individual amount may not cause the financial statements to be materially misstated, it may, when aggregated with other misstatements, render the financial statements taken as a whole to be materially misleading. The SAB, therefore, provides guidance on when and how to aggregate and net misstatements to evaluate whether they materially misstate the financial statements.

The SAB advises that, even if management and auditors find that a misstatement is immaterial, they must consider whether the misstatement results in a violation of the books and records provisions in Section 13(b) of the Exchange Act. Section 13(b) requires that public companies make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect transactions and the disposition of assets of the registrant, and that they maintain internal accounting controls that are sufficient to provide reasonable assurances that financial statements are prepared in conformity with GAAP. In this context, what constitutes "reasonable assurance" and "reasonable detail" are not based on a "materiality" standard but on the level of detail and degree of assurance that would satisfy prudent officials in the conduct of their own affairs.

The SAB sets forth various factors, in addition to those used to evaluate materiality, that a company may consider in deciding whether a misstatement violates its obligation to keep books and records that are accurate "in reasonable detail." Some of these factors are:

  • the significance of the misstatement,
  • how the misstatement arose,
  • the cost of correcting the misstatement, and
  • the clarity of the authoritative accounting guidance with respect to the misstatement.

Finally, the SAB reminds auditors of their obligations under Section 10A of the Exchange Act and auditing standards to inform management and, in some cases, audit committees of illegal acts, such as violations of the books and records provisions of the Exchange Act, coming to the auditor's attention during the course of an audit.

Restructuring Charges, Impairments, and Related Issues (SAB 100)

On November 24, 1999, the staff published Staff Accounting Bulletin No. 100, which provides guidance on the accounting for and disclosure of certain expenses and liabilities commonly reported in connection with restructuring activities and business combinations, and the recognition and disclosure of asset impairment charges.

The Emerging Issues Task Force addressed Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) in Issue No. 94-3. Generally, that consensus limits costs that may be recognized solely pursuant to management's plan to incur them to those costs which result directly from an exit activity, are not associated with and do not benefit continuing activities, and for which there is appropriate authorization, specification, and commitment to execute. SAB 100 discusses the EITF criteria and related disclosure requirements in particular circumstances encountered by the staff in its review of filings by public companies. The SAB expresses the staff's view that a company's exit plan should be at least comparable in its level of detail and precision of estimation to the company's other operating and capital budgets, and should be accompanied by controls and procedures to detect and explain variances and adjust accounting accruals. The SAB discusses disclosures in financial statements and MD&A that are often necessary to make the effects of restructuring activities on reported results sufficiently transparent to investors.

SAB 100 also addresses issues that arise in the application of FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. The SAB reminds registrants that the operational requirement to continue to use an asset disallows accounting for the asset as held for sale. If the asset is held for use, its carrying value must be systematically amortized to its salvage value over its remaining economic life. If management contemplates the removal or replacement of assets more quickly than implied by their depreciation rates, the useful lives of the assets and rates of depreciation must be re-evaluated. The SAB also provides the staff's views regarding the assessment and measurement of any impairment of enterprise level goodwill, and it specifies the accounting policy disclosures that should be provided.

The SAB also highlights the staff's concerns when a registrant records liabilities assumed in a business combination at amounts materially greater than historically reported by the acquired company. That circumstance could indicate that costs incurred before or after the merger were not properly recognized in the reported results of one or the other combining company. The SAB reminds registrants that, if the acquired company's historical accounting for a liability is based on reasonable estimates of undiscounted future cash flows, the estimated undiscounted cash flows underlying the liability recorded by the acquiring company would not be expected to differ materially from those estimates unless the acquirer intends to settle the liability in a manner demonstrably different from that contemplated by the acquired company.

Interpretive Guidance on Revenue Recognition (SAB 101 and 101A)

On December 3, 1999, the staff published Staff Accounting Bulletin 101 to provide guidance on the recognition, presentation and disclosure of revenue in financial statements. The SAB draws on the existing accounting rules and explains how the staff applies those rules, by analogy, to other transactions that the rules do not specifically address. The SAB spells out basic criteria that must be met before registrants can record revenue.

Specific fact patterns discussed in the SAB include bill-and-hold transactions, long-term service transactions, refundable membership fees, contingent rental income, and up-front fees when the seller has significant continuing involvement. The SAB also addresses whether revenue should be presented at the full transaction amount or on a fee or commission basis when the seller is acting as a sales agent or in a similar capacity. Finally, the SAB provides guidance on the disclosures registrants should make about their revenue recognition policies and the impact of events and trends on revenue.

Registrants may need to change their accounting policies to comply with the SAB. Provisions of the SAB addressing the period in which the new policies should be adopted were amended by Staff Accounting Bulletin 101B, which was issued June 26, 2000. Provided the registrant's former policy was not an improper application of GAAP, registrants may adopt a change in accounting principle to comply with the SAB no later than the last fiscal quarter of the fiscal year beginning after December 15, 1999.

Proposed Rule for Disclosure About Valuation and Loss Accruals, Long-Lived Assets

On January 21, 2000, the Commission proposed rule amendments to reposition certain schedule information about valuation and loss accruals which is currently required in exhibits to certain periodic reports and registration statements. (Securities Act Release No. 33-7793) Under the proposed rule, this information would be required by new Item 302(c) of Regulation S-K and be included within the main body of reports and registration statements. Also, a proposed new Item 302(d) of Regulation S-K would require certain information concerning tangible and intangible long-lived assets and related accumulated depreciation, depletion, and amortization. Amendment of Form 20-F is also proposed to include a new Item 8C soliciting identical information in filings by foreign private issuers. The rule proposals are intended to provide investors with (1) more transparent, better detailed disclosures concerning changes in valuation and loss accrual accounts and in the underlying accounting assumptions, and (2) more detailed information to assess the effects of useful lives assigned to long-lived assets.

Under the proposed rule, registrants would be required to provide beginning and ending balances and additions to and deductions from accounts established for each major class of valuation or loss accrual. Examples of accounts for which the disclosure would be required include allowances for doubtful trading accounts or notes receivable; allowances for sales returns, discounts and contractual allowances; unamortized discount or premium; excess of estimated costs over revenues on contracts (losses accrued under SFAS 5); liabilities for costs of discontinued operations; liabilities for exit and employee termination relating to a restructuring or business combination; contingent tax liabilities recorded under SFAS 5; product warranty liabilities, and probable losses from pending litigation. Disclosures provided in response to this item would not be audited, and would not be duplicated if they are presented in the financial statements.

Similarly, the proposed rule would require provision of unaudited information depicting beginning and ending balances and additions to and deductions from accounts established for each major long-lived asset classification and its corresponding accumulated depreciation, depletion and amortization account. Major long-lived asset classifications are those for which separate presentation is made on the balance sheet and include land, buildings, equipment, leaseholds, brand names, non-compete agreements, customer lists, and goodwill.

Proposed Rule for Guarantors and Related Issuers

On February 26, 1999, the Commission proposed rules concerning the financial statement and Exchange Act reporting requirements for subsidiary guarantors and subsidiary issuers of guaranteed securities (Securities Act Release No. 7649). These proposals include revisions to Rule 3-10 of Regulation S-X and new Rule 12h-5 under the Exchange Act. The comment period for these proposals ends on May 4, 1999.

The proposed amendments to Rule 3-10 would, with one principal difference, codify the staff's current positions as articulated in Staff Accounting Bulletin No. 53 and the interpretive positions that the staff has taken with respect to SAB 53. The principal difference between the proposed financial statement requirements and existing practice is that the proposal would eliminate the presentation of summarized financial information. Rather, it would require companies to present condensed consolidating financial information in all situations in which they currently may present summarized financial information about their subsidiaries.

Proposed Rule 3-10 includes specific requirements applicable to recently acquired guarantors. If a significant recently acquired guarantor has not been included in the parent company's consolidation for at least 9 months, one year of audited financial statements would be required in any registration statement for guaranteed securities. A recently acquired guarantor would be significant if the greater of its pre-acquisition net book value or purchase price exceeds 20% of the parent company's consolidated stockholders' equity.

Proposed Rule 12h-5 eliminates the need for subsidiaries to request an exemption from Exchange Act reporting and removes uncertainty regarding the availability of an exemption from Exchange Act reporting. As proposed, Rule 12h-5 would exempt from Exchange Act reporting any subsidiary issuer or subsidiary guarantor permitted to omit financial statements by proposed Rule 3-10.

The proposal would not change the financial statement requirements for affiliates whose stock is pledged as collateral for a registered security, but would re-number that rule as Rule 3-16 to distinguish its requirements.

Matters Involving Auditor Independence

Consistent with its continuing policy of looking to the private sector for leadership in establishing and improving accounting principles and auditing standards, the Commission intends to look to the eight-member Independence Standards Board established in 1997 for promulgating independence standards and interpretations for auditors of public entities. The Board is assisted by a nine-member Independence Issues Committee that helps with the identification and discussion of emerging independence issues within the framework of existing authoritative literature. Standard-setting meetings are open to the public and proposed standards are exposed for public comment before they are issued. On February 18, 1998, the Commission issued a statement of policy (Financial Reporting Release No. 50) reaffirming that maintaining the independence of auditors of financial statements included in filings with the Commission is crucial to the credibility of financial reporting and, in turn, the capital formation process.

The Board issued Standard No. 1, Independence Discussions with Audit Committees, which requires the auditor to discuss its independence with the audit committee and disclose all relationships between the auditor and the company that may reasonably be thought to bear on independence. The Board also issued Standard No. 2, Certain Independence Implications of Audits of Mutual Funds and Related Entities, and an interpretation concerning an auditor's assistance in a client's implementation of FASB Statement No. 133. The Board is working on a conceptual framework, and on other proposed rules dealing with legal services and outsourcing, family-member employment with audit clients, accounting practice structures, appraisal and valuation services, and other matters.

The Commission's existing authority regarding auditor independence remains unchanged. This includes the Commission's authority to institute such enforcement actions as it deems appropriate. During 1999, PricewaterhouseCoopers LLP consented to the entry of an order under Rule 102(e) of the Commission's Rules of Practice censuring the firm for improper professional conduct in connection with numerous instances of direct or material indirect financial interests held by the firm's professionals and a retirement plan in securities of certain of its publicly held audit clients. (See Accounting and Auditing Enforcement Release No. 1098; January 14, 1999. On January 6, 2000, the SEC staff made available at the SEC website the report by independent consultant Jess Fardella, who was appointed by the Commission to conduct a review of possible independence violations by PwC arising from ownership of client-issued securities. The report finds significant violations of the firms, the profession's, and the SEC's auditor independence rules. Another enforcement action involving auditor independence and the accounting firm of Moore Stephens, formerly Mortenson & Associates, P.C., is reported at AAER 1134; May 19, 1999.)

On November 3, 1999, the SEC Practice Section of the AICPA issued new requirements for its members concerning establishment of independence policies, maintenance of a database of restricted investments for professionals in the firm, and development of procedures to ensure that compliance with the firm's independence policies is monitored and enforced on a continuous basis.

Recent Enforcement Action -- America Online, Inc.

On May 15, 2000, America Online, Inc. consented to the entry of a Order by the Commission making findings about the company's accounting for certain advertising costs, and directing AOL to cease and desist from causing any violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and rules thereunder. (See Accounting and Auditing Enforcement Release No. 1257). In addition, AOL agreed to pay a $3.5 million civil penalty.

During the two fiscal years ending June 30, 1996, AOL capitalized certain direct response advertising costs -- primarily the costs associated with sending disks to potential customers. AOL reported those costs as an asset which was amortized over 12 months until July 1, 1995, when the amortization period was increased to 24 months. On a quarterly basis, the effect of capitalizing those costs was that AOL reported profits for six of the eight quarters in the two years ended June 30, 1996, rather than losses that it would have reported had the costs been expensed as incurred.

The AICPA's Statement of Position 93-7, Reporting on Advertising Costs, permits the capitalization and amortization of direct response advertising costs only when persuasive historical evidence exists that allows the entity to reliably predict future net revenues that will be obtained as a result of the advertising. Further, that rule specified that the realizability of the amounts reported as assets must be evaluated at each balance-sheet date on a cost-pool-by-cost-pool basis. Paragraph 70 of the SOP observes that the conditions under which direct response advertising may be capitalized "are narrow because it is generally difficult to determine the probable future benefits of advertising with the degree of reliability sufficient to report the results of the advertising as assets."

AOL based its capitalization of the advertising costs on a model which assumed stability of customer retention rates over an extended period, as well as the maintenance of the company's gross profit margin percentage. The Commission found that AOL did not meet the essential requirements of SOP 93-7 because its unstable business environment precluded reliable forecasts of future net revenues. Moreover, AOL did not assess recoverability of the capitalized cost on a cost-pool-by-cost-pool basis.


Other Commission Rules and Proposals Affecting Registration and Reporting

Interpretive Release on the Use of Electronic Media

On April 28, 2000, the Commission issued an interpretive release providing guidance on the use of electronic media by issuers of all types, including operating companies, investment companies and municipal securities issuers, as well as market intermediaries (Exchange Act Release No. 42728). The release updates previous guidance on the use of electronic media to deliver documents under the federal securities laws, discusses an issuer's liability for web site content and outlines basic legal principles that issuers and market intermediaries should consider in conducting online offerings.

Many publicly-traded companies are incorporating Internet-based technology into their routine business operations, including setting up their own web sites to furnish company and industry information. Some provide information about their securities and the markets in which their securities trade. Investment companies use the Internet to provide investors with fund-related information, as well as security holder services and educational materials. Issuers of municipal securities also are beginning to use the Internet to provide information about themselves and their outstanding bonds, as well as new offerings of their securities.

The increased use of the Internet by issuers as a means of widespread information dissemination has resulted in uncertainty about the application of the federal securities laws to these communications. Through the release, the Commission seeks to reduce this uncertainty and remove interpretively some of the barriers to use of electronic media, while preserving important investor protections.

Highlights of the Interpretations

1.   Electronic Delivery

The guidance in the release resolves several issues that have arisen out of the Commission's 1995 and 1996 releases on the use of electronic media to satisfy delivery obligations. In brief, this guidance:

  • clarifies that, in addition to written consent, investors and security holders may consent to electronic delivery of documents telephonically, as long as the consent is obtained in a manner that assures its validity and a record of the consent is retained;
  • permits market intermediaries (such as broker-dealers and banks) to obtain consent to electronic delivery of documents on a "global," multiple-issuer basis, as long as the consent is informed;
  • clarifies that issuers and market intermediaries may deliver documents electronically in portable document format, or PDF, as long as investors and security holders are adequately informed of the requirements to download PDF and are provided with any necessary software and assistance;
  • clarifies that a hyperlink embedded within a prospectus or any other document required to be filed or delivered under the federal securities laws causes the hyperlinked information to be a part of that document; and
  • clarifies that the close proximity of information on a web site to a public offering prospectus does not, by itself, make that information an "offer to sell," "offer for sale" or "offer" within the meaning of the federal securities laws.

2.   Permissible Web Site Content

The guidance in the release addresses an issuer's responsibility under the anti-fraud provisions of the federal securities laws for information on a third-party web site to which the issuer has established a hyperlink and for its web site communications when conducting a public offering.

Issuer Responsibility for Hyperlinked Information. Issuers have been concerned that by establishing a hyperlink from their corporate web sites to information on a third-party web site they may be held liable for any material misrepresentations or omissions contained in the hyperlinked information. The Commission confirms that the attribution of hyperlinked information on the third-party web site to an issuer depends on the facts and circumstances of the particular situation. "Adoption" of the hyperlinked information by an issuer depends upon whether the issuer, explicitly or implicitly, has endorsed or approved the hyperlinked information. The Commission discusses three, non-exclusive factors that are relevant in answering this question: the context of the hyperlink, the risk of investor confusion and the presentation of the hyperlinked information.

Web Site Content When in Registration. The Commission reminds issuers that, when in registration, their web site content, like their other communications to the securities markets, is subject to Section 5 of the Securities Act of 1933. Issuers are directed to the Commission's long-standing guidance on permissible factual communications while in registration and instructed on how to apply this guidance to their Internet web sites. The Commission further extends this guidance (which was originally directed only to publicly-traded companies) to non-reporting issuers conducting initial public offerings.

3.   Online Offerings

The guidance in the release also addresses the rapidly developing areas of online registered and private offerings.

Registered Offerings. The guidance discusses the general legal principles that have shaped, and will continue to shape, the Commission's views on the evolving practices for conducting online registered offerings. The Commission reserves the development of detailed procedures for conducting online registered offerings to further staff interpretation and Commission regulatory action as it gains more experience through the review and comment process.

Private Offerings. The guidance reminds issuers contemplating an online private offerings that their offering activities must not involve a general solicitation of investors or any general advertising. Current practices have developed for identifying prospective investors for these offerings which deviate from the staff's prior interpretations in this area. The Commission discusses the underlying rationale for these interpretations and the significance of the presence of a broker-dealer to avoid a general solicitation. The Commission also reminds web site operators to consider whether their activities in connection with online private offerings require them to register as broker-dealers under the Securities Exchange Act of 1934.

4.   Technology Concepts

To facilitate any necessary regulatory action in the future, the Commission solicits comment on a number of issues involving the use of electronic media under the federal securities laws, including

  • the circumstances, if any, under which the requirement to deliver a disclosure document could be satisfied by simply posting the document on an Internet web site;
  • the circumstances, if any, under which an investor would be deemed to have consented to electronic delivery of a disclosure document because the investor did not affirmatively reject electronic delivery, so-called "implied consent";
  • the circumstances, if any, under which "account messaging" might constitute adequate notice of the availability of electronic disclosure documents;
  • issues that arise in the context of "electronic-only" offerings;
  • the factors, if any, to be considered in determining anti-fraud liability for outdated information on an issuer's web site;
  • permissible communications when in registration by businesses that operate solely through their web sites; and
  • issues associated with Internet discussion forums.

Effective Date

The interpretations became effective May 5, 2000. In addition, the Commission is seeking public comment concerning issues raised in the release by June 19, 2000.

Regulation of Takeovers and Security Holder Communications

On October 22, 1999, the Commission adopted a new regulatory scheme for business combination transactions and security holder communications (Securities Act Release No. 7760). The new rules and amendments are effective January 24, 2000. The amendments significantly update the existing regulations to meet the realities of today's markets while maintaining important investor protections. Specifically, the amendments reduce restrictions on communications, balance the regulatory treatment of cash and stock tender offers, and update, simplify and harmonize the disclosure requirements.

Reduce Restrictions on Communications

The Securities Act, as well as the proxy and tender offer rules, restrict communications. The new rules and amendments relax these restrictions by permitting the dissemination of more information on a timely basis without triggering the need to file a mandated disclosure document. Under the new scheme, a complete disclosure document still must be provided before a security holder may vote or tender securities, but other communications regarding the transaction are permitted. This should permit more informed voting and tendering decisions. The content of communications is not restricted, but anyone relying on the new rules must file written communications relating to the transaction on the date of first use, so that all security holders have access to the information. In particular, the amendments permit more communications:

  • before the filing of a registration statement relating to either a stock merger or a stock tender offer transaction;
  • before the filing of a proxy statement (regardless of the subject matter or contested nature of the solicitation); and
  • regarding a proposed tender offer without "commencing" the offer and requiring the filing and dissemination of specified information.

The amendments also harmonize the various communications principles applicable to business combination transactions under the Securities Act, tender offer rules and proxy rules. Confidential treatment of merger proxy statements is retained, but only under limited circumstances. Under the new scheme, if parties to a transaction publicly disclose information beyond that specified in Rule 135, the proxy statement must be filed publicly. If a proxy statement is filed confidentially, but later the parties disclose information beyond Rule 135, then the proxy statement must be re-filed publicly.

Balance the Regulatory Treatment of Cash and Stock Tender Offers

Registered stock tender offers (exchange offers) are subject to regulatory delays not imposed on cash tender offers. A cash tender offer may commence as soon as a tender offer schedule is filed and the information disseminated to security holders while an exchange offer may not commence before a registration statement is filed and becomes effective. The delay associated with exchange offers may cause some bidders to favor cash over stock as consideration in a business combination transaction. In addition, the different regulatory treatment can give a bidder offering cash a timing advantage over a competing bidder offering stock. The amendments adopted will balance the regulatory treatment of cash and stock tender offers to the extent practicable.

Under the new rules third-party or issuer exchange offers may commence as early as the filing of a registration statement, or on a later date selected by the bidder, before effectiveness of the registration statement. As a result, a bidder offering securities will not need to wait until effectiveness to commence an exchange offer. Early commencement is not mandatory, but rather at the election of the bidder. A bidder may file a registration statement, wait for staff comments, if any, and then decide to commence its offer. Any securities tendered in the offer could not be purchased until after the registration statement becomes effective, the minimum 20 business day tender offer period has expired, and all material changes are disseminated to security holders with adequate time remaining in the offer to review and act upon the information. A bidder need not deliver a final prospectus to security holders. Security holders may withdraw tendered securities at any time before they are purchased by the bidder.

Update, Simplify and Harmonize Disclosure Requirements

The procedural and disclosure requirements for business combination transactions vary depending upon the form of the transaction. Many of the differences can be minor and unnecessary. The amendments clarify and harmonize many of the requirements. The amendments also make the requirements easier to understand and facilitate compliance with the regulations.

  • The substantive disclosure requirements for tender offers, going-private transactions and other extraordinary transactions remain substantially the same, but are moved to one central location within the rules, called "Regulation M-A." In some cases, harmonization reduces the disclosure requirements. The amendments also update the rules in several respects. The more significant amendments will:
  • combine the existing schedules for issuer and third-party tender offers into one new schedule available for all tender offers, called "Schedule TO";
  • require a plain English summary term sheet in all tender offers, mergers and going-private transactions, except when the transaction is already subject to the plain English requirements of the Securities Act rules;
  • permit an optional subsequent offering period after completion of a tender offer during which security holders can tender their shares without withdrawal rights;
  • revise Rule 13e-1, which requires issuers to report intended repurchases of their own securities once a third-party tender offer has commenced, so that the required information need not be disseminated to security holders and to provide an exclusion from the rule for certain periodic, routine purchases;
  • conform the current security holder list requirement in the tender offer rules with the comparable provision in the proxy rules so that the list will include non-objecting beneficial owners; and
  • clarify the rule that prohibits purchases outside a tender offer (Rule 10b-13), codify prior interpretations of and exemptions from the rule; add several new exceptions to the rule, and redesignate it as new Rule 14e-5.

Update, Simplify and Harmonize the Financial Statements Requirements

Item 14 of the proxy rules for cash-only mergers was revised to clarify that financial statements and other information about a third party acquiror is required only if that information is material to a voting security holder's evaluation of the transaction. As has been the case for cash-only tender offers, information about the acquiror is generally not needed when target security holders are receiving only cash and the acquiror has demonstrated its financial ability to satisfy the terms of the offer. If the financial statements of the acquiror are material, those financial statements are required only for the two most recent fiscal years and interim periods. The new rules eliminate the requirement to furnish in the proxy materials the historical financial statements of the acquiror when only its shareholders are voting, although pro forma financial information would be required if the effect of the acquisition is material. Similarly, the new rules eliminate the requirement to furnish the target's historical financial statements when only its shareholders are voting, except in a going-private transaction.

Cash tender offer rules with respect to two-tier transactions were revised to clarify that pro forma financial information is required in a negotiated third-party cash tender offer when securities are intended to be offered in a subsequent transaction in which remaining target company securities are acquired and the acquisition of the target is significant to the offeror above the 20% level. The rules also clarify that the offeror's financial statements must accompany the pro forma financial information.

Forms S-4 and F-4 used to register shares issued in a merger were revised to eliminate the requirement to provide financial statements for the non-reporting target if security holders of the issuer/acquiror are not voting on the transaction and the target company is not above the 20% significance level relative to the acquiror. In this circumstance, pro forma financial information reflecting the merger is also not required. If the target company exceeds the 20% significance level, its financial statements prepared in accordance with GAAP are required for the most recent year, and also for the two previous fiscal years if they were previously provided to the target's security holders. The new rules did not change the financial statement requirement of target companies in a roll-up transaction.

A reconciliation to U.S. GAAP in accordance with Item 17 of Form 20-F continues to be required in proxy materials and Forms S-4 and F-4 with respect to a non-reporting foreign target's financial statements prepared on the basis of a comprehensive body of accounting principles other than U.S. GAAP. The new rules relax this requirement when a reconciliation is unavailable or not obtainable without unreasonable cost or expense. When a U.S. GAAP reconciliation is not presented under these circumstances, the financial statements must provide, at a minimum, a narrative description of all material variations in accounting principles, practices and methods used in preparing the non-U.S. GAAP financial statements from those accepted in the U.S. A similar provision concerning the U.S. GAAP reconciliation is included in the revised tender offer rules.


The Commission's Electronic Data Gathering, Analysis, and Retrieval ("EDGAR") system has been operational since 1992, with mandated electronic filing by those subject to the Division's review beginning in April 1993. Electronic filings are publicly available on a 24-hour delayed basis in the "EDGAR Database" area of the Commission's web site, http://www.sec.gov. This area also contains other information about EDGAR, including an outline entitled "Electronic Filing and the EDGAR System: A Regulatory Overview."

On June 28, 1999, the Commission began accepting live filings submitted in HTML, as well as documents submitted in the currently required American Standard Code for Information Interchange ("ASCII") format. Filers also have the option of accompanying their required filings with unofficial copies in Portable Document Format ("PDF").

Pursuant to amendments adopted by the Commission on April 24, 2000 (Securities Act Release No. 7855), EDGAR will include the following new features beginning May 30, 2000:

  • the ability to include graphic and image files in HTML documents;

  • the ability to use hyperlinks in HTML documents, including links between documents within a submission and to previously filed documents on our public web site EDGAR database at www.sec.gov; and

  • the addition of the Internet as an available means of transmitting filings to the EDGAR system.

The rule amendments remove the requirement for filers to submit Financial Data Schedules, effective January 1, 2001. They also eliminate diskettes as an available means of transmitting filings to the EDGAR system, effective July 10, 2000.


Current Accounting and Disclosure Issues

Segment Disclosure

Identification of Segments

SFAS 131 defines an operating segment, in part, as a component of an enterprise whose operating results are regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance. Segments may be aggregated in the disclosure only to the limited extent permitted by the standard. If segments are aggregated, that fact must be disclosed. Under SFAS 131, the chief operating decision maker is not necessarily a single person, but is a function which may be performed by several persons.

If the chief operating decision maker receives reports of a component's operating results on a quarterly or more frequent basis, the staff may challenge a registrant's determination that the component is not a segment for purposes of SFAS 131 unless reports of other overlapping sets of components are more clearly representative of the way the business is managed. On a few occasions, the staff has requested copies of all reports furnished to the chief operating decision maker if the reported segments did not appear realistic for management's assessment of a company's performance or conflicted with that officer's public statements describing the company. The staff also has reviewed analysts' reports, interviews by management with the press, and other public information to evaluate consistency with segment disclosures in the financial statements. Where that information revealed different or additional segments, amendment of the registrant's filings to comply with SFAS 131 was required.

Other Compliance Issues

Registrants should remember to identify the products and services from which each reportable segment derives its revenues, and to report the total revenues from external customers for each product or service or each group of similar products and services. Disclosures for products and services that are not substantially similar must be disaggregated. The staff has objected to overly broad views of what constitutes similar products. In its assessment of whether dissimilar products have been aggregated, the staff will review public disclosures and marketing materials which describe the registrant's products.

The reconciliation of segment elements to the consolidated financial statements should quantify and clearly explain each material reconciling item. Effects of measurement differences should be identified, and asymmetrical allocations among segments should be highlighted.

Issues Associated With SFAS 133, Accounting for Derivative Instruments and Hedging Activities

Formal Documentation Under Statement 133

In June 1998, the FASB issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities). SFAS 133 establishes, for the first time, a comprehensive accounting and reporting standard for derivative instruments and hedging activities. One of the fundamental requirements of Statement 133 is that formal documentation be prepared at inception of a hedging relationship. The standard stresses the need for the documentation to be prepared contemporaneously with the designation of the hedging relationship. The formal documentation must identify the following:

  • The entity's risk management objectives and strategies for undertaking the hedge;
  • The nature of the hedged risk;
  • The derivative hedging instrument;
  • The hedged forecasted transaction; and
  • A description of how the entity will assess hedge effectiveness;

Two of these documentation requirements are emphasized below:

The hedged forecasted transaction

Statement 133 stresses that the documentation of the hedged forecasted transaction must be sufficiently specific such that when a transaction occurs, it is clear whether or not that particular transaction is the hedged transaction. Thus, the documentation of the forecasted transaction should include reference to the timing (i.e., the estimated date), the nature, and amount (i.e. the hedged quantity or amount) of the forecasted transaction.

A description of how the entity will assess hedge effectiveness

While Statement 133 provides an entity with flexibility in determining the method for assessing hedge effectiveness, the methodology used must be reasonable, and must be documented at inception of the hedging relationship. Additionally, Statement 133 requires that an entity use the chosen method consistently throughout the hedge period (a) to assess, at inception of the hedge and on an on-going basis, whether it expects the hedging relationship to be highly effective in achieving offset and (b) to determine the ineffective aspect of the hedge. The method used for assessing hedge effectiveness and measuring ineffectiveness must be documented with sufficient specificity so that a third party could perform the measurement based on the documentation and arrive at the same result as the registrant.

Upon adoption of Statement 133, an entity is required to designate all hedging relationships anew and must comply with the formal documentation requirements of the standard as of the date of adoption.

The staff believes that contemporaneous designation and documentation of a hedging relationship are fundamental to the application of hedge accounting; without it, an entity could retroactively identify a hedged item, a hedged transaction, or a method of measuring effectiveness to achieve a desired accounting result. Accordingly, the staff will challenge the application of hedge accounting in instances where an entity has not contemporaneously complied with Statement 133's formal documentation requirements upon designation of a hedging relationship.

Sale of Securities with Adoption of SFAS 133

The transition provisions contained in paragraph 54 of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, provide that at the date of initial application, an entity may transfer any debt security classified as held-to-maturity pursuant to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, into the available-for-sale category or the trading category and that such reclassification shall not call into question an entity's intent to hold other debt securities to maturity in the future. The transition provisions further require that the unrealized holding gain or loss on a transferred held-to-maturity security be reported as part of the cumulative-effect-type adjustment of net income if transferred to the trading category or as part of the cumulative-effect-type adjustment of accumulated other comprehensive income if transferred to the available-for-sale category.

The staff believes that any security transferred from held-to-maturity pursuant to the adoption of Statement 133 and sold in the same reporting quarter should have been transferred to the trading category. Thus, any unrealized gain or loss on the security that exists on the date of transfer would be reported in net income as part of the cumulative effect of adopting Statement 133 and not included in the gain or loss on the sale of the security. This staff position is not intended to provide guidance as to the holding period for trading securities other than in this narrow situation involving the adoption of Statement 133.

Entities that adopt Statement 133 early in order to take advantage of the one-time reclassification of held-to-maturity securities are reminded that all of the provisions of Statement 133 must be applied upon such initial application. Piecemeal adoption of this Statement is not permitted. Consequently, the staff encourages entities to consider carefully all effects of implementing the Statement in forming a decision as to when to adopt the Statement. The staff expects to monitor closely the implementation of Statement 133.

Amortization Periods Selected for Goodwill

In Opinion No. 17, the Accounting Principles Board concluded that the value of any intangible asset eventually disappears, and required that the cost of such assets be amortized by systematic charges over the periods estimated to be benefited. Several factors to be considered in determining the useful lives of intangible assets are identified in paragraph 27 of that opinion. Other factors that the staff believes are relevant in determining useful lives for goodwill include:

  • Significance of competition in the industry, the level of barriers to entry and the ability of competitors to negatively affect the profitability of the acquired business.
  • Current or expected future levels of industry consolidation.
  • Expected impact of changes in technology on product life cycles and the importance of technological innovation to future success.
  • Uncertain or changing regulatory environment.
  • Uncertainty of continued revenues dependent upon retention/departure of key employees.
  • Relative infancy or maturity of the industry.
  • Customer and employee mobility.
  • Customer turnover.

Identification of the useful life of an unidentifiable intangible or goodwill (the excess of the purchase cost over the fair value of all tangible and identifiable intangible net assets) can be problematic. However, the staff rejects the view that the maximum life of such assets is indeterminable, leading always to use of the maximum amortization period permitted by APB 17 of 40 years. In many circumstances, the maximum reasonably likely duration of material future benefit from the acquired goodwill or other unidentifiable intangible is less than 40 years.

Since 1970 when APB 17 was adopted, financial and commercial markets and business practices have undergone fundamental changes, and rates of change in the business environment have increased dramatically. There remain few examples of intangible assets that have retained material revenue generating capacity after 40 years without alteration or enhancement requiring re-investment of amounts that dwarf the asset's original cost. But periods used to amortize goodwill do not appear to reflect these changes in the environment. Unrealistically long amortization periods inflate earnings and fail to accurately portray the diminishing value of acquired assets.

The staff has expressed concern recently in situations where a long life is assigned to goodwill recognized in the acquisition of a business in an industry having little earnings variability and low barriers to entry. In those circumstances, the staff will challenge registrants to furnish evidence supporting the existence of factors in the business that are likely to generate above average earnings for a period extending beyond 10 years after the acquisition. Factors which the staff would find persuasive would be specific to the acquired business, and not the result of resources that could be brought to the business by an acquirer. Because companies are required to establish and continually evaluate the economic life of goodwill, the staff does not find persuasive arguments that justify a life based exclusively on "industry practice."

Recently, some companies have proposed lengthening the period originally assigned to goodwill based on favorable developments in years subsequent to the acquisition. While re-evaluation of the economic life to recognize effects of adverse developments is necessary, the staff have generally objected to post-acquisition extensions of goodwill's economic life because, contrary to the intent of APB 17, that effectively capitalizes the acquirer's own post-acquisition efforts to extend and enhance the earnings of the acquired business.

Accounting for Intangibles Relating to Customer Relationships

Some intangible assets recognized in a purchase business combination derive their value from future cash flows expected to be derived from the acquired business' identified customers. Companies may also recognize this type of intangible asset when they acquire groups of customer accounts or a customer list. Most commonly, valuable continuing relationships are demonstrated by existing contracts or subscriptions.

When acquired in a business combination or as part of a larger group of assets, the fair value of this intangible is often measured as the present value of the estimated net cash flows from the contracts, including expected renewals. The most reliable indication of life expectancy of a subscriber base or similar customer group is the historical life experience of similar customer accounts. The actuarial-based retirement rate method is the method generally accepted in the appraisal profession to estimate life expectancy. That analysis may be developed if customer initiation and termination data are maintained for each acquired customer group.

Customer relationship assets must be amortized systematically to allocate the capitalized amount over the periods expected to be benefited. Management must evaluate at each balance sheet date whether the actual net cash flows from the acquired customers accounts have been or are likely to become different from those underlying the method of allocating the asset's cost. The applicable accounting literature for recognition of the intangible asset, its amortization, and changes in estimates underlying its amortization is found in APB 17, APB 20, and FAS 121.

Typically, customer relationships within a large group of accounts tend to dissipate at a more rapid rate in the earlier periods following a company's succession to the contracts, with the rate of attrition declining over time until relatively few customers remain who persist for an extended period. Under this pattern, the prepondence of cash flows derived from the acquired customer base will be recognized in income in the earlier periods, and they fall to a materially reduced level in later years. In this circumstance, straight-line cost amortization over the period of expected cash flows will exaggerate net earnings when business is growing at the expense of future generations of shareholders when the rate of growth declines. The staff believes that an accelerated method of amortization, rather than the straight-line method, will result in the most appropriate and systematic allocation of the intangible's cost to the periods benefited. The straight-line method is appropriate only if the estimated life of the intangible asset is shortened to assure that recognition of the cost of the revenues, represented by amortization of the intangible asset, better corresponds with the distribution of expected revenues.

Some registrants failed to recognize the financial reporting effects of customer attrition at levels greater than assumed when they initially selected the amortization method and period. These companies maintained and reported only aggregate attrition statistics which combined all past and current acquisitions of customer accounts. Statistics reported in that manner can hide unfavorable customer attrition occurring within particular acquired customer groups, and can delay the recognition of broader unfavorable trends. A customer attrition rate that is actually static or increasing can appear to be a declining if calculated on a base of customers that is rapidly increasing through new acquisitions.

The staff believes that registrants must maintain records and controls necessary to compare actual and estimated attrition for each material acquired customer group throughout its economic life, and must revise accounting estimates on a timely basis when adverse trends develop. A registrant that makes frequent and continuing purchases of blocks of customers may aggregate different acquisitions occurring within a fiscal quarter and periodically evaluate life expectancy of that grouping, rather than individually, if the customer blocks combined in the quarter are reasonably expected to behave in a similar manner over time.

The complete range of assumptions affecting the life expectancy and related cash flows from customer relationship assets should be tested regularly for continuing relevance. For example, original assumptions regarding pricing or the frequency and pattern of payments may differ from subsequent experience and require revision of the cost amortization. Registrants must also consider the requirements of FAS 121, which prescribes when a long-lived asset must be assessed for impairment such that a write-down to current market value becomes necessary.

Purchase Adjustments to Acquired Company's Loss Accruals

If a registrant accounts for its acquisition of another company using the purchase method of accounting, the target's assets and liabilities are recorded in the registrant's financial statements at their fair values. The target's historical accounting for many liabilities often is premised on its estimates of the amounts to be paid. Fair value amounts recorded for those items by the registrant may be expected to differ from the target's carrying amounts due, at least, to the effects of discounting and changes in interest rates. The staff would not expect large differences between the undiscounted amounts previously estimated by the target and those recognized by the registrant upon the acquisition unless the registrant's plans regarding settlement of the liability are markedly different from those underlying the target's estimates. Except in those circumstances, materially different amounts would undermine the credibility of both the target's and the registrant's financial reporting, and indicate the presence of an accounting error. For example, significant increases to the target's estimated contract losses in some cases have turned out to be "cushions" or general reserves against which subsequent changes in estimates occurring in the ordinary course of business were charged, rather than recognized in income.

The Commission has taken a number of enforcement actions because of improper reserves established in connection with purchased businesses, including the following:

  • AAER No. 598 (September 26, 1994), Meris Laboratories. The Commission found that Meris understated its expenses and overstated income in its financial statements because provisions for future operating costs were capitalized as a result of their improper inclusion in the estimated purchase price of certain business acquisitions.
  • AAER Nos. 778 (May 2, 1996) and 804 (July 24, 1996), Sulcus Computer Corporation and Peter C. Ferraro, CPA, and William G. Stayduhar, CPA. The Commission found that Sulcus materially overstated earnings as a result of improper accounting employed in connection with a series of acquisitions. In connection with each of the acquisitions, Sulcus recorded excess liabilities and/or reserves on its books as of the date of the transaction, and thereafter used the excess reserves to improve post-acquisition earnings.
  • AAER No. 1126 (April 20, 1999), Terex Corporation and Randolph W. Lenz. The Commission found that the improper application of purchase accounting to a subsidiary, Fruehauf Trailer Corporation, caused overstatement of its pre-tax earnings by approximately $77.3 million.

Allowance for Loan Losses

General considerations

The determination of the allowance for loans losses requires significant judgment. The balance in the allowance for loan losses should reflect management's best estimate of probable loan losses related to specifically identified loans as well as probable incurred loan losses in the remaining loan portfolio. FASB Statements 5 and 114 limit loss allowances to losses that have been incurred as of the balance sheet date. Accordingly, allowances for loan losses should be based on past events and current economic conditions.

The Commission provided guidance for registrants regarding the determination of loan loss allowances in FRR-28 (FRC 401.09.b.). Registrants must determine the amounts of their loan loss allowances in an appropriately systematic manner that demonstrates procedural discipline. That procedural discipline should include self-correcting policies that adjust loss estimation methods to reduce differences between estimated and actual observed losses. Filings with the Commission should describe the registrant's accounting policies for determining the amount of the allowance in a level of detail sufficient to explain and describe the systematic analysis and procedural discipline applied.

MD&A should explain the period-to-period changes in estimates for specific elements of the allowance for loan losses and should discuss the extent to which actual experience has differed from original estimates. The reasons for changes in management's estimates should indicate what evidence management relied upon to determine that the revised estimates were more appropriate and how those revised estimates were determined. The discussion should clearly explain how the changes in asset quality disclosed in accordance with Industry Guide 3 have affected the allowance and provision. If historical loss experience appears low or high relative to the level of the allowance at the latest balance sheet date, reconciling explanation should be provided. The effects of any changes in methodology should be explained and justified.

Year 2000 considerations

The credit quality of a loan may be affected by the failure of a borrower's operating or other systems as a consequence of a Year 2000 issue or a borrower's failure to comply with debt covenant terms regarding Year 2000 issues. Creditors' allowances for loan losses, however, should be provided only for losses incurred as of the balance sheet date, and should not be based on the effects of future events.

Financial statement presentation

Allowances for credit losses are valuation accounts that should be presented as a reduction of the carrying value of the related balance sheet item. The allowance for loan losses should not include amounts provided for losses on financial instruments that are not classified on the balance sheet as loans. Amounts recognized for credit losses on certain off-balance-sheet financial instruments (e.g. forwards, and swaps) should be classified separately as liabilities.

Financial institutions must present the provision for loan losses as a deduction in the determination of net interest income, pursuant to Article 9 of Regulation S-X. Credit loss provisions on other types of balance sheet and off-balance sheet items which do not affect net interest income should not be included in the provision for loan losses. Loss provisions not related to interest income should be recorded in other appropriate categories of income or expense. Direct transfers of amounts between the allowance for loan losses and other credit loss allowances are not appropriate. Changes in the amount of the allowance for loan losses should be reflected in the provision for loan losses, while changes in other allowances should be reflected in other appropriate categories of income or expense.

Internal Costs Associated with an Acquisition

Paragraph 76 of APB 16 specifies that indirect and general expenses related to business acquisitions are deducted as incurred, rather than capitalized as costs of the acquisition. Interpretation No. 33 of APB 16 further specifies that all "internal costs" associated with the business acquisition must be expensed, while "out of pocket" or "incremental" costs, such as finder's fees or fees paid to outside consultants may be capitalized. The staff believes that amounts paid to employees, even if characterized as finder's fees or payable only upon consummation of an acquisition, are internal costs which must be expensed as incurred, rather than capitalized.

Redeemable Securities and "Deemed Liquidation Events"

Commission releases and staff accounting bulletins (Rule 5-02 of Regulation S-X, Financial Reporting Codification Section 211, SAB 3C, and SAB 6B(1)) describe the accounting and reporting that is applicable to mandatorily redeemable preferred stock and all similar equity securities. Redeemable equity securities should be presented separately from "stockholders' equity" if they are redeemable at the option of the holder, or at a fixed date at a fixed price, or redemption is otherwise beyond the control of the registrant. This presentation is required even if the likelihood of the redemption event occurring is considered remote. For more information, see "Frequently Requested Accounting and Financial Reporting Interpretations and Guidance" at the SEC web site.

In some cases, the feature of the equity security that makes it redeemable is characterized as a "liquidation event." Ordinary liquidation events, which involve the redemption and liquidation of all equity securities, do not result in a security being classified as redeemable equity. However, "deemed" liquidation events that require one or more particular classes or types of equity security to be redeemed cause those securities to be classified outside of permanent equity.

Examples of deemed liquidation events that we have seen as requiring the redemption of preferred stock and such redemption is beyond the control of the registrant include the following:

  • a change in control
  • delisting from a stock exchange
  • inability to deliver common shares under a conversion provision
  • violation of a debt or other covenant
  • failure to have an IPO declared effective by a particular date.

These events are commonly characterized as "deemed liquidation" events, and the clauses describing such events are commonly included in the "Liquidation" section of the preferred stock indentures. By characterization of the provisions as liquidation provisions, registrants have sought to avoid ASR 268 treatment. However, the staff believes that these types of provisions are equivalent to ordinary redemption clauses that would cause the securities to be classified outside of permanent equity.

Changes in Functional Currency

FASB Statement No. 52, Foreign Currency Translation, requires the assets, liabilities, and operations of a foreign operation to be measured using the functional currency of that foreign operation. The functional currency is the currency of the primary economic environment in which the entity operates, normally the currency in which the operation generates and expends cash. Appendix A to SFAS 52 provides guidance for determination of the functional currency. Once the functional currency has been determined, SFAS 52 requires that determination to be used consistently unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed.

Registrants with foreign operations in economies that have recently experienced economic turmoil should evaluate whether significant changes in economic facts and circumstances have occurred that warrant reconsideration of their functional currencies. Registrants with foreign operations in economies that have adopted the Euro currency should make similar evaluations. Determination of the functional currency is also required when the economy in which a foreign operation is located ceases to be highly inflationary.

The staff would expect a registrant's analysis to focus on factors that affect the specific foreign operation's cash flows. For example, problems in an Asian economy could cause local currency cash flow sources to severely diminish for a self-contained foreign operation and clearly indicate a different primary currency. Conversely, these problems generally would not indicate a change in functional currency for a foreign operation that is an integral component or extension of the parent company's operations. The staff generally will be skeptical that currency exchange rate fluctuations alone would cause a self-contained foreign operation to become an extension of the parent company. Remeasurement of assets and results using the registrant's reporting currency in lieu of determining the functional currency is appropriate only when the foreign operations are in a highly inflationary economy as defined by SFAS 52.

SFAS 52 does not prescribe specific disclosures about a change in functional currency. However, the staff believes that disclosures in the financial statements and MD&A may be necessary to permit an investor to understand the foreign operations and their impact on the registrant's results of operations, liquidity, and cash flows. Registrants should consider the need to disclose the nature and timing of the change, the actual and reasonably likely effects of the change, and economic facts and circumstances that led management to conclude that the change was appropriate. The effects of those underlying economic facts and circumstances on the registrant's business should also be discussed in MD&A.

Effects of Changes to Financial Statements Filed with the Commission in an IPO

In some cases, as a result of a correction of an error within the scope of paragraph 36 of APB 20 or retroactive adjustment of an accounting principle under the special provisions of paragraph 29, financial statements previously furnished with an accompanying audit report to security holders who were not promoters or related parties are changed for use in an initial registration statement, or financial statements included in a filing with the Commission are changed in subsequent amendment or other filing. In each of these cases, disclosure must be made in the financial statements pursuant to paragraphs 37 and 30, respectively, of APB 20, and Rule 3-03(c) of Regulation S-X. We believe the change should also be referenced in the auditor's report, as indicated by AICPA Auditing Standards Section 561.06.a., with dual dating of the audit report necessary in some circumstances. If the financial statements used in a "red herring" prospectus circulated to investors are subsequently changed for correction of an error, we believe financial statements and audit report highlighting and explaining the restatement must appear in the final prospectus, or in a prospectus that is recirculated prior to the final prospectus. In any case, we believe it is the responsibility of management to disclose to current users of a prospectus how the financial statements are different from those previously considered by the investors or from those which the registrant used to raise capital from earlier investors.

Market Risk Disclosures

On January 28, 1997, the Commission adopted amendments to Regulation S-K, Regulation S-X, and various forms (Securities Act Release No. 7386) to clarify and expand existing requirements for disclosures about derivatives and market risks inherent in derivatives and other financial instruments. Derivative financial instruments are defined in FASB Statement No. 119 to include futures, forwards, swaps, and options. Derivative commodity instruments are defined in the Release to be commodity contracts that are permitted by contract or business custom to be settled in cash or with another financial instrument (e.g., commodity futures, commodity forwards, commodity swaps, and commodity options). Other financial instruments are defined in FASB Statement No. 107 to include, for example, investments, including structured notes, loan receivables, debt obligations, and deposit liabilities. The requirements for quantitative and qualitative information about market risk apply to all registrants except registered investment companies and small business issuers.

In general, the release:


requires enhanced descriptions of accounting policies for derivatives in the footnotes to the financial statements;


requires quantitative and qualitative disclosures about market risk inherent in derivatives and other financial instruments outside the financial statements; and


provides a reminder to registrants to supplement existing disclosures about financial instruments, commodity positions, firm commitments, and other anticipated transactions with related disclosures about derivatives.

On July 31, 1997, the staff released Questions and Answers about the New "Market Risk" Disclosure Rules. The interpretive answers were prepared by the staffs of the Office of the Chief Accountant and the Division of Corporation Finance. This publication is posted at the Commission's internet site: www.sec.gov.

Based on the Division's reviews of filings by some registrants required to provide the disclosures about derivatives and market risks inherent in derivatives and other financial instruments, we have the following suggestions:

Accounting Policies for Derivatives

Remember to provide all of the disclosures regarding accounting policies for certain derivative financial instruments and derivative commodity instruments, to the extent material, as required by Rule 4-08(n) of Regulation S-X and SFAS 119. Include clear disclosure of the method used to account for each type of derivative financial instrument and derivative commodity instrument.


Remember to cite the new Item specifically (e.g. Item 7A for Form 10-K or Item 9A for Form 20-F) in the form. Registrants can include the quantitative and qualitative disclosures under the Item reference, cross-reference from the Item reference to the disclosures elsewhere in the filing, or indicate under the Item reference that the disclosures are not required (See Rule 12b-13).

Registrants may need to discuss a material exposure under the Item even though they do not invest in derivatives. For example, registrants that have investments in debt securities or have issued long-term debt should discuss risk exposure if the impact of reasonably possible changes in interest rates would be material. Likewise, registrants that have invested or borrowed amounts in a currency different from their functional currency should discuss risk exposure if the impact of reasonably possible changes in exchange rates would be material.

The market risk disclosures can refer to the financial statements but disclosures required by the new rules should be furnished outside the financial statements. The "safe harbor" established under the new rules does not extend to information presented in the financial statements.

Quantitative Disclosures

Tabular Presentation. Include all relevant terms of the related market sensitive instruments. In addition, disclose the method and assumptions used to determine estimated fair value, cash flows and future variable rates. In addition, segregate instruments by common characteristics and by risk classification.

Sensitivity Analysis and Value at Risk (VAR). Disclose the types of instruments (e.g., derivative financial instruments, other financial instruments, derivative commodity instruments) included in the sensitivity analysis and VAR analysis and provide an adequate description of the model and the significant assumptions used such as the magnitude and timing of selected hypothetical changes in market prices, method for determining discount rates, or key prepayment or reinvestment assumptions. Indicate whether other instruments are included voluntarily, such as certain commodity instruments and positions outside the required scope of the rule, cash flows from anticipated transactions, etc.

Qualitative Disclosures

Explain clearly how the Company manages its primary market risk exposures including the objectives, general strategies and instruments, if any, used to manage those exposures. Explain clearly the changes in how the Company manages its exposures during the year in comparison to the prior year and any known or expected changes in the future.

Revenue and Cost Recognition in Co-Marketing Arrangements

Co-marketing agreements allow sharing of risks and rewards of long-term marketing programs. An advertiser, broadcaster or internet service or content provider may charge less for marketing a retailer's products in exchange for a participation in the sales proceeds. In some cases, the retailer or the advertiser will guarantee the other party a minimum sales level. Also, in some cases, the retailer will advance funds for start-up costs. For example, funds advanced for internet marketing may be for hardware and software of the network server, product data-base interfaces, customer interfaces, and special interfaces between the retailer and the internet service. The terms of the co-marketing arrangement may be contained in a single contract, or in several contracts entered into at the same time.

A company advancing funds must recognize the use of the advance as an expense, purchase of a fixed asset, or, in limited cases, as a deferred cost in accordance with the substantive terms and deliverables specified in the co-marketing agreement. In one recent case, a retailer that was deferring recognition of any marketing expense until the advertising program commenced was required to revise its financial statements to expense the advance as the start-up goods and services for which it contracted were delivered by the advertiser.

Guarantees or make-wells by one co-marketing partner to the other typically necessitate deferral of revenue recognition by the guarantor to the extent of its guarantee because realization of its share of revenues under the co-marketing agreement is not reasonably assured unless the likelihood of having to perform under the guarantee is remote. A make-well agreement by the advertiser to furnish additional advertising services to the extent that income to the retailer did not meet specified minimum levels also creates a contingency necessitating the advertiser's deferral of its marketing program income to the extent of the value of the additional advertising contingently offered.

Write-Offs of Prepayments for Services, Occupancy or Usage

Some registrants that make significant prepayments for advertising and promotional services do not expect revenues directly attributable to the advertising during the period of its broadcast to be sufficient to recover its cost. Some have proposed that some or all of the prepayment be written off upon its disbursement, rather than recognized as the services are received. The staff believes that the assessment of recoverability of this prepayment is not different from other amounts prepaid or contractually committed for future services, occupancy or rights to use. While the registrant may believe that losses are likely during the "start-up," "build-out" or "expansionary" phase of its business, general accounting practices do not provide for the write-off of prepaid amounts, or accrual of firmly committed amounts, as a loss upon inception of the service, lease and similar agreement. Instead, GAAP requires that the amounts be amortized or recognized systematically over the period that the service, occupancy or usage occurs. See, for example, paragraph 44 of SOP 93-7. Results of operations for periods in which the services are received would not be accurately presented if the registrant reduced the cost of service to an amount less than both its historical cost to the Company and its fair value.

Cost or Equity Method of Accounting

An investment must be accounted for using the equity method if the investor has significant influence over the investee's operating and financial policies. Significant influence is presumed to exist where the investor owns 20-50% of the investee's voting stock. In some circumstances, that presumption is overcome by predominant evidence to the contrary. FASB Interpretation No. 35 sets forth indicators, which are not all-inclusive, that an investor may be unable to exercise significant influence. Disclosure must be made if the registrant accounts for an investment differently than would be presumed for the voting interest held.

In a recent case, the staff disagreed with a registrant that believed the presumption of significant influence was overcome. Despite holdings exceeding 20 of the voting stock of certain investees, the registrant accounted for the investments at cost (or as marketable securities under FASB Statement No. 115). The registrant argued that it had not influenced the investees, and did not intend to do so. However, since the accounting depends on the ability of the investor to influence the investee, the staff believed revision of the financial statements was necessary.

In another circumstance, the staff questioned a registrant's use of the cost method even though it held less than 20% of an investee, because other facts indicated that significant influence existed. In this case, the staff believed the equity method was necessary where a registrant held only 19% of the voting stock but was entitled to select more than 20% of the investee's board of directors.

FASB Interpretation No. 35 requires an investor to evaluate all facts and circumstances relating to the investment when any of the identified or similar circumstances exist, in order to reach a judgment about whether presumptions concerning the ability or inability to significantly influence the investee should be overcome. In addition to factors identified by FIN 35, the staff considers the nature, form and significance to the investee of all of the investor's financial and operating interest in the investee, the protective and participating rights of the investor and other investors, and whether the investor's participation in the board is disproportionate to its common stock voting interest.

Accounting for Extended Warranty Plans

FASB Technical Bulletin 90-1 provides accounting guidance for separately priced extended warranty and product maintenance contracts. Companies that enter into warranty contracts with customers must recognize the contract revenue over the contract period on a straight-line basis, unless sufficient, company-specific, historical evidence indicates that the costs of performing services under the contracts are incurred on other than a straight-line basis.

The staff recently became aware that some registrants have recognized substantially all of the warranty contract revenue upon sale of the contract to the customer if the registrant simultaneously reinsured its risk under the contract through an insurance company. Restatement of the financial statements to amortize revenue over the warranty contract term was necessary in these cases in accordance with TB 90-1. The amounts paid for insurance must be accounted for in accordance with paragraph 44 of FASB Statement No. 5. Generally, registrants should account for reinsurance contracts with third party insurers by analogy to FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. The registrant's obligation to the holder of the warranty contract and the re-insurance premiums paid to the insurance companies must be reflected on a gross basis in accordance with FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts.

In some cases, the registrant is not the primary obligor under the warranty contract. Instead, a third party is the primarily liable to the customer and the registrant acts solely as a broker that sells that party's warranty contracts to the customer. TB 90-1 is not applicable to the registrant in this circumstance. However, presentation of gross contract revenues and expenses by the broker is inappropriate. Instead, the registrant should present only its net fee as broker. If the registrant has continuing obligations after sale of the warranty contract as an administrative agent or in another capacity, amortization of the fee over the contract term is usually necessary.

SFAS 45 Guidance Limited to Franchise Agreements

The staff believes registrants should not analogize guidance in FASB Statement No. 45, Accounting for Franchise Fee Revenue, to agreements which do not satisfy all the criteria of a franchise agreement specified in paragraph 26 of that statement. The Board extracted from the AICPA Industry Accounting Guide the specialized accounting and reporting principles for franchise agreements without comprehensive reconsideration of that guidance in the context of broader principles of revenue recognition which are generally acceptable for other arrangements. Service contracts and agreements authorizing sales representatives and distributorships generally are not within the scope of SFAS 45.

Disclosures about "Targeted Stock"


Some registrants have issued classes of stock which they characterize as "targeted" or "tracking" stock because they are referenced in some manner to a specific business unit, activity or assets of the registrant. The staff is concerned that the style and content of disclosures about the operations referenced by a class of common stock may give the inaccurate impression that the investor has a direct or exclusive financial interest in that unit.

Notwithstanding the title given to a particular class of stock, an investor in any of a registrant's classes of common stock has a financial interest only in the residual net assets of the registrant, allocated among the shareholder classes in accordance with the formulae stipulated in the coporate charter. Assets and income attributed to units referenced by each class typically are available to all of the registrant's creditors, and even other classes of shareholders, in the event of liquidation. While dividends declared on each class may not exceed some measure of the performance of the referenced business unit, no dividends need be declared at all. Moreover, the dividend declaration policies typically are subject to change and need bear no relationship to the relative performance of the referenced businesses. Methods and assumptions that can significantly affect measurement of the referenced unit's performance typically can be changed at any time without the consent of the security holders.

Characterizations of the security as "tracking" a business unit

If no term of the targeted stock requires or assures that potential distributions will correlate with the performance of the business unit nominally associated with the security, implications that the market value of the security will "track," or is otherwise linked with, a business unit are subject to challenge. The staff has asked registrants to explain in their filings why the formula for determining the amount available for dividends (or any other term or feature of the security) can be expected to link in some fashion the market value of a class of common stock with the value or performance of any subpart of the registrant, or state clearly that management does not intend to imply such a linkage.

Recommended approach to disclosure about targeted stock

While the staff encourages robust disclosure about the registrant's operating segments, presenting information about the referenced businesses as if distinct from the registrant may confuse investors about the nature of the security. We believe companies should integrate discussions and quantitative data about the referenced business units more closely within a comprehensive discussion of the registrant's financial condition and operating results. While schedules or condensed financial information demonstrating the calculation of earnings available for each class of the registrant's common stock are relevant, more extensive presentations can be misunderstood and should be reconsidered. If a company chooses to present more than condensed financial data, the staff has recommended that companies present no greater detail than "consolidating financial statements" that include the referenced businesses together with the financial statements of the registrant. That presentation would show explicitly how management and the board have allocated and attributed revenues, expenses, assets, liabilities, and cash flows, but will not necessarily reflect earnings applicable to the different classes of stock due to features of the allocation formula which are incompatible with GAAP.

Use of separate full financial statements for a referenced business unit

Notwithstanding our recommendation to the contrary, some issuers of targeted stock have chosen to present complete separate audited financial statements of the referenced units. In this case, the staff believes that financial statements of the referenced unit furnished to investors should be accompanied always by financial statements of the registrant, as issuer of the security. Most auditors will permit use of their report on the financial statements of the referenced business only in those circumstances. EPS of one class of stock should not be presented alone or within the separate financial statements of the referenced business security because that business did not issue the security. EPS with respect to any class of the issuer's securities should be presented only with the issuer's consolidated financial statements or with its related consolidated information.

Consequences of formula-based financial statements

In some cases, separate financial statements presented in an issuer's filing do not appear to be an actual business or division, but rather an elaborate depiction of the earnings allocation formula for a class of stock, as if those legal terms defined an accounting entity. For example, sometimes that formula results in the depiction of one of the issuer's businesses as if it had a financial interest in another of its businesses. Financial statements prepared in accordance with the dictates of management, the board and the corporate charter for the purpose of measuring earnings available to a class of shareholders do not necessarily present fairly the financial condition, cash flows and operating results of an actual business unit within the registrant.

The staff has raised a number of questions in these circumstances: Do financial statements based on these formulae comply with GAAP? Does the association of the auditor with these presentations give unwarranted comfort to investors about the fairness to the different shareholder groups of management's assignment of revenues and expenses and its allocation of capital and other costs. Are the financial statements "special purpose" financial statements that are prepared on a basis of accounting prescribed in a contractual agreement, requiring special considerations for disclosure and auditor association?

Non-GAAP measures of performance

In some cases, the terms of the targeted stock stipulate explicitly that the performance of the unit will be measured on a basis that departs from GAAP. Any measurement, classification, allocation or disclosure that departs from GAAP but is necessary to measure or explain amounts available for dividends on stock referenced to the unit should be depicted separately from presentations that are purported to be in accordance with GAAP. An amount should not be labeled as "net income" unless it is calculated in accordance with GAAP. If the financial statements of the unit are purported to be in accordance with GAAP, management should ensure that all information essential for a fair presentation of the entity's financial position, results of operations, and cash flows in conformity with GAAP is set forth in the financial statements. Failure to include all such information should result in a qualification of the auditor's report on the unit's financial statements.

Cost allocations

The units referenced by the targeted stock may share many common costs, such as general and administrative and interest costs. As required by SAB Topic 1B, a complete description of any allocation methods used for cash, debt, related interest and financing costs, corporate overhead, and other common costs should be provided in the notes to the financial statements that purport to be prepared in accordance with GAAP. The amounts likely to be reported by the entity were it a stand-alone entity should be disclosed. In some cases, the staff has questioned whether allocations have been biased. For example, operating results and EPS of operations that are valued on the basis of earnings could be unfairly inflated as a result of excessive allocations of common costs to operations that are valued on the basis of revenue growth. If the methodologies and assumptions underlying the allocations of debt and corporate expenses may change without securityholder approval, that fact should be stated clearly. If the financial statements of the business unit before and after the issuance of the tracking stock will not be comparable, that fact should be disclosed. On occasion, the staff has questioned whether a change in the method of attributing revenue or expense from one shareholder group to another would be reported as a change in reporting entity or, if deemed a change in estimate or principle, how the auditor will determine whether a change is a "better" method of calculating earnings attributable to a particular shareholder group.

Other disclosure issues

Other areas of disclosure that are of particular significance for issuers of targeted stock include the following:

  • Policies for the management of cash generated by and capital investment in the referenced units, and for the pricing of "transactions" between the referenced units.

  • Conflicts of interest.

  • Effects of corporate events (mergers, tender offers, changes in control, adverse tax rulings, liquidation) on rights of the security holders.

  • Terms under which one class may be converted into another class.

  • Effects of changes in relative market values of the registrant's outstanding classes of stock on rights of the security holders.

Gain on Sale or Securitization of Financial Assets

At the March 1998 meeting of the Emerging Issues Task Force, the SEC staff reminded registrants of the requirements of GAAP in accounting for a sale or securitization of financial assets and any assets that are retained or received or liabilities that are incurred.

  • Recognition of gains or losses on the sale of financial assets is not elective. Paragraph 11 of FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, requires that upon completion of a transfer of financial assets that satisfies the conditions for a sale, the transferor shall (a) derecognize all assets sold, (b) recognize and initially measure at their fair value all assets obtained and liabilities incurred, and (c) recognize in earnings any gain or loss on the sale. The transferor should not defer in the balance sheet a gain or loss resulting from the sale of financial assets.
  • In estimating the fair value of retained and new interests, the assumptions used in those valuations must be consistent with market conditions. In accounting for a sale of financial assets, fair value is used in allocating the carrying amount of the financial assets between the assets sold and the interests retained. Fair value also is used in the initial measurement of assets obtained and liabilities incurred in a sale. Fair value is the amount at which an item could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Paragraph 43 of Statement 125 prescribes that if quoted market prices are not available, the estimate of fair value shall be based on the best information available, which may include the results of valuation techniques. If fair values are estimated, those valuations should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. Thus, using assumptions that are not consistent with current market conditions in order to ascribe intentionally low or high values to new or retained interests is not appropriate.
  • Assumptions and methodologies used in estimating the fair value of similar instruments should be consistent. The discussion of fair value in paragraph 43 of Statement 125 provides useful guidance in the determination of fair value for both initial and subsequent measurements. That guidance indicates that in estimating the fair value of instruments that do not have quoted market prices, the quoted market prices of similar investments or the current market information assumed in valuing similar instruments may be considered. Likewise, it would be inappropriate to use significantly different values or assumptions for new or retained instruments that are similar.
  • Significant assumptions used in estimating the fair value of retained and new interests at the balance sheet date should be disclosed. Significant assumptions generally include quantitative amounts or rates of default, prepayment, and interest. FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of fair values at the balance sheet date for retained and new interests that are financial instruments. In addition, paragraph 10 of Statement 107 requires the disclosure of significant assumptions used to estimate the fair value of those instruments. Paragraph 17(e)(2) of Statement 125 requires similar disclosure of fair value and significant assumptions for recognized servicing assets and servicing liabilities. Assumptions regarding defaults, prepayments, and discount rates generally are significant in estimating the fair values of financial instruments, servicing assets, and servicing liabilities and, therefore, should be disclosed.

Combining Companies in a Pooling of Interest

Presenting Different Fiscal Years

Companies combining in a pooling of interests may have fiscal year ends that differ by greater than 93 days. Rule 3A-02(b) of Regulation S-X permits the financial statements of the constituents to be combined retroactively even if their respective fiscal periods do not end within 93 days, except that the financial statements for the fiscal year in which the merger is consummated must be recast to dates which do not differ by more than 93 days.

Companies ordinarily may select among a number of different ways to conform historical periods of a combined company. Parts of the conforming company's fiscal year may be either excluded from or double counted in the combined income statement. The most preferable presentation usually will combine twelve sequential months of the conforming company's results while minimizing the number of days that are omitted or counted twice. The staff will object to methods of retroactively combining the financial statements that do not result in a fair representation of historical results of the combined entities.

Disclosure should be made of the periods combined and of the revenues, net income before extraordinary items and net income of any interim periods excluded from, or included more than once in, the results of operations as a result of such recasting. Disclosure should also be made on the face of the statement of cash flows, or in the notes to the financial statements, of the operating, investing and financing cash flows of any interim period excluded from the recast combined financial statements. Additional quantitative and narrative disclosure about gross profit, selling and marketing expenses, operating income may be necessary to inform readers about the effects of unusual charges or adjustments in the omitted or double counted period.

Requirement for Retroactive Restatement

If a business combination is otherwise properly accounted for as a pooling of interests, a failure to retroactively restate results on a combined basis is a departure from GAAP. The staff will request restatement if the effect on any line item reported in the financial statements for any year presented would be materially different. While registrants may expect the staff to challenge a failure to retroactively restate if the effect on any line item exceeds 3%, they should be aware that effects smaller than 3% could be material to investors in some circumstances.

Issues in the Extractive Industry

Mining Exploration Costs

Recoverability of capitalized costs is likely to be insupportable under FASB Statement No. 121 prior to determining the existence of a commercially minable deposit, as contemplated by Industry Guide 7 for a mining company in the exploration stage. As a result, the staff would generally challenge capitalization of exploration costs, and believes that those costs should be expensed as incurred during the exploration stage under US GAAP.

Definition of Proved Reserves

Over the last several years, the estimation and classification of petroleum reserves has been impacted by the development of new technologies such as 3-D seismic interpretation and reservoir simulation. Computer processor improvements have allowed the increased use of probabilistic methods in proved reserve assessments. These have led to issues of consistency and, therefore, some confusion in the reporting of proved oil and gas reserves by public issuers in their filings with the Commission. This section discusses some issues the Division of Corporation Finance's engineering staff has identified in its review of such filings.

The definitions for proved oil and gas reserves for the SEC are found in Rule 4-10(a) of Regulation S-X of the Securities Exchange Act of 1934. The SEC definitions are below in bold italics. Under each section we have tried to explain the SEC staff's position regarding some of the more common issues that arise from each portion of the definitions. As most engineers who deal with the classification of reserves have come to realize, it is difficult, if not impossible, to write reserve definitions that easily cover all possible situations. Each case has to be studied as to its own unique issues. This is true with the Society of Petroleum Engineers' and others' reserve definitions as well as the SEC's definitions.

1.  Proved oil and gas reserves are the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided by contractual arrangements, but not on escalations based upon future conditions.

The determination of reasonable certainty is generated by supporting geological and engineering data. There must be data available which indicate that assumptions such as decline rates, recovery factors, reservoir limits, recovery mechanisms and volumetric estimates, gas-oil ratios or liquid yield are valid. If the area in question is new to exploration and there is little supporting data for decline rates, recovery factors, reservoir drive mechanisms etc., a conservative approach is appropriate until there is enough supporting data to justify the use of more liberal parameters for the estimation of proved reserves. The concept of reasonable certainty implies that, as more technical data becomes available, a positive, or upward, revision is much more likely than a negative, or downward, revision.

Existing economic and operating conditions are the product prices, operating costs, production methods, recovery techniques, transportation and marketing arrangements, ownership and/or entitlement terms and regulatory requirements that are extant on the effective date of the estimate. An anticipated change in conditions must have reasonable certainty of occurrence; the corresponding investment and operating expense to make that change must be included in the economic feasibility at the appropriate time. These conditions include estimated net abandonment costs to be incurred and duration of current licenses and permits.

If oil and gas prices are so low that production is actually shut-in because of uneconomic conditions, the reserves attributed to the shut-in properties can no longer be classified as proved and must be subtracted from the proved reserve data base as a negative revision. Those volumes may be included as positive revisions to a subsequent year's proved reserves only upon their return to economic status.

2.  Reservoirs are considered proved if economic producibility is supported by either actual production or conclusive formation test. The area of a reservoir considered proved includes that portion delineated by drilling and defined by gas-oil and/or oil-water contacts, if any, and the immediately adjoining portions not yet drilled, but which can be reasonably judged as economically productive on the basis of available geological and engineering data. In the absence of information on fluid contacts, the lowest known structural occurrence of hydrocarbons controls the lower proved limits of the reservoir.

Proved reserves may be attributed to a prospective zone if a conclusive formation test has been performed or if there is production from the zone at economic rates. It is clear to the SEC staff that wireline recovery of small volumes (e.g. 100 cc) or production of a few hundred barrels per day in remote locations is not necessarily conclusive. Analyses of open-hole well logs which imply that an interval is productive are not sufficient for attribution of proved reserves. If there is an indication of economic producibility by either formation test or production, the reserves in the legal and technically justified drainage area around the well projected down to a known fluid contact or the lowest known hydrocarbons, or LKH may be considered to be proved.

In order to attribute proved reserves to legal locations adjacent to such a well (i.e. offsets), there must be conclusive, unambiguous technical data which supports reasonable certainty of production of such volumes and sufficient legal acreage to economically justify the development without going below the shallower of the fluid contact or the LKH. In the absence of a fluid contact, no offsetting reservoir volume below the LKH from a well penetration shall be classified as proved.

Upon obtaining performance history sufficient to reasonably conclude that more reserves will be recovered than those estimated volumetrically down to LKH, positive reserve revisions should be made.

3.  Reserves which can be produced economically through applications of improved recovery techniques (such as fluid injection) are included in the "proved" classification when successful testing by a pilot project, or the operation of an installed program in the reservoir, provides support for the engineering analysis on which the project or program was based.

If an improved recovery technique which has not been verified by routine commercial use in the area is to be applied, the hydrocarbon volumes estimated to be recoverable cannot be classified as proved reserves unless the technique has been demonstrated to be technically and economically successful by a pilot project or installed program in that specific rock volume. Such demonstration should validate the feasibility study leading to the project.

4.  Estimates of proved reserves do not include the following:

  • oil that may become available from known reservoirs but is classified separately as "indicated additional reserves";
  • crude oil, natural gas, and natural gas liquids, the recovery of which is subject to reasonable doubt because of uncertainty as to geology, reservoir characteristics, or economic factors;
  • crude oil, natural gas, and natural gas liquids, that may occur in undrilled prospects;
  • crude oil, natural gas, and natural gas liquids, that may be recovered from oil shales, coal, gilsonite and other sources.

Geologic and reservoir characteristic uncertainties such as those relating to permeability, reservoir continuity, sealing nature of faults, structure and other unknown characteristics may prevent reserves from being classified as proved. Economic uncertainties such as the lack of a market (e.g. stranded hydrocarbons), uneconomic prices and marginal reserves that do not show a positive cash flow can also prevent reserves from being classified as proved. Hydrocarbons "manufactured" through extensive treatment of gilsonite, coal and oil shales are mining activities reportable under Industry Guide 7. They cannot be called proved oil and gas reserves. However, coal bed methane gas can be classified as proved reserves if the recovery of such is shown to be economically feasible.

In developing frontier areas, the existence of wells with a formation test or limited production may not be enough to classify those estimated hydrocarbon volumes as proved reserves. Issuers must demonstrate that there is reasonable certainty that a market exists for the hydrocarbons and that an economic method of extracting, treating and transporting them to market exists or is feasible and is likely to exist in the near future. A commitment by the company to develop the necessary production, treatment and transportation infrastructure is essential to the attribution of proved undeveloped reserves. Significant lack of progress on the development of such reserves may be evidence of a lack of such commitment. Affirmation of this commitment may take the form of signed sales contracts for the products; request for proposals to build facilities; signed acceptance of bid proposals; memos of understanding between the appropriate organizations and governments; firm plans and timetables established; approved authorization for expenditures to build facilities; approved loan documents to finance the required infrastructure; initiation of construction of facilities; approved environmental permits etc. Reasonable certainty of procurement of project financing by the company is a requirement for the attribution of proved reserves. An inordinately long delay in the schedule of development may introduce doubt sufficient to preclude the attribution of proved reserves.

The history of issuance and continued recognition of permits, concessions and commerciality agreements by regulatory bodies and governments should be considered when determining whether hydrocarbon accumulations can be classified as proved reserves. Automatic renewal of such agreements cannot be expected if the regulatory body has the authority to end the agreement unless there is a long and clear track record which supports the conclusion that such approvals and renewal are a matter of course.

5.  Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Additional oil and gas expected to be obtained through the application of fluid injection or other improved recovery techniques for supplementing the natural forces and mechanisms of primary recovery should be included as "proved developed reserves" only after testing by a pilot project or after the operation of an installed program has confirmed through production response that increased recovery will be achieved.

Currently producing wells and wells awaiting minor sales connection expenditure, recompletion, additional perforations or bore hole stimulation treatment would be examples of properties with proved developed reserves since the majority of the expenditures to develop the reserves has already been spent.

Proved developed reserves from improved recovery techniques can be assigned after either the operation of an installed pilot program shows a positive production response to the technique or the project is fully installed and operational and has shown the production response anticipated by earlier feasibility studies. In the case with a pilot, proved developed reserves can be assigned only to that volume attributable to the pilot's influence. In the case of the fully installed project, response must be seen from the full project before all the proved developed reserves estimated can be assigned. If a project is not following original forecasts, proved developed reserves can only be assigned to the extent actually supported by the current performance. An important point here is that attribution of incremental proved developed reserves from the application of improved recovery techniques requires the installation of facilities and a production increase.

6.  Proved undeveloped oil and gas reserves are reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion. Reserves on undrilled acreage shall be limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units can be claimed only where it can be demonstrated with certainty that there is continuity of production from the existing productive formation. Under no circumstances should estimates of proved undeveloped reserves be attributable to any acreage for which an application of fluid injection or other improved recovery technique is contemplated, unless such techniques have been proved effective by actual tests in the area and in the same reservoir. (Emphasis added)

The SEC staff points out that this definition contains no mitigating modifier for the word certainty. Also, continuity of production requires more than the technical indication of favorable structure alone (e.g. seismic data) to meet the test for proved undeveloped reserves. Generally, proved undeveloped reserves can be claimed only for legal and technically justified drainage areas offsetting an existing productive well (but structurally no lower than LKH). If there are at least two wells in the same reservoir which are separated by more than one legal location and which show communication (reservoir continuity), proved undeveloped reserves could be claimed between the two wells, even though the location in question might be more than an offset well location away from any of the wells. In this illustration, seismic data could be used to help support this claim by showing reservoir continuity between the wells, but the required data would be the conclusive evidence of communication from production or pressure tests. The SEC staff emphasizes that proved reserves cannot be claimed more than one offset location away from a productive well if there are no other wells in the reservoir, even though seismic data may exist. The use of high-quality, well calibrated seismic data can improve reservoir description for performing volumetrics (e.g. fluid contacts). However, seismic data is not an indicator of continuity of production and, therefore, can not be the sole indicator of additional proved reserves beyond the legal and technically justified drainage areas of wells that were drilled. Continuity of production would have to be demonstrated by something other than seismic data.

In a new reservoir with only a few wells, reservoir simulation or application of generalized hydrocarbon recovery correlations would not be considered a reliable method to show increased proved undeveloped reserves. With only a few wells as data points from which to build a geologic model and little performance history to validate the results with an acceptable history match, the results of a simulation or material balance model would be speculative in nature. The results of such a simulation or material balance model would not be considered to be reasonably certain to occur in the field to the extent that additional proved undeveloped reserves could be recognized. The application of recovery correlations which are not specific to the field under consideration is not reliable enough to be the sole source for proved reserve calculations.

Reserves cannot be classified as proved undeveloped reserves based on improved recovery techniques until such time that they have been proved effective in that reservoir or an analogous reservoir in the same geologic formation in the immediate area. An analogous reservoir is one having at least the same values or better for porosity, permeability, permeability distribution, thickness, continuity and hydrocarbon saturations.

7.  Topic 12 of Accounting Series Release No. 257 of the Staff Accounting Bulletins states:

In certain instances, proved reserves may be assigned to reservoirs on the basis of a combination of electrical and other type logs and core analyses which indicate the reservoirs are analogous to similar reservoirs in the same field which are producing or have demonstrated the ability to produce on a formation test.

If the combination of data from open-hole logs and core analyses is overwhelmingly in support of economic producibility and the indicated reservoir properties are analogous to similar reservoirs in the same field that have produced or demonstrated the ability to produce on a conclusive formation test, the reserves may be classified as proved. This would probably be a rare event especially in an exploratory situation. The essence of the SEC definition is that in most cases there must at least be a conclusive formation test in a new reservoir before any reserves can be considered to be proved.

8.  Statement of Financial Accounting Standards 69, paragraph 30.a. requires the following disclosure:

Future cash inflows. These shall be computed by applying year-end prices of oil and gas relating to the enterprise's proved reserves to the year-end quantities of those reserves.

This requires the use of physical pricing determined by the market on the last day of the (fiscal) year. For instance, a west Texas oil producer should determine the posted price of crude (hub spot price for gas) on the last day of the year, apply historical adjustments (transportation, gravity, BS&W, purchaser bonuses, etc.) and use this oil or gas price on an individual property basis for proved reserve estimation and future cash flow calculation (this price is also used in the application of the full cost ceiling test). A monthly average is not the price on the last day of the year, even though that may be the price received for production on the last day of the year. Paragraph 30b) states that future production costs are to be based on year-end figures with the assumption of the continuation of existing economic conditions.

9.  Probabilistic methods of reserve estimating have become more useful due to improved computing and more important because of its acceptance by professional organizations such as the SPE. The SEC staff feels that it would be premature to issue any confidence criteria at this time. The SPE has specified a 90% confidence level for the determination of proved reserves by probabilistic methods. Yet, many instances of past and current practice in deterministic methodology utilize a median or best estimate for proved reserves. Since the likelihood of a subsequent increase or positive revision to proved reserve estimates should be much greater than the likelihood of a decrease, we see an inconsistency that should be resolved. If probabilistic methods are used, the limiting criteria in the SEC definitions, such as LKH, are still in effect and shall be honored. Probabilistic aggregation of proved reserves can result in larger reserve estimates (due to the decrease in uncertainty of recovery) than simple addition would yield. We require a straight forward reconciliation of this for financial reporting purposes.

10.  We have seen in press releases and web sites disclosure language by oil and gas companies which would not be allowed in a document filed with the SEC. We will request that any such disclosures be accompanied by the following cautionary language:

Cautionary Note to U.S. Investors -- The United States Securities and Exchange Commission permits oil and gas companies, in their filings with the SEC, to disclose only proved reserves that a company has demonstrated by actual production or conclusive formation tests to be economically and legally producible under existing economic and operating conditions. We use certain terms {in this press release/on this web site}, such as [identify the terms], that the SEC's guidelines strictly prohibit us from including in filings with the SEC. U.S. Investors are urged to consider closely the disclosure in our Form XX, File No. X-XXXX, available from us at [registrant address at which investors can request the filing]. You can also obtain this form from the SEC by calling 1-800-SEC-0330.

Examples of such disclosures would be statements regarding "probable," "possible," or "recoverable" reserves among others.

11.  The SEC staff reminds professionals engaged in the practice of reserve estimating and evaluation that the Securities Act of 1933 subjects to potential civil liability every expert who, with his or her consent, has been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation used in connection with the registration statement. These experts include accountants, attorneys, engineers or appraisers.

Goodwill and Purchase Business Combinations

The staff often has challenged recognition of goodwill in acquisitions of entities whose dominant business is the ownership and operation of oil and gas or mineral properties. In the absence of other substantial business activities, the staff presumes that substantially all the value of the acquired entity not otherwise accounted for by tangible and identifiable intangible assets is derived from the value of the mineral or oil and gas reserves owned by that entity. In these business combinations, the purchase price ordinarily should be allocated entirely to the properties and other net tangible and identifiable intangible assets acquired, with no allocation to goodwill. However, if an excess purchase price is clearly indicated by all reasonable valuations of the oil and gas or mineral properties and other net tangible and intangible assets, recognition of goodwill would be appropriate. Also, the staff does not view recognition of goodwill as inconsistent with business combinations involving entities that have substantial activities outside of owning and operating oil and gas or mineral properties.

Applicability of SFAS 121

Registrants that use the successful efforts method of accounting for oil and gas producing activities are required to assess impairment of proved properties using SFAS 121. The promulgation of SFAS 121 did not supersede the guidance in paragraph 28 of SFAS 19 on how to assess unproved properties for impairment.

Paragraph 25 of SFAS 121, which amends SFAS 19, states that its guidance applies only to proved properties and the costs of the enterprise's wells and equipment and facilities. Future net cash flows from unproved properties should not be grouped with future net cash flows from proved properties for purposes of evaluating proved properties or other related equipment and facilities for impairment.

If a registrant chooses to adopt a policy of evaluating unproved properties for impairment using future net cash flows, i.e., a methodology consistent with SFAS 121, it should consider paragraph 9 of SFAS 121. That paragraph requires a registrant to consider the likelihood of possible outcomes in determining the best estimate of future cash flows. The less objectively verifiable the source of the cash flows, the more likely those cash flows will not be fully realized.

If future net cash flows are used to evaluate unproved properties for impairment, registrants should risk adjust any unproved (sometimes referred to as probable or possible) reserves before estimating future cash flows associated with those resources. A "shortcut" method whereby a discount factor is applied only after calculating net cash flows derived from 100% of unproved reserves may materially overstate cash flows associated with properties where recovery costs currently exceed cash inflows. In addition, registrants should identify the categories of reserves included in assessing impairment of unproved properties, and the extent to which they are risk adjusted, in the notes to the financial statements.

Hedging Transactions

Registrants with financial instruments that are appropriately designated as price hedges of oil and gas quantities under FASB Statement Nos. 80 or 133 (including designation by specific properties) should apply the hedge-adjusted prices to determine proved reserve quantities and the standardized measure of discounted future cash flows. If the impact of the agreements is material to the FASB Statement No. 69 disclosure, the impact should be quantified in a note to the SFAS 69 data. In addition, if hedging activity had a material impact on average oil and gas prices received during the year, the impact should be quantified and discussed in MD&A.

Exploration Stage (Development Stage) Mining Companies

Instructions to paragraph (a) of Industry Guide 7 state that "Mining companies in the exploration stage should not refer to themselves as development stage companies in the financial statements, even though such companies should comply with FASB Statement 7, if applicable." As a result, financial statement headnotes and footnotes for exploration stage companies should describe the companies as being in the "exploration stage," rather than development stage. This is because the term development stage as defined in Industry Guide 7 applies only to companies with established commercially minable deposits (reserves) for extraction, which are not in the production stage.


Internationalization of the Securities Markets

Foreign Issuers in the U.S. Market

Foreign companies raising funds from the public or having their securities traded on a national exchange or the Nasdaq Stock Market are generally subject to the registration requirements of the Securities Act and the registration and reporting requirements of the Exchange Act. The Commission has provided a separate integrated disclosure system for foreign private issuers that provides a number of accommodations to foreign practices and policies. These accommodations include:

  • interim reporting on the basis of home country and stock exchange practice rather than quarterly reports;
  • exemption from the proxy rules and the insider reporting and short swing profit recovery provisions of Section 16;
  • aggregate executive compensation disclosure rather than individual disclosure, if so permitted in an issuer's home country;
  • acceptance of three International Accounting Standards relating to cash flow statements (IAS # 7), business combinations (IAS # 22) and operations in hyperinflationary economies (IAS # 21);
  • offering document financial statements updated principally on a semi-annual, rather than a quarterly basis; and
  • an exemption from Exchange Act registration under Section 12(g) for foreign private issuers that have not engaged in a U.S. public offering or whose securities are not traded on a national exchange or the Nasdaq Stock Market.

Additionally, the Commission staff has implemented procedures to review foreign issuers' disclosure documents on an expedited basis and in draft form, if requested by the issuer. This helps to facilitate cross-border offerings and listings in light of potentially conflicting home-country schedules and disclosure requirements.

Over the last five years, the number of foreign companies accessing the U.S. public markets has increased dramatically. As of December 31, 1999, there were over 1200 foreign companies from over 55 countries filing periodic reports with the Commission.

Reflecting the importance of audit quality in filings by foreign issuers, the SEC Practice Section of the AICPA changed certain of its membership rules to address SECPS member firms with foreign associated firms that audit SEC registrants. Under the new rules, SECPS members must seek the adoption of policies and procedures by the international organization or individual foreign associated firms that are consistent with SECPS objectives for audits of financial statements of SEC registrants. The SECPS member will report to the AICPA the name and country of any foreign associated firms that demonstrates compliance with that objective. The new rules also establish minimum procedures to be performed by a knowledgeable reviewer with respect to documents to be filed with the SEC.

International Accounting Standards

The International Accounting Standards Committee (IASC) is an independent, private sector body that was formed in 1973 by the professional accounting bodies in the U.S. and eight other industrialized countries to improve and harmonize accounting standards. The Commission has worked with the IASC through the International Organization of Securities Commissions (IOSCO) since 1987 in an effort to develop a set of accounting standards for cross-border offerings and listings.

In July 1995, IOSCO and the IASC joined in an announcement that the IASC had developed a four-year work program focusing on a core set of standards previously identified by IOSCO as being the necessary components of a reasonably complete set of accounting standards. The announcement noted that completion of comprehensive core standards that are acceptable to the IOSCO Technical Committee would allow the Technical Committee to recommend endorsement of the standards for cross-border capital raising and listing purposes in all global markets.

In April 1996, the IASC announced that it had accelerated its work program in order to complete work on the core standards in 1998. The Commission responded with a press release expressing support for the IASC's objective. The Commission's statement noted that the standards should include a core set of accounting pronouncements that constitute a comprehensive, generally accepted basis of accounting; that the standards be of high quality, i.e., they must result in comparability and transparency, and they must provide for full disclosure; and that the standards must be rigorously interpreted and applied.

The IASC has completed substantially all the components of its core standards project, and both IOSCO and the Commission currently are engaged in a detailed assessment of the completed standards. On February 16, 2000, the Commission approved and issued for comment a concept release regarding the use of IASC standards (Securities Act Release No. 7801). The release seeks feedback from domestic and foreign parties regarding both the acceptance of IAS and the broader issue of shaping a global financial structure for increasingly globalized markets.

The release solicits comment regarding the quality of the IASC standards and raises questions regarding what supporting infrastructure is necessary in an environment where issuers and auditors often are multinational organizations, providing financial information in many countries. The release seeks to identify what important concerns would be raised by acceptance of IASC standards; and then asks for comment on whether the Commission should modify its current requirement for all financial statements to be reconciled to U.S. GAAP. The release emphasizes a desire to gain knowledge of respondents' first hand experience with IAS. In particular, it asks about experiences that (a) issuers have had with applying IASC standards when preparing financial statements; (b) public accountants have had with auditing the application of the standards; and (c) investors have had with using financial statements prepared using those standards.

The deadline for comments from the public was May 23, 2000.

International Disclosure Standards – Amendments to Form 20-F

On September 28, 1999, the Commission adopted changes to its non-financial statement disclosure requirements for foreign private issuers, to conform those requirements more closely to the International Disclosure Standards endorsed by IOSCO in September 1998 (Securities Act Release No. 7745). The changes are intended to harmonize disclosure requirements on fundamental topics among the securities regulations of various jurisdictions.


The Commission has long supported the concept of a harmonized international disclosure system, and for a number of years has been working with other members of IOSCO to develop a set of international standards for non-financial statement disclosures that could be used in cross border offerings and listings. The International Disclosure Standards developed by IOSCO reflect a consensus among securities regulators in the major capital markets as to the types of disclosures that should be required for cross border offerings and listings. The Standards cover fundamental disclosure topics such as the description of the issuer's business, results of operations and management and the securities it plans to offer or list.

Changes to Foreign Integrated Disclosure System

The Commission amended Form 20-F, the basic Exchange Act registration statement and annual report form used by foreign issuers, to incorporate the International Disclosure Standards. The Commission also revised the Securities Act registration forms designated for use by foreign private issuers, and related rules and forms, to reflect the changes in Form 20-F. The amendments do not change the financial statement reconciliation requirements for foreign issuers, and the Commission will continue to require disclosure on topics not covered by the International Disclosure Standards, such as disclosures relating to market risk and specialized industries such as banks. Unlike the IOSCO International Disclosure Standards, which were intended to apply only to offerings and listings of common equity securities and only to listings and transactions for cash, the amendments to Form 20-F apply to all types of offerings and listings and to annual reports. The Commission also revised the definition of "foreign private issuer," which determines an issuer's eligibility to use certain Commission forms and benefit from certain accommodations under Commission rules, to clarify how issuers should calculate their U.S. ownership for purposes of the definition.

Amended Form 20-F includes new Item 8 which specifies the form, content and age of financial statement requirements for foreign filers. New Item 8 supersedes Rule 3-19 of Regulation S-X. However, Items 17 and 18 of Form 20-F have been retained without substantive change. In general, the financial reporting requirements for foreign registrants will not change, except for the age of financial statements in a registration statement.

Amended Form 20-F reduces the period before audited financial statements of the most recently completed fiscal year are required from 6 months after fiscal year end to 3 months, except the 6-month period has been retained for specified types of continuous offerings, such as outstanding warrants and convertible securities and dividend reinvestment plans. Amended Form 20-F also reduces the period after fiscal year-end within which updating interim financial statements must be provided from 10 months to 9 months. If interim financial statements are required, they must cover a period of at least six months.

Amended Form 20-F also includes a more stringent age of financial statement requirement for initial public offerings. However, an instruction to Item 8 clarifies that this applies only where the registrant's securities are not publicly traded in any jurisdiction. Further, the instruction indicates that the staff will waive the more stringent requirement where it is impracticable or involves undue hardship. Amended Form 20-F retains the requirement that financial information more current than the required interim period must be included in a registration statement if that information has otherwise been published.

These amendments do not change the due date for filing an annual report on Form 20-F, which continues to be 6 months after fiscal year end.

The changes to Form 20-F, the Securities Act registration forms and the "foreign private issuer" definition become effective beginning in September 2000, but foreign registrants are encouraged to use the new forms before that date.

The full text of the rule changes can be found on the SEC's web site at: www.sec.gov/rules/final/34-41936.htm.


Other Information About the Division of Corporation Finance and Other Commission Offices and Divisions

The SEC Website and Other Information Outlines

The Commission's website at www.sec.gov is an excellent source of current information about Commission actions, rule proposals, and other developments of interest to public companies and investors. An outline of Frequently Requested Accounting and Financial Reporting Interpretations and Guidance may be found at www.sec.gov/divisions/corpfin/guidance/cfactfaq.htm. Also, an outline of Current Issues and Rulemaking Projects in the Division of Corporation Finance may be located through the index of Commission Notices and Information at www.sec.gov/rules/othrindx.htm.

Corporation Finance Staffing and Phone Numbers

The Division's organizational structure follows:

Division Director – David B.H. Martin (202) 942-2800

Deputy Director – Michael McAlevey (202) 942-2810


Principal Associate Director (Disclosure Operations) – Shelley Parratt (202) 942-2830

Associate Director (Operations) – Jim Daly

Associate Director (Operations) – Bill Tolbert

Disclosure Support

Associate Director (Legal) – Martin P. Dunn (202) 942-2890

Associate Director (Regulatory Policy) – Mauri Osheroff (202) 942-2840

Senior Counsel to the Director – Anita Klein (202) 942-2980

Office of the Chief Accountant

Associate Director (Chief Accountant) – Robert Bayless (202) 942-2850

Craig Olinger, Deputy Chief Accountant (202) 942-2850


Liaison to:

Foreign Private Issuers

Melanie Dolan, Associate Chief Accountant (202) 942-2960


Liaison to:

Office # 3 (Computers and Office Equipment)


Office # 5 (Transportation & Leisure)


Office # 6 (Manufacturing and Construction)

Joel Levine, Associate Chief Accountant (202) 942-2960


Liaison to:

Office # 2 (Consumer Related Products)


Office # 8 (Real Estate and Business Services)


Office # 10 (Electronics and Machinery)


Office # 12 (Structured Finance)

Leslie Overton, Associate Chief Accountant (202) 942-2960


Liaison to:

Office # 4 (Natural Resources and Food)


Office # 9 (Small Business)


Office # 11 (Telecommunications)

Carol Stacey, Associate Chief Accountant (202) 942-2960


Liaison to:

Office # 1 (Healthcare and Insurance)


Office # 7 (Financial Services)

Assistant Directors and Assistant Chief Accountants

#1 Health Care and Insurance - Jeffrey Reidler (202) 942-1840


Assistant Chief Accountants:


Robert Littlepage

(202) 942-1947


Martin James

(202) 942-1984

#2 Consumer Related Products - H. Christopher Owings (202) 942-1900


Assistant Chief Accountants:


Barbara Stark

(202) 942-2861


Jim Allegretto

(202) 942-1885

#3 Computers and Office Equipment vacant (202) 942-1800


Assistant Chief Accountants:


Lisa Mitrovich

(202) 942-1836


Dennis Muse

(202) 942-1862

#4 Natural Resources and Food Roger Schwall (202) 942-1870


Assistant Chief Accountants:


Kim Calder

(202) 942-1879


Barry Stem

(202) 942-1919

#5 Transportation and Leisure vacant (202) 942-1850


Assistant Chief Accountants:


David Humphrey

(202) 942-1995


Joseph Foti

(202) 942-1952

#6 Manufacturing and Construction - Steven Duvall (202) 942-1950


Assistant Chief Accountants:


Jim Rosenberg

(202) 942-1803


John Hartz

(202) 942-1798

#7 Financial Services - Todd Schiffman (202) 942-1760


Assistant Chief Accountants:


John Sniegon

(202) 942-1765


Don Walker

(202) 942-1799

#8 Real Estate and Business Services - Paula Dubberly (202) 942-1960


Assistant Chief Accountants:


Linda Van Doorn

(202) 942-1964


Hugh Miller

(202) 942-1962

#9 Small Businesses - Richard Wulff (202) 942-2950


Assistant Chief Accountants:


Ed Loftus

(202) 942-2954


Al Pavot

(202) 942-1764

#10 Electronics and Machinery - Peggy Fisher (202) 942-1880


Assistant Chief Accountants:


Margery Reich

(202) 942-1839


Tia Jenkins

(202) 942-1902

#11 Telecommunications - Barry Summer (202) 942-1990


Assistant Chief Accountants:


Terry French

(202) 942-1998


Carlos Pacho

(202) 942-1876

#12 Structured Finance and New Products - Mark Green (202) 942-1940

Other Offices

Office of Chief Counsel – Marty Dunn, Chief (202) 942-2900

Office of Mergers and Acquisitions – Dennis O. Garris, Chief (202) 942-2920

Office of International Corporate Finance – Paul Dudek, Chief (202) 942-2990

Office of EDGAR and Information Analysis – Herbert Scholl, Chief (202) 942-2930

Division Employment Opportunities for Accountants

The Division has about 100 staff accountants with specialized expertise in the various industry offices. The Division provides a fast-paced, challenging work environment for accounting professionals. Our staff works on hot IPOs and current and emerging accounting issues. We influence accounting standards and practices and interact with the top professionals in the securities industry.

A staff accountant's responsibilities include examining financial statements in public filings and finding solutions to the most difficult and controversial accounting issues. A minimum of 3 years' experience in a public accounting firm or public company dealing with SEC reporting is required. If you want to experience a unique learning opportunity and explore the depth and breadth of accounting theory, principles, and practices, call (202) 942-2960 or visit our website at employment opportunities for information on employment opportunities in the Division.