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Explore latest developments in Corporation Finance including SOX Sections 404 and 302, ICFR evaluations, and DCP reviews. Learn about F/S restatements and disclosure controls in this informative guide.
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CURRENT DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE National Conference on Current SEC & PCAOB Developments December 6, 2004
Disclaimer • The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Therefore, the views expressed today are our own, and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission.
Corporation Finance • Overview • Financial Reporting and Disclosure Issues
Corporation Finance • OVERVIEW • Craig Olinger
Accounting Branch Chiefs • Health Care & Insurance • James Atkinson • Consumer Products Michael Moran George Ohsiek • Computers & On Line Services Stephen Krikorian Brad Skinner • Natural Resources & Food • Jill Davis • Structured Finance, Transportation & Leisure Linda Cvrkel Michael Fay David Humphrey
Accounting Branch Chiefs • Manufacturing & Construction • John Cash • Rufus Decker • Financial Services • John Nolan • Kevin Vaughn • Real Estate & Business Services • Kathleen Collins • Donna DiSilvio • Emerging Growth Companies • Hugh West
Accounting Branch Chiefs • Electronics & Machinery • Brian Cascio • Daniel Gordon • Telecommunications • Terry French • Robert Littlepage • Kyle Moffatt
Financial Reporting and Disclosure • SOX Section 404 and 302 • Use of Other Auditors Louise Dorsey Stephanie Hunsaker
SOX Section 404 and 302 Effective Date for 404 404 vs. 302 Requirements Interaction of 404 and 302 • Evaluating ICFR • Management’s Report • FAQs
Effective Date of 404 for Accelerated Filers • 10-K due March 16, 2005 • 11/17/04 – SEC postponed final phase-in period for one year • Annual report deadline still 75 days • Quarterly report deadlines still 40 days • Accelerated filing phase-in resumes for FYE ending on or after 12/15/05 • Annual report- due in 60 days • Quarterly report- due in 35 days
Effective Date of 404 for Accelerated Filers • 11/30/04 – Exemptive Order • 45 Day Extension for cos. with • <$700 mil market cap at end of 2nd Qtr • 10-K still due March 16, 2005 • All required items except 404 reports
Effective Date of 404 for Accelerated Filers • 10-K/A should include: • Two 404 reports • 302 certifications • 307/308 disclosures, revised as needed • Consent, if necessary (i.e. shelf offerings, etc) • Due 5/2/05 for calendar year filers • Co. not timely for S-3 until 10-K/A filed • No 12b-25 on the 10-K/A
404 – ICFR Annually assess ICFR Review conducted as of year-end Quarterly evaluation of any changes in ICFR Documentation requirements for auditor to test Internal control report 302 – DCP Quarterly assess DCP Review conducted as of quarter and year-end Quarterly evaluation of any changes in DCP N/A – no auditor testing requirements Officers’ certification 404 vs 302 Requirements
Interaction of 404 and 302 • Substantial overlap DCP and ICFR • DCP includes components of ICFR that provide reasonable assurance that transactions are recorded as necessary to permit preparation of F/S in accordance with GAAP • Key differences • DCP – apply to material financial and non-financial information required in public reports • ICFR covers items that do not directly relate to disclosure
Interaction of 404 and 302 • To the extent that ICFR impacts public disclosure, DCP are inclusive of such internal controls • Disclosure controls apply to all material information to be included in financial reports, both within & outside f/ss
Interaction of 404 and 302 • Question • Could you have a situation where CFO/CEO reach a conclusion in their 302 certifications that DCP are effective at reasonable assurance level, even though there is a material weakness in ICFR?
Interaction of 404 and 302 • Answer • Generally officers will not be able to conclude DCP are effective when material weaknesses have been identified in IFCR • But…… • There may be some limited circumstances
Interaction of 404 and 302 • Some elements of ICFR are not directly subsumed within the definition of DCP • Example in 404 adopting release– pure safeguarding of assets
Interaction of 404 and 302 • Likely impossible to conclude DCP are effective when material weaknesses exist in certain areas: • Example: • Material weakness in fraud prevention • Multiple material weaknesses
Interaction of 404 and 302 • Question • What if a company has to restate its F/S because it or the auditor discovers a material weakness in ICFR that is also part of the company’s DCP?
Interaction of 404 and 302 • ANSWER • Need to consider whether the disclosures provided under Item 307 in original filing must be: • modified, supplemented or corrected • in order to explain relationship between failure of DCP and restated F/S
Interaction of 404 and 302 • If officers conclude original conclusions are no longer correct: • Disclose this fact based on duty to correct a misstatement when it became known and Rule 12b-20
Interaction of 404 and 302 • Question • Can the officers conclude DCP were not effective as of end of reporting period covered by amended report, but conclude DCP are effective as of date the amendment filed?
Interaction of 404 and 302 • Answer • Yes – • Company should expand disclosure to explain how mgmt determined DCP are now effective given the material weakness and other matters identified
Interaction of 404 and 302 • Other Areas for Disclosure? • MD&A Disclosure • Material weakness in ICFR may constitute a material trend or uncertainty that should be disclosed in MD&A • Detailed discussion of material weakness • quantification and analysis of associated uncertainties & trends
Evaluating ICFR • Will vary among companies • No specific method or procedures required • Must be based on procedures sufficient to evaluate both design & operating effectiveness • Documentation & evidential matter is key • Inquiry alone not adequate!
Evaluating ICFR • Mgmt must attain the level of “reasonable assurance” when formulating conclusions regarding effectiveness of ICFR • Reasonable Assurance • Conforms to current auditing literature (AU 319) • Mgmt must use judgment • Implies consideration by mgmt of the cost of the control and its benefits in reducing risk
Management’s Report • No standard format • Certain statements to be included: • Management’s responsibility for ICFR • Framework used • Mgmt’s assessment of the effectiveness of ICFR, as of end of most recent year • Auditor has issued report on ICFR • Disclosure of any material weaknesses
Management’s Report, cont’d • Other Requirements: • Report should be located in “close proximity” to auditor’s attestation report • If management’s report contains additional information (i.e. plans, corrective actions to be taken, etc.) • Auditor to disclaim additional information
Management’s Report • 2 Possible Options • Effective • Not Effective • Prohibited from concluding effective ICFR if one or more material weaknesses
Management’s Report • What if management does not have the ability to assess certain aspects of ICFR? • Example: • SAS 70 report not available at service organization and no other ability to assess controls in place at the service organization
Management’s Report • NO scope limitation permitted in report • Mgmt must conclude if ICFR effective or not effective based on extent of scope limitation
Management’s Report • EXCEPTIONS ( SEC FAQ 1, 2, 3) • FAQ 1 – FIN 46 – entity in existence prior to 12/15/03 • FAQ 2 – equity method investments • FAQ 3 – acquisitions – 1 yr max.
Required Communications • Mgmt must communicate all significant deficiencies & material weaknesses they detect to audit committee & external auditor • Part of 302 certification • Mgmt also must provide written representations to auditor
SEC FAQs • 23 FAQ’s • Updated October 6, 2004 • www.sec.gov/info/accountants/controlfaq1004.htm • PCAOB also issued 3 separate sets of Staff Q&As (39) • June 23, 2004 • October 6, 2004 • November 22, 2004
SEC FAQs • Scope Limitations – Questions 1–3 • FAQ 1 – consolidated VIEs, proportionate consolidations • What is the meaning of “does not have the right or authority to assess”? • Neither legal rights nor ability of mgmt to remediate deficiencies are necessarily tied to mgmt’s ability to assess ICFR • Facts and circumstances will dictate when mgmt has the ability
SEC FAQs • FAQ 2- Equity investee • Not intended to prohibit registrants from assessing ICFR of investees under the equity method
SEC FAQs • FAQ 3 – Recent business acquisition • Intent of issuing FAQ 3 is not to negatively impact mgmt’s business decisions • Will likely not object to anyone who decides to use this relief in the year of acquisition • “Business” as defined in EITF 98-3 or Article 11 of S-X
SEC FAQs • FAQ 4 – Conclusion that ICFR is not effective • Registrant will still be considered timely & current re: • Rule 144, S-2/S-3/S-8 eligibility
SEC FAQs • FAQ 9 – Disclosure of changes to ICFR made in preparation of 1st Mgmt report • Giving relief for the 302 requirement to disclose material changes in ICFR HOWEVER….. • If change is driven from material weakness, notwithstanding the relief that is being given, registrants should carefully consider disclosing the material weakness and the resulting changes
SEC FAQs • Other most frequent: • FAQ 8 – Transition reports • FAQ 14 – SAS 70 reports • FAQ 21 – Consents • FAQ 22 – Annual “glossy” reports • FAQ 23 – Supplementary information
Other Questions • IPO -Initial 404 assessment • Due with first annual report • once effective date passes • Discontinued operations not finalized as of end of year • No relief
Other Questions • Registrants in Chapter 11 • No automatic exemption from 404 • If registrant qualifies for modified reporting under SLB 2 then registrant does not need to comply with 404 • Must request relief in advance
What we are seeing • Significant deficiencies & material weaknesses identified are being disclosed in Form 8-K and Form 10-Q • Typical areas where significant deficiencies/material weaknesses have been identified: • Personnel issues • Financial systems • Restatements due to lack of controls
Final Remarks • We know there will be material weaknesses Key is disclosure • What the problem is • What it impacts • How are you going to remediate • Timetable for remediation
Use of Other Auditors • EXAMPLE: • U.S. auditor relies on work of foreign audit firm to perform work on foreign subs of registrant • U.S. firm chooses not to place reliance on work of other audit firm (i.e. no reference to other auditor)
Use of Other Auditors • Foreign firm must be registered with PCAOB if: • Performing a “substantial portion of the audit” • Foreign firm must be “recognized” by SEC
Use of Other Auditors • “Recognition” of Foreign Firm • Registration with PCAOB does not supercede existing means by which a firm demonstrates its qualifications to practice before the SEC • US affiliation and Appendix K compliance • Demonstration to OCA of knowledge and experience of applying U.S. GAAP, PCAOB standards, SEC rules and SEC independence requirements
Use of Other Auditors • Other Questions: • What if U.S. firm uses local persons as independent contractors? • i.e., Individuals, not firms • Is the U.S. firm required to travel to the foreign location as part of the audit?
Other Auditor Issues • Licensing Requirements • Have seen instances where auditor is not licensed in the state or country where principal audit procedures were conducted • Problematic in certain instances • Addressing on case-by-case basis • Contact DCF with questions on real life fact patterns