Chapter 14

1. Chapter 14 SEC Reporting

2. SEC • The Securities and Exchange Commission (SEC) is an independent federal agency created in 1934 responsible for regulating securities markets. • The ability of companies to raise capital in the stock markets and the hundreds of millions of shares that are traded daily are both indications of the SEC’s success in maintaining an effective marketplace for companies issuing securities and for investors seeking capital investments

3. History of Securities Regulation • The need for regulation has gone hand in hand with the offering of securities to the general public. • In the thirteenth century, King Edward established a Court of Alderman to regulate security trades in London.

4. History of Securities Regulation • In the latter part of the eighteenth century, England’s Parliament passed several acts, termed the Bubble Acts, to control questionable security schemes that had become popular. • In 1790, the New York Stock Exchange was created to serve as a clearinghouse for securities trades between members of the exchange.

5. History of Securities Regulation • The need for additional sources of capital paralleled the advent of the industrial revolution and the growth of commerce in the United States. • Some individuals took advantage of this situation and offered securities of fictitious companies for sale to the general public or used financial reports that were not factual about the offering company’s financial picture.

6. History of Securities Regulation • In 1911, because of the lack of any federal security regulatory laws, several states began passing what were called “blue sky,” that is, which did not have a sound financial base. • During 1920s, a number of abuses (as shown on the next slide) were occurring in the marketplace.

7. History of Securities Regulation • Certain speculators sought to manipulate selected stock prices by issuing untrue press releases. • Companies were not required to be audited, and some of them issued false and misleading financial statements. • Investors were using excessive amounts of margin; that is, they were borrowing heavily to invest in stocks. • Some employees of companies were using inside information to trade their companies stock personal advantage.

8. History of Securities Regulation • The month of October 1929, is often viewed as the beginning of the Great Depression. • Stock prices plunged to record lows within just a few weeks as panic took over the market. • It became obvious that some form of federal regulation was necessary in order to restore confidence in the stock market.

9. History of Securities Regulation • The Securities Act of 1933 regulated the initial distribution of security issues by requiring companies to make “full and fair” disclosure of their financial affairs before their securities could be offered to the public. • The Securities Exchange Act of 1934 required the periodic updating of financial information for all companies whose stocks were traded on a stock exchange. • In addition, the 1934 act created the Securities and Exchange Commission.

10. History of Securities Regulation • The SEC has the legal responsibility to regulate trades of securities and to determine the types of financial disclosures that a publicly held company must make. • Although the SEC has the ultimate legal authority to establish the disclosure requirements, it has worked closely with the accounting profession to prescribe accounting principals and standards.

11. History of Securities Regulation • The SEC’s role is to ensure full and fair disclosure; it does not guarantee the investment merits of any security. • The SEC has consistently taken the position that investors must have the necessary information to make their own assessments to the risk and return attributes of a security.

12. History of Securities Regulation • The present role of the SEC is complex. • In 1935, its first year of full activity, only 284 new securities were registered for sale to the general public. • Now the number of new securities being registered for sale has grown to more than 5,000 per year. • The SEC also regulates more than 10,000 securities brokers and dealers and must monitor stock exchange volumes often surpassing a billion shares a day.

13. EDGAR • The SEC has developed an electronic report filing systems known as EDGAR (Electronic Data Gathering Analysis, and Retrieval). • EDGAR filings may be on the World Wide Web, under the SEC’s home page (www.sec.gov) within 24 hours of filing.

14. International Harmonization • In the late 1980s, the SEC urged the International Organization of Securities Commission (IOSCO) to increase its efforts to narrow the alternative accounting treatments allowed for international accounting standards.

15. International Harmonization • With the encouragement of the SEC and the IOSCO, the International Accounting Standards Board (IASB) has been working on revising its accounting standards to develop a more comparable and uniform set of standards that could be used by all companies seeking financing through any of the world’s major stock markets, including those of the United States.

16. Organizational Structure of the SEC • The Commission consists of five members appointed by the President of the United States, with the advice and consent of the Senate. • The four divisions of the SEC are as follows: • Division of Corporation Finance • Division of Enforcement • Division of Investment Management • Division of Market Regulation

17. Laws Administered by the SEC • In addition to the Securities Acts of the 1933 and 1934, the Commission is responsible for administering other laws established to regulate companies or individuals involved with the securities markets. The Laws are provided on the next slide.

18. Laws Administered by the SEC • Public Utility Holding Company Act of 1935 • Trust Indenture Act of 1939 • Investment Company Act of 1940 • Investment Advisors Act of 1940 • Securities Investor Protection Act of 1970 • Foreign Corrupt Practices Act of 1977 • Federal Bankruptcy Acts • Sarbanes-Oxley Act of 2002

19. The Regulatory Structure • Regulation S-X and Regulation S-K, govern the preparation of financial statements and associated disclosures made in reports to the SEC. • Regulation S-X presents the rules for preparing financial statements, footnotes, and auditor’s report. • Regulation S-K covers all the non-financial items, such as management’s discussion and analysis of the company’s operations and present financial position.

20. The Regulatory Structure • Financial Reporting Releases (FRRs) disclose amendments or adoption of new rules that affect prepares of financial statements and other disclosures. • Accounting and Auditing Enforcement Releases (AAERs) present the results of enforcement actions taken against accountants or other participants in the filing process. • The use of FRRs and AAERs was initiated in 1982. Prior to that time, Accounting Series Releases (ASRs) were used.

21. The Regulatory Structure • Staff Accounting Bulletins (SABs) allow the Commission’s staff to make announcements on technical issues with which it is concerned as a result of reviews of SEC filings. • SABs are not formal actions of the Commission; nevertheless, most preparers do follow these bulletins because they represent the views of the staff that will be reviewing their companies’ filings.

22. Basic Information Package (BIP) • In the 1980, the SEC undertook a project to reduce the duplicative disclosures companies were required to make for the annual report and in each additional filing with the SEC; that is, the Commission sought to integrate all the disclosures (a.k.a., “incorporation by reference”). • The five classes of information constituting the BIP are provided on the next slide.

23. Basic Information Package (BIP) • Market price and dividends • Selected financial data • Management discussion and analysis (MD&A) • Audited financial statements and supplementary data • Other information

24. The Registration Process • Companies wishing to sell debt (or stock) securities in interstate offerings to the general public are generally required by the Securities Act of 1933 to register those securities with the SEC. • The process of public offerings of securities begins with the preparation of the registration statement. The most common are Form S-1, Form S-2, and Form S-3.

25. SEC Review and Public Offering • Most first-time registrants receive a “customary review,” which is a thorough examination by the SEC and may result in acceptance or, alternatively, a comment letter specifying the deficiencies that must be corrected before that securities may be offered for sale. • Established companies that already have stock widely traded generally are subject to a summary review or a cursory review.

26. SEC Review and Public Offering • Once the registration statement becomes effective, the company may begin selling securities to the public. • This review period is 20 days unless the company receives a comment letter from the SEC.

27. SEC Review and Public Offering • Between the time the registration statement is presented to the SEC and it’s effective date, the company may issue a preliminary prospectus, referred to as a red herring prospectus, which provides tentative information to investors about an upcoming issue.

28. SEC Review and Public Offering • The name “red herring” comes from the red ink used on the cover for this preliminary prospectus, indicating that it is not a offering statement and that the securities being discussed are not yet available for sale. • In addition, the company generally prepares a “tombstone ad” in the business press to inform investors of the upcoming offering. These ads are bordered in black ink, hence the title.

29. SEC Review and Public Offering • The time period between the initial decision to offer securities and the actual sale may not exceed 120 days. In the interim, many factors may effect the stock market and may decrease the company’s ability to obtain capital. • In 1982, the SEC devised the shelf registration rule for large, established companies with other issues of stock already actively traded.

30. SEC Review and Public Offering • These companies file a registration statement with the SEC for a stock issue that may be “brought off the shelf” and, with the aid of an underwriter, updated within a very short time, usually two or three days. • A shelf registration is limited to 10 percent of the company’s currently outstanding stock, but allows large companies to select the optimal time to sell their stock.

31. Accountants’ Legal Liability • Accountants play a key role in the preparation of the registration statement. • Accountants are liable for any materially false or misleading information to the effective date of the registration statement. • Plaintiffs suing the accountant are not required to show they relied on the registration statement, only that the statement was wrong at the effective date!!!

32. Accountants’ Legal Liability • Accountants have a “due diligence” defense, the result of interpretations by the courts as to what is generally required in a reasonable investigation of the company’s financial position; however, the broad legal exposure causes many anxieties for accountants involved with the offering of securities.

33. Periodic Reporting Requirements • Form 10-K is the annual report of the SEC and must be filed within 90 days after the end of the company’s fiscal year. • Form 10-Q is the interim report of the SEC; it is due within 45 days after the end of each quarter except the fourth quarter, when the 10-K is issued.

34. Periodic Reporting Requirements • Form 8-K is used to disclose unscheduled material events. This form is due within 15 days after the occurrence of the “current event,” defined as follows (see next slide):

35. Periodic Reporting Requirements • A change in the control of the registrant. • Acquisition or disposal of major assets. • Bankruptcy or receivership of the registrant. • Changes in the registrant’s certifying accountants. • Resignations of one or more of the registrant’s directors. • A change in the company’s fiscal year. • Any other events deemed to be of material importance to security holders.

36. Accountants’ Legal Liability • The 1934 Securities Exchange Act provides for a limited exposure from involvement in the preparation and filing of periodic reports. • Civil liability is imposed for filing materially false or misleading statements. • The accountant’s liability for registration statements under the 1933 act extends to the date the registration becomes effective.

37. Due Diligence • Plaintiffs suing accountants under the 1934 act must show that a periodic report contains a misleading material fact and that they suffered a loss because they relied on that report. • Accountants are provided with defenses to combat any lawsuits brought under the 1934 act.

38. Foreign Corrupt Practices Act of 1977 • In the mid-1970s, Congress held a number of public hearings which brought to light that millions of dollars in bribes had been paid to high government officials of other countries by United States-based companies seeking to win defense or consumer product contracts. • Alarmed by the size and scope of these activities, Congress passed the Foreign Corrupt Practices Act of 1977 (FCPA) as a major amendment to the Securities Exchange Act of 1934.

39. Foreign Corrupt Practices Act of 1977 • The FCPA has two major sections: • Part I prohibits foreign bribes. • Part II requires publicly held companies to maintain an adequate system of internal controls and accurate records.

40. Foreign Corrupt Practices Act of 1977 • The FCPA also had significant effect on independent auditors by requiring them to evaluate a company’s internal controls and to communicate any material weaknesses in those controls to the company’s top management and board of directors.

41. SEC Policy-Setting Responsibilities • Although the SEC has the statutory responsibility to develop and maintain accounting principles used for financial reporting, it has permitted the rule-making bodies of the accounting profession to take the initiative in establishing accounting principles and reporting standards. • It is expected that this arrangement will continue in the future even in view of Sarbanes-Oxley.

42. Sarbanes-Oxley • The Sarbanes-Oxley Act of 2002 significantly affects auditors and publicly traded companies. • The proposed law gained impetus after the revelations about accounting and financial mismanagement at Enron, WorldCom, and others. • Section 101 of the Act established a new accounting oversight committee to regulate accounting firms, that is, Public Company Accounting Oversight Board (PCAOB).

43. Sarbanes-Oxley • The SEC continues to develop the implementation guidelines for Section 101 and the various other sections of the Act and, therefore, the daily business and accounting press will have continued coverage of the Act. • The complete Act is linked on the SEC’s web site (www.sec.gov).

44. Disclosure Requirements • Virtually every SEC accounting release reminds registrants of the commitment to full and fair disclosure of financial information needed by investors. • The SEC has taken the lead in requiring management to provide its analysis of the operations of the company. • Examples: management discussion and analysis section and pro forma disclosures.

45. Management Discussion and Analysis • The management discussion and analysis (MDA) of a company’s financial condition and results of operations is part of the basic information package required in all major filings with the SEC. • The financial statements are, after all, management’s expressions of the economic consequences of their decisions made during the period.

46. MDA-Required Items • Specific information about the company’s liquidity, capital resources, and results of operations. • The impact of inflation and changing prices on net sales and revenues and on income from continuing operations. • Material changes in line items of the consolidated financial statements from prior-period amount.

47. MDA-Required Items (Continued) • Known material events and uncertainties that may make historical financial information not indicative of future operations or future conditions. • Any other information the company believes necessary for an understanding of its financial condition, changes in financial condition, and results of operations.

48. Pro Forma Disclosures • Pro forma disclosures are essentially “what-if” financial presentations often taking the form of summarized financial statements. • Pro forma statements are used to show the effects of major transactions that occur after the end of the fiscal period, or that have occurred during the year and are not fully reflected in the company’s historical cost financial statements.

49. Pro Forma Disclosures • The SEC requires pro forma statements to be presented whenever the company has made a significant business combination or disposition, a corporate reorganization, an unusual asset exchange, or a restructuring of existing indebtedness.

50. Influence on Auditing • The SEC has consistently taken the lead in requiring the independence of the auditor from the client company and in defining the parameters of the audit function. • The SEC insists on strict independence of the auditor as the best protection of the public investors’ need for full and fair disclosure of a company’s financial position and performance.