DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS 1996 TWENTY-THIRD ANNUAL NATIONAL CONFERENCE ON CURRENT SEC DEVELOPMENTS Christine Q. Davine Associate Chief Accountant Division of Corporation Finance U.S. Securities and Exchange Commission Washington, D.C. 20549 * Copyright 1996, all rights reserved. Portions of this paper may be utilized with other programs. ** As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publications or statement of any of its employees. The views expressed herein do not necessarily represent views of the Commission or its staff. Good morning. It's a pleasure to be here. Initially I will discuss proposed changes to Rule 3-05 of Regulation S-X relating to significant business acquisitions and provide guidance on preparing financial data schedules. For the remainder of the time, I will provide recommendations to help registrants in the preparation of filings, and I will discuss items the staff frequently notices in the review process. I. Streamlining Disclosure Requirements for Significant Business Acquisitions (Proposed amendments to Rule 3-05 of Regulation S- X) In June 1995, the Commission proposed to eliminate the requirement to provide audited financial statements for pending business acquisitions in Securities Act registration statements, other than registrations by "blank check companies." The proposed rules also would automatically waive the required financial statements for significant acquisitions completed within 75 days of a registered offering, if such audited financial statements are not readily available at the time the offer commences. Currently under the Exchange Act, domestic registrants are required to report significant acquisitions on Form 8-K within 15 days after consummation of the transaction, with a further 60 day extension to file the financial statements. However in a registration statement situation, registrants must provide audited financial statements of the acquiree when the acquisition is probable or consummated. By eliminating the concept of a probable acquisition and automatically waiving financial statements for acquisitions completed within 75 days, the proposed rules would allow registrants to provide information about significant acquisitions in registration statements on the same time schedule as for Exchange Act reporting. Similar to the waiver previously adopted for small business issuers, the Commission also proposed to provide an automatic waiver of the earliest year of required audited financial statements for a consummated business acquisition in filings made under either the Securities or Exchange Act if those financial statements are not readily available. Currently, one, two, and three years of financial statements are required at the 10%, 20%, and 40% significance level, respectively. As proposed to be amended, Rule 3-05 of Regulation S-X would provide that, where an acquiree's audited financial statements are not readily available, the requirement for furnishing them would be automatically waived if the significance of the acquired business does not exceed 20%, and the earlier of the two years of the required financial statements would be automatically waived where significance does not exceed 40%. These proposed changes would not apply to target companies presented in a Form S-4. Currently, the staff is in the process of evaluating comments received on this proposal and is considering our intended course of action. II. Financial Data Schedules The staff frequently receives questions regarding financial data schedules, which have been required to be included in filings by all EDGAR registrants since September 1, 1994. The staff published in the October 1995 Edgar News letter answers to some of the most frequently asked questions, a copy of which is presented on page 188 of the Division's outline that is included in your handouts. The following provides guidance on some common areas of confusion in the preparation of financial data schedules. o The schedules do not necessarily have to foot since they only request selected line items from the financial statements. o Selling, general, and administrative expense is not a selected tag, so such amount should not be included in the financial data schedule or combined with other unrelated amounts. o To determine the values that should be used for a particular tag, registrants should use the corresponding item number and item description included in the Edgar Filer Manual. The item number refers to the definition in Regulation S-X. o If the schedule requests an item that is not included on the financial statements, the value "0" (zero) should be entered next to the required tag on the schedule since a response is required for each tag. Zero could mean zero, immaterial, or not applicable. o A financial data schedule included in a Form 10-Q should cover the interim year to date period. For example, the financial data schedule included in the second quarter Form 10-Q should include a column for the 6-month period only and not for the most recent 3-month period. o It is appropriate to enter a zero on the schedule included for the interim period for an amount not presented on the face of the interim financial statements, since it is not necessary to present more information in the schedule than is required on the face of financial statements presented in accordance with Article 10 of Regulation S-X. III. Recommendations Next I will discuss frequently issued staff comments and other staff policies that registrants should consider in their preparation of filings. Some of the items may seem rather basic, however they are applicable to many registrants and are commonly overlooked. A. Staff Accounting Bulletin 74 (Topic 11:M) i. General The staff frequently issues comments requesting the disclosures required by Staff Accounting Bulletin 74 (SAB 74). SAB 74 discusses the disclosures that should be provided in MD&A and the notes to the financial statements regarding the impact on the financial statements of new accounting standards that are not yet adopted. Disclosures that should be considered include a brief description of the standard and the anticipated adoption date, the method of adoption, the impact on the financial statements, and any other reasonably likely effects. Disclosure should be provided for all accounting standards which have been issued unless the registrant has determined that the impact will not be material. ii. Adoption of SFAS 123 (Stock-Based Compensation) I will specifically discuss disclosures required under SAB 74 for the anticipated adoption of SFAS 121 and SFAS 123, since we have recently received questions on expected disclosures for these standards. SFAS 123, which is effective for fiscal years beginning after December 15, 1995, requires pro forma disclosure but only encourages companies to change their accounting for stock-based compensation. Prior to the adoption of SFAS 123, disclosures of the anticipated impact of the standard should be furnished unless the registrant has unequivocally decided that it will continue to apply APB 25 for measurement of stock. So, if a registrant plans on adopting a fair value based method of accounting, it should provide disclosure of the potential effects of such. If a registrant does not plan on changing its accounting, disclosure regarding the adoption of SFAS 123 is not required. However, if the registrant has not determined how it will implement the standard, disclosure of that fact should be provided. In interim financial statements in the year of initial adoption, the staff encourages registrants that are continuing to apply APB 25 to include the pro forma disclosure required by SFAS 123 for the quarter, however the staff will not require pro forma disclosures in interim financial statements. For those registrants who will not continue to apply APB 25, notes to the interim financial statements in the year of initial adoption should include disclosure that SFAS 123 has been adopted for measurement purposes and a brief description of its requirements and all other disclosures identified by the standard to the extent not previously furnished in prior annual financial statements. The quantified disclosures specified in paragraph 47 only need to be provided for options granted or modified during the interim period and only if award activity in the period was material. In addition, since APB 22 requires companies to disclose the accounting policies they follow when alternative policies exist, registrants should disclose in their financial statement footnotes whether they are accounting for employee stock compensation plans under APB 25 or SFAS 123. iii. Adoption of SFAS 121 (Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to Be Disposed Of) Similar to SFAS 123, registrants also should disclose the expected financial statement effects of adopting SFAS 121, if known and if not known, discuss that fact. Since SFAS 121 observes that goodwill that is not related to impaired assets should continue to be accounted for under APB 17, which does not specify a particular quantitative methodology for measuring an impairment, the staff believes registrants should continue to disclose their methodology used to identify and measure impairment of goodwill and other intangibles. When an impairment is recorded, disclosure describing the impairment should not merely indicate that the adoption of SFAS 121 triggered the impairment, since under SFAS 121 a review of assets used in operations is only necessary when events or circumstances indicate that an impairment might exist. The staff would expect a complete and detailed discussion of the facts and circumstances leading to the impairment that were not apparent in an earlier period that caused management to review the asset's recoverability. B. Revisions to Rule 3-06 The staff has noted several instances where nine months to one year of audited financial statements have been substituted for one year of audited financial statements in circumstances besides an acquired business or when a company changed its fiscal year as permitted by Rule 3-06(a) and (b) of Regulation S-X. In other circumstances, registrants are reminded to seek written relief from the Division's Chief Accountant's Office prior to filing, indicating why less than a full year is appropriate. C. Components of a Larger Entity The staff has also noted instances where less than the full financial statements required by Regulation S-X are provided in a filing and concurrence with that presentation was not previously received from the Division's Chief Accountant's Office. For example, a division or a business of a larger entity may be acquired for which separate books and records were not maintained. In such a case, the staff may accept audited statements of assets acquired and liabilities assumed and revenues over direct operating expenses, assuming that it is impracticable to prepare the full financial statements required by Regulation S-X and the registrant includes an explanation of the reasons for the presentation in the filing. Requests for such a presentation should be directed to the Division's Chief Accountant's Office prior to filing. D. Qualified Audit Reports Recently, several registrants have expressed the belief that the SEC generally does not object to the inclusion of a disclaimer of opinion or scope qualification in a 1934 Act filing, such as a Form 10-K. A disclaimer of opinion or a scope limitation does not meet the reporting requirements of Article 2 of Regulation S-X and is not acceptable in either a 1933 Act or 1934 Act filing. E. Statement of Cash Flows The staff regularly issues comments on the Statement of Cash Flows. The following are some of the items most frequently noticed. o Companies throughout all industry groups misclassify items between operating, investing, and financing activities. Registrants are reminded to evaluate the criteria in SFAS 95 for classifying each cash receipt and payment in the appropriate category. o Changes in investing and financing cash flows amounts are commonly reported net instead of gross. For example, borrowings and repayments under debt facilities should be presented gross unless the original maturity of the liability is three months or less. In addition, material purchases and sales of property, plant, and equipment should be presented gross, and stock issuances should be separately reported from purchases of treasury stock. o Restricted cash should be separately disclosed from cash and cash equivalents on the face of the balance sheet and should not be included in the cash total in the Statement of Cash Flows. o Cash overdrafts should be reported as financing activities. o APB 12 requires disclosure of depreciation expense. Unless depreciation is disclosed elsewhere in the financial statements, registrants should separately disclose in the Statement of Cash Flows the amount of depreciation expense and the amount of amortization expense. o Frequently for multi-national companies dealing in multiple foreign currencies, the staff notes that changes in working capital items are determined by simply subtracting the beginning and ending balances on the balance sheet, or the foreign currency translation adjustment is a plug number in the statement of cash flows. Registrants with foreign currency transactions or foreign operations are reminded that the Statement of Cash Flows should report the reporting currency equivalent of foreign currency cash flows using the exchange rates in effect at the time of the cash flows. F. Cheap Stock In initial public offering situations, especially in the technology sector, cheap stock issues receive a significant amount of staff attention. The staff regularly issues comments on the valuation of stock or options issued within a close proximity of the filing date, particularly when there is substantial disparity between the initial public offering price and the issuance price. Registrants should carefully consider all factors in determining the valuation of stock issued before an initial public offering. Generally, there should be persuasive evidence to support a significant change in fair market value of the stock from the various grant dates to the filing date of an initial public offering. Although factors experienced by the industry as a whole may be considered, such as the recent rise in technology stocks, evidence provided to the staff should focus on a registrant's own specific facts and circumstances. Cheap stock issues are very fact specific; however some of the criteria the staff considers in evaluating whether the issuance is compensatory include the proximity of the issuance to the initial filing of the registration statement, specific events, such as introduction of a new product or changes in revenues or earnings, that occur subsequent to the issuance of the stock or option that may have caused the stock price to increase; profitability and financial performance of the company; objective evidence such as transactions with unrelated parties involving issuances or repurchases of stock for cash and current independent appraisals. G. Environmental and Other Loss Contingencies The staff continues to ask for expanded disclosures of environmental and other loss contingencies both in the notes to the financial statements and the Management's Discussion and Analysis section, even though Staff Accounting Bulletin 92 (SAB 92), which discusses accounting and disclosures relating to environmental and other loss contingencies, was issued over 2 1/2 years ago. When describing loss contingencies, registrants should provide "user friendly" disclosure based on the registrant's own specific facts and circumstances, rather than a general boilerplate discussion which does not adequately explain the registrant's potential exposure or the nature, scope, and magnitude of the contingency. In a common departure from the guidance in SAB 92 requiring separate presentation of probable liabilities and related probable claims for recovery, some registrants are still offsetting these amounts. Some registrants continue to provide disclosure that "based on insurance coverage, environmental or other loss contingencies are not anticipated to materially impact the financial statements." The materiality assessment should not be predicated on recoveries from third partes. In addition, many registrants are still not disclosing the estimated additional loss, or range of loss, that is reasonably possible, or stating that such an estimate can not be made. If a registrant chooses to discuss the materiality of a loss contingency, the assessment of materiality should not be limited to a single measure, such as a representation that the contingency is not expected to have a material effect on financial condition. Conclusionary language should address the impact on financial condition, results of operations and liquidity, or refer to the financial statements as a whole. Registrants also are reminded that all disclosures concerning material contingencies must be updated with each quarterly report on Form 10-Q, even though a significant change since year end may not have occurred. H. Software Revenue Recognition Issues With the continual explosion of offerings in the software industry, the staff frequently asks for expanded disclosure of revenue recognition polices for software registrants. Disclosure of software revenue recognition policies should include a description of the registrant's accounting for significant and insignificant vendor and post-contract support obligations remaining at the time of revenue recognition when disclosure elsewhere in the filing indicates that the registrant provides related support services such as installation, calibration, and maintenance. The staff has noticed improved disclosures regarding purchased research and development charges. However, registrants who record purchased research and development charges are reminded to disclose that at the date of acquisition the technological feasibility of the acquired technology had not yet been established and the technology had no future alternative uses. Management's Discussion and Analysis should describe the nature, amount, and timing of the remaining estimated efforts necessary to develop the acquired incomplete technology into commercially viable products. Thank you.