DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS TWENTY-THIRD ANNUAL NATIONAL CONFERENCE ON SEC DEVELOPMENTS FEBRUARY 15-16, 1996 MICHAEL SCHOENFELD * ASSISTANT CHIEF ACCOUNTANT DIVISION OF CORPORATION FINANCE U.S. SECURITIES AND EXCHANGE COMMISSION ** * Copyright 1996, all rights reserved. Portions of this paper may be utilized with other programs. ** The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement of its employees. The views expressed in the paper are those of the author, and do not necessarily represent the views of the Commission or other members of the staff. INTRODUCTION Good morning. I will address several recent recurring issues surrounding financial statements of guarantors as required by Rule 3-10 of Regulation S-X, pro forma information, and recommendations for preparing filings with the Commission. I intend to outline several steps that you as registrants or public accountants can follow to save time in preparing filings with the Commission and working with the staff. I. Rule 3-10 - Financial Statements of Guarantors and affiliates whose securities collateralize an issue registered or to be registered. The first topic I will address is Rule 3-10 of Regulation S- X. It has become increasingly common for parent debt or preferred equity securities to be guaranteed by one or more of its subsidiaries. Typically, the guarantee is full, unconditional, and joint and several; and thus covers 100% of the parent's debt servicing obligations, but there are a myriad of ways to arrange the guarantee. Rule 3-10 covers financial statement requirements when affiliates or subsidiaries, for example, guarantee a debt issuance by the Parent, AND financial statement requirements when an affiliate's securities, be it common stock or otherwise, collateralize securities that are registered with the Commission. There are two distinct and separate requirements of this Rule - guarantor requirements and the requirements for collateralizing or pledging securities. The purpose of Rule 3-10 is to provide financial statements to allow investors to evaluate a guarantor's ability to honor their commitment under the guarantee. That purpose is generally satisfied by providing: first, full and complete disclosure of the nature of the guarantee; meaning, the legal aspects should be prominently available to the reader, and second that legal description coupled with financial information should be set forth to allow investors to determine the assets held by and the operations and cash flows of each of the guarantors including the investors' priority position in the event of default, and third, disclosure that indicates any restrictions on a parent's ability to obtain funds from its subsidiaries by dividend or loan should be highlighted or evident. Given the stated purpose, let us first look at the guarantor financial statement requirement. In analyzing the different aspects of this Rule applicable to guarantors, the staff is trained in identifying key language in filings and indentures covering debt instruments where this issue frequently arises. We use that language to interpret the application of this Rule, using SAB 53 to assess the sufficiency of disclosure to meet the stated purpose. Rule 3-10 requires full financial statement presentation, but the staff has accepted registrants' proposals to include other alternative disclosure in limited circumstances where all of the guarantors are wholly-owned, the guarantee is full and unconditional and joint and several. One such disclosure is, condensed consolidating financial information which is usually less burdensome than full financial statements. Keep in mind the stated purpose of Rule 3-10. Secondly, let us look at a characteristically different aspect of the Rule - the collaterization or pledging of a Company's securities. This portion of the Rule has recently been misinterpreted on several occasions, resulting in the restatement of filings and a time consuming experience for all parties involved. The legal implications between a guarantee and collateral are different, as well as the ability of the debt holder to realize his investment through foreclosure on the collateral. The concepts mentioned earlier surrounding the nature of a guarantee such as full, unconditional, and joint and several do not apply to collateralizations. As such, the relief granted under SAB 53 is not applicable in this situation. Thus, each and every time a subsidiary, and even if all the subsidiaries collateralize the instrument being registered, full financial statements must be provided for each subsidiary or affiliate whose securities constitute a substantial portion of the collateral for any class of security. Before moving on to my next topic, I encourage using the prefiling process to review, with the staff, the application of this Rule in your particular circumstances. II. PRO FORMA INFORMATION The next area I would like to discuss is pro forma information, including, first, how I believe practice has in some situations inappropriately evolved, and then discuss areas where the staff frequently comments and obtains revisions. Although this area is less technical than Rule 3-10 it has become equally time consuming for your preparation and staff review. First let me direct your attention to the Division of Corporation Finance outline on page 154 which contains two very specific topics covering pro forma information affecting a large number of offerings. These topics, which I refer you to but will not comment on here are, Changes in Capitalization and Distributions at the Offering. Following the guidance in these topics will avoid frequently issued comments by the staff. Evolution of pro forma information - Equally important, and perhaps commented on more frequently, is pro forma information required by Article 11 of Regulation S- X. Recently, the staff has noticed an increase in the manner in which pro forma information is presented as well as how companies and their accountants have interpreted the principle or purpose of pro forma financial information. Simply put, pro forma information should portray the accounting and reporting impact that A transaction would have had on the balance sheet and income statement for the requisite time periods and point in time. That uncomplicated objective has been extended at times to incorporate transactions, adjustments, assumptions, and hypothetical scenarios, to imply that the presentation is more a projection or forecast than a pro forma presentation. Whereas financial forecasts and projections are based on assumptions, or one or more hypothetical courses of future action, pro forma presentations should focus only on the transaction triggering the requirement; that is, it should be transaction based; and include adjustments that are only directly attributable, factually supportable and will have a continuing impact on the company, and not be extended by "what if scenarios", assumptions, or alternative courses of action to imply that the presentation is anything more than a pro forma. Perhaps the reason for this evolution results from an extension of the term "directly attributable" as referred to in Article 11. The staff generally views this concept as excluding by definition all transactions and adjustments where, by their nature, present alternative courses of action, or extensions of directly attributable transactions to other possibilities. For example, when company A finances the purchase of B and purchase accounting is applied, the expected adjustments would be the following; 1) the application of APB 16 - for example increased depreciation and amortization of goodwill, 2) the effects of the financing, and 3) other effects that are both directly and objectively determinable from specific contracts implementing the acquisition. Other adjustments such as, expected cost savings due to economies of scale, should be excluded, as they would only be incidental to the transaction, or an extension of the concept "directly attributable." My views expressed here do not change the Commission's policies on projections. Depictions of forward looking estimates by management of the effects of restructurings and changes in the deployment of labor and other operating resources, is encouraged; however, my views do emphasize that there should be a clear distinction made between pro forma information and projections. Frequent comments - An area where the staff frequently comments is a pro forma presentation reflecting a significant acquisition. For example, an expected adjustment resulting from applying purchase accounting is the allocation of the purchase price. The manner in which such adjustments are presented is frequently not sufficiently informative and as a result are subject to comment by the staff. To be informative, not only should companies disclose the purchase price and its components, they should disclose its allocation, presented in a manner which clearly identifies 1) net tangible assets and liabilities acquired, 2) identifiable intangible assets, 3) fair value adjustments to net tangible and intangible assets and liabilities, and 4) the costs and fees of the acquisition. If it is not otherwise apparent, companies should describe all significant adjustments to fair value and disclose how they were determined. Such a gross presentation is necessary in understanding the impact of an acquisition on the historical financial statements, and often forms the basis from which additional staff comments and concerns are communicated. In preparing a pro forma presentation for a business combination including an adjustment for the allocation of the purchase price, registrants and their accountants should be alert that the staff frequently questions these presentations and has obtained restatements for the following three areas. The first is adjustments made through the purchase price allocation by analogy to Topic 2:A:5 of the Staff Accounting Bulletins or SAB 61. The focus of this literature and the staff's concerns is that adjustments of the following nature ordinarily should not be made as purchase accounting adjustments but should have been made in either the historical financial statements or through continuing operations in future periods. For example, the staff frequently challenges adjustments for reserves for warranty, inventory, sales returns, and workers compensation, whether they are characterized as "reserves" or other language that is intended to obscure the nature of the adjustments such as "changes in accounting methodology". The second area commented upon by the staff involves the requirements of APB 16 and 17 to allocate the purchase price to specifically identifiable intangible assets rather than solely to goodwill. Based on the nature of the Company's industry, the staff frequently challenges a lack of allocation, and further after properly allocating the purchase price, a frequent area of comment is on both the amortization method and period of amortization of those intangible assets. For example, the staff frequently use the textual portions of the filings and our knowledge of the financial statements to inquire why amounts were not assigned to management contracts, affiliation agreements, or other intangibles applicable to your industry. This concern bring me to a third area where the staff frequently comments. Companies often disclose that purchase price allocations are preliminary without explaining why. The staff recommends that companies disclose why the allocation is preliminary, what events or activities must occur for it to be final, when management expects it to be finalized, and the potential impact on the financial statements of any reallocation. III. RECOMMENDATIONS FOR PREPARING FILINGS WITH THE COMMISSION The third and last area I will discuss this morning are recommendations that registrants and auditors should follow to expedite the filing process. A. Accounting Policies - My first recommendation concerns disclosures surrounding accounting policies. The staff regularly looks for accounting policies to provide at least the following three disclosures; first, policies should provide useful information rather than merely a citation of the particular GAAP literature being followed. For example; for a company following SOP 93-7 covering capitalized direct response advertising, a policy that solely implies the company is following GAAP without stating for example, the nature of the direct response advertising, and how it is recoverable from specifically identified revenues and what those revenues are is not sufficiently informative, secondly, accounting policies should be comprehensive and correlate with the underlying operations of the Company; that is, they should provide a sense not only of the nature of the business but how and why the adopted policies relate to the Company's operations, to facilitate a more informed understanding of how events and transactions might effect the financial statements, and third, we often encourage plain language be used in describing complex footnote disclosure. The staff also looks for and challenges precedent setting policies. Two accounting policies frequently commented on are the basis of presentation and revenue recognition policy notes. Basis of Presentation or Organization of the Entity - The basis of presentation or organization of the entity note often contains the elements necessary to understand the overall business history and interrelationships of the various entities involved. In reviewing filings we often strive to obtain the big picture, and we often look here for at least the canvas. What is troubling to the staff and consequently raises comments is that too often there is a lack of clarity in three areas. Those areas are: first, how business combinations are described, second, which entities the financial statements represent in combined financial statement presentations, and third, the depooling of entities or derecognition of assets and liabilities in spin-offs or carve-outs. The Wall Street Journal recently reported that 1995 was a record year for spin-offs, thus much attention in the future will be focused on this last point. In preparing the basis of presentation or organization of the entity footnote, which would include disclosures of business combinations, filers should clearly describe the business combination to clarify not only how it is accounted for but what the typical effects are on the financial statements. For example, stating that a combination was treated as a reverse acquisition is not sufficiently informative to a non accountant without stating, at a minimum, which entity the financial statements represent and why as well as what the capital structure represents. For the second issue, combined financial statements, the ownership relationship of the entities involved to each other is often omitted, leaving the reader searching for the details and questioning why the financial statements were presented on a combined basis. With respect to the third area of comment, spin-offs and carve-outs; occasionally the staff notes that the basis of presentation note does not clearly communicate the composition of the financial statements in this unique form of business disposition or transfer. The accounting for the spin-off of a subsidiary is addressed in SAB 93; however, when "change in reporting entity accounting" is permitted, the staff would expect to see certain clarifying disclosures in this note that shed light on why such accounting was appropriate, rather than simply indicating the historical financial statements omit a subsidiary. Revenue Recognition Policies - The other accounting policy that the staff frequently comments on is revenue recognition. Registrants should ensure that all such policies are clear and complete. For example, disclosing that revenue is "recorded when earned or shipped" is not sufficiently informative when it is not clear from management's discussion and analysis, industry disclosure or norm or otherwise apparent what that general statement means. Past conferences highlighted recognition concerns when uncertainties involved customer acceptance or FAS 48 right of return issues. The staff continues to question these issues, and in general, will inquire about all innovative policies. One recurring revenue recognition concern involves bill and hold sales. There is a presumption that with bill and hold sales the earnings process is not complete, yet the staff continually sees this policy described as - "revenue is recognized when earned" or a general statement that such a bill and hold arrangement exists, without clarifying disclosure. This leaves the Company's adopted policies open to interpretation. In these situations the staff encourages a discussion of the risks and uncertainties surrounding warehousing arrangements and their potential impact on the financial statements. Such disclosure might include the company's relationship with distributors, that fixed commitments to purchase goods are obtained prior to recognition, whether the company has modified its normal billing and credit terms, or that the distributor carries the risk of decline in the market value of bill and hold inventory. B. Item 4 of Form 8-K My second recommendation affecting many registrants and accountants at one time or another is disclosure issues surrounding Item 4 of Form 8-K, reporting changes in independent accountants. I encourage all filers to follow every aspect of Item 304 of Regulation S-K, paying particular attention to the requirements covering disagreements. The Rule requires a statement, as applicable, whether there were any disagreements not only through the latest balance sheet date, but the date of resignation, termination, or otherwise. C. Supplemental Earnings Per Share Presentations The final recommendation I would like to make is that companies are reminded that the staff requires supplemental earnings per share presentations be disclosed when registering securities and all or a portion of the proceeds of such offering will be used to retire debt. The staff requires such a supplemental presentation by analogy to paragraph 23 of APB Opinion No 15, and believes that it is a useful indicator of what earnings would have been without such debt for comparative purposes. This presentation is often missing from filings. This concludes my prepared remarks. Thank you.