Congress created the Securities and Exchange Commission (the SEC, or the Commission) through the Securities Exchange Act of 1934 (the 1934 Act). The Securities Act of 1933 (the 1933 Act) was administered by the Federal Trade Commission before the SEC was established.

The 1933 Act and 1934 Act (the Securities Acts) are the main securities statutes of importance to accountants. The Commission also administers the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. In addition, the Commission administers the Securities Investor Act of 1970 and also serves as adviser to the U.S. District Court in connection with Federal Bankruptcy Act reorganization proceedings involving registrants. The SEC's Web site is www.sec.gov.

The Commission is an independent agency of five commissioners. No more than three may be of the same political party. They are appointed by the President (with advice and consent of the Senate) to five-year terms, one term expiring each year.

One commissioner is designated by the President to act as chairman. The Commission has a professional staff, consisting of lawyers, accountants, engineers, financial analysts, economists, and administrative and clerical employees, which is organized into 11 divisions and offices (other than administrative offices). The following are the divisions and offices and their responsibilities:

The main offices of the Commission are located at 450 5th Street NW, Washington, DC 20549. There are also five regional and six district offices.

Because accountants generally deal more with the Division of Corporation Finance than with the other SEC divisions, its duties and operations are considered here in greater detail.

The SEC and the accounting profession have cooperated with each other in developing GAAP. Through its FRRs, SABs, and SLBs, the SEC has informed the accounting profession of its opinions on accounting and reporting. In addition, the Chief Accountant and certain members of his staff attend meetings of the FASB [including the Emerging Issues Task Force (EITF)] and technical committees of the AICPA.

In turn, as stated in FRR No. 1 (Section 101):

Although there has been an attempt to eliminate the differences between GAAP requirements and SEC accounting and reporting requirements, there are still certain key differences. The following lists some of the additional requirements for SEC registrants:

For more detailed information related to these and other differences, see Section 3.4.

In response to several significant restatements by public companies in late 2001 and early 2002, both the House of Representatives and the U.S. Senate proposed bills that could affect almost everyone associated with public companies. The two bills were quickly reconciled into the Sarbanes-Oxley Bill, which the President signed in late July 2002 and thus became the Sarbanes-Oxley Act (the Act).

The Act is very broad in scope and, while it appears to be quite specific, numerous questions of interpretation have arisen and will continue to arise. Future clarification and, possibly, expansion, whether through decisions of the yet-to-be-established Public Company Accounting Oversight Board (Board) and the SEC or through additional legislation, will be forthcoming.

The following is a broad overview of certain provisions of the Act.

In addition to the Act that was proposed by Congress, the SEC had proposed certain rule making and provided certain cautionary advice and other forms of guidance during late 2001 and 2002, as well. Some of the rules the SEC had proposed are basically covered by requirements in the Act; however, some are not specifically addressed. The SEC issued the following:

The above three releases were not formal rule making, but presented the SEC's thoughts on certain issues. The SEC followed up with additional formal rule making later in 2002. The following rules were proposed by the SEC:

To qualify for practice before the SEC, the public accountant auditing the financial statements must be independent, in good standing in the profession, and entitled to practice under the laws of his place of residence or principal office (Rule 2-01 of Regulation S-X).

In November 2000, the SEC issued amendments to modernize its rules for determining whether an auditor is independent and to expand proxy disclosure requirements for nonaudit services. The new rules, which take a more moderate approach than those originally proposed by the SEC, were adopted unanimously after extensive negotiations with the AICPA and other representatives of the accounting profession. The new independence rules apply to all auditors (including non-U.S. auditors) that submit audit reports in SEC filings. The amendments generally took effect on February 5, 2001, although certain restrictions have become effective over an 18-month transition period. The rule changes are based on the assumption that investor confidence in auditor independence depends on whether the auditor is in fact independent and whether a reasonable investor would conclude, in light of all relevant facts and circumstances, that the auditor is capable of exercising objective and impartial judgment.

In summary, the rules:

The SEC and others have expressed concern that the performance of nonaudit services for audit clients might impair the fact or appearance of independence. Rather than prohibit auditors from providing any nonaudit services to audit clients, the SEC adopted a two-pronged approach. First, the rule specifies nine nonaudit services that, if provided by auditors to an audit client, may be deemed inconsistent with an auditor's independence. Second, the new rule requires the following disclosures in annual proxy statements filed after February 5, 2001:

The required disclosures need only be made in the proxy statement relating to an annual meeting of shareholders at which directors are to be elected. Companies reporting solely under Section 15(d) of the Exchange Act and foreign private issuers need not make the disclosures since they are not subject to the proxy rules.

SEC officials have expressed concern over the increase in two types of accounting fraud—"cooked books" and "cute accounting." "Cooking" the books involves falsifying books and records either by creating or accelerating revenues or by deferring or concealing expenses. "Cute" accounting involves misapplying or stretching accounting principles and interpretations to obtain the desired, albeit distorted, financial picture. Both the accounting profession and corporate officials have been reminded by the SEC of their responsibilities to the public investor. More specifically:

The SEC is concerned with "opinion shopping" and requires companies and their former auditors to make certain disclosures upon a change in outside auditor. FRR No. 31 provides additional guidance as to these disclosures.

FRR 31 explains that "the term disagreements should be interpreted broadly, to include any difference of opinion on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which if not resolved to the former accountant's satisfaction would have caused it to refer to the subject matter of the disagreement in connection with its report." It further explains that preliminary differences of opinion that are "based on incomplete facts" are not disagreements if the differences are resolved by obtaining more complete factual information.

When an independent accountant who was the principal accountant for the company or who audited a significant subsidiary and was expressly relied on by the principal accountant resigns, declines to stand for reelection, or is dismissed, the registrant must also disclose:

Finally, the rules also require disclosure of certain "reportable events" during the two most recent fiscal years or any subsequent interim period preceding the resignation or dismissal of the accountant. "Reportable events" include:

Disagreements and reportable events are intended to include both oral and written communications to the registrant. Because these communications deal with sensitive areas that may impugn the integrity of management, they will have to be handled with extreme care on the part of all involved.

The time frame for reporting these changes is as follows:

The SEC has recently proposed changing the time frame from five business days for the initial reporting of the change to two business days.

In addition, the SEC Practice Section of the AICPA has a rule requiring auditors to communicate auditor changes directly to the SEC. Under that rule, when a firm has resigned, declined to stand for reelection, or has been dismissed, it should notify the former client within five business days that the auditor-client relationship has ceased and should simultaneously send a copy to the SEC (generally by fax with a follow-up hard copy).

The Foreign Corrupt Practices Act of 1977 (FCPA) deals with (1) payments to foreign officials and (2) internal accounting control.

Companies whose securities are traded on the New York Stock Exchange are required by the exchange to have audit committees comprising independent members of the board of directors. This requirement is a condition for original and continued listing. Directors who are members of present management or who serve the company in an advisory capacity, such as consultants or legal counsel, and relatives of executives are not considered independent directors. Former company executives who serve as directors can serve on the audit committee if, in the opinion of the board, that person will exercise independent judgment and will materially aid and assist the function of the committee.

The American Stock Exchange, NASDAQ, National Market System, and NASDAQ Small Cap Market require that listed companies have an audit committee with majority membership held by independent directors (and have at least two independent members on their board of directors).

As previously mentioned, the Report of the National Commission on Fraudulent Financial Reporting (1987) recommends that audit committees comprising only independent directors be required for all public companies.

Contact with the staff of the SEC can be both formal and informal and can occur in three situations:

A formal interpretation from the SEC is obtained by receiving a no-action letter. This communication is a staff promise not to recommend to the Commission that it take action if the facts submitted by the applicant and described in the letter are found to be accurate. The Commission has always honored its staff's no-action letters. Typical no-action letters involve exemption from 1933 Act registration and refusals by corporations to include a stockholder proposal in the company's proxy material.

The SEC will respond to informal questions related to interpretations of rules and the like. In certain circumstances the staff will respond to questions without requiring disclosures of the name of the registrant. Generally, these "no-name" inquiries are on more general questions. In fact-specific questions, the staff will often request a written submission regarding the facts and circumstances and will request that the name of the registrant be disclosed in the submission.

To keep abreast of SEC developments, accountants and others mainly consult the following publications:

The preamble to the 1933 Act states that the Act is intended "to provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes."

This statement is misleadingly broad. The 1933 Act does not cover the most common sale of securities: sales of issued and outstanding securities. Those transactions, on a stock exchange, in the over-the-counter (OTC) market or otherwise, are regulated by the 1934 Act. The 1933 Act covers only the original sale of the security by the issuer, along with sales by persons in control of an issuer.

There are two primary aspects to the 1933 Act regulation of securities offerings:

As to the audited financial statements, auditors must prove that they had, "after reasonable investigation, reasonable ground to believe, and did believe, at the time ... the registration statement became effective, that the statements [in the audited financial statements] were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading ..." [1933 Act, § 11(b)(3)]. The Act states: "The standard of reasonableness shall be that required of a prudent man in the management of his own property" [1933 Act, Section 11(c)].

The BarChris case (Escott v. BarChris Construction Corp., 283 F. Supp. 643, U.S. District Court, Southern District of New York, 1968) was the first, and remains the most important, case regarding liability for a misleading 1933 Act registration statement. A major accounting firm was among the defendants found not to have fulfilled due diligence requirements. The court stated: "Accountants should not be held to a standard higher than that recognized in their profession." However, the court relied heavily on the failure of the firm to follow its own guidelines for reviewing events since the date of the statements for the purpose of ascertaining whether the audited financial statements were misleading at the time the registration statement became effective. The complete text of the BarChris case appears in Regulating Transactions in Securities.^[171]

When the securities acts require plaintiffs to prove that information was false, untrue, or misleading, they must also show that the information was material to investors. In general, neither the statutes nor the SEC's rules and regulations offer quantitative tests or useful verbal descriptions of the meaning of "materiality." For example, as to the information required to be filed in a 1933 Act registration statement, information is material if "an average prudent investor ought reasonably to be informed [of it]" (1933 Act, Rule 405).

Many cases involve attempts to further define materiality. In the BarChris case, the judge used the test of "a fact which if it had been correctly stated or disclosed would have deterred or tended to deter the average prudent investor from purchasing the securities in question." Starting in the mid-1970s, some courts admitted that they would have to apply materiality standards in a flexible manner, reflecting the context in which the misleading statement was made (e.g., a 1933 Act registration statement, a 1934 Act registration statement or periodic report, a proxy statement, a case involving insider trading or tipping, etc.).

In SAB No. 99, Materiality, August 12, 1999, the SEC staff states that accountants and independent auditors should not rely exclusively on quantitative benchmarks to determine materiality in preparing or auditing financial statements. Misstatements are not immaterial simply because they fall beneath a numerical threshold. This subject is one the SEC is considering in connection with its campaign to counter earnings management (see Section 3A.1).

In 1992, the SEC adopted new rules to allow small businesses to raise capital in the public markets at a lower cost and with fewer impediments. The new rules also reduce reporting requirements for small businesses. The principal aspects of the new rules are:

For SBIs, Regulation S-B now replaces Regulation S-X and S-K as the central repository of both financial statements and nonfinancial disclosure requirements. An SBI is defined as a company having the following:

For a company filing an Initial Public Offering (IPO) or an initial registration statement, the revenue test is applied to the latest completed fiscal year to be included in the filing. The public float for an initial registration statement is a date within 60 days of the filing. For a company making an IPO, the public float is determined on the date of filing based on the number of shares held by nonaffiliates before the offering and the estimated IPO price. Reporting companies apply the revenues test to the latest completed fiscal year and the public float test as of a date within 60 days prior to year-end.

However, to relieve companies of having to switch back and forth between disclosure systems, an SBI will only lose that status if it fails the same test (revenue or public float) for two consecutive years. Also, a reporting company that is not an SBI may become one by meeting both tests for two consecutive years.

Accompanying the creation of Regulation S-B was the adoption of:

Form SB-2 has no dollar limit on the size of the offering, and may be used for any cash offering, not just initial offerings.

Forms 10-KSB, 10-QSB, and 10-SB are patterned after their "big brothers" with the disclosure to be governed by Regulation S-B. SBIs will continue to use Form 8-K and Form S-4, but referring to Regulation S-B instead of S-X or S-K. Finally, small issuers that are eligible to use short form registration statements S-2 or S-3 can continue to do so, again using Regulation S-B requirements. The principal financial statement concessions in Regulation S-B are:

Exhibit 3.1 presents a comparison of the key differences between the requirements of Regulation S-X to those under Regulation S-B. Exhibit 3.2 illustrates principal differences between Regulation S-K and Regulation S-B. The main distinctions are the elimination of the requirement for five years of selected financial data, market risk disclosures, certain executive compensation disclosures, and the approach to MD&A. Except for those differences noted in Exhibit 3.2, Regulation S-B contains a simplified version of each of the requirements of Regulation S-K. The SEC hopes that the simplified language of the rules will reduce the cost of preparing filings.

In April 1993, the SEC adopted additional revisions to its rules and forms used by SBIs. The following is a summary of those revisions:

Figure 3.1. Differences between Regulation S-X and Regulation S-B.

Figure 3.2. Principal differences between Regulation S-K and Regulation S-B.

The following is a discussion of the exemptions from the registration process and the simplified filings available to a company contemplating an offering under the 1933 Act.

The 1933 Act gives to the SEC the authority to establish rules for exempting securities from registration, if offered in small issues or if offered to a limited number of investors. Rules 501 through 509 of the 1933 Act, referred to as Regulation D, cover limited offerings and sales of securities, whereas Rules 251 through 263, called Regulation A, cover the small offering exemptions.

The SEC made several amendments to Form S-3 in October 1992 to make it available to more issuers. The changes include:

Companies repurchase their shares from the public and, in turn, become privately held. "Going private" transactions include leveraged buyouts, in which a group of investors (normally including company officers) borrows money to purchase company stock, using the assets of the acquired company as collateral for the loan.

In response to numerous complaints from shareholders about going private transactions, the SEC adopted Rule 13e-3, which prohibits going private transactions that are fraudulent, deceptive, or manipulative. Under the rule, companies are required to state whether the transaction is fair to stockholders unaffiliated with management and to provide a detailed discussion of the material factors on which that belief is based. Among the factors that should be addressed are (1) whether the transaction is structured so that approval of at least a majority of unaffiliated stockholders is required and (2) whether the consideration offered to unaffiliated stockholders constitutes fair value in relation to current and historical market prices, net book value, going concern value, liquidation value, purchase price in previous purchases, and any report, opinion, or appraisal obtained on the fairness of the consideration.

Rule 13e-4, relating to an issuer's tender offer for its own securities, also imposes stringent disclosure requirements and other responsibilities on registrants. The rule requires that (1) an issuer's tender offer remain open for at least 20 business days, (2) a shareholder tendering his stock have the right to withdraw within the first 15 business days or after 40 business days following the announcement if the company has not acted on its offer, (3) officers, directors, and major shareholders disclose all their stock transactions during the 40 business days preceding the purchase offer, and (4) an issuer accept tendered securities on a pro rata basis if a greater number of securities is tendered than the issuer is obliged to accept within 20 days of an offer.

The information requirements for initial and annual filings have tended to merge in recent years. The rules applicable to Form 10-K now require much of the same financial statement information required in a registration statement. As a result, the Form 10-K has been referred to as a mini S-1. However, there are some unique aspects of initial filings.

The following are the most commonly used forms for registration under the 1933 Act:

Effective October 1, 1998, the SEC adopted a rule that requires issuers to write the cover page, summary, and risk factors section of prospectuses in plain English. The SEC also gave guidance to issuers of prospectuses on how to make the entire prospectus clear, concise, and understandable. Further, it issued A Plain English Handbook: How to Create Clear SEC Disclosure Documents, which provides techniques and tips on how to create plain English disclosure documents.

The rule was adopted because prospectuses issued before adoption of the rule often used complex, legalistic language not understandable by any except financial or legal experts. The SEC determined that that was unacceptable because prospectuses are intended to provide full and fair disclosure to investors, not all of whom are such experts. The proliferation of complex transactions and securities combined with the complex, legalistic language to magnify the problem. The goal is to result in prospectuses that are simpler, clearer, more useful, and, therefore, more widely read.

The organization, language, and design of the covered sections of the prospectus should conform to plain English principles and be easy to read. Qualities of writing involved in plain English include short sentences; definite, concrete, everyday language; the active voice; tabular presentation or bullet lists for complex information whenever possible; no legal jargon or highly technical business terms; and no multiple negatives. The sections should be designed to make them inviting to the readers. The text should be formatted and the document designed to highlight information important to investors.

The SEC requires registrants to use the following techniques in writing prospectuses:

The goal of the guidance on how to make the entire prospectus clear, concise, and understandable is to rid the entire prospectus of legalese and repetition so that information important to investors is not blurred.

The SEC staff assists registrants in complying with the rule.

The 1934 Act has six principal parts:

The form and content of and requirements for financial statements included in filings with the SEC are set forth in Regulation S-X. Regulation S-X rules, in general, are consistent with GAAP but contain certain additional disclosure items not provided for by GAAP, as discussed later.

Regulation S-X is organized into 13 articles as follows:

Note that Article 8 on Committees issuing certificates of deposit was removed in 1985.

The form and content of accountants' reports are prescribed by Rule 2-02 of Regulation S-X.

In those situations where other independent accountants have audited the financial statements of any branch or consolidated subsidiary of the registrant, Rule 2-05 of Regulation S-X sets forth the reporting requirements. Section 543 of the AICPA's Codification of Statement on Auditing Standards requires disclosure in accountants' reports that exceeds the requirements of Rule 2-05. Therefore, that Statement should govern the form of accountants' reports when another auditor performs part of the audit.

Where part of an audit is made by an independent accountant other than the principal accountant and his report is referred to by the principal accountant, or when the prior period's financial statements are audited by a predecessor accountant, the separate report of the other accountant must be included in the filing. However, such separate reports are not required to be included in annual reports to stockholders.

The SEC generally will not accept opinions that are qualified for scope or fairness of presentation. The SEC will reject opinions that contain an explanatory paragraph that addresses the uncertainty of the registrant's ability to recover its investment in specific assets, for example, a significant receivable, an investment, or certain deferred costs. Since GAAP require such assets to be stated not in excess of their net recoverable amount, the SEC staff views such modifications as indicative of a scope of limitation (i.e., the auditor was unable to determine that the asset was stated at or below net recoverable value).

However, the SEC will accept an audit report that contains a "going concern" paragraph if prepared in conformity with SAS No. 59 and if the filing contains full and fair disclosure as to the registrant's financial difficulties and the plans to overcome them. Also, an audit report with a fourth explanatory paragraph describing an accounting change is acceptable.

Any filings made via EDGAR include a typed signature of the accountant. The registrant is required to keep a manually signed copy of the accountant's report in its files for five years after the filing of the related document.

Article 3 of Regulation S-X establishes uniform instructions governing the periods to be covered for financial statements included in most registration statements and reporting forms filed with the SEC. These are:

Additionally, for 1933 Act filings, Article 3, in general, requires in specified circumstances unaudited interim financial statements for a current period along with financial statements for the comparable period of the prior year. It also allows audited statements of income, stockholders' equity, and cash flows for a nine-month period to substitute for one of the required fiscal year periods in certain specified circumstances or when permitted by the staff.

Article 3 codifies the staff position that 1933 Act filings by companies that have not yet completed their first fiscal year must include audited financial statements as of a date within 135 days of the date of the filing.

Rule 3A-02 requires a registrant to file consolidated financial statements that clearly exhibit the financial position and results of operations of the registrant and its subsidiaries. A brief description of the principles followed in consolidating the financial statements and in determining the entities included in consolidation is required to be disclosed in the notes to the financial statements. If there has been a change in the entities included in the consolidation or in their fiscal year-ends, such changes should also be disclosed.

The latest year of consolidated subsidiaries must be within 93 days of the registrant's fiscal year-end. For such differences in year-end the registrant must disclose the closing date of the subsidiary and the effect of intervening events that materially affect the financial position or results of operation. Where fiscal years differ by more than 13 days, statements of the subsidiary should be adjusted to a period that more nearly corresponds with the fiscal period of the parent.

The following summarizes some of the additional disclosures required by Rules 5-02 and 5-03 of Regulation S-X, based on stated levels of materiality. These disclosures may be made either on the face of the financial statements or in a note.

The SEC has no preference as to the chronological order (i.e., left to right or right to left) used in presenting the financial statements. However, the same order must be used consistently throughout the filing, including numerical data in narrative sections.

The financial statements are not required to be referenced to applicable notes unless it is appropriate for an effective presentation.

Regulation S-X requires certain significant disclosures to the financial statements not required by GAAP. The following is a summary of the nine most common additional requirements (exclusive of those relating to specialized industries). However, if amounts involved are immaterial, disclosures may be omitted.

The SEC publishes the opinions of the Commission on major accounting questions and on the form and content of financial statements and financial disclosures in FRRs. These opinions [originally called Accounting Series Releases], which supplement Regulations S-X and S-K, have been codified by the SEC to present their contents in an organized manner. The SEC's "Codification of Financial Reporting Policies" contains all current releases relating to financial statement information.

SABs are interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant. SABs are not SEC rules; instead, they are a means of documenting the SEC staff's views on matters relating to accounting and disclosure practices. An SAB usually deals with a specific question posed to the SEC relating to a specific situation. However, the staff has indicated that the guidance included in the SABs should be applied in similar cases. Although the SABs are not formal rules of the SEC, they do reflect the staff's current thinking and represent the position that will be taken on various accounting and disclosures matters. As a result, SABs, should be followed when preparing information to be included in a filing with the SEC.

The new SLBs, issued for the first time in 1997, reflect the views of the SEC staff, but are not rules or regulations (similar to SABs).

Regulation S-X emphasizes the disclosure of restrictions on subsidiaries' ability to transfer funds to the parent by requiring the following disclosures in certain instances:

The following footnote disclosures are required when the sum of (1) the proportionate share of subsidiaries' consolidated and unconsolidated net assets (after intercompany eliminations) that are restricted from being loaned or advanced, or paid as a dividend to the parent without third party consent and (2) the parent's equity in undistributed earnings of 50 percent-or-less-owned equity method investees exceed 25 percent of consolidated net assets as of the latest fiscal year-end:

In addition, the rules require presentation of condensed parent company financial position, results of operations, and cash flows in a financial statement schedule (Schedule I) when the restricted net assets of consolidated subsidiaries exceed 25 percent of consolidated net assets at the end of the latest year (Rules 5-04 and 12-04). The condensed data may be in Form 10-Q format and should disclose, at a minimum, material contingencies, the registrant's long-term obligations and guarantees, cash dividends paid to the parent by its subsidiaries and investees during each of the last three years, and a five-year schedule of maturities of the parent's debt.

In determining the amount of restricted net assets, where the limitations on funds that may be loaned or advanced differ from any dividend restriction, the least restrictive amount should be used in the computation. For example, if a subsidiary is prohibited from paying dividends, but can loan funds to the parent without limitation, the subsidiary's net assets will be considered unrestricted. Illustrations of situations involving restrictions may include loan agreements that require a subsidiary to maintain certain working capital or net assets levels. The amount of the subsidiary's restricted net assets should not exceed the amount of its net assets included in consolidated net assets (acquisition of a subsidiary in a "purchase" transaction can result in a significant difference in this regard). Furthermore, consolidation adjustments should be "pushed down" to the subsidiary for the purpose of this test.

In computing net assets, redeemable preferred stock and minority interests should be excluded from equity.

Depending on their significance, Regulation S-X can require the presentation of:

It should be noted that SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries, has reduced the number of unconsolidated subsidiaries to a relatively narrow group of subsidiaries for which control is temporary or ineffectual.

Summarized financial statement footnote information as to assets, liabilities, and results of operations of unconsolidated subsidiaries and 50 percent-or-less-owned equity method investees is required when any one of the following tests [significant subsidiary tests of Rule 1-02(w)] are met on an individual or aggregate basis [Rule 4-08(g)].

The summarized information should include (Rule 1-02(bb)):

The summarized data is required for the same periods as the audited consolidated financial statements (insofar as it is practicable). In presenting the data, unconsolidated subsidiaries should not wbe combined with 50 percent-or-less-owned investees. Furthermore, if the significant subsidiary test is met, the summarized information should be provided for all such companies; requests to omit some entities on the basis of immateriality (i.e., less than 10 percent) will not be routinely granted by the Commission.

In addition to the requirement for footnote disclosure of summarized financial information, separate financial statements are required for any unconsolidated subsidiary or 50 percent-or-less-owned equity method investee that individually meets the Rule 1-02(w) test using 20 percent instead of 10 percent. These separate statements should cover, insofar as is practicable, the same periods as the audited consolidated financial statements and should be audited for those periods in which the 20 percent test is met.

The SEC has eliminated the asset test when determining whether separate audited financial statements of all (both domestic and foreign) equity investees must be provided under Reg. S-X rule 3-09. However, it should be noted that the SEC did not change the Reg. S-X Rule 4-08(g) requirement to provide summary financial information in the notes to the financial statements if equity investees are significant based on any of the three (i.e., assets, investment, and income) significance tests.

Combined or unconsolidated financial statements may be presented when two or more unconsolidated subsidiaries, or two or more 50 percent-or-less-owned investees, meet the 20 percent test.

The inclusion of those separate financial statements required by Rule 3-09 does not eliminate the need to present summarized footnote information pursuant to Rule 4-08(g), and the existence of one 20 percent entity will also automatically trigger the footnote disclosure of summarized information for all entities on an aggregate basis.

The following represent two informal interpretations by the SEC staff of the significant subsidiary test under Rule 1-02(w)(2):

Rule 4-08(h) of Regulation S-X requires detailed disclosures relating to income tax expense. These rules related originally to companies that were using APB No. 11 (but have been updated for SFAS No. 96 and SFAS No. 109). Companies generally only have to make the disclosures required by SFAS No. 109, except that all companies should disclose foreign versus pretax income and the five percent materiality thresholds must be applied as discussed next [see Subsection 3.1(d)]. The primary purposes of the rule are to enable readers of financial statements to:

The rule originally stated that the income statement or related footnotes must disclose domestic and foreign pretax income (if five percent or more of pretax income) and the components of income tax expense including:

Those portions of the preceding components that represent U.S. federal, foreign, and other income taxes should be shown separately. Amounts applicable to foreign or other income taxes need not be separately disclosed if each is less than five percent of the total of the related component.

With the adoption of SFAS No. 96 and 109, the SEC eliminated the requirement to disclose the net tax effect of timing differences. In practice, the components of deferred tax assets and liabilities are displayed in accordance with SFAS No. 109 (based on a five percent threshold).

In some cases, income tax expense will be included in more than one caption in the income statement. For example, income taxes may be allocated to continuing operations, discontinued operations, extraordinary items, and cumulative effect of an accounting change. In that event, it is not necessary to disclose the components of income tax expense (e.g., currently payable, deferred, foreign) included in each caption. Instead, there may be an overall summary of such components, together with a listing of the total amount of income taxes included in each income statement caption. (The totals of the "overall summary" and the "listing" should be in agreement.) An example of footnote disclosure in this situation is contained in SAB Topic 6-1.

The rule requires the registrant to provide a reconciliation (in percentages or dollars) between the reported income tax expense (benefit) and the amount computed by multiplying pretax income (loss) by the statutory federal income tax rate. If none of the individual reconciling items exceeds five percent of such amount, and the total difference to be reconciled is less than five percent of such amount, the reconciliation may be omitted. Even if the five percent test is not met, the reconciliation still should be submitted to the extent that it is considered significant in evaluating the trend of earnings, or if similar information is presented in the reconciliation for another period. When an item is reported on a net of tax basis (e.g., extraordinary item), the taxes attributable to that item should also be reconciled with the statutory federal income tax rate.

In those cases where the registrant is a foreign entity, the statutory rate prevailing in the foreign country should be used in making the computations outlined above.

Regulation S-X calls for disclosure of compensating balances [Rule 5-02(1)] and short-term borrowing arrangements [Rule 5-02(19)]. The purpose of the rules is to provide information on liquidity of the registrant (i.e., short-term borrowings and maintenance of compensating balances) and cost of short-term borrowing.

Rules 5-02(28), (29), and (30) require that amounts relating to equity securities should be separately classified as (1) preferred stock with mandatory redemption requirements, (2) preferred stock without mandatory redemption requirements, and (3) common stock. Redeemable preferred stock, or another type of stock with the same characteristics, may not be concluded under the general heading of "stockholders' equity" or combined with other stockholders' equity captions, such as additional paid-in capital and retained earnings.

The rule defines redeemable preferred stock as any class of stock (not just preferred) that (1) the issuer undertakes to redeem at a fixed or determinable price on a fixed or determinable date or dates, (2) is redeemable at the option of the holder, or (3) has conditions for redemption that are not solely within the control of the issuer, such as provisions for redemption out of future earnings.

The rule also requires registrants to provide a general description of each issue of redeemable preferred stock, including its redemption terms, the combined aggregate amounts of expected redemption requirements each year for the next five years, and other significant features similar to those for long-term debt.

The rules do not require any change in the calculation of debt/equity ratios for the purpose of making materiality computations to determine if an item requires disclosure or for determining compliance with existing loan agreements. However, where ratios or other data involving amounts attributable to stockholders' equity are presented, such ratios or other data should be accompanied by an explanation of the calculation. If the amounts of redeemable preferred stock are material and the ratios presented are calculated treating the redeemable preferred stock as equity, the ratios should also be presented as if the redeemable preferred stock were classified as debt.

According to SAB, Topic 3-C, when preferred stock is issued for less than its mandatory redemption value, the stated value should be increased periodically by accreting the difference, using the interest method, between stated value and the redemption value. The periodic accretions should be included with cash dividend requirements of preferred stock in computing income applicable to common stock unless the preferred stock is a common stock equivalent.

Although Rules 5-02(28), (29), (30) and the related FRR Section 211 speak to preferred stocks that require redemption, the SEC staff applies those provisions to any equity security that has conditions requiring redemption that are outside the control of the issuer. Several EITF consensus positions have applied FRR Section 211, by analogy, to stock purchase warrants and stock issued under certain employee stock plans.

With the general decline in interest rates, it is not uncommon for companies to find that the dividend rates on their outstanding preferred stocks exceed what they believe to be a current rate. The response of many companies in this position has been to either (1) redeem these preferred stocks (typically at a premium to their carrying values), or (2) induce their conversion. As long as redemption of the preferred stock is not outside the control of the issuer (i.e., the security is not a "mandatorily redeemable" preferred stock), accounting practice for such transactions has been to record the excess of (1) the fair value of the consideration transferred to the preferred stockholders over (2) the carrying amount of the preferred stock as a charge to additional paid-in capital and to give no recognition to these amounts in computing net income or earnings per share. However, the SEC staff has stated that it believes that such amounts should be treated as reductions of income applicable to common shareholders (in a manner similar to the treatment of dividends on preferred stock) for earnings per share calculation purposes.

The schedules required by Regulation S-X support information presented in the financial statements and can be filed 120 days after the balance sheet date as an amendment on Form 10-K/A. Each schedule has detailed instructions as to what information is required. It is essential to understand these instructions and tie the schedules in to the related items in the financial statements. The information required by any schedule may be included in the financial statements and related notes, in which case the schedule may be omitted.

The schedules are required to be audited if the related financial statements are audited.

The S-X schedules are required in Forms 10-K, S-1, S-4, and S-11, but are not required in Forms S-2, S-3, 10-KSB, SB-1, and SB-2.

Regulation S-K contains the disclosure requirements for the "textual" (nonfinancial statement) information in filings with the SEC. Regulation S-K is divided into the following 10 major classifications:

Form 10-K comprises four parts that are structured to facilitate incorporation by reference from the annual stockholders' report and the proxy statement for the election of directors. This format reflects the SEC's ongoing program of promoting the integration of reporting requirements under the 1933 and 1934 Acts.

In recent years, the information included in annual reports to stockholders has moved toward compliance with the reporting requirements of Form 10-K.

Rules 14a-3 and 14c-3 of the 1934 Act give the SEC the right to regulate the financial statements included in the stockholders' annual report. Although an annual stockholders' report must be sent to the SEC, technically it is not a "filed" document. Therefore, the annual stockholders' report is not subject to the civil liability provisions of Section 18 of the 1934 Act unless it is an integral part of a required filing, such as when incorporated by reference in Form 10-K. Yet, an annual stockholders' report is subject to the antifraud provisions set forth in Section 10b and Rule 10b-5 of the 1934 Act. The trend toward conforming the annual stockholders' report with Form 10-K is part of the Commission's integrated disclosure system, which requires annual stockholders' reports to contain, in addition to the financial statements, the following:

The similar disclosure requirements allow registrants to use extensive incorporation by reference to the annual stockholders' report in SEC filings. As such, the annual stockholders' report is often expanded to meet the disclosure requirements of Items 1 through 4 of Form 10-K to allow incorporation by reference. In some cases, the Form 10-K and the annual report are even combined into one document.

The annual stockholders' report also must contain a statement, in boldface, that the company will provide the annual report on Form 10-K, without charge, in response to written requests and must indicate the name and address of the person to whom such a written request is to be directed. The statement may alternatively be included in the proxy statement.

Form 10-Q consists of two parts. Part I contains financial information, and Part II contains other information such as legal proceedings and changes in securities.

A company that is required to file annual reports on Form 10-K is required to file current reports on Form 8-K if any of specified reportable events take place. If the registrant is a listed company, it must also file the Form 8-K with the appropriate stock exchange.

Form 8-K is required to report the occurrence of the events specified in Items 1–3, 8, and 9 below, and it must be filed with the SEC within 15 days after the occurrence of the earliest event reported. A report covering an Item 4 or 6 must be filed within five days after the occurrence of the event. A report covering an event in Item 5 is to be filed "promptly" (because the filing of Form 8-K for events includable in Item 5 is optional, there is no mandatory filing deadline). FRR No. 18 has amended the filing requirements of Form 8-K by providing an extension of up to 60 days to file financial statements of acquired businesses as an amendment to Form 8-K that are reportable in Item 2.

If substantially the same information required for Form 8-K has been previously reported by the registrant in a filing with the SEC (such as in Part II of Form 10-Q), there is no need to include it on a Form 8-K.

If a registrant issues a press release or other document within the specified period above, which includes the information meeting some or all of the requirements of Form 8-K, the information may be incorporated by reference to the document. The document incorporated by reference should be included as an exhibit to Form 8-K.

See Section 3.1(f), SEC Proposed Rule Making and Other Guidance, discussed previously.

Because of the geographic dispersion of the owners of a public company, it is unlikely that a quorum could be obtained at any meeting that required a vote of the shareholders. As a result, the use of proxies and proxy statements developed to facilitate such votes. A proxy is broadly defined as any authorization given to someone by security holders to act on their behalf at a stockholders' meeting. The term "proxy" also refers to the document used to evidence such authorization. Persons soliciting proxies must comply with Regulation 14A and the 1934 Act, which prescribes the content of documents to be distributed to stockholders before, or at the same time, such solicitation occurs.

The informational content of the proxy statement provided to the stockholders depends on the action to be taken by the stockholders. Schedule 14A prescribes the informational content required based on the specific circumstances.

When the vote is solicited for (1) an exchange of one security for another, (2) mergers or consolidations, or (3) transfers of assets, the transaction constitutes an "offer to sell securities." As such, a registration statement is required under the 1933 Act and can be filed on Form S-4 (Form F-4 for foreign private issuers in similar transactions).

The SEC derives its authority to regulate the solicitation of proxies from the Exchange Act and from the Investment Company Act of 1940. Section 14(a) of the Exchange Act states:

It shall be unlawful for any person, by the use of the mails or by any means or instrumentality of interstate commerce or of any facility of a national securities exchange or otherwise, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security (other than an exempted security) registered pursuant to Section 12 of this title.

Based on this statutory authority, the SEC established Regulation 14A to regulate proxy solicitations. Regulation 14A comprises the following Rules:

Because of the complexity of these rules, most are not discussed in detail here. However, it is important to remember that proxies and proxy statements are different from other SEC filings because they are required to be sent directly to the security holders. Registration statements are filed directly with the SEC. Annual reports on Form 10-K are filed with the SEC and are furnished to the shareholder only on request. Typically, the proxy materials must be given to the shareholders at least 20 days prior to the meeting date. Companies listed on the New York Stock Exchange provide shareholders 30 days to review the materials.

The proxy rules require companies to provide shareholders with proxy cards to give them more opportunity to participate in corporate elections. Shareholder proxy cards must (1) indicate whether the proxy is solicited on behalf of the board of directors, (2) enable shareholders to abstain from voting on directors and other proxy matters as well as to approve or disapprove each matter, and (3) allow shareholders to vote for or withhold authority to vote for each nominee for the board of directors.

Except as noted below, Rule 14a-6 requires that preliminary copies of the proxy statements and related materials be filed with the SEC at least 10 calendar days prior to the date definitive copies of such material are first sent or given to security holders. Such materials should be appropriately marked as "Preliminary Copies" and the date definitive materials are to be mailed to the shareholders must be stated in the filing. Earlier submission (usually more than 20 days) is advisable to allow time for any changes that may be required as a result of the SEC's selective review process.

In 1988, the SEC provided some relief in the area of proxy material review. Preliminary proxy materials need not be filed with the Commission if the solicitation relates to any meeting of security holders at which the only matters to be acted on include these six:

Information in preliminary proxy material will be made available to persons requesting it after the definitive proxy is filed, unless an application for confidential treatment for such information is made at the time of filing the preliminary proxy material and approved by the SEC. Such preliminary material will also be made available to persons requesting it if no definitive filing is anticipated.

Before the registrant files the preliminary material, the accountant should read the entire text and compare it with the financial statements. This procedure is intended to avoid inconsistencies and misleading comments of which the accountant may have knowledge and to ascertain that the financial statements include disclosures mentioned in the text that are appropriate for a fair presentation of the financial statements in conformity with GAAP.

As previously discussed, effective January 1, 1998, the SEC no longer accepts paper filings that are required to be submitted electronically. Signatures for any electronic submission are in typed form rather than manual format. However, manually signed pages must be obtained prior to the electronic filing and retained for five years.

If the audit has not been completed, the SEC requires that a letter from the independent accountant accompany the preliminary material. The letter should state that the accountant has considered the preliminary material and will allow the use of his or her report on the financial statements. This letter is addressed to the registrant, who, in turn, submits it to the SEC. When preparing the letter, the accountant should avoid using general terms such as "considered" or "reviewed" in describing the work and should avoid expressing approval, either directly or indirectly, of the sufficiency of disclosures in the text. The accountant should state that he or she has read the preliminary proxy statements and will upon completion of the audit allow use of the report on the financial statements. The financial statements covered by the report, and the date of the report, should be specified in the letter. When a proxy statement is prepared for a proposed merger, the letter should relate only to the company with which the accountant is familiar.

Copies of the definitive material that are mailed to stockholders should be filed with the SEC no later than the date such material is mailed to the stockholders.

If changed circumstances or new events arising between the time the proxy solicitation is mailed and the stockholders' meeting date cause the proxy material to be materially false and misleading, the corrected material should be disseminated promptly to the stockholders and to the SEC (with markings clearly indicating the changes).