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CURRENT DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE

CURRENT DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE. National Conference on Current SEC & PCAOB Developments December 6, 2004. Disclaimer.

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CURRENT DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE

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  1. CURRENT DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE National Conference on Current SEC & PCAOB Developments December 6, 2004

  2. Disclaimer • The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Therefore, the views expressed today are our own, and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission.

  3. Corporation Finance • Overview • Financial Reporting and Disclosure Issues

  4. Corporation Finance • OVERVIEW • Craig Olinger

  5. Accounting Branch Chiefs • Health Care & Insurance • James Atkinson • Consumer Products Michael Moran George Ohsiek • Computers & On Line Services Stephen Krikorian Brad Skinner • Natural Resources & Food • Jill Davis • Structured Finance, Transportation & Leisure Linda Cvrkel Michael Fay David Humphrey

  6. Accounting Branch Chiefs • Manufacturing & Construction • John Cash • Rufus Decker • Financial Services • John Nolan • Kevin Vaughn • Real Estate & Business Services • Kathleen Collins • Donna DiSilvio • Emerging Growth Companies • Hugh West

  7. Accounting Branch Chiefs • Electronics & Machinery • Brian Cascio • Daniel Gordon • Telecommunications • Terry French • Robert Littlepage • Kyle Moffatt

  8. Financial Reporting and Disclosure • SOX Section 404 and 302 • Use of Other Auditors Louise Dorsey Stephanie Hunsaker

  9. SOX Section 404 and 302 Effective Date for 404 404 vs. 302 Requirements Interaction of 404 and 302 • Evaluating ICFR • Management’s Report • FAQs

  10. Effective Date of 404 for Accelerated Filers • 10-K due March 16, 2005 • 11/17/04 – SEC postponed final phase-in period for one year • Annual report deadline still 75 days • Quarterly report deadlines still 40 days • Accelerated filing phase-in resumes for FYE ending on or after 12/15/05 • Annual report- due in 60 days • Quarterly report- due in 35 days

  11. Effective Date of 404 for Accelerated Filers • 11/30/04 – Exemptive Order • 45 Day Extension for cos. with • <$700 mil market cap at end of 2nd Qtr • 10-K still due March 16, 2005 • All required items except 404 reports

  12. Effective Date of 404 for Accelerated Filers • 10-K/A should include: • Two 404 reports • 302 certifications • 307/308 disclosures, revised as needed • Consent, if necessary (i.e. shelf offerings, etc) • Due 5/2/05 for calendar year filers • Co. not timely for S-3 until 10-K/A filed • No 12b-25 on the 10-K/A

  13. 404 – ICFR Annually assess ICFR Review conducted as of year-end Quarterly evaluation of any changes in ICFR Documentation requirements for auditor to test Internal control report 302 – DCP Quarterly assess DCP Review conducted as of quarter and year-end Quarterly evaluation of any changes in DCP N/A – no auditor testing requirements Officers’ certification 404 vs 302 Requirements

  14. Interaction of 404 and 302 • Substantial overlap DCP and ICFR • DCP includes components of ICFR that provide reasonable assurance that transactions are recorded as necessary to permit preparation of F/S in accordance with GAAP • Key differences • DCP – apply to material financial and non-financial information required in public reports • ICFR covers items that do not directly relate to disclosure

  15. Interaction of 404 and 302 • To the extent that ICFR impacts public disclosure, DCP are inclusive of such internal controls • Disclosure controls apply to all material information to be included in financial reports, both within & outside f/ss

  16. Interaction of 404 and 302 • Question • Could you have a situation where CFO/CEO reach a conclusion in their 302 certifications that DCP are effective at reasonable assurance level, even though there is a material weakness in ICFR?

  17. Interaction of 404 and 302 • Answer • Generally officers will not be able to conclude DCP are effective when material weaknesses have been identified in IFCR • But…… • There may be some limited circumstances

  18. Interaction of 404 and 302 • Some elements of ICFR are not directly subsumed within the definition of DCP • Example in 404 adopting release– pure safeguarding of assets

  19. Interaction of 404 and 302 • Likely impossible to conclude DCP are effective when material weaknesses exist in certain areas: • Example: • Material weakness in fraud prevention • Multiple material weaknesses

  20. Interaction of 404 and 302 • Question • What if a company has to restate its F/S because it or the auditor discovers a material weakness in ICFR that is also part of the company’s DCP?

  21. Interaction of 404 and 302 • ANSWER • Need to consider whether the disclosures provided under Item 307 in original filing must be: • modified, supplemented or corrected • in order to explain relationship between failure of DCP and restated F/S

  22. Interaction of 404 and 302 • If officers conclude original conclusions are no longer correct: • Disclose this fact based on duty to correct a misstatement when it became known and Rule 12b-20

  23. Interaction of 404 and 302 • Question • Can the officers conclude DCP were not effective as of end of reporting period covered by amended report, but conclude DCP are effective as of date the amendment filed?

  24. Interaction of 404 and 302 • Answer • Yes – • Company should expand disclosure to explain how mgmt determined DCP are now effective given the material weakness and other matters identified

  25. Interaction of 404 and 302 • Other Areas for Disclosure? • MD&A Disclosure • Material weakness in ICFR may constitute a material trend or uncertainty that should be disclosed in MD&A • Detailed discussion of material weakness • quantification and analysis of associated uncertainties & trends

  26. Evaluating ICFR • Will vary among companies • No specific method or procedures required • Must be based on procedures sufficient to evaluate both design & operating effectiveness • Documentation & evidential matter is key • Inquiry alone not adequate!

  27. Evaluating ICFR • Mgmt must attain the level of “reasonable assurance” when formulating conclusions regarding effectiveness of ICFR • Reasonable Assurance • Conforms to current auditing literature (AU 319) • Mgmt must use judgment • Implies consideration by mgmt of the cost of the control and its benefits in reducing risk

  28. Management’s Report • No standard format • Certain statements to be included: • Management’s responsibility for ICFR • Framework used • Mgmt’s assessment of the effectiveness of ICFR, as of end of most recent year • Auditor has issued report on ICFR • Disclosure of any material weaknesses

  29. Management’s Report, cont’d • Other Requirements: • Report should be located in “close proximity” to auditor’s attestation report • If management’s report contains additional information (i.e. plans, corrective actions to be taken, etc.) • Auditor to disclaim additional information

  30. Management’s Report • 2 Possible Options • Effective • Not Effective • Prohibited from concluding effective ICFR if one or more material weaknesses

  31. Management’s Report • What if management does not have the ability to assess certain aspects of ICFR? • Example: • SAS 70 report not available at service organization and no other ability to assess controls in place at the service organization

  32. Management’s Report • NO scope limitation permitted in report • Mgmt must conclude if ICFR effective or not effective based on extent of scope limitation

  33. Management’s Report • EXCEPTIONS ( SEC FAQ 1, 2, 3) • FAQ 1 – FIN 46 – entity in existence prior to 12/15/03 • FAQ 2 – equity method investments • FAQ 3 – acquisitions – 1 yr max.

  34. Required Communications • Mgmt must communicate all significant deficiencies & material weaknesses they detect to audit committee & external auditor • Part of 302 certification • Mgmt also must provide written representations to auditor

  35. SEC FAQs • 23 FAQ’s • Updated October 6, 2004 • www.sec.gov/info/accountants/controlfaq1004.htm • PCAOB also issued 3 separate sets of Staff Q&As (39) • June 23, 2004 • October 6, 2004 • November 22, 2004

  36. SEC FAQs • Scope Limitations – Questions 1–3 • FAQ 1 – consolidated VIEs, proportionate consolidations • What is the meaning of “does not have the right or authority to assess”? • Neither legal rights nor ability of mgmt to remediate deficiencies are necessarily tied to mgmt’s ability to assess ICFR • Facts and circumstances will dictate when mgmt has the ability

  37. SEC FAQs • FAQ 2- Equity investee • Not intended to prohibit registrants from assessing ICFR of investees under the equity method

  38. SEC FAQs • FAQ 3 – Recent business acquisition • Intent of issuing FAQ 3 is not to negatively impact mgmt’s business decisions • Will likely not object to anyone who decides to use this relief in the year of acquisition • “Business” as defined in EITF 98-3 or Article 11 of S-X

  39. SEC FAQs • FAQ 4 – Conclusion that ICFR is not effective • Registrant will still be considered timely & current re: • Rule 144, S-2/S-3/S-8 eligibility

  40. SEC FAQs • FAQ 9 – Disclosure of changes to ICFR made in preparation of 1st Mgmt report • Giving relief for the 302 requirement to disclose material changes in ICFR HOWEVER….. • If change is driven from material weakness, notwithstanding the relief that is being given, registrants should carefully consider disclosing the material weakness and the resulting changes

  41. SEC FAQs • Other most frequent: • FAQ 8 – Transition reports • FAQ 14 – SAS 70 reports • FAQ 21 – Consents • FAQ 22 – Annual “glossy” reports • FAQ 23 – Supplementary information

  42. Other Questions • IPO -Initial 404 assessment • Due with first annual report • once effective date passes • Discontinued operations not finalized as of end of year • No relief

  43. Other Questions • Registrants in Chapter 11 • No automatic exemption from 404 • If registrant qualifies for modified reporting under SLB 2 then registrant does not need to comply with 404 • Must request relief in advance

  44. What we are seeing • Significant deficiencies & material weaknesses identified are being disclosed in Form 8-K and Form 10-Q • Typical areas where significant deficiencies/material weaknesses have been identified: • Personnel issues • Financial systems • Restatements due to lack of controls

  45. Final Remarks • We know there will be material weaknesses Key is disclosure • What the problem is • What it impacts • How are you going to remediate • Timetable for remediation

  46. Use of Other Auditors • EXAMPLE: • U.S. auditor relies on work of foreign audit firm to perform work on foreign subs of registrant • U.S. firm chooses not to place reliance on work of other audit firm (i.e. no reference to other auditor)

  47. Use of Other Auditors • Foreign firm must be registered with PCAOB if: • Performing a “substantial portion of the audit” • Foreign firm must be “recognized” by SEC

  48. Use of Other Auditors • “Recognition” of Foreign Firm • Registration with PCAOB does not supercede existing means by which a firm demonstrates its qualifications to practice before the SEC • US affiliation and Appendix K compliance • Demonstration to OCA of knowledge and experience of applying U.S. GAAP, PCAOB standards, SEC rules and SEC independence requirements

  49. Use of Other Auditors • Other Questions: • What if U.S. firm uses local persons as independent contractors? • i.e., Individuals, not firms • Is the U.S. firm required to travel to the foreign location as part of the audit?

  50. Other Auditor Issues • Licensing Requirements • Have seen instances where auditor is not licensed in the state or country where principal audit procedures were conducted • Problematic in certain instances • Addressing on case-by-case basis • Contact DCF with questions on real life fact patterns

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