Speech: Current Accounting Issues and Related …CURRENT ACCOUNTING ISSUES AND RELATED DEVELOPMENTS...

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CURRENT ACCOUNTING ISSUES AND RELATED DEVELOPMENTS AFFECTING THE DIVISION OF CORPORATION FINANCE (as of July 1, 1993) Teresa E. Iannaconi U.S. Securities & Exchange Commission * Washington, D.C. (c) Copyright 1993, All Rights Reserved. This outline has been and may be used in connection with other programs. * As a matter of policy, the Commission disclaims responsibility for any private pUblications by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff.

Transcript of Speech: Current Accounting Issues and Related …CURRENT ACCOUNTING ISSUES AND RELATED DEVELOPMENTS...

CURRENT ACCOUNTING ISSUES AND RELATED DEVELOPMENTSAFFECTING THE DIVISION OF CORPORATION FINANCE

(as of July 1, 1993)

Teresa E. IannaconiU.S. Securities & Exchange Commission *

Washington, D.C.

(c) Copyright 1993, All Rights Reserved. This outline has beenand may be used in connection with other programs.

* As a matter of policy, the Commission disclaims responsibilityfor any private pUblications by any of its employees. The viewsexpressed are those of the author, and do not necessarilyrepresent the views of the Commission or the author's colleagueson the staff.

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CURRENT ACCOUNTING ISSUES AND RELATED DEVELOPMENTSAFFECTING THE DIVISION OF CORPORATION FINANCE

(as of July 1, 1993)I. Recently Adopted Rules and Interpretive Releases . . 1

A. Small Business Initiatives • • . . . . . • . . 1B. Executive Compensation Disclosure . . . . . . . .. 6C. EDGAR (Electronic Data Gathering, Analysis and

Retrieval) ... 0 8D. Environmental and Product Liability Loss

Contingencies • . • • . . • • • . . . . • • . . . . 10E. Amendments to Multijurisdictional Disclosure System. 13

II. Other Financial Reporting Issues of Current Interest. 13A. Disclosures Regarding the Realization of a

Deferred Tax Asset Recognized Pursuant toSFAS 109. . . . . . . . . . . . . . . . . . . . . . 13

B. Issues Affecting Insurance Companies . . . . . . . . 14C. Management's Discussion and Analysis - Recent

Enforcement Action . . • • . . . . . . . . . . . . 15D. Disclosures about Foreign Operations and Foreign

Currency Transactions • . • . . • . . . . • . . . . 16E. Disclosures and Accounting for Discontinued Operations

. . . . . . . . . . . . . . . . . . . . . . . . . . 17F. Disclosures about New Accounting Standards . . . . 19G. "Other Than Temporary" Declines in Value of Debt and

Equity Marketable Securities . . • . . . • . . . . 21III. Frequent Inquiries Regarding Application of Regulation S-X

and Other Disclosure Practices • . . . . . . . . . . . . 23A. Financial Statements of Businesses Acquired

(Rule 3 05) . . . . . . . . . . . . . . . . . . . . .23B. Financial Statements Relating to Third Party Credit

Enhancements . . . . . . . . . . . . . . . . . . . . 26C. Surviving Company in a Reverse Acquisition . . • . . 26D. Redeemable Equity Securities •• •..•..•.. 27E. Distributions to promoters/Owners at or prior to

CIosing of IPO • • • . • • • • • • • • . . . . • . 28F. Other Changes in Capitalization at or prior to

Closing of IPO • . . . • • • • . . • • . . . . . . 28G. Calcula~ion of EPS in an Initial Public Offering 29H. Accounting for Shares Placed in Escrow in

connection with an Initial Public Offering . . . . 30I. Accounting and Disclosures Involving Lending

Acti vi ties .. . . . . . . . . . . . . . . . . . . 31J. Disclosures Regarding Risks Associated With Real

Estate . . . . . . . . . . . . . . . . . . . . 32

• • • • • • • • • • • " • •

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CURRENT ACCOUNTING ISSUES AND RELATED DEVELOPMENTSAFFECTING THE DIVISION OF CORPORATION FINANCE

(as of July 1, "1993)

I. Recently Adopted Rules and Interpretive ReleasesA. Small Business Initiatives

On July 30, 1992, and April 27, 1993, the Commissionadopted new rules and forms under the Securities Act of1933, the Securities Exchange Act of 1934, and theTrust Indenture Act of 1939 to facilitate capitalraising by small businesses. Specifically, theCommission revised Regulation A and Rule 504 ofRegulation D to expand the categories of companieseligible to use those exemptions and increased thedollar ceiling for an offering under Regulation A. Inaddition, for "small business issuers" reporting underthe Securities Act and the Exchange Act, the Commissionadopted a system of simplified registration andreporting.1. Integrated Disclosure System for Registration and

Reporting for Small Business IssuersThe Commission adopted a new integrated disclosuresystem for Small Business Issuers. The system consistsof specialized forms under the Securities Act and theExchange Act that reference disclosure requirementslocated in one central depository - Regulation S-B.The new forms adopted by the Commission include formsSB-2, 10-SB, 10-QSB, and 10-KSB. Old Form S-18 hasbeen rescinded. The new disclosure system for smallbusiness issuers is optional: an issuer that wouldqualify as a small business may elect to continue touse the present reporting system.A small business issuer is defined as a u.S. orcanadian entity that meets all of the following tests:* revenues of less than $25 million,* the aggregate market value of the entity'S voting

stock held by non-affiliates (referred to as the"public float") is less than $25 million,

* if the small business issuer is a majority ownedsubsidiary of another company, its parent mustalso meet the definition of a small businessissuer, and

* investment companies are excluded from thedefinition.

An estimated 3,000 reporting public companies fallwithin the definition of a small business issuer.

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The information required by Regulation S-B issubstantially the same as that required by old Form S-18. The financial statements required to be includedin small business registration statements and annualreports are an audited balance sheet as of only themost recently completed year end (unless such year endoccurred within the last 90 days) and statements ofoperations and cash flows for each of only the last twofiscal years. Interim financial statements must beprovided if the fiscal year end financial statementsare more than 135 days old. Both annual and interimfinancial statements must comply with generallyaccepted accounting principles, but are not required tocomply with Regulation S-X. Financial statementschedules are not required to be included in filings onsmall business forms. The narrative disclosurerequirements in Regulation S-B generally parallel thoseof Regulation S-K, but where such-requirements weresimplified or not omitted by Form S-18, Regulation S-Bgenerally tracks the reduced requirements of Form S-18.In connection with the development of Regulation S-B,Item 17A (disclosures concerning mining operations) ofold Form S-18 has been redesignated as Guide 7 underthe Securi~ies Act and Exchange Act. The Commissionindicated in the adopting release that small businessissuers engaged in operations involving real estate,mining, insurance, banking, utilities, and oil and gasshould also refer to the applicable industry guide. Inaddition, roll-up transactions are required to furnishthe disclosure required by subpart 900 of RegulationS-K.Form SB-2 is the new designated Securities Actregistration form for small business issuers. There isno dollar limit for offerings on Form SB-2 and the formmay be used for both initial and repeat offerings.For a company entering the Commission's disclosuresystem, either through a Securities Act or an ExchangeAct registration statement, its eligibility to use theoptional SB system will depend on the level of itsrevenues in its last full fiscal year, and itscapitalization as of a date within 60 days prior to theoffering in a Securities Act registration statement orthe filing of the registration statement under theExchange Act. The determination as to the reportingcategory at the time a non-reporting company enters thedisclosure system (i.e. the use of Form S-l or Form SB-2) governs all reports relating to the remainder of thefiscal year. After the initial registration statementon Form S-B, a company may continue to report under the

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SB system until it exceeds the revenue test for twoconsecutive years or the public float test for twoconsecutive years, based on its annual report on Form10-KSB. A small business issuer that elects to fileits initial registration using Form S-l must report forthe remainder of its fiscal year pursuant to RegulationS-K and Regulation S-X.In order for a company currently reporting with theCommission to enter the SB disclosure system, it mustmeet the definition of a small business issuer for twoconsecutive years. The determination made for areporting company at the end of its fiscal year (afterfiling its Form 10-K or 10-KSB) governs all reportsrelating to the next fiscal year. An issuer may notchange from one category to another with respect to itsreports under the Exchange Act for a single fiscalyear.Notwithstanding an issuer's classification as a smallbusiness, small business issuers are permitted toregister securities on Forms S-2, S-3 and S-8 if theyotherwise meet the eligibility requirements for use ofthose forms. References in those forms to thedisclosure requirements of Regulation S-K will bedeemed to be references to Regulation S-B for smallbusiness issuers. Form 8B-2 is available only for theregistration of securities to be sold for cash.Accordingly, small business issuers wishing to enterbusiness combination transactions which involve theregistration of securities will continue to be requiredto register those transactions on Form 8-4 or Form 8-1.If a small business issuer elects, or is required, touse Form S-l, the filing must contain all thedisclosure requirements of Regulation S-K and thefinancial statements required by Regulation S-X.2. Additional Initiatives Relating to SB Disclosure

SystemOn April 27, 1993, the Commission adopted additionalrules and forms to ease a small business issuer'stransition from non-reporting to reporting status andto simplify the disclosure requirements for smallbusiness issuers that engage in exempt offerings.Under the transitional filer rules, a small businessissuer may enter the reporting system using RegulationA disclosure and only one year of audited financialstatements either through an Exchange Act registrationstatement and two years of audited financial statementsfor a public offering of up to $10 million in any

4continuous 12 month period. These small businessissuers would be permitted to meet their subsequentExchange Act reporting requirements using theRegulation A model of disclosure until such time asthey either (1) register more than $10 million in anycontinuous 12 month period, (2) elect to graduate toanother disclosure system, or (3) are no longer smallbusiness issuers.In order to implement this transitional system,amendments to Forms S-2, S-4, 10-SB, 10-KSB, and 10-QSBwere adopted, in addition to amendments to Schedule 14Aunder the proxy rules. Further a new Securities Actregistration statement, Form SB-1, was adopted topermit qualifying small business issuers to make smallregistered offerings up to $10 million annually usingthe Regulation A format with two years of auditedfinancial statements.Two refinements to the financial statement requirementsfor small business issuers were also adopted. Thefirst provides an automatic waiver of the requirementsfor audited financial statements of specifiedsignificant acquired businesses if the required auditedfinancial statements are not otherwise available. Ifan issuer has other financial statements or informationwhich constitute less than the full audited financialstatements required, such other financial statements orinformation will be required to be provided. If noneof the conditions in the definitions of significantsubsidiary exceeds 20%, and the required auditedfinancial statements are not readily available, anautomatic waiver of the required audited financialstatements would be granted. In addition, if none ofthe conditions in the definitions of significantsubsidiary exceeds 40% and the required auditedfinancial statements are not readily available, anautomatic waiver would be available for the fiscal yearpreceding the latest fiscal year. The secondrefinement widens the initial public offering (IPO)financing window for small business issuers bypermitting them to proceed throughout the first quarterof thei~ fiscal years without having to wait forcompletion of the audit for the preceding fiscal year,rather than update 45 days after fiscal year-end.3. Changes to Regulation AThe new rule raises the dollar ceiling for a RegulationA offering from $1,500,000 to $5,000,000, including nomore than $1,500,000 in non-issuer resales. TheRegulation A exemption is now available to all u.S. and

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Canadian issuers not subject to Section 13 or 15(d) ofthe Exchange Act, except the following:* "blank check" companies (issuers having no

specific business or plan),* investment companies required to be registered

pursuant to the Investment Company Act of 1940,* registrants issuing fractional undivided interests

in oil or gas rights or similar interests in othermineral rights,

* registrants disqualified because of the "Bad Boy"disqualification provisions of Section 262 ofRegulation A.

The Commission's safe harbor prov1s10ns for forwardlooking information have been revised to apply tostatements made in a Regulation A offering statement.Therefore, good faith projections, with a reasonablebasis, of revenues, income, earnings per share, capitalexpenditures, dividends, capital structure and otherfinancial items may be made in Regulation A filingsunder the same conditions as for other Commissionfilings.As discussed in the March 1992 Proposing Release, oneof the major impediments to a Regulation A financingfor a small start-up or development company was thecosts of preparing the mandated offering statementwithout knowing whether there would be any investorinterest in the company. To remedy this situation, theCommission adopted the proposal to permit companiesrelying on the Regulation A exemption to "test thewaters" for potential interest in the company prior tofiling and delivery of the mandated offering statement.As adopted, the "testing of the waters" must begin witha written solicitation of interests. The solicitationdocument must also be submitted to the Commission atthe time of its first use. Although the rulesgenerally provide for a "free writing" of thesolicitation document, the document must include thefollowing items:(a) a statement that no money is being solicited, or

will be accepted; that no sales can be made untildelivery and qualification of the offeringcircular, and that indications of interest involveno obligation or commitment of any kind; and

(b) a brief, general identification of the company'sbusiness, products and chief executive officer.

Once the offering statement required by Regulation A isfiled with the Commission, the issuer may not continueto use its written "test the waters" solicitationmaterials.

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4. Changes to Rule 504 of Regulation DAs amended in April 1993, Rule 504 permits a publicoffering of up to $1 million in a 12-month period by anon-Exchange Act reporting company subject only to theanti-fraud and other civil liability provisions of thefederal securities laws. The amendment eliminated theconditions regarding state registration previouslyimposed by the Rule. In addition, Rule 504, asamended, permits general solicitation and generaladvertisement in connection with all offers and salesunder the exemption. Rule 504 is not available to"blank check" companies.

B. Executive Compensation DisclosureOn October 15, 1992, the Commission adopted (SecuritiesAct Release No. 6962) amendments-to the executivecompensation disclosure requirements of Item 402 ofRegulation S-K. The amendments are designed to makecompensation disclosure clearer and more concise, andof greater utility to shareholders.The new rules require disclosure of all compensation tothe named executive officers and directors of theregistrant for services rendered to the registrant inall capacities. The named executive officers consistof the chief executive officer ("CEO") and the otherfour most highly compensated officers (collectively,the "named executive officers"). Except for the CEO,disclosure is limited to those executives with salaryand bonus of over $100,000 (an increase from the former$60,000 threshold) for the last completed fiscal year.The Summary Compensation Table is the linchpin of theCommission's revised executive compensation disclosurescheme. It is intended to provide shareholders with acomprehensive overview of the registrant's executivepay practices, identify trends in the registrant'scompensation of its top managers and allow shareholdersto compare such trends with those disclosed by otherregistrants. The Summary Compensation Table coverscompensation of the named executive officers in each ofthe registrant's last three fiscal years, although twoof the columns ("Other Annual Compensation" and thecatch-all "All Other Compensation") may be phased in bycompanies over the first three years of reporting. Inaddition, small business issuers may phase in theentire table over 3 years. The Summary CompensationTable is required to be presented in the tabular formatspecified in Item 402 of Regulation S-K. Specificallythe table contains three specific columns relating to

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annual compensation (Salary, Bonus, and Other), threespecific columns relating to long-term compensation(Restricted Stock Awards, SARS & Options, and Long TermIncentive Payouts), and a final column reporting anycompensation not reported under the any other column.In addition to the information provided in the SummaryCompensation Table, the new rules require severaladditional tables containing more specific data on thecomponents of compensation disclosed in the SummaryCompensation Table. The five additional tables requirethe registrant provide detailed information concerning:* Grants of options and SARs to each of the named

executives during the last fiscal year.* Exercises by the named executives of options and

SARs during the last fiscal year and the value ofeach of the named executives~ outstanding optionsand SARs at year end.

* Awards under long-term incentive plans during thelast fiscal year. Included in this table iscompensation that is based on the registrant'sperformance for a period of more than one year.

* Compensation and disclosures related to pensionand other defined benefit or actuarial plans.

* Disclosures relating to the repricing of optionsor SARs during the last fiscal year.

Further, in order to allow shareholders to comparecompensation trends with those disclosed by otherregistrants, the new rules require a Performance Graphrequiring registrants to provide a line graph comparingthe registrant's cumulative total shareholder return(stock price appreciation plus dividends, on areinvested basis) with a overall stock market returnperformance indicator (such as the S&P 500 stock index)and either a published industry index or registrant-determined peer comparison. Registrants not includedin the S&P 500 may choose another broad equity marketindex for comparison. Registrants have broaddiscretion in determining their peer comparison. Ifthey do not believe a peer comparison is feasible, theymay disclose this belief and compare their shareholderreturn to one or more companies selected on the basisof similar market capitalization.In addition, the new rules require a Board CompensationCommittee Report on executive compensation whichdiscloses, among other items, the registrant'scompensation policies, including the specificrelationship of corporate performance to executivecompensation (Item 402(k».

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The information required by the option/SAR repricingtable, the Board Compensation Committee Report, and theperformance graph need not be provided in any filingsother than the registrant's proxy or informationstatement relating to an annual meeting of securityholders at which directors are to be elected (orspecial meeting or written consents in lieu of suchmeeting). Such information will not be deemedincorporated by reference into any filing under theSecurities Act or Exchange Act, except to the extentthat the registrant specifically incorporates it byreference.Small business issuers eligible to use the smallbusiness integrated disclosure system will be requiredto provide only the summary compensation table, theoption and SAR grant and exercise-tables (omittingoption valuation information), the long-term incentiveplan awards table, and disclosure concerning option orSAR repricing (omitting the 10-year repricing history),named executive officer employment contracts andtermination/severance arrangements, and directorcompensation (see Item 402 to Regulation S-B, asamended). Small businesses not electing to use thesmall business integrated disclosure system maynonetheless provide this more streamlined disclosurepursuant to Item 402(a) (1)(i) of Regulation S-K. Inaddition, small business issuers are eligible to fileunder the rules in effect prior to the effective dateuntil May 1, 1993.

C. EDGAR (Electronic Data Gathering, Analysis andRetrieval)On February 23, 1993, the Commission issued fourreleases adopting the rules that had been proposed inJuly 1992 requiring most documents processed by theDivisions of Corporation Finance and InvestmentManagement to be filed electronically by directtransmission, diskette, or magnetic tape. The releasesalso contain phase-in schedules to bring registrants(as well as parties making filings with respect tothese registrants) onto the EDGAR system. That phase-in began on April 26, 1993. The new rules becameeffective April 26, except the provisions relating toFinancial Data Schedules are effective November 1,1993. The rules were published in the Federal Registeron March 18, 1993. The EDGAR Filer Manual waspublished in the Federal Register on April 9, 1993.

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The first release (Securities Act Release No. 6977)explains the EDGAR system generally and sets forthrules and procedures that apply to electronicsubmissions by the Division of Corporation Finance andin some cases, to those processed by the Division ofInvestment Management. The second release (InvestmentCompany Act Release No. 19284) adopts rules specific toelectronic submissions made by investment companies.The third release (Public Utility Holding Company ActRelease No. 25746) adopts rules specific to electronicsubmissions made by public utility holding companiesand their subsidiaries. The fourth release (SecuritiesAct Release No. 6980) relates to the paYment of filingsfees, by both paper and electronic filers, to theCommission's lockbox depository at Mellon Bank inPittsburgh, Pennsylvania pursuant to Rule 3a of theRules Relating to Informal and Other Procedures.The EDGAR pilot has been operational since September24, 1984. Through the closing of the EDGAR Pilot onJuly 14, 1992, the Commission received over 116,000electronic filings from over 1800 filers. The newEDGAR system began receiving live filings by the formerEDGAR participants ("Transitional Filers") on July 15,1992. On April 26, 1993, the temporary rules weresuperseded by the new rules adopted in February 1993.The new rules, including the most recent version of theEDGAR Filer Manual, will govern the preparation andtransmission of electronic submissions. Section35A(c} (5) of the Exchange Act requires that mandatedfilings from a "significant test group" of registrantsbe received and reviewed by the Commission for at leastsix months before the final adoption of any rulerequiring electronic filing by registrants.Accordingly, the rules adopted in February 1993 arereferred to as "interim rules."The "significant test group" will be phased in betweenApril and December 1993, in four groups. The firstgroup began phase-in on April 26, 1993. Group CF-01consists of approximately 230 companies - mostlyTransitional Filers, with a few additional volunteers.The next group, Group CF-02, consisting ofapproximately 700 registrants whose filings areprocessed by the Division of Corporation Finance, willbegin mandated electronic filing on July 19, 1993. Thethird group (Group CF-03) and fourth group (Group CF-04) of the significant test group will consist ofapproximately 700 and 900 registrants, respectively,whose filings are processed by the Division.

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After the significant test group has successfully filedfor at least six months, the Commission will adoptfinal EDGAR rules modified to reflect the experiencegained during that period. Registrants will then bephased in, in groups of approximately 500, every threemonths (except for the first calendar quarter of everyyear), with any new registrants or others not named inthe phase-in schedule included in the last group phasedin. This residual category does not include foreignprivate issuers or foreign governments, which will notbe required to file on EDGAR at this time, althoughthey will be considered if they wish to volunteer.

D. Environmental and Product Liability Loss ContingenciesOn June 8, 1993, the staff issued Staff AccountingBulletin No. 92 ("SAB 92") which-expresses certainviews of the staff regarding accounting and disclosuresrelating to loss contingencies. This SAB pertains toall loss contingencies, but provides additionalguidance for environmental and product liabilities.The SAB states that offsetting a claim for recoverythat is probable of realization against a probablecontingent liability in the balance sheet ordinarily isnot appropriate. This view is consistent with theconsensus reached by the Emerging Issues Task Force(EITF) on Issue No. 93-5 that indicated that anenvironmental liability should be evaluated separatelyfrom any potential claim for recovery. Any lossarising form the recognition of an environmentalliability should be reduced by a potential claim onlywhen that claim is probable of realization. Since therisks and uncertainties associated with the liabilityare different from those associated with any potentialrecovery from third parties, the staff believes thatthe liability and the probable recovery should bepresented separately on the face of the balance sheet.The staff will not object to net presentation until theadoption of FIN 39 (to be applied to fiscal yearsbeginning after December 15, 1993) provided that thenotes to the financial statements disclose the grossamount of each component of the net liability. Thestaff believes there is a rebuttable presumption thatno asset should be recognized for a claim for recoveryfrom a party that is asserting that it is not liable toindemnify the registrant. Registrants that overcomethat presumption should disclose the amount of recordedrecoveries that are being contested and discuss thereasons for conclUding that the amounts are probable ofrecovery.

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The EITF also reached a consensus to Issue 93-5 statingthat discounting of environmental liabilities isappropriate only when the aggregate obligation and theamount and timing of the paYments are fixed or reliablydeterminable. That consensus sets forth criteria fordiscounting and disclosure requirements wherediscounting is appropriate. The EITF could not reacha consensus on the appropriate discount rate. Thestaff believes that the rate applicable is that ratewhere the liability could be settled in an arm's lengthtransaction. If that rate is not readily determinable,the SAB states that the rate should not exceed theinterest rate on risk free monetary assets havingmaturities comparable to that of the liability.

Registrants should avoid boiler plate disclosuresregarding the possible impact of significantuncertainties. For example, a statement that thecontingency is not expected to have a material effecton financial condition could be incomplete or confusingif the possible loss would be material to an investorbased on another reasonable measure, such as onerelating to liquidity or operating results. Further,this representation implies that management hasdetermined the range of possible loss. If it isreasonably possible that the outcome of uncertaintiesmay result in a liability exceeding the accruedliability by an amount which would be material,paragraph 10 of SFAS 5 requires disclosure of thatrange of reasonably possible loss or a clear statementthat a range cannot be estimated.Registrants are reminded that, notwithstandingsignificant uncertainties affecting the measurement ofcontingencies, management may not delay loss accrualuntil only a single amount can be reasonably estimated.If management is able to determine that the amount ofthe liability is likely to fall within a range and noamount within the range can be determined to be thebetter estimate, the registrant should record theminimum~ount of the range pursuant to FIN 14.Measurement of a liability for environmental clean-upshould be based on currently enacted laws andregulations and on existing technology. A registrantshould consider all available evidence including itsown and other companies' prior experience in cleaningup contaminated sites and data released by EPA. Thestaff believes information necessary to support areasonable estimate or range of loss may be available

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prior to the performance of any detailed remediationstudy. Estimates of costs associated with alternativeremediation strategies may provide a reasonable basisto recognize a minimum probable loss.Information necessary to an understanding of materialuncertainties affecting both the measurement of theliability and the realization of recoveries should befurnished. This may include the following: the extentto which unasserted claims are reflected in any accrualor may affect the magnitude of the contingency; theextent to which joint and several liability with otherparties may affect the magnitude of the contingency,including disclosure of the aggregate expected cost toremediate sites where the likelihood of contribution byother significant parties has not been established; thenature and terms of cost-sharing arrangements withother PRPs; the extent to which disclosed butunrecorded contingent losses are subject to recoverythrough insurance, indemnification arrangements, orother third parties, with disclosure of the limitationsof that recovery; the extent to which insurancecoverages are subject to dispute; and the effects onthe company's liquidity and capital resources ofexpected expenditures in light of the expected timingof reimbursement by third parties.Registrants may succeed to a material contingentliability as a result of a business combination. Ifthe registrant is awaiting additional informationnecessary for the measurement of a contingency of theacquired company during the allocation period specifiedby SFAS 38, the registrant should disclose that thepurchase price allocation is preliminary. In thiscircumstance, the registrant should describe the natureof the contingency and furnish other availableinformation which will enable a reader to understandthe magnitude of any potential accrual and the range ofreasonably possible loss. Discussion of thecontingency is likely to be warranted in MD&A.The SAB advises registrants operating in a rateregulated environment that the recordation of aliability for a loss contingency does not automaticallygive rise to a regulatory asset. Registrants aredirected to the criteria for asset recognition inparagraph 9 of SFAS 71. The SAB indicates thatrecognition of a contingent loss should not be delayeduntil the registrant is advised by the regulator as towhether such costs are allowable for rate makingpurposes.

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E. Amendments to Multijurisdictional Disclosure SystemOn JUly I, 1993, the Commission adopted amendments tothe MJDS (Securities Act Release No. 7004) to providefor retention of the requirement that financialstatements included in filings on Forms F-10 and 40-Finclude a reconciliation to u.S. GAAP. In connectionwith the adoption of the MJDS in 1991 the Commissionhad provided that the reconciliation requirement wouldcease for certain MJDS filings after July I, 1993unless the Commission acted to retain the requirement.A staff report regarding reconciliation of financialstatements of foreign issuers indicated that therecontinue to be significant differences in accountingprinciples and practices between Canadian and u.S.GAAP. The Commission qoncluded that the differencesbetween Canadian and u.S. GAAP materially affectreported financial position and results of operationsand related trend information which warrant retentionof the currently existing reconciliation requirements.

II. Other Accounting and Disclosure Issues of Current InterestA. Disclosures Regarding the Realization of a Deferred Tax

Asset Recognized Pursuant to SPAS 109SFAS 109 ("Accounting for Income Taxes") requiresrecognition of future tax benefits attributable to taxnet loss carryforwards and deductible temporarydifferences between financial statement and income taxbases of assets and liabilities. Deferred tax assetsmust be reduced by a valuation allowance if, based onthe weight of available evidence, it is more likelythan not that some portion or all of the benefits willnot be realized. Notes to financial statements mustdisclose the amount of the valuation allowance andchanges therein. If a registrant has recognized a netdeferred tax asset that is material to stockholdersequity, it may be necessary to discuss uncertaintiessurrounding realization of the asset and materialassumptions underlying management's determination thatthe net asset will be realized. If the asset'srealization is dependent on material improvements overpresent levels of consolidated pre-tax income, materialchanges in the present relationship between incomereported for financial and tax purposes, or materialasset sales or other nonroutine transactions, adescription of these assumed future events, quantifiedto the extent practicable, should be furnished in theMD&A. For example, the minimum annualized rate by

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which taxable income must increase during the tax NOLcarryforward period should be disclosed if realizationof the benefit is dependent on taxable income higherthan currently reported. Also, if significantobjective negative evidence indicates uncertaintyregarding realization of the deferred asset, thecountervailing positive evidence relied upon bymanagement in its decision not to establish a fullallowance against the asset should be identified.

B. Issues Affecting Insurance Companies1. Retrospectively Rated ContractsAt the March 16, 1993, meeting of the Emerging IssuesTask Force, the FASB staff ancrSEC Observer expressedtheir views regarding the accounting for certainreinsurance arrangements, commonly called "fundedcatastrophe covers". Through a variety of contractualadjustment features, these arrangements may effectivelyrequire a ceding insurer to repay loss reimbursementspreviously received from a reinsurer. The SEC staff isof the view that funded catastrophe covers which do nottransfer insurance risk under SFAS 60 must be accountedfor as a deposit arrangement, rather than asreinsurance. Even when a funded catastrophe covertransfers significant insurance risk to a reinsurer,loss recognition under SFAS 5 is required when theceding insurer has an obligation for future paymentsthat will not result in a commensurate future benefit.Registrants that have accounted for funded catastrophecovers on a basis other than as described above during1991 or 1992 will be required to restate theirfinancial statements accordingly.2. Assumption ReinsuranceInsurance companies should consider the accounting anddisclosures implications of a recent federal districtcourt decision (Security Benefit Life Insurance Companyy. FDIC). That decision held that state laws requirethe consent of the insured before the ceding company'sliabilities may be extinguished in an assumptionreinsurance transaction. Consequently, an insurancecompany may be held primarily or contingently liablefor policy liabilities transferred in assumptionreinsurance transactions where consent of policyholdershas not been obtained. Registrants should consider therequirements of SFAS 5 (with respect to recognition ordisclosure of this contingency in the financialstatements), and Item 303 of Regulation S-K (with

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respect to disclosure in MD&A of the reasonably likelyeffects of this uncertainty) .SFAS 113, Accounting and Reporting for Reinsurance ofShort-Duration and Long-Duration Contracts, effectivefor 1993 year-end financial statements, prohibits theremoval of policy liabilities from the financialstatements when the reinsurance contract does notrelieve the ceding insurer of the legal liability tothe policyholder. Registrants should consider theapplicability of the federal district court decision inassessing whether legal liability has beenextinguished.

C. Management's Discussion and Analysis - RecentEnforcement ActionThe Commission apnounced that oniMarch 31, 1992,administrative proceedings under the Exchange Act wereinstituted against Caterpillar Inc. ("Caterpillar") forviolations of Section 13{a) of the Exchange Act andRules 13a-1 and 13a-13 promulgated thereunder.Simultaneously with the institution of theseproceedings, the Commission accepted Caterpillar'sOffer of Settlement in which it consented to the entryof a Cease and Desist Order. (ReI. No. 34-30532).The Commission determined that Caterpillar failed toadequately disclose the importance of its Braziliansubsidiary's 1989 earnings to Caterpillar's overallresults of operations in the MD&A portion ofCaterpillar's 10-K for the year ended December 31,1989. The Commission also determined that Caterpillarfailed to adequately disclose known trends anduncertainties regarding its Brazilian operations in its1989 10-K and in its Report on Form 10-0 for thequarter ended March 31, 1990.The Commission'S Order requires Caterpillar to ceaseand desist from violating Section 13{a) of the ExchangeAct and Rules 13a-1 and 13a-13 thereunder, andimplement and maintain procedures designed to ensurecompliance with the MD&A requirements.The Commission previously issued an interpretiverelease (ReI. No. 33-6835; May 18, 1989) on MD&A (Item303 of Regulation S-K). The release sets forth theCommission's views regarding several disclosure mattersthat should be considered by registrants in preparingMD&As. The release emphasized the distinction betweenprospective information that is required to bedisclosed, and voluntary forward-looking disclosure.

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The release states that if there is a known trend,demand, commitment, event or uncertainty, managementmust make two assessments to determine what prospectiveinformation is required.First management must determine whether the knowntrend, demand, commitment, event or uncertainty islikely to come to fruition. If management determinesthat it is not reasonably likely to occur, nodisclosure is required.Second, if management cannot make the determinationthat the event is not likely to occur, it must evaluateobjectively the consequences of the known trend,demand, commitment, event or uncertainty, on theassumption that it will come to fruition. Disclosureis then required unless management determines that amaterial effect on the registrant+s financial conditionor results of operations is not reasonably likely tooccur. Each final determination resulting from theassessments made by management must be objectivelyreasonable, viewed as of the time the determination ismade. The release clarifies that the safe harbor rulesapply not only to voluntary forward-looking statements,but also to prospective information that is required tobe disclosed.The release also provides interpretive guidanceregarding the following matters: long and short-termliquidity and capital resources analysis; materialchanges in financial statement line items; requiredinterim period disclosure; MD&A analysis on a segmentbasis; participation in high yield financing, highlyleveraged transactions or non-investment grade loansand investments; the effects of federal financialassistance upon the operations of financialinstitutions; and preliminary merger negotiations.

D. Disclosures about Foreign Operations and ForeignCurrency TransactionsAn increasing number of registrants conduct materialoperations outside their home country and enter intomaterial transactions denominated in currencies otherthan the currency in which their financial statementsare reported. These registrants should reviewmanagement's discussion and analysis and the notes tofinancial statements to ensure that disclosures aresufficient to inform investors of the nature and extentof the currency risks to which the registrant isexposed and to explain the effects of changes inexchange rates on its financial statements. SFAS 14

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requires quantitative disclosures regarding exportrevenues and foreign operations. MD&A should includediscussion of the historical and reasonably likelyfuture effects of changes in currency exchange rates onrevenues, costs, and business practices and plans.Identification of the currencies of the environments inwhich material business operations are conducted isrecommended. Discussion of foreign operations in adisaggregated manner may be necessary, particularlywith respect to businesses operating in a highlyinflationary environment or if operating cash flows ofa foreign operation are not available for legal oreconomic reasons to meet the registrant's other shortterm cash requirements. Registrants also shouldquantify the extent to which trends in amounts reportedin their financial statements are attributable tochanges in the value of the reporting currency relativeto the functional currency of.the-underlyingoperations, and any materially different trends inoperations or liquidity that would be apparent ifreported in the functional currency should be analyzed.Finally, registrants should identify material unhedgedmonetary assets, liabilities or commitments denominatedin currencies other than the operation's functionalcurrency, and strategies for management of currencyrisk should be described.

E. Disclosures and Accounting for Discontinued OperationsIn the course of its reviews of filings by registrantsduring the last few years, the staff has encountered anumber of issues relating to the accounting anddisclosures for discontinued operations. The staff'sviews regarding a number of these matters follows:1. Significant interest retained: A registrant thatdisposes of its controlling interest in an operationthat is a business segment as defined by APB 30 shouldnot classify the historical operating results of thesegment and gain or loss on its disposal outside ofcontinuing operations if the registrant retains asufficiently large minority voting interest directly inthe segment or in the buyer of the segment such thatthe registrant is required by APB 18 to account for itsresidual investment using the equity method. The staffbelieves retention of an interest sufficient to enablethe registrant to exert significant influence over thesegment's operating and financial policies isindicative of a level of continuing involvement withthe segment that is inconsistent with itsclassification as a discontinued business. In thesecircumstances, the transact~on should be accounted for

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as the disposal of a portion of a line of a businesswith its effects classified within continuingoperations pursuant to the AICPA interpretation to APB30.2. Subsequent developments: A registrant thatreceived debt or equity securities of the buyer of adiscontinued segment as consideration in the saleshould not record subsequent changes in the carryingvalue of those securities within discontinuedoperations. The staff believes changes in the netcarrying value of assets received in consideration onthe sale of a segment do not affect the determinationof gain or loss at the disposal date, but represent theconsequences of management's hold-or-sell decisionswith respect to those assets after the disposal date.Gains and losses, dividend and interest income, andportfolio management expenses associated with assetsreceived as consideration for discontinued operationsshould be reported within continuing operations,classified in a manner consistent with the income andexpenses associated with other, similar investments ofthe registrant. However, adjustments of estimates ofcontingent liabilities or contingent assets whichremain after disposal of a segment or which arosepursuant to the terms of the disposal generally shouldbe classified within discontinued operations.3. Disclosures: MD&A should include disclosure ofknown trends, events and uncertainties involvingdiscontinued operations that may materially affect theregistrant's liquidity, financial condition, andresults of operations (including net income) betweenthe measurement date and the date when the materialrisks of those operations will be transferred orotherwise terminated. Contingent liabilities, such asproduct or environmental liabilities, that may remainwith the registrant notwithstanding disposal of theunderlying business should be disclosed in thefinancial statements pursuant to SFAS 5 and discussedin MD&A pursuant to Item 303 of Regulation S-K.4. Qualifying Plan of Disposal: The staff believesthat a plan of disposal of operations does not qualifythe disposition for classification outside continuingoperations unless it contemplates the likelyconsummation of the sale, abandonment, or otherdisposition of all portions of the business segmentwithin twelve months of the plan's adoption. However,if a registrant's plan contemplates the cessationwithin twelve months of all new revenue producingactivity (other than renewal of existing contracts

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where the registrant is obligated to honor renewaldemands), the staff will not object to classificationof the business as a discontinued operation,notwithstanding the fact that the registrant maycontinue for several years to receive payments fromcustomers under existing contracts and incursignificant operating costs to fulfill its obligationsunder the contracts, if the results of operationsthrough final termination of the business can bereasonably estimated. However, in periods in which theresidual operations are material, the staff wouldexpect summarized disclosure of the abandoned segment'soperating results and of material charges or creditsrecognized to adjust any provision for loss that wasaccrued at the measurement date.5. Deconsolidation: Deconsolidation may not be usedordinarily with respect to subsid1aries whichmanagement intends to sell but for which no qualifyingplan of disposal has been adopted. The staff believesthat, until a plan of disposal satisfying the criteriaof APB 30 is adopted by management, subsidiaries shouldcontinue to be consolidated in the Company's financialstatements unless events outside the effectiveinfluence of the registrant are indicative that controldoes not rest with the registrant or is likely to belost.

F. Disclosures about New Accounting Standards1. Before Adoption by the RegistrantStaff Accounting Bulletin 74 (Topic 11:M) discussesdisclosures that a registrant should provide in itsfinancial statements and/or in management's discussionand analysis regarding the impact that recently issuedaccounting standards will have on its financialstatements when the standard is adopted in a futureperiod. Disclosures that should be considered includea brief description of the standard and its anticipatedadoption date, the method by which the standard will beadopted, the impact that the standard will have on thefinancial statements to the extent reasonablyestimable, and any other effects that are reasonablylikely to occur (eg., changes in business practices,changes in availability or cost of capital, violationsof debt covenants, etc.). In this regard, registrantsshould consider the effects of not only standardsrecently issued by the FASB, but also Statements ofposition and Practice Bulletins issued by the AICPA andconsensus positions of the EITF.

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2. Adoption of New Standard in Interim PeriodRule 10-01(a) (5) of Regulation S-X permits registrantsto omit from interim reports on Form 10-Q footnotedisclosures that would be repetitive of informationincluded in the annual financial statements, exceptthat disclosures about material contingencies mustalways be furnished. The rule also indicates that ifevents occur subsequent to the fiscal year-end, such asa change in accounting principles and practices,informative disclosure shall be made. Registrantsshould describe the accounting change and its impactpursuant to APB 28, as amended by SFAS 3. In addition,the staff believes the interim financial statementsshould include, to the extent applicable, alldisclosures identified by the adopted standard asrequired to be included in annual financial statements.If the change in accounting principle is made in aperiod other than the first quarter of the year, noamendment of prior filings is required; however, arestatement of each of the prior quarter's resultsshould be included in the filing for the quarter inwhich the new accounting principle is adopted pursuantto SFAS 3. If the new accounting principle is appliedretroactively to prior years, the prior comparableinterim quarters should be presented on a restatedbasis also. Disclosures specific to SFAS 106 and SFAS109 which the staff would expect to see in the interimfinancial statements of the period in which one ofthose standards was adopted include the following:

(a) SFAS 109 (Income Taxes): Registrants thatadopt SFAS 109 in an interim quarter of theirfiscal year should disclose in the Form 10-0 theitems described in paragraph 43 (total deferredassets, liabilities and valuation allowance;approximate tax effect of each type of temporarydifference and carryforward). This disclosure maybe based on the calculation as of the first day ofthe fiscal year (rather than the last day of thequarter). The allocation of taxes betweencontinuing operations and other items (paragraph46L should be disclosed. If disclosures thatwould be made pursuant to paragraphs 44 (deferredtax exceptions), 45 (significant components ofexpense), 47 (statutory to actual ratereconciliation) and 48 (carryforwards andcarrybacks) would vary materially from thosedepicted in the prior Annual Report, thesevariances should be discussed and quantified.Reasons for significant variations in thecustomary relationship between income tax expense

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and pretax accounting, if not otherwise apparent,should be discussed.(b) SFAS 106 (Other Postemployment Benefits) :Registrants that adopt SFAS 106 in the firstquarter of their fiscal year should include all ofthe disclosures required by paragraph 74 of SFAS106. These disclosures include a generaldescription of the substantive plan; theregistrant's funding policy; the types of assetsheld by the plan and significant nonbenefitliabilities of the plan; a schedule reconcilingthe funded status of the plan with amountsreported in the registrant's statement offinancial position; the rates assumed by theregistrant with respect to health care costtrends, discount factors, compensation increases,and the expected long-term return on plan assets;the effect of a one-percentage-point increase inthe assumed health care cost trend rate; theamounts and types of any securities of theemployer which are included as plan assets; andwhether modifications of the existing plan arecontemplated by the substantive plan. Thisdisclosure may be based on the calculation as ofthe first day of the fiscal year (rather than thelast day of the quarter). The registrant shouldalso disclose the amount of the estimated netperiodic postretirement benefit cost and itscomponents for the interim period.

G. "Other Than Temporary" Declines in Value of Debt andEquity Marketable SecuritiesDuring 1991 and 1992, the Commission institutedproceedings and issued cease and desist orders againstfour financial institutions for violations of Sections13(a), 13 (b)(2)(A) and (B) of the Exchange Act andRules 12b-20, 13a-1 and 13a-13 thereunder in connectionwith financial statements and disclosures concerninginvestment securities which had experienced other thantemporary declines in market value. (See Fleet/NorstarFinancial Group, Release No. 34-29557; Excel BancobP.Inc., Release No. 34-29675; Abington Bankco~. Inc.,Release No. 34-30614; Presidential Life CObPoration,Release No. 34-31934). In each of these situations,the registrant reported an investment securitiesportfolio at a carrying value that substantiallyexceeded the market value of the securities. In eachcase, the registrant accounted for certain marketdeclines as temporary.

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Generally accepted accounting principles provide thattemporary declines in the value of non-currentinvestment securities generally may be recognizedthrough adjustments to a valuation allowance accountwithin stockholders' equity. However, Statement ofFinancial Accounting Standard No. 12, Accounting forCertain Marketable Securities (SFAS 12), requires thata determination be made as to whether a decline inmarket value below cost as of the balance sheet date ofan individual security is "other than temporary". Ifthe decline is judged to be other than temporary, thecost basis of the individual security must be writtendown to a new cost basis and the amount of the writedown must be accounted for as a realized loss. The newcost basis is not changed for subsequent recoveries inmarket value.In each of these cases the registrant held a portfolioof equity and/or debt securities which had substantialand continuing unrealized losses. Staff AccountingBulletin No. 59 (SAB 59) sets forth the staff's viewsconcerning the evaluation of some of the factors which,individually or in combination, indicate that a declinein market value below an investor's carrying value isother than temporary and that a write down of thecarrying value is required. These factors are: (a)the length of time and the extent to which the marketvalue has been less than cost; (b) the financialcondition and near term prospects of the issuer,including any specific events which may influence theoperations of the issuer such as changes in itstechnology that may impair earnings potential of theinvestment or the discontinuance of a segment of thebusiness that may affect the future earnings potential;and (c) the intent and ability of the holder to retainits investment in the issuer for a period sufficient toallow for any anticipated recovery in market value.Pursuant to SAB 59, "unless evidence exists to supporta realizable value equal to or greater than thecarrying value of the investment, a write downaccounted for as a realized loss should be recorded."The Commission stated in the Fleet/Norstar order that"Recoveries that cannot be reasonably expected to occurwithin an appropriate period should not be consideredin the assessment of realizable value."In each of these cases the Commission concluded thatthe registrant had failed to timely recognize losses onother than temporary declines in investments.

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III. Frequent Inquiries Regarding Application of Regulation S-Xand Other Disclosure PracticesA. Financial Statements of Businesses Acquired (Rule 3-05)

1. Definition of a business. Identified byevaluating whether there is sufficient continuityof operations so that disclosure of priorfinancial information is material to anunderstanding of future operations. (See Rule 11-01(d) of Regulation S-X.) There is a presumptionthat a separate entity, subsidiary, or division isa business; a lesser component may be a business,too. Consideration should be given to --* whether the nature of the revenue producing

activity will remain generally the same;* whether the facilities, employee base,

distribution system, sa1es force, customerbase, operating rights, productiontechniques, or trade names remain after theacquisition.

2. Tests of Significance. Rule 1-02.v. describesthree tests of significance that must be appliedto determine the level at which an acquisition issignificant for purposes of determining the numberof years for which financial statements of theacquiree are required. Significance of theacquiree is determined by comparing the mostrecent pre-acquisition annual statements of theacquired business to the registrant's pre-acquisition consolidated statements as of the endof the most recently completed fiscal year forwhich audited financial statements are filed withthe Commission.a. For a combination accounted for as a

purChase, compare registrant's investment in(or consideration paid for) acquiree andadvances to (including loans and receiVables)to registrant's consolidated assets;(1) Contingent consideration should be

considered as part of the totalinvestment in the acquiree unless itspayment is deemed remote.

b. For a pooling or reorganization, compare thenumber of shares exchanged to registrant'soutstanding shares immediately beforecombination;

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c. Compare registrant's share of acquiredentity's total assets to the registrant'sconsolidated assets;

d. Compare registrant's equity in the acquiredentity's income from continuing operationsbefore taxes to that of registrant.(1) If registrant's income for the most

recent fiscal year is 10% or more lowerthan average of last five fiscal years,average income of the registrant may beused for this computation. Loss yearsshould be assigned value of zero incomputing numerator for this average,but denominator should be "5". Thisrule is not applicable if the registrantreported a loss, rather than income, inthe latest fiscal--year. The acquiree'sincome may not be averaged pursuant tothis rule.

e. Other guidance:(1) If the aggregate of all "insignificant"

businesses exceed 20% in any conditionabove, financial statements for themajority (combined if appropriate)should be furnished for most recentfiscal year and the latest interimperiod preceding the acquisition.

(2) If the acquisition was consummatedshortly after the most recent fiscalyear and the registrant files its Form10-K for that year before the due dateof the Form 8-K (including the 60 dayextension) 0' significance may beevaluated relative to that fiscal year.

(3) If the registrant has previously made asignificant acquisition and it was fullyreported on Form 8-K, significance testmay be applied to that pro forma datarather than historical pre-acquisitiondata. The acquired business for whichthe test is made is not considered partof the registrant's. base in determiningsignificance.

(4) If a registrant increases its investmentin a business relative to the prioryear, the tests of significance shouldbe based on the increase in theregistrant's proportionate interest inassets and net income during the year,

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rather than the cumulative interest todate.

(5) Significance should be evaluated onbasis of U.S. GAAP, rather than theforeign GAAP of the acquirer oracquiree.

(6) Ordinary receivables not acquired shouldnevertheless be included in tests ofsignificance on the theory that workingcapital will be required after theacquisition.

(7) Registrant's assets may not be increasedby pro forma effect of anticipatedpublic offering proceeds for purposes ofsignificance tests.

f. Registrants may request staff interpretationin unusual situations or obtain relief wherestrict application of.the rules andguidelines results in a requirement that isunreasonable under the circumstances.

3. Division or Lesser Component Acquired.The staff may accept audited statements of assetsand liabilities acquired and revenues and expensesdirectly related to the business where theregistrant can demonstrate that it isimpracticable to prepare the full financialstatements required by Regulation S-X, and theregistrant includes this explanation in thefiling. Unallocated items (corporate overhead,interest, taxes) may be excluded from thesestatements, but the amounts expected after theacquisition should b~ re~lected in the pro formastatements.

4. Special Rule Applicable to an IPOSAB 80 (Topic 1:J) is an interpretation of Rule 3-05 for application in the case of initial publicofferings involving businesses that have beenbuilt by the aggregation of discrete businessesthat remain substantially intact afteracquisition. The guidance is intended to ensurethat the registration statement include not lessthan three, two and one year(s) of auditedfinancial statements of not less than 60%, 80% and90%, respectively, of the constituent businessesthat will comprise the registrant on an ongoingbasis.

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B. Financial Statements Relating to Third PartyCredit EnhancementsThird party credit enhancements differ slightly fromguarantees. A guarantee running directly to thesecurity holder is a security within Section 2(1) ofthe Securities Act. A guarantor is a co-issuer underthe Securities Act and provides required business andfinancial information and signs the registrationstatement. A third party credit enhancement is anagreement between a third party and the issuer or atrustee. A party providing credit enhancementgenerally is not a co-issuer. However, if aninvestor's return is materially dependent upon thethird party credit enhancement, the staff requiresadditional disclosure. The disclosure must providesufficient information about the third party to permitan investor to determine the ability of the third partyto fund the credit enhancement. In most cases, thethird party's audited financial statements presented inaccordance with generally accepted accountingprinciples would be required. However, if suchfinancial statements are not available, alternativepresentations may be acceptable. For example,statutory financial statements of insurance companiesserving as credit enhancers may be accepted.The staff considers the following factors in assessingthe sufficiency of the disclosure in this area: (i)amount of the credit enhancement in relation to theissuer's income; (ii) duration of the creditenhancement; (iii) conditions precedent to theapplication of the credit enhancement; and (iv) otherfactors that indicate a material relationship betweenthe credit enhancer and the purchaser's anticipatedreturn.

C. Surviving Company in a Reverse AcquisitionAPB No. 16, paragraph 70 states in part "...thatpresumptive evidence of the acquiring corporation in acombination effected by an exchange of stock isobtained by identifying the former common stockholderinterests of a combining company which either retain orreceive the larger portion of the voting rights in thecombined corporation. That corporation should betreated as the acquirer unless other evidence clearlyindicates that another corporation is the acquirer ..."SAB Topic 2A affirms the above principle and discussessome of the factors which may rebut the normalpresumption.

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In December 1989, the Emerging Issues Committee of theCanadian Institute of Chartered Accountants reached aconsensus concerning Reverse Takeover Accounting whichis compatible with the guidance included in Topic 2A.The EIe consensus indicates that the post reverse-acquisition comparative historical financial statementsshould be those of the nlegaln acquiree, withappropriate footnote disclosure concerning the changein the capital structure.The merger of a private operating company into a non-operating public shell corporation is considered by thestaff to be essentially a capital transaction, ratherthan a business combination. That is, it is equivalentto the issuance of stock by the private company for thenet monetary assets of the shell corporation,accompanied by a recapitalization. The accounting isidentical to that resulting from--areverse acquisition,except that no goodwill or other intangible should berecorded.

D. Redeemable Equity SecuritiesThe staff considers the guidance in SX 5-02, FRC 211,SAB 3C, and SAB 6B(1) to be applicable to all equitysecurities (not only preferred stock) the cashredemption of which is outside the control of theissuer. For example, the guidance is applicable tocommon stock and common stock options and warrants thatare subject to a put, and to stock subject torescission rights.Redeemable equity securities should be presentedseparately from nstockholders' equityn if they areredeemable at the option of the holder, or at a fixeddate at a fixed price, or redemption is otherwisebeyond"the control of registrant. The presentation isrequired even if the likelihood of the redemption eventis considered remote. Disclosures include title ofsecurity, carrying amount, and redemption amount onface of balance sheet; in notes, disclose generalterms, redemption requirements in each of thesucceeding five years, number of shares authorized,issued and outstanding.Redeemable securities are initially recorded at theirfair value. In subsequent periods, the security shouldbe accreted to the redemption amount using the interestmethod (unless the likelihood of redemption is remoteor the earliest date which redemption may legally occuris indeterminable). The amount of periodic accretionreduces income applicable to common shareholders in the

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calculation of EPS. [SAB 3C] If accretion is material,separate disclosure of income applicable to commonshareholders on the face of the income statement isrequired. [SAB 6B(1)] If the redemption amount iscurrently redeemable and variable (eg., based on marketvalue of common stock), the security should be adjustedto its full redemption value at each balance sheetdate. The staff believes that an extinguishment ofredeemable securities for consideration that exceedsthe carrying amount of the securities at that timeshould be treated as a reduction of income applicableto common shareholders. However, the staff has notobjected in a situation where an early extinguishment"sweetener" (amount in excess of the instrument'soriginally contracted redemption amount) was notconsidered in the EPS calculation.

E. Distributions to Promoters/Owners-at or prior toClosing of IPO [SAB Topic 1.B.3]If a planned distribution to owners (whether declaredor not, whether to be paid from proceeds or not) is notreflected in the latest balance sheet but would besignificant relative to reported equity, a pro formabalance reflecting the distribution (but not givingeffect to the offering proceeds) should be presentedalong side the historical balance sheet in the filing.If a distribution to owners (whether already reflectedin the balance sheet or not, whether declared or not)is to be paid out of proceeds of the offering ratherthan from the current year's earnings, historical pershare data should be deleted and pro forma per sharedata should be presented (for the latest year andinterim period only) giving effect to the number of~h~r~s whose proceeds would be necessary to pay thedividend. For purposes .of this SAB, a dividenddeclared in the latest year would be deemed to be incontemplation of the offering with the intention ofrepaYment out of offering proceeds to the extent thatthe dividend exceeded earnings during the previoustwelve months.

F. Other Changes in Capitalization at or prior to Closingof IPOGenerally, the historical balance sheet or statement ofoperations should not be revised to reflect conversionsor term modifications of outstanding securities thatbecome effective after the latest balance sheet datepresented in the filing, although pro forma datapresented along side of the historical statements (as

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discussed below) may be necessary. However, if theregistrant and its independent accountants elect topresent a modification or conversion as if it hadoccurred at the date of the latest balance sheet (withno adjustment to earlier periods), the staff ordinarilywill not object unless the original instrument legallyaccrues interest or dividends or accretes towardredemption value after that balance sheet date, or ifthe terms of the conversion do not confirm thehistorical carrying value at the latest balance sheetas current value.If the terms of outstanding equity securities willchange subsequent to the date of the latest balancesheet and the new terms result in a material reductionof permanent equity, or if redemption of a materialamount of equity securities will occur in conjunctionwith the offering, the filing should include a proforma balance sheet (excluding effects of offeringproceeds) presented along side of the historicalbalance sheet giving effect to the change incapitalization.If a conversion of outstanding securities will occursubsequent to the latest balance sheet date and theconversion will result in a material reduction ofearnings applicable to common shareholders (excludingeffects of offering), the staff will not object to thedeletion (or inclusion solely in the notes to financialstatements) of historical earnings per share if suchinformation is not meaningful. Pro forma EPS for thelatest year and interim period should be presentedgiving effect to the conversion (but not the offering).

G. Calculation of EPS in an Initial Public Offering [SABTopic 4D]In the Initial Offering Document: All stock, optionsand warrants issued within one year prior to filing ofthe registration of an entity's initial public offeringof its equity securities are deemed outstanding for allperiods presented (in the manner of a stock split),except that the registrant may assume that thedifference between the IPO offering price and theamount received for the stock or the exercise price ofthe options is applied to repurchase outstanding sharesin the manner of the "treasury stock method" outlinedin APB 15. (However, the "modified treasury stockmethod" described in APB 15 should not be applied,regardless of the proportion of equity represented bycheap stock, options, and warrants.) In periods priorto the offering, these securities should be deemed

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outstanding even if anti-dilutive (ie., when theregistrant reports a loss) .In filings subsequent to the IPO: Stock, options andwarrants deemed outstanding in the IPO pursuant to theSAB should continue to be deemed outstanding in allperiods prior to the year in which the IPO is declaredeffective. In calculations of EPS for the fiscal yearin which the IPO became effective, shares, options andwarrants issued within one year prior to the IPOeffective date should continue to be deemed outstandingas prescribed by the SAB throughout the interim periodincludes in the IPO prospectus. The determination ofcommon stock and equivalents outstanding in remainderof the fiscal year (and in all subsequent reportingperiods) should be determined on a basis consistentwith APB 15. That is, outstanding options and warrantsshould be included in the EPS computation only if theyhave a dilutive effect; the application of the treasurystock method should not assume the IPO price to be themarket price.For example: Assume an option granted on January 1,with the IPO containing March 31 interims; an exerciseprice of $1; a IPO price of $2; and a weighted averagemarket price at year-end of $3. Using the treasurystock method, the option represents one-halfoutstanding share in the first quarter and two-thirdsshare in the last three quarters; or five-eighths sharefor the full year.

H. Accounting for Shares Placed in Escrow in connectionwith an Initial Public OfferingIn order to facilitate an initial public offering bysome companies, underwriters have requested certainpromoter/shareholder groups (or all shareholders of aclosely held company) to place their shares in escrow,with subsequent release of the shares contingent uponthe registrant's attainment of certain performance-based goals. Although these shares are legallyoutstanding and are reported as such on the face of thebalance sheet, the staff considers the escrowed sharesto be "contingent shares" for purposes of calculatingearnings per share under APB 15. In addition, thestaff views the placement of shares in escrow as arecapitalization by promoters similar to a reversestock split. The agreement to release the shares uponthe achievement of certain criteria is presumed by thestaff to be a separate compensatory arrangement betweenthe registrant and the promoters. Accordingly, thefair value of the shares at the time they are released

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from escrow should be recognized as a charge to incomein that period. However, no compensation expense needbe recognized with respect to shares released to aperson that has had no relationship to the registrantother than as a shareholder (for example, is not anOfficer, director, employee, consultant or contractor),and that is not expected to have any other relationshipto the company in the future.

I. Accounting and Disclosures Involving Lending ActivitiesA registrant engaged in significant lending activitiesshould furnish information about its loan portfoliothat is substantially similar to that customarilyfurnished by banks. In particular, registrants shouldconsider the quantitative disclosures described inSections III and IV of Industry Guide 3. Thisinformation includes loans by pereinent category,maturities, concentrations, risk elements, loan statusand loss experience for a five-year historical period.Registrants are cautioned not to overlook disclosure of"potential problem loans" that are not otherwiserequired to be disclosed but involve problems whichcause management to have serious doubts as to theability of the borrowers to comply with loan terms.Registrants should also consider the updatingrequirements of General Instruction 3(d) to theIndustry Guide. In addition, notes to the financialstatements should identify the circumstances underwhich accrual of interest on a loan is ceased, andamounts of interest that have not been accrued inaccordance with loan terms should be disclosed.If an unusually large provision for loan losses isreported in a quarter, registrants should discuss inthe MD&A those factors which arose in the reportingperiod that caused management to materially reduce itsestimate of amounts ultimately realizable fromoutstanding loans.Lenders in all industries should follow the guidance inFRR 401.09c regarding the accounting for substantivelyforeclosed assets. Collateral should be accounted foras substantively foreclosed if the debtor has little orno equity in the collateral (considering its currentfair value), loan repaYment can be expected to comeonly from the collateral, and it is doubtful that thedebtor will rebuild equity in the collateral in theforeseeable future. Foreclosed collateral should berecorded at the lower of the loan'S carrying amount orthe collateral's fair value (discussed below) at thedate of foreclosure, establishing a new cost basis for

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the property. Any excess of the carrying amount overfair value at that date should be recorded as a loss.Thereafter, the accounting principles for assets heldfor sale should normally be followed. Registrantsshould note that fair value, as defined by FASB 15, isthe amount that the creditor could reasonably expect toreceive for the asset in a current sale between awilling buyer and a willing seller, that is, other thanin a forced or liquidation sale. The adoption ofstrategies (such as a hold-for-the-future strategy thatis based on expectations of future price increases, ora strategy of operating the repossessed collateral forone's own behalf) cannot justify use of derivedaccounting valuations that portray results ofoperations more favorably than would use of currentvalues in active markets.

J. Disclosures Regarding Risks Associated With Real EstateIf a significant portion of a registrant's operationsinvolve developing, operating or otherwise investing inreal estate or making loans collateralized by realestate, the description of the registrant's business infilings with the Commission should include informationregarding the registrant's policies and practices withrespect to selection of properties (types, locations,concentration limits), and assessments of impairments(frequency of appraisals, source of appraisals,methodologies employed, etc.). Notes to the financialstatements should clearly describe the registrant'saccounting policies with respect to the carrying valueof real estate assets: the circumstances under whichan impairment is be recognized, the elements enteringinto the measurement of the asset's net realizablevalue, and the procedure for adjusting carrying value(ie., direct write-off or allowance, individual orportfolio basis) .In the MD&A, registrants should discuss how knowntrends, events or uncertainties may materially affectliquidity or results of operations, includingdiscussion of the following, as applicable:significant debt paYments or other funding commitmentsthat will become due, capital requirements of planneddevelopment or refurbishment activities, trends inoccupancy and rental rates, declining real estatevalues, changing interest rates, uncertaintiesunderlying management's estimates of net realizablevalue, risks inherent to particular concentrations,etc. If real estate properties are carried in thefinancial statements at amounts that materially exceedcurrent market prices, this should be disclosed and

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quantified, and the reasons for not recogn~z~ng anypresent impairment should be explained.Financial information about real estate ventures andpartnerships accounted for on the equity method may benecessary: full financial statements are required inall filings (except in annual reports to shareholders)if the investee is significant at the 20% level orgreater pursuant to Rule 3-09; if the investees aresignificant individually or in the aggregate at the 10%level, only summarized financial information isrequired pursuant to Rule 4-08(g).Registrants should be aware also of requirements toprovide separate financial statements of real estateoperations collateralizing significant loans pursuantto SAB 71:* Acquisition, development and construction (ADC)loans: If over 10% of offering proceeds (or totalassets, if greater) have been or will be invested in ansingle acquisition, development, and construction loan,financial statements of the property securing the loanshould be provided in '33 Act filings. Also, where nosingle loan exceeds 10%, but the aggregate of suchloans exceed 20%, a narrative description of theproperties and arrangements is required. In '34 Actreports, the requirement for full financial statementsis triggered at the 20% level, but summarizedinformation is required at the 10% level.* Other loans: If over 20% of offering proceeds (ortotal assets, if greater) have been or will be investedin a single loan (or in several loans on relatedproperties to the same or affiliated borrowers),financial statements of the property securing the loanare required in '33 and '34 Act filings.