Chapter Twelve Financial Reporting and the Securities and Exchange Commission Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 12-1 Understand the origin and expansive role of the securities and Exchange Commission. 12-2

Major Influence on the Development of US GAAP Independent Agency of the Federal Government Established by the Securities Exchange Act of Mandate is to ensure that complete and reliable information is available to investors Direct authority Applies to Publicly Held Companies SEC Securities and Exchange Commission (SEC) 12-3

Deposited over $1.648 Billion of fees in U.S. Treasury in 2012 Commissioners serve 5-year, staggered terms Headed by 5 commissioners appointed by the President (with Senate consent) Only 3 of 5 can belong to the same political party The chairperson is usually from the same political party as the President Securities and Exchange Commission (SEC) SEC 12-4

Composed of four divisions and 23 offices including: Division of Corporation Finance Division of Investment Management Division of Trading and Markets Division of Enforcement Office of Information Technology Office of Compliance Inspections and Examinations Office of the Chief Accountant Securities and Exchange Commission (SEC) 12-5

Learning Objective 12-2 Describe the purpose(s) of various federal securities laws. 12-6

Securities Exchange Act of 1934 Securities Act of 1933 Federal Securities Laws Regulates the initial offering of securities by a company or underwriter. Regulates the subsequent trading of securities through brokers and exchanges. The 1934 Act Established the SEC Spurred by the Great Depression following the 1929 Stock Market Crash, Congress enacted: 12-7

Goals of the SEC   Ensuring full & fair disclosure to all investors.   Prohibiting dissemination of materially misstated information.   Preventing misuse of information by inside parties.   Regulating the operation of securities markets. 12-8

Full and Fair Disclosure Securities Act of 1933 New securities must be registered prior to public sale. Securities Exchange Act of 1934 Requires continuous reporting by publicly traded companies. Prohibits fraudulent and unfair behavior. Securities Exchange Act of 1934 Requires continuous reporting by publicly traded companies. Prohibits fraudulent and unfair behavior. Public Utility Holding Company Act of 1935 Requires registration of interstate holding companies of public utilities. Public Utility Holding Company Act of 1935 Requires registration of interstate holding companies of public utilities. 12-9

Full and Fair Disclosure Trust Indenture Act of 1939 Requires registration of indentures related to public issue of bonds, notes, etc. Trust Indenture Act of 1939 Requires registration of indentures related to public issue of bonds, notes, etc. Investment Company Act of 1940 Requires registration of investment companies. Investment Company Act of 1940 Requires registration of investment companies. Investment Advisers Act of 1940 and Securities Investor Protection Act of 1970 Requires registration of investment advisors and requires them to follow certain standards. Investment Advisers Act of 1940 and Securities Investor Protection Act of 1970 Requires registration of investment advisors and requires them to follow certain standards

Full and Fair Disclosure Foreign Corrupt Practices Act of 1977 Amends Securities Exchange Act of Requires maintenance of accounting records and adequate internal accounting controls. Foreign Corrupt Practices Act of 1977 Amends Securities Exchange Act of Requires maintenance of accounting records and adequate internal accounting controls. Insider Trader Sanctions Act of 1984 & Insider Trader and Securities Fraud Enforcement Act of 1988 increase penalties against persons who profit from illegal use of inside information

Full and Fair Disclosure In 2001 and 2002, corporate scandals shook the confidence of investors in the reliability of financial statement information Causes included: Greed of corporate executives Failure of corporate governance Audit failures Unreasonable market expectations Overburdened SEC 12-12

The SEC’s Impact on Financial Reporting In addition to audited financial statements, Rule 14c-3 of the 1934 Act requires the following to be included in proxy statements sent to shareholders:  5-year summary of operations.  Description of the business’ activities.  3-year summary of industry segments.  Listing of company directors and executive officers.  Market price of the common stock for each quarter of the last 2 years.  Restrictions on the company’s ability to pay dividends.  MD&A 12-13

Information about the auditor to be disclosed: The SEC’s Impact on Financial Reporting  All nonaudit services provided by the independent audit firm.  Whether the Board of Directors approved all nonaudit services and considered whether they would impair the auditor’s independence.  The % of nonaudit fees to the total annual audit fee.  Individual nonaudit fees > 3% of the annual audit fee.  All nonaudit services provided by the independent audit firm.  Whether the Board of Directors approved all nonaudit services and considered whether they would impair the auditor’s independence.  The % of nonaudit fees to the total annual audit fee.  Individual nonaudit fees > 3% of the annual audit fee

Learning Objective 12-3 Understand the Congressional rationale for enacting the Sarbanes-Oxley Act and the responsibilities of the Public Accounting Oversight Board

Corporate Scandals Led to Sarbanes- Oxley in 2002 Enron: Ken Lay received $152.7 million in the year his firm collapsed, zeroing out pensions WorldCom: Improperly Added $9 Billion of Income Adelphia Communications’ founder “looted” the company of over $2 Billion 12-16

Corporate Scandals Led to Sarbanes- Oxley in 2002 Sarbanes-Oxley Act of 2002 designed as a response to the corporate accounting scandals. Sarbanes-Oxley Act of 2002 designed as a response to the corporate accounting scandals. The 2002 Act Established the Public Company Accounting Oversight Board 12-17

Creation of Public Company Accounting Oversight Board Sarbanes-Oxley Act of 2002 Section 101 Under the oversight and enforcement authority of the SEC, the Board is charged with:  Establishing auditing, quality control, and independence standards.  Performing periodic inspections of registered public accounting firms. Could potentially replace the Auditing Standards Board of the AICPA

Creation of Public Company Accounting Oversight Board Sarbanes-Oxley Act of 2002 Section 101 Five members  Allows only 2 of the 5 to be CPAs, past or present.  Remaining 3 must NOT be accountants.  The Board is funded through mandatory fees levied on all publicly traded companies.  Accounting firms, domestic and foreign, must register with the Board and pay fees.  Registered firms are subject to periodic inspections by the PCAOB

Sarbanes-Oxley Act of 2002 Auditor Independence To ensure future independence of audit firms, some previously common concurrent services are now prohibited.  Bookkeeping services.  AIS design and implementation.  Appraisal or valuation services.  Internal audit outsourcing.  Management functions/Human Resource Management.  Investment advising.  Legal services or expert services

Sarbanes-Oxley Act of 2002 Audit Committees  Audit Committees will also be expected to exercise more oversight in the future.  The Committee is responsible for the appointment and compensation of the external auditor.  The auditor now reports to the Committee instead of to management.  The lead audit partner must be rotated off after five years

Learning Objective 12-4 Describe the SEC’s role in establishing generally accepted accounting principles (GAAP)

SEC’s Authority over GAAP Regulation S-K Establishes requirements for all nonfinancial information contained in SEC filings. Regulation S-X Prescribes the form and content of the financial statements, and the related notes and schedules. There are two basic documents which lay out the requirements of the SEC: 12-23

Congress has assigned GAAP-setting authority to the SEC. The SEC allows the FASB to set GAAP. The FASB’s standards can be overridden by the SEC. Authority only extends to publicly traded companies. SEC’s Authority Over GAAP 12-24

The SEC issues authoritative documents: Financial Reporting Releases (FRR’s) Supplements to Regulations S-K and S-X Staff Accounting Bulletins (SAB’s) Views on current accounting and disclosure matters. SEC’s Authority Over GAAP 12-25

Additional SEC Authority When deemed necessary, the SEC may:  Require additional disclosure  Establish a moratorium on specific accounting practices  Challenge individual statements (forcing a specific registrant to change its filings)  Overrule the FASB 12-26

Learning Objective 12-5 Define and describe an issuer’s filings with the Securities and Exchange Commission

Filings with the SEC Legislation and regulations require registrants to make numerous filings including these two basic categories of filings Registration Statements Periodic Filings 12-28

SEC Fees  The SEC charges a registration fee based on the value of securities offered, $ for each $1 million, a small fraction of the offering.  The fees in excess of costs creates a surplus that is a source of debate: – Is it a revenue source for the government? – Are corporations being overcharged for registration? – Is the SEC sufficiently funded? 12-29

Common SEC Registration Statement Forms 12-30

Learning Objective 12-6 Describe an issuer’s registration process, various forms used by the issuers, and the exemption(s) from registration

Registration Process 1. 1.Registration Statements delivered to SEC 2. 2.Review by Div. Of Corp. Finance 3. 3.A deficiency letter sent to registrant 4. 4.Approved after deficiencies are cleared 5. 5.Once the registration is effective, the securities can be sold. Note: This process is both time-consuming and expensive

Registration Requirements – General Contents Report PART I – “Prospectus”  Audited financial Statements.  An explanation of the use of the proceeds.  A description of the security risks.  A description of the business. PART II  Used by the SEC staff.  Includes additional information about the company

Offerings Exempt from SEC Filing  Securities issued by governments, banks, and S&L’s  Securities issued that are restricted to a company’s own existing shareholders.  Offerings < $5 million  Securities issued by non-profit organizations  Offerings < $1 million to be made within a 12- month period.  Offerings < $5 million made to 35 or fewer investors within a 12- month period.  Private placement of securities to < 36 investors who already have knowledge of the company

Form 10-Q Quarterly report filed within 45 days of end of quarter. Financial statement are unaudited. Form 10-K Annual report filed within 90 days of fiscal year-end. Includes audited financial statements. Form 8-K Used to disclose a unique or significant happening, within 15 days of the event. Periodic Filings with the SEC 12-35

Proxy Statements Proxy Statements:  Allow board of directors to vote on behalf of stockholders.  Must be filed with SEC 10 days prior to distribution. Needs to indicate on whose behalf the solicitation is made.  Must disclose fully all matters that are to be voted on at the meeting.  Is usually accompanied by an annual report

Electronic Data Gathering, Analysis, and Retrieval System - EDGAR The SEC’s “Electronic Data Gathering and Retrieval” System:  Designed to reduce overwhelming paper flow into the SEC  Allows for public access to SEC filings and information through the Internet 12-37