Solution manual advanced accounting 9e by hoyle ch12

All accounting firms that audit companies with securities that are publicly traded must register with the Public Company Accounting Oversight Board.. All registered firms are subject to

CHAPTER 12 FINANCIAL REPORTING AND THE SECURITIES AND

EXCHANGE COMMISSION

Chapter Outline

I In the United States, the Securities and Exchange Commission (SEC), created by Act of Congress, is responsible for ensuring that complete and reliable information concerning publicly traded securities is available to investors

A Although the SEC regulates requirements created by many legislative acts, the most significant are the Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes-Oxley Act of 2002

B The SEC has sought to accomplish its objectives by working to achieve several goals that include:

1 Assuring adequate disclosure of data before securities can be bought and sold,

2 Preventing the misuse of information by inside parties,

3 Regulating the operation of stock exchanges and other securities markets, and

4 Prohibiting the dissemination of materially misstated information

C Disclosure requirements of the SEC are contained primarily in two sets of regulations:

1 Regulation S-K establishes rules for all nonfinancial information

2 Regulation S-X prescribes the form and content of the financial statements that are included in the various filings

D The ability to establish disclosure requirements gives the SEC the ultimate authority for accounting principles in this country, although it has generally allowed the FASB to set official guidance

E The SEC's integrated disclosure system requires that most information that is reported

to the SEC must also go to the company's stockholders at various times throughout the year

II As a direct result of the corporate accounting scandals exposed in 2001 and 2002,

Congress passed the Sarbanes-Oxley Act of 2002 This legislation is having a ranging impact on corporate financial reporting and the accounting profession as a whole

wide-A One of the most important results of this act is the creation of the Public Company

Accounting Oversight Board

1 This five-member board is appointed by the SEC and funded by fees assessed against publicly traded companies

2 The board has been given the authority to enforce auditing, quality control, and independence standards Such power reduces the accounting profession‘s ability to regulate itself as it has done in the past seven decades

B All accounting firms that audit companies with securities that are publicly traded must register with the Public Company Accounting Oversight Board

1 This registration process allows the new board to gather considerable information from the public accounting firms

2 All registered firms are subject to inspection by the Public Company Accounting Oversight Board as often as each year

C The Sarbanes-Oxley Act eliminates a number of consulting services that an accounting firm can perform for an audit client The goal of this approach is to strengthen the

independence of the auditing profession

D The Sarbanes-Oxley Act also requires the audit committee of a company‘s Board of Directors to be made up of individuals who are independent of the management The audit committee is now responsible for the appointment and compensation of the

independent auditors

III Several methods can be used by the SEC to affect generally accepted accounting principles

in the United States

A Additional disclosure requirements

B Moratorium on specific accounting practices

C Challenging individual statements and other reporting by companies filing with the SEC

D Overruling the FASB (as shown by the rejection of SFAS 19)

IV Companies that offer securities for sale to the public must meet a number of filing requirements monitored by the SEC

A Registration statements are required prior to the issuance of any new security

1 Depending on specific circumstances, specified forms are required for this purpose (including Forms S-1, S-3, and SB-2)

2 After completing the appropriate registration form, a company will normally receive a letter of comments from the SEC indicating changes or explanations that are

requested

3 Unless exempt from registration, securities cannot be sold until the registration statement is made effective by the SEC

B Companies that have their securities publicly traded on an exchange must also make regular periodic filings with the SEC Some of the most common of these disclosure documents are:

1 Form 10-K is an annual report presenting the company's activities and financial position

2 Form 10-Q contains condensed interim financial statements

3 Form 8-K discloses the occurrence of a unique or significant happening

4 A proxy statement (Form 14A) solicits voting power to be used at stockholders' meetings

V The SEC has developed a system that allows investors to gain access to filed information electronically over the Internet This system is known as EDGAR and contains extensive information and documentation relating to practically every publicly traded security

3 Briefly identify the various securities laws currently enforced by the SEC

4 Indicate the purposes of Regulation S-K and Regulation S-X

5 Discuss the methods by which the SEC has applied its authority over financial reporting in this country

6 Identify the major provisions of the Sarbanes-Oxley Act of 2002 and describe how this legislation is impacting and will continue to impact the public accounting profession in the future

7 Describe the purpose and general content of requiring registration statements

8 Identify the role of a letter of comments within the registration process

9 List several types of securities that are normally exempt from formal SEC registration

requirements

10 Indicate the contents and purpose of a prospectus

11 Identify the following periodic filings made with the SEC: Form 10-Q, Form 10-K, Form 8-K, and proxy statements

12 Understand how EDGAR can be utilized by investors

13 Locate a company‘s latest financial statements and SEC filings using EDGAR

Answer to Discussion Question

Is the Disclosure Worth the Cost?

No ultimate answer exists to the question of how the SEC should weigh the costs of disclosure versus the need for adequate information Students often feel that the importance of the work of the SEC is unquestioned That is far from reality, as many business owners and investors will advise Businesses often resist all demands for additional disclosure as being unimportant and not worth the cost of gathering the data This is also far from reality

This discussion question is intended to show the high cost to the American economy of

ensuring that adequate and fair information is available The $400 million estimation that was made in 1975 is a staggering figure Could investors have been appropriately protected for a smaller amount? This question becomes especially relevant when coupled with the quotation from George Bentson that "I found that there was little evidence of fraud related to financial statements in the period prior to the enactment of the Securities Acts." The question is even more interesting considering the accounting scandals that were discovered in 2001 and 2002 These problems took place despite the presence of the SEC On the other hand, perhaps the disclosure and compliance is still inadequate and the cost of additional compliance will result in future unknown benefits

One method of approaching this question is to ask students to envision what would result if the SEC was simply to be dissolved How would companies entice investors into contributing

funds? What methods would companies invent to provide assurance to investors? Would more

or less money be invested? Would the allocation of resources to the various companies

throughout the country be changed? Would investors be adequately protected? How would a new ‗start up‘ company attract investors? In other words, does the work of the SEC have an actual impact on the amount of investments that are made and the distribution of these funds to the companies in the country?

Once the benefits of having an authority like the SEC are established, how should these

benefits be weighed against the cost of disclosure? Although $400 million (which was the

estimated cost thirty (30) years ago, is an extremely large amount, it is a very small number in comparison to the dollars that are invested each year in the United States Is this just the price that must be paid to provide comfort to the investing public? Although no resolution can be made of this question, it should provide for a good deal of class discussion

Answers to Questions

1 Many of the federal securities laws were passed initially in hopes of putting an end to abuses that were present in securities trading These problems were first brought to the public's attention by the stock market crash in 1929 Two special concerns were the manipulation of stock market prices in part through the dissemination of inaccurate financial data and the misuse of information by insiders, such as corporate officers and directors However, the

passage of legislative actions also was intended to help restore public confidence in the capital market system that was and is so essential to the American economy

2 The corporate accounting scandals of this period took several forms Some were based on manipulating loopholes in generally accepted accounting principles to allow companies to avoid adequately disclosing risky ventures Others were simply fraudulent reporting of transactions; expenses, for example, were recorded as assets to make the company‘s balance sheet(s) look better Even others were based on the use of corporate funds for personal benefit The reasons for such behavior can be many and varied Personal greed

is always a motivator However, the need of a company to report ever-increasing profits in a stock market that was rising at an amazing speed during the mid and late 1990s put significant pressure on many executives In hindsight, the lack of adequate safeguards in place at corporations, at accounting firms, and even at the SEC must also be considered as playing a role in creating an environment where such practices were allowed to take place

3 The Sarbanes-Oxley Act has numerous provisions, almost all of which are designed in one way or another to restore public confidence Several of those provisions include:

 A Public Company Accounting Oversight Board has been created to enforce and regulate auditing, quality control, and independence standards

 All accounting firms that audit publicly-held issuers of securities must register with the Oversight Board and provide detailed information about their operations

 All registered firms must be inspected by the Oversight Board to ensure adequate quality control in their audit work

 Registered firms are prohibited from providing certain consulting services to audit clients

 Corporate audit committees must be composed of members of the Board of Directors who are independent of management

 Audit committees must have authority to employ and compensate the independent auditors

4 The Sarbanes-Oxley Act gives the SEC the power and responsibility to oversee the work of the Public Company Accounting Oversight Board For example, the five board members are appointed by the SEC

5 According to the Sarbanes-Oxley Act, accounting firms are only required to register with the Public Company Accounting Oversight Board if they prepare, issue, or participate in the preparation of an audit report for an ―issuer.‖ An issuer is defined by the Act but normally refers to any organization issuing securities to the public

6 Registration with the PCAOB forces the accounting firm to (a) provide a significant amount

of information about its operations, (b) have its activities open to inspection by the Public Company Accounting Oversight Board, and (c) be subject to the rulings and authority of this Board

7 The Sarbanes-Oxley Act gives the Public Company Accounting Oversight Board authority over auditing independence rules Therefore, all future changes made by this body will be

an indirect result of the legislation Moreover, the Sarbanes-Oxley Act specifically eliminated the accounting firms‘ ability to provide certain non-attestation services to their audit clients

It further required that audit committees be made up of members of an organization‘s Board

of Directors who are independent of management The audit committee must then be responsible for the appointment and compensation of the independent auditors

8 Prior to the Sarbanes-Oxley Act, most accounting firms were required to undergo periodic peer reviews of their audit documentation and their quality control procedures However, those reviews were largely done by one firm on another and, given the accounting scandals discovered during 2001 and 2002, apparently did not do enough to ensure the quality of audit work The new inspection process will be carried out under the authority of the Public Company Accounting Oversight Board That inspection process will attempt to create a process that goes further in making certain that every firm does quality work on every engagement

9 "Regulation S-K" establishes disclosure and other reporting requirements for the nonfinancial information that is contained in filings with the SEC

10 "Regulation S-X" prescribes the form and content of the financial statements, notes, related schedules, and any other financial information included in the various reports filed with the SEC

11 The Securities and Exchange Commission is composed of more than a dozen divisions and major offices These include the following:

— Division of Corporation Finance—ensures that standards for reporting and disclosure are followed

— Division of Market Regulation—regulates national securities exchanges and investment brokers and dealers

— Division of Enforcement—supervises investigations and directs enforcement activities

— Office of the Chief Accountant—responsible for accounting and auditing matters in connection with the securities laws

— Office of Compliance Inspections and Examinations—verifies compliance by brokers, dealers, and investment companies

12 The Securities Act of 1933 regulates the initial offering of securities by a company or its underwriters This Act is often referred to as the ―truth in securities act‖ and it is the statute that now governs the issuers‘ registration statements

13 The Securities Exchange Act of 1934 regulates the subsequent buying and selling of securities through brokers and exchanges This regulation extends to virtually all aspects of the resale of non-exempt securities

14 The goals of the SEC are many However, the most prominent goals are as follows:

— Ensuring that full and fair information is disclosed to all investors before securities can be exchanged

— Prohibiting the use of materially misstated information

— Preventing the misuse of information, especially by parties inside of the company

— Regulating the operation of securities markets

15 Information to be included in proxy solicitation material includes the following data:

— Five-year summary of operations including sales, total assets, income from continuing operations, and cash dividends per share

— Description of business activities

— Three-year summary of industry segments, export sales, and foreign and domestic operations

— A list of the directors of the company and its executive officers

— Market price of the company's common stock for each quarterly period within the two most recent years

— Restrictions on the company's ability to continue dividend payments

— Management's discussion and analysis of financial conditions, changes in financial condition, and results of operations

— All nonaudit services provided by the company's independent auditors

— Statement as to whether the board of directors approved all nonaudit work of the independent auditors

— Percentage of nonaudit fees paid to the independent auditors in relation to total annual audit fees

— Individual nonaudit fees that are larger than 3 percent of the annual audit fee

16 A proxy statement is a request made to stockholders for the right to cast their votes at stockholders' meetings Obviously, the control of the entire company will rest with any group that

is able to get a majority of votes through proxy agreements Thus, the proxy statements are important because they are used in determining the control and direction of the company

17 Any change made by the SEC in its Regulation S-X, the financial reporting regulation, will have a direct impact on the form and content of the financial reporting of the publicly-held companies in this country Thus, the Commission has the ability to dictate generally accepted accounting principles In addition, Financial Reporting Releases are issued by the SEC to explain changes to be made in accounting Staff Accounting Bulletins are also prepared to explain views on current reporting matters

The SEC has historically limited the use of its authority over generally accepted accounting principles to (1) disclosure issues and (2) areas of accounting where authoritative guidance was thought to be lacking For example, additional disclosure of specified matters may be required in areas deemed important by the SEC The Commission can also prohibit

practices that are not thought to be appropriate, especially where official guidance is not available

18 Financial Reporting Releases are issued by the SEC to explain desired changes in reporting requirements FRRs are used to supplement Regulations S-X and S-K Staff Accounting Bulletins inform the financial community of views on current matters relating to accounting and disclosure issues

19 Prior to 1977, the SEC had restricted the use of its accounting authority primarily to disclosure requirements and areas of financial reporting where authoritative guidance was not available The FASB (and its predecessors in the private sector) had been allowed to establish generally accepted accounting principles in the U.S The setting of accounting standards was viewed as a process that should be based on theory and research rather than being subjected to government edict However, when the SEC overruled the FASB's method of reporting unsuccessful exploration costs incurred by gas and oil producing companies, several important precedents were set The government (through the SEC) showed that it was willing to become a more active participant in setting rules for the accounting profession The FASB (and other authoritative bodies) then had to be more concerned about pleasing the government prior to establishing standards Many concerns were raised at the time (as well as since then) as to whether the development of generally accepted accounting principles should be at the mercy of the federal government

20 Registration statements are designed to disclose and make available adequate relevant

data about both a company and its new stock or bond (security) before the security can be

issued to the public

21 Disclosure of sufficient information – Registration Statement disclosure - is required by the Securities Act of 1933

22 Part I of a registration statement is called a prospectus and must be furnished to every

potential buyer of the securities to be issued It contains information such as financial statements and supplementary data, an explanation of the intended use of the money being raised, a description of the capital structure of the company, and a description of the business and the properties that it holds

Part II of the registration statement provides information that is needed by the SEC staff Part II includes data such as marketing arrangements for the new securities, the expenses

of the issuance, sales to special parties, and the like

23 Revenues are raised by the SEC through a registration fee for shares being initially issued

In 1999, this fee was 0264 of 1 percent of the value of the securities offered

24 In the filing of registration statements, a number of different forms are available depending upon the circumstances Of these forms, these two are especially common:

— Form S-1 which is used by new registrants or by companies that have filed with the SEC for less than 36 months;

— Form S-3 which is completed by larger companies, including foreign issuers that have filed with the SEC for a considerable length of time and have a significant following in the stock market Form S-3 permits incorporation of other documents by reference This permits inclusion of significant data concerning the Issuer, where the data has appeared

in other filings

25 Incorporation by reference is a process allowed when preparing filings with the SEC, and often other governmental agencies It is intended to reduce the quantity of redundant information that must be processed When data is required that has already appeared in a previous filing, the company need only refer to the earlier disclosure rather than repeat the information

26 A pre-filing conference is a meeting between a prospective registrant and the staff of the SEC in hopes of resolving potential problems that may be expected to arise in an upcoming filing The reporting and disclosure of complicated financial transactions may be discussed

by the parties The conference may also be used to determine the appropriate handling of unusual problems

27 A letter of comments (which is also known as a "deficiency letter") is issued by the SEC to a filing company after a registration statement has been reviewed The letter lists changes and additional disclosures that the SEC feels are necessary before the registration statement can be made effective

28 A prospectus is the first part of a registration statement, the portion that has to be furnished

to every potential buyer of a new security The prospectus discloses a significant amount of specified information about the issuing company as well as about the new security For example, the financial statements of the company must be included along with a description

of current business operations The prospectus also informs potential buyers of the intended use of the new funds and the capital structure of the company

29 Certain new security issues are exempt from the registration requirements monitored by the SEC For example, securities sold within a single state are normally not subject to these federal laws In addition, the securities of banks, savings and loan associations, and governments do not come under the Securities Act of 1933 Several other offerings are also exempt from completing formal registration statements although other legal filings may be required:

Private placements to a limited number of sophisticated investors;

Securities issued to current stockholders without a commission being paid (usually a stock dividend);

Securities issued by nonprofit organizations;

Small offerings of no more than $5 million;

Offerings of no more than $5 million made to 35 or fewer purchasers (and an unlimited number of accredited investors)

30 Private placements of securities have become extremely popular in recent years because they are exempt from the registration requirements of the SEC The securities are issued to

no more than 35 sophisticated investors (identified as having knowledge and experience in financial matters) who already have sufficient information available to them about the issuing company The securities can also be issued to an unlimited number of accredited investors (such as banks, insurance companies, and individuals with a net worth of more than $1 million) General solicitation is not permitted

31 Blue sky laws are securities laws enforced by individual states In contrast to federal securities laws, blue sky laws usually apply only to sales that are restricted to a particular state

32 A wrap around filing is one in which a company uses its annual report to shareholders to fulfill reporting requirements of the SEC in a Form 10-K Rather than repeat the information within the Form 10-K, incorporation by reference is used to direct the SEC to the location of the required data in the annual report

33 Form 8-K is not issued on a regular basis but only when disclosure of a unique or significant occurrence is to be made Thus, a company has some choice as to the necessity of issuing

a Form 8-K The SEC does, however, list several events that require disclosure in this manner:

—resignation of a director;

—change in control of the company;

—acquisition or disposition of assets;

—changes in independent accountants;

—bankruptcy or receivership

34 The Management's Discussion and Analysis (MD&A) is a narrative description of the company's past, its present, and its future The management describes its priorities, accomplishments, and concerns In many cases, the MD&A allows the management to share information with owners and other interested parties that would not otherwise be conveyed

35 The Form 10-K is an annual report (financial statements and related information) whereas the Form 10-Q contains condensed interim financial statements

36 The EDGAR system is intended to allow companies to file information with the SEC in an electronic format and then make that information available on-line to all interested parties