Acctg for Related Party Transactions

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Portfolio Description

Jack W. Paul, Ph.D., CPAProfessor of AccountingLehigh University

Jack W. Paul, B.A. (Economics), Cornell University, MBA, Ph.D., Lehigh University. Dr. Paul is a licensedCPA in the State of Florida. He is a professor of accounting at Lehigh University and has taught financialand intermediate accounting, auditing, advanced auditing, information systems, CPA review, andmanagerial and cost accounting. He is former director of the MS in Accounting program at LehighUniversity and teaches the capstone course in that program. He has obtained several grants forconducting accounting research and has published in a number of academic and practitioner journals.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Portfolio Description

PORTFOLIO DESCRIPTION SHEETBNA Tax and Accounting Portfolio 5148-2nd, Related Party Transactions (Accounting Policy and PracticeSeries), represents the first of two anticipated Portfolios dealing with related party transactions. ThisPortfolio discusses the pervasiveness of related party transactions throughout a wide spectrum ofbusiness dealings. The Portfolio analyzes the nature of related party transactions and discusses howthese transactions are treated under generally accepted accounting principles. The Portfolio also reviewsthe applicable corporate governance features pertaining to related party transactions.

The Portfolio surveys the history and concepts pertaining to related party transactions and the ratherconsiderable pertinent accounting literature, including Financial Accounting Standards Boardpronouncements, Securities and Exchange Commission rules and regulations, stock exchange listingrequirements and AICPA and PCAOB auditing pronouncements.

This Portfolio discusses in detail the accounting and disclosure requirements pertaining to a number oftopics dealing with asset transfers among related parties, including sales, purchases, nonmonetarytransactions, lease arrangements, and transfers of financial instruments. Although generally acceptedaccounting principles contain guidance concerning the disclosure of related party transactions, theaccounting standards are mainly silent when it comes to accounting for these transactions. This Portfolioanalyzes when related party transactions should be accounted for differently from transactions betweenunrelated parties. The Portfolio offers suggestions regarding possible approaches to the accounting forrelated party transactions under differing circumstances.

This Portfolio may be cited as BNA Tax and Accounting Portfolio 5148-2nd, Paul, Related PartyTransactions (Accounting Policy and Practice Series).

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis I. Introduction, Background, and Scope of Portfolio

A. Perspective

This Portfolio focuses on accounting for transactions between or among related parties and covers

Tax and Accounting Center http://taxandaccounting.bna.com.tjsl.idm.oclc.org/btac/display/ba...

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topical areas most significant and of broadest application to related party transactions. To this end, thePortfolio analyzes the treatment of related party transactions under significant accounting anddisclosure requirements, including Financial Accounting Standards Board (FASB) pronouncements,Securities and Exchange Commission (SEC) regulations, stock exchange rules, pronouncements of the

Public Company Accounting Oversight Board (PCAOB), and auditing standards. 1

1 Worksheet 1 provides a glossary of abbreviations and acronyms used in this Portfolio.

1. Treatment of Related Party Transactions—General

A significant number of enterprises enter into transactions with related parties. These parties includeemployees, subsidiaries, affiliated organizations, stockholders, directors, executive officers, and stockpromoters, among others. From an accounting perspective, related party transactions are recordedsimilarly to transactions between unrelated parties. However, these transactions have broad disclosurerequirements because of their potential impact on financial statement transparency. While the definitionof “related party” is fairly uniform throughout the accounting literature, the disclosure requirementsvary depending on the context.

Nevertheless, some transactions with related parties do not require disclosure. Most notably, relatedparty transactions that are immaterial to a company's financial statements are not subject to thedisclosure rules under FASB Accounting Standards Codification (ASC) 850 (based, in large part, on FASB

Statement No. 57, Related Party Disclosures). 2 Likewise, SEC Regulation S-K does not requiredisclosure of transactions with related parties when those transactions are under a certain dollar

amount and the related parties do not have a direct or indirect material interest. 3

2 FASB ASC 850-10-50-1; FASB Statement No. 57, Related Party Disclosures, ¶ 2.

3 17 C.F.R. §§229.404 (a), 369.

2. Why Related Party Disclosures?

All business enterprises possess a unique risk profile resulting from their specific financing andoperating strategies. Internal forces, such as management's talents, their proclivity towardtransparency and risk aversion, as well as external forces, including industry competition,macroeconomic trends, the industry life-cycle, and global dynamics, all contribute to enterprise risk.These internal and external forces interact to form the portrait of risk that is visible from an outsider'sperspective. Related party transactions have the potential to distort this picture.

Related parties may enter into transactions that give the appearance of having been conducted on anarm's-length basis in order to misrepresent the actual risk of the enterprise. As such, the potential forfraud is significant because related party transactions provide an excellent opportunity to hidemalfeasance. By failing to record related party transactions or reveal their related party nature, insiderscan easily use these transactions as vehicles for disguising compensation, misappropriating assets,and/or misstating financial statements. Even if misrepresentation is not intended, the nature of relatedparty transactions is such that their terms may be more favorable than those attainable by an outsideparty. As a consequence, the economic reality of a particular business event may not be apparentwithout complete disclosure.

3. The Many Varieties of Related Party Transactions

As related party transactions are pervasive, they may enter into almost every facet of business. Thescope of these transactions has led to a vast array of rules, regulations, pronouncements, and standardsdealing primarily with disclosures necessary for reporting many related party transactions. Related partytransactions may appear in a variety of circumstances, including: purchases and sales of merchandiseand services (merchantable assets); purchases and sales of productive (capital) assets; indebtednessand guarantees; investments in the securities of the enterprise or affiliated entities; leases; off-balancesheet financing; use of company assets and personnel; compensation arrangements, including stockoptions and employee pension trusts; inappropriate commingling of company assets; services rendered


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or received; asset transfers; and investments in other entities, including special purpose entities (SPEs).This Portfolio discusses a number of these items in light of significant accounting and disclosurerequirements, in an effort to convey the correct accounting and reporting treatment for such relatedparty transactions.

4. Authoritative Literature

In the United States, the accounting treatment of related party transactions is governed by three main

authoritative sources; these are: (1) SEC Regulation S-X, 4 (2) SEC Regulation S-K, 5 and (3) FASBASC 850. The SEC is charged with assuring that public companies provide full disclosure in theirfinancial reporting. Although the SEC does not issue accounting standards per se, it provides oversight

by governing the broader framework for preparing public companies' financial statements. 6

4 SEC Regulation S-X, Rules 4-08(k) (1) and (2).

5 17 C.F.R. §§229.404, 369.

6 See generally Securities Act of 1933, 15 U.S.C. §77a, et seq. (1933); Securities Act of1934, 15 U.S.C. §78a, et seq. (1934).

Regulation S-X prescribes the statutory requirements for preparing the financial statements and relatedfootnotes in filings with the agency. Regulation S-K, on the other hand, governs the non-financialportions of these filings. While the footnote disclosures required by Regulation S-X are substantiallyconsistent with the FASB rules under FASB ASC 850, Regulation S-K requires additional, and often moreextensive, disclosures than those required by FASB pronouncements.

It is important to understand the differences between Regulations S-X and S-K. As indicated, therequirements under Regulation S-X regarding the financial statement footnotes in filings are generallyconsistent with requirements in accounting standards, which often allow considerable discretion in termsof the wording, scope, and coverage of footnote information. On the other hand, supplementalinformation required by Regulation S-K is highly prescribed and allows little leeway in terms of scopeand specificity.

Although the SEC retains the legal authority to prescribe accounting procedures, 7 the agency hasgenerally left this task to FASB, which is the authoritative body given jurisdiction over accounting

standards that govern the preparation of financial statements. 8 These standards collectively arereferred to as generally accepted accounting principles (GAAP).

7 Id.

8 FASB ASC Term “Related Parties”; FAS 57, ¶ 24(f).

5. Summary of Related Party Transactions and Key Terms

The usual assumption under which business is conducted is that transacting parties are independentand act in their own best interest. This assumption is invalid when transacting parties are related.

A “related party” is one “with which the enterprise may deal if one party controls or can significantlyinfluence the management or operating policies of the other to an extent that one of the transacting

parties might be prevented from fully pursuing its own separate interests.” 9 “Control” is defined as “thepossession, direct or indirect, of the power to direct or cause the direction of the management and

policies of an enterprise through ownership, by contract, or otherwise.” 10 Interestingly, U.S. GAAPdoes not explicitly define the term related party transaction. IASC International Accounting StandardsNo. 24, Related Party Disclosures, does so, but in somewhat nebulous terms. It describes a “relatedparty transaction” as “a transfer of resources, services or obligations between related parties,

regardless of whether a price is charged.” 11 This latter notion is corroborated by FASB ASC 850, whichindicates that a lack of accounting recognition does not mitigate the necessity to disclose material


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related party transactions. 12

9 FAS 57, ¶ 24(f). See also FASB ASC Term “Related Parties,” paragraph (f).

10 FASB ASC Term “Control” (as used in FASB ASC 850-10); FAS 57, ¶ 24(b).

11 IASC International Accounting Standards No. 24, Related Party Disclosures, ¶ 9.

12 FASB ASC 850-10-05-5; FAS 57, ¶ 1.

FASB ASC 850 calls for the disclosure of material related party transactions but excludes,“compensation arrangements, expense allowances, and other similar items in the ordinary course ofbusiness.” Also excluded are those transactions eliminated in the preparation of consolidated or

combined financial statements. 13

13 FASB ASC 850-10-50-1; FAS 57, ¶ 2.

Comment: The phrase, in the ordinary course of business, is taken to mean dailytransactions that are carried out in a more or less routine fashion. For example, inaddition to compensation and travel arrangements, a home mortgage obtained by abank officer from his or her employer, on terms no more favorable than any other

mortgager, is considered to be “in the ordinary course of business.” 14 Similarly, ifexecutive officers of a retail chain and their families are allowed to purchase consumergoods from their employer under terms comparable to those of coworkers, the

transactions are deemed to be in the ordinary course of business. 15

14 FAS 57, ¶ 19 (background information not codified).

15 See id. (stating the following, “Disclosure of compensation arrangements,expense allowances, and other similar items in the ordinary course ofbusiness is not necessary for a user to understand the financialstatements.”) Accordingly, such items may be excluded. See also 17 C.F.R.§373.


B. Background and History

Accounting pronouncements and literature first referenced related party transactions in June 1953, withthe issuance of Accounting Research Bulletin No. 43, Restatement and Revision of Accounting ResearchBulletins. In describing related party transactions, the Bulletin states, “[n]otes or accounts receivabledue from officers, employees, or affiliated companies must be shown separately and not included under

a general heading such as notes receivable or accounts receivable.” 16 This reference was includedamong a set of rules that the American Institute of Certified Public Accountants (AICPA) recommendedto the New York Stock Exchange in 1933, rules formally adopted by the membership of the AICPA in

1934. 17 Thereafter, standards dealing with various types of related party transactions burgeoned, andhave since become commonplace and pervasive in GAAP, Generally Accepted Auditing Standards(GAAS), and International Accounting and Auditing Standards.

16 Accounting Research Bulletin No. 43, Restatement and Revision of Accounting ResearchBulletins, ch. 1, §A, ¶ 5; FASB ASC 850-10-50-2.

17 ARB 43, ch. 1, §A (historical information not codified).


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In 1969, a case involving the criminal indictment of auditors dramatically thrust related partytransactions to the forefront. Three auditors were found guilty of filing false statements in violation of

the Securities Exchange Act of 1934 in the notorious, so-called Continental Vending case. 18 HaroldRoth, president of Continental Vending Company, directed funds to be diverted to Valley CommercialCorporation, an affiliate. The auditors were aware that a footnote in Continental's financial statementsdid not disclose that Roth had borrowed approximately the same amount, which he was unable torepay, forcing Continental into bankruptcy. In July 1975, six years after the resolution of the case in

1969, the AICPA issued AICPA Statement on Auditing Standards 6, Related Party Transactions. 19 ThisStatement was superseded in 1983 by AICPA Statement on Auditing Standards 45, Omnibus Standard

on Auditing Standards (codified as AU Section 334, Related Parties). 20 With the publication of FAS 57in 1982, FASB finally issued a pronouncement covering the disclosure of related parties.

18 U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969).

19 AICPA Statement on Auditing Standards 6, Related Party Transactions (July 1975).

20 AICPA Statement on Auditing Standards 45, Omnibus Standard on Auditing Standards(Aug. 1983).

Comment: The issuance of SAS 6 was unusual in that this auditing standard effectuallypromulgated accounting rules for the disclosure of related party transactions, standardswhich did not exist prior to the date of issuance. No accounting pronouncements onrelated parties were extant, except for the rules concerning the classification ofreceivables described in ARB 43. This situation existed until 1982, when FASB issuedFAS 57.


C. Concepts Related to Financial Statement Disclosure

The requirements to disclose the nature of related party transactions stems from several basicqualitative features that FASB believes financial statements should possess. Those accounting qualities,discussed below in the context of related party transactions, are relevance, reliability, comparability,consistency, and materiality.

1. Relevance

To be useful for decision making, accounting information should be relevant. FASB Concepts StatementNo. 2, Qualitative Characteristics of Accounting Information, indicates that, to be relevant, information

must be timely and have predictive or feedback value, or both. 21 Accounting pronouncements over theyear have required specific undisclosures regarding related-party transactions for the very reason thatsuch disclosures are expected to provide the requisite predictive and confirmative information thatreaders of financial statements require. In particular, related party disclosures possess predictive valuein that they provide financial statement users with a clearer picture of the nature of businesstransactions that were not carried out at arm's-length in the ordinary course of business. Without aclear picture provided by disclosures, predictive models used by analysts and investors may proveuseless as investment tools. Capital markets and resource allocations may be distorted, often with direconsequences.

21 Feedback value refers to the ability of information to confirm or correct earlierexpectations. FASB Concepts Statement No. 2, Qualitative Characteristics of AccountingInformation, ¶ 51 (May 1980).

Comment: The damaging effect of lack of adequate disclosures about related party


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transactions was evident in the collapse of Enron. The abuse of special purpose entities(SPEs) by Enron has been widely reported. By not disclosing the nature of its dealingwith SPEs, Enron's management was able to portray asset transfers and liabilitytransactions as sales, and thereby conceal substantial amounts of off-balance sheet

debt. 22

22 Cecil W. Jackson, Business Fairy Tales (Thomson 2006), at 179.

The Enron situation illustrates that financial statement numbers alone may provide an incompletepicture of enterprise risk.

Comment: The sheer volume and complexity of financial statement disclosures exactsignificant costs for extracting the information that often is used as input for predictivemodels. Given these not insignificant costs, anecdotal evidence suggests that someanalysts may bypass disclosures and simply enter the financial statement numbers intotheir models. The consequences of doing so can be disastrous, however. For example,Enron's related party transactions footnote in the 1999 financial statements reported the

following: “A senior officer of Enron is the managing member of LJM's 23 general partner… LJM2, which has the same general partner as LJM, acquired, directly or indirectlyapproximately $360 million of merchant assets from Enron, in which Enron recognized

pretax gains of approximately $16 million.” 24 The 2000 annual report's related partyfootnote hinted at the extent of Enron's dealings with SPEs: “Enron … contributed tonewly-formed entities … assets valued at approximately $1.2 billion, including $150million in Enron notes payable, [and] 3.7 million restricted shares of outstanding Enron

stock.” 25 Although Enron did not reveal the full nature of its dealings with SPEs, themagnitude of the transactions should have at least alerted analysts and sophisticatedinvestors to its misrepresentations.

23 LJM was a special purpose entity set up by Andrew Fastow, Enron's CFO.

24 Jackson, Business Fairy Tales, above, at 189.

25 Id. at 190.

Through feedback and confirmation, disclosures aid prediction by reducing uncertainty and providing aspringboard to the future, thereby providing more assurance for making sound judgments. In addition,relevant information should be timely, i.e., available soon enough to influence decisions that financialstatement users make.

2. Reliability

Another described qualitative characteristic of accounting information is reliability. Reliability refers tothe representative faithfulness of information, that is, the degree of correspondence between

information and the actual events and transactions. 26 Reliable information is verifiable. 27 As more andmore estimates enter into accounting data, these data may become less verifiable. Reliable information

is also neutral. Neutrality refers to the ability of standards to avoid favoring special interests. 28

26 CON 2, ¶¶ 59, 63-64.

27 Id. ¶¶ 81-89.

28 Id. ¶¶ 98-110.

As related party transactions may conceal fraud, representative faithfulness becomes a concernwhenever these types of transactions occur and require reporting in financial statements. Related partytransactions can easily masquerade as arm's-length transactions entered into in the ordinary course ofbusiness, making it simple to perpetrate a fraud and then cover it up. Fraud concerns are heightened


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when related party transactions involve members of management, since management is in a position tooverride internal controls.

3. Comparability and Consistency

Comparability and consistency are two additional qualitative characteristics that accounting informationshould possess. Comparability measures the degree to which enterprises can be compared, while

consistency refers to the application of methods over time. 29 Greater comparability and consistencyimprove the ability to make informed investment decisions. Because risk profiles vary considerably fromone enterprise to the next, related party disclosures are especially useful for analyzing the unique riskcharacteristics of an enterprise, thereby aiding the decision process and facilitating informed judgments.

29 Id. ¶¶ 111-122.

4. Materiality

Even though reporting entities should strive to present accounting information that possesses thequalitative characteristics of relevance, reliability, comparability, and consistency, it need not strive for

these goals when presenting information that is not material to financial statement users. 30

Determining whether an item may be material to financial statement users requires an accountant to

evaluate both quantitative and qualitative considerations. 31 If magnitude alone were the only criterionfor judging materiality, many related party transactions would not need to be disclosed. Because thesetransactions may be indicative of second, underlying dealings, related party transactions requiredisclosure when other transactions of similar magnitude would not. As CON 2 notes for example,“[a]mounts too small to warrant disclosure or correction in normal circumstances may be considered

material if they arise from abnormal or unusual transactions.” 32

30 Id. ¶¶ 129, 130.

31 Id. ¶ 131.

32 Id. ¶ 128d.

Comment: Because many related party transactions are abnormal or unusualtransactions, they may have considerable ability to dissuade or entice decision makers.As a consequence, preparers of financial statements should employ a lower materialitythreshold when dealing with related party transactions.

As indicated at Section I.A.1, above, FASB ASC 850 calls for the disclosure of related party transactionsthat are material. Given that magnitude should not be the sole criterion for judging the materiality of arelated party transaction, an interesting question arises: “What qualitative characteristics distinguish arelated party transaction that is material from one that is clearly not?”

Courts have customarily used the “prudent” or “reasonable man” concept to distinguish material from

immaterial items. For example, in TSC Industries, Inc. v. Northway, Inc., 33 a case dealing with a proxystatement, the Supreme Court indicated that information omitted from such a statement can beconsidered material even if its inclusion would not have altered a shareholder's vote. The Court noted:

33 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

An omitted fact is material if there is a substantial likelihood that a reasonableshareholder would consider it important in deciding how to vote …. It does notrequire proof of a substantial likelihood that disclosure of the omitted fact wouldhave caused the reasonable investor to change his vote. What the standarddoes contemplate is a showing of a substantial likelihood that, under all thecircumstances, the omitted fact would have assumed actual significance in thedeliberations of a reasonable shareholder. Put another way, there must be a


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substantial likelihood that the disclosure of the omitted fact would have beenviewed by the reasonable investor as having altered the “total mix” of

information made available. 34

34 CCH Federal Securities Law Reports ¶ 95,615 (U.S. Sup. Ct. June 14, 1976) as quoted inCON 2, ¶ 164.

Accordingly, to be considered material, there must be a substantial likelihood that the disclosure is animportant piece of information in the decision making process. Many — if not most—related partytransactions, other than those in the ordinary course of business, would fall into this category.

Comment: Clearly, these kinds of materiality judgments can be difficult. For example,closely held companies may engage in various transactions with family members.Deciding which, if any, of these relationships and transactions to disclose may bedifficult. Moreover, it may not always be necessary to reveal the names of individuals.FASB ASC 850 indicates that, “In some cases, aggregation of similar transactions by

type of related party may be appropriate.” 35 For example, a company that leasesstorage facilities from company officers may simply disclose that fact without namingindividuals. In certain cases, it may be necessary to actually name the related party if it

would be difficult to understand the nature of the relationship without doing so. 36 Inother cases, the effect of the relationship between parties may be “so pervasive that

disclosure of the relationship alone may be sufficient.” 37 This situation may occur, forexample, when a mobile home manufacturer distributes completed homes exclusivelythrough captive retail outlets.

35 FASB ASC 850-10-50-3; FAS 57, ¶ 2 n.3.

36 FAS 57, ¶ 2 n.3 (not codified).

37 FASB ASC 850-10-50-3; FAS 57, ¶ 2 n.3.

Planning Point: Judging the adequacy of related party disclosures is problematic. Forexample, FASB ASC 850 calls for recording material related party transactions “to which

no amounts or nominal amounts were ascribed.” 38 One might argue that transactionsrecorded at a nominal amount are not considered material. Judgments concerning themateriality of related party transactions should, however, turn on an “as if” comparisonwith similar, market-based transactions. In each such case, the following question maybe posed: “If the transactions were consummated between unrelated parties, whatwould the amounts have been?” If the answer is that the amounts would have beenmaterial, then the transactions should be disclosed under FASB ASC 850. Even then,related party transactions do not have a one-to-one equivalency with market-basedtransactions. As mentioned, the qualitative aspects of materiality must also beexamined, even if the transactions are not considered material from a strictlyquantitative point of view. For example, if officers, employees, or family members areparty to transactions with the enterprise, other than amounts for normal compensationand similar such items in the ordinary course of business, disclosure is warranted toforestall the appearance of undisclosed remuneration at the expense ofshareholders/owners.

38 FASB ASC 850-10-50-1(b); FAS 57, ¶ 2.



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D. Fraud Concerns

One concern about related party transactions is the possibility that the parties are committing fraud. Asseen below, the instances of fraud are very low, but the possibility of fraud remains a concern

nonetheless. 39

39 This section is based on Elaine Henry, Elizabeth A. Gordon, Brad Reed, and Tim Louwers,The Role of Related Party Transactions in Fraudulent Financial Reporting, Working Paper(University of Miami 2006).

1. Frequency of Fraudulent Related Party Transactions

Related party transactions appear to be commonplace. In one study, 80% of the companies studied had

disclosed at least one related party transaction. 40 Another study indicated that 75% of companies

polled had disclosed a related party transaction. 41 Despite the common occurrence of related partytransactions, studies indicate that the overall occurrence of fraud, at least that which has beendetected, is low. For example, one study of federal class action suits, covering the period 1996 to 2001,reported only 100 incidences annually of inappropriate financial reporting out of approximately 15,000

audits of public companies. 42 Reported frauds involving related party transactions are fewer still innumber. For example, the percentage of improprieties involving related party transactions ranged from

a low of 10% 43 to a high of 21% in an earlier study. 44

40 Elizabeth A. Gordon, Elaine Henry, and D. Palia, Related Party Transactions and CorporateGovernance, 9 Advances in Financial Economics 1-28 (2004).

41 Many Companies Report Transactions With Top Officers, Wall St. J., Dec. 29, 2003, at A1.

42 Baruch Lev, Corporate Earnings: Fact and Fiction, 17(2) J. Econ. Perspectives 27-50(2003).

43 Securities and Exchange Commission, Report Pursuant to Section 704 of theSarbanes-Oxley Act of 2002 (2003).

44 S. Shapiro, Wayward Capitalists: Targets of the Securities and Exchange Commission (YaleUniversity Press 1984).

2. Related Party Transactions as a Fraud Risk Indicator

While few related party transactions are fraudulent, perhaps more significant is the relative magnitude

of the ones that are fraudulent. Several high-profile cases, including Enron 45 and Tyco 46 havehighlighted concern over the use of related party transactions as a clever means to obscure fraudulentfinancial reporting. AICPA Statement on Auditing Standards 99, Consideration of Fraud in a FinancialStatement Audit, lists as a fraud risk factor, “[s]ignificant related party transactions not in the ordinary

course of business or with related entities not audited or audited by another firm.” 47

45 In re Enron Corp. Secs., 235 F. Supp. 2d 549 (2002).

46 Securities and Exchange Commission v. L. Dennis Kozlowski, Mark H. Swartz and Mark A.Belnick, Civil Action No. 02 CV 7312.

47 AICPA Statement on Auditing Standards 99, Consideration of Fraud in a FinancialStatement Audit (Oct. 2002), Appendix.

Nevertheless, evidence regarding the weight to be given to the significance of these transactions inelevating the risk of fraud is inconclusive. In one study, the authors found that reported fraud cases hadapproximately the same proportion of “significant and unusual related party transactions” as non-fraud

cases. 48 The authors concluded that the mere presence of significant and unusual related party


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transactions did not appear to increase the risk of fraud. Although some studies found similar results,others came to a different conclusion. In one such study, internal auditors viewed related party

transactions as a significant factor in assessing the risk of fraud. 49 And in yet another study, theauthors found that the SEC had ranked the failure to recognize or disclose related party transactions as

one of the top 10 audit deficiencies. 50 Thus, the evidence is mixed concerning the weight to be givento related party transactions as a fraud risk indicator.

48 Timothy Bell and J. Carcello, A Decision Aid for Assessing the Likelihood of FraudulentFinancial Reporting, 19(1) Auditing: Practice and Theory 169-184 (2000).

49 G. D. Moyes, P. Lin, and R.M. Landry, Raise the Red Flag, 62 Internal Auditor 47-51(2005).

50 M. Beasley, J. Carcello, and D. Hermanson, Top Ten Audit Deficiencies-SEC Sanctions,191(4) Acct'g. 63-67 (2001).

3. The Role Related Party Transactions Play in Fraud Cases

An extensive study, published in 2006, examined the role that related party transactions play in fraud

cases. 51 The authors cataloged 48 instances of fraudulent or improper reporting, significant aspects ofwhich involved related party transactions. After gleaning these cases from SEC Accounting and Auditing

Enforcement Releases (AAERs) the authors cataloged them by type of transaction. 52 Their compendiumof cases is instructive since it provides an idea of the means concocted by a host of perpetrators toconceal improprieties through the use of related party transactions. As the cases reveal, insiders usedvarious means to conceal the misappropriation of assets, to cover up fraudulent financial reporting,

and/or to disguise compensation. 53 In each of the following categories, the term related parties refersto individuals or affiliates that are counterparties to transactions with the subject entity:

51 Henry, The Role of Related Party Transactions in Fraudulent Financial Reporting, above.

52 These AAERs covered the period 1980 to 2005.

53 For a detailed account of the cited cases, see Henry, The Role of Related PartyTransactions in Fraudulent Financial Reporting, above, at 12-23 and Table 1.

• Sales of Goods or Services to Related Parties – Ten companies were found to have

recorded fictitious sales or were cited for improper revenue recognition. 54

• Purchases of Goods or Services From Related Parties – In five cases, the subject

companies failed to disclose the related party nature of the transactions. 55 In seven cases,the companies recorded purchases of merchandise that was non-existent, not needed, or

above market. 56

• Sales of Assets to Related Parties – Four companies were found to have overvalued

assets sold to related parties, 57 while one company, Tyco, failed to disclose the relatedparty nature of the transaction. Yet another, Hollinger, sold assets at below market pricesfor the enrichment of a related party.

• Purchase of Assets From Related Parties – Five companies overvalued the purchases,

either to overstate the assets recorded on the books, 58 or in the case of Tyco, to transferwealth to a related party.

• Borrowing From Related Parties – Nine companies were found to have understated

liabilities in conjunction with loans from related parties. 59

• Loans to Related Parties – Six cases involved companies understating liabilities because


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they did not record the loans. 60 In six other instances, the related party feature was not

disclosed. 61 Three companies understated loan losses. 62 In one case, the CEO receivedcash, but the company, Cronos, recorded the disbursements as unsecured loans withoutdivulging the related party nature of the transactions. In two instances, the companies were

lending at below-market rates. 63

• Purchase of Equity Securities by Related Parties – Two cases dealt with companies that

used related party transactions to inflate their statutory capital. 64 Two companies recorded

the consideration received at inflated values to overstate assets. 65 One company,

Altratech, used the transactions to circumvent regulations. 66 Another company, Hollinger,

did not disclose the related party characteristics of the transactions. 67 In another instance,assets of Tonka Corporation were diverted to the CFO through Tonka's investments in an

entity he owned. 68

• Issuing Securities to Related Parties – Two of these cases dealt with companies notidentifying related parties who purchased and subsequently sold securities of the registrant.69 In two other cases, the SEC found that the companies had sold equity securities to

related parties at prices that were below market. 70

54 These companies are Softpoint, Itex, NetEase.com, Horizon, Ciro, Livent, Humatech,C.E.C., Swisher, and FastComm. Id.

55 These companies are Madera, Tyco, Rite Aid, Pace American, First Humanics. Id.

56 These companies are PNF, Chancellor, Livent, Hollinger, Enron (Chewco SPE), ZZZZ Best,and Biomaterials. Id.

57 These companies are MCA, Enron (the LJM SPE), Wilshire, Horizon. The asset values wereinflated to record higher gains. Id.

58 These companies are STDO, Great American, G. C. Tech, and ZZZZ Best. Id.

59 These companies are Adelphia, Novaferon. Enron, Refco, ESM, Tri-Corp Services,Pantheon, First Humanics, and Endotronics. Id.

60 These companies are Adelphia, Novaferon. Enron, Refco, ESM, and Tri-Corp Services. Id.

61 These companies are Rite Aid, Adelphia, ESM, Puryear, BBS, and Printonthenet.com. Id.

62 These companies are Convenient Food, MCA, and Oiltech. Id.

63 These companies are Rite Aid and Adelphia. Id.

64 These companies are Dixie National and Trademark USA. Id.

65 These companies are Pacific Waste Management and PNF Industries. Id.

66 Id.

67 Id.

68 Id.

69 These companies are Swisher and Softpoint. Id.

70 International Teledata and Enron dealt with the special purpose entities known as JEDI,Chewco, and LJM in order to conceal wealth transfers to Andrew Fastow, Enron's CFO, andmembers of his family.

4. Conclusions

The incidence of fraudulent financial reporting is low, and the use of related party transactions to


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perpetrate a fraud is lower still. Despite this low rate of occurrence, the significance of high-profile casesinvolving related party transactions cannot be ignored. Fraudulent reporting has a chilling effect oncapital markets by engendering a lack of faith in financial reporting and the credibility of the accountingprofession. Nevertheless, the evidence is inconclusive as to whether auditors perceive significant andunusual related party transactions to be a substantial fraud risk factor. The frauds enumerated in theprevious section indicate the variety of artifices that insiders have used to conceal the misappropriationof assets, cover up fraudulent financial reporting, and/or disguise additional compensation. Knowledgeof these frauds can help auditors detect future improprieties.


E. Scope of Portfolio

This Portfolio focuses on the accounting treatment and disclosure requirements for related partytransactions. It analyzes the treatment of each covered category of transactions under significantaccounting and disclosure requirements, SEC regulations, stock exchange rules, PCAOBpronouncements, and auditing standards.

Section II, below, discusses the accounting literature relevant to related party transactions. Section III,below, comprehensively covers: (1) sales and purchases of merchandise and services; (2) nonmonetarytransactions; (3) transfers of financial instruments; and (4) lease arrangements. Section IV, below,reviews corporate governance features as they pertain to related party transactions and dealings withcorporate insiders in general. Finally, Section V, below, discusses the auditing literature relevant torelated party transactions. Fraud issues are discussed as they pertain to covered categories.

A subsequent Portfolio will cover: (1) indebtedness, debt arrangements, and guarantees; (2)maintenance of compensating balances; (3) investments in other entities, including special purposeentities; (4) investments in the equity or other securities of the enterprise; and (5) compensationarrangements, stock options, and employee pension trusts.

This Portfolio does not cover items that are immaterial to a proper understanding and presentation offinancial statements. Nor does the Portfolio deal with issues concerning minor defalcations. Alsoexcluded are those transactions in the ordinary course of business that have no impact on financial

statement presentation. These transactions include normal compensation 71 and items such as theroutine sale of merchandise or services on terms no more favorable than those attainable by unrelatedparties.

71 Compensation and items such as travel expense allowances are explicitly excluded byFASB ASC 850. However, SEC regulations require disclosure of compensation arrangementswith the principle executive and financial officers, regardless of income level, and for otherhighly compensated executive officers, subject to a $100,000 threshold. SEC Release Nos.33-8732a and 34-54302a, Final Rule, Executive Compensation and Related Disclosure (2006).

This Portfolio does not merely catalog, compile, and paraphrase applicable rules. Rather, the Portfolioanalyzes the rules and explains how they apply to the covered transactions. The information ispresented in a manner that is both comprehensive and designed to serve the practical needs ofaccounting policymakers and technicians in companies, public accounting firms, and other professionalenvironments. Examples and planning points are integrated into the text.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis II. Authoritative Literature and Guidance

Related party transactions are addressed not only in GAAP literature but also by the SEC and certainstock exchanges. Accordingly, a company may have to follow several sets of rules. This section


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addresses the reporting rules pertaining to the disclosure of related party transactions, as well as theiraccounting treatment.

GAAP pronouncements apply to the preparation of financial statements that are prepared forshareholders on a quarterly and annual basis. Statements filed with the SEC are to be prepared in

accordance with GAAP 72 and also conform to SEC Regulation S-X. Accordingly, financial statementsfiled with the SEC cannot differ substantially from those included in annual reports to shareholders. SECRegulation S-K governs the form and content of the supplemental, non-financial information that is tobe included in registration and other forms filed under the Securities Act of 1933 and the Securities

Exchange Act of 1934, as well as certain aspects of annual reports issued to shareholders. 73 Stockexchanges typically specify that their required disclosures be included in the reporting entity's Form10-K or proxy statement.

72 SEC Regulation S-X, Reg. §210.4-01, Rule 4-01(a) (1).

73 SEC Regulation S-K, Reg. §229.10.


A. Accounting and Disclosures: U.S. GAAP—FAS 57

The authoritative rules regarding related party transactions under U.S. GAAP are in FASB ASC 850,

which is based on FAS 57. According to these rules, related parties include: 74


Affiliates of the enterprise; entities for which investments are accounted for bythe equity method by the enterprise; trusts for the benefit of employees, suchas pension and profit-sharing trusts that are managed by or under thetrusteeship of management; principal owners of the enterprise; itsmanagement; members of the immediate families of principal owners of theenterprise and its management; and other parties with which the enterprisemay deal if one party controls or can significantly influence the management oroperating policies of the other to an extent that one of the transacting partiesmight be prevented from fully pursuing its own separate interests. Anotherparty also is a related party if it can significantly influence the management oroperating policies of the transacting parties or if it has an ownership interest inone of the transacting parties and can significantly influence the other to anextent that one or more of the transacting parties might be prevented from fully

pursuing its own separate interests. 75

75 This and other definitions for the terms used in the FASB Codification are found inWorksheet 2.

Accordingly, parties that are related to a given reporting entity include:

• Principal owners and management, as well as members of their immediate families;

• The parent company, when applicable;

• Any subsidiaries;

• Affiliates, i.e., entities that: 76


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• Directly control or are controlled by the reporting entity;

• Indirectly, through one or more intermediaries, control or are controlled by thereporting entity;

• Are under common control with the reporting entity; and

• Employee trusts, including pensions and profit sharing trusts managed by or under thetrusteeship of the reporting entity's management.

76 FASB ASC 850-10-05-3; FAS 57, ¶ 24(a).

Also included are any other parties who either directly or indirectly possess “the power to direct orcause the direction of management and policies of the enterprise through ownership, by contract, or

otherwise.” 77

77 FASB ASC Term “Control” (as used in FASB ASC 850-10); FAS 57, ¶ 24(b).

Examples of related party transactions include: sales, purchases, transfers and leases; services receivedor rendered; investments in off-balance sheet entities known as special purpose (or variable interest)entities; guarantees; maintenance of compensating balances; use of company assets; compensation,including stock options; and employee pension trusts.

How wide a net should be cast in making a determination as to the individuals or entities that arerelated to a particular reporting entity? Correspondingly, what qualifies as a related party transaction?In many situations, the answer is obvious. Management, subsidiaries, and so on, are undoubtedlyrelated parties. In other cases, it is not so obvious. For example, assume Mrs. Y sits on the boards ofboth Company D and Company E. Mrs. Y and Company D are related parties. Likewise, Mrs. Y andCompany E are related. Are Company D and Company E related parties? Does it matter if there are notransactions between these two companies?

In another example, the CEO of Company P sells real estate in a series of transactions to the presidentof Company S, a major supplier of Company P. Are the purchase transactions between Company P andCompany S related party transactions? Are the real estate deals related party transactions?

A related party “can significantly influence the management or operating policies of the transactingparties … to an extent that one or more of the transacting parties might be prevented from fully

pursuing its own separate interests.” 78 Accordingly, making a determination as to which of theseentities or individuals constitute related parties turns on two major considerations: (1) the degree ofinfluence or control that is present, and (2) any difference in actions taken from what they would be ifthe parties were independent.


In the case of Mrs. Y, it would seem that Company D and E would not be related parties simply becauseMrs. Y sits on both boards whether or not transactions occur between the two entities. The presumptionis that one director typically could not influence transactions between these two entities. However, ifMrs. Y is in a position to influence transactions between these entities to such an extent thattransactions would differ because of her influence, the two entities and Mrs. Y would be related parties.She is able to “significantly influence the management or operating policies of the transacting parties …to an extent that one or more of the transacting parties might be prevented from fully pursuing its own

separate interests.” 79



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In the second example, Company S and Company P are not related parties in the absence of commoncontrol or influence. A determination as to whether the purchase transactions between Company S andP are related party transactions would depend on the degree of influence exerted by the CEO ofCompany P, as well as whether the actions of Company S's president were different from what theywould have been were it not for the real estate deals. One would have to examine the circumstancesand delve further into the real estate transactions themselves. Were these purely private transactions?Were they at market value? If the transactions were at less than market value, they are likely relatedparty transactions because they presumably were effected to influence the president of Company S and,in turn, the purchase transactions between S and P. Under these circumstances, the purchasetransactions between S and P are related party transactions. If the real estate deals were consummatedat market value, the purchase transactions between S and P would likely not constitute related partytransactions assuming the real estate dealings were purely private and did not alter the behavior of

Company S's president or the purchase transactions between the two entities. 80

80 For a more thorough discussion of the limits of related party transactions, see Mason,Alister, K., Related Party Transactions (The Canadian Institute of Chartered Accountants1979), at 28-46.

1. Accounting Recognition

How should related party transactions be recorded? Although the accounting treatment of related partytransactions is not usually different from those between or among unrelated parties, the position inFASB ASC 850 is that, since the parties are not acting independently, one cannot presume that related

party transactions are consummated on an arm's-length basis. 81 Accordingly, such transactions arerecorded according to their form, that is, using the stated exchange price and other such terms.

However, the form of a transaction may differ from its substance. 82 This consideration is a primaryreason for requiring the disclosure of related party transactions. Moreover, if the form of the transactiondiffers substantially from its substance, FAS 57 requires the disclosure of, “such other informationdeemed necessary to an understanding of the effects of the transactions on the financial statements.”83

81 FASB ASC 850-10-50-5; FAS 57, ¶ 3.

82 SAS 45; AICPA Professional Standards, Related Parties, 344.02.

83 FASB ASC 850-10-50-1(b); FAS 57, ¶ 2.

The next section explains the disclosure requirements under U.S. GAAP for related party transactions.

2. Disclosures Required by FASB ASC 850

FASB ASC 850 requires the following disclosures for material related party transactions: 84

84 See Section I.C.4, above, for a description of the term material.

• “The nature of the relationship(s) involved.” 85

• “A description of the transactions, including transactions to which no amounts or nominalamounts were ascribed, for each of the periods for which income statements are presented,and such other information deemed necessary to an understanding of the effects of the

transactions on the financial statements.” 86

85 FASB ASC 850-10-50-1(a); FAS 57, ¶ 2(b).

86 FASB ASC 850-10-50-1(b); FAS 57, ¶ 2(b).


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Comment: The additional information might, for example, include what the exchangeprice would have been if the parties were independent and the transactions had beenconsummated at arm's-length. Depending on the type of transaction, other disclosuresmay be required, for example, those concerning loss allowances or contingencies, orinformation pertaining to normal industry practices.

• “The dollar amounts of transactions for each of the periods for which income statementsare presented and the effects of any change in the method of establishing the terms from

that used in the preceding period.” 87

• “Amounts due from or to related parties as of the date of each balance sheet presented

and, if not otherwise apparent, the terms and manner of settlement. 88

87 FASB ASC 850-10-50-1(c); FAS 57, ¶ 2(b).

88 FASB ASC 850-10-50-1(d); FAS 57, ¶ 2(b).

Financial statements and disclosures are ordinarily required for the current year and one or more

preceding years. 89 An example of these disclosures is found in Worksheet 3, which shows excerptsfrom McKesson Corporation's March 31, 2007 Form 10-K.

89 FASB ASC 205-10-45-1 and 45-2; ARB 43, ch. 2, §A, ¶¶ 1, 2; FASB ASC 250-10-45-5;FASB Statement No. 154, Accounting Changes and Error Corrections, ¶ 7.

There are two decision points when determining which transactions to disclose. The first is deciding if arelated party transaction is a type of transaction subject to the FAS 57 disclosure rules. The second isdeciding whether a related party transaction that is the type subject to the disclosure rules is materialand, thus, must be disclosed.

Regarding the first decision, FASB ASC 850 exempts only a few related party transactions from thedisclosure rules. Specifically, disclosure is not required for “compensation arrangements, expenseallowances, and other similar items in the ordinary course of business.”

Comment: The phrase “and other similar items in the ordinary course of business” mayappear to allow some leeway for items that are conducted among entities on a routinebasis, such as sales of inventory or purchases of supplies. However, this exceptionappears to be fairly narrow and confined to transactions occurring when related partyindividuals are acting in their capacity as employees of a reporting entity. Items similarto the cited examples would be those transactions that are routinely consummated byemployees on a daily basis. Under this interpretation, “other similar items” wouldinclude, for example, purchases of merchandise made by executive officers of a retailer,and their families, when such sales are transacted on terms no different from thoseapplicable to other employees or customers.

The second decision involves a determination of materiality. The materiality standards for related partytransactions are not different from those pertaining to other financial statement components. Materiality

has both a quantitative and qualitative dimension. 90 Perhaps more so than other transactions, thequalitative dimension weighs heavily in judging materiality for related party transactions becauseunderlying dealings may not be evident from an examination of the financial statements. The position ofthe individual involved is an important consideration, as well as the appearance of impropriety even ifnone exists in fact.

90 CON 2, ¶ 31.

3. Transactions Reported in Separate Statements of Affiliates


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FASB ASC 850 does not require disclosure of transactions that are eliminated in the preparation ofconsolidated or combined financial statements. However, the related party disclosures (listed in SectionII.A.2, above) are required, including dollar amounts, when presenting the separate statements of

affiliates, that is, subsidiaries, corporate joint ventures, and 50%-or-less-owned investees. 91 Incontrast, when separate financial statements are presented with those of the parent company in the

same report, duplicate disclosures are not required. 92

91 FASB ASC 850-10-50-4; FAS 57, ¶ 2 n.2.

92 Id.

Comment: Although GAAP prohibits the issuance of parent-only financial statements, itdoes not preclude the issuance of subsidiary-only financial statements withoutaccompanying consolidated statements. However, the related party disclosures need tobe included. Thus, when affiliates' separate financial statements are presented,transactions that were eliminated for presentation of the consolidated group are

restored to afford full disclosure. 93

93 AICPA Technical Practice Aids/Technical Questions and Answers, TIS§1400.27 (not codified).

Worksheet 4 provides an example of the related party footnote disclosures found in Hurco Companies,Inc. October 31, 2006 financial statements on Form 10-K.

4. Management Representations of Equivalency

At times preparers of financial statements and reports may wish to include statements to the extentthat related party transactions were entered into under terms equivalent to those prevailing in arm's-length transactions. If these representations are included, the preparer must be able to substantiate

them. 94 In this regard, FASB ASC 850 states the following:

94 FASB ASC 850-10-50-5; FAS 57, ¶ 3.

Transactions involving related parties cannot be presumed to be carried out onan arm's-length basis, as the requisite conditions of competitive free-marketdealings may not exist. Representations about transactions with related parties,if made, shall not imply that the related party transactions were consummatedon terms equivalent to those that prevail in arm's-length transactions unless

such representations can be substantiated [emphasis added]. 95

95 Id.

The Enron debacle is a classic example of a company that made representations concerning relatedparty transactions that could not be substantiated. Enron's proxy statements and financial reportsincluded representations describing related party transactions as being equivalent to those conductedon an arm's-length basis. For example, the 2000 proxy statement included the following claim:“[M]anagement believes that the transactions were reasonable and no less favorable than the terms of

similar arrangements with unrelated third parties.” 96 Similar wording is also found in the 1999 and2000 Forms 10-K and 10-Q. The Powers Report, an investigation of the debacle by a committee ofEnron's Board of Directors, noted that the company lacked the factual basis required by GAAP to makethese assertions. Indeed, the Report adds that the transactions were structured in such a way that

many of the dealings, in all likelihood, could only have been transacted with Enron insiders. 97

96 Report of Investigation by the Special Investigative Committee of the Board of Directors of


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Enron Corp., William C. Powers, Jr., Chair, 185 (2002).

97 Id. at 199.

Planning Point: Because of notorious accounting scandals, such as Enron, it is evermore likely that authoritative bodies will closely scrutinize related party transactions. Aprudent course of action would be to include representations regarding comparabilityonly when a well-established market exists for a given product or service. Otherwise, itis best to avoid these kinds of representations.

5. Disclosure of Control Relationships

The FASB Codification defines control as “[t]he possession, direct or indirect, of the power to direct orcause the direction of the management and policies of an enterprise through ownership, by contract, or

otherwise.” 98 If a control relationship exists, disclosure of that relationship may be required. Theconditions for disclosure are as follows: (1) an enterprise is a reporting entity, that is, it issues its ownfinancial statements, (2) the enterprise is under common ownership or management control with one ormore other enterprises, and (3) the enterprise's operating results or financial position are different from

what they would have been absent the control relationship. 99 Disclosure is not necessary if thereported financials do not differ despite the existence of the control relationship. However if thefinancials are impacted, disclosure is required even if there are no transactions between or among therelated parties.

98 FASB ASC Term “Control” (as used in FASB ASC 850-10); FAS 57, App. B.

99 FASB ASC 850-10-50-6; FAS 57, ¶ 4.

Planning Point: An extensive search of SEC filings revealed no reported instances ofcontrol relationships of the type under consideration. It may be that there are very fewof these relationships. On the other hand, this is one of the more onerous requirementsfound in FASB ASC 850 and proper implementation is difficult. The question, of course,is how to determine whether operating results would differ in the absence of a controlrelationship. One way to determine whether disclosure is required is to examine thedegree of autonomy enjoyed by affiliates and the effect that membership in theaffiliated group has on their operations. This may prove an easier call if transactionsexist. In either situation, one might consider proceeding in the following manner if: (1)an affiliate operates in a fashion completely independent of other entities within therelated group, and (2) its operations are not impacted in some fashion by the parent orother affiliates, disclosure would normally not be required. On the other hand, ifoperations are affected in some way due to group membership, for example, sales orproduction are restricted by the parent or an affiliate, the subsidiary could then not beconsidered autonomous and disclosure of the control relationship is therefore required.


B. SEC Regulations for Public Companies

1. Financial Statement Disclosures: Regulation S-X Requirements

SEC Regulation S-X governs the reporting of financial information in reports filed with the SEC. Forrelated parties, this regulation requires the following disclosures in financial statements filed with theSEC:

• “Related parties should be identified and the amounts stated on the face of the balance

sheet, income statement, or statement of cash flows.” 100


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• “In cases where separate financial statements are presented for the registrant, certaininvestees, or subsidiaries, separate disclosure shall be made in such statements of theamounts in the related consolidated financial statements which are (i) eliminated, and (ii)not eliminated. Also, any intercompany profits or losses resulting from transactions with

related parties and not eliminated and the effects thereof shall be disclosed.” 101

100 SEC Regulation S-X, Rule 4-08(k)(1), 17 C.F.R. §210.4-08(k)(1); FASB ASC 235-10-S99-1.


The term “certain investees” refers to 50%-or-less-owned entities over which control is exercised (e.g.,SPEs and investments accounted for under the equity method).

The SEC requires the presentation of consolidated balance sheets for the two most recent fiscal years

and consolidated income statements and statements of cash flows for three fiscal years. 102 The relatedparty disclosures are included in the footnotes to these statements. Although the Regulation S-Xrequirements are similar to those of FASB ASC 850, Regulation S-X is more succinct, stating only that,“Related parties should be identified and the amounts stated on the face of the balance sheet, income

statement, or statement of cash flows.” 103 FASB ASC 850 is more explicit, requiring disclosure of: (1)the nature of the relationship(s) involved; (2) a description of the transactions, including transactions towhich no amounts or nominal amounts were ascribed, for each of the periods for which incomestatements are presented, and such other information deemed necessary to an understanding of theeffects of the transactions on the financial statements; (3) the dollar amounts of transactions for eachof the periods for which income statements are presented and the effects of any change in the methodof establishing the terms from that used in the preceding period; (4) amounts due from or to relatedparties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and

manner of settlement. 104

102 SEC Regulation S-X, 17 C.F.R. §§210.3-01, 210.3-02.


104 FASB ASC 850-10-50-1; FAS 57, ¶ 2.

Planning Point: The practical approach is to include the more detailed FASB ASC 850requirements in the footnotes of financial statements filed with the SEC.

2. Non-Financial Statement Disclosures: Regulation S-K Requirements

In addition to the financial statement footnote disclosures set out in Section II.B.1, above, the SECrequires registrants to include certain related party disclosures in the non-financial statement portions

of SEC filings. 105 The disclosures are to be included in registration statements filed under theSecurities Act of 1933 and filings under the Securities Exchange Act of 1934. The latter includes annualreports, proxy statements, registration statements, and all other forms required to be filed pursuant to

the 1934 Act. 106 Item 404 of Regulation S-K, Transactions with Related Persons, Promoters andCertain Control Persons, outlines the disclosures required for related party transactions and covers

disclosures pertaining to the following: 107

105 See generally, SEC Regulation S-K, Item 404, Reg. §229.404.

106 SEC Regulation S-K, Reg. §229.10(a).

107 SEC Regulation S-K, Reg. §229.404.


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• Transactions with related persons – Item 404(a);

• Review, approval or ratification of transactions with related persons – Item 404(b);

• Transactions with promoters and certain control persons – Item 404(c).

The pertinent disclosure requirements for each of these are covered in the sections that follow.

a. Transactions With Related Persons: Item 404(a)

(1) Covered Transactions

According to Item 404(a), related persons include executive officers, directors, nominees for director,

significant shareholders, and the immediate families of these individuals. 108 If the registrant, includingits subsidiaries, has entered into related party transactions with any of these individuals and the amountexceeds $120,000, the company must disclose the transactions if it determines that the related person

had or will have a direct or indirect material interest. 109 The disclosure requirements pertain to any:110

108 A detailed discussion of related persons is set out in Section II.B.2.a.(2) below.


110 Id.

• Financial transaction, arrangement, or relationship, or

• Series of similar transactions, arrangements, or relationships, including indebtedness orguarantees of indebtedness.

A direct interest involves entering into transactions with the registrant, or one or more of itssubsidiaries. For example, holding an equity interest by purchasing shares of the registrant's commonstock and engaging in loan transactions with the registrant or its subsidiaries constitute direct interests.An indirect interest typically involves an intermediary. For example, an individual is a related party if heor she engages in loan transactions with the registrant and has an investment in a company that holdsa substantial equity interest in the registrant or its subsidiaries.

The $120,000 is not a bright-line threshold. It is, however, the starting point for making adetermination as to whether the related party has a material interest and whether the transaction is tobe tracked for disclosure purposes. In deciding whether a party's interest is material, the following

factors should be considered: 111

111 17 C.F.R. §149-50.

• The significance of the information to investors, given all the circumstances;

• The importance to the related person;

• The nature of the related party relationship; and

• The dollar amount of the transactions.

For purposes of Item 404(a), the term, “transaction” includes, but is not limited to, any financialtransaction, arrangement or relationship, including indebtedness or guarantees of indebtedness, or any

series of similar transactions. 112 If the individual has a material direct or indirect interest that exceeds


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$120,000, then the transaction, or series of similar transactions, must be disclosed. Similar or liketransactions pertaining to a specific party should be aggregated to ascertain whether the $120,000 limitis exceeded. A transaction or series of similar transactions should be separately disclosed for eachcounterparty. If the related party's interest in a particular transaction, or series of related transactions,

is not a direct or indirect material interest, disclosure is not required. 113


113 17 C.F.R. §150.

Planning Point: Much has been written about the way Enron used special purposeentities (SPEs) to manipulate earnings. Two SPEs set up by Andrew Fastow, Enron'sCFO, were dubbed LJM1 and LJM2. As general partner of LJM1, Fastow bought and soldEnron assets at prices more favorable to LJM1 than to Enron. By using Enron's loanguarantees, LJM1 acquired huge sums of cash that Fastow used for personal gain. All ofEnron's transactions with the LJM partnerships met the materiality threshold. Althoughdisclosure regarding these transactions was included in the 2001 proxy statement, theinformation omitted facts that were crucial to understanding the transactions. Indeed,

the mindset at Enron was one of obfuscation and avoidance. 114 Of course, Enron wasnot alone. Other companies have used similar ploys. A study published in 2003 foundthat corporations entering into related party transactions are more likely to be

associated with fraudulent financial statements. 115 Given the high probability thatrelated party transactions will be closely scrutinized, full disclosure becomes increasinglyimportant.

114 Report of Investigation by the Special Investigative Committee of theBoard of Directors of Enron Corp., William C. Powers, Jr., Chair, 201 (2002).

115 Lotfi Geriesh, Organizational Culture and Fraudulent Financial Reporting,73 CPA J. 28 (Mar. 2003).

(2) Categories of Related Persons

The disclosure requirements under Item 404(a) differ somewhat depending upon the classification intowhich a related person falls. There are two distinct classifications of related persons: (1) directors andexecutive officers, and (2) significant shareholders.

(a) Directors and Executive Officers

The first classification includes: 116


• Directors and executive officers;

• Nominees for director when the required disclosures are presented in a proxy orinformation statement that provides information regarding the nominee's election;

• The immediate family members of these individuals.

The following are deemed to be immediate family members: children, stepchildren, parents,stepparents, spouses, siblings, mothers-in-law, fathers-in-law, sons-in-law, daughters-in-law, brothers-in-law, and sisters-in-law. Also included are individuals sharing the household of the related person,

excluding tenants and employees. 117 The disclosures set out in Section II.B.2.a.(3), below, arenecessary if any of these persons entered into transactions with the registrant during any part of theyear. Disclosure is also necessary for transactions that were proposed during the fiscal year.


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117 Id.

(b) Significant Shareholders (Certain Beneficial Owners)

The second classification of related persons comprises significant shareholders (certain beneficialowners) and members of their immediate families. Significant shareholders are individuals beneficially

owning more than 5% of any class of the registrant's voting securities. 118 When a significantshareholder is a counterparty to transactions involving the registrant, the disclosures set out in SectionII.B.2.a.(3), below, are required. However, unlike officers and directors, the disclosures are necessaryonly for the time period during which the transaction(s) existed or occurred.


Example: An individual not yet a significant shareholder sells assets to the registrant inJanuary. Later, in June, this person becomes a significant shareholder. Disclosure of the Januaryasset purchase is not required since the individual was not a significant shareholder at the timeof the asset purchase.

On the other hand, if a transaction begins before the individual becomes a significant shareholder andcontinues after that event, disclosure is required. The following example illustrates this point.

Example: An individual not a significant shareholder in Year A loans funds to the registrant inthat year. In Year B, that person becomes a significant shareholder. If the funds are not repaid

prior to the individual becoming a significant shareholder, disclosure is required. 119

119 17 C.F.R. §157.

Note that indebtedness disclosures are not required unless the individual is also an executive officer,director, or director-nominee.

In addition to the disclosures found in the next section, Regulation S-K, Item 403(a), requires theregistrant to provide the following information pertaining to all significant shareholders:

• The title of the class of stock;

• The name and address of the beneficial owner;

• The amount and nature of the beneficial ownership; and

• The percentage of the class of stock. 120


(3) Item 404(a) Disclosures

The following disclosures are required if the registrant or its subsidiaries enter into material transactionswith any of the persons identified in Section II.B.2.a.(2), above: executive officers, directors, nominees

for director, significant shareholders and the immediate family members of these individuals: 121


• The name of the related person;

• The basis on which the individual is a related person: title, position and so on;


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• The individual's interest in the transaction with the registrant (and/or subsidiaries),including:

• The person's position(s) or relationship(s) with the entity that is a counterparty to, orhas an interest in, the transaction;

• The person's ownership interest in the counterparty entity, or in the entity having aninterest in the transaction;

• The approximate dollar value of the amounts involved in the transactions;

• The approximate dollar value of the related person's interest in the transactions,computed without regard to profit or loss; and

• Any additional information about the transactions or the related person that is required tomake the transactions understandable, i.e., any information that would be material toinvestors, given the circumstances of the particular transactions or series of transactions.

Comment: This last requirement is the result of a 2006 revision of Regulation S-K. Therevision was intended to impart a “principles-based” approach. The belief is thatpreparers are more inclined to provide full disclosure under this approach because therequired information is not circumscribed by overly prescriptive wording more indicativeof the competing “rules-based approach.” The contention is that a rules-based approachdevelops a mind-set whereby preparers try to omit as much as possible if the rules donot explicitly state that the information is required. Much of this development was inresponse to insider dealings at Enron and other companies. For example, Enron'smanagement and in-house counsel worked diligently to shoehorn insider dealings intothe existing Regulation S-K rules while revealing as little as possible. In this regard, thePowers Report, an investigation into the debacle by a committee of Enron's board ofdirectors, noted:

… Enron's disclosures and the information we have about how they were draftedreflect a strong predisposition on the part of at least some in the Company tominimize the disclosures about the related-party transactions. Fastow [AndrewFastow, CFO] made clear that he did not want his compensation from the LJMpartnerships to be disclosed, and the process reflected a general effort to say aslittle as possible about these transactions. While we recognize that Enron wasnot alone in seeking to say as little as the law allowed, particularly on sensitivesubjects, we were told by more than one person that the Company spentconsiderable time and effort working to say as little as possible about the LJMtransactions in the disclosure documents. It also appears that Enron

Management structured some transactions to avoid disclosure … 122

122 Report of Investigation by the Special Investigative Committee of the Board of Directorsof Enron Corp., William C. Powers, Jr., Chair, 201 (2002).

The newer requirement to ensure that transactions are understandable should make it more difficult toclaim that the information was omitted because it was not specifically called for. Worksheet 5 providesan example of the Item 404(a) disclosures that are included in Atmel Corporation's July 9, 2007 proxystatement on Schedule 14A.

Regulation S-K requires the registrant to report Item 404 transactions occurring since the beginning of

the registrant's last fiscal year, as well as any currently proposed transactions. 123 For the following

SEC filings, disclosures are to be included for the current year and the two preceding fiscal years: 124



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124 SEC Regulation S-K, Reg. §229.404. See also 17 C.F.R. §151, n.416.

• Form S-1 or Form SB-2 pursuant to the Securities Act of 1933;

• Form 10 or Form 10-SB pursuant to the Securities Exchange Act of 1934.

Accordingly, disclosure is required for three years in registration statements filed under the 1933 Actand the 1934 Act, i.e., for the period specified in Item 404, which is one year, and for two additionalyears. If, however, information is being incorporated by reference into a registration statement on FormS-4, the additional two years of disclosure is not required. In this situation, the necessary disclosure is

for only one year, the period specified in Item 404. 125

125 Form S-4 is submitted to the SEC when a merger or an acquisition occurs. The form isalso used for exchange offers when securities are provided for similar securities at lessdemanding terms, typically to avoid bankruptcy.

In the case of arrangements calling for periodic payments or installments, such as leases, disclosure ofthe aggregate amount of all periodic payments or installments is necessary. The dollar amount is theaggregate of all payments due on or after the beginning of the fiscal year, including any required oroptional payments due during, or at the conclusion of, the lease or other transaction requiring the

periodic payments or installments. 126 Worksheet 6 provides an example of the required disclosures forleases as reported in Frozen Food Express Industries' 2006 proxy statement on Schedule 14A.


(4) Additional Disclosures for Transactions Involving Indebtedness

Indebtedness transactions between the registrant and related persons require disclosures over andabove those outlined in the previous section. For indebtedness transactions, the following additional

items are to be included for the period during which disclosure is required in the filing: 127

127 SEC Regulation S-K, Reg. §229.404(a)(5).

• The amount of principal outstanding as of the latest practicable date;

• The amount of principal paid;

• The amount of interest paid; and

• The rate(s) or amount(s) of interest payable.

Furthermore, the information regarding a related person is to include the largest aggregate principalamount of all indebtedness outstanding at any time during the fiscal year, along with all amounts ofinterest payable on that aggregate amount. Worksheet 7 provides excerpts from Amgen's 2006 proxystatement on Schedule 14A illustrating disclosures pertaining to indebtedness transactions with relatedpersons. As indicated in Section II.B.2.a.(3), above, disclosure is required for one year, unless theregistrant is filing a registration statement, in which case three years of disclosure are required.

Disclosures regarding indebtedness pertain only to those individuals included in the first classificationlisted in Section II.B.2.a.(2), above; executive officers, directors, and nominees for director. Disclosuresregarding material indirect interests in indebtedness transactions by these individuals are also required.As indicated in Section II.B.2.a.(5)(a), below, indebtedness disclosures pertaining to individuals falling

into the second classification of related persons (significant shareholder) are expressly excluded. 128


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Comment: The Sarbanes-Oxley Act of 2002 (SOX) amended the Securities ExchangeAct of 1934, §13, Periodical and Other Reports, by prohibiting “issuers” from making

loans to executive officers and directors. 129 SOX defines an issuer as a “company thatissues or proposes to issue securities, if the securities are registered under section 12 ofthe Securities Exchange Act of 1934, or if the company is required to file reports withthe SEC under section 15(d) of the Securities Exchange Act (or will be required to filethose reports at the end of the fiscal year in which a registration statement for the

issuer's securities has become effective under the Securities Act of 1933).” 130

129 Sarbanes-Oxley Act of 2002 (SOX), Pub. L. No. 107-204, 116 Stat. 745,§402.

130 SOX §2. Section 12 of the 1934 Act pertains to registrants that are notinvestment companies. The latter are covered by Section 15(d).

(5) Exclusions

Section II.B.2.a.(3), above, enumerates the disclosure requirements when the registrant or itssubsidiaries enter into material transactions with related persons, while Section II.B.2.a.(4), above, setsout additional requirements for indebtedness transactions. There are a number of exclusions to theserequirements as they pertain to the following:

• Indebtedness;

• Employment relationships;

• Directors' compensation;

• Certain indirect material interests;

• Other exclusions:

• Determination by competitive bid or governmental authority;

• Certain financial services;

• The ownership of equity securities.

The following subsections cover each of the foregoing categories.

(a) Exclusions Pertaining to Indebtedness

Indebtedness incurred for the following types of transactions entered into in the ordinary course of

business are excluded from the disclosure requirements: 131

131 SEC Regulation S-K, Reg. §404(a).

• Purchases of goods or services that are subject to normal trade terms;

• Ordinary business travel and expense payments;

• Other transactions in the ordinary course of business.

Comment: The phrase in the ordinary course of business is taken to mean those


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transactions of daily living that are carried out in a more or less routine fashion. Forexample, in addition to compensation and travel arrangements, a home mortgageobtained by a bank officer from his or her employer, on terms no more favorable thanany other mortgager, is considered to be “in the ordinary course of business.”

• Indebtedness disclosures pertaining to significant shareholders, i.e., those persons whobeneficially own greater than 5% of any class of the registrant's voting securities, are

expressly excluded; 132

• Disclosures by banks, savings and loans, and broker-dealers extending credit under

Federal Reserve Regulation T 133 for loans that are not categorized as: 134

• Nonaccrual;

• Past due;

• Restructured; or

• Potential problem loans. 135

132 SEC Regulation S-K, Reg. §404(a).

133 See Federal Reserve System, Title 12, Banks and Banking, Chapter II, Federal ReserveSystem, Part 220, Credit by Brokers and Dealers (Regulation T): 12 C.F.R. part 220.


135 See Item III.C.1. and 2. of Industry Guide 3, Statistical Disclosure by Bank HoldingCompanies (17 C.F.R. §229.802(c)).

If these loans do not fall into any of the foregoing categories, the disclosure may consist of a statement

that the loans to the related persons: 136


• Were made in the ordinary course of business;

• Were on substantially the same terms, including interest rates and collateral, as thoseprevailing at the time for comparable transactions with non-related persons; and

• Did not involve more than the normal risk of collectibility or present other unfavorablefeatures.

(b) Employment Arrangements

Disclosures of employment relationships are not required to be duplicated under Item 404 if theinformation is provided elsewhere pursuant to Regulation S-K. Since executive officer compensation isreported under Item 402 of Regulation S-K, Executive Compensation, the disclosures need not be

repeated if the following conditions prevail: 137


• The executive officer is not an immediate family member as enumerated in SectionII.B.2.a.(2), above;


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• The compensation is such that it would be reported as being earned for services to theregistrant under Item 402, Executive Compensation;

• The executive officer is a named executive officer, as defined in Item 402; 138

• The compensation was approved by the compensation committee of the board of directors(or equivalent), or recommended to the entire board by the compensation committee (orequivalent).

138 SEC Regulation S-K, Reg. §402(a)(3), Item 402(a)(3) defines named executive officersas those individuals in the following categories: (1) principal executive officer (PEO); (2)principal financial officer (PFO); (3) the three most highly compensated executive officers,other than the PEO and PFO serving at the end of the fiscal year; (4) up to two individualswho would be in the previous category, except that they were not serving at the end of thefiscal year.

(c) Directors' Compensation

Disclosure of compensation paid to directors need not be reported under Item 404(a) if the

compensation is disclosed pursuant to Regulation S-K, Item 402(k), Compensation of Directors. 139

139 See generally, SEC Regulation S-K, Reg. §229.402(k).

(d) Certain Indirect Material Interests

An individual who holds a position with an enterprise that enters into a transaction with the registrant orits subsidiaries has an indirect interest in the transaction. Even if material, such an interest is excluded

from the disclosure requirements of Item 404(a) if the interest arises: 140


• Exclusively from the individual's position as a director of the enterprise doing businesswith the registrant or its subsidiaries (however, disclosure is required if the individual is anexecutive officer of the enterprise);

• From holding less than a 10% equity interest, whether direct or indirect, in an entity,other than a partnership, that is party to the transaction with the registrant or itssubsidiaries; or

• From both of the foregoing.

Comment: To determine whether the 10% equity interest has been exceeded, theindividual must aggregate his or her equity holdings with those of all other individualsenumerated in Section II.B.2.a.(2), above. These persons include all executive officers,directors, director-nominees, significant shareholders, and immediate family members.If the combined direct or indirect equity holdings of these individuals exceeds 10% ofthe ownership in an enterprise that is a counterparty to transactions with the registrant

or its subsidiaries, disclosure of the related party transactions is required. 141

141 Id.

If the indirect material interest stems from the registrant's transactions with a partnership in which theindividual is a limited partner, disclosure is not required unless:


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• The 10% aggregate threshold is exceeded; or

• The person holds another position in the partnership.

In contrast, disclosure is required if the individual is a general partner.

Comment: The ownership test pertaining to a partnership is analogous to thatmentioned in the previous comment. The direct or indirect ownership interests of allpersons enumerated in Section II.B.2.a.(2), above, are combined. If the aggregatedirect or indirect ownership exceeds 10%, disclosure of the related party transactions is

required. 142

142 Id.

(e) Other Exclusions 143

143 Id.

Certain other exclusions apply to the Regulation S-K requirements for disclosing related partytransactions. Disclosure is not required under the following circumstances:

• The rate or charges involved in the transactions are determined by competitive bids;

• The transaction(s) involve services as a common carrier or contract carrier;

• The rates are fixed in conformity with law or governmental authority (e.g., energy costspaid to a regulated electric utility);

• The transactions involve services as a bank depository;

• Transactions involving certain financial services including entities serving as a transferagent, stock registrar, trustee under a trust indenture, or providing similar types ofservices;

• Where the related person's interest arises solely from his or her investment in theregistrant's securities on terms that are no more favorable than those enjoyed by other

investors in those same securities. 144

144 But see SOX §403 for enhanced disclosure requirements for directors, officers, andprinciple stockholders who purchase or sell a registrant's securities.

b. Disclosure of the Process for Review, Approval or Ratification of Transactions WithRelated Persons: Item 404(b)

Regulation S-K, Item 404(b), requires disclosure of the process for providing assurance thattransactions with related persons are reviewed, approved or ratified. Although the SEC recognizes thatthe characteristics of such a process can vary, Item 404(b) offers examples of the types of features

envisioned, including: 145

145 SEC Regulation S-K, Item 404(b)(1), Reg. §229.404(b)(1).

• The types of transactions covered by the policies and procedures incorporated in theprocess;


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• The standards to be applied in accordance with the stipulated policies and procedures;

• The persons or groups of persons on the board of directors, or others, responsible forapplying these policies and procedures; and

• A statement describing whether the policies and procedures are in writing and, if not, howthe policies and procedures are evidenced.

Planning Point: A practical way of assuring that the policies are communicated andfollowed is to fold this process of identification, review and transaction approval intomanagement's annual assessment of internal control as stipulated by SOX Section

404(a). 146 The requirements for management's assessment of internal control can befound in 5402, Internal Controls: Sarbanes-Oxley Act §404 and Beyond (AccountingPolicies and Practice Series).

146 See SOX §404(a).

Worksheet 8 shows excerpts from General Electric Company's 2007 proxy statement on Schedule 14A.The disclosures illustrate GE's process for providing assurance that transactions with related persons arereviewed, approved, and ratified.

If any related party transactions requiring disclosure under SEC Regulation S-K, Item 404(a), as set outin Section II.B.2.(a), above, were excluded from the registrant's review, approval, or ratification

policies, or if these procedures were ignored, the omissions are to be disclosed. 147 This disclosure is

not required for transactions occurring before an individual became a related person. 148 If, however,the transaction(s) continue(s) after the individual becomes a related person, disclosure of the omissions

are necessary. 149

147 SEC Regulation S-K, Reg. §229.404(b)(2).

148 The categories of related persons under Regulation S-K are set out in Section II.B.2.a.(2)above.

149 SEC Regulation S-K, Reg. §229.404(b).

c. Transactions With Promoters and Certain Control Persons: Item 404(c)

(1) Promoters

A promoter is a person who individually, or with others, takes the initiative in founding or organizing abusiness. Also deemed a promoter is an individual who receives consideration amounting to 10% of anyclass of securities of a registrant or 10% of the proceeds from the sale of those securities. Underwritersare excluded, as are individuals who receive 10% of the securities or proceeds in exchange for property

but do not take part in founding or organizing the business. 150

150 SEC Regulation S-X, Reg. §210.1-02.

If the registrant had a promoter within the past five fiscal years and is filing a registration statement on(1) Form S-1 or Form SB-2 under the Securities Act of 1933 or (2) Form 10 or Form 10-SB, certaindisclosures are required. Anything of value provided to or by promoters within the previous five yearsrequires disclosure. As indicated in Section II.B.2.a.(3), above, Item 404 disclosures on registrationstatements are required for a period of three years.

Comment: There is no materiality test. Disclosure is required when anything of valuechanges hands, including money, property, contracts, services, options, and rights of

any kind. 151


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151 SEC Regulation S-K, Reg. §229.404(c)(1)(i).

When such exchanges take place, the following are to be disclosed: 152

152 SEC Regulation S-K, Reg. §229.404(c)(1)(ii).

• The name(s) of the promoter(s);

• The nature and amount of anything of value received by, or to be received by, eachpromoter, either directly or indirectly; and

• The nature and amount of any assets, services, or other consideration received, or to bereceived, in exchange by the registrant.

Additionally, for any assets acquired, or to be acquired, from a promoter, the following disclosures are

required: 153

153 Id.

• The amount at which the assets were acquired, or at which they are to be acquired;

• The accounting principle(s) followed in determining the amount at which the assets wererecorded on the registrant's books;

• The name of the person(s) determining this amount, as well as the relationship, if any, tothe registrant or any promoter; and

• The cost of the assets to the promoter if acquired within two years of their transfer to theregistrant.

Worksheet 9 provides excerpts from 21st Century Telesis' Form 10, which discloses transactions withpromoters.

(2) Certain Control Persons

The disclosures set out in the foregoing section are also required for any control person, defined as: 154

154 SEC Regulation S-K, Reg. §229.404(c)(2).

• An individual who has acquired control of a registrant that is defined as a shell company;

• A person who is part of a group of individuals acquiring such control, where a “group” isdefined as two or more individuals who agree to act together to acquire, hold, vote, ordispose of the equity securities of a registrant that is a shell company.

A shell company has the same meaning as used in Rule 405 under the Securities Act of 1933 and Rule

12b-2 of the Securities Exchange Act. 155 A shell company is:

155 Id.

A registrant, other than an “asset-backed issuer” as that term is defined in Item 1101(b) of Regulation

AB, that has: 156


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156 Rule 12b-2, Securities Exchange Act of 1934 (17 C.F.R. §240.12b-2).

1. No or nominal operations; and

2. Either:

i. No or nominal assets;

ii. Assets consisting solely of cash and cash equivalents; or

iii. Assets consisting of any amount of cash and cash equivalents and nominal otherassets.

For purposes of this definition, the determination of a registrant's assets (including cash and cashequivalents) is based solely on the amount of assets that would be reflected on the registrant's balancesheet prepared in accordance with generally accepted accounting principles on the date of that

determination. 157

157 Id.

An asset-backed issuer means an issuer whose reporting obligation results from either the registrationof an offering of asset-backed securities under the Securities Act, or the registration of a class of asset-

backed securities under Section 12 of the Exchange Act. 158 An asset-backed security is one that isprimarily serviced by the cash flows of a discrete pool of receivables or other financial assets, eitherfixed or revolving, that, by their terms, convert into cash within a finite time period, plus any rights orother assets designed to assure the servicing or timely distributions of proceeds to the security holders;and provided that in the case of financial assets that are leases, those assets may convert to cash

partially by the cash proceeds from the disposition of the physical property underlying such leases. 159

158 SEC Regulation S-K (Regulation AB), Reg. §229.1101(b).

159 SEC Regulation S-K (Regulation AB), Reg. §229.1101(c)(1).

Comment: A foreign private issuer is deemed to have complied with Item 404(c) if it

provides the information required by Item 7.B of Form 20-F. 160

160 Securities Exchange Act of 1934, Form 20-F, Registration of Securitiesof Foreign Private Issuers Pursuant to Section 12(b) or (g), Annual andTransition Reports Pursuant to Sections 13 and 15(d), and Shell CompanyReports Required Under Rule 13a-19 or 15d-19 17 C.F.R. §249.220f.


C. Stock Exchanges

Various stock exchanges also have rules concerning related party transactions. This section covers NewYork Stock Exchange and NASDAQ requirements.

1. New York Stock Exchange

a. Rules Pertaining to Related Party Transactions

Since the late 1950s, the New York Stock Exchange (NYSE) discouraged material related party


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transactions. When a listed company entered into such a transaction, the Exchange typically made anagreement with the company to rectify the situation within a reasonable period of time, typically within

three to five years. 161 Several developments brought about a modification of this policy. In particular,audit committees were increasingly prevalent due to various mandates, including a 1978 NYSE rulerequiring virtually all listed companies to establish audit committees. In the meantime, the SEC

promulgated rules requiring the disclosure of related party transactions. 162 As a consequence, it is nolonger the policy of the NYSE to discourage related party transactions, although the NYSE still maintainsthe position that large, publicly held corporations can operate effectively without related party

transactions. 163 The current view is that properly constituted audit committees and independent,objective directors can be expected to distinguish between beneficial transactions and those that raisethe suspicion of exploitation by insiders. The NYSE Board of Directors adopted the following statement

regarding related party transactions: 164

161 New York Stock Exchange, Listed Company Manual, §307.00.

162 See Section II.B, above.


164 Id. This statement was adopted in March 1983.

The NYSE believes that the review and oversight of such situations is best left tothe discretion of listed corporations and corporations applying for listing on theNYSE. While no particular method of resolution is suggested, the Auditcommittee or a comparable body could be considered as the forum for reviewand oversight of potential conflicts of interest situations.

The NYSE expects listed corporations and those applying for listing to monitor and review related partytransactions. Additionally, the NYSE requires companies that apply for listing to confirm that they will

“appropriately review and oversee related party transactions on an on-going basis.” 165 The rules alsoindicate that the NYSE will review disclosures in proxy statements and other SEC filings and send

reminder notices when warranted. 166

165 Id.

166 Id.

b. Shareholder Approval Policy: Issuance of Stock

Under NYSE rules, related parties include: 167

167 Id. §312.03(b).

• Directors;

• Officers; and

• Substantial security holders.

A substantial security holder is a person owning 5% or more of the common shares or voting power.168 The concept is similar to that used by the SEC in defining certain beneficial owners (significantshareholders) as set out in Section II.B.2.a.(2).(b), above. Whereas the SEC definition pertains to thoseowning more than 5% of any class of the registrant's stock, the NYSE contemplates a scope that is lessbroad: those owning 5% or more of the outstanding common shares, or voting power. Voting poweroutstanding is defined as “the aggregate number of votes that may be cast by holders of those


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securities outstanding that entitle the holders thereof to vote generally on all matters submitted to the

company's security holders for a vote.” 169

168 Id. §312.04(e).

169 Id. §312.04(f).

(1) Issuances to Related Parties

Shareholder approval is required in any transaction, or series of related transactions, in which relatedparties (directors, officers, and substantial security holders) are the recipients of common stock,

including those securities convertible into common stock or exercisable for common shares. 170

170 Id. §312.03(b). Equity compensation plans also require shareholder approval. Foradditional information on related party transactions as they pertain to compensation, see id.§§312.03(a) and 303A.08.

There is an exception to this approval policy if the individual to whom shares are issued is a substantialsecurity holder but not also a director or officer. When a listed company issues common stock to thesecurity holder (1) in a cash sale, and (2) at a price that is equal to or greater than both the book valueand market value of the stock, a 5% threshold comes into play. Approval is only required if the numberof shares of common stock, including the number of shares into which the securities may be convertible

or exercisable, exceeds, before issuance of the shares, either 5% of: 171

171 Id. §312.03(b).

• The number of shares of common stock outstanding, or

• The voting power outstanding.

(2) Issuances to Related Entities

Shareholder approval is required when the reporting entity issues shares to entities with which thereporting entity's directors, officers, and substantial security holders are associated. Stockholderapproval is required when common stock, including those securities convertible into common stock or

exercisable for common shares, are issued in any transaction or series of related transactions to: 172

172 Id.

• A subsidiary, affiliate or other closely related person of a related party; and

• Any company or entity in which a related party has a substantial direct or indirect interest.

In the latter situation, issuance to an entity in which a related party has a substantial direct or indirectinterest, shareholder approval is only required if the shares to be issued by the listed company or thenumber of shares of common stock into which the securities may be convertible or exercisable exceeds,

before issuance of the shares, either 1% of: 173

173 Id.


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• The number of shares of common stock outstanding, or

• The voting power outstanding.

A substantial interest in a company or entity is defined as 5% or greater of the company's common

shares or voting power outstanding. 174

174 Id. §312.04(e).

In computing the 1% and 5% thresholds, only shares actually issued and outstanding are used. Thefollowing are excluded: (1) treasury shares, (2) shares held by a subsidiary, and (3) unissued shares

reserved for issuance upon conversion of securities or upon exercise of options or warrants. 175

175 Id. §312.04(d).

(3) Exception to Shareholder Approval

The NYSE allows an exception to the foregoing approval procedures if delay would jeopardize theviability of the company. Any exception has to be approved by the audit committee of the board. Theissuer is required to mail a letter to shareholders alerting them to the fact that these equity securitiesare being issued without the approval required by the NYSE but with audit committee approval. The

mailing deadline is 10 days prior to the issuance of the securities. 176

176 Id. §312.05.

2. NASDAQ

a. Audit Committee Approval of Related Party Transactions

NASDAQ requires each issuer to review, on an ongoing basis, all related party transactions for potentialconflicts of interest. Additionally, all related party transactions require approval by the audit committee

or another independent body of the board of directors. 177 Rather than devising yet another definition,NASDAQ simply defines related party transactions as those targeted for disclosure by the SEC under

Regulation S-K, Item 404: 178 those related party transactions exceeding $120,000 when the relatedperson had or will have a direct, or indirect material interest. The requirements pertain to any financialtransaction, arrangement, or relationship, or series of similar transactions, arrangements, orrelationships, including indebtedness or guarantees of indebtedness.

177 NASDAQ Manual, §4350(h).

178 Id.

b. Shareholder Approval Policy 179

179 Equity compensation plans also require shareholder approval. For additional informationon related party transactions as they pertain to compensation, see NASDAQ Manual, §4350(i)(1)(A).

(1) Related Persons Defined

According to NASDAQ rules, related persons include directors, officers and substantial shareholders. Asubstantial shareholder is a person owning 5% or more of the common shares or voting power of the

listed company. 180 The concept is similar to that used by the SEC in defining certain beneficial owners(significant shareholders), as set out in Section II.B.2.a.(2), above. Voting power outstanding is defined


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as “the aggregate number of votes that may be cast by holders of those securities outstanding whichentitle the holders thereof to vote generally on all matters submitted to the company's security holders

for a vote.” 181

180 Id. § 4350(i)(4).

181 Id. §4350(i)(4).

(2) Issuances Resulting in Change of Control

NASDAQ rules require shareholder approval when the issuance, or potential issuance, of the stock of thelisted company will result in a change of control.

(3) Share Transactions Consummated by Related Parties

NASDAQ uses a 20% threshold to flag issuances of stock when related parties are involved. When alisted company issues common shares, or securities convertible into or exercisable for common stockand the issuance is not a public offering, shareholder approval is required if the issued shares, togetherwith sales by officers, directors, or substantial shareholders, equal or exceed (or will equal or exceed)20% of the outstanding shares or voting power before the issuance. The approval is required when the

price is less than the greater of book or market value. 182

182 Id. §4350(i)(1)(D)(i).

(4) Related Persons Having an Interest in a Target Company

NASDAQ also requires shareholder approval when: (1) a listed company issues stock to purchase theshares or assets of another company, and (2) related persons have an interest in the target company.

Specifically, approval is required when: 183

183 Id. §4350(i)(1)(C)(i).

• A related person has a 5% or greater direct or indirect interest in the target company, theassets to be acquired, or consideration to be paid in the transaction or series oftransactions;

• Related persons collectively have a 10% or greater direct or indirect interest in the targetcompany, the assets to be acquired, or consideration to be paid in the transaction or seriesof transactions; or

• The present or potential issuance of common stock, including securities convertible into orexercisable for common stock, could result in a 5% or more increase in the outstandingcommon shares or voting power of the listed company.

Only shares actually issued and outstanding are used to compute the threshold. Excluded are: (1)treasury shares, (2) shares held by a subsidiary, and (3) unissued shares reserved for issuance upon

conversion of securities or upon exercise of options or warrants. 184 This approval is necessary sincethe related person(s) could influence the way the target company votes its shares of stock in the listedcompany.

184 Id. §4350(i)(3).

(5) Exceptions to the Shareholder Approval Policy

NASDAQ allows an exception to shareholder approval when delay in securing shareholder approvalwould seriously jeopardize the financial viability of the enterprise. The exception must be expressly


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approved by the audit committee or a comparable body of the company's board of directors comprised

solely of independent, disinterested directors. 185 The issuer must seek prior written approval fromNASDAQ's Listing Qualifications Department. The company is required to mail a letter to allshareholders not later than 10 days before issuance of the securities informing them of the omission to

seek shareholder approval. The letter must disclose: 186

185 Id. §4350(i)(2).

186 Id.

• The terms of the transaction, including the number of shares of common stock that couldbe issued and the consideration received;

• The fact that the issuer is relying on a financial viability exception to the stockholderapproval rules; and

• That the audit committee, or comparable body of the board of directors comprised solelyof independent and disinterested directors, has approved the exception.

The issuer is also required to promptly make a public announcement through the news media disclosing

the same information, but no later than 10 days before the issuance of the securities. 187

187 Id.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis III. Sales, Purchases, Transfers, and Leases Between Related Parties

This section covers accounting and disclosure requirements pertaining to related party sales, purchases,transfers, and leases of goods and services. Also included are the sales, purchases, and transfers offinancial instruments. First, GAAP accounting and disclosure rules are discussed, next SEC rules andregulations, and finally New York Stock Exchange guidance related to the sales and purchases ofcompany securities.


A. GAAP Accounting and Disclosures

Since related parties are not acting independently, there is the presumption that related party

transactions are not conducted on an arm's-length basis. 188 Nevertheless, the accounting treatmentafforded related party transactions usually does not differ from that used for transactions betweenunrelated parties. An exception arises when related parties are under common control, a considerationimpacting sales, purchases, transfers, and leases among related parties.

188 FASB ASC 850-10-50-5; FAS 57, ¶ 3.

Related party transactions are typically recorded according to form, using the stated exchange price andterms, although there are exceptions to this principle. Because the form of a related party transaction

may differ from its substance, full disclosure is required when the transactions are material. 189


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189 SAS 45 (AICPA AU 334.02).

1. Accounting Treatment—Related Parties Not Under Common Control

When parties are not under common control, transactions between or among related parties should berecorded according to their form. When substance differs from form, FASB ASC 850 requires thedisclosure of, “such other information deemed necessary to an understanding of the effects of the

transactions on the financial statements.” 190

190 FASB ASC 850-10-50-1(b); FAS 57, ¶ 2.

2. Accounting Treatment—Related Parties Under Common Control

The accounting treatment of sales, purchases, transfers, and leases between or among related partiesunder common control differs from the accounting treatment of other related party transactions because

of the presumption that transactions among entities within a control group lack substance. 191

191 FASB Technical Bulletin No. 85-5, Issues Relating to Accounting for BusinessCombinations (background material not codified).

a. Definition of Under Common Control

Although the issue is unsettled, the term under common control usually meansthat a common owner holds greater than 50% of two or more entities. Thecommon owner may be an individual, another enterprise, immediate familymembers voting as a bloc, or a group of shareholders acting in concert.According to the SEC, parties are “under common control” in the following four

situations: 192

192 See generally Donna L. Coallier, Professional Accounting Fellow, Office of the ChiefAccountant, SEC, Remarks at the Twenty-Fifth Annual National Conference on Current SECDevelopments (Dec. 9, 1997). EITF Issue No. 02-5, Definition of “Common Control” inRelation to FASB Statement No. 141 (not codified), provided guidance on the definition ofcommon control in relation to FAS 141, which was superseded by FAS 141(R). Given that FAS141 is no longer authoritative guidance, the related EITF Issue 02-5 is not codified.


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(1) An individual holds greater than 50% of the voting ownership interest of each entity;

(2) An enterprise holds more than 50% of the voting interest;

(3) Immediate family members hold greater than 50% of the voting ownership interest ofeach entity (with no evidence that those family members will vote their shares in any wayother than in concert);

• Immediate family members include a married couple and their children, but not themarried couple's grandchildren;

• Entities might be owned in varying combinations among living siblings and theirchildren;

• Such situations require careful consideration regarding the substance of the ownershipand the voting relationships; and

(4) A group of shareholders holds more than 50% of the voting ownership interest of eachentity, and there is contemporaneous written evidence of an agreement to vote a majorityof the entities' shares in concert.

Comment: FASB's Emerging Issues Task Force discussed the meaning of the termcommon control but came to no consensus. This conclusion was published in EITF IssueNo. 02-5, Definition of Common Control in Relation to FASB Statement No. 141, whichnoted that the SEC Observer indicated SEC registrants should continue to follow theguidance set out in the preceding paragraph. EITF Issue 02-5 is reproduced inWorksheet 10.

b. Accounting Treatment

The SEC's view is that when related parties under common control exchange assets, transfers should be

recorded using carry-over amounts except in limited circumstances. 193 Exceptions turn on: (1) thefrequency of the transactions (recurring versus infrequent) (2) the asset time horizon (current versuslong-term) and (3) valuation uncertainty, i.e., whether the exchanged property is objectively andreadily determinable. Thus, an exception is made when the transactions are (1) recurring, (2) the

transferred assets are short-term (current assets), and (3) valuation is not an issue. 194 For example,market exchange prices would be used for short-term sales and purchases of inventory and the likewhen a ready market is available. Long-term assets, intangibles, and transfers of net assets, as in abusiness combination, present a different sort of problem in that there is usually no readilydeterminable exchange price. In such instances, transfers are effected at carry-over (recorded)

amounts. 195 These considerations are applicable to the presentation of separate affiliate statements.When financial statements are consolidated or combined, all intercompany transactions, including

intercompany gains and gross profit remaining, are to be eliminated. 196 Disclosure is not required for

transactions so eliminated. 197

193 EITF Issue No. 85-21, Changes of Ownership Resulting in a New Basis of Accounting. TheEITF, however, could not reach a consensus on how privately held companies should recordsuch transactions.

194 Id.

195 Id.

196 FASB ASC 810-10-45-1; Accounting Research Bulletin No. 51, Consolidated FinancialStatements, ¶ 6.

197 FASB ASC 850-10-50-1; FAS 57, ¶ 2.


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Comment: FASB's Emerging Issues Task Force discussed the level of ownershiprequired to recognize a new basis of accounting. The SEC Observer expressed the viewof the SEC staff that transactions among parties under common control should berecorded using carry-over amounts. However, the Emerging Issues Task Force wasunable to reach consensus on this issue. This conclusion is reflected in EITF Issue No.85-21, Changes of Ownership Resulting in a New Basis of Accounting, which isreproduced in Worksheet 11. There are two important arguments in favor of the SECviewpoint. The first stems from the basic accounting precept relating to revenuerecognition: revenue should only be recognized when realized. Affiliates transactingamong themselves leave a control group no better or worse off. As there is no outsidecounterparty, the earnings process is not complete. Accordingly, an exchange is deemednot to have taken place. The second reason stems from concerns about fraud. If gainsare recognized when assets are transferred within a control group, income could beboosted simply by moving assets around. These considerations point toward recordingtransactions at existing carrying amounts.

3. Sales

When parties are unrelated, revenue is recognized when a sale is consummated with appropriaterecognition of an estimate for uncollectible accounts. For the most part, sales between related partiesare not accounted for differently from sales between unrelated parties. However, as indicated in SectionIII.A.2.b, above, there are certain differences that turn on whether the related parties are undercommon control.

a. Sales Between Related Parties Not Under Common Control

Related parties not under common control should record recurring sales of nonfinancial assetsconsummated in the ordinary course of business at terms equivalent to those that would prevailbetween unrelated parties the historical exchange price, i.e., the value settled upon by the transacting

parties. 198

198 FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statementsof Business Enterprises, ¶ 69.

In unusual situations or when valuation is not reasonably determinable, it may be more appropriate forrelated parties to record sales using carrying amounts, that is, the historical cost reflected in thetransferor's financial statements. Whether under common control or not, related parties exhibit certaininfluence and control characteristics differentiating them from unrelated parties. Specifically, relatedparties have the ability to, “significantly influence the management or operating policies … to the extentthat one of the transacting parties might be prevented from fully pursuing its own separate interests.”199 Where market measures are readily available and there is no compelling evidence that transactionshave been contrived to arrive at the results desired by the parties, the use of prevailing market prices isappropriate. However, in cases where there is no arm's-length market in the commodities or financialinstruments under consideration, the use of historical cost is more prudent to preclude recording gainsthat subsequently prove to be illusory. In all cases, material related party transactions require

disclosure. 200


200 FASB ASC 850-10-50-1; FAS 57, ¶¶ 2, 15.

Although not entirely analogous, standards covering nonmonetary transfers provide some insight. TheFASB Codification states the following in regards to measuring transfers when fair values are not readily

attainable: 201


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201 FASB ASC 845-10-30-8; APB Opinion No. 29 Accounting for Nonmonetary Transactions,¶ 26.

If neither the fair value of a nonmonetary asset transferred nor the fair value ofa nonmonetary asset received in exchange is determinable within reasonablelimits, the recorded amount of the nonmonetary asset transferred from theenterprise may be the only available measure of the transaction.

Accordingly, when long-term nonfinancial assets are sold, historical cost may be the only objectivemeasure.

Planning Point: When related parties are involved, measurements having little or noobjectivity may raise a question as to whether a sale is in the best interest ofshareholders. For example, assume that Corporation A, which deals in art treasures,sells a painting to Corporation R. The CEO of Corporation A owns less than 1% of theoutstanding shares of A but is the majority shareholder of Corporation R, whose othershareholders are relatives of Corporation A's CEO. Corporation A bought the paintinglast year for $150,000 on speculation. The artist is not well known and there is no readymarket for the painting. Corporation A and Corporation R are contemplating a salesprice of $65,000. In this situation, the preferred course of action is to record the sale atthe carrying amount on the books of Corporation A: $150,000. If the sale is recorded at$65,000, the form of the transaction is not indicative of its substance, which is notdeterminable due to the lack of an arm's-length basis for the transaction. In suchinstances, FASB ASC 850 requires disclosure of “such other information deemed

necessary to an understanding of the effects … on the financial statements.” 202

Whichever amount is used to record the sale, full disclosure in A's financial statementswould necessitate revealing the transaction details and identifying the related parties.For example, if the sale is recorded at $65,000, the disclosure should include theamount that Corporation A paid for the painting and the amount of the resultant loss.Depending on the eventual value of the painting, this sale may not be in the bestinterest of Corporation A's shareholders. A definitive determination depends on theeventual selling price of the painting to an independent third party.

202 FASB ASC 850-10-50-1(b); FAS 57, ¶ 2.

b. Sales Between Related Parties Under Common Control

The treatment of sales between related parties under common control depends on: (1) the frequency ofthe transactions (recurring versus infrequent); (2) the asset time horizon (current versus long-term);and (3) valuation uncertainty (i.e., whether the exchanged property is objectively and readilydeterminable).

(1) Recurring Sales of Short-Term Assets Objective Valuation

As indicated in Section III.A.2.a, above, the term under common control usually means entities whose

common owner holds more than 50% of both enterprises. A common owner may be: 203

203 EITF Issue 02-5 (not codified). See also generally, Securities Exchange Commission,Office of the Chief Accountant, Donna L. Coallier, Professional Accounting Fellow, Office of theChief Accountant, Twenty-Fifth AICPA National conference on Current SEC Developments(1997).

• An individual;

• Another enterprise;

• Immediate family members voting as a bloc; or


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• A group of shareholders acting in concert.

When parties are under common control, recurring sales of short-term nonfinancial assets in the normal

course of business are typically recorded using prevailing market prices if available. 204 A typicalexample is the sale of inventory by one affiliate to another.

204 EITF Issue 85–21 (reiterating the SEC's position as stated in the SEC Observer).

Example: A bauxite extractor sells aluminum ore on a recurring basis to an affiliated companythat processes the bauxite ore and extrudes aluminum tubing to be used in variousmanufacturing processes. Since these sales are recurring and there is a ready market for theprice of the bauxite ore, the sales would typically be recorded at prevailing market prices. If thetubing manufacturer has minimal inventories, the effect of using market prices is likelyimmaterial. When separate statements are presented, intercompany gross profits that arematerial require disclosure. If the statements of the two affiliates are consolidated or combined,accounting standards require the elimination of material intercompany gains or losses, as well

as gross profit remaining in inventory. 205

205 FASB ASC 810-10-45-1 and 45-10; ARB 51, ¶¶ 6, 23.

(2) Sales Using Carry-Over Amounts

When parties are under common control, non-recurring sales of short-term assets, sales of short-termassets when valuation is in question, and most sales of long-term assets should be transferred at

carry-over amounts without recognition of a gain or loss. 206 When a gain or loss is indicated because acash sum is paid that differs from the recorded amount of the assets, alternative treatments depend onwhether the affiliates are combined or whether separate statements will be presented.

206 EITF Issue 85–21 (reiterating the SEC's position as stated in the SEC Observer). TheEITF could not reach a consensus that such treatment is appropriate for privately heldcompanies.

Comment: Although there are some exceptions, GAAP rules generally require the

consolidation of majority-owned subsidiaries. 207 Accordingly, if combined statementswill be presented, each company can record a normal gain or loss entry, which will beeliminated when the statements are combined. When the separate statements ofaffiliates will be presented or the affiliates in a control group will not be combined, analternative is to include the gain or loss in an equity account, such as accumulated othercomprehensive income.

207 FASB ASC 810-10-15-10(a); ARB 51, ¶ 3, as amended by FAS 94, ¶ 13.

Example (Affiliates Combined): Company L and Company D are each greater than 50%owned by Mr. B. Accordingly, these two companies are affiliates under the common control ofMr. B. Combined statements will be presented for the group of related enterprises. Company Lsells land, for which it paid $40,000, to Company D for $72,000 cash. The separate financialstatements of these companies prior to the land sale appear as follows:

L Company: Condensed Financial StatementsBefore Land Sale Transaction

Balance Sheet


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Liabilities &Equity

Liabilities $1,500,000

Stockholdersequity

Capital stock 1,400,000

Retainedearnings -

Assets Beginningbalance

700,000

Land $40,000 Current netincome

400,000

Other assets 3,960,000

Total stockholdersequity

2,500,000

TotalAssets

$4,000,000 Total liabilities &equity

$4,000,000

IncomeStatement

Revenues $10,000,000

Expenses 9,600,000

Net income $400,000

D Company: Condensed Financial StatementsBefore Land Sale Transaction

Balance Sheet

Liabilities &Equity

Liabilities $300,000

Stockholdersequity

Capital stock 500,000

Retainedearnings -

Beginningbalance

220,000

Assets Current netincome

180,000

Other assets $1,200,000 Total stockholdersequity

900,000

Total Assets $1,200,000 Total liabilities &equity

$1,200,000

Income Statement

Revenues $3,600,000

Expenses 3,420,000


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Net income $180,000

Company L would make the following journal entry to record the sale:

Entry Recorded by L DR CR

Cash 72,000

Land 40,000

Gain on sale of property 32,000

Company D would record the following entry:

Entry Recorded by D DR CR

Land 72,000

Cash 72,000

When the statements are combined, the gain is eliminated and the land restored to its original carryingcost to avoid recognizing gains by simply transferring assets within a control group. The followingworking paper presents the condensed combined balance sheets and income statements after the landsale transaction and the elimination entry:

L and D Companies: CondensedCombined Financial Statements

Working Paper

Adjustmentsand

Balance Sheet L Co. D Co. Eliminations Combined

Land $72,000 32,000 $40,000

Other assets $4,032,000 1,128,000 5,160,000

Total Assets $4,032,000 $1,200,000 $5,200,000

Liabilities &Equity

Liabilities $1,500,000 $300,000 $1,800,000

StockholdersEquity

Capital stock 1,400,000 500,000 1,900,000

Retainedearnings –

Beginningbalance

700,000 220,000 920,000

Current netincome

432,000 180,000 32,000 580,000

Totalstockholdersequity

2,532,000 900,000 3,400,000

Total liabilities &equity

$4,032,000 $1,200,000 32,000 32,000 $5,200,000

IncomeStatement


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Revenues $10,000,000 $3,600,000 $13,600,000

Expenses 9,600,000 3,420,000 13,020,000

Operatingincome

400,000 180,000 580,000

Gain - sale ofland

32,000 ______ 32,000 ______ ______

Net income $432,000 $180,000 32,000 $580,000

Example (Presentation of Separate Statements): Assume again that Company L andCompany D are each greater than 50% owned by Mr. B. Separate financial statements will bepresented for the two companies. As before, Company L sells the land with a carrying amount of$40,000 to Company D, which remits $72,000 cash. Since no eliminations will be recorded,Company L should record the $32,000 difference between the carrying amount of the land andthe cash received in an equity account. This amount could be included as a component of othercomprehensive income, as shown:

Entry Recorded by L DR CR

Cash 72,000

Land 40,000

Equity – other comprehensive income

32,000

Company D would record the following entry:

Entry Recorded by D DR CR

Land 40,000

Equity – othercomprehensive income 32,000

Cash 72,000

The separate financial statements for Company L would appear as follows:

L Company: Condensed Financial StatementsBalance Sheet

Liabilities &Equity

Liabilities $1,500,000

Stockholdersequity

Capital stock 1,400,000


1,100,000

Accumulatedother

Assets comprehensiveincome

32,000


2,532,000


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Total Assets $4,032,000 Total liabilities &equity

$4,032,000

Income Statement

Revenues $10,000,000

Expenses 9,600,000

Net income $400,000

Company D's separate financial statements would show the land at Company L's cost:

D Company: Condensed Financial StatementsBalance Sheet

Liabilities &Equity

Liabilities $300,000

Stockholdersequity

Capital stock 500,000


400,000

Assets Accumulatedother

Land 40,000 comprehensiveincome

(32,000)


868,000

Total Assets $1,168,000 $1,168,000

Income Statement

Revenues $3,600,000

Expenses 3,420,000

Net income $180,000

Related party disclosures are required in the separate statements as described in Section II.A.1, above.However, the transaction does not have to be disclosed in the combined statements, since FASB ASC850 does not require disclosure of transactions that are eliminated when entities are consolidated or

combined. 208

208 FASB ASC 850-10-50-1; FAS 57, ¶ 2.

Comment: Where to include the $32,000 difference between the recorded value of theland and the cash remitted remains unsettled. Recording it in accumulated othercomprehensive income appears to be an appropriate solution. Comprehensive income iscomprised of all changes in equity during a period other than additional investments by

owners and distributions to them. 209 Other comprehensive income includes those gainsand losses that are components of comprehensive income but excluded from net

income. 210 There are several compelling arguments for including the $32,000 in othercomprehensive income. First, the $32,000 represents an unrealized gain that will berealized when the land is sold to an independent party. Second, other comprehensiveincome includes items such as unrealized gains and losses, for example, those


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associated with available-for-sale securities. The $32,000 amount is similar in conceptand is therefore a candidate for inclusion in other comprehensive income. Third, withthe conveyance of cash from Company D to Company L, Mr. B's investment hasmigrated. The investment in D has declined by $32,000 with a corresponding increase inthe investment in Company L.

209 FASB ASC Term “Comprehensive Income”; FASB Statement No. 130,Reporting Comprehensive Income, ¶ 8.

210 FASB ASC Term “Other Comprehensive Income”; FAS 130, ¶ 10.

(3) Receivables From Related Parties

Notes and accounts receivable due from officers, employees, or affiliated entities should be classifiedseparately in the balance sheet. These amounts should be separately identified and not included under

a general heading or commingled with trade accounts receivable. 211 Receivables from affiliates thatare the equivalent of unpaid stock subscriptions should not be included in accounts receivable butinstead deducted from stockholders' equity. This treatment is consistent with Rule 5-02.30 of SECRegulation S-X, which states, “Show also the dollar amount of any common shares subscribed but

unissued, and show the deduction of subscriptions receivable therefrom.” 212 Deferred compensationthat arises when capital stock is issued or will be issued to officers or other employees should be

accounted for as a deduction from stockholders' equity. 213

211 FASB ASC 850-10-50-2; ARB 43, ch. 1, §A, ¶ 5.

212 SEC Regulation S-X, Rule 5-02.30, 17 C.F.R. §210.5-02.30; FASB ASC 210-10-S99-1.

213 SEC Staff Accounting Bulletin, Topic 4E.

c. Summary Accounting for Sales

Sales are recorded differently depending on whether the transacting parties are: (1) unrelated, (2)related parties not under common control, or (3) related parties under common control:

• Unrelated Parties – Sales of short-term and long-term nonfinancial assets are recorded atfair value as measured by the monetary consideration given up.

• Related Parties Not Under Common Control – The accounting is similar to that used forunrelated parties except when a market price or fair value is not determinable. In thateventuality, historical cost should be used to preclude skepticism about a transaction'svalidity.

• Related Parties Under Common Control – Recurring sales of short-term nonfinancialassets for which valuation is not a concern should be recorded using prevailing marketprices. Non-recurring sales of short-term assets, sales of short-term assets when valuationis in question, and most sales of long-term non-financial assets should be transferred atcarry-over amounts without recognition of a gain or loss. This accounting is applicable whenthe separate statements of affiliates are presented.

4. Purchases—Long-Term Obligations

a. Accounting

(1) Parties Are Unrelated

FASB ASC 440, based, in part on, FASB Statement No. 47, Disclosure of Long-Term Obligations,requires disclosure of commitments under unconditional purchase obligations when an enterprise has

entered into financing arrangements with a supplier. 214 According to that Topic, an unconditional


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purchase obligation is “an obligation to transfer funds in the future for fixed or minimum amounts or

quantities of goods or services at fixed or minimum prices.” 215 An unconditional purchase contract

having the following characteristics requires disclosure: 216

214 FASB ASC 440-10-50-2; FASB Statement No. 47, Disclosure of Long-Term Obligations,¶ 6.

215 FASB ASC Term, “Unconditional Purchase Obligation”; FAS 47 ¶ 6.

216 FASB ASC 440-10-50-2; FAS 47, ¶ 6.

• Is noncancelable, or cancelable only:

• Upon the occurrence of some remote contingency;

• With the permission of the other party;

• If a replacement agreement is signed between the same parties;

• Upon payment of a penalty in an amount such that continuation of the agreementappears reasonably assured;

• Was negotiated as part of arranging financing for the facilities that will provide thecontracted goods or services or for costs related to those goods or services, for example,

carrying costs for contracted goods; 217 or

• Has a remaining term in excess of one year.

217 A purchaser is not required to investigate whether a supplier used an unconditionalpurchase obligation to help secure financing, if the purchaser would otherwise be unaware ofthat fact. See generally FASB ASC 440-10-50-2(b); FAS 47, ¶ 17.

(2) Related Parties

Analogous to sales transactions, as discussed in Section III.A.3.a, above, related parties not undercommon control should record recurring purchases of nonfinancial assets consummated in the ordinarycourse of business at terms equivalent to those that would prevail between unrelated parties, i.e., the

historical exchange price. 218 This treatment is applicable whether or not the parties are under commoncontrol, since the types of commitments contemplated are those for recurring purchases with a fixedprice that presumably reflects expected market prices. If valuation is in question, the purchases shouldbe recorded at carry-over amounts without recognizing gain or loss.

218 CON 5, ¶ 69 (not codified); EITF Issue 85–21 (not codified).

b. Disclosures

(1) Parties Not Related

The nature of the disclosure is dependent on whether the purchaser has recorded the obligation. If thecontract has been recorded, the disclosures are to include the aggregate amount of payments for each

of the five years following the date of the latest balance sheet presented. 219 If the obligation is not

recorded, the disclosures are more involved and include: 220

219 FASB ASC 440-10-50-6; FAS 47, ¶ 10(a).

220 FASB ASC 440-10-50-4; FAS 47, ¶ 7.


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• The nature and term of the obligation(s);

• The amount of the fixed and determinable portion of the obligation(s) as of the date of thelatest balance sheet presented in the aggregate and, if determinable, for each of the fivesucceeding fiscal years;

• The nature of any variable components of the obligation(s);

• The amounts purchased under the obligation(s), for example, under a take-or-pay orthroughput contract for each period for which an income statement is presented.

A take-or-pay contract is “an agreement between a purchaser and a seller that provides for thepurchaser to pay specified amounts periodically in return for products or services. The purchaser mustmake specified minimum payments even if it does not take delivery of the contracted products or

services.” 221 A throughput contract is “an agreement between a shipper (processor) and the owner ofa transportation facility (such as an oil or natural gas pipeline or a ship) or a manufacturing facility thatprovides for the shipper (processor) to pay specified amounts periodically in return for thetransportation (processing) of a product. The shipper (processor) is obligated to provide specifiedminimum quantities to be transported (processed) in each period and is required to make cash

payments even if it does not provide the contracted quantities.” 222

221 FASB ASC Term “Take-or-Pay Contract”; FAS 47, ¶ 23

222 FASB ASC Term “Throughput Contract”, FAS 47, ¶ 23.

(2) Disclosures—Related Parties

In addition to the disclosures described in the preceding section, related party disclosures shouldidentify the related parties and describe the nature of the transactions. Applicable related partydisclosures are found in FASB ASC 850 and set out in Section II.A.1, above.

c. Purchase Obligations That Are Leases

If a lease has the characteristics of an unconditional purchase contract, FASB ASC 440 indicates that thefuture minimum lease payments do not require disclosure under that standard if the payments are

disclosed pursuant to FASB standards dealing with leases. 223 Section III.A.7, below, discusses theaccounting and disclosure requirements pertaining to leases.

223 FASB ASC 440-10-50-3; FAS 47, ¶ 6.

5. Nonmonetary Transactions

Transactions are normally recorded at historical exchange prices as evidenced by the amount of cash

paid, or its equivalent. 224 When an asset is exchanged in a monetary transaction, the cashconsideration ostensibly represents the fair value of the asset acquired. The same basis (fair value)should be used to record nonmonetary transactions. Accordingly, nonmonetary transactions are usuallyrecorded at fair value. FASB ASC 845 addresses the topic of nonmonetary transactions. The nextseveral sections cover the pertinent concepts in more detail. See Worksheet 12 for a listing of the termsused.

224 CON 5, ¶¶ 67, 69.

a. Nonmonetary Transactions Excluded From the General Rule

Not all nonmonetary transactions are recorded using fair values. Accounting standards explicitly excludea number of topics, including the following that deal with business combinations and certain


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stockholders' equity transactions. 225

225 FASB ASC 845-10-15-4; APB 29, ¶ 4.

• Business combinations;

• Acquisition of nonmonetary assets or services on issuance of the capital stock of anenterprise;

• Stock issued or received in stock dividends and stock splits;

• A transfer of assets to an entity in exchange for an equity interest in that entity;

• A pooling of assets in a joint undertaking intended to find, develop, or produce oil or gasfrom a particular property or group of properties;

• The exchange of a part of an operating interest for a part of an operating interest ownedby another party.

The standards dealing with nonmonetary transactions do not address transfers of financial assets, whichare covered in Section III.A.6, below. Also not explicitly addressed by these standards are transfers ofnonmonetary assets solely between enterprises or persons under common control, such as between:226

226 Id.

• A parent company and its subsidiaries;

• Two subsidiary corporations of the same parent;

• A corporate joint venture and its owners.

Except for recurring transfers of current assets when valuation is not in question, transfers between oramong related parties under common control are accounted for using the value recorded on the books

of the transferring entity: the carry-over amounts. 227 This treatment is appropriate for both reciprocaltransfers (exchanges) and nonreciprocal transfers, terms that are defined in Worksheet 12 andexplained in the sections that follow. There are several reasons for recording these transfers at recordedamounts: (1) the earnings process has not culminated in a transaction with an independent partyoutside the affiliated or controlled group, (2) valuation is typically an issue in related party nonmonetarytransfers, and (3) nonmonetary transfers are usually nonrecurring. If related party transactions areeliminated in consolidation, disclosure is not required. Transactions between related parties undercommon control that are not eliminated are to be disclosed in accordance with FASB ASC 850, asdescribed in Section II.A.2, above.

227 EITF Issue 85–21 (not codified) (reiterating the SEC's position as stated in the SECObserver). The EITF could not reach a consensus that such treatment is appropriate forprivately held companies.

b. Types of Nonmonetary Transactions

The treatment afforded a nonmonetary transaction depends on the classification into which it falls. 228

There are three types: 229 (1) exchanges of nonmonetary assets or services, (2) nonreciprocaltransfers to owners, and (3) nonreciprocal transfers to non-owners. Each is described in the followingthree sections.


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228 See Section III.A.5.d, below, for a description of the accounting treatment of each classof nonmonetary transaction.

229 FASB ASC 845-10-05-3; APB 29, ¶ 5.

(1) Exchanges of Nonmonetary Assets or Services

The most prevalent type of nonmonetary transaction is the exchange of nonmonetary assets or

services. As used in GAAP, a nonmonetary exchange is also known as a reciprocal transfer. 230

Examples include: 231

230 FASB ASC Term “Exchange”; APB 29, ¶ 3.

231 FASB ASC 845-10-05-6; APB 29, ¶ 7.

• The exchange of product held for sale in the ordinary course of business, such asinventory, for dissimilar property as a means of selling the product to a customer;

• Exchange of product held for sale in the ordinary course of business, such as inventory,for similar product as an accommodation that is, at least one party to the exchange reducestransportation costs, meets immediate inventory needs, or otherwise reduces costs orfacilitates the ultimate sale of the product and not as a means of selling the product to acustomer;

• The exchange of productive assets — assets employed in production rather than held forsale in the ordinary course of business — for similar productive assets or for an equivalentinterest in similar productive assets.

This last category includes the following types of exchanges: 232

232 FASB ASC 845-10-05-6; APB 29, ¶ 7.

• Trades of player contracts by professional sports organizations;

• Exchanges of leases on mineral properties;

• The exchange of one form of interest in an oil-producing property for another form ofinterest;

• Exchanges of real estate for real estate.

(2) Nonreciprocal Transfers to Owners

Certain nonmonetary transactions are termed nonreciprocal transfers. Nonreciprocal transfers arecharacterized by a one-way conveyance from transferor to transferee. There are two types: (1)nonreciprocal transfers to owners, and (2) nonreciprocal transfers to other than owners. The first type isdescribed in this section, while the second type is discussed in the section that follows. Examples ofnonreciprocal transfers to owners include distributions of nonmonetary assets, including marketable

equity securities, to stockholders: 233

233 FASB ASC 845-10-05-4; APB 29, ¶ 5.

• As dividends;

• To redeem or acquire outstanding capital stock of the enterprise;


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• In corporate liquidations or plans of reorganization that involve disposing of all or asignificant segment of the business (variously referred to as spin-offs, split-ups, and split-offs);

• Pursuant to plans of rescission or other settlements relating to a prior businesscombination to redeem or acquire shares of capital stock previously issued in a businesscombination.

(3) Nonreciprocal Transfers to Other Than Owners

Examples of transfers included in this category are the contribution of nonmonetary assets by anenterprise to a charitable organization and the contribution of land by a governmental unit for

construction of productive facilities by an enterprise. 234

234 FASB ASC 845-10-05-5; APB 29, ¶ 6.

c. Measurement Issues

(1) Determining Fair Value

How should fair value be determined? FASB ASC 820, based, in large part, on FASB Statement No. 157,Fair Value Measurements, contains the rules for determining fair values under U.S. GAAP. Under thatTopic, fair value is “the price that would be received to sell an asset or paid to transfer a liability in an

orderly transaction between market participants at the measurement date.” 235 This price is known asthe “exit price” because it refers to the amount an entity would receive for selling an asset, not the

amount it would pay for acquiring the asset. 236 The transaction is assumed to occur in a principalmarket, which is “the market in which the reporting entity would sell the asset or transfer the liability

with the greatest volume and level of activity for the asset or liability.” 237 If a principal market doesnot exist, then fair value is determined in the most advantageous market, defined as “the market inwhich the reporting entity would sell the asset or transfer the liability with the price that maximizes theamount that would be received for the asset or minimizes the amount that would be paid to transfer the

liability.” 238

235 FASB ASC Term “Fair Value” (as used in FASB ASC 820-10); FASB Statement No. 157,Fair Value Measurements, ¶ 5.

236 FASB ASC 820-10-35-3; FAS 157, ¶ 7. See also FASB ASC 820-10-35-5(a).

237 FASB ASC Term “Principal Market”; FAS 157, ¶ 8.

238 FASB ASC Term “Most Advantageous Market”; FAS 157, ¶ 8. See also FASB ASC820-10-35-5(b).

For an exhaustive discussion on determining fair values under FASB ASC 820, see BNA Tax andAccounting Portfolio 5127-2nd, Fair Value Measurements: Valuation Principles and Audit Techniques(Accounting Policy and Practice Series).

Since it may at times prove difficult to determine the fair value of nonmonetary assets, under certainconditions it may be necessary to record the exchange at the recorded (i.e., historical cost) amount of

the asset relinquished. This may be the case if any of the following are applicable: 239

239 FASB ASC 845-10-30-3; APB 29, ¶ 20.

• Neither the fair value of the assets relinquished, nor of those received, is determinablewithin reasonable limits;


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• The exchange transaction is carried out to facilitate sales to customers; or

• The exchange transaction lacks commercial substance.

An exchange transaction carried out to facilitate sales to customers is an exchange of product orproperty held for sale in the ordinary course of business for product or property to be sold in the sameline of business to facilitate sales to customers, who are not parties to the exchange. The next sectiondiscusses the last exception — exchange transactions that lack commercial substance.

(2) Exchanges Lacking Commercial Substance

If the exchange lacks commercial substance, it should also be recognized using recorded amounts

(historical cost) rather than fair values. 240 An exchange lacks commercial substance unless the entity's

future cash flows are expected to change significantly as a result of the exchange. 241 According toGAAP, cash flows are expected to undergo a significant change if either of the following criteria are met:

240 FASB ASC 845-10-30-3; APB 29, ¶ 20.

241 FASB ASC 845-10-30-4; APB 29, ¶ 21.

• The configuration (risk, timing, and amount) of the future cash flows of the asset(s)received differs significantly from the configuration of the future cash flows of the asset(s)

transferred; 242

• The entity-specific value of the asset(s) received differs from the entity-specific value ofthe asset(s) transferred, and the difference is significant in relation to the fair values of the

assets exchanged. 243

242 FASB ASC 845-10-30-4(a); APB 29, ¶ 21(a).

243 FASB ASC 845-10-30-4(b); APB 29, ¶ 21(b).

Consequently, if an entity is in a different economic position after the exchange, the transaction isassumed to have commercial substance. Making a determination as to commercial substance is ajudgment call. Accounting standards indicate that the configuration of future cash flows is composed ofthe risk, timing, and amount of the flows. A change in any one of those components is considered to be

a change in configuration. 244 Furthermore, an entity-specific value, referred to as an entity-specificmeasurement in FASB Concepts Statement No. 7, Using Cash Flow and Present Value Measurements, isdifferent from a fair value measurement and is only used as a test for determining whether the

exchange transaction has commercial substance. 245 An entity-specific value attempts to capture thevalue of an asset as it is or will be utilized by a particular entity. The entity would, for example, have toincorporate expectations about its particular use of that asset rather than any use assumed bymarketplace participants in general. If the transaction is found to have commercial substance, the

enterprise should measure the exchange at fair value, not the entity-specific value. 246

244 FASB ASC 845-10-30-4(a); APB 29, ¶ 21(a) n.5c.

245 FASB Concepts Statement No. 7, Using Cash Flow and Present Value Measurements,¶ 24(b) (Feb. 2000).

246 FASB ASC 845-10-30-4(b); APB 29, ¶ 21(b) n.5d.

d. Accounting for Nonmonetary Transactions

(1) Exchanges


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(a) Commercial Substance Assumed

Exchanges of nonmonetary assets or services between unrelated parties or between related parties notunder common control are accounted for using fair value if the transaction has commercial substance.247 The term commercial substance is discussed in Section III.A.5.c.(2), above. Each entity records thevalue of the asset received at the fair value of the asset given up, as well as a gain or loss on the assetrelinquished. If the fair value of the asset received is more clearly evident, that value should be used torecord the exchange. Worksheet 13 provides an example of the accounting treatment of nonmonetaryexchanges having commercial substance when a gain is involved. Worksheet 14 illustrates a loss.

247 FASB ASC 845-10-30-1; APB 29, ¶ 18.

If neither the fair value of the nonmonetary asset transferred nor the fair value of the asset received isdeterminable within reasonable limits, the transferring entity should record the exchange using the

historical cost (i.e., carrying amount) of the asset surrendered without recognizing gain or loss. 248

248 FASB ASC 845-10-30-3(a); APB 29, ¶ 20(a).

(b) Exchanges Lacking Commercial Substance

Nonmonetary exchanges that lack commercial substance are accounted for using recorded (carry-over)

amounts. 249 All losses are recognized. Gains are not recognized unless monetary consideration, called

boot, is involved. 250 The entity paying the cash records the asset received at the recorded amount ofthe asset surrendered plus the amount of cash paid without recognizing a gain. The entity receiving themonetary consideration recognizes a partial gain. The proportion of the gain that is recorded iscomputed by multiplying the unrealized gain by the following ratio:

249 FASB ASC 845-10-30-3c; APB 29, ¶ 20c.

250 FASB ASC 845-10-30-6; APB 29, ¶ 22.

Boot

Boot + FVAR

In this ratio, “boot” is the amount of the monetary consideration received and “FVAR” is the estimatedfair value of the asset received. If the estimated fair value of the asset surrendered is more evident,that value should be used instead. Worksheet 15 provides an example of the applicable accounting. Aloss situation is illustrated in Worksheet 16.

(c) Exchanges Between Related Parties Under Common Control

FASB ASC 845 does not apply to transfers of nonmonetary assets between parties under common

control. 251 In transfers of nonmonetary assets between related parties under common control, eachtransferee records the asset received using the historical cost on the books of the transferor (i.e., the

carry-over amount), and thus do not record a gain or loss. 252 Any difference between cash paid orreceived (or the fair value of liabilities assumed or discharged) should be recorded in an equity accountif separate statements are being presented. Worksheet 17 provides an example of the accounting whenrelated parties under common control exchange nonfinancial assets.

251 FASB ASC 845-10-15-4(b); APB 29, ¶ 4.



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Comment: Asset transfers among parties within a control group are recorded atcarry-over amounts because, as a whole, the group is not in a different position afterthe transfer. An exception is made for recurring transfers of current assets when

valuation is not in question and the exchange has commercial substance. 253

253 Id.

(d) Summary—Accounting for Nonmonetary Exchanges

(i) Exchanges Having Commercial Substance

If an exchange has commercial substance, fair value accounting is used. However, exchanges betweenrelated parties call for different treatments depending on whether or not the parties are under commoncontrol.

• Unrelated Parties – Nonmonetary exchanges are recorded using fair values. Gains and lossesare recognized. If fair value is not determinable within reasonable limits, an entity should recordthe exchange using the recorded amount of the asset surrendered. In the latter situation, a gainor loss is not recognized.

• Related Parties Not Under Common Control – The accounting is usually the same as forunrelated parties.

• Related Parties Under Common Control – Nonmonetary exchanges of short-term nonfinancialassets are recorded at prevailing market prices. Gains and losses are recognized. When marketprices are unavailable, the exchange should be recorded using carry-over amounts withoutrecording a gain or loss. Exchanges of long-term nonfinancial assets should be recorded usingcarry-over amounts whether or not the exchange has commercial substance. No gain or loss isrecognized.

(ii) Exchanges Lacking Commercial Substance

If an exchange lacks commercial substance, the transaction is recorded using recorded amounts.Exchanges between related parties differ depending on whether or not the parties are under commoncontrol.

• Unrelated Parties – Nonmonetary exchanges are recognized using the recorded amounts.All losses are recorded. A realized gain is recognized to the extent of boot involved, if any.

• Related Parties Not Under Common Control – The accounting is usually the same as forunrelated parties.

• Related Parties Under Common Control – Exchanges of short-term nonfinancial assetslacking commercial substance are recorded using recorded amounts without recognizinggain or loss. Exchanges of long-term nonfinancial assets are also recorded using recordedamounts without recognizing a gain or loss.

(2) Nonreciprocal Transfers to Owners

As indicated in Section III.A.5.b.(2), above, there are several categories of nonreciprocal transfers toowners. These transfers may include the conveyance of nonmonetary assets, including marketable

equity securities, to stockholders: 254

254 FASB ASC 845-10-05-4; APB 29, ¶ 5.

• As dividends;

• To redeem or acquire outstanding capital stock of the enterprise;


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• In corporate liquidations or plans of reorganization that involve disposing of all or asignificant segment of the business (variously referred to as spin-offs, split-ups, and split-offs); and

• Pursuant to plans of rescission or other settlements relating to a prior businesscombination to redeem or acquire shares of capital stock previously issued in a businesscombination.

Nonreciprocal transfers to owners who are unrelated parties and related parties not under commoncontrol are recorded at fair value. The transferring entity records the surrendered asset at its fair value

and records a gain or loss. 255 The receiving party records the asset received using its fair value. 256

Nonmonetary transfers to owners who are related parties under common control are recorded at

carry-over amounts. 257 Each category of nonreciprocal transfers to owners is discussed in the followingsections.

255 FASB ASC 845-10-30-1; APB 29, ¶ 18.

256 FASB ASC 845-10-30-1; APB 29, ¶ 18.


(a) Distributions of Nonmonetary Assets: Dividends-In-Kind

Nonmonetary assets, including marketable equity securities, conveyed to owners in a nonreciprocaltransfer are recorded at the fair value of the asset transferred with a gain or loss recognized upon the

disposition of the assets. 258 This type of conveyance is known as a dividend-in-kind. This treatment,

however, does not apply to the entity's own capital stock. 259 If the owner is a related party under

common control, the transfer is recorded using carry-over amounts. 260 Presumably, this conceptpertains to all nonmonetary asset distributions to a party under common control, including those

distributions for the purpose of acquiring treasury stock or retiring securities. 261

258 FASB ASC 845-10-30-1; APB 29, ¶ 18.

259 FASB ASC 845-10-30-2; APB 29, ¶ 18.


261 EITF Issue 85-21.

(b) Distributions to Redeem or Reacquire Outstanding Stock

(i) Shareholders Not Related Parties Under Common Control

At times, companies may distribute nonmonetary assets to eliminate a disproportionate part of owners'interests in order to acquire the stock for the treasury or retirement. When stockholders are unrelatedor are not related parties under common control, such transfers are recorded at fair value with a gain or

loss recognized on the disposition of the assets relinquished. 262 The receiving party records the assetsat fair value. In these situations, the value of the reacquired stock may be more readily discernible thanthe value of assets transferred to the owners. If so, the transaction should reflect the stock value.

262 FASB ASC 845-10-30-1; APB 29, ¶ 18.

(ii) Related Parties Under Common Control


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The foregoing accounting is proper for stockholders who are not related parties under common control.If the recipient stockholder is also a related party under common control, the distribution should be

recorded at cost. 263


(c) Liquidations, Reorganizations, and Settlements Related to Prior Combinations

Transfers of nonmonetary assets in conjunction with liquidations or plans of reorganization are recorded

using historical cost. These types of plans include: 264

264 FASB ASC 845-10-30-10; APB 29, ¶ 23.

• Disposing of all or a significant segment of the business, variously referred to as spin-offs,split-ups, and split-offs.

• Rescission or other settlements relating to a prior business combination to redeem oracquire shares of capital stock previously issued in a business combination.

The following types of plans are considered equivalent to spin-offs: 265

265 FASB ASC 845-10-30-10; APB 29, ¶ 23.

• The pro-rata distribution of shares of a subsidiary or other enterprise that has been or isbeing consolidated;

• The pro-rata distribution of shares of a subsidiary or other enterprise that has been or isbeing accounted for under the equity method.

Transfers in conjunction with all of these reorganization plans are accounted for at the recordedamounts of the nonmonetary assets given up after appropriate reduction for any indicated impairment

of value. 266

266 FASB ASC 845-10-30-10; APB 29, ¶ 23.

(3) Nonreciprocal Transfers to Other Than Owners

The transferring entity records a nonreciprocal transfer to other than owners at fair value, recognizing a

gain or loss on disposition of the nonmonetary assets. 267 The recipient records the assets at that

value. 268 If the recipient is a related party and the transactions are material, disclosure is required inaccordance with FASB ASC 850.

267 FASB ASC 845-10-30-1; APB 29, ¶ 18.

268 FASB ASC 845-10-30-1; APB 29, ¶ 18.

Example: Company A donates property to a charitable organization. The charitable organizationis headed by the CEO of Company A. This transfer would be recorded by both entities at the fairvalue of the property.

e. Involuntary Conversions


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When a nonmonetary asset is involuntarily converted to a monetary asset, a gain or loss is recordedwhether or not the enterprise reinvests, or is obligated to reinvest, the monetary assets to replace the

nonmonetary assets. 269

269 FASB ASC 605-40-15-2; APB 29, ¶ 4.

f. Disclosures—Nonmonetary Transactions

The following financial statement disclosures are required for periods during which nonmonetary

transactions occurred: 270

270 FASB ASC 845-10-50-1; APB 29, ¶ 28.

• The nature of the transactions;

• The basis of accounting for the assets transferred; and

• Any gains or losses recognized on the transfers.

Worksheet 18 illustrates these types of footnote disclosures found in the Coca-Cola Company's 2004Form 10-K.

6. Transfers of Financial Instruments

This section covers the accounting and disclosure rules dealing with transfers of financial assets. Exceptfor the rather extensive rules dealing with variable interest entities, including SPEs, transfers of financialinstruments are usually not handled differently when related parties are involved unless the parties areunder common control. However, if the form of a transaction between related parties differs from itssubstance, the records should reflect the economic substance.

Financial instruments include cash, evidence of an ownership interest in an entity, or an agreement with

the following two stipulations: 271

271 FASB ASC Term “Financial Instrument”; FASB Statement No. 107, Disclosures About FairValue of Financial Instruments, ¶ 3.

• One entity is obligated to: (1) deliver cash or another financial instrument to a secondentity; or (2) exchange other financial instruments on potentially unfavorable terms with thesecond entity.

• A second entity has a contractual right to: (1) receive cash or another financial instrumentfrom the first entity; or (2) exchange other financial instruments on potentially favorableterms with the first entity.

A transfer of a financial instrument is defined as the “conveyance of a noncash financial asset by and to

someone other than the issuer of that financial asset.” 272 A transfer includes selling receivables,putting them it into a securitization trust, or pledging them as collateral. Excluded, for example, are theorigination of, settlement, or restructuring of receivables into a security in a troubled debt restructuring.273

272 FASB ASC Term “Transfer” (as used in FASB ASC 860); FASB Statement No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,¶ 364.

273 FASB ASC Term “Transfer” (as used in FASB ASC 860); FASB Statement No. 140,


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Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,¶ 364.

The accounting standards dealing with transfers of financial instruments utilize what is termed a

“financial-components approach.” 274 This means that after a transfer of financial instruments iseffected, the enterprise should record the financial assets it controls and the liabilities it incurs.Likewise, when control has been surrendered, the applicable financial assets and liabilities are removed

from the books. 275 When control is surrendered, the transfer is treated as a sale, but only to theextent of the consideration received that is not held to be beneficial interests in the transferred assets.The term “beneficial interests” is defined in the next section. If the transfer does not meet the criteriafor a sale, it is accounted for as a secured borrowing with a pledge of collateral.

274 See, e.g., FASB ASC 405-20-10-1; FAS 140, Summary.

275 Accounting standards use the term “derecognize.” FASB ASC Term “Derecognize.” SeeWorksheet 19 for a listing of terms used in the standards governing transfers of financialinstruments.

a. Sales

(1) Related Parties Not Under Common Control

The proper accounting treatment for sales of financial instruments between related parties depends onwhether the parties are under common control. Sales between related parties not under common

control are typically not recorded differently from sales between unrelated parties. 276 If a transferringentity relinquishes control, the exchange is accounted for as a sale, but only to the extent that theconsideration received does not amount to beneficial interests in the transferred assets. The term

beneficial interests is defined as: 277

276 See generally EITF Issue 85-21.

277 FASB ASC Term “Beneficial Interests”; FAS 140, ¶ 364.

Rights to receive all or portions of specified cash inflows to a trust or otherentity, including senior and subordinated shares of interest, principal, or othercash inflows to be “passed-through” or “paid-through,” premiums due toguarantors, commercial paper obligations, and residual interests, whether in theform of debt or equity.

In order to qualify as a sale, the transferring entity has to have surrendered control of the assets. Each

of the following conditions must be met in order to satisfy this requirement: 278

278 FASB ASC 860-10-40-5; FAS 140, ¶ 9.

• “The transferred assets have been isolated from the transferor–put presumptively beyondthe reach of the transferor and its creditors, even in bankruptcy or other receivership;”

• “Each transferee (or, if the transferee is a qualifying SPE [special purpose entity], eachholder of its beneficial interests) has the right to pledge or exchange the assets (orbeneficial interests) it received, and no condition both constrains the transferee (or holder)from taking advantage of its right to pledge or exchange and provides more than a trivialbenefit to the transferor;”

• “The transferor does not maintain effective control over the transferred assets througheither: (1) an agreement that both entitles and obligates the transferor to repurchase orredeem [these assets] before their maturity or (2) the ability to unilaterally cause the holder


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to return specific assets, other than through a cleanup call.” 279

279 See Worksheet 19 for the definition of the term cleanup call; see also FASB ASC Term“Cleanup Call Option.”

Assuming each of the foregoing considerations is satisfied, the transferring entity carries out the

following steps to account for the transfer as a sale: 280

280 FASB ASC 860-10-35-3; FASB ASC 860-20-25-1; FASB ASC 860-20-30-1; FAS 140,¶¶ 10, 11.

• “Initially recognize and measure at fair value, if practicable, servicing assets and servicingliabilities that require recognition;”

• “Allocate the previous carrying amount between the assets sold, if any, and the intereststhat continue to be held by the transferor, if any, based on their relative fair values at thedate of transfer;”

• “Continue to carry on its balance sheet any interest it continues to hold in the transferredassets, including, if applicable, beneficial interests in assets transferred to a qualifyingspecial purpose entity in a securitization, and any undivided interests;”

• “Derecognize all assets sold,” i.e., remove them from the books;

• “Recognize all assets obtained and liabilities incurred in consideration as proceeds of thesale, including cash, put or call options held or written (for example, guarantee or recourseobligations), forward commitments (for example, commitments to deliver additionalreceivables during the revolving periods of some securitizations), swaps (for example,provisions that convert interest rates from fixed to variable), and servicing assets andservicing liabilities, if applicable;”

• “Initially measure at fair value assets obtained and liabilities incurred in a sale or, if it isnot practicable to estimate the fair value of an asset or a liability, apply alternativemeasures;” and

• “Recognize in earnings any gain or loss on the sale.”

(2) Related Parties Under Common Control

The proper accounting treatment for sales of financial instruments between related parties undercommon control is dependent on the prevailing circumstances. The accounting is the same as that forrelated parties not under common control if: (1) the sales are routine transactions, and (2) there is a

ready market, such that valuation is not an issue. 281 The transferring entity records a gain or loss.Absent these two conditions, no gain or loss should be recorded. Proper treatment is important whenseparate financial statements of a subsidiary are being presented. Otherwise gains or losses that areeliminated in consolidation are not required to be disclosed in accordance with the related party

transaction rules. 282 The profit or loss should be accounted for in accordance with the accounting

standards covering consolidation or the use of the equity method, whichever is applicable. 283

281 See generally EITF Issue 85–21 (reiterating the SEC's position as stated in the SECObserver).

282 FASB ASC 860–20–25–1; FASB ASC 860–20–30–1; FASB ASC 860–20–40–1A and40-1B; FAS 140, ¶¶ 10, 11.


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283 See generally FASB ASC 810 (ARB 51, as amended) or FASB ASC 323 (APB Opinion No.18, The Equity Method of Accounting for Investments in Common Stock, as amended).

When statements of affiliates are to be combined, a gain or loss can be recorded by one affiliate andthen eliminated when the statements are combined. An alternative when separate statements ofaffiliates are presented is to record the gain or loss in an equity account such as accumulated othercomprehensive income. The following example illustrates the accounting.

Example: Ardmoor Corporation is a holding company. Ardmoor Builders, Inc., a wholly ownedsubsidiary, manufactures modular homes sold through another wholly owned subsidiary,Ardmoor Sales. Ardmoor Savings and Loan (AS&L), a wholly owned subsidiary of ArdmoorCorporation, presents separate financial statements. AS&L typically arranges financing forcustomers who buy from Ardmoor Sales. AS&L often pools packages of qualifying mortgagesand converts them into securities that are sold on the secondary mortgage market. Periodically,the parent, Ardmoor Corporation, purchases some of these securities, for which there is a readymarket. Recently, Ardmoor Corporation paid $500,000 for securities that AS&L carried on itsbooks for $490,000. Whether AS&L should record a gain on these sales to the parent turns onwhether they are routine transfers, for which valuation is not an issue. As there is a readymarket for the securities, AS&L could record the gain in income. Despite the fact that thesecurities are not short-term, the gain can be recorded in income because there is a readymarket. If valuation is an issue, AS&L should record the gain in accumulated othercomprehensive income, an equity account. In that case, Ardmoor Corporation would record thesecurities at AS&L's carrying amount of $490,000 and reduce equity by $10,000. In all cases,these related party transactions require disclosure if they are material and are not eliminated inconsolidation. [Note that all gains or losses between affiliates are to be eliminated if thestatements are combined.]

b. Transfers Accounted for as Secured Borrowings

If an entity transfers a financial instrument for cash or other consideration that excludes beneficialinterests in the transferred assets and the transfer does not meet the criteria for a sale, the transfer is

treated as a secured borrowing with a pledge of collateral. 284 Both the transferor and transferee recordthe transaction accordingly and include the appropriate disclosures in their respective financialstatements.

284 FASB ASC 860-20-40-2; FAS 140, ¶ 12.

7. Leases

Leases are of two basic types: capital and operating. When virtually all of the benefits and risks ofownership rest with the lessee, the agreement is treated as a capital lease. Otherwise, it is classified asan operating lease. A capital lease is similar to an installment purchase of an asset in that the lease actsas a financing arrangement. Accounting for leases incorporates a number of technical terms that areused in the sections that follow. Worksheet 20 contains the definitions.

a. Types of Leases

(1) Classification by Lessees

Lessees classify leases into the two types mentioned in the previous section: capital leases or operating

leases. A lease is classified as a capital lease if it meets any one of the following criteria: 285

285 FASB ASC 840-10-25-1; FASB Statement No. 13, Accounting for Leases, ¶ 7.

• The lease transfers ownership of the property to the lessee by the end of the lease term;

• The lease contains an option to purchase the leased property at a bargain price;


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• The lease term is equal to or greater than 75% of the estimated economic life of theleased property; and

• The present value of rental and other minimum lease payments equals or exceeds 90% ofthe fair value of the leased property less any investment tax credit retained by the lessor.

If the lease does not meet at least one of the foregoing criteria, it is classified as an operating lease.

(2) Classification by Lessors

Lessors use a more extensive classification scheme than lessees. The reason stems from the varioustypes of activities in which lessors may engage when they are leasing assets. For example, a lessor maybe a dealer such that profit on the leased asset is to be recognized. In this type of situation, the lease istermed a sales-type lease. Or, the lease may be a leveraged lease because the arrangement includes a

third-party that participates in the financing. 286

286 FASB ASC 840-10-25-43(c)(2); FAS 13, ¶ 6.

(a) Direct Financing Leases

A direct financing lease is simply a capital lease from the perspective of the lessor. The lease must meetone of the four criteria enumerated in Section III.A.7.a.(1), above. In addition, the collectibility of theminimum lease payments must be reasonably predictable and no important uncertainties can surroundthe amount of unreimbursible costs yet to be incurred by the lessor under the lease. Direct financingleases do not give rise to manufacturer's or dealer's profit (or loss) to the lessor and also do not meet

the criteria established for leveraged leases discussed next. 287

287 FASB ASC 840-10-25-43(b)(2); FAS 13, ¶ 6.

(b) Leveraged Leases

A leveraged lease is a financing lease with the additional feature that the lessor has borrowed funds tofinance a portion of the leased asset. For a lease to be classified as a leveraged lease, it must have all of

the following characteristics: 288

288 FASB ASC 840-10-25-43(c); FAS 13, ¶ 42.

• It meets each of the criteria of a direct financing lease as set out in Section III.A.7.a.(1),above.

• It involves at least three parties: a lessee, a long-term creditor, and a lessor, who iscommonly called the equity participant;

• The financing provided by the long-term creditor is nonrecourse as to the general credit ofthe lessor, although the creditor may have recourse to the specific property leased and theunremitted rentals relating to it. The amount of the financing is sufficient to provide thelessor with substantial leverage in the transaction.

• The lessor's net investment declines during the early years once the investment has beencompleted and rises during the later years of the lease before its final elimination. Suchdecreases and increases in the net investment balance may occur more than once.

(c) Sales-Type Leases

Leases that provide the lessor with a mercantile profit or loss are classified as sales-type leases. The


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characteristic that distinguishes a sales-type lease is that the cost of the leased property is differentfrom its fair value. Accordingly, for classification as a sales-type lease, the fair value of the leasedproperty at the inception of the lease must be different from its cost or from the carrying value if notthe same as cost. In addition, the lease must meet one of the capital lease criteria specified in SectionIII.A.7.a.(1), above. There are two stipulations: (1) the collectibility of the minimum lease paymentsmust be reasonably predictable, and (2) no important uncertainties surround the amount of

unreimbursible costs yet to be incurred by the lessor under the lease. 289 A lease involving real estate

is classified as a sales-type lease even if it does not meet these latter two stipulations. 290

289 FASB ASC 840-10-25-42 and 25-43(a)(2); FAS 13, ¶ 6.

290 FASB ASC 840-10-25-43(a)(1); FAS 13, ¶ 6.

(d) Operating Leases

All other leases not meeting the criteria established for direct financing, leveraged, and sales-type

leases are classified as operating leases. 291

291 FASB ASC 840-10-25-43(d); FAS 13, ¶ 8.

b. Accounting for Leases

(1) Lessees

(a) Capital Leases

Since a capital lease is viewed as a mechanism for financing the purchase of an asset, the lessee hasboth an asset, the leased property, and a liability, the lease obligation. The asset is initially recorded atthe present value of the minimum lease payments over the term of the lease or the fair market value ofthe leased asset, whichever is less. The minimum lease payments include any obligations that thelessee is required to pay, such as penalties for failure to renew or guaranteed residual value. The lesseesubsequently depreciates this asset in accordance with its normal depreciation policy. However, if theownership does not revert to the lessee at the end of the lease or the lease contains a bargain purchase

option, the asset is depreciated over the term of the lease. 292

292 FASB ASC 840-30-35-1(b); FAS 13, ¶ 11.

A bargain purchase option is a provision that allows the lessee to purchase the leased property at astipulated exercise date. The option purchase price has to be sufficiently lower than the fair market

value at that point in time such that the lessee's exercise of the option is reasonably assured. 293

293 FASB ASC Term “Bargain Purchase Option”; FAS 13, ¶ 5(d).

The lessee amortizes the lease obligation using the effective interest rate method to produce a constantperiodic rate that allocates the periodic payments between the reduction in liability and interest

expense. 294

294 FASB ASC 840-30-35-6; FAS 13, ¶ 12.

(b) Operating Leases

Operating leases are recorded on a “pay-as-you-go” basis. The periodic rental on an operating lease ischarged to expense as incurred. If lease payments are not a constant periodic amount over the term of

the lease, the expense should reflect the time pattern by which use benefit is derived. 295


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295 FASB ASC 840-20-25-1; FAS 13, ¶ 15.

(2) Accounting by Lessors

(a) Direct Financing Leases

Lessors' accounting for direct financing leases mirrors lessees' accounting for capital leases. The lessorremoves the carrying amount of the leased asset and records a lease receivable. The latter reflects thepresent value of the minimum lease payments plus the present value of any portion of the asset'sresidual value that is not paid by the lessee. The minimum lease payments include any obligations thelessee is required to pay, such as penalties for failure to renew or a guaranteed residual value. Thelease receivable, often termed, “net investment in capital leases,” is treated as a note receivable. It isamortized using the effective interest rate method, by which the lessor records revenue at a constantperiodic rate of interest. The standards require that the lessor record the gross investment in the leaseas the gross amount of the lease payments plus the residual value of the property at the end of thelease term. The net investment in the lease is subtracted from the gross investment to obtain the

unearned income that is amortized. 296

296 FASB ASC 840-30-30-11 and 30-13; FASB ASC 840-30-25-7; FAS 13, ¶ 18(b), asamended by FAS 98, ¶ 22(i).

(b) Sales-Type Leases

Sales-type leases are accounted for in a manner analogous to that of a direct financing lease. Thedifference is that the lessor records the gross profit on the sale of the asset up front by recognizingsales revenue and cost of goods sold. Both are reduced by the present value of any residual value not

guaranteed by the lessee. 297

297 FASB ASC 840-30-30-8 through 30-10; FAS 13, ¶ 17.

(c) Operating Leases

Rental income is recorded as the payments are received. If lease payments are not a constant periodicamount over the lease term, the income should reflect the time pattern by which use benefit from theleased property is diminished. The leased asset is depreciated in accordance with the lessor's normal

depreciation policy. 298

298 FASB ASC 840-20-35-3; FAS 13, ¶ 19.

c. Related Parties

(1) Form Does Not Reflect Economic Substance

Lease transactions among related parties are typically not accounted for differently from agreementsconsummated among unrelated parties. However, if the legal form of the contract fails to reflect itseconomic substance, the transaction's accounting treatment should portray its substance rather than its

form. 299

299 FASB ASC 840-10-25-26; FAS 13, ¶ 29.

(2) Related Parties Under Common Control: Affiliated Enterprises

Lease transactions among affiliated enterprises within a control group are accounted for according tothe standards governing consolidation or the equity method, whichever is applicable to the investment.300 If an affiliated company is to be consolidated, the necessary eliminations are recorded, includingintercompany gains and losses associated with lease transactions. If the equity method is called for, the


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investor records its share of the income of the investee and records elimination entries similar to thosemade when preparing consolidated statements. If the principal business activity of an affiliate is leasingproperty or facilities to a parent or another affiliated enterprise, proper accounting calls for consolidatingthat entity since the equity method does not provide sufficiently transparent presentation due to the

significance of the assets and liabilities of that affiliate to the overall consolidated group. 301 If affiliates'separate financial statements are presented, gains or losses should be included in an equity account,such as accumulated other comprehensive income, rather than net income. Assuming leased assets arebeing used within the affiliated group and the intent is not to resell those assets to parties outside thegroup, depreciation should be recorded on the carrying amount on the books of the transferring entity

to reflect amortization of the assets. 302

300 FAS 13, ¶ 30 (not codified).

301 FASB ASC 840-10-45-1; FAS 13, ¶ 31.


d. Disclosures

Lease transactions among related parties are to be disclosed in accordance with the related party

transaction rules. 303 These requirements are set out in Section II.A.1, above. For additional accountingrules and disclosures required of all lessors and lessees, refer to 5114, Accounting for Leases:Fundamental Principles (Accounting Policy and Practice Series).

303 FASB ASC 850-10-50-1(d); FAS 57, ¶ 2.


B. SEC Regulations for Public Companies

The previous section covers requirements for transactions involving sales, purchases, transfers, andleases consummated among related parties. This section discusses the SEC regulations that apply tothose types of transactions. Transactions among related parties not under common control are generallyrecorded using market values, while transactions among parties under common control are usuallyrecorded using carry-over amounts. The SEC typically requires companies filing financial statementswith the Commission to prepare those statements in accordance with GAAP. SEC Regulation S-X furthergoverns the form, content, and presentation aspects of those financial statements filed with the SEC,including the required footnote disclosures.

1. Sales

In accordance with Regulation S-X, the various categories of receivables are to be properly segregated.

Those filing financial statements are to separately state amounts receivable from: 304


• Trade customers;

• Related parties;

• Underwriters, promoters, and employees, other than related parties, not arising in theordinary course of business; and


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• All others.

If receivables include amounts due under long-term contracts, the following amounts are to be stated

separately in the balance sheet or in a note to the financial statements: 305

305 SEC Regulation S-X, Rule 5-02.3(c), 17 C.F.R. §210.5-02.3(c); FASB ASC 210-10-S99-1.

• Balances billed but not paid by customers under retainage provisions in contracts;

• Amounts representing the recognized sales value of performance and such amounts thathad not been billed and were not billable to customers at the date of the balance sheet,along with a general description of the prerequisites for billing;

• Billed or unbilled amounts representing claims or other similar items subject to uncertaintyconcerning their determination or ultimate realization;

• A description of the nature and status of the principal items comprising amounts that aresubject to uncertainty as to their determination or realization.

Also required are the amounts included in each of the foregoing categories that are expected to becollected after one year, as well as when any amounts of retainage are expected to be collected, byyear, if practicable.

2. Purchases—Long-Term Obligations

SEC Regulation S-X also covers the reporting of accounts and notes payable arising from purchases andlong-term commitments. In addition to reporting notes payable to banks, factors, holders of commercialpaper, and other financial institutions for borrowings, those who file financial statements with the SEC

need to separately state amounts due to: 306


• Trade creditors;

• Related parties;

• Underwriters, promoters, and employees, other than related parties;

• All others.

3. Transfers—Nonmonetary Transactions

The SEC requires filers to record nonmonetary transactions in accordance with standards issued by the

FASB, as outlined in Section III.A.5, above. 307 In general, that section indicates that nonmonetarytransactions among related parties not under common control should be recorded at fair value. Whenparties are under common control, the transactions should usually be recorded using carry-overamounts.

307 SEC Regulation S-X, Rule 4-01(a)(1), 17 C.F.R. §210.4-01(a)(1); FASB ASC 205-10-S99-1.

Accounting standards governing nonmonetary exchanges do not apply to the issuance of stock for

nonmonetary assets or services in conjunction with a first-time public offering. 308 The question arisesas to the proper accounting when nonmonetary assets are exchanged by promoters or shareholders for


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all or part of a company's common stock just prior to, or contemporaneously with, a first-time publicoffering. The SEC staff has indicated that such transfers should be recorded at the transferors' historicalcost basis determined under GAAP. Deviations from this policy have been rare. Exceptions are possiblewhen: (1) the fair value of either the stock issued or the assets acquired is objectively measurable, and(2) the shareholder's resulting ownership in the enterprise was not so significant that he or she retained

a substantial indirect interest in the assets. 309

308 FASB ASC 845-10-15-4(c); APB 29, ¶ 4.

309 SAB Topic 5.G; FASB ASC 845-10-S99-1.

4. Sales and Purchases of Registered Securities

a. Reporting Transactions

When certain related persons acquire the securities of registered companies or change their holdings,these individuals are required to report those transactions in accordance with the Securities ExchangeAct of 1934 (the 1934 Act). Under Section 16 of the 1934 Act, directors, officers, and principalstockholders (those beneficially owning 10% or more of any class of registered securities) are required

to file reports with the registered company. 310 Section IV.B.2.d, below, discusses the company'srequirements under the 1934 Act.

310 Securities Exchange Act of 1934, Section 16(a), Directors, Officers, and PrincipalStockholders: Disclosures Required, Securities Exchange Commission (2004).

Initial statements of beneficial ownership are filed on Form 3. Statements of changes in beneficialownership are filed using Form 4. Form 5 is used for annual reporting but is not required if reported

earlier on Form 4. 311 These reports are filed with the registered company. The term beneficial owner is

defined in Rule 13d-3 of the 1934 Act as: 312

311 Securities Exchange Act of 1934, Rule16a-3, Reporting Transactions and Holdings,Securities Exchange Commission (2004).

312 Securities Exchange Act of 1934, Rule 13d-3a, Determination of Beneficial Ownership,Securities Exchange Commission (2004).

Any person who, directly or indirectly, through any contract, arrangement, understanding, relationship,or otherwise has or shares:

• Voting power which includes the power to vote, or to direct the voting of, such security;and/or,

• Investment power which includes the power to dispose, or to direct the disposition of,such security.

The definition adds that: 313

313 Securities Exchange Act of 1934, Rule 13d-3b, Determination of Beneficial Ownership,Securities Exchange Commission (2004).

Any person who, directly or indirectly, creates or uses a trust, proxy, power ofattorney, pooling arrangement or any other contract, arrangement, or devicewith the purpose or effect of divesting such person of beneficial ownership of asecurity or preventing the vesting of such beneficial ownership as part of a planor scheme to evade the reporting requirements … of the Act shall be deemed for


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purposes of such sections to be the beneficial owner of such security.

b. Blackout Trading Restrictions

SOX Section 306(a) prohibits officers and directors from engaging in transactions involving equity

securities during “blackout periods.” 314 This section of SOX was a direct result of the Enron scandal. Atabout the same time Enron was experiencing financial difficulties, the company changed pension planadministrators, which resulted in a blackout period during which plan participants were unable to selltheir Enron stock. While participants were thus precluded from transacting in the market, Enronexecutives were selling their stock due to Enron's looming financial crisis. The resulting political falloutled to the blackout restrictions on officers and directors that were subsequently incorporated as SOXSection 306. The SEC subsequently incorporated the SOX Section 306(a) requirements into RegulationBTR, a section of the Securities Exchange Act of 1934. In this Regulation a “blackout period” is defined

as: 315

314 SOX §306(a).

315 Securities and Exchange Commission, Securities Exchange Act of 1934, Regulation BTR,Blackout Trading Restrictions, Definitions, §245.100.

any period of more than three consecutive business days during which theability to purchase, sell or otherwise acquire or transfer an interest in any equitysecurity of such issuer held in an individual account plan is temporarilysuspended by the issuer or by a fiduciary of the plan with respect to not fewerthan 50% of the participants or beneficiaries located in the United States and itsterritories and possessions under all individual account plans … maintained bythe issuer that permit participants or beneficiaries to acquire or hold equitysecurities of the issuer;

During such a blackout period, a director or officer of the company is not allowed to: “purchase, sell orotherwise acquire or transfer any equity security of the issuer…if such director or executive officeracquires or previously acquired such equity security in connection with his or her service or employment

as a director or executive officer.” 316 There are certain exemptions, such as acquisitions resulting fromthe reinvestment of dividends on securities made in accordance with a plan that provides for regular

reinvestment. 317

316 Id. §245.101(a).

317 Id. §245.101(c).

SOX Section 306(b), Notice Requirements to Participants and Beneficiaries Under ERISA, amended theEmployee Retirement Income Security Act (ERISA) by requiring plan administrators to give a 30-day

advance written notice to plan participants and beneficiaries as to when a blackout period will occur. 318

The provisions are applicable to both public and private companies. For these purposes, a “blackout

period” in connection with an individual account plan is: 319

318 SOX §306(b).

319 Id. §306(b)(1), Notice Requirements to Participants and Beneficiaries Under ERISA.

any period for which any ability of participants or beneficiaries under the plan,which is otherwise available under the terms of such plan, to direct or diversifyassets credited to their accounts, to obtain loans from the plan, or to obtaindistributions from the plan is temporarily suspended, limited, or restricted, ifsuch suspension, limitation, or restriction is for any period of more than 3consecutive business days.


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5. Leases

While SEC Regulation S-X covers financial statement form, content, and presentation, including footnotedisclosure, the SEC also requires registrants to include certain other disclosures in the non-financial

statement portions of SEC filings. 320 The latter disclosures are covered by SEC Regulation S-K. Whenan enterprise consummates lease transactions with related parties, Regulation S-K requires thedisclosure of the aggregate amount of all periodic payments or installments due on or after theregistrant's last fiscal year including any required or optional payments due during or at the conclusion

of the lease. 321

320 See generally, SEC Regulation S-K, Reg. §229.404.



C. New York Stock Exchange

1. Sales and Purchases of Securities by Officers and Directors

The NYSE has issued guidance to cover the sale or purchase of a listed company's securities by itsofficers and directors. This guidance is designed primarily to allay concerns about insider dealings and toforestall government sanctions that apply when insiders use nonpublic information for personal gain. Forexample, Section 16(b) of the Securities Exchange Act of 1934 allows registered companies to recoverprofits from related persons when those individuals deal in the securities within six months after

purchase or sale. 322

322 Securities Exchange Act of 1934, Section 16(b), Directors, Officers, and PrincipalStockholders, Securities Exchange Commission (2004).

Comment: In addition to this provision, Rule 10b-5 makes it illegal to employ

“manipulative and deceptive devices” to defraud. 323 Rule10b5-1 further makes it illegal

to trade on the basis of material nonpublic information. The rule states: 324

323 Securities Exchange Act of 1934, Rule10b-5, Employment ofManipulative and Deceptive Devices, Securities Exchange Commission(2004).

324 Securities Exchange Act of 1934, Rule10b5-1a, Trading “on the Basisof” Material Nonpublic Information in Insider Trading Cases, SecuritiesExchange Commission (2004).

The “manipulative and deceptive devices” prohibited by Section 10(b) of the Actand Rule 10b-5 thereunder include, among other things, the purchase or sale ofa security of any issuer, on the basis of material nonpublic information aboutthat security or issuer, in breach of a duty of trust or confidence that is oweddirectly, indirectly, or derivatively, to the issuer of that security or theshareholders of that issuer, or to any other person who is the source of thematerial nonpublic information.

Trading on the basis of nonpublic information means that the individual dealingin the securities was aware of the material nonpublic information when making

the purchase or sale. 325


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325 Securities Exchange Act of 1934, Rule10b5-1b, Trading “on the Basis of” MaterialNonpublic Information in Insider Trading Cases, Securities Exchange Commission (2004).

As a consequence of the foregoing considerations, NYSE guidance deals primarily with the timing ofmarket transactions. Shareholder approval requirements for issuances to related parties are covered inSection II.C.1.b, above.

2. Specific NYSE Guidance

NYSE guidance is designed to promote better shareholder relationships and to forestall the appearanceof insider dealings.

a. Periodic Investment Programs

The NYSE suggests that registered companies establish periodic investment programs, 326 under whichdirectors and officers can make regular purchases. The program should be administered by a broker sothat the timing of purchases is outside the individual's control. A further suggestion is to establish a30-day period when officers and directors can deal in the securities. This period could, for example,begin a week after the annual report has been mailed and the information has been widelydisseminated.


Timing is important to forestall the appearance of insider trading. The NYSE offers the following

suggestions regarding the timing of market participation: 327

327 Id.

• “Following a release of quarterly results, which includes adequate comment on newdevelopments during the period;”

• “Following the wide dissemination of information on the status of the company and currentresults;”

• “At those times when there is relative stability in the company's operations and themarket for its securities;”

• “After the release of earnings, dividends, or other important developments have appearedin the press permitting the news to be widely disseminated and negating the inference thatofficials had an inside advantage.”

Trading just before important press releases should be avoided. In addition, directors and officersshould avoid trading if major developments are expected to impact the market within the next severalmonths. To be safe, the corporate official who intends to trade should contact the chief executive officerto be sure that there are no pending developments that may create the appearance of insider trading ifthose eventualities were to unfold. The foregoing suggestions should also be applied to family membersand close associates, since the public may perceive that these individuals have access to insiderinformation.

b. Securities of Other Companies

Officers and directors may at times trade in the securities of companies 328 with which their companydoes business. Business partners are not considered to be related parties unless one party can


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significantly influence the policies and actions of the other, such that one party is prevented from

pursuing its own interests. 329 Nevertheless, caution regarding the timing of trades should be appliedwhen dealing in the securities of business partners to forestall the appearance of a conflict of interest.Accordingly, it is prudent to be aware of transactions such as important supply contracts, mergers thatare pending or contemplated, and significant financing or leasing arrangements.

328 Id.


Planning Point: This consideration, along with the suggestions enumerated in theprevious section, should be included in conflicts of interest statements to make thecompany, as well as officers and directors, aware of possible pitfalls. In addition, officersand directors should be made aware of important existing and pending transactions sothat these individuals can make informed trading decisions.

c. Stock Options

Corporate officials should apply the foregoing suggestions to stock options for officers and directors. As

in the case of securities, the main consideration is avoiding the appearance of insider dealings. 330


Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis IV. Corporate Governance and the Control Environment

This section discusses corporate governance and how it relates to the inappropriate use of companyassets and services. Inappropriate use can result from outright misappropriation or by falsifyingfinancial statements. In the latter case, inflated income figures can benefit insiders by providingwindfalls in the form of higher bonuses, additional compensation, the ability to unload stocks at inflatedprices, and the exercise of stock options that are not genuinely “in the money.”

Corporate governance encompasses the various methods to assure that business entities are run in amanner consistent with the best interests of shareholders. These measures address the independence ofdirectors, codes of ethics, audit committees, and other elements of the relationship amongshareholders, directors, and management. Corporate governance serves a dual purpose. The first ofthese is to assure that directors and management carry out their fiduciary responsibilities with integrity.Second, corporate governance serves as a mechanism for monitoring the control environment, animportant component of the COSO internal control framework that was incorporated into AICPAStatement on Auditing Standards No. 78, Consideration of Internal Control in a Financial Statement

Audit, 331 in 1995 and sanctioned by the SEC as an acceptable standard for an audit of internal control.332

331 See AICPA Professional Standards, Volume 1, AU §319, Consideration of Internal Controlin a Financial Statement Audit. The COSO framework can be found at http://www.coso.org.

332 SEC Final Rule, Management's Reports on Internal Control Over Financial Reporting andCertification of Disclosure in Exchange Act Periodic Reports.

The control environment includes integrity and ethical values; commitment to competence; board ofdirectors or audit committee participation; management's philosophy and operating style; theorganizational structure; assignment of authority and responsibility; and human resource policies and

practices. 333 The control environment sets the “tone at the top,” provides an overarching mechanismthat has a supervisory role in the hierarchy of controls, and impacts the effectiveness of all othercontrols. When operating properly, corporate governance features, working in harmony with the control


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environment, can effectively deter related parties from using corporate assets and servicesinappropriately.

333 AU §329.34.

This section explains numerous corporate governance measures that have emerged in the wake of SOX.These measures also are summarized in Worksheet 27. Moreover, Worksheet 28 summarizes severalSEC enforcement action that illustrate the effects of corporate governance failures. The corporategovernance measures enacted in SOX should increase the likelihood that the kinds of failuresrepresented in these cases are minimized.


A. The Corporate Governance Rules of Sarbanes-Oxley

Congress enacted SOX on July 30, 2002 in the aftermath of unprecedented corporate scandals andsensational bankruptcies that included Enron, WorldCom, and the fall of their auditors, Arthur Andersen.SOX contains some 50 provisions, most of which touch on corporate governance in one way or another.Some of these, such as Section 404, Management Assessment of Internal Control, are covered in otherparts of this Portfolio. This section discusses the following five SOX sections having a significant impacton corporate governance:

• 301, Public Company Audit Committees;

• 302, Corporate Responsibility for Financial Reports;

• 402, Enhanced Conflict of Interest Provisions;

• 406, Code of Ethics for Senior Financial Officers; and

• 407, Disclosure of Audit Committee Financial Expert.

Each of these five provisions is discussed in the sections that follow.

1. Section 301: Public Company Audit Committees

SOX Section 301 is one of the most important pieces of financial legislation to emerge in recent years.By requiring that the audit committee of the board of directors appoint external auditors, set theircompensation, and oversee their work, the audit committee is now the de jure intermediary between

management and the auditor. 334 This arrangement makes it exceedingly difficult for management tofire auditors over disagreements; thus, outside auditor independence is considerably bolstered.Moreover, SOX mandates that the audit committee members are kept “in the loop,” substantiallyfacilitating their oversight responsibilities. Other provisions of Section 301 specify that each auditcommittee member must be a member of the board of directors; each member is to be independent;the audit committee should establish procedures for receiving, processing, and resolving, or otherwiseacting on, complaints dealing with accounting, control, or auditing issues; the audit committee isauthorized to engage independent counsel as it deems necessary in the course of carrying out its

functions; and the committee is to be adequately funded. 335

334 SOX §301.

335 Id.

2. Section 302: Corporate Responsibility for Financial Reports


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Congress designed SOX Section 302 to remind executives of their fiduciary responsibilities and to deterfraudulent activities. Section 302 requires the principal executive officer(s) and principal financialofficer(s) to certify as appropriate each quarterly and annual report filed under the Securities ExchangeAct. This certification must specify that the signing officer has reviewed the report; based on theofficer's knowledge the report does not contain any untrue statement of a material fact or omit to statea material fact necessary to make the statements not misleading; and based on such officer'sknowledge, the financial statements and other financial information included in the report fairly present,in all material respects the financial condition and results of operations of the issuer as of, and for, the

periods presented in the report. 336

336 Id. §302.

The signing officers are responsible for establishing and maintaining internal controls. Section 302 alsospecifies that these officers must have designed the controls in such a way that management is madeaware of important issues impacting the company and its financial statements. Additionally, the signingofficers must have evaluated the effectiveness of the company's internal controls within 90 days of eachquarterly or annual report and include their conclusions about control effectiveness based on their

evaluation as of that date. 337

337 Id. §302(a)(4).

In certifying the quarterly and annual reports, the signing officers also certify that they have disclosedto the company's independent auditors and the audit committee of the board of directors, or personsfulfilling the equivalent function, all significant deficiencies in the design or operation of internal controlsthat could adversely affect the company's ability to record, process, summarize, and report financialdata, and that they have identified for the company's auditors any material weaknesses in internalcontrols, including any fraud, whether or not material, that involves management or other employees

who have a significant role in the issuer's internal controls. 338

338 Id. §302(a)(5).

Finally, the signing officers must indicate in the report whether there were significant changes ininternal controls or in other factors that could significantly affect internal controls after the date of theirevaluation, including any corrective actions with regard to significant deficiencies and material

weaknesses. 339

339 Id. §302(a)(6).

3. Section 402: Enhanced Conflict of Interest Provisions

SOX Section 402 was prompted by corporate scandals that channeled millions of dollars in personalloans to top executives of large publicly held corporations such as Enron, Tyco, and Adelphia. Section

402 prohibits personal loans to directors and executive officers: 340

340 Id. §402.

It shall be unlawful for any issuer…directly or indirectly, including through anysubsidiary, to extend or maintain credit, to arrange for the extension of credit,or to renew an extension of credit, in the form of a personal loan to or for anydirector or executive officer (or equivalent thereof) of that issuer.

The law makes exceptions for specified types of loans granted by consumer credit companies, such ashome improvement loans, loans for manufactured homes, and consumer credit or any extension of


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under an open end credit plan or charge card. 341

341 Id.

Credit extensions by registered brokers or dealers to an employee are also exempted. To be exempt,loans must be granted in the ordinary course of business of the issuer, be of the type generally madeavailable to the public, and on market terms, or terms that are no more favorable than those offered bythe issuer to the general public for such extensions of credit. For example, a brokerage may extendcredit to an officer or director by means of a margin account. The balance in the account would have tocomply with all Federal Reserve Board Regulation T and stock exchange requirements pertaining tomargin agreements.

4. Section 406: Code of Ethics for Senior Financial Officers

SOX Section 406 requires the company to adopt a code of ethics for senior officers. The SEC requirescertain disclosures regarding this code in reports filed with the SEC. These disclosure requirements areset out in Section IV.B.2.e, below. The term “Code of Ethics” is defined to mean a set of standards

reasonably necessary to promote: 342

342 Id. §406.

honest and ethical conduct, including the ethical handling of actual or apparentconflicts of interest between personal and professional relationships; full, fair,accurate, timely, and understandable disclosure in the periodic reports requiredto be filed by the company; and compliance with applicable governmental rules

and regulations. 343

343 Id.

5. Section 407: Disclosure of Audit Committee Financial Expert

SOX Section 407 contains provisions for assuring that audit committees have the necessary expertise tocarry out their oversight functions. SOX amended the Securities Exchange Act of 1934 to requireinformation about an audit committee “financial expert.” It did not define that term, but rather gave theSEC the power to do so. Nevertheless, the following characteristics were specified as being highly

desirable: 344

344 Id. §407.

• An understanding of generally accepted accounting principles and financial statements;

• Experience in preparing or auditing financial statements of generally comparable issuersand applying such principles in connection with the accounting for estimates, accruals, andreserves;

• Experience with internal accounting controls; and

• An understanding of audit committee functions.



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B. SEC Regulations Covering Corporate Governance

Certain provisions of SOX amend existing legislation. For instance, SOX directs the SEC to issue rulesfor implementing various sections of the Act. This section covers those SEC rules pertaining to corporategovernance, as well as other SEC regulations dealing with this topic.

1. SEC Regulation S-X—Recording Compensation Expenses

Many corporate failures have involved related parties, in particular executive officers receiving largesums of undisclosed compensation. Loans were apparently forgiven and properties purchased by theentity for the personal use of executives. In many cases the transactions were either undisclosed or, ifdisclosed, their true nature concealed. The transactions, which represented additional compensation,often were not authorized by the board of directors.

Example: In one company, the Adelphia Communications Corporation, senior officers allegedlyused company funds to support a lavish lifestyle. In another case, the SEC filed a civilenforcement action against the former top executives of Tyco International, alleging that theseindividuals used hundreds of millions of dollars from undisclosed company loans to financepersonal expenditures. Millions of dollars of these loans were allegedly forgiven without the

required shareholder disclosures. 345

345 Jackson, Business Fairy Tales, above, at 207.

Proper accounting requires such expenditures to be recorded as salary or some other type ofoperational expense, appropriately classified and labeled. Although SEC Regulation S-X does not, strictlyspeaking, encompass corporate governance features, it does govern the presentation of financialstatements in filings with the Commission. This Regulation requires that operating expenses be included

in the income statement and material amounts be stated separately. 346 Additionally, amounts incurredin conjunction with related party transactions must be identified and those amounts properly included in

the financial statements. 347


347 SEC Regulation S-X, Rule 4-08(k), 17 C.F.R. §210.4-08(k); FASB ASC 235-10-S99-1.

2. SEC Regulation S-K—Corporate Governance Requirements

Subpart 400 of SEC Regulation S-K, entitled Management and Certain Security Holders, consists of

seven sections, or “Items,” all of which deal with corporate governance issues. 348 Six of these arediscussed in this section. Item 401 requires the company to identify directors, executive officers,promoters, and control persons. Item 402 addresses the disclosure of executive compensation. Item403 requires companies to disclose information on individuals owning more than 5% of the company'ssecurities, as well as ownership by management, defined for purposes of Item 403 to include directors,director nominees, and executive officers. Item 405 requires the disclosure of directors, officers, andbeneficial security holders who failed to report trades of company securities on a timely bases. Item 406contains rules for disclosure of the company's code of ethics pertaining to the principal executive officer,principal financial officer, principal accounting officer or controller, or persons who perform thesefunctions. Finally, Item 407 is a general section covering corporate governance in the following six

areas: 349

348 SEC Regulation S-K. Reg. §229.400.

349 SEC Regulation S-K, Item 407, Reg. §229.407.

• Director independence;


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• General meetings of the board of directors, committee meetings, and attendance data;

• The nominating committee;

• Audit committee;

• The compensation committee; and

• Shareholder communications.

Each Item is discussed in sections that follow. Item 404, Transactions With Related Persons, Promoters,and Certain Control Persons, is covered extensively in Section II.B.2, above, and thus is not addressedin this section.

a. Item 401: Directors, Executive Officers, Promoters, and Control Persons

Item 401 requires companies to identify all directors and individuals who have been nominated orchosen as directors. The disclosures about directors must include names; ages; terms of office asdirector; periods during which the individuals have served as directors; and any arrangement orunderstanding with any other person, who is to be identified by name, by which any director was or is

to be selected as director or nominee. 350

350 SEC Regulation S-K, Item 401(a), Reg. §229.401(a).

Similar information is to be supplied for executive officers and “significant employees.” 351 The latterindividuals are those who may not necessarily be designated by the enterprise as executive officers butwho nevertheless are key employees. These are persons who, “make or are expected to make

significant contributions to the business.” 352 Examples include production managers, sales managers,and research scientists.

351 SEC Regulation S-K, Item 401(b), Reg. §229.401(b).

352 SEC Regulation S-K, Item 401(c), Reg. §229.401(c).

Item 401 also requires the disclosure of family relationships between directors, executive officers, orindividuals who are nominated or chosen to become directors or executive officers. Family relationshipsfor these purposes are defined as, “any relationship by blood, marriage, or adoption, not more remote

than first cousin.” 353

353 SEC Regulation S-K, Item 401(d), Reg. §229.401(d).

This Item further requires the disclosure of each named individual's business experience andbackground, as well as any additional directorships held by these persons. Such directorships pertain tocompanies having registered securities under the Securities Exchange Act of 1934 or an investment

company subject to the Investment Company Act of 1940. 354

354 SEC Regulation S-K, Items 401(e)(1) and (2), Reg. §229.401(e)(1) and (2).

Additionally, companies must disclose the named individuals' involvement in certain legal proceedings

during the previous five years. 355 Such disclosures also apply to persons who were promoters or

designated as “control persons” during the past five fiscal years. 356 Control persons are individualswho have “acquired control of a registrant that is defined as a shell company or a person who is part ofa group of individuals acquiring such control, where a “group” is defined as two or more individuals whoagree to act together to acquire, hold, vote, or dispose of the equity securities of a registrant that is a


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shell company.” 357 Control persons are discussed more extensively in Section II.B.2.c.(2), above.

355 SEC Regulation S-K, Item 401(f), Reg. §229.401(f).

356 SEC Regulation S-K, Item 401(g), Reg. §229.401(g).

357 SEC Regulation S-K, Item 404(c)(2), Reg. §229.404(c)(2).

b. Item 402: Executive Compensation

The SEC issued revised executive compensation rules in July, 2006. The rules are set out in Item 402 ofSEC Regulation S-K. This section requires companies to comprehensively disclose all compensationawarded, earned by, or paid to executive officers and directors. The disclosure is required for the

following named executive officers: 358

358 SEC Regulation S-K, Item 402(a)(3), Reg. §229.402(a)(3).

• All individuals serving as the company's principal executive officer (PEO) or acting in asimilar capacity during the last completed fiscal year, regardless of compensation level;

• All individuals serving as the company's principal financial officer (PFO) or acting in asimilar capacity during the last completed fiscal year, regardless of compensation level;

• The company's three most highly compensated executive officers other than the PEO andPFO who were serving as executive officers at the end of the last completed fiscal year; and

• Up to two other individuals who would have been among the three most highlycompensated executive officers had they remained in that capacity at year end.

Considerable additional information must be disclosed. This additional information includes the following

specific items: 359

359 SEC Regulation S-K, Items 402(b) through (k), Reg. §229.402(b) through (k).

• A comprehensive discussion and analysis of the compensation programs, includingobjectives, what the programs are designed to reward, and each element of compensation;

• A Summary Compensation Table;

• Information concerning grants of plan-based awards made to executive officers;

• A table of outstanding equity awards at the end of the fiscal year;

• A table of options that have been exercised and stock that has vested;

• Executive officer pension benefits;

• A table of defined contribution and other deferred compensation plans that are nottax-qualified;

• Potential payments to be made to executive officers in connection with any termination;and

• Compensation of directors in tabular format.

Six months after issuing the new rules in July, 2006, the SEC amended the stock option disclosure


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requirements. This action came in response to numerous comments critical of the manner in whichstock options were to be reflected in the Summary Compensation Table. The Commission originally

required companies to present the entire estimated value of options in the year awarded. 360 Under therevised rules, the Summary Compensation Table is to reflect the dollar amount of stock option awardsrecognized for financial statement purposes under the premise that including the entire fair value would

artificially inflate executive compensation. 361 The estimated value of the options (the “grant date fairvalue”) is also to be disclosed, but in an additional column that was added to the “Grants of Plan-BasedAwards“ table.

360 SEC Release No. 33-8732A; 34-54302A, Executive Compensation and Related PersonDisclosure, Final Rule (July 26, 2006), at 337.

361 SEC Release No. 33-8765; 34-55009, Executive Compensation Disclosure, Interim FinalRules (Dec. 22, 2006), at 49-50.

c. Item 403: Security Ownership

Item 403 of SEC Regulation S-K requires the disclosure of the beneficial ownership of all classes ofvoting securities. A “beneficial owner” of a security includes any person who directly or indirectly,through any contract, arrangement, understanding, relationship, or otherwise has or shares voting

power or investment power. 362 Voting power includes the power to vote, or to direct the voting of,such security. Investment power includes the power to dispose, or direct the disposition, of suchsecurity.

362 Securities Exchange Act of 1934, Rule 13d-3a, Determination of Beneficial Ownership,Securities Exchange Commission.

The company must furnish the required information for beneficial owners of more than 5% of any votingclass of security, as well as for “management,” defined as directors, director nominees, and the “namedexecutive officers” specified in the previous section. The following information is required with regard toeach of these individuals: the title of the class of securities, the person's name (as well as the addressesof those beneficially owning more then 5%), the amount and nature of the beneficial ownership, and the

percentage of the class that is owned. 363

363 SEC Regulation S-K, Item 403(a)-(b), Reg. §229.403(a)-(b).

d. Item 405: Compliance With Section 16(a) of the Exchange Act

As indicated in Section III.B.4.a, above, directors, officers, and principal stockholders of a registeredcompany must file reports with that company when these individuals acquire the company's securitiesor change their holdings. The reports are filed on Forms 3, 4, or 5, as applicable. While SectionIII.B.4.a. discusses the related persons' responsibilities under Section 16(a) of the 1934 Act, thisPortfolio section describes registered companies' responsibilities under Item 405 of that Act.

In addition to identifying each director, officer, and principal stockholder, 364 Item 405 requires eachcompany to disclose for each of these individuals: the number of late reports, the number of

transactions not reported on a timely basis, and any known failure to file a required form. 365

364 Defined as a “beneficial owner of more than 10% of any class of equity securities.” SeeSEC Regulation S-K, Item 405(a)(1), Reg. §229.405(a)(1).

365 SEC Regulation S-K, Item 405(a)(2), Reg. §229.405(a)(2).

e. Item 406: Code of Ethics

Item 406 of SEC Regulation S-K covers the code of ethics for senior management. Each company is


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required to: (1) disclose whether it has adopted such a code, and (2) if not, the reason(s) for not doingso. The code is to apply specifically to the company's principal executive officer, financial officer, and

accounting officer or controller. 366 If the company does not use these titles, then the code applies tothose individuals performing functions typical of these offices.


The code of ethics must contain written standards designed to deter wrongdoing and promote a

well-described series of good corporate governance behaviors. 367 These include the following:

367 SEC Regulation S-K, Item 406(b), Reg. §229.406(b).

• Honest and ethical conduct, including the ethical handling of actual or apparent conflicts ofinterest between personal and professional relationships;

• Full, fair, accurate, timely, and understandable disclosure in reports and documents that acompany files with, or submits to, the SEC and in other public communications made by thecompany;

• Compliance with applicable governmental laws, rules and regulations;

• The prompt internal reporting of violations of the code of ethics to an appropriate personor persons identified in the code; and

• Accountability for adherence to the code of ethics.

In addition to disclosing the existence of a code of ethics for senior officials, the company also must filewith the SEC a copy of its code of ethics that applies to the registrant's principal executive officer,principal financial officer, principal accounting officer or controller, or persons performing similar

functions, as an exhibit to its annual report. 368 The company must post the text of its code of ethics onits Internet Web site and disclose, in its annual report, its Internet address and the fact that it hasposted the code on its Internet Web site. Alternatively, a company must offer in its annual report filedwith the Commission to provide to any person without charge, upon request, a copy of its code of ethicsand explain the manner in which such a request may be made. An example of a code of ethics for seniorofficials is found in Worksheet 21, which shows North American Scientific's code.

368 SEC Regulation S-K, Item 406(c), Reg. §229.406(c).

f. Item 407: Corporate Governance

Item 407 of SEC Regulation S-K contains rules on the following six corporate governance topics: (1)director independence; (2) information on the frequency of both general board meetings and committeemeetings, as well as data on attendance at these meetings; (3) information on the nominatingcommittee and its processes; (4) the structure, independence, and processes of the audit committee;(5) the authority, structure, and workings of the compensation committee; and (6) communication with

shareholders. 369 The sections that follow briefly elaborate on each of these corporate governancefeatures.

369 SEC Regulation S-K, Item 407, Reg. §229.407.

(1) Item 407(a): Director Independence

In November 2003, the SEC approved changes to NYSE and NASDAQ standards dealing with corporate

governance. 370 These changes included the requirement that a majority of the board of directors be


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independent and set out the criteria for independence. The criteria adopted by the NYSE are found inSection IV.C.1, below. The NASDAQ criteria are discussed in Section IV.D.1, below, and reproduced inWorksheet 26. Item 407(a), Director Independence, requires a company to identify each director who isindependent, as well as each member of the compensation, nominating and audit committee who is not

independent. 371 In making these independence determinations, the company follows the standardsissued by its national exchange or inter-dealer quotation system. If the company is not listed, it uses adefinition of independence set out by a national securities exchange or inter-dealer quotation system

having the requirement that a majority of the board be independent. 372

370 SEC Release No. 34-48745, NASDAQ and NYSE Rulemaking: Relating to CorporateGovernance (Nov. 4, 2003).


372 SEC Regulation S-K, Item 407(a)(1), Reg. §229.407(a)(1)(i)-(ii).

(2) Item 407(b): Board Meetings and Committees

Item 407(b) of SEC Regulation S-K requires the company to provide the following data regarding

directors' attendance at meetings of the full board and committee meetings: 373

373 SEC Regulation S-K, Item 407(b)(1)-(2), Reg. §229.407(b)(1)-(2).

• The total number of meetings of the full board, both regularly scheduled and specialmeetings, that were held during the last full fiscal year;

• Names of directors attending less than 75% of the aggregate of the total meetings of thefull board and all committees on which that director served; and

• The company's policy regarding director attendance at annual shareholders' meetings andthe number of board members who attended the prior year's annual meeting.

The following information about committees is also required: a statement as to whether the companyhas standing audit, nominating, and compensation committees; the names of members serving on eachof the committees; the number of meetings held by each committee during the previous fiscal year; and

a brief description of the committee functions. 374

374 SEC Regulation S-K, Item 407(b)(3), Reg. §229.407(b)(3).

(3) Item 407(c): Nominating Committee Policies

Item 407(c) of SEC Regulation S-K addresses the policies and procedures of the nominating committee.If the company does not have a standing nominating committee, Item 407(c) requires the company todisclose that fact, state the board's rationale for not having such a committee, and identify each director

who participates in the consideration of nominees. 375 The company is also required to furnish the

following information about the process for nominating directors: 376



• An assertion as to whether the committee has a charter and whether it is available on thecompany's Web site or in the proxy statement;

• The policy for considering candidates recommended by security holders and the


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procedures to be followed by security holders for making such nominations;

• The process for identifying and evaluating nominees;

• The source(s) of the recommendations for nominees;

• If a fee is paid to a third party for assistance in identifying and evaluating nominees,disclosure of the services provided; and

• The source of the recommendation for any nominees beneficially owning more than 5% ofthe voting common stock.

(4) Item 407(d): Audit Committee

Item 407(d) of SEC Regulation S-K requires companies to disclose the structure and functioning of theaudit committee. As indicated in Section IV.B.2.f.(1), above, companies are to adhere to theindependence standards issued by their exchange or association. The SEC issued rules governing theaudit committee requirements mandated by SOX. These standards are found in Rule 10A-3, discussednext.

i. Independence Standards Relating to Audit Committees

SOX Section 301 amended the Securities Exchange Act of 1934 and directed the SEC to issue rules forimplementing audit committee requirements. In response, the Commission issued Rule 10A-3, ListingStandards Relating to Audit Committees, requiring national securities exchanges and associations to

craft regulations for listed companies. 377 The NYSE standards are described in Section IV.C.6, below,while the NASDAQ standards are described in Section IV.D.2, below.

377 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of1934, Rule 10A-3, Listing Standards Relating to Audit Committees, ¶ (a).

The independence requirements for audit committee members set out in Rule 10A-3 are more stringent

than those for independent directors who are general board members. 378 Each member of the auditcommittee must be a member of the board of directors of the listed company, and must otherwise beindependent. To be considered independent, the committee member may not accept, directly orindirectly, any consulting, advisory, or other compensatory fee from the company or any subsidiarythereof. And the member may not be an affiliated person of the company or its subsidiaries.

378 Id. ¶ (b)(1)(i).

Rule 10A-3 defines the term affiliated person as a person that directly, or indirectly through one ormore intermediaries, controls, or is controlled by, or is under common control with, the personspecified. A person will be deemed not to be in control of a specified person if the person: (1) is not thebeneficial owner, directly or indirectly, of more than 10% of any class of voting equity securities of the

specified person, and (2) is not an executive officer of the specified person. 379 The following are alldeemed to be affiliates and therefore not independent: executive officers of affiliates; directors who are

also employees of affiliates; general partners of affiliates; and managing members of affiliates. 380

Audit committee members may still receive pensions from the listed company for prior service as longas the amount is fixed, or unless the rules of the national securities exchange or association provide

otherwise. 381

379 Id. ¶ (e)(1).

380 Id. ¶ (e)(1)(iii).

381 Id. ¶ (b)(1)(ii)(A).


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ii. Audit Committee Responsibilities

In addition to promulgating audit committee independence standards in Rule 10A-3, Listing StandardsRelating to Audit Committees, the SEC set forth four additional standards dealing with audit committeeresponsibilities. These relate to: (1) external auditors, (2) procedures for dealing with complaints, (3)authority to engage advisors, and (4) funding. Each of these topics is covered in sections that follow.

(a) Responsibilities Relating to Registered Public Accounting Firms

Section b(2) of Rule 10A-3 sets forth audit committee responsibilities for appointing, compensating,retaining, and overseeing the work of external auditors. The Rule also delineates audit committeeresponsibilities for resolving disagreements between management and auditors when thosedisagreements pertain to audit, review, and other attestation engagements. The Rule further specifies

that external auditors are to report directly to the audit committee. 382

382 Id. ¶ (b)(2).

(b) Procedures for Responding to Complaints

The audit committee must establish procedures for responding to complaints received by the companyregarding accounting, internal control, or auditing matters. The committee should set up similarprocedures to confidentially handle anonymous submissions by employees (whistleblowers) for

revealing questionable accounting or auditing matters. 383

383 Id. ¶ (b)(3).

(c) Authority to Engage Advisers

The company is required to provide the audit committee with the authority to engage independent

counsel and other advisers, as deemed necessary by the committee to fulfill its responsibilities. 384

384 Id. ¶ (b)(4).

(d) Funding

The company is also required to provide adequate funding for the audit committee, as determined bythe committee, so it is in a position to compensate any registered public accounting firm that the auditcommittee has engaged to prepare and issue an audit report or to perform other audit, review or attestservices for the company; compensate any advisers employed by the audit committee; and pay the

ordinary administrative expenses necessary for the committee to be able to carry out its duties. 385

385 Id. ¶ (b)(5).

Rule 10A-3, Paragraph (c), General Exemptions, spells out certain exceptions to audit committeerequirements. For example, if the company has common equity securities listed on a national exchange,

listing securities of a consolidated subsidiary would not be subject to the requirements. 386

386 Id. ¶ (c).

iii. Audit Committee Disclosures Required Under Item 407(d)

Item 407(d) requires companies to disclose whether the audit committee has a charter and whether

that charter is available on the company's Web site or in the proxy statement. 387 Companies must alsoidentify any committee member who fails to meet the independence standards and the nature of therelationship that makes the member not independent. In addition, the audit committee must include in


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filings with the Commission a statement certifying that it has carried out certain oversight procedures.This report must contain representations that the committee has reviewed and discussed the audited

financial statements with management. 388 The report must also represent that the committee hasdiscussed with the independent auditors the matters required to be discussed by AICPA Statement onAuditing Standards No. 61, as amended (AICPA, Professional Standards, Vol. 1. AU Section 380,Communication With Audit Committees), as adopted by the PCAOB in Rule 3200T, and reviewed anddiscussed the audited financial statements with management. In addition, companies in the report mustrepresent that they have discussed with their independent auditors the matters required to be discussedby SAS 61, as amended (AICPA, Professional Standards, Vol. 1. AU Section 380, Communication WithAudit Committees), as adopted by the PCAOB in Rule 3200T, and also that they have received thewritten disclosures and the letter from the independent accountants required by IndependenceStandards Board Standard No. 1, Independence Discussions With Audit Committees, as adopted by thePCAOB in Rule 3600T, and has discussed these matters with the independent accountant. Finally, Item407(d) requires that companies must represent that they have recommended to the full board that theaudited financial statements be included in the company's annual report on Form 10-K, based on thereview and discussions referred to in the preceding items. The names of each audit committee member

are to appear directly below this certification. 389

387 SEC Regulation S-K, Item 407(d)(1)-(2), Reg. §§229.407(d)(1)-(2).

388 SEC Regulation S-K, Item 407(d)(3)(i)(A)-(D), Reg. §§229.407(d)(3)(i)(A)-(D).

389 SEC Regulation S-K, Item 407(d)(3)(ii), Reg. §229.407(d)(3)(ii).

AU Section 380, Communication With Audit Committees, requires the auditor to communicate several

matters to the company's audit committee. 390 In their communication to the committee, auditors mustindicate the significant accounting policies the company initially selected and any changes in thosepolicies. The auditor must describe the company's processes for formulating accounting estimates,especially those that are particularly sensitive, as well as the auditor's basis for concluding whether ornot the estimates are reasonable. Another requirement is to enumerate those audit adjustmentsrevealed by the audit and which could, in the auditor's opinion, have a significant impact on thecompany's financial reporting process. Moreover, the auditor is to identify those adjustments thatmanagement determines to be immaterial and were waived by the auditors. The standard alsostipulates that the communication is to include the auditor's judgment concerning the quality of thecompany's accounting principles as they apply to its financial reporting, as well as the auditor'sresponsibility for assuring that the non-financial statement portions of the annual report, such as theManagement's Discussion and Analysis section, do not conflict with the financial statements. Anydisagreements with management are to be included, along with the manner in which these wereresolved. If the auditor is aware that management has discussed auditing and accounting matters withother accountants, the auditor should include his or her views on these matters. Finally, the auditor isrequired to reveal any serious difficulties with management relating to the performance of the audit.

390 AU §380.06-.14.

Independence Standards Board Standard No. 1 contains specific requirements for auditors whose clientsare subject to the jurisdiction of the SEC. In order to be considered independent, as that term applies tothe Securities Acts, auditors are required by Independence Standards Board Standard No. 1 to disclose,in a written document to the audit committee, or the board of directors if there is no audit committee,all relationships between the auditor and the company, including related entities, that in the auditor'sprofessional judgment may reasonably be thought to impair independence. Auditors must also confirmin that document that, in their professional judgment, they are independent of the company within themeaning of the Securities Acts. Additionally, auditors are required to discuss their independence withthe audit committee.

iv. Additional Disclosures: Audit Committee Financial Expert

In addition to the disclosures referred to in the preceding section, the company is also required to


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disclose information regarding the audit committee financial expert. These disclosures are to includewhether the company has a financial expert serving on its audit committee or an explanation as to whyit does not, the name of the financial expert, and whether the named financial expert is independent asthis term relates to audit committee members.

(5) Item 407(e): Compensation Committee

Item 407(e) of SEC Regulation S-K addresses the policies and procedures of the compensationcommittee. If the company does not have a standing compensation committee, paragraph 407(e)requires the company to disclose that fact, state the board's rationale for not having such a committee,and identify each director who participates in the consideration of executive officer and director

compensation. 391 Regarding the process for nominating directors, the company also must assertwhether the committee has a charter and whether that charter is available on the registrant's Web siteor in the proxy statement, and describe in narrative form the policies for considering and determining

executive officer and director compensation. 392 The company must also describe the compensationcommittee's scope of authority; whether that authority can be delegated and to whom; the role ofexecutive officers in determining or recommending the amount or form of compensation; and theidentity of any compensation consultants, as well as their role and the nature and scope of theirassignment.

391 SEC Regulation S-K, Item 407(e)(1), Reg. §229.407(e)(1).

392 SEC Regulation S-K, Item 407(e)(2)-(5), Reg. §§229.407(e)(2)-(5).

In addition to the foregoing disclosures, the company must disclose each member of the compensationcommittee who was an executive officer during the last completed fiscal year; each member who wasformerly an officer of the company; and each member who was a related person as set out in

Regulation S-K, Item 404. 393 This information is to be included under the caption “Compensation

Committee Interlocks and Insider Participation.” 394

393 Related persons are discussed in Section II.A.2.a, above.

394 SEC Regulation S-K, Item 407(e)(4), Reg. §229.407(e)(4).

(6) Item 407(f): Shareholder Communications

Item 407(f) of SEC Regulation S-K requires companies to disclose the process that enables security

holders to communicate with the board. The required disclosures include the following: 395

395 SEC Regulation S-K, Item 407(f)(1)-(2), Reg. §§229.407(f)(1)-(2).

• Specifying whether or not the board has a process in place for security holders to sendcommunications to the board, and if not, the basis for the board's view that such a processis inappropriate;

• A description of the manner by which security holders can send communications to theboard, and if applicable, to individual directors; and

• If security holders are not provided the opportunity to communicate directly withindividual board members, the process by which the board determines thosecommunications that will be relayed to directors.

At its discretion, the company may either disclose the communication process in the proxy statement or

provide the Web site address where this information can be found. 396


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396 SEC Regulation S-K, Instruction 1 to Item 407(f), Reg. §229.407(f).


C. New York Stock Exchange Corporate Governance Standards

Corporate governance is covered in the NYSE Listed Company Manual. With few exceptions, the rules

apply to all companies listing common equity securities. 397 Rule 10A-3, Listing Standards Relating toAudit Committees, specifies the SEC's standards related to audit committees. Accordingly, the NYSErequires listed companies to “have an audit committee that satisfies the requirements of Rule 10A-3

under the Exchange Act.” 398 In addition, the NYSE has augmented the Rule 10A-3 requirements.These additional requirements are found in the NYSE Listed Company Manual, Section 303A.07, Audit

Committee Additional Requirements 399 and described in Section IV.C.6, below.

397 The exceptions are described in Section IV.C.13, below.

398 New York Stock Exchange, Listed Company Manual, §303A.06.

399 Id.

1. Independent Directors

The NYSE requires that a majority of directors be independent. The rationale is to increase the quality ofboard oversight and reduce conflicts of interest. Listed companies must determine which boardmembers are independent, identify independent directors, and disclose the basis on whichindependence is determined. In making that determination, a company's board must establish that “thedirector has no material relationship with the listed company (either directly, or as a partner,shareholder or officer of an organization that has a relationship with the company or any of the

company's subsidiaries in the same consolidated group).” 400

400 Id. §303A.02(a).

To be able to specify which members are independent, the board should establish standards within the

guidelines specified by the NYSE. The board is required to disclose standards it adopts. 401 Indeveloping these standards, a board needs to take into consideration those relationships that areexplicitly proscribed by the NYSE. The NYSE does not consider a director to be independent if thedirector is a current employee or has been an employee in the last three years. Independence is alsoconsidered to be impaired if an immediate family member is currently an executive officer, or wasemployed in that capacity within the past three years. However, an individual's prior employment as aninterim CEO or other executive officer would not preclude that person from being considered

independent. 402

401 Id.

402 Id. §303A.02(b).

Independence is considered to be impaired if the director received more than $100,000 in direct

compensation from the company during any 12-month period within the previous three years. 403 Thisrule also applies if the director has an immediate family member who has received such compensation.Director and committee fees, pensions, and other forms of deferred compensation for prior service areexempted provided this compensation is not contingent in any way on continued service. Compensationreceived for prior service as an interim CEO or other executive officer is excluded. Also excluded is


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compensation received by immediate family members who are or were employed as non-executiveofficer employees.

403 Id. §303A.02(b)(ii).

A director is not considered independent if that person, or the individual's immediate family member, iscurrently a partner of any firm that provides internal or external audit services; or the director is a

current employee of such a firm. 404 If the director has an immediate family member who is a currentemployee of such a firm and that family member participates in the firm's audit, assurance, or taxcompliance (but not tax planning) practice, independence is considered to be impaired. Even if thedirector or an immediate family member has left the employ of such a firm, that director is notconsidered to be independent if: (1) the director or an immediate family member was a partner oremployee of the firm within the last three years, and (2) personally worked on the listed company's

audit within that time. 405

404 Id. §303A.02(b)(iii).

405 Id. §303A.02(b)(iii).

If the director or an immediate family member is an executive officer of another company,independence may be impaired. Impairment occurs if a current executive officer of the listed companyserves on the compensation committee of the company employing the director as an executive officer.The look-back period is three years. If a current executive officer served on the compensationcommittee during a three-year period when the director was an executive officer, independence isimpaired.

If the director is a current employee, or an immediate family member is a current executive officer, of acompany that has made payments to, or received payments from, the listed company, the director maynot be independent. Independence is impaired if the payments for property or services exceed thegreater of $1 million or 2% of the other company's consolidated gross revenues. The lookback period isthree years. Accordingly, if the payments exceed the limits in any of the last three fiscal years,independence is impaired. The company should only consider the director or immediate familymember's current employer. That is, the three-year look-back applies to the individual's current

employer and does not extend to previous employers during that period. 406

406 Id. §303A.02(b).

When applying these independence tests, an immediate family member includes “a person's spouse,parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person's home. When applyingthe [three-year] look-back provisions…, listed companies need not consider individuals who are nolonger immediate family members as a result of legal separation or divorce, or those who have died or

become incapacitated.” 407

407 Id.

In crafting standards within the NYSE independence guidelines, the objective is to assure that materialrelationships between a board member and management are identified. Material relationships would beof the type whereby management's decisions hold sway over the director. Material relationships of thisnature could include, among others, commercial, industrial, banking, consulting, legal, accounting,charitable, and familial relationships. While, as indicated, certain relationships have been explicitlyproscribed by the NYSE, the board may wish to establish materiality thresholds for others. In making adetermination about a particular director, the board should consider all the circumstances from theviewpoint of both the director and the organization or person with which the director has a relationship.


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In this regard, the board should include all affiliates of the listed company. 408

408 Id. §303A.02(a).

A straightforward approach for determining whether a relationship is material is first to establish

thresholds and make a general disclosure that each director meets these standards. 409 The board isrequired to disclose the standards it adopts. The board can then state that board members meet thesestandards. This procedure avoids having to disclose immaterial relationships between the company and

directors. 410 If the board has made a determination that a director is independent even if thestandards are not met, the relationship must be disclosed. The NYSE notes that this approach providesinvestors an appropriate means for assessing board independence, as well as the propriety of theindependence assessments made by the board.

409 Id.

410 Id.

Disclosures regarding director independence must be included in the company's annual proxystatement. These disclosures must set forth any standards that the company adopts; the identities ofthe independent directors; the basis for determining that a relationship is not material; and the basis for

concluding that a director who does not meet the standards is nevertheless independent. 411 If thecompany does not file an annual proxy statement, then the disclosures should be included in the Form10-K. Worksheet 22 illustrates the independence disclosures found in General Electric Company's 2007proxy statement.

411 Id.

2. Executive Sessions

The NYSE corporate governance rules provide that non-management directors must meet at regularlyscheduled executive sessions without management. The rationale is that this approach will promoteopen discussion and thereby enable the non-management directors to serve as a more effective checkon management's decisions and actions. Non-management directors are defined as “all those who arenot executive officers, and includes such directors who are not independent by virtue of a material

relationship, former status or family membership, or for any other reason.” 412

412 Id. §303A.03.

To ensure that executive sessions accomplish the intended effect, the NYSE requires that the meetingsbe conducted in accordance with a prescribed protocol. The independent directors should scheduleregular meetings. This feature fosters communication and forestalls any negative inference that may be

associated with calling unscheduled executive sessions of the non-management directors. 413

413 Id.

In addition, a non-management director must preside at the regular meetings, although it is notrequired that the same person preside over all the sessions. If one individual is chosen to preside overall the meetings, that person's name is to be disclosed in the annual proxy statement, or in the Form10-K if an annual proxy statement is not filed. If one individual does not preside over all the meetings,the company is required to disclose the procedure for selecting the presiding director, for example, the

use of rotation among the directors. 414 If the group of non-management directors includes individualswho are not independent, as described in Section IV.C.1, above, the company must schedule at least

one meeting per year comprising solely independent directors. 415


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414 Id.

415 Id.

Planning Point: Some companies, including Alcoa, Boeing, and Intel, have designateda “Lead Director.” This individual is selected from among either the non-management orindependent directors to preside over the executive sessions and sometimes performother functions, such as presiding at general board meetings in the absence of theChair.

3. Communication With Non-Management Directors

The NYSE requires listed companies to disclose a procedure for interested parties to communicatedirectly with the non-management directors or with the presiding director. This disclosure should beincluded in the company's annual proxy statement or in the Form 10-K if the company does not file an

annual proxy statement. 416 The NYSE allows companies to use the same procedure for this purpose asthe system that has been established to allow the audit committee to deal with complaints under Rule

10-A3, Listing Standards Relating to Audit Committees. 417 That standard is discussed in SectionIV.B.2.f.(4)(ii)(b), above.

416 Id.

417 Id.

4. Nominating/Corporate Governance Committee

One of the board's most important functions is assuring the continuation of effective and ethical policiesthrough the selection of exceptional new board members and committee chairs. When theseresponsibilities are put in the hands of independent directors, there is an increased likelihood ofenhancing the quality and objectivity of both. Accordingly, the NYSE requires that the nominating

committee must comprise entirely independent directors. 418 The board may allocate thenominating/corporate governing process among several committees, as determined by the board. Eachcommittee, however labeled, must comprise solely independent directors, and each committee must

have a published charter. 419

418 Id. §303A.04(a).

419 Id. §303A.04.

The NYSE also expects the committee to take the lead in formulating and championing the company'scorporate governance policies. At a minimum, the functions of the committee are to identify individualsqualified to become board members, consistent with the board's criteria, and select on its own, or

recommend that the board select, the director nominees for the next annual shareholders' meeting. 420

The nominating/corporate governance committee must also develop and recommend to the board a setof corporate governance for the company, oversee the process for evaluating the board andmanagement, and establish procedures for carrying out its own annual self-evaluation.

420 Id. §303A.04(b)(i)-(ii).

Planning Point: The committee may wish to establish metrics for evaluating the boardand management, and for carrying out the annual self-evaluation. The evaluation of theboard and management may be a quarterly or an annual process that compares actualresults with pre-established goals. The committee's annual self-evaluation might includecriteria pertaining to: (1) the efficacy of the nominating process, (2) the number ofnominees submitted, and (3) metrics for evaluating how the committee's nomineeshave functioned as board members.


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The committee must have a written charter that incorporates each of the foregoing procedures. At a

minimum, the charter should include the following items: 421

421 Id. §303A.04.

• Function, purpose, and responsibilities;

• Process for carrying out the annual self-evaluation;

• Qualifications for sitting on the committee;

• Appointment and removal of members;

• Committee structure and operations, including authority to delegate to subcommittees;

• Procedure for reporting to the full board; and

• A statement to the effect that the committee is to have sole authority for retaining andterminating any search firm to be used in the process of identifying candidates, includingthe sole authority to approve the search firm's fees and retention terms.

If third parties have the legal authority to nominate directors, through contract or otherwise, anydirectors selected and nominated through that process do not need to follow the committee's selectionand nominating procedures. Such contractual or legal authority to nominate directors may arise when,for example, preferred stockholders have the right to nominate directors as a consequence of a dividend

default or as a result of a shareholder or management agreement. 422

422 Id.

5. Compensation Committee

The compensation committee is charged with the important task of recommending and/or approving acompensation package for the CEO and other executive officers. The NYSE requires the committee to

consist entirely of independent directors and to have a written charter. 423

423 Id. §303A.05(a)-(b).

a. CEO Compensation

At a minimum, the compensation committee's charter must describe: (1) the responsibility of thecommittee to review and approve corporate goals and objectives relevant to CEO compensation; (2) theassessment of the CEO's performance in relation to those goals and objectives; and (3) the setting and

approval of CEO compensation based on the assessment of performance. 424 In the spirit of opencommunication among board members, the committee may find it desirable to discuss CEOcompensation with the full board. Accordingly, the process of deciding on the type and level ofcompensation may be carried out by the compensation committee alone or in conjunction with the other

independent board members, as indicated by the full board. 425

424 Id. §303A.05(b)(i)-(ii).

425 Id. §303A.05(b)(i)(A).

When considering an appropriate level of CEO compensation, the committee should take several factors

into account. 426 One such factor is the company's overall performance compared to historical and


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market benchmarks. Another is the relative shareholder return when compared to other companies inthe same industry. In addition, the committee should consider the value of similar incentive rewards atcomparable companies and amounts awarded CEOs in prior periods.

426 Id. §303A.05.

Planning Point: Incentives should align with the company's strategy and link toshareholder value. Moreover, the committee should consider the appropriate mix ofshort- and long-term incentives. Short-term compensation might consist of annualsalary and bonuses. Long-term compensation can be a mix of stock options and stockgrants, in proper balance. If the stock price is “out of the money,” executives may takerisks to boost the per-share price. Adding stock grants imparts ownership and tiesexecutives to downside risk.

b. Other Compensation Committee Functions

Other functions, which at a minimum must also be included in the charter, include recommending to theboard a compensation package for non-CEO executive officers, including incentives and equity-based

plans subject to approval by the full board. 427 In addition, the committee must draft a report requiredby the SEC for inclusion in the annual proxy or the Form 10-K. Moreover, the committee must preparean annual self-evaluation report.

427 Id. §303A.05(b)(i)(B)-(C),(ii).

c. Items to Be Included in the Compensation Committee Charter

The following is a list of items that, at a minimum, should be found in the committee's charter: 428

428 Id. §303A.05.

• Function, purpose, and responsibilities;

• Process for carrying out the annual self-evaluation;

• Qualifications for serving on the committee;

• Appointment and removal of members;

• Committee structure and operations, including authority to delegate to subcommittees;

• Process for reporting to the full board; and

• A statement to the effect that the committee is to have sole authority to retain andterminate a consulting firm engaged to assist in evaluating or setting compensation levelsfor the CEO, non-CEO executive officers, or directors, including sole authority to approve thefirm's fees and retention terms.

The committee is not precluded from approving awards, either with or without ratification of the board,as might be required to comply with applicable tax laws. In this regard, the board may delegate its

authority to the compensation committee. 429 Additionally, the board may allocate the compensationprocedures among several committees, as determined by the board. Each such committee, however

labeled, must be composed solely of independent directors and have its own published charter. 430


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429 Id.

430 Id.

6. Audit Committee

SOX Section 301 amended the Securities Exchange Act of 1934 and directed the SEC to issue rules forimplementing audit committee requirements. In response, the SEC issued Rule 10A-3, Listing StandardsRelating to Audit Committees. This Rule requires the national securities exchanges and associations to

craft regulations for listed companies. 431 To be in compliance with Rule 10A-3, the NYSE now requireslisted companies to “have an audit committee that satisfies the requirements of Rule 10A-3 under the

Exchange Act.” 432 In addition, the Exchange augmented the Rule 10A-3 regulations by developing anexpanded set of standards that are codified in the NYSE Listed Company Manual as Section 303A.07,

Audit Committee Additional Requirements. 433 These requirements are discussed in the paragraphs thatfollow. As indicated in Section IV.C.13, below, not all entities are required to comply with theaugmented standards.



433 Id.

a. Committee Composition

The NYSE Listed Company Manual requires that the audit committee have a minimum of threemembers. The NYSE requires that all members of the committee be “financially literate,” or become sowithin a reasonable period after appointment to the committee. At least one member must haveaccounting or related financial management expertise. The NYSE leaves it up to each company's boardto determine the qualifications constituting “financial literacy” and the degree of expertise in accounting

or financial management that is required. 434

434 Id. §303A.07(a).

Planning Point: The NYSE does not require the designation of an “audit committee financial

expert,” as that term is defined in SEC Regulation S-K. 435 (See Section IV.A.5 and SectionIV.B.2.f.(4)(iv), above.) Item 407(d) of Regulation S-K requires the following disclosure in theannual proxy or Form 10-K: “Disclose that the registrant's board of directors has determinedthat the registrant either (1) Has at least one audit committee financial expert serving on itsaudit committee; or (2) Does not have an audit committee financial expert serving on its auditcommittee … [and, if not, the company should]…explain why it does not have an audit

committee financial expert.” 436 A disclosure indicating that the company does not have afinancial expert sitting on the audit committee may send up a red flag, not only at the SEC butalso among investors. A disclosure of this sort may raise the company's risk profile and result inan increased cost of capital. It appears that the most prudent course of action would be toappoint a financial expert who meets the SEC definition.

435 Id.

436 SEC Regulation S-K, Item 407(d)(5)(i), Reg. §229.407(d)(5)(i).

Due to the demands on the time of audit committee members, the NYSE recommends that listedcompanies restrict audit committee members from serving on more than three public company auditcommittees. If the listed company does not specify this limitation, the board must make adetermination in each case that the member's service would not be impaired. In addition, the company


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must disclose the basis for the board's determination in the annual proxy statement, or in the Form

10-K if the company does not issue an annual proxy. 437

437 New York Stock Exchange, Listed Company Manual, §303A.07(a).

b. Committee Member Independence

Committee members must meet the independence standards for audit committee members set out inRule 10A-3, Listing Standards Related to Audit Committees. These standards are explained in SectionIV.B.2.f.(4)(i), above. Each member of the audit committee must be a member of the company's boardof directors and otherwise be independent. Audit committee members must satisfy the NYSE

independence tests that are set out in Section IV.C.1, above. 438 The committee member may notaccept, directly or indirectly, any consulting, advisory, or other compensatory fee from the company orany of its subsidiaries. The audit committee member may not be an affiliated person of the company or

any subsidiary. 439

438 Id. §303A.07(b).

439 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of1934, Rule 10A-3, Listing Standards Relating to Audit Committees, ¶ (b)(1)(i).

c. Committee Charter

The audit committee is to have a written charter. The charter must address the committee's purposeand function, procedures for conducting an annual self-evaluation, and the committee's duties and

responsibilities. 440 At a minimum, the charter must specify that the committee has the responsibility toassist with board oversight of the integrity of the listed company's financial statements and compliancewith legal and regulatory requirements. In addition, the independent auditor's qualifications andindependence must be covered, as well as the performance of the listed company's internal audit

function and independent auditors. 441 Finally, the charter must specify that the committee must

prepare an audit committee report as required by the SEC for inclusion in the annual proxy. 442 Thematters to be included in this report are set out in Section IV.B.2.f.(4)(iii), above.

440 New York Stock Exchange, Listed Company Manual, §303A.07(c).

441 Id.

442 Id.

d. Internal Audit Function

The NYSE requires all listed companies to have an internal audit function. Internal audit responsibilitiesassigned to the audit committee by the NYSE may not be delegated to a different committee. Internalaudit does not have to be staffed by company employees; the company may outsource the internal

audit function. 443

443 Id. §303A.07(d).

e. Duties and Responsibilities of the Audit Committee

The duties and responsibilities of an audit committee, set out in Rule 10-A3, Listing Standards for AuditCommittees, are addressed in Section IV.B.2.f.(4)(ii), above. These include those responsibilities thatare related to: (1) external auditors, (2) procedures for dealing with complaints, (3) authority to engageadvisors, and (4) funding.

(1) Responsibilities Relating to External Auditors


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The charter must describe the committee's responsibility for appointing, compensating, retaining, and

overseeing the work of any registered public accounting firm that has been engaged. 444 Also, thecharter must address the committee's responsibility for resolving disagreements between managementand the auditor as they pertain to the auditor's annual audit report or any other audit, review, or attestservices, and include a statement that external auditors report directly to the audit committee.

444 Id. §303A.07(c)(B)(iii).

(2) Additional Responsibilities

In addition to addressing the foregoing matters, the charter must incorporate additional duties andresponsibilities. The committee must evaluate the qualifications, performance, and independence of theexternal auditors at least annually. Moreover, the charter must cover the following additional

responsibilities: 445

445 Id. §303A.07(c)(iii)(A)-(H).

• Meet on an annual and quarterly basis with management and the independent auditors forthe purpose of discussing the annual and quarterly financial statements, including reviewingmanagement's discussion and analysis disclosures;

• Provide guidance regarding the release of financial information to media, analysts andrating agencies;

• Discuss company policies related to risk assessment and risk management;

• Periodically hold separate meetings with management, internal auditors, and theindependent auditors;

• Meet with independent auditors to review audit problems and difficulties, as well asmanagement's response to any such items;

• Set clear policies related to hiring employees or former employees of the independentauditors; and

• Report regularly to the board of directors.

Comment: Since individuals are generally more open when potentially adversarialgroups are not present, quarterly and annual sessions with management and theexternal auditors should usually be held separately. Such meetings are typically moreeffective than joint sessions in assuring that problems that may have arisen arediscussed in an open and candid manner.

(3) Evaluation of Independent Auditors

At least annually, the committee should evaluate the qualifications, performance, and independence ofthe external auditors by obtaining and reviewing the independent auditor's report describing the audit

firm's internal quality control procedures. 446 The committee should review any issues raised by aquality control or peer review that the audit firm has undergone. In addition, the committee shouldexamine any inquiry or investigation of one or more of the firm's audits undertaken either by aprofessional organization or governmental authorities within the preceding five years, as well as anysteps that were taken to remedy deficiencies that may have been revealed by the inquiry orinvestigation. Moreover, it is the committee's responsibility to examine all relationships between the

company and the auditors in order to assess the auditor's independence. 447

446 Id. §303A.07(c)(iii)(A).


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447 Id.

In evaluating the external auditors' qualifications, performance, and independence, the NYSE suggeststhat the committee solicit the opinions of management and the internal audit staff. The process shouldinclude an evaluation of the lead partner's performance, and assuring the regular rotation of the leadpartner every five years as required by SOX Section 203. Moreover, the NYSE suggests that thecommittee consider a regular rotation of audit firms to enhance independence.

Comment: Research into the effect of audit firm tenure is mixed. Some findings

suggest a favorable effect of longer auditor tenure. 448 According to this view, thefavorable findings are a result of learning and carry-over effects whereby longer tenureenables an auditor to learn more about a client's risks, industry, and internal control.Shorter tenure is believed to impair independence because auditors initially lowball feesand give concessions to attract and retain clients. Other findings indicate that longertenure impairs independence and audit quality. These findings suggest that longertenure is associated with greater earnings management and auditors' increased

reluctance to qualify opinions. 449 Accordingly, there is no clear support for the rotationof audit firms.

448 M. Knapp, Factors That Audit Committees Use as Surrogates for AuditQuality, 10 Auditing: A Journal of Practice and Theory 35-52 (1991).

449 A. Vanstraelen, Impact of Renewable Long-Term Audit Mandates onAudit Quality, 9 European Accounting Review 419-42 (2000).

After the committee has completed its evaluation of the auditors, it should present its findings to the full

board. 450

450 New York Stock Exchange, Listed Company Manual, §303A.07(c)(iii)(A).

(4) Release of Financial Information

The committee should review and discuss the adequacy of the company's guidelines covering therelease of financial information to the media, financial analysts, rating agencies, trade associations,

government agencies, and so forth. 451

451 Id. §303A.07(c)(iii)(C).

Planning Point: Guidelines might include the types of financial information to bereleased, the venues, and types of acceptable presentations. For example, thecommittee should discuss to whom analysts' inquiries should be directed, who within theorganization should be authorized to release the information, the kinds of information tobe released, and agreed-upon release dates. Standards should be established todesignate which information is especially sensitive and at which level in the organizationthe information should be reviewed.

(5) Risk Assessment and Control

An important part of management's responsibilities is to assess and control the organization's risks,including business and financial risks. The audit committee should review the company's guidelinesconcerning risk assessment and discuss the effectiveness of the policies governing the process of

evaluating and managing risks. 452

452 Id. §303A.07(c)(iii)(D).

Planning Point: In the process of reviewing these guidelines, the committee should


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seek the input of management, organizational components that currently perform riskassessments, if any, and the internal audit staff. In its deliberations, the committeeshould evaluate the adequacy of the current process and the proper venue within theorganization for performing risk assessments. The committee should also discuss theorganization's major risk exposures and the steps taken by management to monitor andcontrol these exposures. Because setting appropriate policies governing risk analysisand control can prove to be a daunting task, especially in larger organizations, thecompany should consider hiring outside consultants who are conversant in riskassessment and control.

(6) Discussions With Independent Auditor

The committee has the important responsibility to meet regularly with the independent auditors to

discuss the progress of the audit. 453 A number of items should be discussed. A prime consideration isany difficulties the auditor has encountered in the course of the audit work, including any restrictions onthe scope of the auditor's activities or on access to requested information. The committee would want toknow of any significant disagreements between the auditors and management. High on the list areaccounting adjustments that were noted or proposed by the auditor but were “passed” as immaterial orotherwise. The committee should be aware of any communications between the audit team and theaudit firm's national office respecting auditing or accounting issues presented by the engagement. Thecommittee should ask for any “management” or “internal control” letter issued, or proposed to beissued, by the audit firm. Finally, because external auditors often work extensively with the company'sinternal audit staff, the committee should solicit the external auditors' views on the effectiveness of theinternal audit function. Accordingly, the committee should inquire about such matters as the internalaudit department's responsibilities, the department's staffing, and the adequacy of the department'sbudget.

453 Id. §303A.07(c)(iii)(F).

(7) Reporting to the Board

In order to be effective when reporting to the board, the committee should review major issuesregarding accounting principles and financial statement presentations, including any significant changes

in the company's selection or application of accounting principles. 454 The committee should addressimportant concerns regarding the adequacy of internal controls and any specific audit steps adopted inresponse to material control deficiencies. It should also carefully consider analyses prepared bymanagement and/or the independent auditor setting forth significant financial reporting issues andjudgments made in connection with the preparation of the financial statements, including analyses of

the effects of alternative GAAP methods on the financial statements. 455 Other issues to be reviewedinclude the effect of regulatory and accounting initiatives, as well as off-balance sheet structures, on thefinancial statements, and the type and presentation of information to be included in earnings pressreleases. The committee should be paying particular attention to any use of “pro forma,” or “adjusted”non-GAAP, information, as well as review any financial information and earnings guidance provided to

analysts and rating agencies. 456

454 Id. §303A.07(c)(iii)(H).

455 Id.

456 Id.

After performing its review, the committee should present its findings to the full board. The presentationshould cover any issues affecting the quality or integrity of the financial statements, which wouldinclude the company's compliance with legal or regulatory requirements, the independence of the

external auditors, and the performance of the company's internal audit function. 457


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457 Id.

7. Corporate Governance Guidelines

Due to the importance of corporate governance, each listed company must draft a set of corporategovernance guidelines to be included on its Web site, together with the charters of the most importantcommittees. At a minimum, the committees whose charters are represented should include the audit,compensation, and nominating committees. The guidelines should include key areas including directorqualifications, responsibilities, and compensation, as well as the responsibilities of the major board

committees. 458

458 Id. §303A.09.

In addition, a statement is to be included in the annual proxy statement, or the Form 10-K if thecompany does not file an annual proxy, indicating that the information is available on the company's

Web site and in print to any shareholder who requests it. 459 Making this information available helpspromote investor understanding of the company's policies and procedures, as well as to enhancemanagement and board awareness of these provisions. The corporate governance guidelines that theNYSE requires all listed companies to cover are reproduced in Worksheet 23.

459 Id.

8. Code of Business Conduct and Ethics

The NYSE Listed Company Manual requires listed companies to “adopt and disclose a code of businessconduct and ethics for directors, officers and employees, and promptly disclose any waivers of the codefor directors or executive officers.” The code of ethics should be designed to focus management and theboard on areas of ethical risk, provide guidance for personnel in dealing with ethical issues, offer amechanism for reporting unethical conduct, and help promote an atmosphere of integrity and ethical

conduct. 460

460 Id. §303A.10.

The code of ethics must be accompanied by compliance standards to ensure that a company takes fair,consistent, and prompt action when violations arise. Any waivers from the code that are granted toexecutive officers or directors can be authorized only by the board or a board committee and have to be

disclosed to shareholders. 461 This provision should prevent waivers except for unusual or pressingcircumstances and should assure that any waivers are accompanied by controls that deter abuse.

461 Id.

The code of ethics must be included on the company's Web site. A statement is to be included in theannual proxy statement, or the Form 10-K if the company does not file an annual proxy, indicating thatthe foregoing information is available on the company's Web site and that the code of ethics is available

in print to any shareholder who requests it. 462 The NYSE allows a listed company to create its owncodes of ethics. However, the NYSE does specify certain topics that should be addressed by allcompanies. These topics are reproduced in Worksheet 24.

462 Id.

9. Foreign Private Issuer Disclosure

Because corporate governance procedures vary from country to country, listed foreign private issuers


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need to make their U.S. investors aware of how their home country corporate governance practices

differ from those prevalent in the United States. 463 The NYSE requires only a brief, general summaryrather than extensive analysis.

463 Id. §303A.11.

Disclosure on the company's Web site is required. The site must be available in the English languageand accessible in the United States. The fact that the disclosures are found on the Web site should be

made known in the annual report, along with the Web site address. 464 Worksheet 25 illustrates thedisclosures provided by Elan Corporation.

464 Id.

10. Certification Requirements

The CEO of each company must certify annually that he or she is not aware of any violations of NYSE

corporate governance standards and is to qualify the report as required. 465 This certification, alongwith those required to be filed with the Form 10-K under SOX Section 302, are to be included in thecompany's annual report to shareholders. If the company does not issue an annual report, thecertification is to be included in the Form 10-K. Section IV.A.2, above, describes the SOX certificationsthat are to be included in the Form 10-K. Each issuer also must submit to the NYSE annually anexecuted Written Affirmation. A company is to promptly notify the NYSE upon learning that it is notmaterially in compliance with NYSE corporate governance standards. Additionally, the company is tosubmit an interim Written Affirmation whenever there is a change in the composition of the board or

any of the committees required by NYSE corporate governance standards. 466 The Written Affirmation

form and instructions are available on the NYSE Web site. 467

465 Id. §303A.12.

466 Id.

467 The NYSE Web site can be found at http://www.nyse.com. Click on “Listed Companies,”and then “Corporate Governance Forms” to locate the Written Affirmations form.

11. Public Reprimand Letter

The NYSE sanctions companies for violations of the listing standards, including those pertaining tocorporate governance. The sanctions range from a public reprimand letter to suspension of trading and

delisting. 468 Since the more severe sanctions have a deleterious impact on shareholders, thesemeasures are used sparingly. For initial violations, the NYSE will typically use the less severe sanction ofissuing a public letter of reprimand. The more severe sanctions are still available for repeat offenders or

more flagrant violations. 469 Letters of reprimand are not used when companies fall below thecontinued listing standards thresholds or fail to comply with the audit committee listing standards. Themore severe sanctions—suspension and delisting—are used in such situations. The continued listingstandards are found in the NYSE Listed Company Manual, Section 802.01, Continued Listing Criteria.The NYSE's audit committee listing standards are found in Section IV.C.6, above.


469 Id.

12. Web Site Requirement

The NYSE requires all listed companies to create and maintain a public Web site. If a company isrequired to have committees (nominating/corporate governance, compensation, or audit committees) aprintable version of the charters must be on the Web site. Those companies required to establish


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corporate governance guidelines and adopt a code of ethics must make printable versions of these

documents available. 470 Foreign private issuer disclosures must appear on the Web sites of thosecompanies. See Section IV.C.9, above, for more detail. The next section describes the types ofcompanies that are exempted from certain of the NYSE corporate governance rules.

470 Id. §303A.14.

13. Exceptions to NYSE Corporate Governance Standards

Some companies are required to follow the SEC Rule 10A-3 requirements but are exempt from certainrequirements of the additional NYSE audit committee found in the Listed Company Manual, Section303A.07, Audit Committee Additional Requirements, which are discussed in Section IV.C.6, above. Thetypes of companies exempt from certain additional NYSE audit committee requirements are controlledcompanies, limited partnerships and companies in bankruptcy, closed- and open-end funds, certainother entities, foreign private issuers, and companies that list only preferred or debt securities.

a. Controlled Companies

A controlled company is a “listed company of which more than 50% of the voting power is held by an

individual, a group or another company.” 471 A controlled company is exempt from the corporategovernance standards pertaining to director independence and the requirements to establish nominatingand compensation committees. It must, however, comply with the rest of the rules. The company mustdisclose its choice to exercise these exemptions, stating that it is a controlled company, as well as thebasis for using this designation. These disclosures should appear in the annual proxy statement or in

the Form 10-K if the company does not issue an annual proxy statement. 472

471 Id. §303A.00.

472 Id.

b. Limited Partnerships and Companies in Bankruptcy

Limited partnerships and all companies in bankruptcy proceedings are not required to comply with thestandards dealing with director independence and the requirements to establish nominating and

compensation committees. 473 Companies in bankruptcy proceedings and limited partnerships at thegeneral partner level must comply with the rest of the standards.

473 Id.

c. Closed-End and Open-End Funds

(1) Closed-End Funds

Since closed-end funds are subject to the Investment Company Act of 1940, they are exempt from most

of the NYSE corporate governance standards. 474 Closed-end funds must have an audit committee thatsatisfies the requirements of Rule 10A-3, Listing Standards Relating to Audit Committees. (See SectionIV.C.6, above, for more details.) In addition, these funds must have an audit committee consisting of atleast three members with one member having accounting or related financial management expertise asdefined by the board. However, since the same board members typically serve all the funds in thecomplex, closed-end funds are exempt from the requirement to disclose simultaneous service of a

member on more than three public company audit committees. 475 (See Section IV.C.6.a, above, formore details.) In addition, Rule 10A-3 requires companies to establish procedures allowing employeesto submit confidential, anonymous information regarding questionable accounting or auditing matters.476 The NYSE requires closed-end funds to establish those procedures for employees of themanagement company plus implement similar procedures for employees of the investment adviser,administrator, principal underwriter, and any other provider of accounting services. This responsibility is


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to be included in the audit committee charter. 477

474 Id.

475 Id.

476 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of1934, Rule 10A-3, Listing Standards Relating to Audit Committees, ¶ (b)(3)(iii), Complaints.


(2) Open-End Funds

These funds must have an audit committee consisting of at least three members with one memberhaving accounting or related financial management expertise as defined by the board. They are subjectto the same requirement as closed-end funds regarding the extension of the complaint procedures (see

previous section). 478

478 Id.

(3) Business Development Companies

These entities are a type of closed-end management investment company. They are defined in theInvestment Company Act of 1940, but not registered under that Act. Business development companiesare required to adhere to all the corporate governance listing standards, except that standard pertaining

to director independence. 479 A director of a business development company is considered to beindependent if he or she is not an “interested person” as that term is defined in Section 2(a)(19) of the

Investment Company Act. 480

479 Id.

480 Id.

d. Other Entities

The NYSE's corporate governance standards do not apply to passive business organizations. 481 Thelatter are organizations such as trusts, derivatives and special purpose securities as described inSections 703.16, .19, .20, and .21 of the NYSE Listed Company Manual. To the extent that Rule 10A-3,Listing Standards Related to Audit Committees, applies to these entities, they must establish an auditcommittee in compliance with that Rule. Passive business organizations are also required to comply withthe NYSE standard requiring entities to notify the NYSE of any material noncompliance. In the instanceat hand, the notification pertains to any material noncompliance with the applicable audit committee

provisions. (See Section IV.C.6, above). 482

481 Id.

482 Id.

e. Foreign Private Issuers

Companies that are foreign private issuers may follow home company corporate governance practices.483 However, they must meet the Rule 10A-3 audit committee requirements. Foreign private issuersare also required to comply with the NYSE standard requiring disclosure of differences between homecompany and U.S. corporate governance practices (see Section IV.C.9, above) and the standard

requiring notification of material non-compliance (see Section IV.C.10, above). 484

483 Id.


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484 Id.

f. Preferred and Debt Listings

The corporate governance standards generally do not apply to companies that list only preferred or debt

securities. 485 However, to the extent required by Rule 10A-3, Listing Standards Relating to AuditCommittees, those companies listing only preferred or debt securities must comply with the NYSE listingstandard, Section 303A.06, Audit Committee, which states, “Listed companies must have an audit

committee that satisfies the requirements of Rule 10A-3 under the Exchange Act.” 486 The Rule 10A-3guidance is set out in Section IV.B.2.f.(4), above. Additionally, the company must notify the NYSEwhenever it is not materially in compliance with the audit committee requirements and also execute a

Written Affirmation. 487 The non-compliance standard is covered in Section IV.C.10, above.

485 Id.

486 Id. §303A.06.

487 Id. §303A.00.


D. NASDAQ Corporate Governance Standards

NASDAQ terms its corporate governance standards “qualitative listing requirements.” These apply to alllisted companies except limited partnerships. Additionally, certain exemptions apply. These exemptionsare found in Section IV.D.5, below.

1. Independent Directors

NASDAQ requires that a majority of the board of directors be independent as that term is defined inRule 4200 of the NASDAQ Manual. Rule 4200 is reproduced in Worksheet 26. The listed company isrequired to disclose the names of the directors that the board has determined to be independent. Thedisclosure is to appear in the company's annual proxy or, if the company does not file a proxy, in its

Form 10-K (or Form 20-F if a foreign private issuer). 488

488 NASDAQ Manual, §4350(c)(1).

If a company is unable to comply due to a vacancy or because one director ceases to be independentand the circumstances are beyond the control of the issuer, the company is required to comply by theearlier of its next annual shareholders meeting or one year from the event causing the noncompliance.489 If the annual shareholders' meeting occurs 180 days or less after that event, the company is given180 days from that date to regain compliance. As soon as the company learns of the event or

circumstance causing the non-compliance, it is to notify NASDAQ of the circumstances. 490

489 Id.

490 Id.

a. Executive Sessions

Independent directors are to hold regular meetings composed only of independent directors. 491

491 Id. §4350(c)(2).


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b. Executive Officer Compensation

Chief executive officer compensation, as well as compensation for all other executive officers, must bedetermined, or recommended to the board for determination, either by a majority of the independent

directors, or a compensation committee comprised solely of independent directors. 492 The CEO is notallowed to be present during the voting or deliberations on his or her compensation.

492 Id. §4350(c)(3).

c. Compensation Committee

NASDAQ does not require the listed company to form a compensation committee if executive officercompensation is determined by a majority of the independent directors. If a compensation committee isestablished, however, it must comprise solely independent directors. If the committee comprises atleast three members, one non-independent director may serve on the committee (see Worksheet 26 for

NASDAQ's definition of an independent director). 493 This individual may not be a current officer oremployee of the company or a family member of an officer or employee. This appointment should be anexception, made only under limited circumstances, when, as determined by the board, the exception isin the best interests of the company and its shareholders. Moreover, the listed company must disclosethis exception in the proxy statement for the next annual meeting following a determination that theexception is necessary. If the company does not file a proxy, the disclosure appears in the issuer's Form10-K (or Form 20-F if a foreign private issuer), along with the nature of the relationship and the reasonsfor the exception. A member appointed under these circumstances cannot serve for more than two

years. 494

493 Id.

494 Id.

d. Nomination of Directors

Nominees for director must be selected, or recommended for the board's selection, either by a majority

of the independent directors, or a nominations committee comprising solely independent directors. 495

The company must certify that it has adopted a formal written charter or board resolution, asapplicable, that describes the process for nominating directors and any related matters that may be

required under the federal securities laws. 496

495 Id. §4350(c)(4)(A).

496 Id. §4350(c)(4)(B).

Independent director oversight of the nomination process does not apply in cases where the right tonominate a director rests with a third party. This exception is allowable only if the company is subject toa binding obligation that requires a director nomination process inconsistent with the NASDAQprocedures and the obligation pre-dates the approval date of the NASDAQ rules. The company isnevertheless required to comply with the committee composition requirements applicable to

nominations and audit committees. 497

497 Id. §4350(c)(4)(D).

As indicated above, NASDAQ does not require the listed company to have a nominations committee if amajority of independent members carries out the nomination process. If a nominations committee isformed, however, it must comprise solely independent directors. If the committee comprises at leastthree members, one director who is not independent (see Worksheet 26 for NASDAQ's definition of anindependent director) may be appointed. This individual cannot be a current officer or employee of the


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company or a family member of an officer or employee. The appointment is to come about only underlimited circumstances, when the board determines that the exception is in the best interests of thecompany and shareholders. The issuer is to disclose the exception in the proxy statement for the next

annual meeting subsequent to the board's decision that an exception is warranted. 498 If the companydoes not file a proxy, the disclosure is to appear in the issuer's Form 10-K (or Form 20-F if a foreignprivate issuer), along with the nature of the relationship and the reasons for the exception. A member

who is appointed under these circumstances cannot serve for more than two years. 499

498 Id. §4350(c)(4)(C).

499 Id.

To obtain NASDAQ's booklet entitled Corporate Governance Guidelines for the Board of Directors, go to

the NASDAQ website at http://www.nasdaq.com. 500

500 Once on the website, click on “Investor Relations” and “Corporate Governance.”

2. Audit Committee

SEC Rule 10A-3, Listing Standards Relating to Audit Committees, sets out the required standards foraudit committees under the Securities Exchange Act of 1934. The SEC has required national securities

exchanges and associations to craft regulations for listed companies. 501 The standards issued byNASDAQ in response to this SEC requirement are found in the sections that follow.


a. Committee Composition

NASDAQ requires each listed company to certify that it has and will continue to have an auditcommittee comprising at least three members. These members must possess certain characteristics.They must meet the independence criteria defined in Rule 4200(a)(15) of the NASDAQ Manual (whichare set out in Worksheet 26, NASDAQ Definition of Independent Director). They must also meet theaudit committee independence criteria set forth in Rule 10A-3(b)(1), subject to the exemptions provided

in Rule 10A-3(c). 502 A discussion of these independence standards is found in Section IV.B.2.f.(4)(i),above. Rule 10A-3, paragraph (c) lists various exemptions to the audit committee requirements set outin the Rule.

502 NASDAQ Manual, §4350(d)(2)(A).

NASDAQ rules further require that audit committee members must not have participated in preparingthe financial statements of the company or any current subsidiary of the company at any time duringthe past three years. They must be able to read and understand fundamental financial statements,including a company's balance sheet, income statement, and statement of cash flows. Moreover, eachlisted company “must certify that it has, and will continue to have, at least one member of the auditcommittee who has past employment experience in finance or accounting, requisite professionalcertification in accounting, or any other comparable experience or background which results in theindividual's financial sophistication, including being or having been a chief executive officer, chief

financial officer or other senior officer with financial oversight responsibilities.” 503

503 Id.

A company may appoint one audit committee member who does not meet the NASDAQ independencecriteria found in Worksheet 26. This individual is, however, required to meet the standards set forth in


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Section 10A(m)(3) of the Securities Exchange Act of 1934. 504 Those standards stipulate that eachaudit committee member must be a member of the board of directors. There are also compensationcriteria that are more stringent than for general board members. The audit committee member cannotaccept any consulting, advisory, or other compensatory fee from the company or be an affiliated person

of the company or any of the company's subsidiaries. 505

504 Id. §4350(d)(2)(B).

505 Securities Exchange Act of 1934 (17 C.F.R. §240.12b-2), §10A, ¶ (m)(3).

For the independence exception to be valid under the NASDAQ rules, the individual may not be acurrent officer or employee, or a family member of an officer or employee. The appointment is to occuronly as an exception under limited circumstances, and the board must determine that the exception isin the best interests of the company and shareholders. The company is required to disclose theexception in the proxy statement for the next annual meeting subsequent to the board's making itsdetermination that the exception is advantageous to the company. If the company does not file a proxy,the disclosure is to appear in the issuer's Form 10-K (or 20-F if a foreign private issuer), along with thenature of the exception, as well as the rationale. A member who is appointed under these circumstances

cannot serve for more than two years. 506

506 NASDAQ Manual, §4350(d)(2)(B).

Example: The NASDAQ independence requirements reproduced in Worksheet 26 contain athree-year lookback period for employees. Accordingly, to be considered independent, a directorcannot have been an officer employed by the company within the previous three-year period.However, a former CFO who had just retired from the company's employ could become amember of the company's audit committee under the foregoing exception.

b. Committee Charter

NASDAQ requires each company to certify that it has adopted a formal written charter for its auditcommittee. Additionally, the committee is required to annually reassess the adequacy of its charter,

which is to encompass the following matters: 507

507 Id. §4350(d)(1)(A)-(D).


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• The committee's responsibilities and how it carries them out;

• Structure, procedures, and membership requirements;

• Its responsibility to ensure the receipt of a formal written statement from the externalauditors delineating all relationships between the auditor and the company, consistent withIndependence Standards Board's Standard No. 1, Independence Discussions With AuditCommittees;

• Its responsibility to discuss with the outside auditors any relationships or services thatmay impact their independence;

• Its responsibility for taking appropriate action to oversee the independence of the outsideauditor or for recommending that the full board take such action;

• The committee's oversight function as it pertains to the company's accounting andfinancial reporting processes and the financial statement audits; and

• The responsibilities and authority that are required to assure the committee is incompliance with SEC Rule 10A-3, Listing Standards Relating to Audit Committees.

The specific responsibilities of audit committees are covered in the next section.

c. Specific Responsibilities of Audit Committees

As indicated in the previous section, each audit committee is to have the authority necessary to meet itsresponsibilities under SEC Rule 10A-3. The specific responsibilities enumerated in that standard cover:(1) those functions pertaining to registered public accounting firms; (2) procedures for handlingcomplaints and the confidential, anonymous submission of concerns regarding questionable accountingor auditing matters; (3) the authority to engage advisors as the committee deems necessary; and (4)

the authority for adequate funding to enable the committee to effectively carry out its functions. 508

These four items are enumerated in Section IV.B.2.f.(4)(ii), above.

508 Id. §4350(d)(3).

Investment company audit committees have the additional responsibility to extend the procedures forhandling confidential anonymous submissions beyond their own employees. These procedures are to bemade available to employees of the investment adviser, administrator, principal underwriter, or any

other provider of accounting related services for the investment company. 509

509 Id.

d. Exemption From NASDAQ Audit Committee Standards

If a company lists certain securities of: (1) a direct or indirect consolidated subsidiary, or (2) asubsidiary that is at least 50% beneficially owned by the issuer, those securities are not subject to theNASDAQ audit committee requirements. Equity securities are not exempt, except for non-convertible,non-participating preferred stock. Additionally, the issuer must have listed on another national securitiesexchange or association a class of equity or similar securities that are subject to the requirements of

SEC Rule 10A-3. 510

510 Id. §4350(d)(5).

3. Notification of Material Noncompliance

If a company finds that it is not materially in compliance with the NASDAQ qualitative listing


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requirements covering corporate governance as set out in the NASDAQ Manual, Section 4350, the

company is required to promptly notify NASDAQ that it is non-compliant. 511

511 Id. §4350(m).

4. Code of Conduct

NASDAQ qualitative listing requirements require each company to adopt a code of conduct that pertainsto directors, officers, and employees. This code is to be publicly available, typically on the issuer's Website. The code must comply with the rules pertaining to a “code of ethics” as set out in SOX Section

406(c), as well as the rules issued by the SEC to assure compliance with SOX. 512 The company mustalso set up enforcement procedures. Waivers for directors or executive officers require board approvaland are required to be disclosed on a Form 8-K and filed within four business days of the waiverauthorization. (Foreign private issuers should disclose waivers either on Form 6-K or the next regularly

filed Form 20-F or 40-F.) 513

512 Id. §4350(n).

513 Id.

5. Exemptions From the NASDAQ Qualitative Listing Standards

With few exceptions, NASDAQ qualitative listing requirements apply to all listed companies exceptlimited partnerships. The exemptions are set out in the paragraphs that follow.

a. Foreign Private Issuers

A foreign private issuer may follow its home country corporate governance practices rather than thosepromulgated by NASDAQ. If the company does so, it must disclose in its annual SEC filings each

NASDAQ requirement that is not followed and describe the alternative home country practice. 514

514 Id. §4350(a).

A foreign private issuer making its initial public offering or first U.S. listing on NASDAQ is required tomake these same disclosures in its registration statement. Additionally, the issuer must have an auditcommittee that satisfies the audit committee responsibilities and independence requirements that are

found in SEC Rule 10A-3, Listing Standards Relating to Audit Committees. 515

515 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of1934, Rule 10A-3, Listing Standards Relating to Audit Committee.

b. Management Investment Companies

Management investment and business development companies are subject to all the NASDAQqualitative listing requirements, except that management investment companies subject to theInvestment Company Act of 1940 are exempt from: (1) the independent director requirements, and (2)

the provision to adopt a code of conduct. 516

516 NASDAQ Manual, §4350(a).

c. Asset-Backed Issuers and Other Passive Issuers

The following types of entities are exempt from those provisions pertaining to director independence, as

well as the requirements to form an audit committee and adopt a code of conduct: 517


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517 Id.

• Asset-backed issuers;

• Other passive entities;

• Unit investment trusts that are organized as trusts;

• Other unincorporated associations that –

• Do not have a board of directors or persons acting in a similar capacity, and

• Engage in activities that are limited to passively owning or holding, as well asadministering and distributing, amounts associated with securities, rights, collateral orother assets on behalf of, or for the benefit of, the holders of the listed securities.

d. Cooperatives

Cooperative entities, such as agricultural cooperatives, are often structured solely to comply withrelevant state law and with federal tax law. Typically, they do not have a publicly traded class ofcommon stock. These entities are exempt from the requirements that deal with the independence ofdirectors. Nevertheless, they must comply with all federal securities laws, including Section 10A(m) ofthe Exchange Act, Standards Relating to Audit Committees, and Rule 10A-3, Listing Standards Relating

to Audit Committees. 518

518 Id.

e. Controlled Companies

A “controlled company” is a company in which more than 50% of the voting power is held by anindividual, a group, or another company. These companies are exempt from the requirement that the

board is to consist of a majority of independent directors. 519 Nevertheless, those independent directorson the board must hold regularly scheduled executive sessions. A controlled company that relies on thisexemption is required to disclose that it is a controlled company and the rationale for its designation assuch. These disclosures are to appear in the annual proxy or, if a proxy statement is not filed, in the

Form 10-K (or Form 20-F, if a foreign private issuer). 520

519 Id. §4350(c)(5).

520 Id.

E. Corporate Governance Summary and Illustrative Cases

The previous sections provide an extensive discussion of the numerous corporate governance featuresthat have emerged in the wake of Sarbanes-Oxley. These measures are summarized in Worksheet 27.When appropriately implemented, corporate governance measures provide an effective mechanism forpreventing and detecting deceptive practices. Worksheet 28 contains a number of SEC enforcementactions that illustrate how corporate governance failures can lead to the inappropriate use of companyassets and services.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis V. Financial Statement Audit Issues

A. AICPA Audit Rules


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The controlling audit pronouncement dealing with related parties is AICPA Statement on AuditingStandards 45, Omnibus Statement on Auditing Standards–1983, which supersedes AICPA Statement onAuditing Standards 6, Related Party Transactions. SAS 45 is codified as AU Section 334, Related Parties,in AICPA, Professional Standards, Vol. 1.

Planning Point: Management should become familiar with auditing requirementsdealing with related party transactions because such an awareness can aid inmanagement's development of effective controls for assuring the proper accounting anddisclosure of related party transactions. Such controls can facilitate a SOX 404 audit ofinternal control. Moreover, management can better prepare not only for both the auditof internal controls, but also for the audit of financial statements. Supplying externalauditors with the necessary documentation and accounting records will help assure asmooth-functioning audit and can reduce audit fees.

1. Accounting Considerations

As indicated in Section II.A, above, FASB ASC 850 sets out the accounting and disclosure requirementsfor related party transactions. Although the accounting treatment of related party transactions is usuallynot different from those transactions between or among unrelated parties, the nature of related partytransactions requires special considerations. Accordingly, the adequacy of disclosure is of primaryimportance. This caution is warranted since related party transactions are not always what they purportto be. As noted in SAS 45, “… the auditor should be aware that the substance of a particular transactioncould be significantly different from its form and that financial statements should recognize the

substance of particular transactions rather than merely their legal form.” 521

521 AU §334.02.

Comment: The issuance of SAS 6 in 1975 was unusual in that this standard effectuallypromulgated accounting rules for the disclosure of related party transactions. Noaccounting pronouncements on related parties were in force at the time, except for rulesconcerning the classification of receivables found in ARB 43. In fact, an accountingpronouncement dealing specifically with related party transactions was not publisheduntil 1982, when FASB issued FAS 57, which does not differ substantially from SAS 6.FASB remarked at the time it issued FAS 57, “The Board has not undertaken acomprehensive reconsideration of the accounting and reporting issues discussed in SAS6 and related interpretations thereof. The related party disclosure requirementscontained in those documents have been extracted without significant change, exceptthat this Statement does not address the issues pertaining to economic dependency.”522 SAS 6 had required consideration of one entity's economic dependence on another,for example, a large retailer being the sole customer of a small supplier. SAS 6 indicatedthat disclosure of the relationship may be necessary if one entity exercises “significant

management or ownership influence over the other.” 523 FASB indicated it may take upthis issue at a later time. One other notable difference is the succinctness of FAS 57compared to SAS 6. This aspect can be a blessing in today's world of overly prescriptiveaccounting pronouncements. The downside is that the codified rules under FASB ASC850, which are based primarily on FAS 57, provide less guidance.

522 FAS 57, ¶ 10 (background material not codified).

523 AICPA Statement on Auditing Standards No. 6, Related PartyTransactions (1975).

Auditing standards caution auditors to be alert to certain types of transactions whose nature suggests

that they may be of the kind consummated with related parties, including: 524

524 AU §334.03.


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• Borrowing or lending on an interest-free basis or at a rate significantly above or belowmarket rates prevailing at the time of the transaction;

• Selling real estate at a price that differs significantly from its appraised value;

• Exchanging property for similar property in a nonmonetary transaction; and

• Making loans with no scheduled terms for when or how the funds will be repaid.

Comment: Even if transactions between related parties are not recorded, they are considered

to be related party transactions. 525

525 FASB ASC 850-10-05-5; FAS 57, ¶ 1. See also AU §334.03 n.3.

2. Audit Procedures

An audit designed to reveal the proper treatment of related party transactions should generally have thefollowing seven steps:

• Carrying out procedures to become aware of the possible existence of related partytransactions;

• Becoming familiar with the dynamics, business model and processes by obtaining athorough understanding of the enterprise;

• Conducting procedures to become aware of existing conditions that may providemotivation for related party transactions;

• Determining the existence of related parties;

• Identifying transactions with related parties;

• Examining identified related party transactions; and

• Performing more extensive procedures when confronted with unusual or complexcircumstances.

a. Gaining an Awareness of Related Party Transactions

Paragraph 4 of AU Section 334 indicates that an audit performed in accordance with GAAP cannot be

expected to provide assurance that all related party transactions will be discovered. 526 Nevertheless, inaddition to being familiar with the disclosure requirements set out in FASB ASC 850, auditors arecautioned to be aware of the possible existence of related party transactions. As part of this process,

auditors are directed to obtain: 527

526 AU §334.04.

527 Id.

• The names of those individuals who are defined as related parties in FASB ASC 850; and

• A listing of common ownership or control relationships.

Throughout an engagement, auditors conduct many procedures that may reveal related partytransactions. Other procedures specifically targeting related party transactions are set out in SAS 45


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(AU §334).

Comment: While Paragraph 4 of AU Section 334 indicates that an audit cannot be reliedon to reveal all related party transactions, an audit conducted in accordance withGenerally Accepted Auditing Standards is supposed to be designed to providereasonable assurance that material related party transactions are detected anddisclosed. In this regard, AU Section 110, Responsibilities and Functions of the

Independent Auditor, states: 528

528 AU §110.02.

The auditor has a responsibility to plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement, whether caused by error or fraud. Because of the natureof audit evidence and the characteristics of fraud, the auditor is able to obtainreasonable, but not absolute assurance that material misstatements aredetected.

Planning Point: In order to be more effective in uncovering material related partytransactions, auditors are directed to comply with all applicable auditing standards, especiallyAICPA Statement on Auditing Standards 99 (AU §316), Consideration of Fraud in a Financial

Statement Audit. 529 The successful prosecution of auditors has often come about becausedefendants were not able to satisfy the court that their audit procedures were effective andcomplete. With the passage of SOX, auditors have an additional defense. SOX Section 303

makes it unlawful for management to knowingly mislead an auditor. 530 Consequently, it is inmanagement's best interest to fully cooperate with auditors by revealing all known related partytransactions.

529 AU §316.

530 SOX §303(a).

b. Becoming Familiar With the Enterprise

Normally, the structure of the entity and the manner by which its operations are conducted are afunction of: (1) management's abilities and talents, (2) tax and legal considerations, (3) productdiversification, and (4) geographic dispersion. Nevertheless, corporate structure and/or operating style

may have been designed to conceal related party transactions. 531 For this reason, when determiningthe procedures for revealing, accounting for, and disclosing material related party transactions, auditors

are instructed to become aware of the many aspects of enterprise dynamics, including: 532

531 AU §334.05.

532 Id.

• An understanding of management responsibilities and operating style;

• The relationship of each component to the total entity;

• The business purpose served by each component; and

• Controls over management activities.

c. Indicators of Related Party Transactions

AU Section 334.06 indicates that an auditor should not assume that related party transactions are


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outside the ordinary course of business unless evidence indicates otherwise. 533 However, AU Section334.06 points out that certain conditions may have been the impetus for related party transactions,

including: 534

533 AU §334.06.

534 Id.

• A lack of sufficient working capital or credit to continue in business;

• An urgent desire for a continued favorable earnings record in the hope of supporting theprice of the company's stock;

• An overly optimistic earnings forecast;

• Dependence on a single or relatively few products;

• A declining industry characterized by a large number of business failures;

• Excess capacity;

• Significant litigation, especially litigation between stockholders and management; and

• Significant obsolescence dangers because the company is in a high-technology industry.

Each of the foregoing conditions may provide incentive for recording fraudulent related partytransactions or related party transactions that management is reluctant to disclose.

d. Determining the Existence of Related Parties

Early in the process, auditors should determine the parties that are related to the entity in order tocompile a listing of related parties and the possible existence of related party transactions. An initialstep consists of reviewing the corporate structure to ascertain the company's subsidiaries and investees.

In addition, AU Section 334.07 suggests following these procedures: 535

535 AU §334.07.

• Evaluating the company's internal procedures aimed at identifying and properly accountingfor related party transactions;

• Asking management to supply the names of all related parties;

• Inquiring whether there were any transactions with the related parties that managementhas identified;

• Reviewing filings with the SEC and other regulatory agencies to ascertain the names ofrelated parties and other businesses in which officers and directors may hold managementor directorship positions;

• Obtaining the names of all pensions and other trusts established for the benefit ofemployees, as well as the names of the officers and trustees of these entities;

• Reviewing stockholder listings of closely held companies to identify principal stockholders;

• Reviewing prior years' working papers for the names of known related parties;

• Inquiring of predecessor, principal, or other auditors of related entities concerning their


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knowledge of existing relationships and the extent of management involvement in materialtransactions; and

• Reviewing material investment transactions during the period under audit to determinewhether the nature and extent of investments during the period create related parties.

If part of the audit examination is being conducted by other auditors, the principal auditor and the otherauditors are to exchange information on known related parties. This discussion should take place early

in the planning stages of the engagement. 536

536 AU §§9334.12 and .13

In addition to the procedures outlined above, an auditor should consider obtaining representations fromsenior management and the board of directors as to whether they have engaged in transactions with

the entity during the period covered by the audit engagement. 537 Auditing standards point out thatthere are risks associated with management's representations in that management is not anindependent source of evidence. Accordingly, auditing standards caution auditors to assess any financialstatement assertions regarding related party transactions with more scrutiny than those associated withother types of evidential matter. The reason is that management may be using related party

transactions to conceal fraud, defalcations, or undisclosed compensation. 538

537 AU §§9334.20 and .21.

538 AU §9334.18.

e. Identifying Transactions With Related Parties

Once auditors identify parties that are related to the entity under examination, subsequent steps

include: 539

539 AU §334.08.

• Determining whether there were transactions between the identified parties and theentity; and

• Identifying transactions that may indicate the existence of related parties that the auditorswere previously unaware of.

AU Section 334.08 enumerates the following procedures that are aimed at achieving these two

objectives: 540

540 Id.

• Provide audit personnel performing segments of the audit or auditing and reportingseparately on the accounts of related components of the reporting entity with the names ofknown related parties so that they may become aware of transactions with such partiesduring their audits;

• Review the minutes of meetings of the board of directors and executive or operatingcommittees for information about material transactions authorized or discussed at theirmeetings;

• Review proxy and other material filed with the SEC and comparable data filed with other


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regulatory agencies for information about material transactions with related parties; and

• Review conflict-of-interest statements.

Planning Point: Conflict-of-interest statements can benefit both management andauditors since they are a good tool for revealing previously unidentified related partytransactions. Many organizations direct the internal audit department to canvass allemployees to determine the existence of conflicts of interest and, ultimately, relatedparty transactions.

Here are additional procedures often used by auditors to identify transactions with related

parties: 541

541 Id.

• Review the extent and nature of business transacted with major customers, suppliers,borrowers, and lenders for indications of previously undisclosed relationships;

• Consider whether transactions are occurring, but are not being given accountingrecognition, such as receiving or providing accounting, management or other services at nocharge, or a major stockholder absorbing corporate expenses;

• Review accounting records for large, unusual, or nonrecurring transactions or balances,paying particular attention to transactions recognized at or near the end of the reportingperiod;

• Review confirmations of compensating balance arrangements for indications that balancesare or were maintained for or by related parties;

• Review invoices from law firms that have performed regular or special services for thecompany for indications of the existence of related parties or related party transactions; and

• Review confirmations of loans receivable and payable for indications of guarantees anddetermine their nature and the relationships, if any, of the guarantors to the reportingentity.

f. Examining Related Party Transactions

Having identified related party transactions, the next step is to apply auditing procedures to obtainsufficient, competent evidential matter. Auditors' procedures should be extensive enough to determinethe purpose and extent of related party transactions and their impact, if any, on the financial

statements. 542

542 AU §334.09.

Inquiry of management is a starting point for these purposes. However, taken alone, managementrepresentations do not constitute sufficient competent evidence. Accordingly, management

representations need to be corroborated with supporting evidence. 543

543 Id.

AU Section 334.09 states that an auditor should consider utilizing the following procedures to examine

the related party transactions that were identified: 544


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544 Id.

• Obtain an understanding of the business purpose of the transaction;

• Examine invoices, executed copies of agreements, contracts, and other pertinentdocuments, such as receiving reports and shipping documents;

• Determine whether the transaction has been approved by the board of directors or otherappropriate officials;

• Test for reasonableness the compilation of amounts to be disclosed, or considered fordisclosure, in the financial statements;

• Arrange for the audits of intercompany account balances to be performed at concurrentdates, even if the fiscal years differ, and for the examination of specified, important, andrepresentative related party transactions for each of the related parties, with appropriateexchanges of relevant information; and

• Inspect or confirm and obtain satisfaction concerning the transferability and value ofcollateral.

Auditors' procedures should be extensive enough to provide reasonable assurance that the financialstatements are free of material misstatement. Since the true nature of related party transactions maybe purposefully obscured, such transactions represent a greater audit risk than similar transactionscarried out at arm's-length. Accordingly, auditors are cautioned to scrutinize related party transactionsmore closely. In assessing audit risk, auditors are to obtain an understanding of the business purpose ofthe transaction. Unless auditors understand the business purpose, an audit cannot be completed

without having a scope limitation that would preclude an unqualified opinion. 545 Understanding thepurpose of related party transactions may require consulting with experts having the requisiteknowledge of the transactions. In addition, auditors may have to obtain the audited or unauditedfinancial statements of the related party and apply audit procedures at the related party's premises,

and/or audit the financial statements of the related party. 546

545 For a more detailed treatment of auditors' opinions, see 5400, Auditors' Reports(Accounting Policy and Practice Series).

546 AU §§9334.17 and .19.

The so-called Continental Vending case illustrates the importance of auditing a related party's financial

statements when questions remain unanswered. 547 In that case, Harold Roth, president of ContinentalVending, directed funds to be diverted to Valley Commercial Corporation, a company in which Roth hada controlling interest. Roth diverted funds to Valley, thereby creating a large receivable on Continental'sbalance sheet. When Roth was unable to repay, Continental Vending went into receivership. Theauditors declined to examine Valley's financial statements. Had they done so, they probably would havediscovered that the receivable from Valley was worthless. The auditors were found guilty of filing falsestatements in violation of the Securities Exchange Act of 1934.

547 U.S. v. Simon, 425 F.2d 796 (2d Cir.1969).

Planning Point: This case illustrates the joint responsibility of management andauditors for the sufficiency of evidence. Auditors need to attain sufficient competentevidence even if that means auditing an affiliate. Management is responsible forproviding access to the financial statements and records of all affiliated entities.

When there is a principal auditor-other auditor relationship, the principal auditor may perform the audit


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of the affiliate's books, or may request the other auditor to do so. If the other auditor has alreadyconducted the audit, the principal auditor should request relevant portions of those working papers thatmay be required to understand complex or unusual transactions. The other auditor ordinarily should

allow the principal auditor access to those working papers. 548

548 AU §9334.15.

g. Performing More Extensive Procedures

In ordinary situations, the procedures enumerated in the preceding section may be sufficient. At times,auditors may need to conduct more extensive procedures in order to fully understand a related partytransaction or series of transactions. When unusual or complex situations are encountered, auditors aresupposed to consider modifying the nature, extent, and/or timing of audit procedures. In such

circumstances, AU Section 334.10 suggests that auditors carry out the following procedures: 549

549 AU §334.10.

• Confirm transaction amounts and terms, including guarantees and other significant data,with the other party or parties to the transaction;

• Inspect evidence in possession of the other party or parties to the transaction;

• Confirm or discuss significant information with intermediaries, such as banks, guarantors,agents, or attorneys, to obtain a better understanding of the transaction;

• Refer to financial publications, trade journals, credit agencies, and other informationsources when there is reason to believe that unfamiliar customers, suppliers, or otherbusiness enterprises with which material amounts of business have been transacted maylack substance; and

• With respect to material uncollected balances, guarantees, and other obligations, obtaininformation about the financial capability of the other party or parties to the transaction.

The foregoing information may be obtained from:

• Audited financial statements;

• Unaudited financial statements;

• Income tax returns; and

• Reports issued by regulatory agencies, taxing authorities, financial publications, or creditagencies.

With regard to determining the financial viability of a counterparty, auditors should assure that he orshe has obtained an adequate degree of assurance. When the available information does not providesufficient assurance regarding the other party's financial viability, there is a limitation on the scope of

the audit, which necessitates a modified audit opinion. 550

550 See generally AU §§334.10.e, 508.22.

h. Adequacy of Financial Statement Disclosures

The disclosures required by FASB ASC 850 are outlined in Section II.A.2, above. To adequately addressthese disclosure requirements, AU Section 334.11 instructs an auditor to gain an understanding of: (1)


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the relationship of the parties involved, and (2) the effect of related party transactions on the financial

statements for each: 551

551 AU §334.11.

• Material related party transaction (or aggregation of similar transactions);

• Common ownership; and/or

• Control relationship.

An auditor is cautioned to obtain sufficient, competent evidence to assure that he or she has anunderstanding of each of the foregoing. When an auditor is convinced that he or she has obtainedenough evidence to gain the required understanding, the auditor will evaluate all the available evidenceand decide whether: (1) the disclosures are adequate, (2) the transactions have been properlyaccounted for, and (3) all requirements set out in FASB ASC 850 have been addressed.

If management omits related party disclosures required to make the financial statements notmisleading, auditing standards stipulate a qualified or adverse opinion. AU Section 431, Adequacy ofDisclosure in Financial Statements, indicates that an auditor should provide the omitted information inhis or her report if that is practicable. In this context, the term practicable means that “the informationis reasonably obtainable from management's accounts and records and that providing the information inthe report does not require the auditor to assume the position of a preparer of financial information.”552

552 AU §431.03.

i. Representations That Infer Comparability With Arm's-Length Transactions

At times, preparers of financial statements and reports may include statements to the extent thatrelated party transactions were entered into under terms equivalent to those prevailing in arm's-lengthtransactions. If these representations are included, the preparer must be able to substantiate them inaccordance with FASB ASC 850, which states that such representations cannot be included in financial

statement disclosures unless the representations can be substantiated. 553 (See Section II.A.4, above.)Since it is usually not possible to ascertain comparability to arm's-length transactions, suchrepresentations are difficult to substantiate. If these representations are included and an auditorbelieves they are unsubstantiated, a modified opinion is called for. Depending on the materiality of thetransactions, auditing standards call for a qualified or adverse opinion due to a departure from GAAP.554

553 FASB ASC 850-10-50-5; FAS 57, ¶ 3.

554 AU §334.12. Opinion modifications due to a departure from GAAP because of inadequatedisclosure are found in AU §508.41.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis V. Financial Statement Audit Issues

B. PCAOB Audit Rules

SOX requires public accounting firms that audit public companies to register with the Public CompanyAccounting Oversight Board (PCAOB) and adhere to professional standards established by that Board foraudits of public companies. On June 5, 2003, the SEC issued Release No. 33-8238 to implement Section404(a) of SOX, which requires management to include in the annual report to shareholders their


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assessment of the effectiveness of the company's internal control. Under Section 404(b) of SOX, the

company's external auditors must attest to and report on this assessment. 555 In that same year, thePCAOB issued PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial ReportingPerformed in Conjunction With an Audit of Financial Statements, to provide guidance to external

auditors. 556 Three years later, this standard was superseded by PCAOB Auditing Standard No. 5, AnAudit of Internal Control Over Financial Reporting That Is Integrated With An Audit of Financial

Statements. 557

555 This requirement pertains to accelerated filers for their fiscal years beginning on or afterNovember 15, 2004. Accelerated filers are defined in SEC Release Nos. 33-8128 and33-8128A. See Management's Report on Internal Control Over Financial Reporting andCertification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8392,Exchange Act Release No. 49,313, Investment Company Act Release No. 26,357, 69 Fed.Reg. 9722 (Mar. 1, 2004). After several SEC extensions to delay this requirement fornon-accelerated filers, Congress granted non-accelerated filers a permanent exemption fromSection 404(b) of SOX. Dodd-Frank Wall Street Reform and Consumer Protection Act,111-203, §989G (July 21, 2010) (amending Section 404 of SOX). See 5402, InternalControls: Sarbanes-Oxley Act §404 and Beyond (Accounting Policy and Practice Series), atSection III.A.

556 PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial ReportingPerformed in Conjunction With an Audit of Financial Statements (Mar. 9, 2004).

557 PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial ReportingThat Is Integrated With An Audit of Financial Statements (May 24, 2007).

1. Approach to the Audit

PCAOB Auditing Standard No. 5 differs from PCAOB Auditing Standard No. 2 in that PCAOB Auditing

Standard No. 5 takes a “top-down approach,” beginning with an assessment of overall control risks. 558

Accordingly, the auditor is to identify risks that controls will not prevent, detect, and/or correct financialstatement errors. The focus begins with controls at the entity level and works down to significantaccounts, classes of transactions, and financial statement disclosures. Entity-level controls include, forexample, audit committee oversight, the internal audit function, and codes of ethics. Next isidentification of the financial statement assertions that are related to accounts, classes of transactions,and disclosures. After confirming his or her understanding of the company's processes and controlprocedures, the auditor assesses the control risks associated with all assertions pertaining to theaforementioned accounts, classifications, and disclosures.

558 Id. ¶ 21.

With these assessments, the auditor is in a position to select controls for testing. Those that areselected should address control risks that have been identified for each of the relevant financialstatement assertions associated with the significant accounts, classes of transactions, and disclosures.559 Having tested those controls, the auditor evaluates any deficiencies and communicates them, as

well as any control weaknesses, to appropriate company officials. 560 The auditor also obtains written

representations from management concerning the effectiveness of internal control. 561

559 Id. ¶ 39.

560 Id. ¶¶ 62-70, 78-84.

561 Id. ¶¶ 75-77.

The auditor's opinion on the effectiveness of internal control over financial reporting relates to a point in

time and taken as a whole. 562 The time dimension implies that the auditor must be assured that


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controls have operated effectively for a sufficient length of time. The idea behind “internal control takenas a whole” is that there is evidence of little control risk for all financial statement assertions that areassociated with the identified significant accounts, classes of transactions, and financial statementdisclosures. An unqualified opinion is precluded if any material weaknesses in internal control areidentified. In that instance, the auditor is required to render an adverse opinion on the effectiveness of

internal control over financial reporting. 563

562 Id. ¶¶ B1-B2.

563 Id. ¶ 90.

Comment: Unlike the earlier standard, PCAOB Auditing Standard No. 5 does not requirea report on management's assessment of internal control unless that assessment is

deficient in some respect. 564 The auditor is required to modify the audit report ifmanagement's internal control certifications required by SOX Section 302 and the

Securities Exchange Act are misstated. 565

564 Id. ¶ C2.

565 Id. ¶¶ C1, C15; Securities Exchange Act of 1934, Rules 13a-14(a) and15d-14(a).

2. Related Party Aspects of an Internal Control Audit

Embedded within the internal control audit are a number of considerations dealing specifically withrelated parties and related party transactions. The issues include:

• Fraud considerations;

• Identifying significant accounts;

• Evaluating deficiencies in internal control over financial reporting; and

• The effect of substantive procedures on the auditor's conclusions about the operatingeffectiveness of controls.

Each of these topics is discussed in the following sections.

a. Fraud Considerations

Management is responsible for establishing controls designed to prevent, deter, and detect fraud. Suchcontrols, in conjunction with a culture of honesty and integrity, can contribute significantly towardreducing the incentives and opportunity to commit fraud. Controls designed specifically to address therisk of fraud are typically of a broad and overarching nature and therefore are pervasive throughout theorganization. PCAOB Auditing Standard No. 5 specifically states that controls over related party

transactions are important in addressing the risk of fraud. 566 Examples of these types of controlsinclude audit committee oversight, internal audit, self-assessment, internal risk assessment, and conflictof interest statements. PCAOB Auditing Standard No. 5 requires auditors to identify risks that materialmisstatements may occur due to fraud and evaluate whether controls adequately address those risks.567

566 PCAOB Auditing Standard No. 5, ¶ 14.

567 Id.

b. Identifying Significant Accounts


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The top-down approach of PCAOB Auditing Standard No. 5 begins with an assessment of overall controlrisks, a procedure that, of necessity, requires the auditor to obtain an understanding of the company'sbusiness processes, operations, and accounting and control procedures. Having obtained thisorganizational knowledge, the auditor is in a position to identify those accounts, classes of transactions,and financial statement disclosures that are significant. The term “significant,” as used in the standard,means those accounts and disclosures that have a reasonable possibility of being materially misstated.568 Accordingly, identifying significant accounts is an important aspect of determining the scope of theinternal control audit.

568 Id. ¶ A10.

PCAOB Auditing Standard No. 5 indicates that an auditor needs to evaluate the qualitative andquantitative risk factors that are associated with the various financial statement line items anddisclosures. The auditor should consider the following risk factors when deciding which accounts pose

significant exposure. The existence of related party transactions is among these considerations: 569

569 Id. ¶ 29.

• Size and composition of the account;

• Susceptibility to misstatement due to errors or fraud;

• Volume of activity, complexity, and homogeneity of the individual transactions processedthrough the account or reflected in the disclosure;

• Nature of the account or disclosure (for example, suspense accounts generally warrantgreater attention);

• Accounting and reporting complexities associated with the account or disclosure;

• Exposure to losses in the account (for example, loss accruals related to a consolidatedconstruction contracting subsidiary);

• Likelihood (or possibility) of significant contingent liabilities arising from the activitiesreflected in the account or disclosure;

• Existence of related party transactions in the account [emphasis added]; and

• Changes from the prior period in the characteristics of the account or disclosure (forexample, new complexities, altered circumstances, increased subjectivity or new types oftransactions).

Comment: Although the dollar amounts of related party transactions in an account maybe important, a more significant aspect of these transactions is the possibility offraudulent activities.

c. Evaluating Control Deficiencies

Auditors may find that a company's controls are insufficient to assure the timely disclosure of relatedparty transactions. Whether this finding would preclude the issuance of an unqualified opinion dependson the severity of the control deficiency and the likely impact on the financial statements. According toPCAOB Auditing Standard No. 5, an internal control deficiency exists when the design or operation of a

control does not allow for the timely prevention or detection of misstatements. 570 Paragraph A11 ofthe Standard defines a significant internal control deficiency as one that is less severe than a materialweakness but sufficiently important to warrant attention from those who are responsible for overseeing


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the financial reporting process (e.g., the audit committee of the board of directors). 571

570 Id. ¶ A2.

571 Id. ¶ A11.

Example: A company does not reconcile its intercompany transactions. If the auditor expectsthe impact of a misstatement to be significant but not material, the deficiency would beconsidered a significant deficiency but not a material weakness because the impact on thefinancial statements is not material.

To formulate an opinion on internal control, an auditor has to evaluate all the evidence obtained in theaudit. If the auditor finds that controls are unreliable and that a material weakness exists, PCAOBAuditing Standard No. 5 calls for an adverse opinion on the effectiveness of internal control.

Paragraph A7 defines a material weakness as, “… a deficiency, or combination of deficiencies, in internalcontrol over financial reporting such that there is a reasonable possibility that a material misstatement

of the annual or interim financial statements will not be prevented or detected on a timely basis.” 572

The term “reasonable possibility” used in PCAOB Auditing Standard No. 5 is not analogous to the term

“reasonably possible” as used in FASB ASC 450, Contingencies. 573 In PCAOB Auditing Standard No. 5,the term reasonable possibility contemplates a broader probability range encompassing the two FASB

ASC 450 intervals: “reasonably possible” and “probable.” 574

572 Id. ¶ A7.

573 FASB ASC Term “Reasonably Possible”; FASB Statement No. 5, Accounting forContingencies, ¶ 3. (“[T]he chance of the future event or events occurring is more thanremote but less than likely.”).

574 PCAOB Auditing Standard No. 5, ¶ A7.

Identifying material weaknesses requires auditors to: (1) examine identified deficiencies to determinewhether any should be classified as “significant deficiencies,” and (2) consider whether to classify any ofthe significant deficiencies as “material weaknesses.” Considerable professional judgment is requiredwhen assessing the significance of a deficiency. Auditors should consider:

• The potential for a misstatement, not whether a misstatement has actually occurred;

• The impact of a deficiency, including the amounts or totals of transactions exposed andthe volume of transactions in the affected accounts; and

• How the interaction of controls with other controls, including their interdependence andredundancies, affects their proper functioning.

Differentiating a significant deficiency from a material weakness is highly subjective. The distinguishingcharacteristic of a material weakness is the existence of a reasonable possibility that a materialmisstatement will not be prevented or detected on a timely basis. Determining just what constitutes amaterial weakness is a tough call. The difficulty lies in operationalizing the phrase “reasonablepossibility.” A practical way for an auditor to proceed is as follows:

• Estimate the monetary impact of each weakness uncovered;

• Assign a “material misstatement likelihood factor” to each weakness, for example,“remote,” “reasonably possible,” “probable,” similar to the labels found in FAS 5;

• Rank all weaknesses on this material misstatement likelihood factor;

• Denote all weaknesses with more than a remote likelihood as “material weaknesses;”


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• Determine the “significance” of the remaining deficiencies by reviewing the estimatedmonetary impact of each; and

• Examine those deficiencies designated “significant” to decide whether a combinationthereof constitutes a material weakness.

d. Effect of Substantive Procedures

A significant component of a financial statement audit consists of testing dollar amounts. These testingprocedures are termed substantive tests. The results of these tests may directly impact an auditor'sassessment of the adequacy of internal control. For example, substantive testing may reveal a materialmisstatement in the financial statements. If this misstatement was not identified by the company, theusual conclusion is that a material control weakness exists. Accordingly, the stronger the company'scontrols, the lower the likelihood of a material misstatement that may result in an adverse opinion onthe controls.

According to PCAOB Statement No. 5, auditors are required to evaluate the possible impact ofsubstantive audit testing and assess the implications of the results as they pertain to the effectivenessof internal control. This evaluation normally will include, but not necessarily be limited to, the following:575

575 Id. ¶ B8.

• “The auditor's risk assessments in connection with the selection and application ofsubstantive procedures, especially those related to fraud;

• Findings with respect to illegal acts and related party transactions [emphasis added];

• Indications of management bias in making accounting estimates and in selectingaccounting principles; and

• Misstatements detected by substantive procedures.”

The magnitude of any misstatements that are uncovered by substantive testing might alter an auditor'sjudgment about the effectiveness of the company's internal control. Related party transactions occupy aprominent position in considering the impact of the financial statement audit on the adequacy of internalcontrol over financial reporting.

e. Impact of Related Party Transactions on an Audit of Internal Control

This Portfolio illustrates the pervasiveness of related party transactions in financial reporting. In thecontext of evaluating the adequacy of internal control, related party transactions can impact thefollowing aspects of an external auditor's internal control audit: (1) the evaluation of controls developedby management to assess the risk of fraud, (2) the identification of accounts for testing, (3) theevaluation of deficiencies in internal control, and (4) the impact of substantive testing on the evaluationof control effectiveness.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

TABLE OF WORKSHEETS

B-101 Worksheet 1 Principal Acronyms and Abbreviations Used in Portfolio

B-201 Worksheet 2 FASB ASC 850 Definitions: Excerpts From FASB ASC850 Glossary


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B-301 Worksheet 3 Disclosures Required by FASB ASC 850: Excerpts FromAnnual Report of McKesson Corporation, Inc. on Form10-K (Mar. 31, 2007)

B-401 Worksheet 4 Disclosures Required by FASB ASC 850 in ConsolidatedStatements: Excerpts From Annual Report of HurcoCompanies, Inc. on Form 10-K (Oct. 31, 2006)

B-501 Worksheet 5 Regulation S-K, Section 404(a) Disclosures—Transactions WithRelated Persons: Excerpts From Atmel CorporationProxyStatement on Schedule 14A (Jul. 9, 2007)

B-601 Worksheet 6 Regulation S-K, Section 404(a) Lease Disclosures—Transactions With Related Persons: Excerpts FromFrozen Food Express Industries, Inc. Proxy Statement

B-701 Worksheet 7 Regulation S-K, Section 404(a) IndebtednessDisclosures: Excerpts From Amgen, Inc. ProxyStatement on Schedule 14A (Mar. 22, 2006)

B-801 Worksheet 8 Regulation S-K, Section 404(b) Disclosure of Processfor Reviewing Transactions With Related Parties:Excerpts From General Electric Company's ProxyStatement on Schedule 14A (Feb. 27, 2007)

B-901 Worksheet 9 Regulation S-K, Section 404(c) Disclosure ofTransactions WithPromoters: Excerpts From 21st Century Telesis, Inc.Form 10(Aug. 19, 1998)

B-1001 Worksheet 10 EITF Issue No. 02-5: Definition of “Common Control”in Relation to FASB Statement No. 141

B-1101 Worksheet 11 EITF 85-21: Changes of Ownership Resulting in a NewBasis ofAccounting

B-1201 Worksheet 12 Nonmonetary Transactions: Definitions: Excerpts FromFASB Current Standards, Nonmonetary Transactions

B-1301 Worksheet 13 Nonmonetary Exchanges—Unrelated Parties andRelated Parties Not Under Common Control: ExchangeHaving CommercialSubstance—Gain

B-1401 Worksheet 14 Nonmonetary Exchanges—Unrelated Parties andRelated Parties Not Under Common Control: ExchangeHaving CommercialSubstance—Loss

B-1501 Worksheet 15 Nonmonetary Exchanges—Unrelated Parties andRelated Parties Not Under Common Control: ExchangeWithout CommercialSubstance—Gain

B-1601 Worksheet 16 Nonmonetary Exchanges—Unrelated Parties andRelated Parties Not Under Common Control: ExchangeWithout CommercialSubstance—Loss

B-1701 Worksheet 17 Nonmonetary Exchanges—Exchange Between RelatedParties Under Common Control


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B-1801 Worksheet 18 Disclosure of Nonmonetary Exchange Among RelatedParties:Excerpts From The Coca-Cola Company, Form 10-K,Item 9(Dec. 31, 2004)

B-1901 Worksheet 19 Transfers of Financial Instruments: Definitions—Excerpts From FASB Current Standards FinancialInstruments: Transfers

B-2001 Worksheet 20 Leases: Definitions—Excerpts From FASB CurrentStandards, Leases

B-2101 Worksheet 21 Regulation S-K, Item 406 Code of Ethics: ExcerptsFrom North American Scientific, Inc.'s ProxyStatement on Schedule 14A(Apr. 25, 2007)

B-2201 Worksheet 22 New York Stock Exchange Listed Company Manual,Section 303A.02(a), Disclosures Pertaining to DirectorIndependence:Excerpts From General Electric Company's ProxyStatement on Schedule 14A (Feb. 27, 2007)

B-2301 Worksheet 23 New York Stock Exchange Listed Company Manual,CorporateGovernance Guidelines (June 1, 2006)

B-2401 Worksheet 24 New York Stock Exchange Listed CompanyManual—Code of Ethics Guidelines

B-2501 Worksheet 25 Sample Disclosure of Corporate GovernanceDifferences—NYSE Listed Company Manual Section303A.11: Excerpts From ElanCorporation's Web site: www.elan.com

B-2601 Worksheet 26 NASDAQ Definition of an Independent Director—Excerpts From NASDAQ Manual Section 4200Definitions: Independent Director

B-2701 Worksheet 27 Summary of Corporate Governance Features

B-2801 Worksheet 28 SEC Enforcement Actions


Worksheet 1 Principal Acronyms and Abbreviations Used in Portfolio

AICPA American Institute of Certified PublicAccountants

• National member organization forCPAs• Plays a significant role in developingthe profession and GAAP• Has primary role in the developmentof standards for tax services andauditing

APB Accounting Principles Board • Predecessor of the FASB• Formed by the AICPA• Existed from 1959-1973• Issued 31 APB Opinions

ARB Accounting Research Bulletin • Piece of authoritative accountingliterature• Issued by the Committee on


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Accounting Procedures• Earliest predecessor of the FASB• Existed from 1939-1959

ASB Auditing Standards Board • An AICPA technical committee• Produces auditing guides, Statementson Auditing Standards, and Statementson Standards for AttestationEngagements• Successor to Auditing StandardsExecutive Committee• Issues only auditing standards forprivate companies as standards forpublic companies now issued by thePCAOB

AS Auditing Standard • Auditing pronouncement issued by thePCAOB

AU Auditing Standards Section of AICPAProfessional Standards

• AICPA Professional Standards are thecurrent text version of Statements onAuditing Standards (SASs)

BTR Blackout Trading Restrictions • SEC regulation governing sales ofsecurities• Purpose is to prevent directors andofficers from trading in a company'ssecurities during periods when pensionplan participants are unable to do so

CON Statement of Financial AccountingConcepts

• Issued by the Financial AccountingStandards Board• Sets forth fundamentals on whichfinancial accounting and reportingstandards are based

EITF Emerging Issues Task Force • Formed by FASB in 1984• Issues consensus opinions helping toset standards for complicated issueswhere there is often no otherauthoritative guidance

ERISA Employee Retirement Income SecurityAct

• Sets standards for most voluntarilyestablished pension plans in privateindustry

FAS Financial Accounting Standard • FASB Statement of AccountingStandards

FASB Financial Accounting Standards Board • Formed in 1973• Plays most significant role indeveloping U.S. GAAP• Issues Statements of FinancialAccounting Standards (FASs) andInterpretations• Issues Technical Bulletins• Issues “Qs and As”• Issues Statements of FinancialAccounting Concepts

IASB International Accounting StandardsBoard

• Standard-setting body forinternational accounting standards• Successor to International AccountingStandards Committee


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• Issues International FinancialReporting Standards (IFRSs)

IASC International Accounting StandardsCommittee

• Predecessor standard-setting body toInternational Accounting StandardsBoard (IASB)• Issued International AccountingStandards (IASs)• IASs have authority equal tostandards issued by the InternationalAccounting Standards Board

ISB Independence Standard Board • An AICPA technical committee• Issues standards dealing withauditors' independence issues• Produces Independence BoardStandards (ISBs)

NASDAQ National Association of Securities DealersAutomated Quotations

• A national stock exchange• Sets forth rules and regulations forissuers of listed securities

NYSE New York Stock Exchange • A national stock exchange• Issues rules and regulations for listedcompanies

PCAOB Public Company Accounting OversightBoard

• Created by Sarbanes-Oxley Act of2002• Oversees the auditors of publiccompanies• Sets standards for the audits of publiccompanies• Issues Auditing Standards• Successor to the ASB for standardspertaining to audits of public companies(as of April 16, 2003)

SAB Staff Accounting Bulletin • Staff Accounting Bulletins issued bythe SEC

SEC Securities and Exchange Commission • Enforces the Securities Act of 1933 andthe Securities Exchange Act of 1934• Issues Regulations• Issues Accounting and AuditingEnforcement Releases (AAERs)

SAS Statement on Auditing Standards • Statements issued by the AICPA'sAuditing Standards Board• All SASs pertaining to public companieswere adopted by the PCAOB

S-K Regulation S-K • SEC Regulation governingnon-financial disclosures in filings withthe Commission

S-X Regulation S-X • SEC Regulation governing thedisclosures in financial statementsincluded with SEC filings

SOP Statement of Position • Statements issued by the AICPA• Most often issued by variouscommittees


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SOX Sarbanes-Oxley Act of 2002 • A United States federal law designedto reform the oversight of publiccompany audits and protect investors• Created the PCAOB• Contains wide-ranging corporategovernance provisions


Worksheet 2 FAS 57 Definitions

Excerpts From FASB ASC 850 Glossary 11

11 FASB ASC 850-20.

Affiliate. A party that, directly or indirectly through one or more intermediaries, controls, iscontrolled by, or is under common control with an entity.

Control. The possession, direct or indirect, of the power to direct or cause the direction ofthe management and policies of an entity through ownership, by contract, or otherwise.

Immediate family. Family members who might control or influence a principal owner or amember of management, or who might be controlled or influenced by a principal owner or amember of management, because of the family relationship.

Management. Persons who are responsible for achieving the objectives of the entity andwho have the authority to establish policies and make decisions by which those objectivesare to be pursued. Management normally includes members of the board of directors, thechief executive officer, chief operating officer, vice presidents in charge of principal businessfunctions (such as sales, administration, or finance), and other persons who perform similarpolicymaking functions. Persons without formal titles also may be members of management.

Principal owners. Owners of record or known beneficial owners of more than 10 percent ofthe voting interests of the enterprise.

Related parties. Affiliates of the entity; entities for which investments in their equitysecurities would be required, absent the election of the fair value option, are accounted forby the equity method by the investing entity; trusts for the benefit of employees, such aspension and profit-sharing trusts that are managed by or under the trusteeship ofmanagement; principal owners of the entity and members of their immediate families;management of the entity and members of their immediate families; other parties withwhich the enterprise may deal if one party controls or can significantly influence themanagement or operating policies of the other to an extent that one of the transactingparties might be prevented from fully pursuing its own separate interests; and other partiesthat can significantly influence the management or operating policies of the transactingparties or that have an ownership interest in one of the transacting parties and cansignificantly influence the other to an extent that one or more of the transacting partiesmight be prevented from fully pursuing its own separate interests.


Worksheet 3 Disclosures Required by FASB ASC 850


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Excerpts From Annual Report of McKesson Corporation, Inc. on Form 10-K

(Mar. 31, 2007)

McKESSON CORPORATIONFINANCIAL NOTES (Continued)

20. Related Party Balances and Transactions

Notes receivable outstanding from certain of our current and former officers and senior managerstotaled $25 million and $45 million at March 31, 2007 and 2006. These notes related to purchases ofcommon stock under our various employee stock purchase plans. The notes bear interest at ratesranging from 4.7 % to 7.1 % and were due at various dates through February 2004. Interest income onthese notes is recognized only to the extent that cash is received. These notes, which are included inother capital in the consolidated balance sheets, were issued for amounts equal to the market value ofthe stock on the date of the purchase and are full recourse to the borrower. At March 31, 2007, thevalue of the underlying stock collateral was $20 million. The collectability of these notes is evaluated onan ongoing basis. As a result, we recorded net credits of $2 million, $9 million and $6 million in 2007,2006 and 2005 based on changes in price of the underlying stock collateral. At March 31, 2007 and2006, we provided a reserve of approximately $6 million and $12 million for the outstanding notes.Other receivable balances held with related parties, consisting of loans made to certain officers andsenior managers and an equity-held investment, at March 31, 2007 and 2006 amounted to $1 million.

In 2007, 2006 and 2005 we incurred approximately $7 million to $8 million annually of rental expensepaid to an equity-held investment. In addition, in 2007, 2006 and 2005 we purchased $3 million ofservices per year from an equity-held investment. At March 31, 2007, we had a $6 million loanreceivable from an equity held investment. The loan bears interest at 7.9%.


Worksheet 4 Disclosures Required by FASB ASC 850 in ConsolidatedStatements

Excerpts From Annual Report of Hurco Companies, Inc. on Form 10-K(Oct. 31, 2006)

HURCO COMPANIES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

9. RELATED PARTY TRANSACTIONS

We own approximately 24% of one of our Taiwanese-based contract manufacturers. This investment of$1.3 million is accounted for using the equity method and is included in Investments and Other Assetson the Consolidated Balance Sheets. Purchases of product from this contract manufacturer totaled $2.0million, $2.7 million and $4.4 million for the years ended October 31, 2006, 2005 and 2004,respectively. Sales of product to this contract manufacturer were $70,000, $117,000 and $199,000 infiscal 2006, 2005 and 2004 respectively. Trade payables to this contract manufacturer were $256,000at October 31, 2006, and $509,000 at October 31, 2005. Trade receivables were $32,000 at October31, 2006, and $136,000 at October 31, 2005.

As of October 31, 2006, we owned 35% of Hurco Automation, Ltd. (HAL), a Taiwan based company.


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HAL's scope of activities includes the design, manufacture, sales and distribution of industrialautomation products, software systems and related components, including control systems andcomponents produced under contract for sale exclusively to us. We are accounting for this investmentusing the equity method. The investment of $2.0 million at October 31, 2006 is included in Investmentsand Other Assets on the Consolidated Balance Sheets. Purchases of product from this supplieramounted to $10.5 million, $7.7 million and $6.6 million in 2006, 2005 and 2004, respectively. Sales ofproduct to this supplier were $2.0 million, $1.8 million and $1.9 million for the years ended October 31,2006, 2005 and 2004, respectively. Trade payables to HAL were $1.9 million and $1.6 million atOctober 31, 2006 and 2005, respectively. Trade receivables from HAL were $235,000 and $242,000 atOctober 31, 2006 and 2005, respectively.

Summary financial information for the two affiliates accounted for using the equity method ofaccounting is as follows:

(in thousands) 2006 2005 2004

Net Sales $ 58,286 $ 50,896 $ 23,469

Gross Profit 10,932 8,947 7,780

Operating Income 4,209 2,676 2,210

Net Income 3,727 2,313 1,479

Current Assets $ 27,903 $ 21,553 $ 16,194

Non-current Assets 7,684 1,824 2,031

Current Liabilities 20,156 14,857 17,215


Worksheet 5 Regulation S-K, Section 404(a) DisclosuresTransactions With Related Persons

Excerpts From Atmel Corporation Proxy Statement on Schedule 14A(Jul. 9, 2007)

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

In accordance with the charter for the Audit Committee, our Audit Committee reviews and approves inadvance in writing any proposed related person transactions. The most significant related persontransactions, as determined by the Audit Committee, must be reviewed and approved in writing inadvance by our Board. Any related person transaction will be disclosed in the applicable SEC filing asrequired by the rules of the SEC. For purposes of these procedures, “related person” and “transaction”have the meanings contained in Item 404 of Regulation S-K. During 2006, we paid approximately$250,000 to MartSoft Corporation pursuant to a development agreement. The Chief Executive Officer ofMartSoft is the wife of Tsung-Ching Wu, Ph.D., an executive officer and director of Atmel.


Worksheet 6 Regulation S–K, Section 404(a) Lease DisclosuresTransactions With Related Persons


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Excerpts From Frozen Food Express Industries, Inc.Proxy Statement on Schedule 14A(Aug. 29, 2006)

Regulation S-K, Section 404(a) Lease Disclosures


Worksheet 7 Regulation S-K, Section 404(a) Indebtedness DisclosuresExcerpts From Amgen, Inc. Proxy Statement on Schedule 14A(Mar. 22, 2006)

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Loans to Executive Officers

As a result of the Sarbanes-Oxley Act, the Company no longer makes personal loans to executiveofficers that are prohibited by such act. Prior to the Sarbanes-Oxley Act, the Company had madepersonal loans to the executive officers of the Company listed below, generally in connection with theirrelocation closer to the Company. The annual interest rate on the loans to each officer, except the loanto Mr. Nanula, was 3% during the year ended December 31, 2005 and will be 3% for the year endingDecember 31, 2006. These interest rates are established and adjusted annually based on the averageintroductory rates on adjustable loans offered by California banks and savings and loans. The loan toMr. Nanula is fixed at 5% for the term of the loan.

NameDate of

Loan

OriginalAmount of

Loan($)

LargestAggregate

IndebtednessSince

January 1,2005($)

AggregateOutstanding

Indebtednessat

March 13,2006($)

MaturityDate (1)

Hassan Dayem July 2002 500,000 500,000 0

George J.Morrow

March 2001 1,000,000 500,000 0

Richard D.Nanula

June 2001 3,000,000 3,162,500 3,105,000 June 2010

Roger M.Perlmutter

June 2001 1,000,000 1,000,000 1,000,000 June 2006


Worksheet 8 Regulation S-K, Section 404(b) Disclosure of ProcessFor Reviewing Transactions With Related Parties

Excerpts From General Electric Company's Proxy Statement on Schedule 14A(Feb. 27, 2007)


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Certain Relationships and Related Person Transactions

Review and Approval of Related Person Transactions. We review all relationships and transactions inwhich the company and our directors and executive officers or their immediate family members areparticipants to determine whether such persons have a direct or indirect material interest. Thecompany's legal staff is primarily responsible for the development and implementation of processes andcontrols to obtain information from the directors and executive officers with respect to related persontransactions and for then determining, based on the facts and circumstances, whether the company or arelated person has a direct or indirect material interest in the transaction. As required under SEC rules,transactions that are determined to be directly or indirectly material to the company or a related personare disclosed in the company's proxy statement. In addition, the Audit Committee reviews and approvesor ratifies any related person transaction that is required to be disclosed. As set forth in the AuditCommittee's key practices, in the course of its review and approval or ratification of a disclosablerelated party transaction, the committee considers:

• the nature of the related person's interest in the transaction;

• the material terms of the transaction, including, without limitation, the amountand type of transaction;

• the importance of the transaction to the related person;

• the importance of the transaction to the company;

• whether the transaction would impair the judgment of a director or executiveofficer to act in the best interest of the company; and

• any other matters the committee deems appropriate.

Any member of the Audit Committee who is a related person with respect to a transaction under reviewmay not participate in the deliberations or vote respecting approval or ratification of the transaction,provided, however, that such director may be counted in determining the presence of a quorum at ameeting of the committee that considers the transaction.


Worksheet 9 Regulation S-K, Section 404(c)Disclosure of Transactions With PromotersExcerpts From 21st Century Telesis, Inc. Form 10 (Aug. 19, 1998)

Item 7 – Certain Relationships and Related Transactions

(a) Transactions with management and others

Philip J. Chasmar and Jeffery V. Barbieri, both of whom are promoters and directors of registrant,control Aventine, Inc., a Texas corporation which in turn owns all the outstanding capital stock ofAtlantic-Pacific Financial, Inc., an NASD broker-dealer which has participated in private placements ofthe securities of registrant. For the twelve months ended September 30, 1996 registrant paid brokeragecommissions of $453,512 to Atlantic-Pacific Financial for sale of registrant's securities, and $618,648 forthe comparable period ended September 30, 1997. Registrant also paid finders fees and fees formarketing consulting to Aventine totaling $1,010,444 for the twelve months ended September 30, 1996and $436,959 for the like period ended September 30, 1997. Aventine, Inc. paid salaries of $45,000during calendar year 1996 to each of Messrs. Chasmar and Barbieri, and to Mr. Lawrence Kaufman, apromoter and a director of registrant, and $62,000 each to Messrs. Chasmar, Barbieri and Kaufman forcalendar year 1997.


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During December, 1996 and January, 1997 registrant paid a total of $174,104 to Hart Engineers, atelecommunications engineering firm owned by Mr. Robert Andrew Hart IV, the Chairman and ChiefExecutive Officer of registrant, and one of registrant's promoters. The payments were reimbursementsfor advances made by Hart Engineers for the benefit of registrant, principally during the period prior tothe commencement of and during the FCC's PCS auctions. Registrant utilizes the services of HartEngineers to provide engineering oversight services for the deployment of registrant's PCS systems. Thearrangement, as authorized by registrant's board, calls for Hart Engineers to be compensated for suchservices on a time and materials basis, at rates not to exceed those customary in the industry forservices of like character. Registrant paid $227,170 to Hart Engineers for services for the twelve monthperiod ended September 30, 1997, and had an unpaid balance of an additional approximately $254,752as of such date . . ..

(d) Transactions with Promoters

Registrant was formed through the promotional efforts of Messrs. Robert Andrew Hart IV, Philip J.Chasmar, Jeffery V. Barbieri, Lawrence Kaufman and Dion Whitman. All five individuals continue toserve in executive capacities, and all save Mr. Whitman are members of registrant's board of directors.Compensation received by the promoters is as shown in Item 7 (a) above and Item 6. The ownership ofregistrant's stock by each promoter is shown in Item 4. All shares shown in Item 4 were issued forservices rendered by the promoters.


Worksheet 10 EITF Issue No. 02-5: Definition of “Common Control”in Relation to FASB Statement No. 141

FASB Emerging Issues Task forceEITF 02-5 Dates Discussed

March 20–21, 2002; June 19-20, 2002

EITF 02-5 References

FASB Statement No. 141, Business Combinations

FASB Technical Bulletin No. 85-5, Issues Relating to Accounting for Business Combinations

AICPA Accounting Research Bulletin No. 51, Consolidated Financial Statements

APB Opinion No. 16, Business Combinations

AICPA Accounting Interpretation 27, “Entities Under Common Control in a Business Combination,” ofAPB Opinion No. 16

AICPA Accounting Interpretation 39, “Transfers and Exchanges Between Companies Under CommonControl,” of APB Opinion No. 16

EITF 02-5 ISSUE

1. Consistent with the guidance previously provided in Opinion 16, paragraph 11 of Statement 141provides that the term business combination excludes transfers of net assets or exchanges of equityinterests between entities under common control. Paragraph D12 of Statement 141 further providesthat, in those situations, related assets and liabilities are to be recorded at their carrying amounts at thedate of transfer. However, neither Opinion 16 nor Statement 141 defines the term common control.

2. Questions exist with respect to whether separate entities are under common control when commonmajority ownership exists by an individual, a family, or a group affiliated in some other manner. Forexample, some suggest that the accounting should presume that immediate family members will votetheir shares in concert absent evidence to the contrary. If that presumption is appropriate, an additional


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issue is how to define “immediate family member.” Further, some question whether companies ownedby individuals that are not members of an immediate family could ever be under common control.

3. The FASB staff understands that the SEC staff has indicated that common control exists between (oramong) separate entities only in the following situations:

a. An individual or enterprise holds more than 50 percent of the voting ownership interest of eachentity.

b. Immediate family members hold more than 50 percent of the voting ownership interest of each entity(with no evidence that those family members will vote their shares in any way other than in concert).

(1) Immediate family members include a married couple and their children, but not the married couple'sgrandchildren.

(2) Entities might be owned in varying combinations among living siblings and their children. Thosesituations would require careful consideration regarding the substance of the ownership and votingrelationships.

c. A group of shareholders holds more than 50 percent of the voting ownership interest of each entity,and contemporaneous written evidence of an agreement to vote a majority of the entities' shares inconcert exists.

4. The issue is how to determine whether separate entities are under common control in the context ofStatement 141 when common majority ownership exists by an individual, a family, or a group affiliatedin some other manner.

EITF 02-5 DISCUSSION

5. The Task Force did not reach a consensus on the issue of how to determine whether common controlof separate entities exists. The Task Force discussed the practice being followed by SEC registrants.Some Task Force members expressed uncertainty as to whether common control might exist insituations other than those described above.

6. Additionally, the Task Force noted that the FASB expects to address this Issue in its businesscombinations project.

7. The SEC Observer stated that SEC registrants should continue to follow the guidance in paragraph 3,above, when determining whether common control of separate entities exists.

EITF 02-5 STATUS

No further EITF discussion is planned.


Worksheet 11 EITF 85-21: Changes of Ownership Resulting in a New Basisof Accounting

FASB Emerging Issues Task ForceEITF 85-21 Dates Discussed

June 27, 1985; September 4, 1986; October 16, 1986

EITF 85-21 References

FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries

AICPA Issues Paper, “Push Down” Accounting , dated October 30, 1979

SEC Staff Accounting Bulletin No. 54, Application of “Push Down” Basis of Accounting in Financial


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Statements of Subsidiaries Acquired by Purchase

EITF 85-21 ISSUE

What level of ownership change in a company should result in a new basis of accounting for thatcompany?

How would the new basis of accounting be computed? At what amount would minority interests bereported?

EITF 85-21 DISCUSSION

The Task Force was unable to reach a consensus on this issue. One Task Force member indicated, andothers agreed, that current practice with respect to application of a new basis is diverse. Severalmembers stated that this diversity results from lack of authoritative guidance and inconsistent positionstaken about the applicability of new basis accounting as expressed in SAB 54 when the situationinvolves less than 100 percent acquisition of a company or when step acquisitions are involved.

The SEC Observer stated that new basis accounting is being required (with one exception) only in thosesituations in which there is both virtually a 100 percent acquisition (for example, 97 percent) and nooutstanding publicly held debt or preferred stock. Any inconsistencies in application are unintended andmay have resulted because not all registrant filings are examined. The SEC Observer stated that theSEC staff's views on carrying over historical cost to record, in the separate financial statements of eachentity, transfers between companies under common control or between a parent and its subsidiary runprimarily to transfers of net assets (as in a business combination) or long-lived assets.

Those views would not normally apply to recurring transactions for which valuation is not in question(such as routine transfers of inventory) in the separate financial statements of each entity that is aparty to the transaction.

The Task Force members were not in agreement as to whether new basis accounting is acceptable forprivately held companies. One Task Force member indicated that the authoritative literature could beread to support the practice. One Task Force member indicated that a concept of the reporting entitywould be helpful. Some Task Force members indicated a need for FASB guidance. The Task ForceChairman encouraged Task Force members as well as the SEC to provide the FASB staff with examplesof new basis accounting.

EITF 85-21 STATUS

In October 1987, the FASB issued Statement 94, which addresses the consolidation of allmajority-owned subsidiaries. However, Statement 94 does not address the above issue. Issues affectingreporting by an entity that is or has been a subsidiary (which include so-called push-down or new basisaccounting questions) will be addressed in later stages of the FASB's project on the reporting entity,including consolidations and the equity method.

No further EITF discussion is planned.


Worksheet 12 Nonmonetary Transactions: Definitions

Excerpts From FASB Current Standards, Nonmonetary Transactions 1

1 APB 29, ¶¶ 1-3.

Exchange (or exchange transaction). A reciprocal transfer between an enterprise andanother entity that results in the enterprise's acquiring assets or services or satisfyingliabilities by surrendering other assets or services or incurring other obligations. A reciprocal


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transfer of a nonmonetary asset shall be deemed an exchange only if the transferor has nosubstantial continuing involvement in the transferred asset such that the usual risks andrewards of ownership of the asset are transferred.

Monetary assets (and liabilities). Assets and liabilities whose amounts are fixed in termsof units of currency by contract or otherwise. Examples are cash, short- or long-termaccounts and notes receivable in cash, and short- or long-term accounts and notes payablein cash.

Nonmonetary assets and (liabilities). Assets and liabilities other than monetary ones.Examples are inventories; investments in common stocks; property, plant, and equipment;and liabilities for rent collected in advance.

Nonmonetary transactions. Exchanges and nonreciprocal transfers that involve little orno monetary assets or liabilities.

Nonreciprocal transfer. A transfer of assets or services in one direction, either from anenterprise to its owners (whether or not in exchange for their ownership interests) oranother entity or from owners or another entity to the enterprise. An enterprise'sreacquisition of its outstanding stock is an example of a nonreciprocal transfer.

Productive assets. Assets held for or used in the production of goods or services by theenterprise. Productive assets include an investment in another entity if the investment isaccounted for by the equity method but exclude an investment not accounted for by thatmethod.

Similar productive assets. Productive assets that are of the same general type, thatperform the same function or that are employed in the same line of business.


Worksheet 13 Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common ControlExchange Having Commercial Substance – Gain

Assumptions Prior to Exchange

Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $ 1,100 forAsset B having a fair value of $1,400. Company A pays $300 cash in addition to transferring Asset A.

Company A Company B Recorded amount of AssetA

$ 600 Recorded amount of AssetB

$1,200

Fair value of Asset A $ 1,100 Fair value of Asset B $1,400

Cash paid 300 Cash paid -0-

Total value surrendered $ 1,400 Total value surrendered $1,400

Accounting Entries

Each company records the asset received at the fair value of the assets surrendered and recognizes again:

CompanyA

CompanyB

Dr Cr Dr Cr

Asset B 1,400 Asset A 1,100

Asset A 600 Cash 300

Cash 300 Asset B 1,200


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Gain 500 Gain 200

Computation of Gain Computation of Gain

Fair value of Asset A $1,100 Fair value of Asset B $1,400

Book value 600 Book value 1,200

Gain $500 Gain $200


Worksheet 14 Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common ControlExchange Having Commercial Substance – Loss


Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $400 forAsset B having a fair value of $900. Company A pays $500 cash in addition to the Asset A exchanged.

Company A Company B Recorded amount of Asset A $600 Recorded amount of Asset B $1,200

Fair value of Asset A $400 Fair value of Asset B $900


Total value surrendered $900 Total value surrendered $900

Accounting Entries

Each company records the asset received at the fair value of the assets surrendered and recognizes aloss:

Company A Company B

Dr Cr Dr Cr

Asset B 900 Asset A 400

Loss 200 Cash 500

Asset A 600 Loss 300


Computation of Loss Computation of Loss



Loss ($200) Loss ($300)


Worksheet 15 Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common ControlExchange Without Commercial Substance – Gain


Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $1,100 forAsset B having a fair value of $1,400. Company A pays $300 cash in addition to transferring Asset A.


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$1,200




Accounting EntriesCompany A

Company A records the exchange at the recorded amount of the asset surrendered plus the cash paidwithout recognizing a gain:

Dr Cr

Asset B 900

Asset A 600

Cash 300

Company B

Company B records the exchange by realizing a gain on a proportionate amount of the assetsurrendered (Asset B). The proportion is based on the cash received. The contention is that the amountof cash received represents the proportion of Asset B that was sold. The proportion assumed to be

“sold” is the ratio of the cash received to the total value received. *Asset A is recognized at its recordedamount less the proportion sold ($1,200 - $257=$943).

Dr Cr

Asset A 943

Cash 300

Asset B 1,200

Gain 43

Computation of Gain Cashreceived

300 Fair value ofAsset B

$1,400 Realized

Total valuereceived

1,400 Book value 1,200 Gain

Proportion“sold”

21.4% × Gain $200 = $43

* Proportion sold: 300

____ × $1,200 = $257

1400


Worksheet 16 Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common ControlExchange Without Commercial Substance – Loss


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Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $400 forAsset B having a fair value of $900. Company A pays $500 cash in addition to the Asset A exchanged.

Company A Company B Recorded amount of Asset A $600 Recorded amount of Asset B $1,200



Total value surrendered $900 Total value surrendered 900

Accounting Entries

Each company records the asset received at recorded amounts recognizing any loss indicated by theexchange:

Company A Company B

Dr Cr Dr Cr

Asset B 900 Asset A 400

Loss 200 Cash 500

Asset A 600 Loss 300


Computation of Loss Computation of Loss



Loss ($200) Loss ($300)

Company A records Asset B at the amount of the assets surrendered. Company B records thetransaction using the recorded amount of Asset B given up, recognizing the loss on Asset B. Asset Acannot be recorded at an amount greater than its fair value.


Worksheet 17 Nonmonetary ExchangesExchange Between Related Parties Under Common Control

Assumptions Prior to Transfer

Companies A and B are affiliates under common control. A and B exchange assets. Company Aexchanges Asset A having a fair value of $1,100 for Asset B having a fair value of $1,400. Company Apays $300 cash in addition to the Asset A exchanged.



$1,200




Accounting EntriesCompany A

Company A records the exchange at carry-over amounts without recognizing a gain. Any difference


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between cash paid (or the fair value of liabilities assumed) and the carrying value of the asset receivedis recorded in an equity account.*

Dr Cr

Asset B 1,200

Asset A 600

Cash 300

Equity* 300

Company B

Company B records the exchange using carry-over amounts. No loss is recognized. Any differencebetween cash received (or the fair value of liabilities discharged) and the carrying value of the assetreceived is recorded in equity.

Dr Cr

Asset A 600

Cash 300

Equity* 300

Asset B 1,200

*For example, Accumulated Other Comprehensive Income


Worksheet 18 Disclosure of Nonmonetary Exchange Among RelatedPartiesExcerpts From The Coca-Cola Company, Form 10-K, Item 9(Dec. 31, 2004)

NOTE 2: BOTTLING INVESTMENTS (Continued)

Effective May 6, 2003, one of our Company's equity method investees, Coca-Cola FEMSA consummateda merger with another of the Company's equity method investees, Panamerican Beverages, Inc.(‘‘Panamco”). Our Company received new Coca-Cola FEMSA shares in exchange for all Panamco sharespreviously held by the Company. Our Company's ownership interest in Coca-Cola FEMSA increased from30 percent to approximately 40 percent as a result of this merger. This exchange of shares was treatedas a nonmonetary exchange of similar productive assets, and no gain was recorded by our Company asa result of this merger.


Worksheet 19 Transfers of Financial Instruments: Definitions

Excerpts From FASB Current Standards Financial Instruments: Transfers 1

1 FAS 140, ¶ 364.

Beneficial interests. Rights to receive all or portions of specified cash inflows to a trust orother entity, including senior and subordinated shares of interest, principal, or other cashinflows to be “passed-through” or “paid-through,” premiums due to guarantors, commercial


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paper obligations, and residual interests, whether in the form of debt or equity.

Benefits of servicing. Revenues from contractually specified servicing fees, late charges,and other ancillary sources, including “float.”

Cleanup call. An option held by the servicer or its affiliate, which may be the transferor, topurchase the remaining transferred financial assets, or the remaining beneficial interests notheld by the transferor, its affiliates, or its agents in a qualifying SPE (or in a series ofbeneficial interests in transferred assets within a qualifying SPE), if the amount ofoutstanding assets or beneficial interests falls to a level at which the cost of servicing thoseassets or beneficial interests becomes burdensome in relation to the benefits of servicing.

Collateral. Personal or real property in which a security interest has been given.

Derecognize. Remove previously recognized assets or liabilities from the statement offinancial position.

Financial asset. Cash, evidence of an ownership interest in an entity, or a contract thatconveys to a second entity a contractual right (a) to receive cash or another financialinstrument from a first entity or (b) to exchange other financial instruments on potentiallyfavorable terms with the first entity.

Financial liability. A contract that imposes on one entity a contractual obligation (a) todeliver cash or another financial instrument to a second entity or (b) to exchange otherfinancial instruments on potentially unfavorable terms with the second entity.

Proceeds. Cash, derivatives, or other assets that are obtained in a transfer of financialassets, less any liabilities incurred.

Recourse. The right of a transferee of receivables to receive payment from the transferorof those receivables for (a) failure of debtors to pay when due, (b) the effects ofprepayments, or (c) adjustments resulting from defects in the eligibility of the transferredreceivables.

Seller. A transferor that relinquishes control over financial assets by transferring them to atransferee in exchange for consideration.

Servicing asset . A contract to service financial assets under which the estimated futurerevenues from contractually specified servicing fees, late charges, and other ancillaryrevenues are expected to more than adequately compensate the servicer for performing theservicing. A servicing contract is either (a) undertaken in conjunction with selling orsecuritizing the financial assets being serviced or (b) purchased or assumed separately.

Servicing liability. A contract to service financial assets under which the estimated futurerevenues from contractually specified servicing fees, late charges, and other ancillaryrevenues are not expected to adequately compensate the servicer for performing theservicing.

Transfer . The conveyance of a noncash financial asset by and to someone other than theissuer of that financial asset. Thus, a transfer includes selling a receivable, putting it into asecuritization trust, or posting it as collateral but excludes the origination of that receivable,the settlement of that receivable, or the restructuring of that receivable into a security in atroubled debt restructuring.

Transferee. An entity that receives a financial asset, a portion of a financial asset, or agroup of financial assets from a transferor.

Transferor. An entity that transfers a financial asset, a portion of a financial asset, or agroup of financial assets that it controls to another entity.


Worksheet 20 Leases: Definitions

Excerpts From FASB Current Standards, Leases


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Bargain purchase option. A provision allowing the lessee, at the lessee's option, topurchase the leased property for a price that is sufficiently lower than the expected fairvalue of the property at the date the option becomes exercisable that exercise of the optionappears, at the inception of the lease, to be reasonably assured. FAS 13, ¶ 5(d).

Estimated economic life of leased property. The estimated remaining period duringwhich the property is expected to be economically usable by one or more users, with normalrepairs and maintenance, for the purpose for which it was intended at the inception of thelease, without limitation by the lease term. FAS 13, ¶ 5(g).

Estimated residual value of leased property. The estimated fair value of the leasedproperty at the end of the lease term. FAS 13, ¶ 5(h).

Executory costs. Those costs such as insurance, maintenance, and taxes incurred forleased property, whether paid by the lessor or lessee. Amounts paid by a lessee inconsideration for a guarantee from an unrelated third party of the residual value are alsoexecutory costs. If executory costs are paid by a lessor, any lessor's profit on those costs isconsidered the same as executory costs. FAS 13, ¶¶ 7, 10.

Fair value of the leased property. The price that would be received to sell the property inan orderly transaction between market participants at the measurement date. Marketparticipants are buyers and sellers that are independent of the reporting entity, that is, theyare not related parties at the measurement date. FAS 13, ¶ 5(c).

Minimum Lease Payments.

From the standpoint of the lessee: The payments that the lessee is obligated to make or canbe required to make in connection with the leased property. Contingent rentals shall beexcluded from minimum lease payments. However, a guarantee by the lessee of the lessor'sdebt and the lessee's obligation to pay (apart from the rental payments) executory costs inconnection with the leased property shall be excluded. If the lease contains a bargainpurchase option, only the minimum rental payments over the lease term and the paymentcalled for by the bargain purchase option shall be included in the minimum lease payments.Otherwise, minimum lease payments include the following:(1) The minimum rental payments called for by the lease over the lease term.(2) Any guarantee by the lessee or any party related to the lessee of the residual value atthe expiration of the lease term, whether or not payment of the guarantee constitutes apurchase of the leased property. When the lessor has the right to require the lessee topurchase the property at termination of the lease for a certain or determinable amount, thatamount shall be considered a lessee guarantee. When the lessee agrees to make up anydeficiency below a stated amount in the lessor's realization of the residual value, theguarantee to be included in the minimum lease payments shall be the stated amount, ratherthan an estimate of the deficiency to be made up.(3) Any payment that the lessee must make or can be required to make upon failure torenew or extend the lease at the expiration of the lease term, whether or not the paymentwould constitute a purchase of the lease property. In this connection, it should be notedthat the definition of lease term includes “all periods, if any, for which failure to renew thelease imposes a penalty on the lessee in an amount such that renewal appears, at theinception of the lease, to be reasonably assured.” If the lease term has been extendedbecause of that provision, the related penalty shall not be included in minimum leasepayments.

From the standpoint of the lessor: The payments described above plus any guarantee of theresidual value or of rental payments beyond the lease term by a third party unrelated toeither the lessee or the lessor, provided the third party is financially capable of dischargingthe obligations that may arise from the guarantee. FAS 13, ¶ 5(j).



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Worksheet 21 Regulation S-K, Item 406 Code of EthicsExcerpts From North American Scientific, Inc.’s Proxy Statement onSchedule 14A (Apr. 25, 2007)

CODE OF ETHICS

The Company has a written Code of Ethics that applies to all employees, including our Chief ExecutiveOfficer, Chief Financial Officer, and Corporate Controller. The full text of the Company's Code of Ethics ispublished on our website at www.nasmedical.com under the “Investor Center-Corporate Governance”caption. The Company will disclose any future amendments to, or waivers from, certain provisions ofthe Code of Ethics applicable to our Chief Executive Officer, Chief Financial Officer and CorporateController on our website within four business days following the date of such amendment or waiver.

Excerpts From North American Scientific, Inc.’s Websitewww.nasmedical.com

North American ScientificBusiness Ethics Program

INTRODUCTION

North American Scientific (sometimes referred to as “the Company”) and its operating business unitsare dedicated to achieving our business objectives. At the same time, we are equally dedicated toachieving those objectives in accordance with the high ethical standards we have set in our Code ofEthics. Often, good common sense is all we need to act in an ethical manner. However, in somesituations, more guidance may be needed. That is the purpose of our Guidelines of Business Conduct.

Our Code of Ethics is a reflection of our core values. Our core values are:

* Professionalism and ethical behavior in all our actions

* Pursue innovation, creativity and discovery

* Quality in everything we do

* Commitment to unparalleled customer service, both internally and externally

* Success through teamwork

* Corporate growth that benefit our employees and shareholders

The nature and scope of North American Scientific's operations place a significant trust in individualemployees. North American Scientific rewards the contribution of its employees by providing challengingemployment as well as competitive compensation, benefits and retirement plans.

Employees over the years have understood and met the high ethical standards demanded by NorthAmerican Scientific. With continued growth and the addition of new operating units, however, it is


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appropriate to be more specific concerning how the Company's ethical standards apply to certainbusiness situations. For this reason North American Scientific has prepared the following BusinessConduct Guidelines and Code of Ethics, which apply to all units of the Company.

This booklet sets forth our Code of Ethics and our Guidelines for Business Conduct. It specifies thelegally correct and ethical conduct expected of employees in a variety of identified business situations.

However, this booklet does not and cannot cover every situation in which you will be faced with ethicalquestions. Questions will arise concerning interpretation, intent, and application. All such questionsshould be discussed with your supervisor, who will consult with an appropriate member of management.

All employees must comply with all applicable laws and regulations and must avoid situations that couldresult in the appearance of wrongdoing or impropriety under these guidelines. Any violation of theseguidelines that you become aware of must be reported immediately to any of the following:

• The Chief Executive Officer of North American Scientific

• The President of Theseus Imaging Corp.

• The Director of Human Resources/Legal Affairs of North American Scientific

If you prefer to make an anonymous report, you may submit a report, in writing, to any of the threepeople listed above, whereupon your request will be held in confidence.

As an employee of North American Scientific, you are expected to study the Guidelines and Code ofEthics, and to pledge personal commitment and compliance. A response card is provided for you tocertify your compliance with the program. All supervisory employees have a special obligation tomaintain exemplary business conduct as a model for their subordinates.

We are confident that North American Scientific people will appreciate this expression of the ethicalstandards that are vital to the continued success of the Company and its employees. All of us are on ateam. We must be able to depend on our teammates to support these standards for the mutual benefitof all of us.

L. Michael Cutrer

President & Chief Executive Officer

North American ScientificCode of Ethics

North American Scientific is committed to the highest standards of ethical business conduct. Thesestandards reflect our core values. We believe that adherence to these standards ensures our long-termsuccess, even though they may cause us to forgo some perceived near-term business opportunities.


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We expect the business behavior of the Company and each of its employees, directors and agents toconform to the following principles:

* We are committed to:

• Quality products and services, delivered on time and at competitive prices

• Mutually fair, responsible and beneficial arrangements with our suppliers

• Fairness, respect, and opportunity for all employees

• Competitive compensation and benefits

• Operating for prudent long-term growth while sustaining historic or improved operating ratios,sound and conservative financial policies and an attractive rate of return for our shareholders

• Ensuring that all company operations and products are safe and environmentally sound

• Communicating with competitors only under appropriate circumstances and in strict accordancewith the law

• Existing as a good corporate citizen in the communities in which we operate

* We will only employ persons who:

• Are qualified to fulfill their assigned responsibilities

• Make a commitment to quality in their work

• Have initiative and creativity

• Demonstrate high standards and integrity

• Have respect and concern for others

• Understand the value of teamwork in achieving the Company's business objectives

• Handle company assets prudently

• Are honest, accurate, complete, and timely in all Company communications and records

Our Code of Ethics can also be expressed as commitments to the following stakeholders in NorthAmerican Scientific:

Our Customers

Unless we consistently fulfill our customers' needs, we cannot serve any of our other stakeholders.Thus, we are committed to providing high quality products at competitive prices. We constantly strivefor technical excellence through innovation, creativity and discovery. We are forthright and honest inour communications and transactions with customers.

Our Shareholders

We are committed to providing a superior long-term return to our shareholders. We are also committedto protecting and improving the value of their investment through the prudent utilization of corporateresources and by observing the highest standards of legal and ethical conduct in all of our businessdealings.

Our Employees

Our employees are North American Scientific's most important resource. As such, we are committed totreating one another with respect and fairness. We respect each other's privacy and treat each other


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with dignity and respect regardless of age, race, color, gender, religion, disability, sexual orientation, ornationality. We will provide safe and healthy working conditions for every employee. We strive tomaintain an atmosphere of open communication.

Our Suppliers

We deal honestly and openly with our suppliers. We encourage competition and, at the same time,value our long-term relationships with suppliers.

Our Communities

North American Scientific is a good corporate citizen and we encourage and support all of ouremployees to be good citizens. We respect the environment and natural resources.

By their very nature, the Code of Ethics is a brief list of principles and values we believe are veryimportant. Additional topics and more detail are included in the Guidelines of Business Conduct. If moreclarification or guidance is needed, we urge employees to consult with management or the other listedCompany sources of assistance.

North American ScientificGuidelines of Business Conduct

Business Conduct Guideline #1

BE HONEST IN ALL BUSINESS DEALINGS

The Company expects its employees to be honest in dealings with all of its stakeholders, including:

* Fellow employees

* The Company

* Suppliers

* Customers

* All members of the business community

At some time or another, you may have the opportunity to profit, at the expense of the Company andfellow employees, by dishonesty. Such behavior could take the form of:

* Filing a false expense statement

* Accepting a bribe or kickback from a supplier

* Copying computer software

* Lying to a supervisor or customer concerning business facts, such as mischarging time on a companytime sheet

* Taking company products, supplies, or money, etc.


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The Company has taken precautions to reduce temptation and to encourage honesty. We would like tosee each of you enjoy a long-term, productive relationship with North American Scientific. We will nothesitate, however, to discharge and prosecute anyone who knowingly violates the rule of basic honesty,whether or not covered specifically by the Guidelines of Business Conduct.

Expense reports must be completed accurately and on time. Expenses must be properly documentedand only those that are reasonable and necessary to our business will be reimbursed. Personal expensesmust not be submitted to the Company for reimbursement. In addition, North American Scientific haspublished a Travel Policy which can be obtained through the Company's Finance Department. It isexpected that all employees will adhere to the guidelines set forth in the Travel Policy.


AVOID CONFLICTS OF INTEREST IN ANY FORM

A conflict of interest is a divided loyalty between the interests of North American Scientific and thepersonal interest of the employee. Employees must not allow personal considerations or relationships,whether actual or potential, to influence them in any way when representing the Company in dealingswith other persons or organizations. All of us have the obligation to avoid not only situations that giverise to a conflict of interest, but also those situations that create the appearance of a conflict of interest.You may encounter potential conflicts of interest in a variety of situations. Some of the most likely areasare:

* Relationships with customers or suppliers, especially relating to entertainment situations or gifts

* Financial or other dealings with outside organizations that do business with our Company

* Outside employment with any competitor, customer, or supplier of the Company, or any other outsideemployment arrangements that could jeopardize our interests or interfere with our productivity

You should not give or receive gifts or similar business courtesies without the approval of a director orabove at North American Scientific. There should never be a benefit given to a customer with an explicitor implicit requirement to use or purchase a North American Scientific product without the approval ofthe Legal Department or an Officer of the Company. If any questions arise about gifts, tickets, orbusiness-related gifts, please contact the Legal Department.

You should reexamine your investments, relationships and activities periodically to avoid becominginvolved in a conflict of interest. If you are in doubt concerning the propriety of any activity, you areobliged to review the situation with your supervisor. The Company reserves the right to determinewhether certain activities constitute a conflict of interest. If, after such determination and appropriatediscussion, you persist in engaging in such activities, discharge may result.


MAKE SURE THAT ALL ENTRIES IN THE BOOKS AND RECORDS OF NORTH AMERICANSCIENTIFIC ARE COMPLETE AND ACCURATE

All entries made in North American Scientific's books, records and accounts must properly and fairlyreflect the actual transactions being recorded, to the best knowledge, information, and belief of theemployee(s) making the entries. Any person who reports Company information (which likely comprises


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every employee of the Company in one fashion or another) is required to report such informationcompletely, correctly, and honestly.

Our policy expressly forbids the improper handling of our funds and assets. All funds and assets of theCompany must be disclosed and recorded properly; no undisclosed or unrecorded fund or asset of theCompany is to be established for any purpose.


DO NOT USE COMPANY FUNDS OR RESOURCES, DIRECTLY OR INDIRECTLY, FORUNAUTHORIZED POLITICAL OR CHARITABLE PURPOSES

In support of the democratic process, we encourage our employees to actively participate personally inpolitical activities which are kept separate from their work. If you are engaged in a political activity ofany kind, you must be careful not to use North American Scientific's name or resources, and ensure thatsuch activities do not adversely affect any business relationships. In addition, you should exercisediscretion in discussing political subjects with business contacts. If you have any questions about yourparticipation in political activities, you are obliged to discuss the situation with your supervisor.

Company funds or assets should not be used for making political contributions or personal contributionsto charity of any kind, whether in the United States or in a foreign country. This prohibition covers notonly direct contributions, but indirect support of candidates or political parties, for example, thepurchase of tickets for special dinners or other fund-raising events, the loan of employees to politicalparties or committees, the furnishing of transportation or duplicating services, etc. Company political orcharitable activity is limited to those matters which are:

1. Clearly lawful

2. Closely related to the interests of the Company, its employees, or its shareholders

3. Performed with the prior written approval of the President of North American Scientific


DO NOT USE THE COMPANY NAME, ASSETS OR INFORMATION FOR PERSONAL GAIN

North American Scientific's name, assets, and information belong to the Company, and not to individualemployees, regardless of their position in the Company.

Employees may not use the Company name in connection with personal activities, except as part ofbiographical summaries of work experience. If you intend to participate in meetings or publish materialswhere the Company name is coupled with the participant's or author's name, you must have advancewritten approval by the President of North American Scientific. In addition, any approved speech,presentation material, paper, or article to be published must be reviewed prior to publication by any ofthe following: President of North American Scientific, President of Theseus Imaging Corp., Director ofLegal Affairs of North American Scientific.

Employees should regard the protection of Company assets (both physical and intangible) and servicesas a vital responsibility. Company assets include Company manuals, samples, forms, plans, customer


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lists and files, software, and all other documents, writings, and copies used or relied upon in youremployment. These materials are proprietary and confidential to North American Scientific. They mustnot be used for personal benefit or any other improper purpose. They must not be sold, lent, givenaway, or otherwise disposed of, regardless of condition or value, except with proper authorization. Theymust be returned upon request or upon termination of employment. Personal use of Companytelephones and computers must be reasonable and may not interfere with the accomplishment of one'sassigned duties.

Company information is valuable both to the Company and to outsiders. Employees should follow theonly safe rule: Give to outsiders only information that is:

* Clearly immaterial

* Already available to the public (via press releases, annual reports, quarterly reports, filings with theSEC, etc.),

* Required to properly perform the job

* Not in response to a media inquiry. All media inquiries must be directed to an Officer of the Company

North American Scientific's Information Technology Department has established a prudent set ofcontrols to prevent unauthorized distribution of Company information. Access to classified orconfidential information stored on the mainframe computer system is controlled by a combination ofpasswords, physical access controls, and other security procedures. Similar security and controlmeasures have been established for individual computers within and outside the Company. For furtherinformation about these procedures, you should consult with North American Scientific's ChiefInformation Officer.

A specific area of concern relates to non-public information about the Company, positive or negative,that could have a material effect on the market price of the Company's securities. Please ensure thatyou have read and understood the Company's most recent policy on insider trading, entitled “InsiderTrading Policies and Related Conduct.” If you have any questions, or if you have not received thedocument and returned the acknowledgment, please contact North American Scientific's Director ofLegal Affairs.


REFRAIN FROM THE PROMOTION, USE, OR SELLING OF ILLEGAL DRUGS

Improper use of narcotics and other controlled substances has become a significant problem tobusinesses, employees and society in general. Their sale, use and abuse, when connected to theconduct of business and the work environment, can threaten the safety, morale and public image ofboth the Company and its employees. Because of our strong concern in this area, we have establishedthe following policy regarding illegal drugs:

1. No person will be hired who is known to be a promoter, user or seller of illegal drugs

2. Possession or use of illegal drugs on Company premises or during working hours, including break ormeal periods, or working under the influence of illegal drugs, is strictly prohibited. Violation of thispolicy may result in immediate disciplinary action, up to and including discharge

3. Employees who are found to be sellers or involved in the sale, solicitation, or dealing of illegal drugs


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will be subject to immediate discharge from the Company


EXERCISE GOOD JUDGMENT IN THE USE OF ALCOHOL

It is the Company's policy to discourage the use of alcoholic beverages during business hours, includinglunch. The possession or use of alcoholic beverages on Company premises, except for authorizedfunctions, is prohibited. Reporting to work or performing one's job assignments under the influence ofalcohol is a safety risk and will result in immediate disciplinary action, up to and including discharge.


STRICTLY ADHERE TO ALL SAFETY PROCEDURES, RULES AND REGULATIONS

North American Scientific considers employee safety and health as one of its highest priorities. Theproducts made by North American Scientific and handled by many of our employees require strictadherence to safety procedures, rules and regulations. Your safety and the safety of each of yourcolleagues depend upon constant safety consciousness.

Employees must report any unsafe situation to one of the following persons: President of NorthAmerican Scientific, President of Theseus Imaging Corp., Radiation Safety Officer, Alternate RadiationSafety Officer, Health Physicist, Director of Human Resources. In addition to complying with federal andstate safety and health laws and regulations, employees will receive training on and should be familiarwith the Company's safety and health policies.


UPHOLD LAWS WITH RESPECT TO COMPETITIVE PRACTICES

North American Scientific operates in highly competitive markets. As a result, antitrust laws are animportant fact of everyday business life. The antitrust laws are complex and must be strictly followed.Routine business decisions involving prices, terms and conditions of sale, dealings with suppliers andcustomers, and many other matters present sensitive situations under antitrust laws. The penalties forviolating antitrust laws can be severe. It is therefore essential that every Company employee be awareof the antitrust laws and guard against their violation.

North American Scientific employees should not:

* Discuss pricing or pricing practices with competitors

* Divide customers, markets, or territories with competitors

* Agree with anyone not to deal with another company

* Force a customer to buy one product in order to get another product

* Attempt to control a customer's resale price


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The purpose of these laws is to promote vigorous, free, and open competition in the marketplace.Competition helps ensure that the customer will get the best product at the lowest price. If in doubtabout whether a certain practice violates antitrust laws, employees should consult the LegalDepartment.

North American ScientificBusiness Ethics Program

IMPLEMENTATION

Employees are encouraged to seek advice about any issues raised by this booklet or encountered intheir work. Advice may be obtained from your supervisor or any other member of management. YourHuman Resources, Legal, Health Physics, Finance, and Information Technology Departments also canprovide specific advice.

Any employee who becomes aware of conduct inconsistent with this booklet should report itimmediately to appropriate management, as identified herein. Simply put, it is your duty to contactan appropriate member of management if you become aware of a violation of our Code ofEthics. Appropriate remedial action will be taken by the Company, up to and including termination ofemployment for offending parties. In addition, intentional violations may give rise to civil sanctions andcriminal prosecution.

Attempts to use the Business Ethics Program to libel, slander, or otherwise harm another individualthrough false accusations, malicious rumors, or other irresponsible actions are prohibited.

Also prohibited is reprisal or the threat of reprisal against an employee who, in good faith, raises aconcern about the implementation or enforcement of Company policy, including specifically theGuidelines of Business Conduct.

Such reprisal not only violates explicit Company policy, but also various federal and state laws andregulations.

COOPERATION WITH GOVERNMENT INVESTIGATIONS

If North American Scientific becomes involved in a government investigation regarding its operations,employees, customers, or suppliers, we will fully cooperate. North American Scientific will not alter ordestroy any Company documents in anticipation of government investigation. Furthermore, NorthAmerican Scientific will not lie or make any misleading statements to any government investigator orattempt to cause any other person to provide any false or misleading information.


Worksheet 22 New York Stock Exchange Listed Company ManualSection 303A.02(a)Disclosures Pertaining to Director Independence


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Excerpts From General Electric Company's Proxy Statement on Schedule 14A (Feb.27, 2007)

Director Independence. With 12 independent directors out of 16, the Board has satisfied its objectivethat at least two-thirds of the Board should consist of independent directors. For a director to beconsidered independent, the Board must determine that the director does not have any direct or indirectmaterial relationship with GE. The Board has established guidelines to assist it in determining directorindependence, which conform to, or are more exacting than, the independence requirements in the NewYork Stock Exchange listing standards. In addition to applying these guidelines, which are set forth inSection 4 of our Governance Principles and attached as Appendix B to this proxy statement, the Boardwill consider all relevant facts and circumstances in making an independence determination. Theindependent directors are named above under “Election of Directors.”

In the course of the Board's determination regarding the independence of each nonmanagementdirector, it considered any transactions, relationships and arrangements as required by the company'sindependence guidelines. In particular, with respect to each of the most recent three completed fiscalyears, the Board evaluated for:

• each of directors Gonzalez, Lafley and Lane, the annual amount of sales to GE by the company wherehe serves as an executive officer, and purchases by that company from GE, and determined that theamount of sales and the amount of purchases in each fiscal year was below one percent of the annualrevenues of each of those companies;

• director Jung, (1) the annual amount of purchases from GE by the company where she serves as anexecutive officer, and determined that the amount of purchases in each fiscal year was below onepercent of the annual revenues of that company, and (2) the total amount of that company'sindebtedness to GE, and determined that the amount of indebtedness was below one percent of thatcompany's total consolidated assets;

• director Hockfield, the annual amount of sales to GE by a company where one of her immediate familymembers serves as an executive officer, and determined that the amount of sales in each fiscal yearwas below one percent of the annual revenues of that company; and

• director Lazarus, the annual amount of sales to GE by the company where she serves as an executiveofficer, and determined that the amount of sales in each fiscal year was below one percent of the annualrevenues of that company.

In addition, with respect to directors Cash, Fudge, Gonzalez, Hockfield, Jung, Lafley, Lane, Larsen,Lazarus, Nunn, Swieringa and Warner, the Board considered the amount of GE's discretionary charitablecontributions to charitable organizations where he or she serves as an executive officer, director ortrustee, and determined that GE's contributions constituted less than the greater of $200,000 or onepercent of the charitable organization's annual consolidated gross revenues during the organization'slast completed fiscal year.

All members of the Audit, Management Development and Compensation, and Nominating and CorporateGovernance Committees must be independent directors as defined by the Board's GovernancePrinciples. Members of the Audit Committee must also satisfy a separate Securities and ExchangeCommission (SEC) independence requirement, which provides that they may not accept directly orindirectly any consulting, advisory or other compensatory fee from GE or any of its subsidiaries otherthan their directors' compensation. As a policy matter, the Board has determined to apply a separate,heightened independence standard to members of both the Management Development andCompensation Committee and the Nominating and Corporate Governance Committee. No member ofeither committee may be a partner, member or principal of a law firm, accounting firm or investmentbanking firm that accepts consulting or advisory fees from GE or any of its subsidiaries below onepercent of the annual revenues of that company.



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Worksheet 23 New York Stock Exchange Listed Company ManualCorporate Governance Guidelines (June 1, 2006)578

New York Stock Exchange Listed Company Manual


Worksheet 24 New York Stock Exchange Listed Company ManualCode of Ethics Guidelines579

Worksheet 24


Worksheet 25 Sample Disclosure of Corporate Governance DifferencesNYSE Listed Company Manual Section 303A.11Excerpts From Elan Corporation's Web site: www.elan.com

Sample Disclosure of Corporate Governance Differences


Worksheet 26 NASDAQ Definition of an Independent DirectorExcerpts From NASDAQ Manual Section 4200Definitions: Independent Director 1

1 NASDAQ Manual, Section 4200(a)(15), Independent Director.

“Independent director” means a person other than an executive officer or employee of the company orany other individual having a relationship which, in the opinion of the issuer's board of directors, wouldinterfere with the exercise of independent judgment in carrying out the responsibilities of a director. Thefollowing persons shall not be considered independent:

(A) a director who is, or at any time during the past three years was, employed by the company;

(B) a director who accepted or who has a Family Member who accepted any compensation fromthe company in excess of $100,000 during any period of twelve consecutive months within thethree years preceding the determination of independence, other than the following:

(i) compensation for board or board committee service;

(ii) compensation paid to a Family Member who is an employee (other than an executiveofficer) of the company; or

(iii) benefits under a tax-qualified retirement plan, or non-discretionary compensation.


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Provided, however, that in addition to the requirements contained in this paragraph (B), auditcommittee members are also subject to additional, more stringent requirements under Rule4350(d), [Audit Committee]

(C) a director who is a Family Member of an individual who is, or at any time during the pastthree years was, employed by the company as an executive officer;

(D) a director who is, or has a Family Member who is, a partner in, or a controlling shareholder oran executive officer of, any organization to which the company made, or from which the companyreceived, payments for property or services in the current or any of the past three fiscal yearsthat exceed 5% of the recipient's consolidated gross revenues for that year, or $200,000,whichever is more, other than the following:

(i) payments arising solely from investments in the company's securities; or

(ii) payments under non-discretionary charitable contribution matching programs.

(E) a director of the issuer who is, or has a Family Member who is, employed as an executiveofficer of another entity where at any time during the past three years any of the executiveofficers of the issuer serve on the compensation committee of such other entity; or

(F) a director who is, or has a Family Member who is, a current partner of the company's outsideauditor, or was a partner or employee of the company's outside auditor who worked on thecompany's audit at any time during any of the past three years.

(G) in the case of an investment company, in lieu of paragraphs (A)–(F), a director who is an“interested person” of the company as defined in Section 2(a)(19) of the Investment CompanyAct of 1940, other than in his or her capacity as a member of the board of directors or any boardcommittee.


Worksheet 27 Summary of Corporate Governance Features

Sarbanes-Oxley Act of 2002 1

Section Title Corporate Governance Feature

301 Public Company Audit Committees Establishes audit committeeresponsibilities

302 Corporate Responsibilities forFinancial Reports

Requires executive officer certificationof SEC filings

402 Enhanced Conflict of InterestProvisions

Prohibits personal loans to executiveofficers

406 Code of Ethics for Senior FinancialOfficers

Requires adoption of a code of ethics

407 Disclosure of Audit CommitteeFinancial Expert

Requires one member of the auditcommittee to be a “financial expert.”

1 Sarbanes-Oxley Act of 2002.

Securities and Exchange Commission

Regulation S-K 1

Section Title Corporate Governance Feature 2

229.401(Item401)

Directors, Executive Officers,Promoters and Control Persons

Requires the identification ofdirectors, executive officers,promoters, and control persons.


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229.402(Item402)

Executive Compensation Calls for disclosure of executivecompensation.

229.403(Item403)

Security Ownership of CertainBeneficial Owners and Management

Requires disclosure of informationregarding individuals owning morethan 5% of the registrant's votingsecurities, as well as ownership bymanagement.

229.406(Item406)

Code of Ethics Requires a code of ethics pertainingto the principal executive officer,principal financial officer, principalaccounting officer or controller, orpersons who perform these functions

229.407(Item407)

Corporate Governance Covers corporate governance in sixareas.

Item407(a)

Director Independence

Establishes standards coveringdirector independence.

Item407(b)

Board Meetings and Committees;Annual Meetings Attendance

Calls for disclosure of data regardingdirector attendance at meetings.

Item407(c)

Nominating Committee Establishes requirements pertainingto nominating committee policies andprocedures.

Item407(d)

Audit Committee Establishes requirements for auditcommittee policies and procedures.

Item407(e)

Compensation Committee Establishes requirements forcompensation committee policies andprocedures.

Item407(f)

Shareholder Communications Calls for procedures that enablesecurity holders to communicate withthe board of directors.

1 SEC Regulation S-K. Reg. §229.400.

2 Regulation S-K, Section 229.404 (Item 404), Transactions With Related Persons,Promoters, and Certain Control Persons, is discussed extensively in Section II.B.2,Non-Financial Statement Disclosures: Regulation S-K Requirements. Section 229.405(Item 405), Compliance of Section 16(a) of the Exchange Act, is covered in SectionIII.B.4.a, Reporting Transactions.

NYSE Corporate Governance Standards

Listed Company Manual 1

Section Title Corporate Governance Feature303A.00 Introduction-General Application Specifies the entities to which the

NYSE corporate governancestandards apply.

303A.01 Independent Directors Calls for a majority of directors tobe independent.

303A.02 Independence Tests Covers standards for determiningdirector independence.

303A.03 Executive Sessions Calls for non-managementdirectors to meet regularly atseparately scheduled executive


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sessions without management; atleast one annual meeting of onlyindependent directors.

303A.04 Nominating/CorporateGovernance Committee

Covers principles governing theoperations of thenominating/corporate governancecommittee composed entirely ofindependent directors.

303A.05 Compensation Committee Deals with principles governingthe operations of thecompensation committeecomposed entirely of independentdirectors.

303A.06 Audit Committee Calls for establishing an auditcommittee that satisfies SEC Rule10A-3, Listing Standards Relatingto Audit Committees, requiring,among other items, memberswho are independent directors.

303A.07 Audit Committee AdditionalRequirements

Sets out audit committeestandards for NYSE listedcompanies.

303A.08 Shareholder Approval of Equity

Compensation Plans 2Establishes requirement thatstockholders vote on all equitycompensation plans and planrevisions.

303A.09 Corporate Governance Guidelines Requires that listed companiesadopt and disclose corporategovernance guidelines.

303A.10 Code of Business Conduct andEthics

Requires listed companies toadopt a code of ethics applicableto directors, officers, andemployees.

303A.11 Foreign Private Issuer Disclosure Requires foreign private issuers todisclose differences betweenhome country and US corporategovernance standards.

303A.12 Certification Requirements Requires the CEO of a listedcompany to certify annually thathe or she is not aware of anyviolation of the NYSE corporategovernance listing standards.

303A.13 Public Reprimand Letter Indicates the Exchange has theoption of issuing a publicreprimand letter to any companythat violates a NYSE listingstandard.

303A.14 Website Requirement Requires companies to maintain apublic website with printableversions of committee charters,company code of ethics, andcorporate governance guidelines.

1 New York Stock Exchange, Listed Company Manual.


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2 Not covered in this Portfolio.

NASDAQ Qualitative Listing Requirements for Issuers

NASDAQ Manual 1

Section Title Corporate Governance Feature4350(a) Applicability Specifies the entities to which

NASDAQ qualitative listingrequirements apply.

4350(c)(1) Independent Directors Calls for a majority of directors tobe independent.

4350(c)(2) Independent Directors Must HaveRegularly Scheduled Meetings(Executive Sessions)

Requires independent directors tomeet at regularly scheduledexecutive sessions withoutnon-independent directors ormanagement.

4350(c)(3) Compensation of Officers Establishes requirements thatexecutive officer compensation bedetermined by or recommended tothe board by either a majority ofindependent directors or acompensation committee comprisedonly of independent directors.

4350(c)(4) Nomination of Directors Specifies that directors are to beselected by or recommended for theboard's selection by either amajority of independent directors orby a nominations committeecomprised solely of independentdirectors.

4350(d)(2) Audit Committee Composition Requires certification that issuerhas, and will continue to have, anaudit committee of at least threeindependent members who satisfythe independence requirements ofSEC Rule 10A-3, Listing StandardsRelating to Audit Committees.

4350(m) Notification of MaterialNoncompliance

Requires company to notifyNASDAQ after any executive officerbecomes aware that the issuer isnot in compliance with the NASDAQqualitative listing requirements.

4350(n) Code of Conduct Stipulates that each issuer adopt acode of conduct applicable todirectors, officers, and employees.To be made publicly available.

1 NASDAQ Manual.



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Worksheet 28 SEC Enforcement Actions

This Worksheet illustrates how corporate governance failures can lead to the inappropriate use ofcompany assets and services. The schemes appear in many forms. This Worksheet discusses a few ofthe deceptive practices, including:

• Undisclosed compensation;

• Using company funds to pay personal expenses;

• Inappropriate use of company services;

• The commingling of funds and expenses;

• Sales to related parties;

• Personal loans; and

• Profiteering in overvalued stock.

1. Undisclosed Compensation—Collins and Aikman Corporation

The SEC filed civil fraud charges against Collins & Aikman Corporation, an auto parts manufacturer,David A. Stockman, Collins's former CEO and chairman of the board, and eight other Collins directorsand officers, including the chief financial officer, corporate controller, the treasurer, and a former

member of Collins's board of directors. 1 The SEC alleges that by improperly accounting for supplierpayments, Stockman and other officers inflated net income between 2001 and 2005. The complaintalleges that the defendants carried out the scheme by obtaining false documents from suppliers.According to the complaint, during this same time period, Stockman collected millions of dollars inmanagement fees that were paid by Collins to a private equity fund owned by Stockman. Theallegations stated that after certain elements of these activities were revealed, Stockman and otherofficers engaged in a public disinformation campaign to mislead investors by minimizing the extent ofthe fraudulent activities and hiding Collins's true financial condition. Collins and Aikman Corporationsimultaneously settled the charges, without admitting or denying the allegations, by consenting to theentry of a final judgment enjoining the company from violating provisions of the Securities Act of 1933and the Securities Exchange Act of 1934. Further, the complaint seeks permanent injunctions againstthe individual defendants against future violations of these provisions.

1 U.S. Securities And Exchange Commission Litigation Release No. 20055 / March 26, 2007Accounting and Auditing Enforcement Release No. 2581 /March 26, 2007 Securities andExchange Commission v. Collins & Aikman Corporation, David A. Stockman, J. Michael Stepp,Gerald E. Jones, David R. Cosgrove, John G. Galante, Elkin B. McCallum, Paul C. Barnaba,Christopher M. Williams and Thomas V. Gougherty, United States District Court for theSouthern District of New York, SEC v. Collins & Aikman Corporation, et al., Civil Action No.

1:07-CV-2419(LAP) (S.D.N.Y. March 26, 2007).

2. Using Company Funds to Pay Personal Expenses—Buca, Inc.

The SEC filed a complaint against Joseph P. Micatrotto, Sr., former chief executive officer, president,and chairman of the board of Buca, Inc., the corporate parent of the restaurant chains Buca di Beppo

and Vinny T's of Boston. 2 In the complaint, the Commission alleges that Micatrotto receivedcompensation that was not disclosed in SEC filings and that he also participated in undisclosed relatedparty transactions. From 2000 to 2003, Micatrotto is alleged to have improperly billed Buca fornumerous personal and non-business expenditures amounting to $849,100, for which he receivedreimbursement. These expenditures included $131,000 in ATM withdrawals; $127,000 in airline ticketsthat were submitted for reimbursement multiple times; a bill for the groom's dinner at his son'swedding; dog kenneling; and remodeling houses he owned in California, Las Vegas, and Minneapolis.


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2 U.S. Securities and Exchange Commission Litigation Release No. 19719 / June 7, 2006;Accounting and Auditing Enforcement Release No. 2438 / June 7, 2006; SEC v. Joseph P.Micatrotto, Sr. (U.S.D.C. Minnesota, Civil Action Number 06-CV-2319, filed June 7, 2006).

According to the complaint, since these expenses constituted additional compensation, they should havebeen disclosed in Buca's proxy statements. Allegedly, Buca's financial statements during this periodunderstated Micatrotto's annual compensation by amounts ranging from 27% to 74%. Moreover, Buca'sfilings, which were reviewed and approved by Micatrotto, did not reveal two related party transactions.First, Micatrotto sought reimbursement for the purchase and renovation of a villa he owned in Italy.Second, instead of turning over to Buca a $65,000 payment made by a vendor for one of the company'scorporate conferences, Micatrotto deposited the payment in his personal bank account.

Without admitting or denying the allegations in the complaint, Micatrotto consented to the entry of afinal judgment enjoining him permanently from violating specified sections of the Securities Act of 1933and the Securities Exchange Act of 1934. In addition, he agreed to be barred from acting as a directoror officer of a publicly traded company, paid disgorgement of $65,000 plus interest and was assessed apenalty of $500,000.

3. Inappropriate Use of Company Services—ITB

The SEC brought public administrative proceedings against William H. Warner, chief financial officer and

treasurer of ITB from 1983, and Robert J. Quigley, a director of ITB from 1980 and former president. 3

Nunzio DeSantis was a member of the board and chief executive officer from January 1997 until heresigned in January 1999. The Commission's findings are as follows. In February 1997, DeSantisinstructed Warner to start making payments for the operating expenses and salaries of Southwest Jet, acorporate airline charter service. Southwest was operated by Louis DeSantis, DeSantis's 23-year-oldson. The company, which had no assets of its own, operated an airplane that was partially owned byNunzio DeSantis. Around this same time, DeSantis instructed Warner to place DeSantis's personal cookon the ITB payroll. As of March 31, 1997 ITB's payments to Southwest Jet and DeSantis's cookamounted to approximately $160,000. As these dealings constituted related party transactions, theyrequired disclosure in ITB's financial statements and in SEC filings. Warner instead concealed thesepayments by classifying them as general and administrative expenses. The payments constitutedapproximately 10% of ITB's net loss for the first quarter of 1997 and contributed to a burgeoningcash-flow crisis.

3 United States Of America Before The Securities And Exchange Commission SecuritiesExchange Act Of 1934 Release No. 45441 / February 13, 2002 Accounting And AuditingEnforcement Release No. 1505 / February 13, 2002 Administrative Proceeding File No.3-10699.

These findings were binding only on Warner and Quigley, who were ordered to cease and desist fromcausing violations or any future violations of specified sections of the Securities Exchange Act. The SECfiled a related civil injunctive action against Nunzio DeSantis and ITB.

4. Commingling Funds and Expenses—Sentinel

On August 20, 2007, the SEC filed an emergency civil action in U.S. District Court for the Northern

District of Illinois against Sentinel Management Group, Inc. 4 Sentinel is an investment adviser locatedin Northbrook, Illinois. The Commission alleged that Sentinel had improperly commingled,misappropriated, and leveraged client securities in violation of the Investment Advisor Act of 1940. TheSEC stated that “Sentinel's advisory clients suffered undisclosed losses and risks of losses as a result of

several unauthorized practices engaged in by Sentinel.” 5 These practices allegedly included the

following: 6

4 SEC v. Sentinel Management Group, Inc., Civil Action No. 07 C 4684 (N.D. IL), SEC NewsDigest, Issue 2007-161, August 21, 2007.

5 SEC v. Sentinel Management Group, Inc., Civil Action No. 07 C 4684 (N.D. IL), SEC News


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Digest ,Issue 2007-161, August 21, 2007.

6 SEC v. Sentinel Management Group, Inc., Civil Action No. 07 C 4684 (N.D. IL), SEC NewsDigest ,Issue 2007-161, August 21, 2007.

Pledging securities owned by clients as collateral in order to obtain a line of credit as high as $500million for Sentinel;

Placing at least $460 million of client securities properly belonging in segregated customer accounts inSentinel's house proprietary account;

Commingling client assets without the ability to verify ownership of particular securities by particularclients; and

Providing false client account statements that did not accurately reflect client portfolio holdings or thefact that securities had been encumbered by Sentinel.

Accordingly, Sentinel was ordered to provide, within five days of the court's order, a full accounting ofits assets and liabilities, as well as those of its clients. Sentinel was also ordered to produce brokerageand bank documents so that a determination could be made regarding its clients' holdings and securityownership.

5. Sales to Related Parties—Hollinger International, Inc.

On March 16, 2007, the SEC settled an enforcement action that was pending in U.S. District Court,Northern District of Illinois, against F. David Radler, former deputy chairman and chief operating officer

of Hollinger International, Inc. 7 Radler was ordered to pay approximately $23.7 million in disgorgementand prejudgment interest and a $5 million civil penalty. Furthermore, he was barred from serving as anofficer or director of a public company. Radler consented to the judgment without admitting or denyingthe allegations in the Commission's complaint.

7 U.S. Securities And Exchange Commission Litigation Release No. 20043 / March 16, 2007Accounting and Auditing Enforcement Release No. 2582 / March 16, 2007 U.S. Securities andExchange Commission v. Conrad M. Black, F. David Radler and Hollinger Inc., Civil Action No.04C7377 (N.D. Ill. 2004).

The enforcement action had been filed on November 15, 2004 against Radler; Hollinger, Inc., HollingerInternational's controlling shareholder; and Conrad M. Black, Hollinger International's former chairmanand CEO. In their complaint, the Commission alleged that “from approximately 1999 through 2003, thedefendants engaged in a fraudulent and deceptive scheme to divert cash and assets from Hollinger

International, Inc., through a series of related party transactions.” 8 The Commission alleged thatthrough these transactions, Black and Radler diverted approximately $85 million to themselves, to othercorporate insiders, and to Hollinger, Inc. According to the compliant, these funds were portrayed as“non-competition” payments by the defendants but arose from proceeds of Hollinger International'ssales of newspaper publications. Black and Radler also allegedly directed Hollinger International to sellnewspaper publications at below-market prices to a privately-held company that was owned andcontrolled by the defendants, including one sale that was consummated for $1.00. In addition, it wasalleged that the defendants misled both Hollinger International's audit committee and board of directorswith regard to the true nature of these related party transactions.

8 U.S. Securities And Exchange Commission Litigation Release No. 20043 / March 16, 2007Accounting and Auditing Enforcement Release No. 2582 / March 16, 2007 U.S. Securities andExchange Commission v. Conrad M. Black, F. David Radler and Hollinger Inc., Civil Action No.04C7377 (N.D. Ill. 2004).

Given that these transactions slipped past Hollinger International's audit committee and board, it isworthwhile to examine whether these two bodies adequately carried out their fiduciary responsibilities.One of the related party sales involved the conveyance of assets for $1.00. This highly unusual


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transaction should have raised red flags with the committee and the board. This episode illustrates thatit is in the best interests of audit committees to prepare a list of possible related parties, including allsubsidiaries and affiliates, and closely scrutinize all transactions involving the listed company and theseparties. In addition, the committee should investigate any unusual transactions that are consummatedamong related parties. Of course, the board has the ultimate responsibility for the financial statementsand reports and should assure that the audit committee has carried out a reasonable investigation.

6. Personal Loans—Tyco

The SEC filed a civil enforcement action against three former top executives of Tyco International Ltd.,including L. Dennis Kozlowski, former chief executive officer and chairman of the board, Mark H. Swartz,

former chief financial officer and a director, and Mark A. Belnick, former chief legal officer. 9 Thesedefendants allegedly directed the company to grant to them hundreds of millions of dollars inundisclosed loans that carried a low or zero rate of interest. The defendants allegedly used the proceedsfrom these loans for personal expenses. According to the complaint, they later directed the company toforgive tens of millions of dollars of the outstanding loans. The complaint indicated that neither thenature of the loans nor their forgiveness was disclosed as required by law. According to the complaint,the defendants also engaged in other related party transactions that were likewise not disclosed toinvestors. These transactions allegedly bilked shareholders out of hundreds of thousands or evenmillions of dollars. According to the complaint, Belnick failed to disclose that he had received more than$14 million of interest-free loans from the company and used more than $10 million of the proceeds toacquire two residences that included an apartment in New York City and a house in Park City, Utah.Moreover, at about the same time they were granted the undisclosed loans, the complaint alleges thatKozlowski, Swartz, and Belnick were profiting by selling Tyco stock valued in the millions of dollars.

9 United States Securities and Exchange Commission Litigation Release No. 17722 /September 12, 2002

Accounting and Auditing Enforcement Release No. 1627 / September 12, 2002.

7. Profiteering on Overvalued Stock—CEC Industries

The SEC filed a complaint on September 28, 1999 in U.S. District Court for the District of Columbiaalleging that Gerald and Marie Levine overstated the assets of CEC in reports filed with the Commission

for fiscal years 1996 and 1997. 10 Gerald Levine was CEC's chief executive officer. His wife Marie wassecretary-treasurer and principal financial officer. The complaint further alleged that the Levines,cognizant that CEC's assets were overstated and the stock therefore overvalued, profited by selling CECstock through an affiliate, Wire to Wire Inc. The Levines claimed that two overstated assets werecorporate-owned: (1) a tract of land in Tennessee described as holding 52 million tons of coal andsubstantial timber assets, and (2) a large number of paintings, which, according to the Levines, had avalue of $1.7 million. At trial, the SEC proved that CEC and its corporate affiliates did not have title tothe land and that the paintings were worth only slightly more than $10,000. The Court found that theLevines had violated specific sections of both the Securities Act of 1933 and the Securities Exchange Actof 1934. They were enjoined for a period of 10 years from violating these provisions. The Levines werealso barred for a period of 10 years from serving as an officer or director of a company that hassecurities registered under Section 12 of the Exchange Act or that is required to file reports underSection 15(d) of that Act.

10 U.S. Securities and Exchange Commission Litigation Release No. 20124 / May 22, 2007Accounting and Auditing Enforcement Release No. 2610 / May 22, 2007 SEC v. Gerald H.Levine and Marie A. Levine, Civil Action No. 99 CIV 02568 (D.D.C.) (May 8, 2007).

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Bibliography

OFFICIAL


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Public Laws:

Pub. L. No. 107-204, 116 Stat. 745, Sarbanes-Oxley Act of 2002.

Securities and Exchange Commission (SEC):

Accounting and Auditing Enforcement Releases

United States Securities and Exchange Commission Litigation Release No. 17722 / September 12, 2002and Accounting and Auditing Enforcement Release No. 1627 / September 12, 2002.

U.S. Securities and Exchange Commission Litigation Release No. 19719 / June 7, 2006; Accounting andAuditing Enforcement Release No. 2438 / June 7, 2006; SEC v. Joseph P. Micatrotto, Sr., (U.S.D.C.Minnesota, Civil Action Number 06-CV-2319, filed June 7, 2006).

U.S. Securities and Exchange Commission Litigation Release No. 20043 / March 16, 2007 Accountingand Auditing Enforcement Release No. 2582 / March 16, 2007 U.S. Securities and ExchangeCommission v. Conrad M. Black, F. David Radler and Hollinger Inc., Civil Action No. 04C7377 (N.D. Ill.2004).

U.S. Securities and Exchange Commission Litigation Release No. 20055 / March 26, 2007 Accountingand Auditing Enforcement Release No. 2581 / March 26, 2007 Securities and Exchange Commission v.Collins & Aikman Corporation, David A. Stockman, J. Michael Stepp, Gerald E. Jones, David R. Cosgrove,John G. Galante, Elkin B. McCallum, Paul C. Barnaba, Christopher M. Williams and Thomas V.Gougherty, United States District Court for the Southern District of New York, SEC v. Collins & AikmanCorporation, et al. Civil Action No. 1:07-CV-2419(LAP) (S.D.N.Y. March 26, 2007).

U.S. Securities and Exchange Commission Litigation Release No. 20124 / May 22, 2007 Accounting andAuditing Enforcement Release No. 2610 / May 22, 2007 SEC v. Gerald H. Levine and Marie A. Levine,Civil Action No. 99 CIV 02568 (D.D.C.) (May 8, 2007).

United States of America Before the Securities and Exchange Commission Securities Exchange Act of1934 Release No. 45441 / February 13, 2002 Accounting and Auditing Enforcement Release No. 1505 /February 13, 2002 Administrative Proceeding File No. 3-10699.

Acts

Securities Act of 1933, 17 C.F.R. §220 (1933).

Securities Exchange Act of 1934, 17 C.F.R. §240 (1934).

News Digest

SEC v. Sentinel Management Group, Civil Action No. 07 C 4684 (N.D. IL), SEC News Digest, Issue2007-161,August 21, 2007.

Regulations

17 C.F.R. §229, Regulation S-K (1934).

17 C.F.R. §210, Regulation S-X (1934).

17 C.F.R. §245, Regulation BTR—Blackout TradingRestriction (2003).

Reports

Securities and Exchange Commission, Report Pursuant to Section 704 of the Sarbanes-Oxley Act of2002 (2003).

Securities Act Industry Guides

Industry Guide 3, Statistical Disclosure by Bank Holding Companies, 17 C.F.R. §229.802(c).


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Staff Accounting Bulletins

SEC Staff Accounting Bulletin 4, Equity Accounts.

SEC Staff Accounting Bulletin 5, MiscellaneousAccounting.

Federal Reserve System

Title 12, Banks and Banking, Chapter II, Federal Reserve System, Part 220, Credit by Brokers andDealers(Regulation T): 12 C.F.R. part 220.

Court Cases:

TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969).

In re Enron Corp. Securities, 235 F. Supp. 2d 549 (2002).

Financial Accounting Standards Board (FASB):

FASB Accounting Standards Codification

FASB ASC 205-10, Presentation of Financial Statements – Overall

FASB ASC 210-10, Balance Sheet – Overall

FASB ASC 235-10, Notes to Financial Statements – Overall

FASB ASC 250-10, Accounting Changes and ErrorCorrections – Overall

FASB ASC 323, Investments – Equity Method and Joint Ventures

FASB ASC 405-20, Liabilities – Extinguishments ofLiabilities

FASB ASC 440-10, Commitments – Overall

FASB ASC 450, Contingencies

FASB ASC 605-40, Revenue Recognition – Gains and Losses

FASB ASC 810-10, Consolidation – Overall

FASB ASC 820-10, Fair Value Measurements andDisclosures – Overall

FASB ASC 840-10, Leases – Overall

FASB ASC 840-20, Leases – Operating Leases

FASB ASC 840-30, Leases – Capital Leases

FASB ASC 845-10, Nonmonetary Transactions – Overall

FASB ASC 850-10, Related Party Disclosures – Overall

FASB ASC 860-10, Transfers and Servicing – Overall

FASB ASC 860-20, Transfers and Servicing – Sales of Financial Assets

FASB ASC Term “Bargain Purchase Option”

FASB ASC Term “Beneficial Interest”


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FASB ASC Term “Comprehensive Income”

FASB ASC Term “Control”

FASB ASC Term “Derecognize”

FASB ASC Term “Exchange”

FASB ASC Term “Fair Value” (as used in FASB ASC 820)

FASB ASC Term “Financial Instrument”

FASB ASC Term “Most Advantageous Market”

FASB ASC Term “Other Comprehensive Income”

FASB ASC Term “Principal Market”

FASB ASC Term “Reasonably Possible”

FASB ASC Term “Related Parties”

FASB ASC Term “Take-or-Pay Contract”

FASB ASC Term “Throughput Contract”

FASB ASC Term “Transfer” (as used in FASB ASC 860)

FASB ASC Term “Unconditional Purchase Obligation”

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Bibliography

UNOFFICIAL

American Institute of Certified Public Accountants (AICPA):

AICPA Accounting Interpretations

AICPA Accounting Interpretations 18-1, 18-2, 18-3, The Equity Method of Accounting for Investments inCommon Stock: Accounting Interpretations of APB Opinion No. 18.

AICPA Accounting Principles Board Opinions

APB Opinion No. 18, The Equity Method for Investments in Common Stock (Mar. 1971).

APB Opinion No. 29, Accounting for NonmonetaryTransactions (May 1973).

AICPA Accounting Research Bulletins

ARB No. 43, Restatement and Revision of AccountingResearch Bulletins (June 1953).

ARB No. 51, Consolidation (Aug. 1959).

AICPA Statements on Auditing Standards

Statement on Auditing Standards No. 1, Codification of Auditing Standards and Procedures, AU §110.

Statement on Auditing Standards No. 6, Related Party Transactions (July 1975). Superseded by SAS 45.

Statement on Auditing Standards No. 45, Omnibus Standard on Auditing Standards, AU §334.

Statement on Auditing Standards No. 78, Consideration of Internal Control in a Financial StatementAudit: An Amendment to Statement on Auditing Standards No. 55, AU § 319.


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Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit, AU§316.

AICPA Technical Practice Aids

AICPA Technical Practice Aids/Technical Questions and Answers, TIS Section 1400.27, ConsolidatedFinancial Statements.

Financial Accounting Standards Board (FASB):

FASB Concepts Statements

FASB Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of AccountingInformation (May 1980).

FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in FinancialStatements of Business Enterprises (Dec. 1984).

FASB Statement of Financial Accounting Concepts No. 7, Using Cash Flow and Present Value inAccountingMeasurements (Feb. 2000).

FASB Emerging Issues Task Force

EITF Issue No. 02-5, Definition of Common Control in Relation to FASB Statement No. 141 (June 19-20,2002).

EITF Issue No. 85-21, Changes in Ownership Resulting in a New Basis of Accounting (Oct. 16, 1986).

FASB Statements of Standards

FASB Statement No. 5, Accounting for Contingencies.

FASB Statement No. 13, Accounting for Leases.

FASB Statement No. 47, Disclosure of Long-TermObligations.

FASB Statement No. 57, Related Party Disclosures.

FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries — An Amendment of ARB No.51, With Related Amendments of APB Opinion No. 18 and ARB No. 43, Chapter 12.

FASB Statement No. 98, Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate,Sales-Type Leases of Real Estate, Definition of the Lease Term, and Initial Direct Costs of DirectFinancing Leases— An Amendment of FASB Statements No. 13, 66, and 91 and a Rescission of FASBStatement No. 26 and TechnicalBulletin No. 79-11.

FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments.

FASB Statement No. 130, Reporting ComprehensiveIncome.

FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.

FASB Statement No. 141, Business Combinations.

FASB Statement No. 154, Accounting Changes and Error Corrections.

FASB Statement No. 157, Fair Value Measurements.

FASB Technical Bulletins

FASB Technical Bulletin 85-5, Issues Relating to Accounting for Business Combinations.


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International Accounting Standards Committee:

Statements of International Accounting Standards

Statement of International Accounting Standard No. 24, Related Party Disclosures (Dec. 2003).

Public Company Accounting Oversight Board:

Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in ConjunctionWith an Audit of Financial Statements (Mar. 9, 2004).

Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated WithAn Audit of Financial Statements (May 24, 2007).

Stock Exchange Regulations:

National Association of Securities Dealers AutomatedQuotations, NASDAQ Manual (NASDAQ, 2007).

New York Stock Exchange, New York Stock Exchange Listed Company Manual (NYSE, 2007).

Books, Handbooks, and Treatises:

Cecil W. Jackson, Business Fairy Tales (Thomson 2006).

Alister, K. Mason, Related Party Transactions (TheCanadian Institute of Chartered Accountants 1979).

William C. Powers, Jr., Chair, Report of Investigation by the Special Investigative Committee of theBoard of Directors of Enron Corporation (2002).

S. Shapiro, Wayward Capitalists: Targets of the Securities and Exchange Commission (Yale UniversityPress 1984).

Articles:

Timothy Bell and J. Carcello, A Decision Aid for Assessing the Likelihood of Fraudulent FinancialReporting, 19(1) Auditing: A Journal of Practice and Theory, 169-184 (2000).

M. Beasley, J. Carcello and D. Hermanson, Top Ten Audit Deficiencies-SEC Sanctions, 191(4)Accounting, 63-67 (2001).

Geriesh, Lotfi, Organizational Culture and FraudulentFinancial Reporting, 73 CPA J., 28-32 (Mar. 2003).

Lev, Baruch, Corporate Earnings: Fact and Fiction, 17(2) J. Econ. Perspectives, 27-50 (2003).

Wall Street Journal, Many Companies Report Transactions With Top Officers, (Dec. 29, 2003), at A1.

Henry, Elaine, Elizabeth A. Gordon and D. Palia, Related Party Transactions and Corporate Governance,9Advances in Financial Economics, 1-28 (2004).

G. D. Moyes, P. Lin and R.M. Landry, Raise the Red Flag, 62 Internal Auditor, 47-51 (2005).

Henry, Elaine, Elizabeth A. Gordon, Brad Reed and Tim Louwers, The Role of Related Party Transactionsin Fraudulent Financial Reporting, Working Paper,University of Miami (2006).

BNA Portfolios:

5114, Sebik and Starczewski, Accounting for Leases:Fundamental Principles (Accounting Policy andPractice Series).

5127, Ketz and Zyla, Fair Value Measurements: Valuation Principles and Audit Techniques (Accounting


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Policy and Practice Series).

5400, Guy and Blanco-Best, Auditors' Reports (Accounting Policy and Practice Series).

5402, Lorne, Smalley and Schultz, Internal Controls:Sarbanes-Oxley Act §404 and Beyond (Accounting Policy and Practice Series).

Contact us at http://www.bna.com.tjsl.idm.oclc.org/contact/index.html or call 1-800-372-1033

ISSN 1947-3923Copyright © 2011, The Bureau of National Affairs, Inc. Reproduction or redistribution, in whole or in part, and

in any form, without express written permission, is prohibited except as permitted by the BNA CopyrightPolicy. http://www.bna.com.tjsl.idm.oclc.org/corp/index.html#V


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Documents

Acctg for Related Party Transactions