July 2004 Financial Reporting Update

BDO SEIDMAN, LLP’S

JULY 2004 FINANCIAL REPORTING UPDATE

PCAOB and SEC Matters(Jeff Lenz)

2

• AS 1 Auditor Reports• AS 2 Audits of Internal Control• AS 3 Audit Documentation

UpdateUpdate

3

PCAOB Developments – AS No. 1

AS No. 1 - References in Auditors' Reports to the Standardsof the Public Company Accounting Oversight Board

• Changes to Audit Reports:

– Directs auditors to refer to "standards of the Public Company Accounting Oversight Board (United States)" in lieu of references to GAAS in audit reports relating to F/S of issuers

– Applies to U.S. firms and non-U.S. firms that have not yet registered with PCAOB

– Effective for audit reports issued or reissued on or after May 24, 2004, irrespective of whether engagement was conducted before or after this date

4

Internal Control Over Financial Reporting – FAQs

PCAOB’s Frequently Asked Questions document

Can be accessed on PCAOB’s web site at www.PCAOBUS.org/documents/staff_Q_A/Staff_Internal_Control.pdf

New guidanceavailablefrom theSEC on

and PCAOB on Internal Control Over Financial Reporting

SEC’s Frequently Asked Questions document

Can be accessed on SEC’s web site at www.sec.gov/info/accountants/controlfaq0604.htm

5

Internal Control Over Financial Reporting – PCAOB FAQ

Q7. Addresses paragraph 140 -– If auditor identifies a misstatement in a

prelim draft of F/S, does this represent a significant deficiency & strong indicator of material weakness?

– Do accounting discussions need to be postponed until management has completed the accounting?

6

Internal Control Over Financial Reporting – PCAOB FAQ

A7. Company must have effective internal control on its own (without results of auditing procedures)– Auditor preparing a checklist and finding a material

disclosure to be missing from F/S would be an indicator of a significant deficiency & strong indicator of material weakness

– Auditors may review drafts, but management needs to communicate status of F/S, reason for auditor’s review and whether controls had operated at the time

– Apply the same concept in accounting discussions

Careful structuring. Clear communication.

7

Issues Discussed in FAQ Document1. Requirements related to entities consolidated pursuant to

FASB Interpretation No. 46(R) (VIEs) and EITF 00-1 (proportionate consolidation)

- SEC requires management’s ICFR report to include all consolidated entities, irrespective of consolidation method.

- However, for entities: in existence prior to 12/15/03 and consolidated pursuant to FIN

46; and consolidated pursuant to EITF 00-1

management may exclude these entities from its ICFR evaluation where necessary

Internal Control Over Financial Reporting – SEC FAQ

8


Issues Discussed in FAQ Document 1. Requirements related to consolidated entities excluded:

- Mention in mgmt. report on ICFR and refer to separate scope discussion

- Separate section of annual report should stating: ICFR evaluations and conclusions don’t apply to this entity Reason for scope exception Size of this entity

9


Issues Discussed in FAQ Document2. Requirements re: equity method investees

- ICFR evaluation of recording of transactions into the equity method investee’s accounts is not required

- This guidance applies regardless of significance of equity method investee to registrant

10

Issues Discussed in FAQ Document

3. Requirements re: recently purchased businesses

- ICFR evaluation of a purchased business may be deferred if current assessment is not possible

Until one year after acquisition date

- Disclose exclusion of purchased business from scope of management’s ICFR evaluation separately in issuer’s annual report. In addition, disclose: Identity of acquired business

Significance of entity to issuer’s consolidated F/S

- Disclose material changes in issuer’s ICFR as a result of acquisition


11

Issues Discussed in FAQ Document4. Conclusions on effectiveness of ICFR

- Management may not qualify its conclusions in its report on effectiveness of the issuer’s ICFR

- Management’s or auditor’s conclusion that issuer’s ICFR are not effective does not affect issuer’s timely/current filer status for purposes of Rule 144 and Forms S-2, S-3, and S-8 eligibility as long as: Report that includes assessment is timely filed;

Auditor’s report on the F/S is unqualified; and

All other reporting obligations are timely satisfied


12

Issues Discussed in FAQ Document5. Changes in Controls - Regulation S-K Item 308(c)

- Changes made as a result of preparing for company’s first management report on ICFR

- Business combinations

- Enhancements

- Corrections of significant deficiencies


13

Issues Discussed in FAQ Document6. ICFR evaluation requirements re: third party service providers

- Management is responsible for maintaining and evaluating controls over flow of information to and from service providers

- Management may rely on a Type 2 SAS 70 report in assessing controls of the service provider, even if auditors for both companies are the same However, if management engages issuer’s audit firm to also

prepare SAS 70 report on the service provider, it may not rely on the report for purposes of assessing ICFR

- Management may rely on a SAS 70 report for a service provider that is as of a different year-end than the issuer


14

Issues Discussed in FAQ Document7. Effective date

- First fiscal year ending on or after November 15, 2004 for accelerated filers

- Applies in 2004 to new accelerated filers Did your June 30, 2004 public equity float exceeded $75 million?


15

AS 3 Audit DocumentationAS 3 Audit Documentation

• Not yet approved by SEC• Effective – November 15, 2004• Key Principles

– Procedures Performed– Evidence Examined – Conclusions Reached

• Written Documentation

16

Experienced AuditorExperienced Auditor

“an experienced auditor has a reasonable understanding of audit activities and has studied the company’s industry as well as the accounting and auditing issues relevant to the industry”

17

SEC Matters - Update

• Public Access to SEC Comment Letters and Responses

• New Form 8-K Rules• SEC Hot Buttons

18

Public Access to SEC Comment Letters

– Currently, SEC releases staff comment letters and responses only in response to individual Freedom of Information Act (FOIA) requests after staff review is complete

– Beginning with SEC filings made after 8/1/2004, all comment letters and response letters will be made publicly available via EDGAR and the SEC’s Public Dissemination Service

– Correspondence will be released no earlier than 45 days after staff has completed a filing review

Public access to SEC comment letters on SEC filings and registrants’ responses

19

– All comment letters will be released – no confidential treatment exceptions

– Companies can request confidential treatment of sensitive portions of response letters under Rule 83 of the FOIA


Public access to SEC comment letters on SEC filings and registrants’ responses

20

– Consult with counsel experienced in confidentiality matters

– File redacted company response via EDGAR

• Omit sections for which confidential treatment will be requested

• Each page should be clearly marked “Confidential Treatment Requested by [Name]”

– Submit complete unredacted copy of response letter to SEC in paper form indicating confidential treatment request

• Specify which portions of the letter for which issuer seeks confidential treatment and why


Procedures for confidential treatment request under Rule 83

21

Form 8-K Revisions

• Final Rule issued March 16, 2004• Effective date: August 23, 2004 • Applicable to all domestic issuers, including small

business issuers• Adds 8 new items which would require 8-K• Requires 2 items currently reported in 10-K or

10-Q to be filed on 8-K• Expands disclosure requirements regarding departure of

director/change in certain officers• Shortens time frame for filing 8-K to 4 business days

(from 5 or 15 business days)• Safe harbor

22

Form 8-K Revisions

What has not changed:• Information requirements in acquisitions

and dispositions• Extended due date for historical and pro

forma F/S after an acquisition• Information requirements in connection

with auditor changes

23

Form 8-K - New Disclosures

Entry into material agreement (not ordinary course of business)

Termination of material agreement (not ordinary course of business)

Creation of material direct financial obligation or contingent financial obligation under an Off B/S arrangement

Event triggering direct financial obligation or contingent financial obligation under an Off B/S arrangement

24

Form 8-K - New Disclosures (cont’d)

Exit activities including material write-offs and restructuring charges

Material impairment Delisting events

25

No reliance on previously issued F/S– 4.02(a) – Requires company to file 8-K if it

determines its F/S are misstated– 4.02(b) – Requires company to file 8-K if

its auditor informs it that F/S are misstated • Auditor would then provide letter to SEC

indicating agreement/disagreement w/ disclosures to be attached as an exhibit to 8-K filing

Form 8-K - New Disclosures (cont’d)

26

Proposed 8-K Items Not Adopted

• Temporary suspension of trading under employee benefit plan– This items was addressed by Regulation

BTR and was already incorporated into Form 8-K

• Certain rating agency information• Termination or reduction of a business

relationship w/ a customer

27

Form 8-K - Other Changes

• Items added from 10-K/Q– Sales of unregistered securities– Material modification to rights of holders of

securities

• Expansion of existing requirement– Departure of a director– Change in certain officers– Changes in articles and by-laws

28

SEC Hot Buttons

• IPR&D Charges in Pro Forma Income Statements

• Contingencies• Segments• Materiality

29

IPR&D Charges in Pro Forma Income Statement

• SEC staff’s views on treatment in pro forma financial statements of In-Process R&D purchased in a business combination:– Pro forma F/S for period prior to acquisition should include pro

forma adjustment to reflect IPR&D charge– Pro forma F/S for period in which acquisition occurred should

include historical IPR&D charge (i.e., no pro forma adjustment to remove historical IPR&D charge)

30

Contingencies

• Critical assessment of claims against company required– Accrue for probable losses– Disclose nature and possible range when

maximum reasonably possible loss is material• SEC is skeptical when first disclosure about a long-

standing problem is made when a liability is recorded

• FAS 5 applies to tax cushion• Expectation is that PCAOB inspections will

focus on audit documentation

31

Segments

• High hurdle to aggregation (para. 17 of FAS 131)• Questions to ask:

– Will providing more detailed information enhance user’s understanding of company’s financial results and prospects?

– Is aggregation consistent w/ objectives and principles of FAS 131?

• Recent addition to EITF agenda

32

Materiality

Accounting issue:

– Methods used to evaluate materiality of an error (rollover method vs. iron curtain method)

33

Materiality

• Rollover Method – A.k.a “income statement” or “current-period”

method– Auditor compares misstatements that affect

current year against only current year operations

• Iron Curtain Method– A.k.a. “balance sheet” or “cumulative” method– Auditor compares all misstatements, regardless of period to

which misstatement relates, against current year results

34

Materiality

Example of Rollover vs. Iron Curtain Method

• Inventory is overstated by $100 in year 20X2; no adjustment is made to correct error

• Inventory is overstated by $150 in year 20X3– Under rollover method, 20X3 overstatement would be $50– Under iron curtain method, 20X3 overstatement would be $150

BDO SEIDMAN, LLP’S

JULY 2004 FINANCIAL REPORTING UPDATE

FASB and EITF Updates(Ben Neuhausen)

36

Recent FASB Staff Positions (FSPs)

• FSP FAS 106-2, Accounting for Effects of Medicare Act of 2003

• FSP FAS 129-1, Disclosure Requirements under FAS 129 – related to contingently convertible securities

• FSP 97-1, Life Insurance industry issue • FSP 141-1 and 142-1, Mining industry issue

37

Status of Recent Exposure Drafts

• Share-Based Payments– Issued March 2004, comment period ended June

30– June 2004 Roundtables

• Recording compensation expense based on fair value of options

• Auditability of assumptions for option pricing models

• Accounting for income taxes

• Effective date and transition

• Private company provisions

38


• Conditional Asset Retirement Obligations– To provide more consistent recognition of liabilities

relating to AROs and enhance information on future cash outflows

– Big change in practice: fair value (FV) of legal obligation of a “conditional” asset retirement to be recognized when obligation incurred or as soon as FV can be estimated• Legal obligation to remove and dispose of asbestos

upon renovation or demolition– Issued June 2004, comments due August 1

39


• Fair Value Measurement– General framework for measuring FV

applied to financial and nonfinancial assets and liabilities

– Does not extend FV to any new categories of assets or liabilities

– Issued June 2004, comments due September 7

40

EITF Update

EITF ISSUES DISCUSSED AT JULY MEETING

41

EITF Issues Discussed at July meeting

• 02-14, Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock If the Investor Has the Ability to Exercise Significant Influence Over the Operating and Financial Policies of the Investee (Consensus reached; further discussion planned)

• 03-9, Evaluating the Criteria in Sub-Paragraph 11(d) of FASB Statement No. 142, “Goodwill and Other Intangible Assets,” Regarding Renewal or Extension When Determining the Useful Life of an Intangible Asset (Further discussion planned)

42

Issues Discussed at July meeting

• 03-13, Applying the Conditions in Paragraph 42 of FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, in Determining Whether to Report Discontinued Operations (Further discussion planned)

• 04-1, Accounting for Pre-Existing Contracts between the Parties to a Purchase Business Combination (Further discussion planned)

43


• 04-5, Investor's Accounting for an Investment in a Limited Partnership When the Investor Is the Sole General Partner and the Limited Partners Have Certain Rights (Further discussion planned)

• 04-6, Mining industry issue (Further discussion planned)

44


• 04-7, Determining Whether an Interest Is a Variable Interest in a Variable Interest Entity (Further discussion planned)

• 04-8, Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share (Tentative consensus; further discussion planned)

Documents

July 2004 Financial Reporting Update