Advanced Financial Accounting 8e Chap014







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Q14-1 The basis of the SEC's legal authority to regulate accounting principles stems from the Securities Exchange Act of 1934. In the 1934 Act, the SEC was given the legal responsibility to regulate trades of securities and to determine the types of financial disclosures that a publicly held company must make.

Q14-2 The Securities Act of 1933 regulates the initial registration of securities. The Securities Exchange Act of 1934 regulates the periodic reporting of publicly traded companies.

Q14-3 The Division of Corporation Finance receives the registration statements of companies wishing to make public offerings of securities. The Division of Enforcement investigates individuals or firms who may be in violation of a security act.

Q14-4 The Foreign Corrupt Practice Act of 1977 requires that companies maintain accurate accounting records and an adequate system of internal control. An adequate system of internal control should contain the following:

a. Strong budgetary controls

b. An objective internal audit function that helps develop, document, and then monitor the control system

c. An active audit committee comprised of nonmanagement members from the company's board of directors

d. A review of the internal control system by the independent auditors

Q14-5 Regulation S-X covers the form and content of financial disclosures; specifically, this Reg. covers the form and content of financial statements, schedules, footnotes, reports of accountants, and pro forma disclosures. Items included in Regulation S-K include a description of business, management's discussion and analysis, disagreements with accountants, and required information about new stock issues.

Q14-6 Two types of public offerings of securities are exempted from the comprehensive registration requirements of the SEC. The first type of offering exempted from the full registration process is a small offering of less than $1.5 million of stock sales during any 12-month period. The second type of offering exempted from the full registration requirements is limited offerings to accredited investors of up to $5 million in securities within a 12-month period.


Q14-8 A customary review is a thorough examination by the SEC and may result in acceptance of the registration or a comment letter from the SEC.

A comment letter is issued by the SEC specifying the deficiencies that must be corrected before the securities may be offered for sale.

A red herring prospectus is a preliminary prospectus providing information to investors about an upcoming issue. This type of prospectus has a cover printed in red ink indicating it is not an offering statement and the securities being discussed are not yet available for sale.

Shelf registration allows large, established companies with other issues of stock already actively traded to file a registration statement with the SEC for a stock issue which may be brought off the shelf and updated within a very short time when the company wants to actually issue the stock.

Q14-9 Form 10-K is broken into four parts. Parts I, II, and III contain the basic financial information including the audited financial statements, the management discussion and analysis, the report by management on internal control, and the auditor‟s opinion. Part IV contains additional schedules and exhibits. For “accelerated filers” (those companies having at least $75 million in aggregate market value and been subject to the periodic and annual reporting requirements for at least one year), the Form 10-K must be filed with the SEC within 60 days after the end of the company's fiscal year-end. Other companies, such as small businesses, have 90 days in which to file their 10-Ks.

Q14-10 Interim reports submitted to the SEC are not required to be audited. The public accountant is expected to review, on an ex post basis, the information provided in the company's Form 10-Qs as part of the annual, year-end audit.

Q14-11 In 2004, the SEC enlarged the list of items that must be reported on the Form 8-K. The entire list is presented in the chapter. Although the registrant‟s accounting function would be involved with almost of the specific items, those items for which the particular involvement of the accounting function would be the greatest are:

1.03. The bankruptcy or receivership of the company 2.01. Completion of the acquisition or disposition of assets 2.02. Public announcement of material financial results


Q14-13 Part I of the Foreign Corrupt Practices Act (FCPA) prohibits individuals associated with United States companies from giving bribes to foreign governmental or political officials for the purpose of securing a contract or otherwise increasing the company's business. Part II of the FCPA requires all public companies, whether operating internationally or not, to keep detailed records that accurately and fairly reflect the company's financial transactions, and to develop and maintain an adequate internal control system. The impact of this act is to require companies to establish and maintain an adequate internal control system, to require public accountants to evaluate the company's internal controls, and to communicate any material weaknesses in those controls to the company's top management and board of directors.

Q14-14 The MD&A must include a discussion of trends and expected changes on the company‟s financial condition, changes in financial condition, and its results from operations for the last three-year period. In 2003, the SEC released new rules on the items management is required to discuss in the MD&A.

a. Liquidity

b. Capital resources

c. Results of operations (a line-item analysis of material changes) d. Off-balance sheet arrangements

e. Tabular disclosure of contractual obligations



C14-1 Objectives of Securities Acts [CMA Adapted]

a. Investment practices of the 1920s that contributed to the erosion of the stock market include the following:

– The prices of securities were manipulated through the use of "wash sales" or "matched orders." Brokers or dealers engaged in prearranged buy and sell orders that created the impression of activity and drove up prices. When the public began buying, driving prices up even higher, the brokers and dealers would sell, making huge profits before prices fell back to market level.

– False or misleading financial statements were issued to lure unwary investors. – The excessive use of credit to finance speculative activities served to

undermine the market. There was no limit to the amount of credit or "margin" that a broker could extend to a customer. As a result, a slight decline in market prices often caused overextended customers to sell when margins could not be covered, thus further reducing prices.

– Corporate officials and other "insiders" misused information about corporate activities to take advantage of fluctuations in stock prices.

b. 1. The objectives of the Securities Act of 1933 are to:

– provide investors with financial and other information concerning the initial offering of securities for sale, thus ensuring full and fair disclosure. Companies were required to file a registration statement and prospectus for review.

– prohibit misrepresentation, deceit, and other fraudulent acts and practices in the sale of securities.

2. The objectives of the Securities Exchange Act of 1934 are to:

– regulate the trading of securities on secondary markets by requiring the registration of securities traded on any national exchange.

– create a regulatory agency, the Securities and Exchange Commission, to administer the requirements of both the 1933 and 1934 acts.


C14-2 Roles of SEC and FASB [CMA Adapted]

a. The Securities and Exchange Commission (SEC) was created through the Securities Exchange Act of 1934. As a result of this Act, the SEC has legal authority over accounting practices. The U.S. Congress has given the SEC broad regulatory power to control accounting principles and procedures in order to fulfil its goal of full and fair disclosure. Specific responsibilities of the SEC include:

– Regulating the sale of securities on secondary markets

– Regulating the initial offerings and actual sales of stock in interstate commerce

– Prescribing the forms and reports to be filed and be made publicly available (Students may include a number of other responsibilities. The important

learning objective is that students understand that the SEC is very important in the U.S.‟s capital formation process.)


C14-3 Information Content of Proxy

The information presented in the company‟s proxy is expected to change from year to year. Some instructors will select a local company or other one of interest to their students as an exemplar for their discussions during the semester. There are strong learning advantages to using one company for applications of the concepts presented in your advanced financial accounting course. This case can be applied to any publicly traded company.

a. The proxy includes the proposals placed before the shareholders. Common examples of such proposals include:

1. Election of Directors. The company lists the Directors up for election this year The Board of Directors normally unanimously recommends a vote “For” the nominees. 2. Ratification of Independent Registered Public Accounting Firm. The Board‟s Audit

Committee appoints the independent registered public accounting firm (auditors) for the year. The Board of Directors normally unanimously recommends a vote “For” this proposal.

3. Stockholder Proposals. Sometimes groups of stockholders will make proposals they wish to have placed for vote by the shareholders. These resolutions may include provisions regarding shareholders‟ rights, establishment of specific committees by the Board of Directors to issue reports on issues of concern to corporate governance by the management of the company, and proposals to revise specific sections of the company‟s By-Laws. Management typically makes a recommendation either in favor of, or in opposition to, each of the stockholder proposals.

b. The Board of Directors of most registrants have four standing committees, as follows: 1. Audit Committee. This committee has a number of oversight responsibilities for

financial matters, as defined in the Sarbanes-Oxley Act of 2002. Included is the responsibility to appoint, retain, compensate, evaluate, and if appropriate, to replace the auditors. The members of the Audit Committee must be nonmanagement members of the Board of Directors.

2. Compensation Committee. The Compensation Committee approves and recommends standards for the company‟s compensation program and plans, including incentive compensation, retirement, and other benefit plans. The Committee reviews the performance of the Chief Executive Officer and fixes his compensation. In addition, the Committee reviews the company‟s compensation practices for employees and officer workers, and fixes the salary and other compensation of all officers of the company.

3. Governance Committee. This committee reviews the company‟s Shareholder Rights Plan, makes recommendations regarding the appropriate size and composition of the board, recommends a slate of nominees for the board, and makes recommendations for candidates for election as officers of the company.

4. Public Policy Committee. The Public Policy Committee assists in the board‟s oversight responsibilities for company matters related to public and social policy, including investor, consumer and community relations issues and employee safety programs, policies and procedures, and labor relations issues. The committee also oversees the company‟s business conduct code.


C14-4 Form 10-K Disclosures

a. The Management‟s Discussion and Analysis must contain information on the following five items: liquidity, capital resources, results of operations, off-balance sheet arrangements, and a tabular disclosure of contractual obligations. Companies may present additional analysis, but those five items are required by the SEC. Caterpillar begins with an overview of the year and presents a discussion at a line-of-business level, on a comparative basis for a three-year period. Caterpillar‟s MD&A is one of the most extensive of those provided by publicly traded companies and includes comments on a number of important issues affecting the company.

b. The information presented in the Management‟s Report on Internal Control Over Financial Reporting states that the management of the company is responsible for establishing and maintaining adequate internal control over financial reporting, that internal control over financial reporting may not prevent or detect misstatements, that management has assessed the effectiveness of the company‟s internal control over financial reporting as of the end of the fiscal year and found the internal control system to be effective, and that management‟s assessment of the effectiveness of the company‟s internal control over financial reporting has been audited by the company‟s independent registered public accounting firm. (Note that several of these provisions are requirements of the Sarbanes-Oxley Act of 2002.)

c. The Report of Independent Registered Public Accounting Firm includes substantial discussion of their evaluation of management‟s assessment of the effectiveness of internal control over financial reporting, including a description of the criteria and methodology of that review. The assessment criteria for internal control over financial reporting are those developed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).


C14-5 Registration Process [CMA Adapted]

a. The Securities Act of 1933 requires a filing by any firm that raises capital in the primary capital market through the initial sale of a new security, whether by a public offering made directly by the firm or through an underwriter. The registration applies only to the specific quantity of the specific security being offered.

The Securities Exchange Act of 1934 requires a filing by any firm whose securities are being traded publicly in the secondary capital market. These securities are registered as an entire class with no amount specified. A secondary offering of a firm's securities also requires the filing of a registration statement.

b. An objective of the 1933 Act is to provide investors with material information concerning the issuing firm, its management, the securities offered for public sale, and the proposed use of the proceeds from the sale. The SEC does not evaluate the creditworthiness of the firm or attest to the potential of the security as an investment. The 1933 Act is an attempt to ensure that investors are given full and fair disclosure of all pertinent information about the issuing firm, including audited financial statements.

c. SEC Publication Explanation

Regulation S-X Instructions as to the form and content of the required financial statements.

Regulation S-K Instructions as to the form and content of required disclosures other than the required financial statements (i.e., supplementary financial information, summary financial data, and non-financial information).

Financial Reporting Releases Constitute part of Regulation S-X in the (formerly Accounting Series determination of the form and content of the Releases) required financial statements.


C14-6 Change in Auditors and Form 8-K [CMA Adapted]

(Students can access Item 304 of Regulation S-K on the SEC‟s Website.)

a. Jerford Company must include the following information in Form 8-K to the SEC regarding its change in auditors:

1. State if the former accountant resigned, declined to stand for re-election or was dismissed, and the date thereof.

2. A statement whether the former auditor's report on the financial statements for either of the previous two years contained an adverse opinion or a disclaimer of opinion, or was qualified in any way and the nature of each adverse opinion, disclaimer of opinion, or qualification.

3. A statement as to whether the decision to change accountants was recommended or approved by the audit or similar committee, or by the board of directors if the company does not have an audit committee.

4. A statement whether there were any disagreements with the former auditor on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure during the 24 months before the change. Each disagreement, if any, would have to be fully described whether or not it was resolved to the satisfaction of the former auditor. In addition, those disagreements which would have caused the former auditor to make reference to the subject matter of the disagreement in his report had they not been resolved would have to be identified.

5. A letter from the former auditor as an exhibit with Form 8-K that states whether the former auditor agrees or disagrees (including reason for disagreement) with the facts of the case as presented by the registrant.


C14-7 Form 8-K [CMA Adapted]

a. 1. The purpose of Form 8-K, called the Current Report, is to ensure that any significant event affecting a firm's policies or financial position is immediately reported to the SEC. Covering the period since the filing of the latest annual or quarterly report, Form 8-K provides a continuous stream of material information concerning specified events between filings.

2. Form 8-K must be filed with the SEC within 4 business days after the occurrence of a reportable event. Violation of the 8-K filing requirement may jeopardize a registrant's status.

3. Form 8-K is a narrative report with sufficient flexibility to permit management to describe any significant events. The first page must contain the standard 8-K heading identifying the reporting company, and the body of the report details the specified event or events in accordance with the disclosure requirements outlined in the SEC‟s regulations for each event. The company may include other information, financial or otherwise, it deems appropriate for a complete description of the event. The report must be signed by an officer of the corporation.

4. The inclusion of audited and pro forma financial statements is required when reporting the acquisition of a business. Financial statements may be included in a Form 8-K in order to clarify the effect of any event on the corporation. In general practice, financial statements are included if an event is deemed to have a material financial impact.


C14-8 Audit Committees [CMA Adapted]

a. The Sarbanes-Oxley Act specifies that audit committees be composed of nonmangement members of a company‟s board of directors. Generally, the chair of the audit committee has financial experience. The Sarbanes-Oxley Act requires the auditor to report directly to, and have its work overseen by, the company‟s audit committee, not the company‟s management. The audit committee is responsible for the appointment, compensation and oversight of the work of the public accounting firm employed by the company. Furthermore, the audit committee must approve all services provided by the auditor, and the auditor must report the following additional information to the audit committee: critical accounting policies and practices, alternative treatments within GAAP that have been discussed with the company‟s management, accounting disagreements between the auditor and management, and any other important issues arising between the auditor and management.

b. The audit committee should act as an overseer of the company's internal audit staff. The audit committee would be concerned with such matters as the scope of internal audits, the completion of assignments, and discussion of the results of reviews conducted by the internal audit staff.


C14-9 SEC

a. A listing of recent SABs can be found on the SEC‟s web site ( Click on Staff Accounting Bulletins under the Staff Interpretations heading. There are now over 100 of these SABs and it is expected that the staff will continue to publish new ones in the future. Encourage students to select an interesting SAB that interests them.

The statements in Staff Accounting Bulletins are not rules or interpretations of the Commission nor are they published as bearing the Commission's official approval. Rather they reflect the Commission staff‟s views and provide interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws.

The SABs may be very narrowly written to describe the staff view of a particular event or circumstance. The purpose of the SABs is to disseminate staff views on particular matters for guidance in other situations where events and transactions have similar accounting implications.

b. (1) & (2) The SEC‟s web site ( brings up a Litigation link. That link includes information on SEC enforcement actions (including both Federal Court and Administrative Proceedings), briefs filed by the SEC staff, and notices on specific cases.

(1) The Division of Enforcement was created in August 1972.

(2) In general, the Commission's enforcement staff conducts investigations into possible violations of the federal securities laws. The Commission will prosecute the civil suits in the federal courts or conduct administrative proceedings.

In civil suits, the Commission seeks injunctions (i.e., an order that prohibits future violations) and will often seek civil money penalties and the return of illegal profits. In addition, the courts may also bar or suspend individuals from acting as corporate officers or directors.

The Commission can bring a variety of Administrative Proceedings. These proceedings are heard by administrative law judges and by the Commission itself. There are many types of proceedings, a few examples include: a cease and desist order, an order to the respondent to disgorge ill-gotten funds, and an order to suspend employment.

(3) A listing of recent Litigation Releases can be found at the SEC‟s web site. Encourage students to select a recent case that looks interesting to them.


C14-10 EDGAR Database

a. Internet URL:

The above Internet address provides access to the EDGAR database homepage. From the homepage, the user is able to select “Search for Company Filings,” then select “Historical EDGAR Archive.” Students may now enter the name of their selected company. It is easiest to identify a company name prior to performing the search. Students will quickly see the large number of filings made by publicly held companies. As for describing the purposes of each of the filings, students could access the “Descriptions of SEC Forms” link on the opening page of the SEC‟s web site.

C14-11 Discovery Case

The Sarbanes-Oxley Act (SOX) presents a number of major changes in the auditing/consulting relationship between companies and accounting firms. The Act was written because of the major accounting and financial mismanagement cases discovered in 2000 and 2001. These cases resulted in the bankruptcies of very large companies such as Enron and WorldCom and the demise of Arthur Andersen, LLP, one of the Big-5 public accounting firms at that time.



E14-1 Organization Structure and Regulatory Authority of the SEC [CMA Adapted]

1. c

2. b

3. b

4. d

5. d

6. d

E14-2 Registration of New Securities [CMA Adapted]

1. e

2. c

3. b

E14-3 Reporting Requirements of the SEC [CMA Adapted]

1. a

2. c

3. b

4. d

5. e

6. b

7. d

E14-4 Corporate Governance [CMA Adapted]

1. a

2. e

3. b


E14-5 Application of Securities Act of 1933 [CMA Adapted]

The impact of the registration requirements of the Securities Act of 1933 on each of the proposals is as follows:

1. The offering of the participation units in the citrus groves, although ostensibly the sale of an interest in land, constitutes an offer to sell, or the sale of, securities within the meaning of section 2 of the Securities Act of 1933. Although land itself is not a security, the offering of the land in conjunction with a management contract has been held to constitute the offering of a security. Since interstate commerce and communications are to be used and since there is no apparent transactional exemption available, a registration under the 1933 act is required. Whatever hope there was of an intrastate offering exclusion is dashed by the fact that the units will be offered and sold in two states.

2. The short-term borrowings evidenced by the promissory notes of Various Enterprises are exempt from registration. This exemption from categorization as a security for purposes of registration under the act applies to commercial paper such as notes, drafts, checks, and similar paper arising out of a current transaction that have a maturity not exceeding nine months. In addition, the private placement exemption is applicable.

3. If Various is deemed to be a controlling person insofar as Resistance is concerned, it must register the securities in question before it can legally sell them. The Securities Act of 1933 provides in connection with its definition of the term “underwriter,” that, “the term ‟issuer‟ shall include in addition to an issuer, any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer.”


E14-6 Federal Securities Acts [AICPA Adapted]

1. a

2. d

3. b

4. d

5. a

6. c

7. b