Chapter 14

SEC Reporting

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 SEC
• The Securities and Exchange Commission
(SEC) is an independent federal agency
created in 1934 responsible for regulating
securities markets.

• The ability of companies to raise capital in the

stock markets and the hundreds of millions of
shares that are traded daily are both indications
of the SEC’s success in maintaining an effective
marketplace for companies issuing securities
and for investors seeking capital investments
14-2
History of Securities Regulation

• The need for regulation has gone hand in

hand with the offering of securities to the
general public.

• In the thirteenth century, King Edward

established a Court of Alderman to regulate
security trades in London.

14-3
 History of Securities Regulation

• In the latter part of the eighteenth century,

England’s Parliament passed several acts,
termed the Bubble Acts, to control questionable
security schemes that had become popular.

• In 1790, the New York Stock Exchange was

created to serve as a clearinghouse for
securities trades between members of the
exchange.

14-4
 History of Securities Regulation

• The need for additional sources of capital

paralleled the advent of the industrial revolution
and the growth of commerce in the United
States.

• Some individuals took advantage of this situation

and offered securities of fictitious companies for
sale to the general public or used financial
reports that were not factual about the offering
company’s financial picture.

14-5
History of Securities Regulation

• In 1911, because of the lack of any federal

security regulatory laws, several states began
passing what were called “blue sky,” that is,
which did not have a sound financial base.

• During 1920s, a number of abuses (as shown

on the next slide) were occurring in the
marketplace.

14-6
History of Securities Regulation
• Certain speculators sought to manipulate
selected stock prices by issuing untrue press
releases.
• Companies were not required to be audited,
and some of them issued false and misleading
financial statements.
• Investors were using excessive amounts of
margin; that is, they were borrowing heavily to
invest in stocks.
• Some employees of companies were using
inside information to trade their companies
stock personal advantage.
14-7
History of Securities Regulation

• The month of October 1929, is often viewed

as the beginning of the Great Depression.

• Stock prices plunged to record lows within just

a few weeks as panic took over the market.

• It became obvious that some form of federal

regulation was necessary in order to restore
confidence in the stock market.

14-8
 History of Securities Regulation
• The Securities Act of 1933 regulated the initial
distribution of security issues by requiring
companies to make “full and fair” disclosure of
their financial affairs before their securities could
be offered to the public.
• The Securities Exchange Act of 1934 required
the periodic updating of financial information for
all companies whose stocks were traded on a
stock exchange.
• In addition, the 1934 act created the Securities
and Exchange Commission.
14-9
 History of Securities Regulation

• The SEC has the legal responsibility to regulate

trades of securities and to determine the types
of financial disclosures that a publicly held
company must make.

• Although the SEC has the ultimate legal

authority to establish the disclosure
requirements, it has worked closely with the
accounting profession to prescribe accounting
principals and standards.

14-10
History of Securities Regulation

• The SEC’s role is to ensure full and fair

disclosure; it does not guarantee the
investment merits of any security.

• The SEC has consistently taken the position

that investors must have the necessary
information to make their own assessments
to the risk and return attributes of a security.

14-11
History of Securities Regulation

• The present role of the SEC is complex.

• In 1935, its first year of full activity, only 284
new securities were registered for sale to the
general public.
• Now the number of new securities being
registered for sale has grown to more than
5,000 per year.
• The SEC also regulates more than 10,000
securities brokers and dealers and must
monitor stock exchange volumes often
surpassing a billion shares a day.
14-12
 EDGAR

• The SEC has developed an electronic report

filing systems known as EDGAR (Electronic
Data Gathering Analysis, and Retrieval).

• EDGAR filings may be on the World Wide Web,

under the SEC’s home page (www.sec.gov)
within 24 hours of filing.

14-13
International Harmonization

• In the late 1980s, the SEC urged the

International Organization of Securities
Commission (IOSCO) to increase its efforts to
narrow the alternative accounting treatments
allowed for international accounting standards.

14-14
 International Harmonization

• With the encouragement of the SEC and the

IOSCO, the International Accounting Standards
Board (IASB) has been working on revising its
accounting standards to develop a more
comparable and uniform set of standards that
could be used by all companies seeking
financing through any of the world’s major stock
markets, including those of the United States.

14-15
 Organizational Structure of the SEC

• The Commission consists of five members

appointed by the President of the United States,
with the advice and consent of the Senate.

• The four divisions of the SEC are as follows:

• Division of Corporation Finance
• Division of Enforcement
• Division of Investment Management
• Division of Market Regulation
14-16
 Laws Administered by the SEC

• In addition to the Securities Acts of the 1933

and 1934, the Commission is responsible for
administering other laws established to regulate
companies or individuals involved with the
securities markets. The Laws are provided on
the next slide.

14-17
Laws Administered by the SEC

• Public Utility Holding Company Act of 1935

• Trust Indenture Act of 1939
• Investment Company Act of 1940
• Investment Advisors Act of 1940
• Securities Investor Protection Act of 1970
• Foreign Corrupt Practices Act of 1977
• Federal Bankruptcy Acts
• Sarbanes-Oxley Act of 2002

14-18
 The Regulatory Structure
• Regulation S-X and Regulation S-K, govern
the preparation of financial statements and
associated disclosures made in reports to the
SEC.
• Regulation S-X presents the rules for preparing
financial statements, footnotes, and auditor’s
report.
• Regulation S-K covers all the non-financial
items, such as management’s discussion and
analysis of the company’s operations and
present financial position.
14-19
 The Regulatory Structure
• Financial Reporting Releases (FRRs) disclose
amendments or adoption of new rules that affect
prepares of financial statements and other
disclosures.
• Accounting and Auditing Enforcement Releases
(AAERs) present the results of enforcement
actions taken against accountants or other
participants in the filing process.
• The use of FRRs and AAERs was initiated in
1982. Prior to that time, Accounting Series
Releases (ASRs) were used.
14-20
 The Regulatory Structure

• Staff Accounting Bulletins (SABs) allow the

Commission’s staff to make announcements on
technical issues with which it is concerned as a
result of reviews of SEC filings.

• SABs are not formal actions of the Commission;

nevertheless, most preparers do follow these
bulletins because they represent the views of
the staff that will be reviewing their companies’
filings.

14-21
 Basic Information Package (BIP)

• In the 1980, the SEC undertook a project to

reduce the duplicative disclosures companies
were required to make for the annual report
and in each additional filing with the SEC; that
is, the Commission sought to integrate all the
disclosures (a.k.a., “incorporation by reference”).

• The five classes of information constituting the

BIP are provided on the next slide.

14-22
Basic Information Package (BIP)

• Market price and dividends

• Selected financial data
• Management discussion and analysis (MD&A)
• Audited financial statements and
supplementary data
• Other information

14-23
The Registration Process

• Companies wishing to sell debt (or stock)

securities in interstate offerings to the general
public are generally required by the Securities
Act of 1933 to register those securities with
the SEC.

• The process of public offerings of securities

begins with the preparation of the registration
statement. The most common are Form S-1,
Form S-2, and Form S-3.

14-24
 SEC Review and Public Offering

• Most first-time registrants receive a “customary

review,” which is a thorough examination by the
SEC and may result in acceptance or,
alternatively, a comment letter specifying the
deficiencies that must be corrected before that
securities may be offered for sale.

• Established companies that already have stock

widely traded generally are subject to a
summary review or a cursory review.

14-25
SEC Review and Public Offering

• Once the registration statement becomes

effective, the company may begin selling
securities to the public.

• This review period is 20 days unless the

company receives a comment letter from
the SEC.

14-26
 SEC Review and Public Offering

• Between the time the registration statement is

presented to the SEC and it’s effective date, the
company may issue a preliminary prospectus,
referred to as a red herring prospectus, which
provides tentative information to investors about
an upcoming issue.

14-27
SEC Review and Public Offering

• The name “red herring” comes from the red

ink used on the cover for this preliminary
prospectus, indicating that it is not a offering
statement and that the securities being
discussed are not yet available for sale.

• In addition, the company generally prepares a

“tombstone ad” in the business press to inform
investors of the upcoming offering. These ads
are bordered in black ink, hence the title.

14-28
 SEC Review and Public Offering

• The time period between the initial decision to

offer securities and the actual sale may not
exceed 120 days. In the interim, many factors
may effect the stock market and may decrease
the company’s ability to obtain capital.

• In 1982, the SEC devised the shelf registration

rule for large, established companies with other
issues of stock already actively traded.

14-29
SEC Review and Public Offering

• These companies file a registration statement

with the SEC for a stock issue that may be
“brought off the shelf” and, with the aid of an
underwriter, updated within a very short time,
usually two or three days.

• A shelf registration is limited to 10 percent of

the company’s currently outstanding stock, but
allows large companies to select the optimal
time to sell their stock.

14-30
 Accountants’ Legal Liability

• Accountants play a key role in the preparation of

the registration statement.

• Accountants are liable for any materially false or

misleading information to the effective date of
the registration statement.

• Plaintiffs suing the accountant are not required

to show they relied on the registration statement,
only that the statement was wrong at the
effective date!!!
14-31
Accountants’ Legal Liability

• Accountants have a “due diligence” defense,

the result of interpretations by the courts as
to what is generally required in a reasonable
investigation of the company’s financial
position; however, the broad legal exposure
causes many anxieties for accountants
involved with the offering of securities.

14-32
Periodic Reporting Requirements

• Form 10-K is the annual report of the SEC

and must be filed within 90 days after the
end of the company’s fiscal year.

• Form 10-Q is the interim report of the SEC;

it is due within 45 days after the end of each
quarter except the fourth quarter, when the
10-K is issued.

14-33
Periodic Reporting Requirements

• Form 8-K is used to disclose unscheduled

material events. This form is due within 15
days after the occurrence of the “current
event,” defined as follows (see next slide):

14-34
Periodic Reporting Requirements
• A change in the control of the registrant.
• Acquisition or disposal of major assets.
• Bankruptcy or receivership of the registrant.
• Changes in the registrant’s certifying
accountants.
• Resignations of one or more of the
registrant’s directors.
• A change in the company’s fiscal year.
• Any other events deemed to be of material
importance to security holders.

14-35
 Accountants’ Legal Liability

• The 1934 Securities Exchange Act provides for a

limited exposure from involvement in the
preparation and filing of periodic reports.

• Civil liability is imposed for filing materially false

or misleading statements.

• The accountant’s liability for registration

statements under the 1933 act extends to the
date the registration becomes effective.
14-36
Due Diligence

• Plaintiffs suing accountants under the 1934

act must show that a periodic report contains a
misleading material fact and that they suffered
a loss because they relied on that report.

• Accountants are provided with defenses to

combat any lawsuits brought under the 1934
act.

14-37
Foreign Corrupt Practices Act of 1977

• In the mid-1970s, Congress held a number

of public hearings which brought to light that
millions of dollars in bribes had been paid to
high government officials of other countries
by United States-based companies seeking
to win defense or consumer product contracts.

• Alarmed by the size and scope of these

activities, Congress passed the Foreign
Corrupt Practices Act of 1977 (FCPA) as
a major amendment to the Securities
Exchange Act of 1934.
14-38
Foreign Corrupt Practices Act of 1977

• The FCPA has two major sections:

• Part I prohibits foreign bribes.
• Part II requires publicly held
companies to maintain an
adequate system of internal
controls and accurate records.

14-39
Foreign Corrupt Practices Act of 1977

• The FCPA also had significant effect on

independent auditors by requiring them to
evaluate a company’s internal controls and
to communicate any material weaknesses
in those controls to the company’s top
management and board of directors.

14-40
SEC Policy-Setting Responsibilities
• Although the SEC has the statutory
responsibility to develop and maintain
accounting principles used for financial
reporting, it has permitted the rule-making
bodies of the accounting profession to take
the initiative in establishing accounting
principles and reporting standards.

• It is expected that this arrangement will

continue in the future even in view of
Sarbanes-Oxley.
14-41
 Sarbanes-Oxley
• The Sarbanes-Oxley Act of 2002 significantly
affects auditors and publicly traded companies.
• The proposed law gained impetus after the
revelations about accounting and financial
mismanagement at Enron, WorldCom, and
others.
• Section 101 of the Act established a new
accounting oversight committee to regulate
accounting firms, that is, Public Company
Accounting Oversight Board (PCAOB).
14-42
Sarbanes-Oxley

• The SEC continues to develop the

implementation guidelines for Section 101 and
the various other sections of the Act and,
therefore, the daily business and accounting
press will have continued coverage of the Act.

• The complete Act is linked on the SEC’s web

site (www.sec.gov).

14-43
 Disclosure Requirements

• Virtually every SEC accounting release reminds

registrants of the commitment to full and fair
disclosure of financial information needed by
investors.

• The SEC has taken the lead in requiring

management to provide its analysis of the
operations of the company.

• Examples: management discussion and analysis

section and pro forma disclosures.
14-44
Management Discussion and Analysis

• The management discussion and analysis

(MDA) of a company’s financial condition
and results of operations is part of the basic
information package required in all major
filings with the SEC.

• The financial statements are, after all,

management’s expressions of the economic
consequences of their decisions made
during the period.

14-45
MDA-Required Items

• Specific information about the company’s

liquidity, capital resources, and results of
operations.

• The impact of inflation and changing prices

on net sales and revenues and on income
from continuing operations.

• Material changes in line items of the

consolidated financial statements from
prior-period amount.
14-46
MDA-Required Items (Continued)

• Known material events and uncertainties that

may make historical financial information not
indicative of future operations or future
conditions.
• Any other information the company believes
necessary for an understanding of its financial
condition, changes in financial condition, and
results of operations.

14-47
 Pro Forma Disclosures

• Pro forma disclosures are essentially “what-if”

financial presentations often taking the form of
summarized financial statements.

• Pro forma statements are used to show the

effects of major transactions that occur after the
end of the fiscal period, or that have occurred
during the year and are not fully reflected in the
company’s historical cost financial statements.

14-48
 Pro Forma Disclosures

• The SEC requires pro forma statements to be

presented whenever the company has made a
significant business combination or disposition,
a corporate reorganization, an unusual asset
exchange, or a restructuring of existing
indebtedness.

14-49
Influence on Auditing

• The SEC has consistently taken the lead in

requiring the independence of the auditor
from the client company and in defining the
parameters of the audit function.

• The SEC insists on strict independence of the

auditor as the best protection of the public
investors’ need for full and fair disclosure of a
company’s financial position and performance.

14-50
 Influence on Auditing

• In turn, many of the present auditing standards

are results of actions taken by the Commission.

• In addition to its registration review process,

the SEC’s Division of Enforcement has actively
investigated instances of possible false or
misleading statements that may have been
caused by the failure of generally accepted
auditing standards.

14-51
You Will Survive This Chapter!!!

• Remember SEC does not mean

Southeastern Conference !!!

14-52
 Chapter 14

End of Chapter

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.