Hero Image for page

New SEC Rules Focus on Financial Accountability

A version of this article was published in The Daily Record on March 20, 2003.

As companies prepare to file their Form 10-K, recent rule changes promulgated by the Securities and Exchange Commission should be considered. While most of the form and disclosure changes are applicable to the next year’s Form 10-K and proxy, the new standards will go into effect in the current fiscal year. Below is a summary of the SEC’s recent actions.

Generally accepted accounting principles are the standard for reporting financial results. At times, companies use measures of performance that are not computed in accordance with GAAP. Regulation G requires that public companies which use non-GAAP financial measures include a presentation of the most directly comparable GAAP-based financial measure and reconciliation between the two. This rule goes into effect on March 28, 2003.

A non-GAAP financial measure is defined by Regulation G as a numerical measure of financial performance, financial position or cash flows that includes amounts to or excludes amounts from (or otherwise adjusts) the GAAP number. An example of this would be a measure of performance or liquidity that is calculated differently from those contained in the profit and loss statement or statement of cash flow.

Excluded from Regulation G are non-GAAP financial measures relating to (1) proposed business combination disclosures, such as merger related proxy statements; (2) non-GAAP per share measures in filed SEC reports; (3) certain measures used by foreign private issuers; (4) EBIT (earning before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation and amortization); and (5) certain adjustments to eliminate or “smooth” items identified as non-recurring, infrequent or unusual, unless the charge or gain is reasonably likely to recur within two years, or occurred within the prior two years.

Regulation G is not intended to capture measures that fall outside the scope of financial statements, such as operating and statistical measures, unit sales, numbers of subscribers, etc., or ratios or statistics relating to GAAP-based financial measures. Regulation G contains a general disclosure requirement that prohibits material misstatements or omissions that would make the presentation of a non-GAAP financial measure, in light of the circumstances in which it is made, misleading.

Regulation G also requires a reconciliation of the non-GAAP financial measure to the most directly comparable GAAP financial measure. In the case of oral disclosures, the company may provide the required Regulation G information by (1) posting that information on its Web site; and (2) disclosing the location and availability of the information during the presentation.

Item 10 of Regulation S-K has been amended to require in filings made with the SEC:

  • A presentation with equal or greater prominence of the most directly comparable GAAP measure;
  • A quantitative reconciliation (by schedule or other clearly understandable method) of the differences;
  • The reasons why management believes that the presentation of the non-GAAP financial measure provides useful information and;
  • To the extent material, a statement disclosing other purposes for which the non-GAAP measure is used.In addition, the amendment to Item 10 of Regulation S-K prohibits:
    • Excluding from non-GAAP liquidity measures (except EBIT and EBITDA) charges or liabilities that require cash settlement absent an ability to settle in another manner;
    • Adjusting a non-GAAP measure to eliminate or smooth items when the charge or gain has occurred in the past two years or is reasonably likely to recur within two years;
    • Presenting non-GAAP financial measures on the face of the financial statement;
    • Presenting non-GAAP financial measures on the face of any required pro-forma financial information; and
    • Using titles or descriptions for non-GAAP financial measures that are the same as or confusingly similar to GAAP measures.

Form 8-K earnings disclosure

Form 8-K has been amended to add new Item 12, “Disclosure of Results of Operations and Financial Condition,” requiring companies to file a Form 8-K within five business days of any public announcement or release regarding operations or financial condition for an annual or quarterly fiscal period. New Item 12 excepts oral communications or web casts which occur within 48 hours after a related written release that triggers the Form 8-K filing requirement. In this situation, no Form 8-K is required for a presentation if the announcement was furnished on Form 8-K prior to the presentation, the presentation is broadly accessible, the financial and statistical information contained in the presentation is provided on the company’s Web site together with any additional information required under Regulation G, and the presentation was announced by a widely disseminated press release that included instructions on accessing the presentation.

This new Form 8-K reporting requirement does not require public companies to issue an earnings release or similar announcement, but if a public company does issue such a release and it contains material non-public information regarding results of operations or financial condition for an annual or quarterly period that has ended, it would trigger a Form 8-K reporting obligation. Information furnished to the SEC pursuant to new Item 12 of Form 8-K is not deemed “filed” but rather merely furnished for public availability. This reduces the liability of the company for the information so provided. Earnings releases and other disclosures that trigger the requirements of new Item 12 are also subject to Regulation FD. A Form 8-K furnished to the SEC would satisfy the Regulation FD obligation only if the Form 8-K is furnished within the time frame required by Regulation FD. If the Regulation FD obligation is satisfied by another form of public disclosure, a Form 8-K would still be required to be furnished within the five business day limit required by Item 12.

Disclosure of Audit Committee financial expert Effective March 3, 2003

The SEC adopted final rules (amended Item 401 of Regulation S-K) requiring a company to disclose whether it has at least one “audit committee financial expert” serving on its Audit Committee, and if so, the name of the expert and whether the expert is independent. The new definition of financial expert means a person who has:

  • An understanding of GAAP financial statements;
  • The ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves;
  • Experience preparing, auditing, analyzing or evaluating financial statements that are generally comparable to the nature and complexity of issues that can reasonably be expected to be raised by the company’s financial statements, or experience in actively supervising one or more persons engaged in such activities;
  • An understanding of internal controls and procedures for financial reporting; and
  • An understanding of audit committee functions.

The rules require that the expert must have acquired the above attributes through any one or more of the following:

  • Education and experience as a principal financial officer, accounting officer, controller, public accountant or auditor, or similar position;
  • Experience actively supervising any such person;
  • Experience overseeing or assessing the performance of companies or accountants with respect to the preparation, auditing or evaluation of financial statements;
  • Other relevant experience.

If the expert qualifies by virtue of “other relevant experience”, the company’s disclosure must briefly list that person’s experience. At the same time the SEC has included a safe harbor provision stating that the audit committee financial expert will not be deemed an “expert” for any purpose under the securities laws, and that the designation of the person as the audit committee financial expert does not impose any additional duties, obligations or liabilities upon that person or affect the duties, obligations, or liabilities of any other member of the audit committee or board of directors. The new audit committee disclosure item is included in Part III of Form 10-K. Therefore, a company that includes the disclosure in its proxy statement may incorporate that information into its Form 10-K if it files its proxy statement within 120 days after the end of its fiscal year. The new audit committee disclosure requirement commences with the Forms 10-K for fiscal years ending on or after July 15, 2003 (December 15, 2003 for small business issuers).

Code of Ethics

Further implementing the requirements of the Sarbanes-Oxley Act, the SEC has adopted new Item 406 of Regulation S-K requiring a company to adopt a Code of Ethics that applies to the principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, or disclose the reasons why it has not done so. Any amendments to or waivers from the Code of Ethics relating to any of those officers must be promptly disclosed. A “Code of Ethics” is a written standard designed to deter wrongdoing and to promote:

  • Honest and ethical conduct (including handling conflicts of interest);
  • Full, fair, accurate, timely and understandable disclosure in SEC reports and other public communications;
  • Compliance with applicable laws;
  • Prompt internal reporting of code violations;
  • Accountability for adherence to the code.

The company must make the code of ethics publicly available through one of three alternative methods:

  • Filing the Code as an exhibit to the annual report;
  • Posting the text on the Web site and disclosing in the Form 10-K the company’s Web site address and intention to post the Code on the Web site;
  • Providing an undertaking in the Form 10-K to furnish a copy of the Code of Ethics to any person without charge upon request.

Any amendment to the Code of Ethics and any waiver granted to one of the specified officers must be disclosed on Form 8-K within 5 business days. Alternatively, a company may disseminate the information on its Web site, but only if it has previously disclosed in its most recent Form 10-K the intention to use its Web site as a method of disclosure. The new Code of Ethics disclosure requirement commences with the Forms 10-K for fiscal years ending on or after July 15, 2003.

Disclosure of off-balance sheet arrangements and aggregate contractual obligations

Item 303 of Regulation S-K, relating to Management’s Discussion and Analysis (MD&A), has been amended to require disclosure regarding all material off-balance sheet transactions, arrangements, and obligations, as well as relationships of the issuer with unconsolidated entities and other persons, all as mandated by the Sarbanes-Oxley Act. An “off-balance sheet arrangement” includes any contractual arrangement in which an unconsolidated entity is a party and pursuant to which the company:

  • is obligated under guarantees;
  • has a retained or contingent interest in assets transferred to the entity that serves as credit, liquidity or market risk support;
  • has any obligation under derivative instruments;
  • has any obligation as a result of any interest in the unconsolidated entity which provides financing, liquidity, market risk or credit risk support to the company; or
  • engages in leasing, hedging or research and development services for the company.

These arrangements include contracts that contingently require the company to make payments based upon certain changes to assets or based on the entity’s failure to perform, or an indemnification contract that is based on changes in an underlying asset, liability or equity security, or indirect guarantees of indebtedness of others which requires a transfer of funds to the other. The threshold for disclosure requires the arrangement to have, or to be reasonably likely to have, a current or future effect on the company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors.

This disclosure is required to be made in a separately captioned section of MD&A. In addition, companies will be required to disclose in tabular format the amount of payments due under specified contractual obligations for specified periods of time. Contractual obligations include for example, long-term debt, capital lease obligations, operating leases, purchase obligations, and other long term liabilities reflected on the GAAP balance sheet. In addition to a total column, required payments must be disclosed in separate columns for periods of less than 1 year, 1 to 3 years, 3-5 years, and more than 5 years. The new rule applies the safe harbor for forward looking information to the disclosure included under this new category. The new disclosure requirement is applicable to filings containing financial statements for fiscal years ending on or after June 15, 2003.

Auditor independence requirement

Strengthening the auditor independence rules, the SEC adopted new rules under the provisions added by the Sarbanes-Oxley Act to Section 10A of the Securities Exchange Act of 1934. The Sarbanes-Oxley provisions prohibit many non-audit services; require the audit committee to pre-approve allowed non-audit services; establish mandatory rotation of lead partner and concurring partner every five years; require the auditor’s report to be timely presented to the audit committee disclosing critical accounting policies used by the company, alternative accounting treatments discussed with management, and other written communications, including a schedule of unadjusted audit differences; and prohibit audit services by an audit firm if key members of management were recently employed in an audit capacity by that firm.

In addition, an auditor would not be considered independent if the audit partner received compensation based on selling engagements for services other than auditing. The new SEC adopted Rules impose a one year “cooling off” period before any member of the audit engagement team can begin working for the company in certain key positions. Moreover, the Sarbanes-Oxley Act is silent as to the “time-out” period and to rotation of other members of the audit team; therefore, the SEC rules require at least a two year time-out and a seven year rotation for all other members of the audit team. The SEC also adopted transition rules for certain non-auditing services approved by the audit committee, and not prohibited under the statute.

Item 9 of Schedule 14A, which requires proxy statement disclosure regarding the accounting fees, has also been modified. Under the caption “Audit Fees,” the company must disclose the aggregate fees billed for each of the last two fiscal years for professional services rendered by the independent accountant. Under the caption “Audit Related Fees,” the company must disclose the aggregate fees for the last two fiscal years not reported as audit fees for services reasonably related to either the audit or the review of financial statements. Under the caption “Tax Fees,” disclosure is required of aggregate fees billed for tax compliance, tax advice and tax planning. Finally, under the caption “All Other Fees,” the company must disclose the aggregate fees billed in the last two years for services not specified above. In each case, the company should describe the nature of the services rendered. In addition, the company must disclose the audit committee’s pre-approval policies and procedures, the percentage of services that were approved by the audit committee, and, if greater than 50 percent, the percentage of hours expended by the accountant that was attributable to work performed by persons other than full-time employees of the accounting firm.

Implementation of standards of Professional Conduct for Attorneys

An attorney representing or advising a company in regard to SEC matters that becomes aware of evidence of a material violation by the company or by any officer, director, employee, or agent of the company, must report the evidence to the company’s chief legal officer or to both the chief legal officer (CLO) and to the chief executive officer (CEO).

The CLO is required to institute an inquiry to determine whether a material violation has occurred, is on-going, or is about to occur. If the CLO determines that no violation has occurred, is on-going, or about to occur, he or she must notify the reporting attorney, describing the basis for such determination. Otherwise, the CLO must take all reasonable steps to cause the company to adopt an appropriate response, and advise the reporting attorney accordingly. In lieu of this inquiry, the CLO may report evidence of the violation to a qualified legal compliance committee established by the company.

If the reporting attorney believes that an appropriate response has not been provided, the attorney must report the evidence of material violation to the audit committee, or to another committee consisting solely of independent directors, or to the board of directors. If the reporting attorney believes it is futile to report to the CLO and CEO, the reporting attorney may report directly to the board or the independent committee. (This reporting procedure does not apply to an attorney engaged or directed to investigate or assert a colorable defense on behalf of the company.) If the attorney believes that an appropriate response was not given within a reasonable time to his or her report, the attorney must explain his or her reasons to the CLO, the CEO and the directors to whom the report was made.

Under the new rules, an attorney may reveal to the SEC, without the company’s consent, confidential information relating to the representation of the company to the extent the attorney reasonably believes necessary to prevent a material violation that is likely to cause substantial injury to the financial interest or property of the company or its investors; to prevent the company from committing perjury, or perpetrate a fraud in an SEC investigation or proceeding; or to rectify the consequences of a material violation by the company that caused, or may cause, substantial injury to the financial interest or property of the company or its investors.

The new rule also contains a provision protecting an attorney that complies in good faith with the new rule to ensure that he or she is not subject to sanction under any other standards imposed by any state or jurisdiction. In light of vigorous opposition, the SEC did not adopt its proposal to require a “noisy withdrawal” by the reporting attorney if the company’s response is not reasonably acceptable. Although not adopted, however, it is not withdrawn. The SEC has re-proposed the “noisy withdrawal” rules, and the comment period expires at the end of March. Obviously, these rules impose frightful new standards that could well result in a “chilling effect” on the relationship between a company and its counsel. Stay tuned.