July 2005 Financial Reporting Update

BDO SEIDMAN, LLP’S

July 27, 2005

FINANCIAL REPORTING UPDATE

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• Speakers– Ben Neuhausen – National Director – Accounting

Standards– Jay Howell – Associate Director – Assurance

Practice and 404 Practice Leader– Jeff Lenz – National SEC Department

• Replay Access– www.bdo.com/about/publications/assurance

Speakers and Replay Information

Mid-Year FASB/EITF Update

July 2005

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FASB Statement No. 154 Accounting Changes and Error Corrections – A Replacement of APB 20 and FAS 3

• Applies to:– All voluntary changes in accounting principle– Changes required by pronouncements where no specific

transition provisions are included• Requires retrospective application to prior periods for

changes in accounting principle unless impracticable to determine either period-specific effects or the cumulative effect of change.– APB 20 previously required most voluntary changes to be

included as a cumulative effect adjustment to net income of the period of the changes).

• Effective for accounting changes made in fiscal years beginning after 12/15/2005.

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Accounting Changes

• Restatement: defined as the revising of previously issued F/S to reflect the correction of an error.

• Retrospective application: defined as application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. – Requires:

1. Cumulative effect of change on periods prior to those presented shall be reflected in carrying amounts of assets and liabilities as of beginning of first period presented;

2. An offsetting adj., if any, shall be made to opening balance of RE for that period; and

3. F/S for each individual prior period presented shall be adj. to reflect period-specific effects of applying the new accounting principle.

– Limited to “direct effects” of change (including income tax effects)• Indirect effects (e.g., change in nondiscretionary profit-sharing payments)

should be recognized in period of accounting change

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FASB Interpretation No. 47 Accounting for Conditional Asset Retirement Obligations an interpretation of FASB Statement No. 143

• This Interpretation clarifies the term “conditional asset retirement obligation.”

• The asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement.

• Uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists to make a reasonable estimate of the fair value of the obligation.

• Effective for fiscal years ending after December 15, 2005.

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FSP EITF 00-19-1, “Application of EITF Issue No. 00-19, ‘Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,’ to Freestanding Financial Instruments Originally Issued as Employee Compensation”

• The final FSP discusses options and share rights originally issued as employee compensation. If they can only be settled by delivering registered shares, the FSP nullifies the provisions of Issue 00-19 that require the company to assume cash settlement.

• The terms of such instruments should be evaluated using paragraph 34 of FASB Statement No. 123(R), Share-Based Payment, to determine whether they should be recorded as equity or as liabilities.

• The guidance in this FSP is to be applied in accordance with the effective date and transition provisions of Statement 123(R).

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FASB Exposure Draft on GAAP Hierarchy

• ED carries forward the GAAP hierarchy as set forth in AICPA SAS 69, subject to certain modifications that are not expected to result in a change in current practice.– Expand sources of category (a):

• Include accounting principles issued after being subject to the FASB’s due process

• Include FASB Staff Positions and FAS 133 Implementation Issues

• Proposal would eliminate Rule 203 audit opinions re: departures from GAAP

• Proposed statement effective for periods beginning after 9/30/2005.

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FASB Exposure Draft on Uncertain Tax Positions

• This project seeks to clarify what criteria must be met to recognize a financial statement benefit for a position taken in a tax return.

• The proposed Interpretation would require an evaluation that a tax benefit is probable of being realized prior to recognizing the tax benefit, in the context of Statement No. 5.

• If a tax return is filed with a tax position that does not meet the probable criterion, a tax liability should be calculated on the difference between the probable tax basis and the “as-filed” tax basis.

• Disclosures continue to be made in accordance with Statement No. 5.

• Proposed Interpretation effective the first annual period ending after 12/15/05. Applies to all existing positions taken in tax returns of open years.

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FASB Exposure Draft on Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries—a replacement of ARB No. 51

• Would require noncontrolling (minority) interests to be presented in shareholders’ equity, not as a liability or in the mezzanine section.

• Net income attributed to controlling and noncontrolling owners based on ownership %, unless contractually specified otherwise.

• Acquisition of noncontrolling (minority) interests not accounted for as a purchase.

– Any difference between consideration paid and carrying value of minority interest is recognized in the equity of controlling shareholder (i.e., APIC).

• On the date control of a subsidiary is lost, any retained investment in the former subsidiary would be remeasured to its fair value and a gain or loss, if any, would be recognized in consolidated income.

• Would be effective for years beginning after 12/15/06.

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FASB Exposure Draft on Business Combinations—a replacement of FASB Statement No. 141

• Acquisition-related costs are generally treated as an expense, not as part of total consideration.

• All items of consideration are measured and recognized at FV at the acquisition date, including contingent consideration.

• Measure and recognize assets and liabilities at FV– Eliminate SFAS No. 5 approach to recognizing contingencies. Assets and

liabilities arising from contingencies acquired or assumed as part of acquisition are measured and recognized at FV at the acquisition date.

– Prohibit restructuring and exit activities that are not liabilities at the acquisition date from being recognized as liabilities in the business combination

• Only recognized as liabilities if they meet the criteria in SFAS No. 146– Purchased in-process R&D is capitalized, not expensed.– Acquirer measures the FV of the acquiree, as a whole

• If acquirer owns less than 100% of the target’s equity at acquisition date, goodwill attributable to the noncontrolling interest would be recognized.

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FASB Exposure Draft on Business Combinations—a replacement of FASB Statement No. 141 (cont’d)

• In a step acquisition, the acquirer would remeasure its preacquisition noncontrolling equity investments to FV at the acquisition date and recognize any gain or loss in income.

• Subsequent adjustments to preliminary purchase price allocations are recognized as if completed at the acquisition date– I.e., comparative information for prior periods would be adjusted.

• Would apply prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual period beginning on or after 12/15/06.

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EITF Update

SELECTED JUNE 2005 EITF ISSUES DISCUSSED or EFFECTIVE

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EITF Issues Discussed in June 2005

• 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (Consensus reached)

– Additional consolidation guidance for partnerships expected to result in more consolidation than in the past.

– If basis for not consolidating has been that a supermajority of LPs can remove GP, EITF concludes that GP must consolidate.

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EITF Issues Discussed in June 2005 (cont’d)

• 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty(Tentative conclusions reached)

• When applying APB 29, Accounting for Non Monetary Transactions– If an entity exchanges FG for RM or WIP, and the inventory

relates to the same line of business, recognize at fair value.• Otherwise, recognize at recorded amounts.

– Inventory purchase and sale transactions with the same counterparty should be combined for accounting purposes if they were entered into in contemplation of each other.

• Otherwise, recognize as separate transactions

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• 05-1, The Accounting for the Conversion of an Instrument That Becomes Convertible upon the Issuer's Exercise of a Call Option

(Tentative conclusions reached)– Since original terms provide for possibility that issuer will

exercise call option, conversion should be treated same as conversion of a noncontingent convertible debt instrument. That is, upon conversion, (a) equity would be credited for the carrying value of the instrument and (b) a gain or loss would not be recognized.

• Additional discussion planned…

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• 05-2, The Meaning of "Conventional Convertible Debt Instrument" in EITF Issue 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock“ (Consensus reached)– “Conventional” convertible debt scope exception retained

• Conversion option is not bifurcated and treated as a derivative

– “Conventional” means convertible into a fixed number of shares

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05-3, Accounting for Rental Costs Incurred During the Construction Period (No consensus; to be removed from the EITF agenda)

– Project was subsequently added to the FASB’s agenda

– FSP FAS 13-b requires these costs to be expensed– Effective for periods beginning after September 15,

2005

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• 05-6, Determining the Amortization Period for Leasehold Improvements (Consensus reached)

– Provides for the amortization period used for leasehold improvements acquired in a business combination or purchased after the inception of the lease to be the lesser of:

• the subsequently acquired leasehold improvements’ useful life, or• a period that reflects renewals that are reasonably assured upon the

acquisition or purchase

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What’s On the Horizon?

• Business Combinations ED– Combination of not-for-profits by year-end

• Fair Value Measurements: Final in 3Q• SFAS No. 140 Issues: 3 EDs in 3Q, final in 1Q 2006

– Qualifying SPEs– Hybrid financial instruments– Servicing rights

• Short Term International Convergence– EPS: final standard originally scheduled for 3Q; likely to be

delayed– Income Taxes: ED in 3Q

Mid Year Section 404 Update

July 2005

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Summary of Quarter’s Developments

• April SEC Roundtable• May 16 PCAOB and SEC Policy Releases

– Posted on SEC and PCAOB Websites

• June open meeting of the PCAOB Staff Advisory Group (SAG)

• New standard for elimination of a material weakness

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Common Themes

– No amendments to AS2 believed necessary – basic framework is conceptually sound.

– May 16 policy guidance is interpretive in nature– Common themes from this guidance that we will

discuss today include:• Integrating the audit of internal controls with the financial

statement audit• Assessing significance with respect to accounts and locations• Client documentation requirements• Auditor assistance with GAAP accounting matters

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Integrated Audit

• All of the firms had difficulty in effectively integrating the financial statement and internal control audits in the 1st year. – Due to implementation of Auditing Standard No. 2 late in the

year and other factors

• Current year focus on effectively integrating • Placing reliance on internal controls should generally

result in a more efficient financial statement audit. – Need to test controls throughout the year to benefit

• Importance of strong control environment

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Significant Accounts & Locations

• Under Auditing Standard No. 2, Management is required to evaluate controls over all relevant assertions related to all significant accounts and disclosures.– These requirements also pertain to all significant

locations.

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• Significant accounts are generally the same for financial statement purposes and internal control audit purposes– F/S audit covers entire year– Internal control audit is as of year-end

• Accounts that are monetarily significant will only rarely not be significant due to inherent risk

• Examples:– Fixed assets, payroll, deposits

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• Use an annual measure of materiality for scoping / significance is allowed– However use quarterly materiality to assess

deficiencies

• Consider accounts and locations both individually and in the aggregate.

• Assess significance at the account component level when components have different risks

• Don’t forget locations with specific risks

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Nature, Timing and Extent of Testing

• Judgment in determining the nature timing and extent of testing based on assessment of risk.

• Focus on controls that are relevant to addressing meaningful risks.

• No requirement to document and test all controls• Risk should be considered in determining which controls

are sufficient and how much testing of those controls should be performed.

• The quantity and quality of client testing is inversely correlated with the nature, timing and extent or auditor testing.

• Sufficiency of company testing – No general rules of thumb

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Company Documentation

Distinguish between:• Company documentation of a control activity

– No requirement for management to document in writing

• Company documentation of its assessment of controls over financial reporting– Management must document in writing

Inverse relationship between quality of client documentation and our efficiency to audit

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Auditor Assistance with GAAP Accounting Matters

• As long as management, and not the auditor, makes the final determination as to the accounting used, including estimates and assumptions, and the auditor does not design or implement accounting policies, such auditor involvement is appropriate

• Management should not be discouraged from providing its auditors with draft financial statements

SEC UPDATE

April 2005

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SEC Update

• Miscellaneous Developments • Rulemaking – Reporting Requirements in

Shell Mergers• Rulemaking – Securities Offering Reform• Practice Issues

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Miscellaneous Developments

• Chairman Donaldson stepped down June 30– President nominated Christopher Cox, congressman

from California

• SEC has moved to new offices– New address, phone numbers

• Posting of comment letters has begun (slowly)– “Upload” – SEC comment letters– “Corresp” – Company responses

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Miscellaneous Developments (cont’d)

• Off-balance sheet report issued– SOX mandated study– Empirical review of 200 public companies– Resulted in initiatives to improve transparency and

understandability of financial statements

• Materiality/PAJEs project– New guidance still expected “soon”

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Rulemaking – Reporting Requirements in Shell Mergers

• Final rules adopted on June 29 – amended Forms 8-K, S-8, and 20-F

• Defined “shell company”– Company with cash only or cash and nominal assets

• Shell companies prohibited from using S-8• Additional disclosures required when company

ceases to be a shell company:– Domestic registrants report on Form 8-K in 4 days– FPIs report on Form 20-F in 4 days

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Rulemaking – Reporting Requirements in Shell Mergers (cont’d)

• Expanded disclosures – those that would be required in a registration statement (e.g., Form 10)

• Objective is to assure that investors in shell companies that acquire operations or assets have timely access to the same kind of information as is available to investors in public companies with continuing operations

• Effective Date – August 22, 2005

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Rulemaking – Securities Offering Reform

• Final rules adopted on June 29• Focused on 3 areas of offering process

– Communications about registered securities offerings

– Registration process– Delivery of final prospectuses to investors

• Require additional disclosures in annual reports

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Rulemaking – Securities Offering ReformRegistration Process

• Establishes a new class of issuers: “well-known seasoned issuer (WKSI)”– Must be S-3/F-3 eligible and– Public float > $700M or $1B registered

nonconvertible securities over previous 3 years

• Automatic effectiveness for shelf registration statements (not subject to SEC staff review)

• Forms S-1/F-1 amended (backward IBR)• Forms S-2/F-2 rescinded

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Rulemaking – Securities Offering ReformSection 11 Liability

• Liability under Section 11 of 1933 Act– Affects all parties to a registration statement

• Issuers, underwriters, officers and directors, and experts have exposure if the registration statement is misleading

– Proposed rules would have created new effective date when prospectus supplement is issued and extended liability for all parties

• No consent of experts would have been required

– Final rules only create new effective date for issuers and underwriters

• No new liability for auditors• No additional consent required

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Rulemaking – Securities Offering Reform New Annual Report Disclosures

• Risk factors (10-K filers)• “Voluntary” filer status• Material unresolved SEC staff

comments – 180 Days old– Accelerated filers (including FPIs) and

WKSIs

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Practice Issues

• June 30 market cap – new accelerated filers– Section 404 applies this year

• IPR&D in pro formas – position reversed• Significance of dispositions –

investment/proceeds test