BDO SEIDMAN, LLP’S

December 22, 2005

FINANCIAL REPORTING UPDATE

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• Speakers– Jeff Lenz– Jay Howell– Wendy Hambleton– Adam Brown– Reva Steinberg

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

Speakers and Replay Information

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• SEC Update• Internal Control Reporting Update• SEC Conference Report• Questions and Answers

Agenda

SEC UPDATE

December 2005

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SEC Update – Agenda

• Rulemaking – Changes in accelerated filing rules• Other SEC activities

– Proposed rules– Interpretive release– FAQ

• Advisory Committee on Smaller Public Companies

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Changes in Accelerated Filing Rules

• Final rules adopted 12/14/05; release not yet posted – Remarks are subject to reading the release– Press release at http://www.sec.gov/news/press/2005-176.htm

• Changes from Proposed Rules– Large accelerated filers given one more year to file 10-K within

75 days– Will be easier to change to a less accelerated status (this year)

• Accelerated filer becomes a non-accelerated filer in same year as Q2 public float drops below $50M

• Since only accelerated filers are required to report on internal control, some companies will get a reprieve

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Changes in Due Dates

Category of Filer

 

Deadlines for Reports Beginning w/ Annual Report forFiscal Year Ending on or after 12/15/05 Under Previous Rules

Category of Filer

 

Deadlines for Reports Beginning w/ Annual Report forFiscal Year Ending on or after

12/15/05 Under New Rules

10-K Deadline 10-Q Deadline 10-K Deadline 10-Q Deadline

Accelerated Filer

($75M or more)

60 days 35 days 

Large Accelerated Filer ($700M

or more)

75 days(Years ending on or after 12/15/06

– 60 days)

40 days

Accelerated Filer

(between $75M and $700M)

75 days 40 days

Non-Accelerated

Filer (less than $75M)

90 days 45 days Non-Accelerated Filer (less

than $75M)

90 days 45 days

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Exiting an Accelerated Filing Category

• Previous – Revenue and public equity float < $25M for two years

• New – Large accelerated filer → accelerated filer – Change status in same year as Q2 float drops below $500M

• New – Accelerated filer → non-accelerated filer – Change status in same year as Q2 float drops below $50M

• Tests performed at year-end– First report in a new category is always an annual report

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• Accelerated filer with a December year-end• 6/30/06 public equity float drops to $49 million • Issuer must file its 6/30/06 and 9/30/06 Form 10-Qs on

an accelerated basis (within 40 days)• Issuer may file its 12/31/06 Form 10-K on a non-

accelerated basis (within 90 days)• 404 reporting not required in 2006 Form 10-K• See Financial Reporting letter at

www.bdo.com/about/publications/assurance

Exiting an Accelerated Filing Category - Example

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Other SEC ActivitiesProposed Rules

• Internet Availability of Proxy Materials (Release 34-52926)– http://www.sec.gov/rules/proposed/34-52926.pdf

• Amendments to the Tender Offer Best-Price Rule (Release 34-52968)– http://www.sec.gov/rules/proposed/34-52968.pdf

• Allowing foreign private issuers to exit the Exchange Act reporting system (release not yet posted)

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Other SEC Activities

• Interpretive release – Revenue recognition – sales of certain vaccines for government stockpile programs – http://www.sec.gov/rules/interp/33-8642.pdf

• FAQ – Securities Offering Reform, 11/30/05– http://www.sec.gov/divisions/corpfin/faqs/

securities_offering_reform_qa.pdf

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Advisory Committee on Smaller Public Companies - Background

• Established December 2004 to assess regulatory system for smaller public companies, including the impact of SOX

• Recommendations due to SEC by April 2006• Four subcommittees

– Accounting Standards– Corporate Governance and Disclosure– Capital Formation– Internal Controls

• http://www.sec.gov/info/smallbus/acspc.shtml

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Advisory Committee Definitions

• Smaller public company– Aggregate market cap = lowest 6% ($700-750M) AND– Revenues no greater than $250M

• Microcap company– Aggregate market cap = lowest 1% ($100-125M) AND– Revenues no greater than $125M

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Advisory Committee Process

• August 2005 recommendations– 1-year deferral of internal control reporting (non-accelerated filers) – No further acceleration for smaller public companies

• 12/14/05 – Approved preliminary formal recommendations

• 1/23/06 – Approve draft report for public comment• 3/31/06 – Finalize report• April 2006 – Submit recommendations to SEC

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Advisory Committee RecommendationsAccounting Standards

• Reduce the number of years of financial statements required in SEC filings from 3 to 2

• Implement a de minimis provision for auditor independence rules

• Permit microcap companies to apply the same effective dates as the FASB provides for private companies

• Consider additional guidance with respect to materiality related to previously issued financial statements

• Develop a “safe harbor” protocol for accounting

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Advisory Committee RecommendationsCorporate Governance & Disclosure

• As a condition to the relief from 404 reporting recommended by the 404 subcommittee, require:– Additional disclosure regarding internal controls and– Additional audit committee corporate governance

standards

• Increase the thresholds requiring registration and permitting de-registration

• Allow smaller public companies to use Form S-3 and eliminate timely filing requirements

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Advisory Committee RecommendationsCapital Formation

• Adopt a new private offering exemption that does not prohibit general solicitation and advertising for transactions with certain purchasers

• Make it easier for microcap companies to go private

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Advisory Committee RecommendationsInternal Controls

• Internal control reporting recommendations will be covered in the internal control reporting update

Internal Control Reporting Update

December 2005

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Section 404 Update Topics

• PCAOB Update• COSO’s draft guidance on internal controls for

smaller public companies• Smaller Public Company Advisory Committee

– Recent Section 404 recommendations

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PCAOB Update – Report on Initial Implementation of AS2

• Issued November 30 and located at:– http://www.pcaobus.org/Rules/Docket_014/2005-

11-30_Release_2005-023.pdf

• Based in significant part on inspections of the larger accounting firms

• Focuses on effectiveness and efficiency of audits of internal controls

• Provides additional clarifications

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PCAOB Update – Report on Initial Implementation of AS2

• Matters pertaining to efficiency:– Integrating the audit of internal control – Applying the top-down approach– Altering the nature, timing and extent of

testing– Performing more effective walkthroughs– Using the work of others

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PCAOB Update – Report on Initial Implementation of AS2

• Matters pertaining to effectiveness:– Identification and testing of compensating

controls – Controls over the financial statement

preparation process • Disclosure checklists• Non-standard, consolidating, and eliminating

journal entries• Cash flow and equity statements• Footnote disclosures

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PCAOB Update – Report on Initial Implementation of AS2

• Additional Clarifications:– “More than remote” = “at least reasonably possible”– Strong indicators of material weaknesses in AS2

do not automatically result in a material weakness– Scope of audit should not be set to detect

deficiencies that individually or in the aggregate are less severe than material weaknesses

– Tests of control can be used to meet the objectives of both the financial audit and the internal control audit

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PCAOB Update – Recent Personnel Changes

• William J. McDonough - Retired Chairman of the Public Company Accounting Oversight Board

• Bill Gradison – Acting Chairman• Douglas Carmichael – Outgoing Chief Auditor• Thomas Ray – New Chief Auditor

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COSO Exposure DraftGuidance for Smaller Public Companies

• Recognition of differences between larger vs. smaller entities

• Twenty-six fundamental principles– Detailed guidance and examples for each principle

• Controls need to be cost effective

• Comments due December 31, 2005

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Advisory Committee Recommendations Pertaining to Section 404

1. Exempt Microcaps from Section 404– Market cap = lowest 1% ($100-125M), and – Revenues no greater than $125M

2. Exempt smaller public companies from the audit requirements of Section 404– Market cap = lowest 6% ($700-750M), and – Revenues no greater than $250M

3. Alternatively to #2, develop a right-sized audit approach focused on the design of internal controls

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Advisory Committee Recommendations Pertaining to Section 404

• Complete recommendations located at:– http://www.sec.gov/info/smallbus/acspc/pr-intcontrol.pdf

• BDO’s recent comment letter and recommendations located at:– http://www.sec.gov/rules/proposed/s70603/

bdoseidman103105.pdf

AICPA SEC Conference Report December 2005

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Conference Themes

• Overall themes of keynote speeches– Accounting standards are too complex– Management and auditors should be able to use

judgment

• Complexity is increased by exceptions in GAAP– Indirect cash flow method– Hedge accounting– Aggregation of segments– Narrow interpretations of rules

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Conference Themes (cont.)

• Carol Stacey (Chief Accountant in the Division of Corporation Finance) – Key comments:– MD&A area of filings needing most

improvement– Other areas discussed by staff:

• Classification in cash flow statements• Segment issues

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Materiality SAB

• The staff is aware of diversity in practice resulting from difference between “rollover” and “iron curtain” approaches to analyzing proposed adjustments– Believes both methods should be used

• No clear indication from the SEC for timing of new guidance– However, the staff indicated any new guidance would not be

effective for 2005 calendar year-ends– Transition will be a key issue

• What should registrants do?– Analyze existing policies to ensure they’re consistently

understood throughout the company– Start thinking about SAB 74 disclosures

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Segments & Reporting Units

• Proper aggregation of operating segments depends on – Similar economic characteristics, and– 5 criteria in paragraph 17 of SFAS 131

• Identification of operating segments impacts determination of reporting units under SFAS 142– Affects goodwill impairment analysis– If material, treatment of reporting units may be a

critical accounting policy

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Valuation Issues

• Prohibition of block discounts– The use of quoted market prices is required in

existing GAAP (SFAS 107 and 115)– No longer allowed in specialized industries when Fair

Value standard becomes effective (paragraph 28 of SFAS 15X)

• Warrants issued to non-employees– Typically no transfer restrictions and little/no vesting

period– When using Black-Scholes, use contractual term, not

expected term

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Income Statement Geography

• EITF 99-19 was drafted in the context of internet-based companies, but its scope applies broadly. For example,– Cable television operator – who is responsible for vendor taxes?– Consider all facts and circumstances– Use consistent application for similar revenue streams, similar to

adopting an accounting policy

• Amortization of intangibles determined by function, as well as SEC rules for public cos.– Influences Cost of Sales vs. SG&A determination– S-X Rule 5-03– SAB Topic 11B

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Cash Flow Statement Geography

• Discontinued operations presentation– Option to present cash flows from discontinued operations

separately– If elected, present effect for all 3 categories

• Dealer floor plan financing– If finance entity is a subsidiary of supplier, purchases are

reflected as increases to inventory and trade loans in operating activities

– If finance entity is not a subsidiary of supplier, cash flows to/from 3rd party lender are financing activities

• Insurance settlements– Classification depends on nature of proceeds

• Impacts MD&A discussion

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Financial Instrument Issues

• FAS 133 – Short cut method• Redeemable equity securities• Convertible debt and warrants• Implicit variable interests

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FAS 133 – Short-Cut Method

• Exception to certain requirements for assessing and testing hedge effectiveness

• ALL conditions of paragraph 68 must be met – There is no “spirit” or “principle” that can be met

• Interest rate swaps with financing elements– Would not meet shortcut criteria as swap fair value

would not be equal to zero at inception

• Inappropriate application of the shortcut method results in loss of hedge accounting

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Redeemable Equity Securities

• EITF Topic D-98– Redeemable shares recognized at fair value and

classified outside permanent equity– Subsequent treatment depends upon whether

securities are currently redeemable, or probable of becoming currently redeemable in the future

• Probability assessment should NOT consider likelihood that other options (such as a conversion option) might be exercised first

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Convertible Debt & Warrants

• Common area of accounting mistakes as guidance is very complex– FAS 133, EITF Issues 00-19, 98-5, 00-27

• Companies often focus on beneficial conversion feature issues and overlook the need to evaluate the instrument for embedded derivatives under Statement 133

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Is Convertible Debt “Conventional”?

• Conventional is defined in 00-19 and 05-2– The holder may realize the value of the conversion option only

by exercising the option and receiving the entire proceeds in a fixed number of shares, or the equivalent amount of cash (at the discretion of the issuer)

• If conventional, conversion right generally is not separated from the debt instrument– Might have beneficial conversion feature– Might also have other embedded derivatives

• If not conventional, must analyze conversion right under paragraphs 12-33 of EITF 00-19

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Registration Rights

• Often requires issuer to use best efforts to register underlying shares within a certain timeframe

• If provisions are not met, the company is typically required to pay liquidating damages– If liquidating damages are not limited to the

difference between the fair value of a registered share and an unregistered share, security would not be classified as equity

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Sufficient Authorized and Unissued Shares

• Another requirement for equity classification is that the company have sufficient authorized and unissued shares to settle the conversion option– Must consider ALL commitments that might require

issuance of stock

• If the number of shares to be issued is not capped, the company cannot conclude that sufficient authorized and unissued shares exist– Equity classification is not appropriate

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Implicit Variable Interests

• FSP FIN 46(R)-5 provides guidance for determining when activities around the entity would cause a reporting enterprise to have a variable interest

• Driven by facts and circumstances, but the following questions should be considered:– Was the arrangement entered into in contemplation of the

entity’s formation?– Was the arrangement entered into contemporaneously with

the issuance of a variable interest?– Why was the arrangement entered into with a variable

interest holder instead of with the entity?– Did the arrangement reference specified assets of the VIE?