COMMENTS ON FINANCIAL STATEMENTSFILED WITH THE SECURITIES AND EXCHANGE CO~rrSSION

Address ofANDREW BARR

Chief AocountantSeourities and Exohange Commission

Washington, D. C.

before the57th Annual Oonvention

of

THE MICHIGAN ASSOOIATION OF OERTIFIED PUBLIO AOCOUNTANTS

Grand Hotel, Maokinao IslandJune 14, 1957

The title I have chosen for my remarks today is"Comments on Financial Statements Filed with the Securitiesand Exchange Commission" .~l-This is broad enough to cover,in part at least, the three suggestions made in the invitationto participate in these proceedings. These suggestions were:"What can the public accountant do to further improve financialreporting to the S. E.C.?" i "Some current account ing problemswith particular emphasis on 'pooling of interest8accounting'''iand "A discussion of common deficiencies in financial state-ments submitted to the S.E.C." A survey of the literatureproduced by my predecessors in office reveals that all ofthese subjects have been discussed from time to time eitherWhen in official or in alumni status. Current accountingproblems and common deficiencies have been popular recurringsubjects since Mr. Carman G. Blough's official release No.7in the Commission's Accounting Series, pUblished in May 1938,listed many commonly cited deficiencies in financial state-ments filed under the Securities Act of 1933 and the Securi-ties Exchange Act or 1934. Experienced practitioners shouldnot need the advice this release contains, but the unitiatedshould find it quite helpful. A similar study of deficiencies

.:l-TheSecurities and ExChange commIssion, as a matter of policy,disclaims responsibility for any private publication by anyof its employees. The views expressed herein are those ofthe author and do not necessarily reflect the views of theCommission or of the author's colleagues upon the staff ofthe Cor.mt1ssion.

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11was reported upon by"Mr. William W. Werntz in 1941, whichwas soon after the adoption of the Commission's RegulationS-X governing the form and content of finanoial statementstor inclusion in most filings in the Commission except thoseof brokers or dealers in securities. A similar survey wasmade again in 1947 and was reported upon by Mr. Earle C.

SfKing soon atter he became chief aocountant of the Commission.Changing conditions, the increase in volume of our work andthe resulting increase in the number of registrants andtheir independent accountants, make it appropriate to con-sider some of the recurring comments we find it necessary tomake with respect to the financial statements being filedwith the Commission today.

The prinoipal Acts administered by the Commission arethe Securities Aot of 1933, the Seourities Exohange Aot of1934, the Publio Utility Holdi~ Company Aot of 193" andthe Investment Company Aot of 1940. The statements requiredin the Commission's torms presoribed under these Aots arethe oonventional balanoe sheets, inoome and surplus state-ments and oertain supporting sohedules. The registrationforms for new issues of securities usually require three-year income and sU'1'plusstatements and in the prospectus17 Current DeficIencIes In FInancIal statements, The Ac-counting Review, Vol. XVI, No.4, December 1941; The Journalof Accountancy, January 1942, pp. 25-34.£t What the S.E.C. Requires in Financial statements Filedwith the Commission, The Journal of Accountancy, November1947, pp. 377-384.

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to be delivered to the investor a summary of earnings foran appropriate period, usually not less than five years.

The form and oontent of the required financial state-ments are set forth in Regulation S-X. This regulation doesnot purport to define aooounting principles. It descr1bes

the extent of the detailed lnro~ation required inoonventional terminology and present'aocounting practice.It was worked out with the advioe and oooperation of theaocounting profession, and is under oonstant revision inthe same spirit of oooperation.

The Seourities Aot provides that the financial state-ments required to be made available to the public throughfiling with the Commission shall be certified by "an inde-pendent publio or oertified accountant." The other threestatutes permit the Commission to require that such state-ments be aooompanied by a certificate of an independentpublic accountant, and the Commission's rules require, withminor exceptions, that they be certified.

Statf consideration of financial statements to be filedwith the Commission may be obtained at various stages in theprooessing of the filing. ~uestions may be answered by tele-phone or letter or in conference prior to the filing ofmaterial. These usually involve interpretations of theinstructions as to the financial statements required by thevarious forms and matters of accounting principles where itis recognized that controversial issues may be present.

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After filing the registration statement, application,proxy statement or report, the staff examines the materialand issues a letter of comment which contains, when necessary,suggestions for ohanges in the financial statements includedin the filing; requests for additional information in supportof the accounting reflected in the statements; or in the caseof annual and other periodic reports. we may suggest thatchanges in presentation or more precise compliance with ourregulations be followed in future filings. This latter courseis taken when the fo~ of the financial statements could beimproved or the failures to comply completely with the in-structions are of relatively minor significance and do notresult in a misleading report of income or loss or misleadingclassification of accounts in the balance sheets and incomestatements.

Following receipt of the l~tter of comments the regis-trant may feel that the questions raised warrant reconsid-eration either in light of additional information which maybe turnished or because ot the oontroversial or unique natureot the problem. Such reoonsideration may be by telephone,study of material furnished by letter, or in confer~nces.Oonferences, whether before or after a filin&may includerepresentatives of the registrant, underwriters, counselfor both of these, and a representative of the accountantswho are to certify the financial statements. On strlctl~

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accounting matters it is essential that a complete under-standing be reached with representatives of the registrantwho are responsible for the financial statements and withthe accountants who are to express their independent opinionwith respect to them.

A paragraph from the Co~ssionts annual report toCongress for the tiscal year ended June 30, 1956, is pertin-ent at this point: "It is not the function of the staff ofthe Commission to prepare or rewrite registration statements.The members ot the staff are ready to assist registrantswhen it appears that a bona fide effort has been made toprepare a registration statement meeting the standards ofthe Act and are as helpful as possible in suggesting whatevermay.be needed by way of additional information if the regis-tration statement as tiled is not entirely complete. Butthe Commdss1onts policy, 1n the public interest and for theprotect1on of investors, is immediately to commence stop-orderproceedings in those cases in which the issuer and underwriterrefuse to comply with, or ignore, the disclosure standards ot

the law or where the registration statement appears on itsface to be false and mislead1ng."

In keeping w1th this policy, accountants and registrantswho are embarking on a first experience with the Commiss1onshould become acquainted w1th pertinent sections of the law,general regulations, the form on which the filing 1s to be

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made and of course Regulation S-X. We have had 'easeswhereit was necessary to issue only one accounting comment:furnish revised financial statements complying with the regu-lations 1

We have had a number of eases in the last few yearswhich emphasize the necessity for practicing public ac-countants to be familiar with the Commission's rules on in-dependence. These cases show that frequently closely heldcorporations unexpectedly find it necessary or desirable to

.sell securities to the public in interstate commerce, thusbecoming subject to the registration requirements of theSecuri~ies Act of 1933, and that companies whose securitieshave been traded on the over-the-counter market desire tolist on a na~ional securities eXchange, thus becoming subjeotto the finanoial reporting requirements of the SecuritiesExchange Act or 1934. Other companies may come under thejurisdiction of the Commission by making publio orteringsof their securities under Regulation A, which prescribes thesimplified filing procedures for issues not in excess of$300,000. In the event that an accountant's certifioate isused in any of these circ~tances, the Commission1s testsof independence are applicable and compliance with generallyaccepted accounting and auditing standards is subject to ourscrutiny.

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The rule on independence for qualification of account-ants practicing before the Commission is stated as follows:

neb) The Commission will not recognize any.certified public accountant or public accountantas independent who is not in fact independent.For example, an accountant will not be consideredindependent with respect to any person, or anyaffiliate thereof, in w.hom he has any financialinterest, direct or indirect, or with whom he is,or was during the period of report, connected asa promoter, underwriter, voting-trustee, director,officer or employee.

If (c) In determining whether an accountant isin fact independent with respect to a particularregistrant, the Commission will give appropriateconsideration to all relevant circumstences in-cluding evidence bearing on all relationships betweenthe accountant and that registrant or any affiliatethereOf, and will not confine itself to the relation-ships existing in connection with the filing of re-por-tis with the Com.1't1ission.If ~/

InJorder for an accountant to be independent under theCommission's rules, he is prohibited from having any financialinterest in the registrant or its affiliates. On the otherhand, the rules of the American Institute of Certified PublicAccoun,tants merely require disclosure of a substantial inter-est of the accountant if he renders an opinion on financialstatements which are used as a basis of credit and prohibitownership of a substantial interest in an enterprise financedin whole or in part by public distribution of securities.These two conflicting standards of independence often causeconfusion. It has been urged by some accountants that in-dependence is a state of mind -- the accountant's conscienceand that standards of professional work should not be affectedJI Regulation S-X, Rule 2-01.

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by his financial interest in the registrant. However, theobjective tests of independence to whiCh certifying account-ants are held by the rules of the Commission have been adoptedfor the purpose of avoiding both the opportunity tor, and theappearance ot, bias and prejudice, or the possibility ot undueinfluence on' the part of a client.

Public accountants whose practice involves the renderingot certificates based upon audits should be mindful thattheir clients may come under the jurisdiction of the Com-mission. This may require certification of income statementstor at least three years, and in some cases the client maydesire certified summaries of earnings for five or more years.Serious personal embarrassment to the aocountant and addedexpense for the client can be avoided if the accountant isSUfficiently foresighted to disengage himself from any en-tangling relationships with his olients. With present dayinterest in developing services to management, care shouldbe taken to maintain a clear distinction between the givingof advice to management and the making of decisions formanagement.

In addition, the fact of coming under the Commission'sjurisdiction for the first time may require an extension ofthe audit program. Extension ot auditing procedures torequire confirmation of receivables and observation ofinventory-taking was adopted by the profession as a result

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of the McKesson affair. Our experience indicates that theseprocedures have frequently been omitted by companies attempt-ing to register for the first time. Acquiescence in theclient's desire to reduce auditing costs While the companyis closely held and not seeking pUblic financing may be adisservice in the long run.

During the process of clarifying the accountant's statuswith respect to our rules on independence and his compliancewith generally accepted auditing standards, it is our practiceto request letters from the certifying accountants statingthe facts upon which they rely.

The accountants' certificate is a subject for commentperhaps more frequently than it should be. The standardshort form of certificate meets the requirements of Rule 2-02of Regulation S-X in most cases. When more than one account-ant is relied upon, it is sometimes necessary to issue areminder that certificates and consents of all the accountantsare required. It is frequently necessary to call attentionto the requirement that certificates be manually signed andaccurate in all particulars, such as specifying dates andstatements covered. If the principal accountant assumesfull responsibility for the work done by other accountantson divisions or subsidiaries of the registrant, his certifi-oate should be olear on the matter as required by Rule 2-05.~hether or not the principal accountant assumes the

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responsibility for the work of the other accountant, hedoes, of course, assume responsibility as a part of hisaudit of the parent company for the propriety and consistencyof the accounting principles and practices followed by thesubsidiary and for the adequacy of the audit program andstanding of the other accountants. Certification by ac-countants of recognized standing knovTn to the principalaccountant presumably would require minimum or no inquiries;however, upon first contact with unknown accountants appro-priate inquiries must be made.

Ambiguous opinions have also caused some trouble overthe years. The phrase "SUbject toll is mentioned in AccountingSeries Release 7 to which I referred at the outset. Thesewords are rarely acceptable. If an exception is intended,it should be clearly stated. If an explanation is beinghighlighted, the wording should be clear that no exceptionis being taken. "Subject to It may be used with reference tosome problem which cannot be resolved, such as the effectof pending court or regulatory agency proceedings fullyexplained in the certificate or in a note to the finanoialstatements to which reference is made. Before leaving thecertificate it may be well to reemphasize that anything theaccountant wants to say about the financial statements orhis audit should be said in the certificate. The financialstatements, including the notes, are considered to be thoseof the management, hence the notes should not containlanguage written from the point of view of the auditorsuch as references by him to management or explanations ofauditing procedures employed.

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Some of our suggestions which we believe ar~ most helpfulare best made in conference before filing. These are oonoernedwith multi-company problems and improvement in the layout ofthe statements. Examples are columnar presentation of regis-trant and oonsolidated statements when both are required,group statements, reoasting to oommon fisoal periods, inte-gration of notes, use of inoome statements tor the summary ot

earnings and other devioes tor reducing the length ot theprospeotus with better presentation of material and a reductionin printing and mailing oosts. In this conneotion we applythe provisions of Rules 3-01 to '3-05 of Regulation S-X relatingto torm, order, and terminology; immaterial items; inapplicablecaptions; oombining of notes and grouping of subsidiaries andthe provision of the various forms permitting deviations fromspecific instructions when appropriate. Occasionally, however,registrants and their accountants are overzealous in relyingon these rules, particularly as to what is material. otten,a suggestion is made to restore information to a torm givenin prior filings. This may be the right plaoe to mentionthat publioation of finanoial statements in a report to stook-holders or elsewhere prior to filing them with the Commissiondoes not preclude comment and a request for oorrection of thestatements if suCh action appears to us to be necessary in thecircumstances.

The financial statements included in reports to stock-holders and those prepared for filing with the commission are

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substantially the smme for many corporations. A.commonexception is that our rules require more disclosure in foot-notes than is customary' in reports to stockholders. Commentswith respect to these notes are common. Additional infor-mation frequently must be requested with respect to methodsof prioing inventories, olassification of plant assets,methods followed in measuring depreoiation, depletion andamortization and methods of aooounting for maintenanoe andrepairs and the reoording of disposition of assets. Notes

.relating to pensions, stook options, income taxes and re-strictions on surplus frequently require expansion to meetthe requirements of the rules.

\Adequate disolosure of these matters is essential to anunderstanding of the finanoial statements. This is partiou-larly tr~ when the aooounting for signifioant items affeotingthe determination of inoome is treated differently for oorpor-ate reporting purposes and fo r inoome taxes. A number ofcases have oome to our attention in which sum-of-the-years-digits or deolining balanoe depreciation has been claimedfor tax purposes but straight line depreoiation has beencontinued on the books without any adjustment for deferredtaxes. The improvement in earnings resulting from thispractioe has been so large in ~ome cases that mmendment ofthe statements to include an additional amount equal to thetax benefit has been required on the grounds that failure to

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do so would make the statements seriously mislead1r~. Wehave encountered very flexible concepts of materiality insome instances. In those cases in Which the accelerateddepreciation methods correspond with operating realities itappears that the books should reflect the basis used for thetax returns.' Praotice seems to vary by industries and hasbeen influenced in the regulated industries by the positiontaken by the federal or state commissions having primaryaooounting jurisdiction.

Problems raised in connection with proposed businesscombinations are usually the subject of a prefiling confer-ence on proxy material in which the proposal is to be placedbefore stockholders ~or approval or on drafts of a regis-tration statement covering an offer of exchange of shares.In clear cut cases these discussions may cover questions ofpresentation of financial data rather than of principle.Usually the parties involved mow when'.they have a marginalcase and arrange a discussion before printing rather thanrisk a oonflict :tn vie,.;swhioh might require reprinting to

reflect, for example, "acqUisition accounting" rather thana "pooling of' interests" solution. Such a result may arisein a situa tion when factors favoring a "pooling 0 f interests"solution have been deemed by the registrant to outweighadverse evidence but we are more impressed with the lattero

The eVidence is fairly clear at times that the result desired

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carries more weight with the registrant than the'facts broughtforward in support.

The concept of "pooling of interests" accounting (whichavoids the booking of goodwill as would be required in many"purchase" transactions and permits the combining of earnedsurplus of the constituent companies rather than "acquisitionaccounting") has been recognized by the Commission for aboutfifteen years. At first this accounting was deemed appro-priate when the corporations to be combined were of about

'equal size and were engaged in similar or complementarybusinesses. This latter test is now outmoded with theemphasis on diversification in corporate mergers.

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In 1945 the Commission considered a merger proposal inwhich all factors other than size clearly supported a poolingof interests solution. The result was that goodwill was notrecorded and the earned surplus .of both companies was carriedforward. In this case the assets and common stock equity ofthe smaller company were less than one-fifth and one-thirdrespectively of the larger. Fram this point on, relativesize was considered to be less important than other factorsin considering whether a business combination was a poolingof interests or not.

The significant next step in the case by case considera-tion of the problem by the Commission was raised in a pro-posed merger involving the possibility that a minority interest

- 15 -would remain after an exchan~e offer and the smaller companywould continue as a subsidiary. It was concluded that inthese circumstances it would be inappropriate to treat thetransaction as a t'pooling of interests" and therefore theearned surplus of the acquired company could not be combinedWith that of the registrant. On a purchase basis goodwillwould have been negligible.

Adhering to this interpretation that pooling of interestsaccounting was inapplicable when p~rties. to a merger continuedin a subsidiary relationship led to a reconsideration ofSect10n C of Chapter 7 of Bulletin No. 43 which succeededBulletin 40 with only minor changes. Bulletin No. 48,~publ~shed in January of this year, om1 ts the requirement ofsimilar or oomplementarr business and permits a pooling ofinterests when substantially!!! of the ownership interestsin the constituent corporations continue and per.mitsa sub-sidiary relationship to survive "if no significant minorityinterest remains outstanding, and if there are important tax,legal, or economic reasons for maintaining the subsidiaryrelationship, suCh as the preservation of tax advantages,the preservation of franchises or other rights, the preserva-tion of the position of outstanding debt securities, or thedifficulty or costliness of transferring oontracts, leases,or licenses.1t The revision retains the tests of continuityof ownership and of management or power to control theY7 Issued by the Committee on Accounting Procedure of theAmerican Institute of Accountants.

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management and introduces a specific test of relative size.Although relative size may not necessarily be dete~1native,the bulletin says that "where one of the constituent corpo-rations is clearly dominant (fo~ example, Where the stock-holders of one of the constituent corporations obtain 90% to95% or more of the voting interest in the oombined enterprise),there is a presumption that the transaction is a purchaserather than a pooling of interests. It

As you would suspect, the first questions raised underBulletin 48 were with regard to the size test and minorityinterests. The first cases invo:lYed combinations in whichthe smaller company fell in the range of 5% to 10% of thecombined equity. No objec~ion was raised to pooling ofinterests accounting in these cases when it appeared that astrong case had been made under the other tests. We haveobjeoted to pooling of interest~ When the equity of thesmaller company would be less than 5%. On the minorityintere~lt question the words "substantially all".we construeas haVil1g the same meaning as in our definition of a totally-held subsidiary. This permits a minority of directors Iqualifying shares and negligible amounts due to other causes.

The summary of earnings is generally considered to be

one of the most important parts of the prospectus. As suchit must be prepared with great care in order that it not bemisleading. Effective and fair disclosure of the results ofoperations for interim periods is often troublesome,

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particularly when a company's operations are subject tomarked seasonal variation. In other situations the effectof declining sales on earnings must be clearly disClosed.

The staff, men examining the suntr.laryof earnings, makesappropriate inquiry with respect to all uncertified interimperiods in such summaries to determine the existence of anyunusual conditions affectihg the propriety of the presentationand the necessity for the inclusion of an appropriate previousperiod. If it appears that a significant decline in earningsmay have occurred, unaudited interim figures to the latestpracticable date and for the same interim period in theprevious year are requested.

In addition to inquiries as to the trend of the businesssince the date of the financial statements and requests forexplanation of the results reported, it is often necessary torequest that footnotes be clarit~ed, that the basis ofcalculation of earnings per share be stated, that retroactiveadjustments of the accounts be made in the years affected,that the order of the statement be changed to emphasizesignificant factors and all too often that informationspecified in the instructions be furnished.

Financial statements used in offering circulars underRegulation A are examined in the commission's regional offices,and comments, if any, are sent from these offices. Althoughthese financial statements are not required to be certified,

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it is not unusual to find that they are. In such cases thesame tests of independence are applied to the accountant aspertain in other filings with the Commission. We do notrecognize two standards.

A common fault in financial statements furnished underRegulation A is excessive detail. This appears to be due inmany cases to the use of material prepared for managementwith no effort made to edit and rearrange the material forthe use of investors.

Common deficiencies in the content of the financialstatements include the use of written up values of assets;improper accounting for deferred charges; improper classifi-cation of items, usually resulting in an overstatement ofworking capital; failure to disclose the pledging of assets;inadequate description of securities of the issuer; failureto disclose the basis of valuation of inventories and fixedassets; and failure to make appropriate accruals, especiallyin interim period statements. Many of these deficienciesappear in filings of small companies under the 1933 and 1934Acts.

A discussion of this kind would not be complete withoutsome reference to broker-dealers in securities. At June 30,1956, there were 4,497 effective registrations of brokersand dealers, of which 1,274 were in New York City. Of thetotal, 1,471 were corporations, 1,306 were partnerships,

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and 1,720 were sole proprietorships. Every registered broker-dealer is required to file with the Commission during eachoalendar year a report of financi81 condition. Under ourpresent rules a substantial number of these reports are notrequired to be certified by in1ependent accountants. A pro-posal to amend the rule to limit the exemption and to clarify

2Jthe filing date for the reports is now out for comment.This release includes a revision of an earlier proposal uponwhich comments had been received. Howev'er, further' actionon the original proposal was delayed pending the publicationby the American Institute of -Accountants of a booklet entitled"Audits of Brokers or Dealers in Securities" which was issued

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by the Committee on Auditing Procedure after several years ofstudy. This booklet, which should fill the need for anauthoritative guide in this specialized field of auditing,describes the special acoounting records used by brokers anddealers, and auditing procedures and forms of reports to beused in connection with the examination of their books andrecords.

The deficiencies which have been cited most frequentlywith regard to the reports of broker-dealers appear to bedue to a lack of knowledge of stock brokerage techniqueswith respect to the maintenance of securities accounts. At21 Securities Exchange Act of 1934, Release No. 5515, May 10,1957.

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times deficiencios appear to arise from the failUre of ac-countants to read the applicable rules and to comply withthe instructions in the forms. The booklet to which I havereferred was prepared by an Institute committee at the sug-gestion of the Commission's staff. It is hoped that it willreoeive wide circulation among accountants serving brokersand dealers and that the result will .be improved reports filedwith the Commission.

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