M - SEC Historical Society

200 SECURITIES AND EXCHANGE COMMISSIONpendent accountants of the parent companymay be engaged to examine the financialstatements of the division or subsidiary.Inquiry has been made whether in thesituation where the financial statements of adivision or subsidiary which represents anonmaterial segment of an internationalbusiness are examined by another accountingfirm or its affiliated firm, Rule 2-01 ofRegulation S-X3 is construed so as to precludeall the partners of such other accountingfirm or its affiliated firm from owningany securities of the parent company of thesubsidiary in order for the other accountingfirm to be considered in depend net as to theparent company or the subsidiary.3 Rule 2-01 of Regulation S-X provides that "an accountantwill be considered not independent with respectto any person or any of its parents or subsidiariesin whom he has, or had during the period of report, anydirect financial interest or any material indirect financialinterest." Where the "accountant" is a firm, theCommission has construed the restriction to apply toeach partner of the firm whether or not he has anyconnection with the examination. Note-Rule 2-01 ofRegulation S-X was subsequently revised in AccountingSeries Release No. 125 (June 23, 1972) and the citedsection now reads:"an accountant will be considered not independentwith respect to any person or any of its parents, itssubsidiaries, or other affiliates (1) in which, during theperiod of his professional engagement to examine thefinancial statements being reported on or at the dateof his report, he or his firm or a member thereof had,or was committed to acqu~re, any direct financialWe believe that the purposes of Rule 2-01would be adequately served by a less restrictiveconstruction. Insofar as ownership ofsecurities by partners is concerned, the otheraccounting firm would be held to· be notindependent only if securities of the parentcompany or the subsidiary are owned by anyof the partners of the other accounting firmor its affiliated firm who are located in theoffice which makes the examination of thedivision or subsidiary or who are otherwiseengaged in such examination.This interpretation relates exclusively tothe ownership of securities and does notextend to any other relationship prescribedby Rule 2-01.interest or any material indirect financial interest, or(2) with which, during the period of his professionalengagement to examine the financial statementsbeing reported on, at the date of his report or duringthe period covered by the financial statements, he orhis firm or a member thereof was connected as apromoter, underwriter, voting trustee, director, officer,or employee, except that a firm will not be deemednot independent in regard to a particular person if aformer officer or employee of such person is employedby the firm and such individual has completely disassociatedhimself from the person and its affiliates anddoes not participate in auditing financial statementsof the person or its affiliates covering any period of hisemployment by the person. For the purposes of Rule2-01 the term "member" means all partners in thefirm and all professional employees participating inthe audit or located in an office of the firm participatingin a significant portion of the audit."INVESTMENT COMPANY ACT OF 1940Release No. 5847substantial quantities of securities that cah-not be offered to the public for sale withoutfirst being registered under the SecuritiesAct of 1933 ("restricted securities"). For theyear 1968, annual reports filed by registeredinvestment companies indicate that openend and closed-end companies together heldThe Securities and Exchange Commissiontoday made public the following statement."Restricted Securities"The Commission is aware that many investmentcompanies have been acquiringRELEASE NO. 113October 21, 1969Statement Regarding "Restricted Securities"

202 SECURITIES AND EXCHANGE COMMISSIONtinues throughout the period these securitiesare retained in the company's portfolio.Restricted securities should be included inthe portfolio of a company and valued todetermine current net asset value on thedate that the investment company has anenforceable right to demand the securitiesfrom the seller.Where the investment company negotiatesthe acquisition of the restricted securitiesdirectly with the owner of the securities,there are three significant dates. The firstoccurs when the investment company andthe seller orally agree upon the price and theamount of the securities (the "handshake. date"). At this point, there would not seem tobe any enforceable right of the investmentcompany to demand the securities from theseller since, in most states, particularlythose which have adopted the Uniform CommercialCode, there is no enforceable rightunless there exists some writing "sufficientto indicate that a contract has been made forsale of a stated quantity of described securitiesat a defined or stated price" (Section 8-319(a) of the Uniform Commercial Code). Ifthe terms of the oral understanding do notcontemplate compliance with any conditionby the seller, it is suggested that the investmentcompany procure, from the seller, asigned memorandum setting forth the priceand quantity of securities to be sold. Uponreceipt of that memorandum, an enforceableright would be obtained. The securitiesshould be valued as of that date.In those situations where the oral understandingcontemplates the execution of aformal contract of purchase and sale, noenforceable right exists until the time theformal contract is signed (the "contractdate"). If the formal contract does not requirecompliance with any conditions by thesell~r, an enforceable right is then obtained,and the securities should be valued as of thatdate.Where the formal contract requires compliancewith stated conditions which the investmentcompany believes should not bewaived, no enforceable right is obtained untilthe stated conditions are satisfied. In thatsituation, the valuation date should be thedate upon which the conditions are satisfied(the "closing date").Restricted securities are often purchasedat a discount, frequently substantial, fromthe market price of outstanding unrestrictedsecurities of the same class. This reflects thefact that securities which cannot be readilysold in the public market place are less valuablethan securities which can be.· sold, andalso the fact that, by the direct sale of restrictedsecurities, sellers avoid the expense,time and public disclosure which registrationentails.As a general principle, the current fairvalue of restricted securities would appear tobe the amount which the owner might reasonablyexpect to receive for them upon theircurrent sale. This depends upon their inherentworth, without regard to the restrictivefeature, adjusted for any diminution in valueresulting from the restrictive feature. Consequently,the valuation of restricted securitiesat the market quotations for unrestrictedsecurities of the same class would,except for most unusual situations, be improper.!Further, the continued valuation ofsuch securities at cost would be improper if,as a result of the operations of the issuer,change in general market conditions or otherwise,cost has ceased to represent fairvalue. In such circumstances, maintainingthe value of the restricted securities at costwould mislead investors as to the value ofthe portfolio of the investment companywhich holds restricted securities.Instead of valuing restricted securities atcost or at the market value of unrestrictedsecurities of the same class, some investmentcompanies value restricted securities held intheir portfolio by applying either a constantpercentage or an absolute dollar discount tothe market quotation for unrestricted securitiesof the same class. The automatic valuationof restricted securities by such amethod, however, would also not appear to1 See Proposed Guidelines For The Preparation 0/Form N-8B-l, Investment Company Act Release No.5633, p. 21 (March 11, 1969). Note-The guidelines weresubsequently adopted in Investment Company Act ReleaseNo. 7221 (June 9, 1972).

204 SECURITIES AND EXCHANGE COMMISSIONties present special problems of portfoliomanagement.The concept of the Securities Act exemptionof a private placement of securities ispremised on the belief that in such a situationthe investor has such information concerningthe issuer that he is able to fend forhimself without need for the disclosures thatwould be provided by an effective registrationstatement. Correlatively, where theinvestor is a registered investment company,it would seem to be the fiduciary duty of thepersons responsible for the investment decisionsof the investment company to obtain,prior to purchase, the necessary informationto make an independent analysis of the investmentmerits of the particular restrictedsecurities. 2 Also, in order to enable the continuingvaluation of such securities, the investmentcompany should require the sellerto undertake to provide, to the extent knownto the seller, information on a continuingbasis as to any subsequent private sales ofthe issuer's securities. The investment companyshould also assure itself that it is in theposition to obtain the appropriate financialinformation at appropriate times. It is assumedthat any public disclosures, such asthat made in periodic reports filed pursuantto the Securities Exchange Act, are carefullyconsidered by the investment company portfoliomanager.There is also the paradox of too muchsuccess to consider. For example, if restrictedsecurities rapidly appreciate invalue, perhaps because of an improvement inthe business of the issuer, an investmentcompany may find instead of having, forexample, 5 per cent of its assets invested in· aparticular company, it has instead, 25 percent of its assets in that company. The investmentcompany to which this happens. suffers a· loss in diversification and may findthat it has become overly sensitive to anyadverse developments in the affairs of thatparticular portfolio company.The foregoing factors in portfolio manage-2 See The Value Line Fund v. Marcus (,64·'66 TransferBinder) CCH Fed'J. Sec. Law Rep. ~91,523 at p. 94,970(S.D. N. Y. 1965).ment relate to both open-end and closed-endmanagement companies. There are additionalspecial factors that relate only toopen-end companies.Section 2(a)(31), when read together withSection 5(a), of the Investment Company Actrequires that the holders of redeemableshares issued by an open-end investmentcompany be entitled to receive approximatelytheir proportionate share of the issuer'scurrent net assets, or the cash equivalentthereof, upon presentation of thesecurity to the issuer or to a person designatedby the issuer. Section 22(e) of the Actprovides that, absent specified unusual conditions,payment of the redemption pricemust be made within seven days after thetender of a redeemable security to an investmentcompany or its agent designated ·forthat purpose.It is desirable that an open-end companyretain maximum flexibility in the choice ofportfolio securities which, on the basis oftheir relative investment merits, could bestbe sold where necessary to meet redemptions.To the extent that the portfolio consistsof restricted securities, this flexibility isreduced.Restricted securities may not be publiclysold-nor can they be distributed to redeemingshareholders as an in-kind redemption.While they may be sold privately, there maynot be sufficient time to obtain the best pricesince the date of payment or satisfactionmay not be postponed more than seven daysafter the tender of the company's redeemablesecurities for redemption. A private salewithin that period may result in the investmentcompany receiving less than its carryingvalue of the restricted securities. Thiswould result in a preference in favor of theredeeming shareholders and a diminution ofthe net asset value per share of shareholderswho have not redeemed. Therefore, insteadof arranging a private sale of restricted securities,an open-end company that is· facedwith redemptions may decide to sell unrestrictedsecurities which it would otherwisehave retained on the basis of comparativeinvestment merit.Significant holdings of restricted securities

ACCOUNTING SERIES RELEASES 205not only magnify the valuation difficultiesbut may also present serious liquidity questions.Because open-end companies holdthem!?elves out at all times as being preparedto meet. redemptions within sevendays, it is essential that such companiesmaintain a portfolio of investments that enablethem to fulfill that obligation. This requiresa high degree of liquidity in the assetsof open-end companies because the extent ofredemption demands or other exigencies arenot always predictable. It has been with thisin mind that the staff of the Commission hasfor several years taken the position that anopen-end company should not acquire restrictedsecurities when the securities to beacquired, together with other such assetsalready in the portfolio, would exceed 15 percent of the company's net assets at the timeof acquisition. The Commission, however, isof the view that a prudent limit on any openendcompany's acquisition of restricted securities,or other assets not having readilyavailable market quotations, would be 10 percent. 3 When as a result of either the increasein the value of some or all of the restrictedsecurities held, or the diminution in thevalue of unrestricted securities in the portfolios,the restricted securities come to representa larger percentage of the value of thecompany's net assets, the same valuationand liquidity questions occur. Accordingly, ifthe fair value of restricted holdings increasesbeyond 10 per cent, it would be desirablefor the open-end company to considerappropriate steps to protect maximum flexibility.The Commission will re-examine appropriatelimitations in this area in light ofall the policy objectives of the InvestmentCompany Act.3. The Problem of DisclosureSection S(b)(I)(D) of the Investment Com-3 'The Commission is aware that certain open-end com-::nies may have acquired restricted securities in excessC10 per cent of net assets. It is assumed that suchornp' .obI" a~les wIll not undertake commitments, beyond anySe 19~t~on existing on this date, to acquire restrictedhOld'CUfltlesunt'l'1, III the normal course of business, suchass It ngs are not in excess of 10 per cent of current nete value.pany Act requires that an investment companyinclude, in its registration statementfiled with the Commission under the Act,information as to its policy with respect to"engaging in the business of underwritingsecurities issued by other persons." Item 4(c)of Form N-SB-l requires that a registrantunder the Act describe its policy or proposedpolicy with respect to "the underwriting ofsecurities of other issuers." In response tothis item, registrant's policy with respect tothe acquisition of restricted securities shouldbe disclosed. 4 In view of the fact that policieslisted under Item 4 are fundamental policieswhich cannot be changed without priorshareholder approval, the importance ofadopting a clear policy with regard to suchinvestments is apparent.The prospectus of a registered investmentcompany should also fully disclose the company'spolicy with respect to restricted securities.5 It is also clear that an investmentcompany which has a policy of acquiringrestricted securities is responsible for fulland adequate disclosure with respect to allmatters relating to the valuation of suchsecurities. Specifically, there should be included,in a note to the financial statements,(1) identification of any restricted securitiesand the date of acquisition, (2) disclosure ofthe methods used in valuing such securitiesboth at the date of acquisition and the dateof the financial statements, (3) disclosure ofthe cost of such securities and the marketquotation for unrestricted securities of thesame class both on the day the purchaseprice was agreed to (the so-called "handshakedate"), and on the day the investmentcompany first obtained an enforceable rightto acquire such securities, and (4) a statementas to whether the issuer or the registrantwill bear costs, including those in-4 See Proposed Guidelines For the Preparation ofForm N-8B-l, Investment Company Act Release No.5633, p. 7 (March 11, 1969). Note-See Note 1 regardingthe adopted guidelines.5 See Proposed Guidelines For The Preparation OfForms 8-4 and 8-5, Investment Company Act ReleaseNo. 5634, pp. 11, 13 (March 11, 1969). Note-The guidelineswere subsequently adopted in Investment CompanyAct Release No. 7220 (June 9, 1972).

206 SECURITIES AND EXCHANGE COMMISSIONvolved in registration under the SecuritiesAct, in connection with the disposition ofsuch securities.Section 10(b) of the Securities ExchangeAct of 1934 and Rule 10b-5 thereunder makesit unlawful, among other things, for anyperson, in connection with the purchase orsale of securities, to employ any device,scheme, or artifice to defraud or to make anyuntrue statement of a material fact or toomit to state a material fact necessary inorder to make the statements made not misleading,or engage in any act, practice, orcourse of business which operates or wouldoperate as a fraud or deceit upon any persons.The offering price of securities issued by amanagement investment company is premisedupon the net asset value of such sharesas determined pursuant to Section 2(a)(39) ofthe Act and Rule 2a-4 thereunder and is sorepresented in its prospectus. The impropervaluation of restricted securities held bysuch a company would distort the net assetvalue of the shares being offered or, in thecase of an open-end company, redeemed, andwould therefore constitute a fraud and deceitwithin the meaning of Section 10(b) and Rule10b-5.An open-end company, of course, representsto investors, in its prospectus, that itwill: as required by Section 22(e) of the Act,redeem its securities at approximate net assetvalue within seven days after .tender. To,the extent a material percentage of the assetsof an open-end company consist of re-. stricted securities which cannot publicly besold without registration under the SecuritiesAct, the ability of the company to complywith the provisions of the Investment CompanyAct relating to redemption, and to fulfillthe implicit representations made in itsprospectus with respect thereto, may be adverselyaffected. 6 In any such situation, theinvestment company concerned and the personsresponsible for the sale of its securitiesshould give careful consideration to the possibleapplication of the provisions of Section10(b) of the Exchange Act and Rule 10b-5thereunder.6 See Proposed Guidelines For The Preparation OfForm N-8B-l, Investment Company Act Release No.5633, p. 7 (March 11, 1969). Note-See Note 1 regardingthe adopted guidelines.RELEASE NO. 114December 31, 1969INVESTMENT COMPANY ACT OF 1940Release No. 5943SECURITIES EXCHANGE ACT OF 1934Release No. 8788SECURITIES ACT OF 1933Release No. 5035Adoption of Amendments to Rule 6-02-9 of Article 6 of Regulation S-X and Rule 2a-4 under theInvestment Company Act of 1940 with Respect to Provision by Registered Investment Companiesfor Federal Income TaxesOn August 20, 1969, the Securities andExchange Commission published notice (InvestmentCompany Act Release No. 5780)that it had under consideration the amendmentof Rule 6-02-9 of Article 6 of RegulationS-X and a related amendment of Rule 2a-4under the Investment Company Act of 1940("Act").Article 6 of Regulation S-X governs theform and content of financial statements. sfiled by management investment compam e .(other than those which are issuers of perIodicpayment plan certificates) under theAct, the Securities Act of 1933 and the Secuirities Exchange Act of 1934. Rule 6-02~9. 0Article 6 requires that appropriate provISIon

ACCOUNTING SERIES RELEASES 207 .shall be made in the financial statements ofsuch companies for Federal income taxes.Rule 2a-4 under the Act defines the term"current net asset value" of redeemable securitiesissued by registered investmentcompanies us~d in computing periodicallythe current price of such securities for thepurpose of distribution, redemption, and repurchase.Subparagraph (a)(4) of Rule 2a-4provides that in computing such current netasset value expenses shall be included to thedate of calculation.The proposed amendment of Rule 6-02-9 ofRegulation S-X would specifically providethat a company which retains realized capitalgains and designates such gains as adistribution to shareholders in accordancewith Section 852(b)(3)(D) of the Internal RevenueCode ("Code") shall, on the last day ofits taxable year (and not earlier), make provisionfor taxes on such undistributed capitalgains realized during such year. The amendmentwould also revise the reference in Rule6-02-9 to the section of the Code defining acompany's status as a "regulated investmentcompany" to its present designation of SubtitleA, Chapter 1, Subchapter M. The proposedamendment of Rule 2a-4 under the Actwould add a sentence to subparagraph (a)(4)to require that appropriate provision shall bemade for Federal income taxes in accordancew~th Rule 6-02-9 of Regulation S-X.The primary purpose of the proposedamendment is to assure that regulated investmentcompanies excepted by provisionsof the Code from payment of Federal incometaxes on net income and realized gains distributedto shareholders will make appropriateprovision for taxes on any realized undistributedcapital gains designated asdistributions to sharehold,ers under the provisionsof the Code. Most regulated investm~ntcompanies follow the practice of distnbutingrealized capital gains tos~areholders, thereby relieving such compantesof the payment of Federallncome taxeso~ Such gains. However, under the pro vi­~~ons of S~ction 852(b)(3)(D) of the Code, at gulated Investment company which electst~l do ~o may retain realized long-term capig. gaIns and, in effect, pay the tax on thoseaIns on behalf of the shareholders. Everysuch shareholder at the close of the company'staxable year shall include in his taxreturn his pro rata portion of the company'srealized capital gains as if it had been distributedto him, accrue his capital gains taxthereon, and elsewhere in his tax return isallowed credit or refund for his pro ratashare of the capital gains tax which has beenpaid for his benefit by the company butwhich is deemed to have been paid by him.At the same time, such shareholder shallincrease the tax basis of his shares by theexcess of his pro rata portion of the realizedgains over the tax credit or refund allowed tohim.The question of the appropriate method oftax accrual or adjustment of net asset valueby ihvestment companies which retain realizedcapital gains under Section 852(b)(3)(D)of the Code was considered by the NationalAssociation of Investment Companies (thepredecessor to the present Investment CompanyInstitute) and the Committee on Relationswith the S.E.C. of the American Instituteof Accountants in 1956 following theenactment of the provisions of the Code in itspresent form. On November 2, 1956, the Associationsent a memorandum to its membersstating in part that the question hadbeen considered by the Committee which wasof the opinion that, since for a companyintending to proceed under Section852(b)(3)(D) the tax on realized undistributedcapital gains would be on the shareholderand not the company, no allowance need bemade, either for possible Federal income taxon unrealized appreciation or for Federalincome tax on capital gains realized duringthe year. The memorandum stated that atthe end of a company's taxable year theFederal income tax to be paid on realized butundistributed capital gains would be carriedin an accrual account until paid.The above procedure is followed as thegenerally accepted accounting practice byregulated investment companies which electto retain realized capital gains and pay thetax on behalf of shareholders. Most of suchcompanies are capital exchange funds whichissued their shares for securities in tax-freeexchanges and which are not making publicofferings of shares. Of a total 34 active ex-

208 SECURITIES AND EXCHANGE COMMISSIONchange funds, 30 elected for their fiscal yearsended in 1968 to retain realized capital gains,in whole or in part, and pay the tax on behalfof the shareholders. All except four of theseexchange funds followed the practice of makingprovision for such taxes on the last dayof the taxable year. The four funds which didnot follow the general practice, made provisionfor ta;xes on realized undistributed capitalgains throughout the year as the gainswere realized.The proposed amendments to the ruleswould codify the generally accepted practiceof making provision, on the last day of thetaxable year of the investment company, fortaxes on realized undistributed capital gainsdesignated as distributions to shareholders.The amended rules would not affect therights of any person who may have redeemedshares prior to the adoption of the amendments.Under the provisions of the Code, the taxeson realized capital gains retained by thecompany are payable by the company onlyon behalf of those persons who are shareholderson the last day of the taxable year inwhich the gains were realized. It is onlythose persons who are shareholders on thelast day of the taxable year who are deemedunder the provisions of the Code to have paidthe tax imposed on the designated capitalgains retained by the company and who,accordingly, are allowed credit or refund forthe tax so deemed to have been paid by themand are entitled to increase the tax basis oftheir shares by the excess of their pro rataportion of the realized gains over the taxcredit or refund allowed to them. Accrual ofthe tax by the company at any time prior tothe last day of its taxable year thereforereduces the net asset value of the shares of~lOlders who redeem or sell their shares durmgthe year and who consequently receiveno credit for the tax so accrued.After consideration of the comments andsuggestions received from interested persons,the Commission has determined toadopt the amendments to the rules.The amendment of Rule 6-02-9 of Article 6of ~egulation S-X is adopted pursuant toSectIOns 8, 30, 31(c) and 38(a) of the InvestmentCompany Act of 1940; Sections 7 and19(a) of the Securities Act of 1933; and Sections12, 13, 15(d), and 23(a) of the SecuritiesExchange Act of 1934. The proposed amendmentof Rule 2a-4 under the InvestmentCompany Act of 1940 is adopted pursuant toSections 22 and 38(a) of that Act.The rules as amended are set forth below.Rule 6-02-9 of Article 6 of Regulation S-X isamended to read as follows:9. Federal income taxes.-Appropriateprovision shall be made, on the basis of theapplicable tax laws, for Federal incometaxes that it is reasonably believed are, orwill become, payable in respect of (a) currentnet income, (b) realized gain on investmentsand (c) unrealized appreciationon investments. The company's status as a"regulated investment company" as definedin Subtitle A, Chapter 1, SubchapterM of the Internal Revenue Code asamended shall be stated in a note referredto in the appropriate statements. Suchnote shall also indicate briefly the principalpresent assumptions on which the companyhas relied in making or not makingprovisions for such taxes. However, a companywhich retains realized capital gainsand designates such gains as a distributionto shareholders in accordance with Section852(b)(3)(D) of the Code shall, on the lastday of its taxable year (and not earlier),make provision for taxes on such undistributedcapital gains during such year.Subparagraph (a)(4) of Rule 2a-4 under theInvestment Company Act of 1940 is amendedso that paragraph (a) and subparagraph(a)(4) read as follows:(a) The current net asset value of anyredeemable security issued by a registeredinvestment company used in computing periodicallythe current price for the purposeof distribution, redemption, and repurchasemeans an amount which reflects calculations,whether or not recorded on thebooks of account, made substantially inaccordance with the following, with estimatesused where necessary or appropriate:* * * * *

210 SECURITIES AND EXCHANGE COMMISSIONtion of earnings year by year, the registrationstatement is defective because thecertificate does not meet the requirementsof Rule 2-02 of Regulation S-X."The problem is an important one. If thebusiness will not continue and the proceedsof the present offering will simply be used topay existing creditors, then the offering maybe deceptive to the public. The Commissiondoes not expect accountants to express opinionsthat are unwarranted in the circumstances.Indeed, if there is a question as towhether the business will continue, noamount of changing the accountant's certificatewould appear to solve the underlyingproblem.The Commission has concluded that a registrationstatement under the 1933 Act willbe considered defective because the certificatedoes not meet the requirements of Rule2-02 of Regulation S-X when the accountantqualifies his opinion because of doubt as towhether the company will continue as agoing concern. The Commission does not intendto preclude companies with pressingfinancial problems from raising funds bypublic offerings of securities. It does, however,believe it clear that an accountant'sreport cannot meet the certification requirementsof the 1933 Act unless the registrantcan arrange its financial affairs so that theimmediate threat to continuation as a goingbusiness is removed. The independent accountantmust be satisfied that it is appropriateto use conventional principles andpractices for stating the accounts on a goingconcern basis before a registration statementunder the 1933 Act can be declaredeffective.INVESTMENT COMPANY ACT OF 1940Release No. 6026RELEASE NO. JIGApril 13, 1970Disclosure Concerning "Restricted Securities"On October 21, 1969, the Commission issueda statement (Investment Company ActRelease No. 5847; Accounting Series ReleaseNo. 113) which discusses the problems createdby purchasing and holding restrictedsecurities by such companies. One section ofthis release deals with The Problem of Disclosureand enumerates specific informationregarding these securities which should beincluded in the financial statements. 11 The pertinent language of that Release is:"It is also clear that an investment company which hasa policy of acquiring restricted securities is responsiblefor full and adequate disclosure with respect to allmatters relating to the valuation of such securities.Specifically, there should be included in a note to thefinancial statements, (1) identification' of any restrictedsecurities and the date of acquisition, (2) disclosure ofthe methods used in valuing such securities both at thedate of acquisition and the date of the financial statements,(3) diaclosure of the cost of such securities andAlthough the release refers only to disclosuresto be made in a prospectus, the principleset forth in the release is also applicableto lists of portfolio securities contained inregistration statements filed pursuant toSection 8(b) of the Investment Company Actof 1940 ("Act"), reports filed with the Commissionand reports mailed to shareholderspursuant to Section 30 of the Act, sales literaturedistributed to existing and prospectiveinvestors under Section 24(b) of the Act, andin proxy statements filed pursuant to Section20 of the Act. Consequently, the disclothemarket quotation for unrestricted securities of thesame class both on the day the purchase price wasagreed to (the so-called "handshake date"), and on theday the investment company first obtained an enforceableright to acquire such securities, and (4) a statementas to whether the issuer or the registrant will bearcosts, including those involved in registration under theSecurities Act, in connection with the disposition of suchsecurities."

ACCOUNTING SERIES RELEASES 211sure requirements set forth in its release ofOctober 21, 1969 will be applied by the Commissionto lists of portfolio securities setforth not only in registration statements, butalso in reports to the Commission and toshareholders, in sales literature and in proxystatements. Registered investment companiesshould act accordingly.RELEASE NO. 117October 14, 1970SECURITIES ACT OF 1933Release No. 5090SECURITIES EXCHANGE ACT OF 1934Release No. 8997PUBLIC UTILITY HOLDING COMPANY ACT OF 1935Release No. 16857Adoption of Article llA of Regulation S-XThe Securities and Exchange Commissiontoday adopted an amendment to RegulationS-X consisting of a new section designatedArticle llA to govern the content of statementsof source and application of funds, forwhich a requirement has recently beenadopted in certain registration and reportingforms under the Securities Act of 1933 andthe Securities Exchange Act of 1934.The adoption of a requirement for certifiedstatements of source and application offunds in the registration and reporting formswas an implementation of a recommendationcontained in the Disclosure Policy Study reportsubmitted to the Commission last year.In 1963 the Accounting Principles Board ofthe American Institute of Certified PublicAccountants, in its Opinion No.3, stated itsbelief that a statement of source and applicationof funds should be presented as supplementalinformation in financial reports, butindicated that inclusion was not mandatoryand coverage of the statement in the reportof the certifying accountant was optional.The opinion was endorsed by the New York~~oCk ~xchange and by the Directors of theInanclal Analysts Federation. A survey byt~e Institute (Accounting Trends and Tech­~~qUe8, 196~) o~ t~e 1968 annual reports of. 0 ~ompallles mdIcated that 535 (89%) com­PaOIes presented a funds statement withtheir financial statements and that suchstatements were .covered in the auditor's reportin 443 (83%) of the cases.The amendment was published in preliminarydraft form for public comment on September15, 1969, in Securities Act ReleaseNo. 4998 (Securities Exchange Act ReleaseNo. 8686 and Public Utility Holding CompanyAct Release No. 16460). A number of helpfulcomments have been received and were carefullyconsidered in the preparation of thedefinitive article.This amendment is adopted pursuant toauthority conferred on the Securities andExchange Commission by the Securities Actof 1933, particularly Sections 6, 7, 8, 10, and19(a) thereof; the Securities Exchange Act of1934, particularly Sections 12, 13, 15(d), and23(a) thereof; and the Public Utility HoldingCompany Act of 1935, particularly Sections5(b), 14, and 20(a) thereof.(The text of Article llA is omitted.)The amendment shall be effective with respectto registration statements and reportsfiled with the Commission after December31,1970.By the Commission.ORVAL L. DuBoISSecretary

212 SECURITIES AND EXCHANGE COMMISSIONINVESTMENT COMPANY ACT OF 1940Release No. 6295RELEASE NO. 118December 23, 1970SECURITIES ACT OF 1933Release No. 5120SECURITIES EXCHANGE ACT OF 1934Release No. 9049Accounting for Investment Securities by Registered Investment CompaniesThe Securities and Exchange Commissiontoday announced the publication of its viewsrelating to some of the more important questionsconcerning the accounting by registeredinvestment companies for investmentsecurities in their financial statements andin the periodic computations of net assetvalue for the purpose of pricing their shares.The questions relate both to the amounts atwhich investment securities should be carriedand to the circumstances under whichindividual securities may be included amongthe assets. This release discusses certain accountingmatters in order to give additionalguidance to the management of investmentcompanies, as well as certain related auditingprocedures which are considered appropriatefor the guidance of independent accountants.A release was issued by theCommission on October 21, 1969 1 on the specificsubject of the problems relating to socalled"restricted securities," i.e., thosewhich must be registered under Section 5 ofthe Securities Act of 1933 prior to publicsales, and the discussion of valuation hereindoes not alter any of the special considerationsapplicable to such securities as discussedin that release.The financial statements of registered investmentcompanies appearing in registrationstatements, proxy statements, and annualreports filed with the Commission aregoverned by various provisions of the Invest-I Investment Company Act Release No. 5847; AccountingSeries Release No. 113. See also a supplementaryrelease issued on April 13, 1970, Investment CompanyAct Release No. 6026; Accounting Series Release No.116.Note. See letter to the American Institute of CertifiedPublic Accountants, p. 217, of this publication.ment Company Act of 1940 (the "Act"), therules thereunder, and by Regulation S-X,Article 6 of which sets forth accounting rulesapplicable to such companies. While RegulationS-X does not by its terms apply to periodicreports to stockholders, Section 30(d) ofthe Act provides that such reports "shall notbe misleading in any material respect in thelight of the reports" (including annual reports)required to be filed under Section 30(a)and (b). To the extent that any provisions inan investment company's articles of incorporation,trust indenture or other governinglegal instruments specify accounting proceduresinconsistent with those required byRegulation S-X, the latter must be followedin accordance with Rule 6-02-1 thereof.Inclusion of Securities in the PortfolioThe statement of assets and liabilities of aregistered investment company comprises,for the most part, not only investments insecurities which are held by a custodian orare on hand, but also frequently includessecurities as to which contracts to purchasehave been entered into but which have notbeen received. Securities held by a custodianor are on hand, but also frequently includessecurities as to which contracts to purchasehave been entered into but which have notbeen received. Securities held by a custodianor on hand that have been contracted to besold are excluded from the investments insuch statement. In the ordinary transactionthrough a broker, recording the transactionon the date the broker advises the investmentcompany that the securities have beenpurchased or sold (the "trade da\;e"), ratherthan when delivery is made or due (the "settlementdate"), is the established and accept-

ACCOUNTING SERIES RELEASES 213able practice in investment company accounting.In r.he case of purchases or sales of securitiesother than in the usual brokerage transactior..s,the date on which the investmentcompany obtains an enforceable right to demandthe securities or the payment therefore-thedate the transaction should be recorded-issometimes difficult to determine.The considerations involved in determiningsuch transaction date are similar to thosediscussed in the aforementioned release No.113 on restricted securities. When a questionarises as to the date an enforceable right isobtained by the investment company, an opinionof legal counsel as to when the right occurredshould normally be obtained by thecompany's management and made available tothe independent accountant. Such an opinionshould be in writing, and a copy should be.ineludedin the accountant's working papers.Where the propriety or validity of an investmentin a security by an investmentcompany is questionable because of particularprovisions of the Act, or state law, or thecompany's investment policy or other representationsas stated in its filings with theCommission, or legal obligations in respect ofa contract or transaction, a written opinionof legal counsel should also be obtained bythe company's management, made availableto the independent accountant, and a copyincluded in the working papers. If the questionsof propriety or validity are not satisfactorilyresolved, the circumstances of the investmentshould be disclosed in the financialstatements or notes thereto.Securities held by the company or its custodianshould be substantiated by the company'sindependent accountant in the courseof an audit by inspection Qf such securities orby obtaining confirmation from a custodianwhich maintains the securities in custodypursuant to clause (1) of Section 17(f) of theAct. When securities contracted to be purchasedbut not yet received are included inthe statement of assets and liabilities confirma t· Ion of the contract to purchase should ' beobtaIned.from the bank,' broker, or otherPerson responsible for the delivery of suchh securI't' les. Where satisfactory confirmationas been received, audit procedures normallyneed not be extended to obtain evidenceof subsequent receipt of the securitiesby the company or its custodian unless additionalsubstantiation is considered necessaryby the independent accountant under thecircumstances. Where satisfactory confirmationhas not been received, subsequent receiptof such securities should be substantiatedby other appropriate procedures.In accordance with Section 30(e) of the Act,the certificate of the company's independentaccountant should include a brief statementconcerning the substantiation of securitiesowned. Except for securities contracted to bepurchased but not received, the certificateshould state that the securities were eitherinspected by the independent accountant or,where the company's securities were maintainedin custody pursuant to clause (1) ofSection 17(f) of the Act, were confirmed tohim by the custodian. In the case of securitiescontracted to be purchased but not receivedby the company or its custodian, referenceshould be made to confirmation bybanks, brokers, or others or to alternativeprocedures, as appropriate in the circumstances.Valuation of SecuritiesUnder Rule 6-02-6 of Regulation S-X, thestatements of assets and liabilities of openendinvestment companies must reflect allassets at value, showing cost parenthetically,while closed-end companies may electto use either this basis or to reflect all assetsat cost, showing value parenthetically."Value" is defined in Section 2(a)(39)2 ofthe Act. For purposes of determining theamounts at which securities and other assetsare carried in the statements of assets andliabilities included in annual and other reportsand in registration statements filed byinvestment companies, "value" is defined inpertinent part as: "(i) with respect to securitiesfor which market quotations are readilyavailable, the market value of such securi-2 Section 2(a) (39) was redesignated 2(a) (41), effectiveDecember 14, 1970, Public Law 91-547, sections 2(a)(2), 84Stat. 1413.

214 SECURITIES AND EXCHANGE COMMISSIONties; and (ii) with respect to other securitiesand assets, fair value as determined in goodfaith by the board of directors ... " This definitionis also used in Rule 2a-4 under the Actas the required basis for computing periodicallythe current net asset value of redeemablesecurities of investment companies forthe purpose of pricing their shares.In some circumstances value can be determinedfairly in more than one way. Hence,the standards set forth below should be consideredas guidelines, one or more of whichmay be appropriate in the circumstances of aparticular case. These standards should befollowed, and a company's stated valuationpolicies should be consistent with them. Anyvariation from the standards should be disclosedin the financial statements or notesthereto even though the variation is in accordancewith the company's stated valuationpolicy. In addition, any deviation froma stated valuation policy, whether or not inconformity with the standards, should bedisclosed in the financial statements or notesthereto.Securities Listed or Traded on a NationalSecurities ExchangeOrdinarily, little difficulty should be experiencedin valuing securities listed or tradedon one or more national securities exchanges,since quotations of completedtransactions are published daily. If a securitywas traded on the valuation date, thelast quoted sale price generally is used. Inthe case of securities listed on more than onenational securities exchange the last quotedsale, up to the time of valuation, on theexchange on which the security is principallytraded should be used or, if there were nosales on that exchange on the valuationdate, the last quoted sale, up to the time ofvaluation, on the other exchanges should beused. With respect to the time of valuationRule 22c-l under the Act requires that currentnet asset value shall be computed notless frequently than once daily as of the timeof the close of trading on the N ew York StockExchange.If there was no sale on the valuation datebut published closing bid and asked pricesare available, the valuation in such circumstancesshould be within the range of thesequoted prices. Some companies as a matterof general policy use the bid price, others usethe mean of the bid and asked prices, andstill others use a valuation within the rangeconsidered best to represent value in thecircumstances; each of these policies is acceptableif consistently applied. Normaliy, itis not acceptable to use the asked pricealone. Where, on the valuation date, only abid price or an asked price is quoted or thespread between bid and asked prices is substantial,quotations for several days shouldbe reviewed. If sales have been infrequent orthere is a thin market in the security, furtherconsideration should be given towhether "market 'quotations are readilyavailable." If it is decided that they are notreadily available, the alternative method ofvaluation prescribed by Section 2(a)(39}­"fair value as determined in good faith bythe board of directors" -should be used.Over-the-Counter SecuritiesQuotations are available from varioussources for most unlisted securities tradedregularly in the over-the-counter market.These sources include tabulations in the financialpress, publications of the NationalQuotation Bureau and the "Blue List" ofmunicipal bond offerings, several financialreporting services, and individual brokerdealers.These quotations generally are inthe form of inter-dealer bid and asked prices.Because of the availability of mUltiplesources, a company frequently has a greaternumber of options open to it in valuing securitiestraded in the over-the-counter marketthan it does in valuing listed securities. Acompany may adopt a policy of using a meanof the bid prices, or of the bid and askedprices, or of the prices of a representativeselection of broker-dealers quoting on a particularsecurity; or it may use a valuationwithin the range of bid and asked pricesconsidered best to represent value in thecircumstances. Any of these policies is acceptableif consistently applied. Normally,the use of asked prices alone is not acceptable.

ACCOUNTING SERIES RELEASES 215Orqinarily, quotations for a securityshould be obtained from more than one broker-dealer,particularly if quotations areavailable only from broker-dealers notknown' to be established market-makers forthat security, and quotations for several daysshould be reviewed. If the validity of thequotations appears to be questionable, or ifthe number of quotations is such as to indicatethat there is a thin market in the security,further consideration should be given towhether "market quotations are readilyavailable." If it is decided that they are notreadily available, the security should be consideredone required to be valued at "fairvalue as determined in good faith by theboard of directors."Securities Valued "in Good Faith"To comply with Section 2(a)(39) of the Actand Rule 2a-4 under the Act, it is incumbentupon the Board of Directors to satisfy themselvesthat all appropriate factors relevantto the value of securities for which marketquotations are not readily available havebeen considered and to determine themethod of arriving at the fair value of eachsuch security. To the extent considered necessary,the board may appoint persons toassist them in the determination of suchvalue, and to make the actual calculationspursuant to the board's direction. The boardmust also, consistent with this responsibility,continuously review the appropriateness ofthe method used in valuing each issue ofsecudty in the company's portfolio. The directorsmust recognize their responsibilitiesin this matter and whenever technical assistanceis requested from individuals who arenot directors, the findings of such individuals~ust be carefully reviewed by the directorsIn order to satisfy themselves that the resultingvaluations are fair.No single standard for determining "fairv.alue ... in good faith" can be laid down,SInce fair value depends upon the circumst~nc.esof each individual case. As a generalprInCIple, the current "fair value" of an issue~~ securities being valued by the Board ofw~,ectors would appear to be the amountlch the Owner might reasonably expect toreceive for them upon their current sale.Methods which are in accord with this principlemay, for example, be based on a multipleof earnings, or a discount from market of asimilar freely traded security, or yield tomaturity with respect to debt issues, or acombination of these and other methods.Some of the general factors which the directorsshould consider in determining a valuationmethod for an individual issue of. ~ecu~j.: __ties include: 1) the fundamental analyticaldata relating to the investment, 2) the natureand duration of restrictions on dispositionof the securities, and 3) an evaluation ofthe forces which influence the market inwhich these securities are purchased andsold. Among the more specific factors whichare to be considered are: type of security,financial statements, cost at date of purchase,size of holding, discount from marketvalue of unrestricted securities of the sameclass at time of purchase, special reportsprepared by analysts, information as to anytransactions or offers with respect to thesecurity, existence of merger proposals ortender offers affecting the securities, priceand extent of public trading in similar securitiesof the issuer or comparable companies,and other relevant matters.This release does not purport to delineateall factors which may be considered. Thedirectors should take into consideration allindications of value available to them indetermining the "fair value" assigned to aparticular security. 3 The information so consideredtogether with, to the extent practicable,judgment factors considered by theboard of directors in reaching its decisionsshould be documented in the minutes of thedirectors' meeting and the supporting dataretained for the inspection of the company'sindependent accountant.Auditing Security ValuationsIn the case of securities for which marketquotations are readily available, the inde-3 With regard to restricted securities, considerationshould be given to the discussion in the release on thissubject (see Note 1 supra),

216 SECURITIES AND EXCHANGE COMMISSIONpendent accountant should independentlyverify all the quotations used by the companyat the balance sheet date and satisfyhimself that such quotations may properlybe used under the standards stated above.In the case of securities carried at "fairvalue" as determined by the Board of Directorsin "good faith," the accountant does notfunction as an appraiser and is not expectedto substitute his judgment for that .of thecompany's directors; rather, he should reviewall information considered by the boardor by analysts reporting to it, read relevantminutes of directors' meetings, and ascertainthe procedures followed by the directors. Ifthe accountant is unable to express an unqualifiedopinion because of the uncertaintyinherent in the valuations of the securitiesbased on the directors' subjective judgment,he should nevertheless make appropriatemention in his certificate whether in thecircumstances the procedures appear to bereasonable and the underlying documentationappropriate.When considering values assigned to securitiesby the company, the independent accountantshould consider any investmentlimitations or conditions on the acquisitionor holding of such securities which may beimposed on the company by the Act, by itscertificate or by-laws, by contract, or by itsfilings with the Commission. If such restrictionsare met by a narrow margin, the independentaccountant may need to exerciseextra care in satisfying himself that the evidenceindicates that the security valuationdeterminations were not biased to meetthose restrictions.Investments in Affiliates or Affiliated PersonsVarious rules of Regulation S-X requirethat the financial statements of an investmentcompany state separately investmentsin, investment income from, gain or loss onsales of securities of, and management orother service fees payable to, (a) controlledcompanies and (b) other "affiliates." Asstated in Rule 6-02-4 of Regulation S-X, theterm "affiliate" means an affiliated personas defined in Section 2(a)(3) of the Act, andthe term "control" has the meaning given inSection 2(a)(9) of the Act. The term "affiliatedperson" is defined in Section 2(a)(3) ofthe Act in such a manner as to encompasssuch control relationships and also the director indirect ownership of five percent or moreof the outstanding voting securities of anissuer. An affiliated person as there definedalso includes any officer, director, partner,co-partner, or employee or, with respect toan investment company, any investment adviseror member of an advisory boardthereof.In ascertaining the existence of any suchaffiliations, the independent accountantshould consider the facts obtained during thecourse of an audit and also make inquiries ofthe company's management; and his workingpapers should include written representationsfrom the management as evidence ofsuch inquiries. The representations shouldbe in the form of a statement that the company,except to the extent indicated, (i) doesnot own any securities either of persons whoare directly affiliated, or, to the best informationand belief of management, of personswho are indirectly affiliated, (ii) has not receivedincome from or realized gain or losson sales of investments in or indebtedness ofsuch persons, (iii) has not incurred expensesfor management or other service fees payableto such persons, and (iv) has not otherwiseengaged in transactions with such persons.Where there is a question as to theexistence of an affiliation, a written opinionof legal counsel should be obtained by thecompany's management, made available tothe independent accountant, and a copy includedin the working papers. Regulation S­X requires disclosure in the financial statementsor notes thereto of details of suchinvestments and transactions.By the Commission.ORVAL L. DuBoISSecretary

ACCOUNTING SERIES RELEASES . 217SECURITIES AND EXCHANGE COMMIS-SIONWASHINGTON, D.C. 20549December 16,1970MR. ROBERT M. MAYNARD, Chairman,Committee on Investment CompaniesAmerican Institute of CertifiedPublic Accountants .666 Fifth AvenueNew York, NY 10019DEAR MR. MAYNARD:I want to· thank you and your committeefor the assistance you have given us in developinga much needed Accounting Series Releaseon Accounting for Investment Securitiesby Registered Investment Companieswhich the Commission has approved for publication.The Commission has considered your committee'ssuggestions with particular referenceto the circumstances in which a "subjectto" opinion would be appropriate. I amauthorized to advise you that the "subjectto" form of qualified opinion may be usedwhen an investment company's portfolio includesa significant amount represented bysecurities for which market quotations arenot readily available and when the auditor issatisfied that the procedures followed andthe information obtained are adequate toenable the board of directors to value thesecurities but is unable to form an opinion as'to the fairness of the specific values deter-'mined in good faith by the board of directors ..As developed in our conversations, an opinionin the following form, introduced by thestandard scope paragraph, in the interests ofuniformi.ty of language should be used:As discussed more fully in Note 1 to thefinancial statements, securities amountingto $

218SECURITIES AND EXCHANGE COMMISSIONcome or investment income earned on fundsin excess of the requirements for working .capital and (2) gains on retirement of debt atless than its principal amount. In some casesregistrants have, in computing the pro formaratio, imputed interest or investment incomeon amounts of funds to be obtained from theregistered offering which is in excess of theimmediate requirements for debt retirementor capital expenditures and have deductedsuch imputed income from the pro formafixed charges in computing the pro formaratio of earnings to fixed charges.The propriety of reducing fixed charges byamounts representing interest or investmentincome or gains on retirement of debt hasbeen considered in the light of the purposesfor which ratios of earnings to fixed chargesare used and the Commission has determinedthat the reduction of fixed charges bythe amount of either actual or imputed interestor investment income or debt retirementgains for the purpose of computing fixedcharge ratios results in incorrect ratios andis therefore inappropriate. Accordingly, suchreductions will no longer be deemed acceptablein registration statements or reportsfiled with the Commission.By the Commission.THEODORE L. HUMESAssociate SecretaryRELEASE NO. 120July 15, 1971INVESTMENT COMPANY ACT OF 1940Release No. 6620SECURITIES EXCHANGE ACT OF 1934Release No. 9250Notice of Revision of Annual Report Form N-IR for Management Investment Companies andWithdrawal of Proposal to Amend Rule 30a-lNOTICE IS HEREBY GIVEN that theSecurities and Exchange Commission hasadopted certain revisions of Form N-IR forannual reports of most registered managementinvestment companies and has withdrawnits proposal to amend Rule 30a-1. Noticesof the proposed reVISIons werepublished in Investment Company Act ReleaseNos. 6284 on December 16, 1970, and6349 on February 16, 1971, in which interestedpersons were invited to submit writtenstatements of their views and comments.The revisions of Form N-IR require moreexplicit information with respect to the registrationof investment company shares; theprocessing of orders for sales, redemptionsand repurchases of such shares; and investmentcompany portfolio transactions generallyand in "restricted securities." Informationrelating to the status of shareholderaccounts and the processing of shareholderinquiries is also required. The Opinion of theIndependent Public Accountant filed withthe annual report on Form N-IR is requiredto include comments upon any material inadequaciesin the accounting system and thesystem of internal accounting control of theinvestment company and any corrective actiontaken or proposed.Revisions of Form N-IRForm N-IR, a comprehensive form for annualreports filed by management investmentcompanies, was adopted January 25,1965 (Investment Company Act Release No.4151). It was designed to assist the Commissionmaterially in its inspection program andto achieve a substantial degree of self-inspectionby laying before persons responsible forthe management and operations of an investmentcompany information which wouldassist them in determining· more readilywhether the investment company is in factcomplying with the statutory standards andrequirements of the Act and rules thereunder.

ACCOUNTING SERIES RELEASES 219When Form N-1R was adopted, the Commissionrecognized that it might require furtherrevision and supplementation in thefuture. It therefore directed its Division ofCorporate Regulation, in light of experiencewith the revise.d form, to bring to its attentionany special problems encountered in thereports filed on this form. The Division recommendedthat those items of the form designedto provide information about the issuanceand redemption of investment companyshares, Item 1.07, Issuance and Redemptionof Securities (Sections 22(g) and 23); Item2.23, Procedures Followed upon Receipt ofOrders for. Purchase, Repurchase, or Redemptionof Registrant's Shares; Item 2.24, TimeLapse between Sale of Shares of, and Receiptof Proceeds by, Registrant; Item 2.25, Suspensionor Postponement of Right of Redemption(Section 22(e)); and the item relating to "restrictedsecurities," Item 1.27, Holdings of"Restricted Securities" Other Than StraightDebt Securities; be revised as indicated belowto provide more specific information andbetter serve the purposes for which Form N-1R was designed. The Division also recommendedthat three new items be added, Item2.30, Portfolio Transactions Not Settled bySpecified Settlement Dates; Item 2.31, CorrespondenceReceived by Registrant Relating toShareholder Accounts; and Item 2.32, Confirmationsand Statements of Shareholders' Accounts;to assist the Commission more effectivelyin its inspection program and to aidinvestment company management in preventingand detecting potential back-officeproblems.The above revisions and additional itemsof Form N -lR were proposed by the Commissionin its Notice of December 16, 1970. Inaddition, the Commission's Notice of February16, 1971 proposed the use in Item 1.27 ofthe EDP attachments to Form N-1R (in additionto the use in certain other Commissionreporting forms) of securities identificationnumbers assigned by the system developedunder the sponsorship· of the Committee onUniform Security Identification Procedures(CUSIP) of the American Bankers Association.The Commission has considered the writtencomments received on the proposed revisionsof Form N-1R and has adopted a numberof the comments which suggestedchanges in the revisions of the form as theywere proposed. It has also withdrawn theproposed amendment to Rule 30a-1 whichwould have reduced the time for filing annualreports on Form N-1R from 120 to 90days.(The text of the amended items and relatedinstructions is omitted.)The Commission, acting pursuant to Sections30, 31, 38(a) and 45(a) of the InvestmentCompany Act of 1940 and Sections 13, 15(d),23(a) and 24 of the Securities exchange Act ofi934, and deeming it necessary to the functionsvested in it, and necessary and appropriatein the public interest and for theprotection of investors, hereby adopts therevisions of Form N-1R, including the EDPattachments, effective for all fiscal yearsending on or after December 31, 1971.By the Commission.THEODORE L. HUMESAssociate Secretary

220 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 121July 19, 1971SECURITIES ACT OF 1933Release No. 5172SECURITIES EXCHANGE ACT OF 1934Release No. 9253. Adoption of Amendments to Regulation S-X and to Forms 10 and 10-K to Revise the Exemptionfrom Certification of Financial Statements of Banks Filed Under the Securities Act of 1933 andthe Securities Exchange Act of 1934.The Securities and Exchange Commissiontoday adopted amendments of Article 9 ofRegulation S-X and Instructions 13 and 7 ofthe Instructions as to Financial Statementsof Forms 10 and 10-K, respectively, whichrevise the exemption from certification offinancial statements of banks filed under theSecurities Act of 1933 and the SecuritiesExchange Act of 1934.Proposed amendments of the rules andforms to delete the exemption from certificationof financial statements of banks and lifeinsurance companies were issued for publiccomment on May 17, 1971 in Securities ActRelease No. 5149 (Securities Exchange ActRelease No. 9175). Letters of comment werereceived which have been given careful considerationin determining the extent of thedefinitive amendments.The Commission has determined to adoptthe amendments deleting the exemptionfrom certification of financial statements ofbanks. However, such amendments do notapply to financial statements for periodsending on or before November 30, 1971, includedin registration statements and reportsfiled with the Commission so that areasonable period of time will be provided foraffected registrants to plan and arrange forappropriate audit work and because of thedifficulties that may be encountered by registrantsif retroactive independent auditsfor periods ending prior to the effective datewere required.With respect to life insurance companies,the exemption from certification of financialstatements for such companies filed underthe Securities Exchange Act of 1934 is retainedat this time. This will permit theaccounting profession in collaboration withthe life insurance industry to complete worknow underway to develop and promUlgateaccounting guidelines for life insurance companieswhich will enable the financial statementsof such companies to be certified inaccordance with generally accepted accountingprinciples.These amendments are adopted pursuantto authority conferred on the Securities andExchange Commission by the Securities Actof 1933, particularly Sections 6, 7, 8, 10 and19(a) thereof and the Securities ExchangeAct of 1934, particularly Sections 12, 13, 15(d)and 23(a) thereof.The amendments are set forth below.I. Paragraph (a) of Rule 9-05 of RegulationS-X has been amended to read as follows:"(a) Statements of banks need not be certifiedfor periods ending on or before N ovember30, 1971."II. Instructions 13 and 7 of Instructions asto Financial Statements in Forms 10 and 10-K, respectively, have been amended to readas follows:Statements of Banks and Life InsuranceCompaniesNotwithstanding the requirements of theforegoing instructions, financial statementsfiled for banks for periods ending on or beforeNovember 30,1971 and for life insurancecompanies need not be certified.* * * * *The foregoing amendments shall be effectiveJuly 19, 1971.By the Commission.THEODORE L. HUMESAssociate Secretary

ACCOUNTING SERIES RELEASES 221RELEASE NO. 122August 10, 1971SECURITIES ACT OF 1933Release No. 5176SECURITIES EXCHANGE ACT OF 1934Release No. 9279Coverage of Fixed ChargesCertain registration forms under the SecuritiesAct of 1933 require, where debt securitiesare to be registered, a statement of theratio of earnings to fixed charges. Certainregistration and report forms under the SecuritiesExchange Act of 1934 permit theshowing of such ratio. Registration statementshave been filed recently with the Commissionwherein the ratio of earnings tofixed charges was computed on the basis ofthe revenues and expenses set forth in financialstatements which did not reflect therevenues and expenses of a substantial portionof the enterprise carried on by the registrant.For example, some issuers operatelarge affiliated credit companies or suppliercompanies which themselves are obligatedfor substantial amounts of fixed charges byreason of debt, leases or other contractualobligations. In addition, the registrant mayhave guaranteed the debt of a supplier companywhich is not a subsidiary of the registrantor may have entered into contractswith such supplier which provide for paymentsdesigned to service debt of the supplier.The fixed charges of such related companiesare frequently not taken into accountin computing the ratio of earnings to fixedcharges for the registrant (or registrant andconsolidated subsidiaries) and, therefore,such ratio standing by itself may be misleadingwhere consideration of the revenues andexpenses of the total enterprise would producea materially different result. It is theposition of the Commission that, in such instances,the ratio of earnings to fixedcharges for the registrant must be accompaniedby effective disclosure of the significanceof fixed charges of other companiesincluded in the enterprise whether or not therevenues and expenses of such companiesare set forth in the financial statements ofthe registrant. Such disclosure usuallyshould be accomplished by presenting theratio of earnings to fixed charges for thetotal enterprise in equivalent prominencewith the ratio for the registrant or registrantand consolidated subsidiaries.By the Commission.THEODORE L. HUMESAssociate SecretaryRELEASE NO. 123March 23, 1972SECURITIES ACT OF 1933Release No. 5237SECURITIES EXCHANGE ACT OF 1934Release No. 9548'PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17514INVESTMENT COMPANY ACT OF 1940Release No. 7091Standing Audit Committees Composed of Outside DirectorsAs far back as 1917 it was urged thatauditors in the United States should be appointedor selected by the stockholders inaccordance with the practice in Great Brit-

222 SECURITIES AND EXCHANGE COMMISSIONain and in Canada, and that state laws orcompany by-laws "should contain a provisionfor an independent report on the affairs ofthe company by an auditor appointed by thestockholders." 1Following the McKesson-Robbins investigation,in 1940 the Commission advocatedthe adoption of a program for: (1) currentelection of auditors at the annual meeting ofstockholders; (2) nomination of auditors andarranging the details of the audit by a committeeof nonofficer members of the board ofdirectors; (3) addressing of the auditors' certificate,report or opinion to the stockholders;(4) mandatory attendance by auditors atthe annual meetings of stockholders atwhich the audit report is presented; and (5)mandatory submission by auditors of a reporton the amount of work done and of thereasons for noncompletion in situationswhere audit engagements are not completed.The stress of the program was on the responsibilityof auditors to public investors.2More recently others have supported thesesuggestions. In 1967 the executive committeeof the American Institute of Certified PublicAccountants recommended that standing auditcommittees of outside directors shouldnominate auditors for the annual audits ofpublicly-owned companies and should discussthe audit work with the auditors appointedto perform the audit. The Institute consideredthat such standing audit committees" ... can be a constructive force in the overallIJohn Thomas Madden, Accounting Practice and Auditing:Modern Business Texts, Vol. 21 (New York: AlexanderHamilton Institute, 1917, pp. 248-9).2 Accounting Series Release No. 19, December 5, 1940.review of internal controls and financialstructure, and give added assurance to stockholdersas to the objectivity of corporatefinancial statements."3A 1970 study has concluded that "[t]hepotential for usefulness of corporate auditcommittees, ... sufficiently exceeds the possibilitiesfor disturbance that we stronglyrecommend that all companies with significantnonmanagement shareholder interestsconsider carefully the desirability of establishingan audit committee .... "4The Commission has a statutory duty tosatisfy itself that the consolidated financialstatements filed with it by publicly-held companiesof increasingly sophisticated and interlockingaffiliations satisfy the requirementsof Rules 2-02(b) and (c) of RegulationS-X and/or Instruction 5 to Item 6 of Form S-1, as appropriate. To this end, the Commission,in the light of the foregoing historicalrecital, endorses the establishment by allpublicly-held companies of audit committeescomposed of outside directors and urges thebusiness and financial communities and allshareholders of such publicly-held companies.to lend their full and continuing support tothe effective implementation of the abovecitedrecommendations in order to assist inaffording the greatest possible protection toinvestors who rely upon such financial statements.3"AICPA Executive Committee Statement on AuditCommittees of Boards of Directors," Journal of Accountancy,Vol. 124 (September 1967), p. 10.4 R. K. Mautz and F. L. Neumann, Corporate AuditCommittees (Urbana, Ill.: Bureau of Economic and BusinessResearch, University of Illinois, 1970), p. 96.

ACCOUNTING SERIES RELEASES 223 .RELEASE NO. 124June 1, 1972SECURITIES ACT OF 1933Release No. 525~.SECURITIES EXCHANGE ACT OF 1934Release No. 9618PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17583INVESTMENT COMPANY ACT OF 1940Release No. 7204Pro Rata Stock Distributions to ShareholdersSeveral instances have come to the attentionof the Commission in which registrantshave made pro rata stock distributions whichwere misleading. These situations arise particularlywhen a registrant makes distributionsat a time when its retained earnings orits current earnings are substantially lessthan the fair value of the shares distributed.Under present generally accepted accountingrules, if the ratio of distribution is lessthan 25 percent of shares of the same classoutstanding, the fair value of the sharesissued must be transferred from retainedearnings to other capital accounts. Failure tomake this transfer in connection with a distributionor making a distribution in theabsence of retained or current earnings isevidence of a misleading practice. Distributionsof over 25 percent (which do not normallycall for transfers of fair value) mayalso lend themselves to such an interpretationif they appear to be part of a program ofrecurring distributions designed to misleadshareholders.It has long been recognized that no incomeaccrues to the shareholder as a result of suchstock distributions or dividends, nor is thereany change in either the corporate assets orthe. shareholders' interests therein. However,it is also recognized that many recipientsof such stock distributions, which arecalled or otherwise characterized as dividends,consider them to be distributions ofcorporate earnings equivalent to the fairvalue of the additional shares received. Inreco gnl 't' Ion of these circumstances theA.merican Institute of Certified Public Ac­COuntants has specified in Accounting ResearchBUlletin No. 43, Chapter 7, paragraph10, that " ... the corporation should in thepublic interest account for the transactionby transferring from earned surplus to thecategory of permanent capitalization (representedby the capital stock and capital surplusaccounts) an amount equal to the fairvalue of the additional shares issued. Unlessthis is done, the amount of earnings whichthe shareholder may believe to have beendistributed will be left, except to the extentotherwise dictated by legal requirements, inearned surplus subject to possible furthersimilar stock issuances or cash distributions."Both the New York and AmericanStock Exchanges require adherence to thispolicy by their listed companies. 1The Commission also considers that if suchstock distributions are not accounted for inthis manner the shareholders may be misled.In a recent stop order proceeding2 the Commissionfound that a registration statementwas materially misleading because a seriesof four stock distributions made between1966 and 1968 " ... were 'part of a frequentrecurrence of issuances of shares'... [and] . .. under generally accepted accountingprinciples they should have beenaccounted for as stock dividends."If; in addition to failing to account for thedistribution properly, the registrant does nothave sufficient retained earnings or currentincome to cover the appropriate transfer topermanent capital, a question immediatelyarises whether these factors may be part of a1 See New York Stock Exchange Manual, page A-235,and American Stock Exchange Guide, 1110,046.2 Monmouth Capital Corporation, Securities Act ReleaseNo. 5169 (July 14, 1971).

224 SECURITIES AND EXCHANGE COMMISSIONmanipulative or fraudulent scheme, and assuch are proscribed under Rule 10b-5 of theSecurities Exchange Act of 1934. The Commissionhas stated in published opinions, 3 insituations where companies did not have retainedor current earnings, that the declarationof a dividend not warranted by thebusiness condition of a company is characteristicof a manipulative scheme.The Commission emphasizes that it will"Gob Shops of America, Inc., 39 S.E.C. 92 (1959); MacRobbins & Co., Inc., 41 S.E.C. 116 (1962).deem the types of transactions noted aboveto be misleading if the accounting is improperor disclosure is inadequate, and ifthere is a question of whether the conditionof the business warrants the distribution, afurther investigation will be considered todetermine whether' such distribution may bepart of a manipUlative or fraudulent scheme.By the Commission.RONALD F. HUNTSecretaryRELEASE NO. 125June 23, 1972SECURITIES ACT OF 1933Release No. 5261SECURITIES EXCHANGE ACT OF 1934Release No. 9648PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17617INVESTMENT COMPANY ACT OF 1940Release No. 7236Notice of Adoption of Amendments to Regulation S-XProposals to amend Articles 1, 2, 3, 4, 5, 9,11 and Rules 12-01 to 12-16 (exclusive of 12-06A), and to omit Rules 12-17 and 12-32 ofRegulation S-X were issued for public commenton August 20, 1971 in Securities ActRelease No. 5177 (Securities Exchange ActRelease No. 9264, Public Utility HoldingCompany Act Release No. 17215 and InvestmentCompany Act Release No. 6645).The letters of comment which were receivedhave been given careful considerationin determining the definitive amendments ofthe above articles and rules. Amendments toArticle 9 and Rule 12-32 have been deferredtemporarily. Rule 12-17 has been retained foruse in other articles of the regulation notaff~cted by these amendments. Manychanges of an editorial or clarifying naturehave been made. Parts of the index of theregulation and certain rules in Articles 7 and7 A have been revised to reflect changes inrule numbers and caption headings. Othermore substantive changes have been madein rules discussed below. The Commissionalso plans to issue in the near future aproposal to revise the instructions to thefinancial statements and summaries of operationsin various filing forms to reflect thechanges in terminology and caption headingsadopted in Regulation S-X and to clarify andmodify the instructions in some respects.Rule 1-OJ. Application of Regulation S-x. Additionalcross-referencing to pertinent AccountingSeries Releases has been made atvarious points in the revised articles andrules as an aid to utilization of the releasesas part of Regulation S-X. A study of thereleases is being made to provide a codificationand to determine whether certain of thereleases should be rescinded.Rule 1-02. Significant Subsidiary. Achange has been made in the tests in thisdefinition to base them on the parent's andthe parent's other subsidiaries' proportionateshare of revenues and assets of a subsidiaryrather than on the total of such revenuesand assets.hRule 2-02. Accountants' Reports, paragrap

ACCOUNTING SERIES RELEASES 225(c), Opinion to be expressed. More generalwording was adopted in part (1) regardingthe financial statements and accountingprinciples reflected therein in lieu of parts (1)and .(2) of the proposal to avoid improperinterpretation~ of what is required by therule. Part (4) of the proposal was omittedbecause the requirement is no longer considerednecessary.Rule 2-06 (proposed). Examination of PolicyReserves of Life Insurance Companies byan Actuary. Adoption of the proposed rulehas been deferred pending completion of astudy by the American Institute of CertifiedPublic Accountants regarding accountants'responsibility in connection with such examinations.Rule 3-08. Summary of Accounting Principlesand Practices. The original permissivebasis for the presentation of a single statementregarding information on accountingprinciples and practices reflected in financialstatements,as specified under other rules ofArticle 3, has been restored in view of thefact that the Accounting Principles Board ofthe American Institute of Certified PublicAccountants has recently issued an opinionon "Disclosure of Accounting Policies."Rule 3-09. Translation of Items in ForeignCurrencies (as proposed). Paragraph (a) ofthe proposal was combined with Rule 3-16(b)to elimInate some duplication and to place itmore logically under the requirements fornotes to financial statements, and paragraph(b) which dealt with bases of translation wasomitted pending completion of studies by theAmerican Institute of Certified Public Accountantson translation of foreign currenciesand intercorporate investments.Rule 3-16(g). Pension and retirement plans.The original rule was revised to require disclosuresspecified in the Accounting PrinciplesBoard Opinion on "Accounting for theCost of Pension Plans" in addition to thediSclosures originally required, including theamount of unfunded past service cost.o R~le 3-16(i). Commitments and contingentltab lOt Ot t tes. Part (2) of this rule has beenCfanged to restrict the requirements for discosure to noncancelable leases which havenot been capitalized.RUle 3-16(0). Income tax expense. This rulewas adapted from instructions proposed f9rRule 5-03-15 and placed with the· require~ments for notes to the financial statementsto provide more flexibility for presentation ofthe data in the body of a financial statementor in a footnoteo The instruction is intendedto insure that the components of income taxexpense, including taxes currently payable,are adequately disclosed.Rule 3-16(p). Warrants or rights outstanding.This rule conforms to the present practiceof requiring the data, which is specifiedin the schedule under Rule 12-15, to be presentedin the notes to the financial statementsfor more informative disclosure.Rule 4-02. Consolidated Financial Statementsof the Registrant and Subsidiaries.Additional instructions were included in paragraphs(b) and (c) to clarify the rule, and thedisclosure requirement specified under paragraph(b)(4) of the proposed rule was includedwith other disclosure requirements inparagraph (b) of Rule 4-04.Rule 4-05. Reconciliation of Investment of aPerson in Subsidiaries Not Consolidated and50 Percent or Less Owned Persons Accountedfor by the Equity Method, and Equity of SuchPerson in Their Net Assets. Part (a) of theproposed rule has been omitted since, with theadvent of the equity method of accounting, thedisclosure specified therein is not meaningful.The second paragraph of part (b) of theproposed rule has been omitted since substan.,.tially the same information will be obtainedunder a new caption in the income statement.Rule 4-07. Consolidation of FinancialStatements of a Registrant and Its SubsidiariesEngaged in Diverse Financial Activities.The rule has been revised to clarify theconditions under which consolidated statementsare permissible [paragraph (a)] andare not permissible [paragraph (b)].Rule 5-02-20. Deferred research and developmentexpenses, preoperating expenses andsimilar deferrals. An instruction was addedto obtain disclosure in the notes to financialstatements of significant data which wouldotherwise be disclosed under the schedulerequirements adopted in Rule 12-08 for thesetypes of expenses. (See comment under Rule5-04, Schedule VII.)Rule 5-02-39. Other stockholders' equity.

226 SECURITIES AND EXCHANGE COMMISSIONThe caption of this rule has been changed toprovide a clearer distinction between retainedearnings and other types of additionalcapital. The proposed requirement in paragraph(a) for disclosure regarding retainedearnings capitalized has been omitted as unnecessaryin light of requirements for analysesof the various equity accounts on a continuingbasis. The change in terminology hasalso been reflected in Article II.Rule 5-03-17. Equity in earnings of unconsolidatedsubsidiaries and 50 percent or lessowned persons. An additional instruction hasbeen included to recognize that in some circumstancesthis item may be presented in adifferent position and in a different manner.Rule 5-03-20. Cumulative effects of changesin accounting principles. This new captionwas adopted to provide for the presentationof cumulative effects of changes in accountingprinciples in the income statement in thecircumstances specified in Accounting PrinciplesBoard Opinion No. 20 of the AmericanInstitute of Certified Public Accountants.Rule 5-04, Schedule VII. The instructionsand the schedule prescribed in Rule 12-08have been revised to require inclusion ofdata in support of balance sheet caption 20,Deferred research and development expenses,preoperating expenses and similardeferrals, comparable to the data presentlyrequired to be reported in the schedule insupport of balance sheet caption 16, Intangibleassets. This addition to the schedule providesfor more complete disclosure regardingthe caption 20 items than was originallyproposed under Rule 12-16 for research anddevelopment costs. This is considered desirablein light of the importance of expenditureson these types of activities to the currentand future welfare of a company.Rule 5-04, Schedules XVII and XVIII. Thein:;;tructions have been changed to relate tonew schedules adopted as Rules 12-42 and 12-43 to replace Rules 12-37 and 12-38 which hadbeen adapted in Form S-l1 from another usef~r reporting by certain real estate companIeson real estate held for investment andmortgage loans on real estate. The newschedules reflect the current structure of thereal estate industry and will enable the companiesto provide better disclosure regardingthese important assets. The Instructions asto Financial Statements of Form S-l1 will beamended in the near future to conform thoseinstructions to these changes.Rule 12-16. Supplementary Income StatementInformation. In order to simplify andreduce the overall requirements of theschedule, the requirement for disclosure ofcharges to other than income accounts for allitems listed and the item Management andservice contract fees have been omitted; thetwo elements of the item Rents and royaltieshave been listed separately; and a restrictingdefinition for the item Advertising costshas been included.The amendments to Regulation S-X areadopted pursuant to authority conferred onthe Securities and Exchange Commission bythe Securities Act of 1933, particularly Sections6, 7, 8, 10 and 19(a) thereof; the SecuritiesExchange Act of 1934, particularly Sections12, 13, 15(d) and 23(a) thereof; thePublic Utility Holding Company Act of 1935,particularly Sections 5(b), 14 and 20(a)thereof; and the Investment Company Act of1940, particularly Sections 8, 30, 31(c) and38(a) thereof.(The text of the amendn:tents revising Articles1, 2, 3, 4, 5, 11 and Rules 12-01 to 12-16(exclusive of 12-06A) and rescinding Rule 12-17, all of Regulation S-X, is omitted.)These amendments shall be effective withrespect to financial statements for periodsending on or after December 31, 1972, exceptthat the inclusion of professional employeesIin the definition of "member" in Rule 2-01(b)is effective commencing January 1, 1973, inregistration statements and reports filedwith the Commission.By the Commission.RONALD F. HUNTSecretary

AccouNTING SERIES RELEASES 227RELEASE NO. 126July 5, 1972SECURITIES ACT OF 1933Release No. 527.9SECURITIES EXCHANGE ACT OF 1934Release No. 9662PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17636INVESTMENT COMPANY ACT OF 1940Release No. 7264Independence of Accountants; Guidelines and Examples of Situations Involving theIndependence of AccountantsThe Securities and Exchange Commissiontoday amiounced the publication of an additionalrelease in its Accounting Series on thesubject of the independence of the certifyingaccountant. The primary purpose of this releaseis to set forth presently existing guidelinesemployed by the Commission in resolvingthe various independence questions thatcome before it. This release, therefore, is notintended to supersede Accounting Series ReleaseNo. 47 issued on January 25, 1944, orNo. 81 issued on December 11, 1958, butshould be read as complementing and implementingfurther the policy developed inthose prior releases. However, to the extentthat any inconsistency exists between theseprior releases and the release presentedherein, the latter should be regarded as indicativeof the Commission's current position.The Commission's authority and responsibilityfor determining that accountants areindependent are found in the statutory languageof the acts it administers. These acts,and the rules adopted pursuant to them,principally provide for the adequate and accuratedisclosure of all material facts to thepUblic. The concept of independence, as itrelates to the accountant, is fundamental tothis purpose because it implies an objectiveanalysis of the situation by a disinterestedthird party. In order to assure ppblic confidencein the objective reporting of thesematerial facts, certain rules, particularly~ule 2(e)1 of the Commission's Rules of Prac­~e and Rule 2-012 of Regulation SoX, were~ 17 CFR 201.2(e).17 CFR 210.2-01.adopted. Under Rule 2(e) "the Commissionmay deny, temporarily or permanently, theprivilege of appearing or practicing before itin any way to any person who is found by theCommission after notice of and opportunityfor hE'aring in the matter (i) not to possessthe requisite qualifications to represent others,or (ii) to be .lacking in character or integrityor to have engaged in unethical or improperprofessional conduct, or (iii) to havewillfully violated, or willfully aided and abettedthe violation of any provision of thefederal securities laws, or the rules and regulationsthereunder."3 Contrasted with Rule2(e), under which the Commission may imposesanctions once the issue of lack of independenceor other improper professional conducthas been determined, is Rule 2-01 ofRegulation SoX which deals with the qualificationsof accountants and broadly illustrateshow the qualification of independencecan be impaired. Audited financial statementswhich are used in connection with anoffering of securities within the Commission'sjurisdiction, including those offeringswhich are exempted from certification underthe Securities Act of 1933, must be auditedby an accountant who satisfies the independencerequirements of this rule.In Rule 2-01(b) the use of the introductorywords "[fJor example" implies that situationsinvolving possible loss of independence include,but are not limited to, the relationshipsset forth therein. Rule 2-01(b) asamended states that " ... an accountant willbe considered not independent with respect317 CFR 201.2(e)(1).

228 SECURITIES AND EXCHANGE COMMISSIONto any person or any of its parents, its subsidiaries,or other affiliates (1) in which, duringthe period of his professional engagementor at the date of his report, he or hisfirm or a member 4 thereof, had, or was committedto acquire, any direct financial interestor any material indirect financial interest;or (2) with which, during the period ofhis professional engagement, at the date ofhis report or during the period covered bythe financial statements, he or his firm or amember thereof, was connected as a promoter,underwriter, voting trustee, director,officer, or employee."5 The Accounting SeriesReleases issued on the subject of independenceattempt to clarify the intent of Rule 2-01 by applying these abstract principles toconcrete factual situations.The critical distinction which must be recognizedat the outset is that the concept ofindependence is more easily defined thanapplied. As a result, the guidelines and illustrationspresented in these releases cannotbe, nor are they intended to be, definitiveanswers on any aspect of this subject.Rather, they are designed to apprise thepractitioner of typical situations which haveinvolved loss of independence, whether inappearance or in fact, and by so doing toplace him on notice of these and similarpotential threats to his independence.An important consideration in determiningwhether an accountant is independent is therelationship between the company, its stockholdersand the accountants. Ratification ofaccountants by stockholder vote and attendanceof accountants at the company's annualmeeting to answer stockholder questions aredesirable actions to strengthen the accountant'sindependent position. The existence ofan audit committee of the board of directors,particularly if composed of outside directors,should also strengthen such independence. 6• For the purposes of Rule 2-01 [17 CFR 210.2-01(b)] theterm "member" means "all partners in the firm and allprofessional employees participating in the audit orlocated in an office of the firm participating in a significantportion of the audit."517 CFR 210.2-01(b)."Securities Act Release No. 5237 (March 23. 1972);Accounting Series Release No. 123.In Accounting Series Release No. 81 it wassaid that the growth of the accountingprofession and the number of inquiries receivedfrom public accountants necessitatedthe publication of rulings in this category.We find ourselves today in a similar situation.Since the publication of Accounting SeriesRelease No. 81 in 1958 technologicaladvances have been considerable and haveresulted in not only faster and more efficientmeans of rendering the customary servicesto clients but also in an expanded range ofpossible services which could be rendered.Consequently, although the principles affectingthe determination of independence haveremained unchanged, the application ofthese principles has been complicated by thedifficulty in properly delineating the permissiblescope of these expanded services. TheEthics Division of the American Institute ofCertified Public Accountants has also recognizedthe need for further guidelines in thisarea. In April 1971 it issued Ethics OpinionNo. 22, which deals with the "impact of dataprocessing services on audit independence."This opinion supports the Commission's philosophythat "the fundamental and primaryresponsibility for the accuracy of informationfiled with the Commission and disseminatedamong investors rests upon management."7It also recognizes that when"securities issued by the client are offered tothe public and become subject to regulationby the Securities and Exchange Commissionor other federal or state regulatory bodies,the matter of appearance, in addition to independencein fact, becomes more significant."BA part of the rationale which underlies anyrule on independence is that managerial anddecision-making functions are the responsibilityof the client and not of the independentaccountant. It is felt that if the independentaccountant were to perform functions of thisnature, he would develop, or appear to develop,a mutuality of interest with his clientwhich would differ only in degree, but not in7 Interstate Hosiery Mills. Inc., 4 S.E.C. 706, 721 (1939).8 Ethics Opinion No. 22: "Impact of Data ProcessingServices on Audit Independence," American Institute ofCertified Public Accountants (April 1971).

ACCOUNTING SERIES RELEASES 229kind, ,from that of an employee. And wherethis' relationship appears to exist, it may belogically inferred that the accountant'sprofessional judgment toward the particularclient might be p.rejudiced in that he would,in effect, be audIting the results of his ownwork, thereby destroying the objectivitysought by shareholders. Consequently, theperformance of such functions is fundamentallyinconsistent with an impartial examination.However, it is the role of the accoUntantto advise management and to offerprofessional advice on their problems. Therefore,the problem posed by this dilemma is toascertain the point where advice ends andmanagerial responsibility begins.In this context, managerial responsibilitybegins when the accountant becomes, or appearsto become, so identified with thecli~nt's management as to be indistinguishablefrom it. In making a determination ofwhether this degree of identification hasbeen reached, the basic consideration iswhether, to a third party, the client appearsto be totally dependent upon the accountant'sskill and judgment in its financialoperations or to be reliant only to the extentof the customary type of consultation or advice.A particularly difficult situation ariseswhen a small client for whom accountingservices were performed desires to go publicto meet the needs ofits expanding business.If any of these services involved managerialfunctions or the maintenance of basic accountingrecords, the accountant may findhimself unqualified to render an independentopinion on the financial statement forany period in which these services were performed.The financial statements are theresponsibility of the client and all decisionswith respect to them must ultimately beassumed by the client. Consequently, it isessential that the company and its account~ntallow for an adequate transitional pertodto avoid this problem. ...The Commission has said that the questionOf. independence is one of fact, to be determInedin the light of all the pertinent circumstancesin a particular case. 9 No set of----9 Accounting Series Release No. 47, January 25,1944.rules or compilation of representative situationscan embrace all the circumstanceswhich could affect such a determination. Butwhat they can do, and what they are intendedto do, is act as a general notificationwhich simultaneously educates the practitionerand places on him the responsibilityfor recognizing these general areas of potentialloss of independence. The Commission isaware of the fact that situations arise whichrequire judgment in determining whetherthe Commission's standards of independencehave been met and that a company or itsaccountants may wish assurance that noquestion as to independence will be raised ifthe company files financial statements withthe Commission. Where this is the case, theCommission urges the parties concerned tobring the problem to its attention so that atimely and informed decision on the mattermay be made.EDP AND BOOKKEEPING SERVICESThe Commission is of the opinion that anaccountant cannot objectively audit booksand records which he has maintained for aclient. The performance of these services,whether accomplished manually or by meansof computers and other mechanized instruments,ultimately places the accountant inthe position of evaluating and attesting tohis own recordkeeping. In some cases theamount of recordkeeping by the accountantmay be limited and a strict application of therecordkeeping prohibition may cause an unreasonablehardship on companies goingpublic for the first time. When no questionrelating to recordkeeping exists in the latestfull year certified, the Commission may, insome' cases, not raise a question as to independencein the earlier periods.a. Systems design is a proper function forthe qualified public accountant. Computerprogramming is an aspect of systemsdesign and does not constitute abookkeeping service.b. Where source data is provided by theclient and the accountant's work is limitedto processing and production of listingsand reports, independence will be

230 SECURITIES AND EXCHANGE COMMISSIONadversely affected if the listings and reportsbecome part of the basic accountingrecords on which, at least in part,the accountant would base his opinion.In this situation the accountant, by preparingbasic accounting records, has placedhimself in a position where he wouldbe reviewing his own recordkeeping andcould therefore appear to a reasonablethird party to lack the objectivity andimpartiality with respect to that clientwhich an independent audit requires. Onthe other hand, if the processing resultsin the production of statistical summariesand analyses which do not becomepart of the basic accounting records, independencewould not be adversely affectedbecause the accountant, in thecourse of his audit, would not be put inthe position, actual or apparent, of evaluatingand attesting to the accuracy ofhis own recordkeeping.Examples based upon situations broughtto the attention of the staff are set forthbelow:1. Accounting firm provided services tothe client which included writing up thebooks, making adjusting entries, and preparingfinancial statements. Audited statementsprepared under these circumstancesare acceptable to the State Attorney Generalunder that state's financing act. Conclusion,independence is adversely affected since theaggregate of these activities appears to placethe basic responsibility for the accountingrecords and financial statements with thesame accounting firm which is expected toperform an objective audit.2. Accounting firm, through the use oftheir data processing equipment, maintainedthe sales, purchase, cash receipts and disb1:lrsements,and general journals for five ofthe client's subsidiaries. In addition, theyposted the general ledger, coded and reclassifiedvoucher checks, and reconciled certainaccounts. The financial statements for themost recent year are to be audited by anotheraccounting firm and those of the priory~ar by the subject accounting firm. Conclu-8'Wn, the extent of the services performed issuch as to cause the subject firm to be notindependent either with regard to the parentor its subsidiaries.3. In order to keep certain informationconfidential the client has asked the accuuntingfirm to perform the following work:(1) Preparation of executive payroll.(2) Maintenance of selected general ledgeraccounts in a private ledger. "Conclusion, the performance of the foregoingwork would adversely affect independence.4. Client personnel will prepare from thebooks of original entry printed tapes thatcan be read on an optical scanner and willsend the tapes to the accountant's office. Theaccountants will forward the tapes to a servicebureau. The accountants will receive theprint-outs of the financial statements andgeneral ledgers and will send them to theclient. The accountants will not edit inputdata prior to transmission to the servicebureau. Conclusion, independence would beadversely affected. Although the function ofthe accountant appears totally mecha~ical,the service bureau appears to be acting as anagent of the accountant and this relationshipshould be changed so that the printed tapeswill be transmitted directly to the servicebureau by the client and the resulting printoutreturned directly to the client.5. Bookkeeping department of public accountingfirm has .kept and posted theclient's general ledger " from the start of theclient's business. All other bookkeeping workhas been done by the client's employees.Conclusion, since the accounting firm hadcontrol of the general ledger for the life ofthe company, their independence is adverselyaffected. However, another public accountingfirm, if engaged to audit the company,could reduce its work by reference tothe work papers and schedules of the presentaccountants but only to the extent that theycould" be accepted as the work of the client'sbookkeeping staff.6. Public accounting firm recorded theclient's books of original entry, posted thegeneral ledger, and determined the accountclassification of expenditures. The client waSin the preoperating stage when this workwas done and consequently had no need for afull-time bookkeeper. A controller has re-

ACCOUNTING SERIES RELEASES 231cently been hired by the client. Conclusion,accounting firm could not be considered independentfor the purpose of auditing financialstatements to be filed with the Commission.The maintenance of records in the absence ofqualified personnel, as in this case, would notbe considered an emergency situation whichwould permit such services.7. Accounting firm proposed, by use of itscomputer, to perform certain data processingactivities in connection with the client'sstockholder ledger. Programming, keypunchingand computer processing would be performedby personnel of the data processingdepartment who are separate from the auditstaff. The work proposed would consist of acomplete restatement of the stockholder'sledger and its subsequent maintenance andupdating to reflect future transactions. Inthe course of restating the ledger accountscertain audit procedures would be appliedwhich would lead to the correction of errorsin the restated accounts. Conclusion, theseservices would adversely affect independence.The accountant has assumed the responsibilityfor maintaining the client's stockrecords.8. Accounting firm did certain computerservicing work for a client during the periodto be covered by their opinion. The client isnot using the computer services of the accountingfirm for the current fiscal year butstill employs this firm as its accountants.The client's personnel had complete controlover the preparation and coding of thevouchers. These vouchers were sent to theaccounting firm but were not accompaniedby the source data. These vouchers were fedinto the computer and voucher registers and~eneral journals were printed. All correctionswere made by the client. The accountantsperformed only those services necessaryto prepare the data for the computer.Conclusion, no question of independence willb d"eraIse. dbecause these services have beenlscontinued prior to the current fiscal year:nd ~ppear to have been mechanical in na-Ure Involving neither the exercise of judgmentnor the making of any decisions by theje aCCOunt" t Ing fi lrm, and the processmg .' was subcto controls of the client. .FINANCIAL INTERESTRule 2-01(b) states that an accountant willbe considered not independent if "he or hisfirm or a member thereof had, or was committedto acquire, any direct financial interestor any material indirect financial interest"in a client. For purposes of interpretingthis section, any financial interest in a clientowned by the accountant, or by the accountant'sspouse is considered to be a directinterest. Also, any financial interest in aclient by someone other than the accountantmay be treated as a direct financial interestof the accountant himself if, under the circumstances,. it appears that the holder issubject to the accountant's supervision orcontrol. On the other hand, if the interest isconsidered indirect, it is necessary to determinewheth~r or not it is also material. And,in this context, the determination is primarilymade with reference to the net worth ofthe accountant, his firm, and the net worthof his client.9. Corporation A is acquiring CorporationB in a merger to be accounted for as apooling of interests and proposes to pay theaccountant for Corporation B for his auditservices with stock of Corporation A. Theaccountant for Corporation B will not auditfuture reports of the acquiring company.Conclusion, independence would be adverselyaffected because of the receipt ofstock.10. Accounting Firm A is considering amerger with Firm B, one of whose partnersowns stock in a client of Firm A. The partnerproposed to put the stock in an, irrevocabletrust for the benefit of his children and controlledby two un associated trustees. Conclusion!independence would be adversely affectedif the shares were not sold. Puttingthe shares in an irrevocable trust would notbe sufficient.11. A partner in the accounting firm,whose proposed client was a wholly ownedsubsidiary of the registrant, owned one percentof the stock of the parent company.Conclusion, not independent.12. A partner in an accounting firm ownsstock in a company which has recently askedhis firm to perform the audit for the current

232 SECURITIES AND EXCHANGE COMMISSIONyear. The partner would sell his stock priorto accepting the engagement. Conclusion, noquestion of independence would be raised.13. Accounting firm received a five percent,ten-year debenture of the client in settlementof accounting fees pursuant to aplan of reorganization approved by the U. S.District Court. The firm intends to sell thedebenture as soon as possible after issuance,providing any reasonable market exists.Conclusion, if securities taken in reorganizationare disposed of promptly, no question asto independence will be raised. Although thisis not an equity security, the debenturesshould be disposed of promptly.14. A partner in an accounting firm is amember of an investment club. The clubowns stock in a company which is a client ofthe accounting firm. Neither the number northe value of the shares purchased is materialto the club or the company. Conclusion, thefirm's independence would be adversely affectedas a result of the partner's interest inthe investment club. In this regard, an investmentclub does not stand on the samefooting as a mutual fund because the formeris comprised of relatively few members andeach member plays an active part in theselection of investments.Accountant as Creditor of ClientWhen the fees for an audit or other professionalservice remain unpaid over an extendedperiod of time and become material inrelation to the current audit fee, it may raisequestions concerning the accountant's independencebecause he appears to have a financialinterest in his client. While no preciserules can be set forth, normally the feesfor the prior year's audit should be paid priorto the commencement of the current engagement.When such unpaid fees become materialthe accountant cannot be considered independentbecause he may appear to have adirect interest in the results of operations ofthe company for the period to be audited.15. Recent operations of a client companyhave not been profitable and in order toimpr?ve. its current working capital ratio ithas. InVIted unsecured creditors to extendtheIr settlement dates and subordinate theirinterests in exchange for receiving the firstproceeds from a proposed offering. The accountingfirm's fee was one of the debts to besubordinated. Conclusion, if the accountingfirm subordinates the amount due them itsindependence would be adversely affected.16. Pursuant to a plan of recapitalization,the existing debt of the company was to beexchanged for five-year promissory notes.The accounting firm was to receive! thesepromissory notes in payment of its audit fee;Conclusion, accountant should dispose ofsuch notes as promptly as possible and, ifmaterial, before undertaking any additionalauditing work for this company.FAMILY RELATIONSHIPSAs a general rule, an accountant cannot beconsidered independent where the family relationshipexisting between the accountantor member of his firm and the client is suchthat, because of the strong bond which customarilyexists in such a relationship, anoutside party could reasonably question theaccountant's impartial examination. In thiscontext and in the absence of any otherfactors, the presumption of impairment toindependence is greater in husband-wife orfather-son relationships than in that of, forexample, an uncle-nephew. In other words,the presumption is directly related to thepresumed strength of the family bond. But,in resolving cases of this nature, attention isdirected not only to the nature of the familyrelationship involved but also to such otherfactors, particularly the positions occupiedby the parties in their respective employment,as may make the related parties appearto have the opportunity to mold theshape of the financial statements.17. A is the controller of Company Z. He isnot an elected officer nor does he have anystock holdings in Company Z. A's brother, B,is a partner in the public accounting firmthat audits Company Z's books. However, Bis not the partner in charge of this client.Conclusion, the accountant could not be consideredindependent because of this relation~ship.18. Partner in a national public accountingfirm has a brother-in-law who is sales vice

-ACCOUNTING SERIES RELEASES 233president for a recently acquired client company.The brother-in-law is not directly involvedin the financial affairs of the companyand the partner would not be connected withthe audit in any way. Conclusion, no questionOf independence would be raised becauseof this relationship.19. An accountant has a sister-in-lawwhose husband is a 40 percent stockholder ofa client company. There is no other businessconnection between the company, the stockholder,the accountant or his wife. Conclusion,independence is adversely affected becauseof the family relationship between theaccountant and a major stockholder in aclient company.20. An attorney's father and brother arepartners in an accounting firm. The law firmin which the attorney is a partner acts ascounsel for several companies which are alsoclients of the accounting firm. As partialcompensation for legal services, the law firmreceives securities from the client. The attorneydoes not live in the same home or dwellingas either the father or brother and doesnot have any financial interest in their accountingfirm. Nor .do the accountants haveany interests in the law firm. Conclusion, noquestion of independence will be raised.21. The father of a partner in a publicaccounting firm was the chairman of theboard and chief executive officer of a clientcompany. The accounting firm had approximately400 general partners and had officesthroughout the U. S. The client was a largeand diverse company with many consolidatedsubsidiaries. The partner's office waslocated over 500 miles from the client's homeoffice L. and the partner was totally isolatedfrom the audit engagement. This situationand the independence issue involved werepresented to and reviewed by the company'sboard of directors. This body, which performsthe functions typically delegated to an auditcommittee of directors, decided 'that if theson would not be involved in the audit in anyway his association with the accounting firmWould not be incompatible with the indep.endentrelationship. Conclusion, no questIonf' d. 0 In ependence was raised under thesecIrcumstances.22. A client of the accounting firm acquireda 20 percent interest in a publiclyheld- company and consequently could electtwo members of the board of directors. Oneof the individuals they proposed to elect isthe brother of a partner in the accountingfirm as well as a senior partner in the lawfirm which acts as general counsel for theclient. The offices of the law firm and accountingfirm are located in the same cityand, in addition, both brothers, their affiliationsand relationships are well known in thecommunity. Conclusion, independence wouldbe adversely affected.BUSINESS RELATIONSHIPS WITHCLIENTDirect and material indirect business relationships,other than as a consumer in thenormal course of business, with a client orwith persons associated with the client in adecision-making capacity, such as officers,directors or substantial stockholders, will adverselyaffect the accountant's independencewith respect to that client. Such a mutualityor identity of interests with the client wouldcause the accountant to lose the appearanceof objectivity and impartiality in the performanceof his audit because the advancementof his interest would, to some extent,be dependent upon the client. In addition tothe relationships specifically prohibited byRule 2-01(b), joint business ventures, limitedpartnership agreements, investments in supplieror customer companies, leasing interests,except for immaterial landlord-tenantrelationships, and sales by the accountant ofitems other than professional services areexamples of other connections which are alsoincluded within this classification.23. Accounting firm will process theclient's data on the firm's computer if theclient's computer becomes inoperable. Conclusion,accountant's independence is not adverselyaffected if he assisted a client bymaintaining books and records for a shortperiod because of an emergency. The inoperabilityof the client's computer may be consideredsuch an emergency.24. Accounting firm plans to rent blocktime on its computer to a client if the client's

234 SECURITIES AND EXCHANGE COMMISSIONcomputer becomes overburdened. Conclusion,renting excess computer time to aclient, except in emergency or temporarysituations, is a business transaction with aclient beyond the customary professional relationshipand would therefore adversely affectindependence.25. An individual owns 100 percent of thestock of a corporation which acts as thegeneral partner in the limited partnership Aand 51 percent of the stock of another corporationwhich acts as general partner for limitedpartnership B. The accounting firm,which has a one percent interest in partnershipB, has been asked to audit partnershipA. Conclusion, independence as to partnershipA is adversely affected because partnershipB, in which the accounting firm has aninterest, was promoted under the same sponsorshipas A. However, if the one percentinterest is disposed of, no question will beraised.26. Client of an accounting firm is engagedin the business of selling franchises. Twopartners of this firm have invested approxi- _mately five percent of their personal fortunesto buy one half of the stock of a corporationwhich holds a franchise granted bythis client. Except for the payment of a percentageof sales to the franchisor, the franchiseeoperates independently. Conclusion,the firm cannot be considered independentbecause the partners have a material investmentin the franchise which has a closeidentity in fact and in appearance with theclient.27. A retired partner of an accounting firmplans to accept election as a director of one ofthe firm's clients. Under the terms of thepartnership agreement this partner will continueto share in the earnings of the firm ata reducing rate but would be precluded fromparticipating in the fees from this client if hewere to become associated with it either asan employee, officer, director, or shareholder.Conclusion, when a retired partner ofan accounting firm accepts a position with aclient of that firm, all active connectionswith the firm must be severed if the firm isto remain independent. If this partner is stillreceiving retirement benefits from the firm,this severance requirement can be met onlyif the benefits flow from a fixed settlementpayable in predetermined annual amounts.28. Partner in accounting firm is also afinancial vice president and stockholder of areal estate investment trust. In addition, heis a limited partner in a company whichmanages the trust. A client of his firm hasasked him to help them get a loan from theinvestment trust. Conclusion, independencefor future periods would be adversely affectedif the company were to obtain the loanfrom the real estate investment trust. However,no question would be raised as to periodsprior to the commencement of negotiationsfor the loan.29. An accounting firm's client, a realtorcorporation, is the general partner and tenpercent owner in a limited partnership whichowns unimproved land for appreciation. Theaccounting firm also owns a five percentinterest in this limited partnership and apartner in the firm has a two percent interest.Conclusion, independence is adverselyaffected because of this joint investmentwith the client.30. Partners in the accounting firm have acommon investment with stockholders of aprospective client. These partners own approximately11 percent of Company A andthe other investors, who own approximately78.5 percent of Company A, also own 22 percentof the prospective client. Conclusion,independence is adversely affected becausethe common investment which the partnersof the firm have with the substantial minorityshareholders of the prospective client issuch a circumstance as could lead a thirdparty to question the firm's 'objectivity.31. A partner in an accounting firm managesa building owned by an audit client.Conclusion, independence is adversely affected.32. An employee of an accounting firm wasasked by an audit client to assume part-timemanagement functions for the client. Theseservices would be provided with the fullknowledge and consent of the accounting·d afirm and the employee would be palmonthly retainer directly by the client. c' 0n -elusion this would create an inapproprIate, . derelationshipand would adversely affect Inpendence.

ACCOUNTING SERIES RELEASES 23533. A broker-dealer, an audit client,planned to manage a discretionary account. for principals of the accounting firm. Theaccouht would be opened as a margin accountwith a different broker who is not aclient. The client, however, would have discretionaryauthority to execute transactionsfor the account. No investment in this accountcould exceed $25,000 nor would it representa material portion of any of the participants'net worth. Conclusion,independence is adversely affected in thosecases where the broker has extended creditto his accountant or where the accountanthas given his client-broker discretionary authorityto execute transactions for his account.However, no objection will be raisedwhere an accountant executes his securitiestransactions in a regular cash account with a, broker who is also his audit client if neithercash nor securities are left with the brokerbeyond a normal settlement period.34. An accounting firm planned to constructoffice buildings in which it would occupya relatively small portion of the spaceand would rent the remainder to other tenants,some of whom might be clients of thefirm. Conclusion, the activity of owning andmanaging real property is more in the natureof a commercial business activity thanof a professional service. Rental of a materialamount of space to a client would raise aquestion of independence since the accountingfirm would appear to have a material. business relationship with the client. Somereasonable tests which would be applied indetermining what constitutes a rental of materialamount might be the relationship of asingle lease to the fees earned in the officelocated in the building concerned, total leaserentals from all clients to' the firm's totalfees, and lease rentals from a particularclient to the auditing fee paid by that clientfor the same period.35. An accounting firm has itS' office in abUilding which is owned by a client. TheaCCounting firm, which occupied approxilllately25 percent of the available officesPace in the building, was the only tenant~~her than the client. Conclusion, the factt at the accounting firm was the only otherenant in the client's building and leased asubstantial portion of the available officespace are circumstances that would lead areasonable third party to question the firm'sobjectivity. Therefore, independence is adverselyaffected.OCCUPATIONS WITH CONFLICTINGINTERESTSCertain concurrent occupations of certifiedpublic accountants engaged in the practice ofpublic accounting involve relationships withclients which may jeopardize the certifiedpublic accountant's objectivity and, therefore,his independence. In general, this situationarises because the relationships and activitiescustomarily associated with thisoccupation are not compatible with the auditor'sappearance of complete objectivity orbecause the primary objectives of such occupationsare fundamentally different fromthose of a public accountant. Acting as counselor as a broker-dealer, or actively engagingin direct competition in a commercialenterprise are examples of occupations soclassified and the following discussion relatingthereto is intended to be illustrativeonly. The principles involved are equally applicableto any other undertaking which issimilarly referable to them.Accountant-AttorneyA legal counsel enters into a personal relationshipwith a client and is primarily concernedwith the personal rights and interestsof such client. An independent accountant isprecluded from such a relationship under thesecurities acts because the role is inconsistentwith the appearance of independencerequired of accountants in reporting to publicinvestors.36. A partner in an accounting firm alsoacted as legal counsel for. an audit client. Hereceived fees for such legal services and,through the accounting partnership, for accountingservices rendered concurrently.Conclusion, independence is adversely affected.Accountant-Broker-DealerConcurrent engagement as a broker-dealer

236 SECURITIES AND EXCHANGE COMMISSIONis incompatible with the practice of publicaccounting. The functions customarily performedin such employment include the recommendationof securities, the solicitation ofcustomers and the execution of orders, anyone of which could involve securities transactionsof clients either as issuer or investorand provide third parties with sufficient reasonto question the accountant's ability to beimpartial and objective.37. A practicing accountant is also a broker-dealerand, functioning as a brokerdealer,makes a market in the stock of anaudit client. Conclusion, accountant is notindependent.38. A partner in an accounting firm is alsoa principal for broker-dealer A. The accountingfirm has been engaged to perform theaudit for broker-dealer B. Firm A, which isprimarily involved in mutual fund sales,clears some transactions through Firm B.Conclusion, the accounting firm is not independent.Accountant-Commercial CompetitorOccasionally accountants engage in a com- .mercial business concurrently with the practiceof public accounting. Where such commercialbusiness is directly competitive withthat of a client, there would appear to thirdparties to be a conflict of interests whichmight influence the firm's objectivity sincethe public accounting firm would have accessto the records, policies and practices of abusiness competitor of that firm.39. Four partners in im accounting firmwere among the six founders of a companywhich was engaged in the same type of businessand was directly competitive with anaudit client. In addition to owning stock,they also served as directors and officers ofthis company. The accountants informed thepresident of the client-company of their investmentin a business competitor but he didnot object to the business venture and permittedthem to continue as auditors. Bothcompanies were located in the same geographicalarea. Conclusion, the accountantswere not independent.

ACCOUNTING SERIES RELEASES 237APPENDIXPrincipal References Concerning the Practice of Accountants Before theCommissionOPINIONS AND ORDERS OF THE COMMISSIONCornucopia Gold Mines, 1 S.E.C. (1936)American Terminals and Transit Company, 1 S.E.C.701 (1936)National Boston Montana Mines Corporation, 2S.E.C. 226 (1937)Richard Ramore Gold Mines, Ltd., 2 S.E.C. 377 (1937)Metropolitan Personal Loan Company, 2 S.E.C. 803(1937)Interstate Hosiery Mills, Inc., 4 S.E.C. 706 (1939)marginA. Hollander & Son, Inc., 8 S.E.C. 586 (1941)Abraham H. Puder and Puder and Puder, SecuritiesExchange Act of 1934 Release No. 3073 (1941)Southeastern Industrial Loan Company, 10 S.E.C.617 (1941)Kenneth N. Logan, 10 S.E.C. 982 (1942) (AccountingSeries Release No. 28)Associated Gas and Electric Company, 11 S.E.C. 975(1942)C. Cecil Bryant, 15 S.E:C. 400 (1944) (AccountingSeries Release No. 48)Red Bank Oil Company, 21 S.E.C. 695 (1946)Drayer-Hanson, Incorporated, 27 S.E.C. 838 (1948)Cristina Copper Mines, Inc., 33 S.E.C. 397 (1952)Coastal Finance Corporation, 37 S.E.C. 699 (1957)Sports Arenas (Delaware) Inc., 39 S.E.C. 463 (1959)American Finance Company, 40 S.E.C. 1043 (1962)Advanced Research Associates, Inc., 41 S.E.C. 579(1963)South Bay Industries, Inc., Securities Act of 1933Release No. 4702 (1964)Idaho Acceptance Corp,-, Securities Exchange Act of1934 Release No. 7383 (1964)Dixie Land and Timber Corporation, Securities Actof 1933 Release No. 4841 (1966) [For details seeinitial decision of Hearing Examiner,Administrative Proceeding File No. 3-215.]ACCOUNTING SERIES RELEASESNo.2 (1937) Independence of accountants­Relationship to registrantNo. 19 (1940) McKesson & Robbins, Inc.No. 22 (1941) Independence of accountants­Indemnification by registrantNo. 28 (1942) Kenneth N. Logan, 10 S.E.C. 982No. 47 (1944) Independence of certifyingaccountants-Summary of past rltleases of theCommission and a compilation of hithertounpublished cases or inquiriesNo. 48 (1944) C. Cecil Bryant, 15 S.E.C. 400No. 51 (1945) Disposition of Rule II(e) proceedingsagainst certifying accountantNo. 59 (1947) Williams and KingsolverNo. 64 (1948) Drayer-Hanson, Incorporated, 27S.E.C.838No. 67 (1949) Barrow, Wade, Guthrie & Co., Henry H.Dalton and Everett L. MangamNo. 68 (1949) F. G. Masquelette & Co., and J. E.Cassel'No. 73 (1952) Haskins & Sells and Andrew StewartNo. 77 (1954) Disposition of Rule lI(e) proceedingsagainst certifying accountantNo. 78 (1957) Touche, Niven, Bailey & Smart, et al.,37 S.E.C. 629No. 81 (1958) Independence of Certifyingaccountants-Compilation of representativeadministrative rulings in cases involving theindependence of accountants.No. 82 (1959) BoHt and Shapiro, 38 S.E.C. 815No. 88 (1961) Myron Swartz, 41 S.E.C. 53No. 91 (1962) Arthur Levison and Levison andCompany, 41 S.E.C. 150No. 92 (1962) Morton I. Myers, 41 S.E.C. 156No. 97 (1963) Harmon R. StoneNo. 105 (1966) Homer E. KerlinNo. 108 (1967) Nicholas J. Raftery [Misspelled inrelease]No. 110 (1968) Meyer WeinerNo. 112 (1968) Independence of accountants, examining a nonmaterial segment of aninternational businessCHANGES IN THE INDEPENDENCE RULEArticle 14, Rules and Regulations under theSecurities Act of 1933,' Federal TradeCommission, July 6,1933Article 41, Rules, Regulations and Opinions underthe Securities Act of 1933 as Amended, April 29,1935Rule 650, General Rules and Regulations under theSecurities Act of 1933, January 21,1936Rule 2-01, Regulation SoX, Adopted February 21,1940, Accounting Series Release No. 12Amendments of Rule 2-01:Accounting Series Release No. 37, November 7,1942Accounting Series Release No. 44, May 24, 1943Accounting Series Release No. 70, December 20,1950Accounting Series Release No. 79, April 8, 1958Accounting Series Release No. 125, June 23,19721 The Securities and Exchange ComIlJission was establishedunder provisions of the Securities Exchange Actof 1934 and was authorized to continue in effect untilmodified all rules and regulations issued by the FederalTrade Commission under the Securities Act of 1933.

238' SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 127September 11, 1972Notice that initial decision has become final in the Matter of Martin L. Sanchez.(Rules of Practice-Rule 2(e»In these proceedings pursuant to Rule2(e)(3) of the Commission's Rules of Practice,no petition for review of the hearing examiner'sinitial decision with respect to MartinL. Sanchez has been filed. The examinerfound that Sanchez was permanently enjoinedby a court of competent jurisdictionfrom further violations of certain provisionsof the securities laws, and he ordered thatSanchez be permanently disqualified fromappearing or practicing before the Commission.The time for filing any such petitionhas expired, and the Commission has notdetermined to review the matter on its owninitiative.Accordingly, notice is hereby given, pursuantto Rule 17(0 of the Commission's Rulesof Practice, that the hearing examiner's initialdecision with respect to Martin L. Sanchezhas become the final decision of theCommission. The examiner's order disqualifyingSanchez from appearing or practicingbefore the Commission is hereby declaredeffective.RONALD F. HUNT,SecretaryRELEASE NO. 128September 20, 1972SECURITIES ACT OF 1933Release No. 5301SECURITIES EXCHANGE ACT OF 1934Release No. 9776PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17698INVESTMENT COMPANY ACT OF 1940Release No. 7360Notice of Adoption of Revision of Article 9 of Regulation S-XThe Commission today adopted a generalrevision of Article 9 of Regulation S-X pertainingto the form and content of financialstatements of bank holding companies andbanks. The revision was issued for publiccomment on August 20, 1971 1 as part of ageneral revision of Regulation S-X but, becausea number of unexpected problemsarose, its adoption was deferred when otherI Securities Act Release No. 5177, Securities ExchangeAct Release No. 9264, Public Utility Holding CompanyAct Release No, 17215 and Investment Company ActRelease No. 6645.portions of the proposed revision wereadopted on June 23, 1972.2Letters commenting on the proposal weregiven careful consideration in determiningthe final form of the revision of Article 9. Themore significant changes from the existingArticle 9 are discussed below:Rule 9-01. Application of Article 9. A. requirementhas been added that in preparingconsolidated statements, holding companies2 Securities Act Release No. 5261, Securities ExchangeAct Release No. 9648, Public Utility Holding CompanYAct Release No. 17617, Investment Company Act ReleaseNo. 7236 and Accounting Series Release No. 125.

ACCOUNTING SERIES RELEASES 239shall.give consideration to utilization of theform and content of financial statementsprescribed for banks.Rule 9-02. Balance Sheets of Bank HoldingCompanies. The ~ormer special requirementsfor holding company balance sheets pertainingto disclosure of balances with affiliatedbanks have been eliminated.Rule 9-03. Income Statements of BankHolding Companies. This rule was revised toprovide for use of the equity method of reflectingincome of subsidiaries and for separatereporting of income from operations,securities gains and losses and extraordinaryitems.Rule 9-04. What Schedules Are To Be Filedfor Bank Holding Companies. The requirementfor filing the schedule of investmentsin securities of affiliate banks, Rule 12-32,has been deleted.Rule 9-05. Financial Statements and Schedulesof Banks. This rule has been revised torequire that statements of banks shall generallyfollow the form and content prescribedin Regulation F of the Board of Governors ofthe Federal Reserve System. These statementsshall be supplemented by a statementof source and application of funds, informationas to market value of investment securities,a schedule of amounts receivable fromdirectors, officers and certain other persons,and a schedule of supplementary incomestatement information. Requirements for filingschedules have been provided.The amendments to Regulation S-X areadopted pursuant to authority conferred onthe Securities and Exchange Commission bythe Securities Act of 1933, particularly Sections6, 7, 8, 10 and 19(a) thereof; the SecuritiesExchange Act of 1934, particularly Sections12, 13, 15(d) and 23(a) thereof; thePublic Utility Holding Company Act of 1935,particularly Sections 5(b), 14 and 20(a)thereof; and the Investment Company Act of1940, particularly Sections 8, 30, 31(c) and38(a) thereof.(The text of the amendments revising Article9 of Regulation S-X is omitted.)Rule 12-32 of Regulation S-X is herebydeleted.The amendments shall be effective withrespect to financial statements for periodsending on or after December 31, 1972.By the Commission.RONALD F. HUNTSecretaryRELEASE NO. 129September 26, 1972Order accepting resignation from Commission practice in the Matter of Barry L. Kessler.(Rules of Practice-Rule 2(e»On April 6, 1972, the Commission institutedan injunctive action in the United StatesDistrict Court for the Northeastern Districtof Ohio alleging, among other things, thatBarry L. Kessler, an accountant, violatedantifraud provisions of the Securities Exc~angeAct of 1934 by recommending to hischents and others the purchase of orangegrove investment contracts of AmericanA~onomics Corporation (" Agronomics")WIthout disclosing that he was paid a substant·IaIfee for each sale consummated. 1-~--IAct· S.E.c .. v A mertcan . A gronOmtC8 . C orp., et a., l C··1IVIIOn No. C72-331.Without admitting or denying the allegationsin the Commission's complaint, Kesslerconsented to entry of a permanent injunctionin that action enjoining him from fraudulentconduct in connection with the purchaseand sale of securities of Agronomics orany other issuer.2Having been advised that the Commissionwas contemplating the institution of administrativeproceedings pursuant to Rule 2(e) ofits Rules of Practice, based on the allegationsin the injunctive action, to determine2The injunction was entered on September 14, 1972.

240 SECURITIES AND EXCHANGE COMMISSIONwhether he should be temporarily or permanentlydenied the privilege of appearing orpracticing before it as an accountant, Kessleragreed to resign from Commission practiceon condition that no administrative actionbe brought against him. He furtheragreed that if he subsequently applies forreadmission to such practice, the allegationsin the injunctive action shall, for purposes ofany such application only, be deemed proven.After due consideration, and upon the recommendationof its staff, the Commissiondetermined to accept Kessler's resignationfrom Commission practice.Accordingly, IT IS ORDERED that theresignation of Barry L. Kessler from appearingor practicing before the Commission be,and it hereby is, accepted, and he shall nolonger have the privilege of so appearing orpracticing.'For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.RONALD F. HUNTSecretaryRELEASE NO. 130September 29, 1972SECURITIES ACT OF 1933Release No. 5312SECURITIES EXCHANGE ACT OF 1934Release No. 9798PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17712INVESTMENT COMPANY ACT OF 1940Release No. 7395Pooling-of-Interests AccountingIn recent months, the Commission hasnoted an increasing number of business combinationswhich appear to meet the individualrequirements for pooling-of-interests accountingset forth in Accounting PrinciplesBoard Opinion No. 16 but which do not conformwith the overriding thrust of that Opinionwhich requires that a combination representa sharing of rights and risks amongconstituent stockholder groups if it is to be apooiing of interests. Paragraphs 28, 45 and 47of that Opinion clearly provide that such asharing of risk is an essential element inpoolings, and the specific requirements setforth in paragraphs 46, 47 and 48 shouldcertainly not be construed as a formulawhich, if followed with precision, may beused to overcome an essential concept whichunderlies the entire Opinion. Despite theclarity of the Opinion in articulating theneed for a sharing of risk, a number of registrantsand their auditors have proposed toaccount for combinations which did not meetthis basic requirement as poolings.Accordingly, the Commission has concludedthat any confusion regarding thismatter should be laid to rest. It is the Commission'sunderstanding that the AccountingPrinciples Board has authorized its staff toissue an interpretation providing that a businesscombination should be accounted for asa purchase if its consummation is contingentupon the purchase by a third party of any ofthe common stocks to be issued. Includingsuch a contingency in the arrangement ofthe combination, either explicitly or by intent,would be considered a financial arrangementwhich is precluded in a poolingunder Opinion 16.The Commission endorses this interpretation.Recent questions by registrants indicatethat maximum prompt exposure shouldbe given to this interpretation and to theCommission's policies for dealing with qu es -

ACCOUNTING SERIES RELEASES 241tions which arise under it both in the interimperiod during which the interpretation isbeing assimilated by the financial communityand on a continuing basis thereafter.As. a matter of policy, the Commission believesthat it is. unwise to set forth absoluterules in such 'an accounting matter whichwill be followed regardless of all other factualsituations which may surround a particulartransaction. To do so would be to encouragethe application of form oversubstance. Nevertheless, it appears reasonablefor the Commission to establish guidelineswhich it will use in making determinationsas to disposition of various individualcases brought before it and to make theseguidelines known to registrants and independentpublic accountants.The Commission will henceforth considerthat the risk sharing required for the applicabilityof pooling-of-interests accounting willhave occurred if no affiliate of either companyin the business combination sells or inany other way reduces his risk relative toany common shares received in the businesscombination until such time as financial resultscovering at least 30 days of post mergercombined operations have been published.This would include all sales whether privateor public. Publication of combined financialresults can take the form of a post-effectiveamendment, a Form 10-Q or 8-K filing, theissuance of a quarterly earnings report, orany other public issuance which includescombined sales and net income. 1t This paragraph reflects amendment in AccountingSeries Release No. 135 (January 5, 1973.)This release is not intended to restrict saleof stock at the option of the stockholders .subsequent to the pooling as long as a sharingof risks for the period of time indicatedabove has taken place. An arrangement toregister shares subsequent to the combinationwould therefore not bar pooling. However,an agreement which requires sale ofshares after such a period would precludepooling treatment as would any agreementto reduce the risk borne by the stockholderssubsequent to the transaction.During an interim period of 75 days whilethis release and interpretation are being as~similated and where transactions previouslynegotiated are being filed with the Commission,it seems reasonable to apply a lessrigorous risk-sharing test while at the sametime recognizing that in the Commission'sgeneral view a transaction in which no riskis shared is not appropriately treated as apooling. During this interim period, therefore,the Commission will raise no questionsas to the appropriateness of pooling accountingin transactions where at least 25% of thestock issued in the pooling is retained at riskby shareholders of the pooled company andwhere effective date of any registrationstatement covering sale of the stock to besold is subsequent to the date the combinationis consummated.By the Commission.RONALD F. HUNTSecretaryRELEASE NO. 131October 19, 1972Order accepting resignation from Commission practice in the Matter of Robert Trivison.(Rules of Practice-Rule 2(e».:aobert Trivison, an accountant, has sub-1l1Itted an offer to resign from practice before~~e CO~~ission. Having been advised by the. ~mlsslon that it was contemplating theInStitution of administrative proceedingsPursuant to Rule 2(e) of its Rules of Practice,based on the allegations in a pending injunctionaction,1 to determine whether he shouldbe temporarily or permanently denied theprivilege of appearing or practicing before it,t S.E.C. v. American Agronomics Corp., et al., CivilAction No. C72-331 (N.E.D. Ohio).

242 SECURITIES AND EXCHANGE COMMISSIONTrivison agreed to resign on condition· thatno administrative action be brought againsthim, and that, if his offer of resignation wereaccepted, he would, without admitting or denyingthe allegations in the injunctive action,consent to a permanent injunctiontherein. 2Trivison further agreed that if he subsequentlyapplies for readmission to Commissionpractice, the allegations in the injunctiveaction shall, for purposes of any suchapplication only, be deemed proven. Thoseallegations charged that Trivison violatedantifraud provisions of the Securities ExchangeAct of 1934 by recommending to hisclients and others the purchase of orange2 The injunction, enjoining Trivison from fraudulentconduct in connection with the purchase or sale ofsecurities of American Agronomics Corporation or anyother issuer, was entered on September 1, 1972.grove investment contracts of AmericanAgronomics c:orporation without disclosingthat he was paid a substantial· fee· for eachsale consummated.After due consideration, and upon the recommendationof its staff, the Commissiondetermined to accept Trivison's resignationfrom Commission practice.Accordingly, IT IS ORDERED that theresignation of Robert Trivison from appearingor practicing before the Commission be,and it hereby is, accepted, and he shall nolonger have the privilege of so appearing orpracticing.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.RONALD F. HUNTSecretarySECURITIES ACT OF 1933Release No. 5333RELEASE NO. 132November 17, 1972SECURITIES EXCHANGE ACT OF 1934Release No. 9867PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17772Reporting of Leases in Financial Statements of LesseesIt has recently come to the Commission'sattention that some confusion exists as tothe proper accounting treatment to be followedby a lessee in certain lease transactions.These are transactions in which a lessoris created with no real economicsubstance other than to serve a conduit bywhich debt financing can be obtained by the"lessee." The cases which have called thispractice to our attention have been arrangelnentsby which a nuclear fuel core is financedby a public utility, but the principleis a general one.Lease accounting principles are presentlyset forth in Accounting Principles BoardOpinion No.5 issued in 1964. The thrust ofthis opinion provides that when a lease isequivalent to an installment purchase, itshould be accounted for as a purchase. Theopinion also provides that "in such cases, thesubstance of the arrangement, rather thanits legal form, should determine the accountingtreatment."The opinion deals (in paragraph 12) withthe situation in which a lessor without independenteconomic substance exists:"In cases where the lessee and the lessorare rel~ted, ... a lease should be recordedas a purchase if a primary purpose of ownershipof the property by the lessor is tolease it to the lessee and (1) the leasepayments are pledged to secure the debt~of the lessor or (2) the lessee is able, dIrectlyor indirectly, to control or influe~cesignificantly the actions of the lessor wIth

ACCOUNTING SERIES RELEASES 243respect to the lease. The following illustratesituations in which these conditionsare frequently present:*****c. The lesstlr has been created, directlyor indirectly, by the lessee and is substantiallydependent on the lessee for its operations."It is apparent from the overall thrust ofthe opinion and the frequent use of thephrase "directly or indirectly" that the relationshipdescribed between lessor and lesseeneed not be one of equity ownership. When alessor is created at the direction of the lesseeand exists as an economic entity because ofthe lease agreement entered into with thelessee, there can be no question that thelessor and the lessee "are related."Accordingly, the Commission reaffirmsthat when lease transactions are enteredinto with lessors without material independenteconomic substance, the transactionshould be accounted for as a purchase inaccordance with the procedures described inAccounting Principles Board Opinion No.5.Because many questions have come up inregard to lease accounting, the Commissionhas urged that the new Financial AccountingStandards Board place this item high onits agenda for consideration early in 1973.RELEASE NO. 135*January 5, 1973SECURITIES ACT OF 1933Release No. 5348SECURITIES EXCHANGE ACT OF 1934Release No. 9927PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17841INVESTMENT COMPANY ACT OF 1940Release No. 7606Revised Guidelines for the Application of Accounting Series Release No. 130RELEASE NO. 136*January 11, 1973SECURITIES ACT OF 1933Release No. 5351SECURITIES EXCHANGE ACT OF 1934Release No. 9937PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17854INVESTMENT COMPANY ACT OF 1940Release No. 7616Notice of Adoption of Amendment to Regulation S-X Deferring Effective Date of Rule 5-02-1 as itRelates to Disclosure of Compensating Balances'.------.. Text of release omitted.

244 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 138January 12, 1973SECURITIES ACT OF 1933Release No. 5354SECURITIES EXCHANGE ACT OF 1934Release No. 9944Notice of Adoption of Amendments to Forms 8-K, 10-K, 12-K, S-l, S-7, S-8, S-9, S-l1, 10 and 12Requiring Increased Disclosure of Unusual Charges and Credits to IncomeThe Securities and Exchange Commissiontoday adopted amendments to its registrationand reporting forms to require moredetailed and timely reporting, and timelyreview by independent accountants of extraordinaryor material unusual charges andcredits to income or material provisions forlosses effected by registrants. Proposals toamend these forms, as well as Forms 7 -Q and10-Q, for these purposes were published forcomment in Securities Act Release No. 5313(Securities Exchange Act Release No. 9801)on October 2, 1972. Form 8-K is the form forreporting certain specified material eventsand transactions pursuant to Sections 13 and15(d) of the Securities Exchange Act of 1934(Exchange Act); Forms 10-K and 12-K arethe forms for annual reports pursuant tothose sections of the Exchange Act; Forms S-1, S-7, S-8, S-9, and S-l1 are forms for registrationof securities pursuant to the SecuritiesAct of 1933; and Forms 10 and 12 areforms for registration of securities pursuantto the Exchange Act.The Commission noted when it proposedamendments to these forms that it had observedan increasing number of largecharges to income which often appearedwithout warning and were not generallyunderstood by investors. The Commission isconcerned that this trend seems to haveaccelerated in recent months. While many ofsuch charges result from an identifiableevent, many also appear to be made on thebasis of a discretionary decision to dispose ofmarginal facilities or operations or to writeoff deferred development or excess productioncosts. In the latter situations, wherefacilities or operations gradually deteriorateor the outlook for a contract or programgradually worsens to the point where awrite-off is deemed necessary, registrantshave an obligation to forewarn public investorsof the deterioratIng conditions whichunless reversed may result in a subsequentwrite-off. ThIs includes an obligation to provideinformation regarding the magnitude ofexposure to loss.The Commission, therefore, reiterates itsview that registrants should make specialefforts to recognize incipient problems thatmight lead to such charges and to identifythem clearly at the earliest possible time infinancial statements and other forms of publicdisclosure, including public reports filedwith the Commission, so that public investorsmay recognize the risks involved. In thisconnection, registrants should consider disclosureof the investment involved in divisionsoperating at a loss; the undepreciatedcost of plant and equipment currently consideredto be obsolete or of marginal utility;the extent of deferred research and developmentcosts incurred in connection with productswhose success is not reasonably assured;and other similar items wheresignificant uncertainties exist as to realization.The Commission has previously urgedmore comprehensive disclosure of progressand problems encountered in defense andother long-term contracts whiGh may alsogive rise to major charges against income(Securities Act Release No. 5263 dated June22, 1972) and has urged greater diligence inthe release of quarterly and other interimreports of operations (Securities ExchangeAct Release No. 9559 dated April 5, 1972).In addition to disclosure of incipient problems,the Commission believes that substantialadditional disclosure in regard to eXitraordinary items and material unusu~. roV!-charges and credits to income or major P rsions for loss is necessary to enable pub!e

ACCOUNTING SERIES RELEASES 245invest9rs to assess the impact of such items.This' would include transactions that areclassified as extraordinary items under generally~ccepted accounting principles andother unusual or nonrecurring materialtransactions or provisions for loss, such as(but not restricted to) material write-downsof inventories, receivables, or deferred researchand development costs, provisions forloss on major long-term contracts or purchasecommitments, and losses on dispositionof assets or business segments. The releaseof October 2 (33-5313 and 34-9801)contained' proposals for such disclosure. Thecomments received on these proposals havebeen given careful consideration in determiningthe amendments to adopt.The Commission has determined not toadopt the proposed amendment calling forpro forma statements to reflect allocation ofcharges and credits to prior years since, onthe basis of comments received, it concludedthat the proposed pro forma disclosure mightleave the improper implication that past historicalstatements were in error as well asimposing substantial clerical burdens on registrants.The amendments adopted hereincall, for disclosure of the years in which thecosts being included in the charge were orare expected to be incurred and the amountof cost in each year by major category ofcost.The Commission has further determinednot to adopt the proposed amendments toForms 7-Q and 10-Q and other relatedamendments which would have required anestimate of losses by quarters and a subsequentquarterly reconciliation of reservesprovided. Comments indicated that quarterlyestimates and reconciliations would be difficultto make within acceptable limits of accu­~acy, would not supply significant data forInVestors, and would impose a clerical burdenon registrants. The amendments~doPted herein require an estimate,of lossest. Y year and a subsequent annual explana-IOn of differences between estimated andactual amounts and a reconciliation of anyreserve provided.tn!n addition, the Commission has deterlnedto omit the definition of "material"COntained in the proposed note to Item 10(a)of Form 8-K. Comments indicated that adefinition which relates materiality to a criterionbased on separate reporting of an itemto stockholders might have the effect of discouragingsuch disclosure rather than improvingthe quality thereof. Materiality,therefore, must be considered within the contextof the definition contained in Rule 1-02of Regulation 8-X.(The text of the amendments of Forms 10-K, 12-K, 8-1, 8-7, 8-8, 8-9, 8-11, 10 and 12 isomitted.)A. Form 8-KI. The caption of Item 10 and paragraph(a) have been amended as follows:Item 10. Extraordinary Item Charges andCredits, Other Material Chargesand Credits to Income of an UnusualNature, Material Provisionsfor Loss, and Restatements ofCapital Share Account.(a) If there have been any extraordinaryitem charges or credits, any other materialcharges or credits to income of an unusualnature, or any material provisions for loss,the following shall be furnished for eachsuch charge, credit, or provision:(1) The date of the registrant's determinationto make the charge, credit, or provision;(2) A statement of the reasons for makingthe charge, credit, or provision;(3) An analysis of the components (indollar amounts) of the charge, credit, orprovision, which includes(i) A description of the various types ofitems written down or off;(ii) A description of any provision forlosses on liquidation of assets or forother losses including a detailed scheduleshowing the components of anylosses provided for, which scheduleshows the amount of administrative andfixed costs, if any, allocated to the loss;(iii) A description of any estimated recoveriesor costs netted against thecharge or credit;(4) A statement setting forth the yearsin which costs being reflected in the charge

246 SECURITIES AND EXCHANGE COMMISSION(or net credit) being described were or areexpected to be incurred and the amount ofcost for each year by major category (e.g.,fixed assets, research and developmentcosts, operating losses);(5) A statement setting forth the estimatedamount of net cash outlays (or inflows)associated with the charge (orcredit) in the year the charge (or credit) ismade and in each subsequent year inwhich such estimate of the cash amountdiffers from the amount of total costsstated in part (4) for that year;(6) A description of the accounting principlesor practices followed and anychanges therein or in the methods of applyingsuch principles or practices whichwas made in connection with the transaction;and(7) A report from the registrant's independentaccountants in which they statethat they have read the description in theForm 8-K of the facts set forth therein andof the accounting principles applied andwhether they believe that on the basis ofthe facts so set forth that such accountingprinciples are fairly applied in conformitywith generally accepted accounting principlesor, if not, the respects in which theybelieve the principles do not conform togenerally accepted accounting principles.II. The following new instruction 8 hasbeen added under EXHIBITS of Form 8-K.8. Reports from the independent accountantsfurnished pursuant to Item 10.*****The amendments are adopted pursuant toSections 6, 7, 8, 10 and 19(a) of the SecuritiesAct of 1933 and Sections 13, 15(d) and 23(a) ofthe Securities Exchange Act of 1934. Theamendments shall be effective with respectto reports on Form 8-K and registrationstatements on Forms S-l, S-7, S-8, S-9, S-11,10 and 12, and with respect to annual reportson Forms 10-K and 12-K filed on or afterFebruary 28, 1973.By the Commission.RONALD F. HUNTSecretaryRELEASE NO. 139January 17, 1973Order accepting resignation from Commission practice in the Matter of Ralph Duckworth.(Rules of Practice-Rule 2 (e»Following the entry of an injunction pernlanentlyenjoining Ralph Duckworth, an accountant,from violating the antifraud provisionsof Section 10(b) of the SecuritiesExchange Act of 1934 and Rule 10b-5 thereunder,Ihe submitted an offer to resign fromappearing or practicing before the Commissionin settlement of any possible adminis-. trative proceeding based on the injunction orthe activities involved. The injunction, whichwas issued with Duckworth's consent andwithout his admitting or denying the allega-1 S.E.C. v. American Agronomics Corp., et al., CivilAction No. C72-331 (N.D. Ohio, August 8, 1972).tions of the Commission's complaint, enjoinedhim in connection with the purchaseor sale of the securities of American AgronomicsCorporation or any other issuer fromengaging in certain fraudulent activities includingrecommending the purchase of securitieswithout disclosing his receipt of compensationwith respect to each suchpurchase consummated.Duckworth represented that he had neverpracticed before the Commission, and beagreed that, should he apply for reinsta~ementof the privilege of appearing or practIcingbefore the Commission pursuant to R.ul e2(e) of the Commission's Rules of PractIce,the allegations in the injunctive action may

ACCOUNTING SERIES RELEASES 247be deemed proven only for purposes of suchapplication.After due consideration, and upon the recommendationof its staff, the Commissiondetermined to accept Duckworth's resignationfrom Commission practice.Accordingly, IT IS ORDERED that theresignation of Ralph Duckworth from appearingor practicing before the Commissionbe, and it hereby is, accepted, and he shall nolonger have the privilege of so appearing or, practicing.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.RONAW F. HUNTSecretaryRELEASE NO. 141February 15, 1973SECURITIES ACT OF 1933Release No. 5373SECURITIES EXCHANGE ACT OF 1934Release No. 10006PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 17882INVESTMENT COMPANY ACT OF 1940Release No. 7673Interpretations and Minor Amendments Applicable to Certain Revisions of Regulation S-XThe Commission adopted amendments toRegulation S-X in Accounting Series ReleaseNos. 125 (June 23, 1972) and 128 (September20, 1972) in which various sections of theRegulation were extensively revised. Theamendments were made effective with respectto financial statements for periods endingon or after December 31, 1972.*Subsequent to the issuance of the releasesa number of inquiries have been received bythe staff regarding the meaning or interpretationof new terms, instructions or rules inthe revised regulations. Interpretations ofsU~h items on the basis of the questionsraIsed are given in Part A of this release. In~art B, a number of minor amendments haveeen adopted to correct errors of a typographicalor editorial nature which havebeen noted or to clarify certain items.-in .. Theb ef£ec t'lye date of the requirement for compensatbeg,a!ance disclosure was deferred to cover periodsSerigInnIngR on or afterDecerrlber 30, 1972 (Accountmg'es elease No. 136).GeneralPART A-INTERPRETATIONSFinancial statements, notes and schedulesfiled for fiscal periods ending before December31, 1972, the effective date specified inAccounting Series Release Nos. 125 and 128,need not, but may if a registrant prefers, beconformed to the amendments to RegulationS-X adopted in those releases.In instances where, because of the newtest for a significant subsidiary, the separatefinancial statements of additional subsidiariesare required in filings which had notbeen required in prior filings on the basis ofthe old tests of significance, the requirementsin the filing forms for audited financialstatements of such subsidiaries for earlierperiods will be applicable. However, arequest for waiver of the audit requirementfor the financial statements for the earlierperiods will be considered if such requirementis impracticable or would cause unduehardship.

248 SECURITIES AND EXCHANGE COMMISSIONRule 1-02. Definitions of Terms Used in RegulationS-X.In making the tests for significance calledfor in the definition of "significant subsidiary"in this rule the proportionate share ofthe assets or sales of the subsidiary afterintercompany eliminations would be comparedto the consolidated assets or salesafter normal intercompany eliminations butwithout elimination of the investments andadvances to subsidiaries and 50 percent orless owned persons. With respect to applicationof the test to unconsolidated subsidiariesor other persons who also have equityinterests in other subsidiaries or other persons,the proportionate share of the assets(in lieu of the investment and advances) or ofsales of such other subsidiary or other personsshould not be added to the assets orsales of the unconsolidated subsidiary or 50percent or less owned person for the purposeof this test.Rule 3-16(iJ. Commitments and contingentliabilities.The disclosure regarding noncancelableleases specified in part (2) of this rule may belimited to such leases which have a noncancelableterm of one year or longer.Rules 3-16(j) and (n).The term "key employees" used in thoserules is interpreted in the sense of "selectedemployees or the employees to which a bonusplan or plan for the sale of stock is applicablewhen' such plan is not available to all employeeson a pro rata basis.Rule 3-16(0). Income tax expense.With regard to the separate disclosure ofother income taxes specified in this rule,state and foreign income taxes should bereported separately if either item amounts tofive percent of the component.Rule 4-03. Group Financial Statements ofSubsidiaries Not Consolidated and 50 Percentor Less Owned Persons.Under this rule, significant majorityownedunconsolidated subsidiaries may notbe combined with 50 percent or less ownedpersons and significant 50 percent or lessowned persons may not be combined withmajority-owned unconsolidated subsidiaries.However, if all such persons are not significantindividually or as a group, they may becombined in one statement.Rule 4-07. Consolidation of Financial Statementsof a Registrant and Its SubsidiariesEngaged in Diverse Financial Activities.With regard to the separate audited financialstatements for each significant financialsubsidiary or each significant group of financialsubsidiaries required under part (a) ofthis rule, different types of insurance companies(e.g., life; fire and casualty) may not beconsidered together as one group of financialsubsidiaries.With regard to whether specific subsidiariesare financial or nonfinancial activitiesfor purposes of part (b) of this. rule, thecircumstances in each case would have to beconsidered. For example, it is consideredthat a leasing subsidiary with both financingand nonfinancing types of leases is a financialactivity; an investment banking subsidiaryor a broker-dealer subsidiary is a financialactivity; and a real estate subsidiarywhose primary business is holding mortgageloans would be considered a financial activity,while such subsidiary whose primarybusiness is constructing homes or developingland would be a nonfinancial activity. Otherexamples of nonfinancial activities are subsidiarieswhich sell mutual fund securities orare advisers to mutual funds or to real estatecompanies which are not related to the parentor its subsidiaries.In the determination of whether an activityis principally for the benefit of the operationsof the major group as specified in part(b) of this rule, if 50 percent or more of theactivity benefits or supports the major groupall of the activity would be so classified.Rule 5-02-6. Inventories.In the determination of replacement orcurrent cost for the purpose of disclosing theexcess of that amount over the stated LIFOvalue, any inventory method may be used(such as FIFO or average cost) which derivesa figure approximating current cost.Rule 5-02-39. Other stockholders' equity.In providing the disclosure regarding theundistributed earnings of unconsolidated

ACCOUNTING SERIES RELEASES 249subsidiaries and 50 percent or less ownedpersons as specified in part (b) of this rule,the amount to be disclosed would be thedifference between the cumulative equity inearnings of the unconsolidated persons reflectedin con!'jolidated retained earnings andthe cumulative dividends received from suchpersons by the consolidated group. Dividendspaid to shareholders of the consolidatedgroup should not be considered in the calculationsince they are not relevant to theundistributed earnings of such persons.Rule 9-05. Financial Statements and Schedulesof Banks.When Schedule VIII, specified in part (b)(4)of this rule, is filed with the consolidatedfinancial statements of a registrant bankholding company, the directors, officers andprincipal holders of equity securities of theregistrant and its affiliates shall be consideredas persons in those relationships withthe registrant bank holding company andeach bank and other affiliate, and theamounts to be reported shall be aggregateindebtedness of each of those persons to allcompanies in the consolidated group. Writeoffsof any such indebtedness during theperiod being reported on shall be separatelydisclosed. Information need not be reportedconcerning indebtedness to the consolidatedgroup from an otherwise unaffiliated personin which one or more of the persons in thecategories specified above are directors, officersor principal holders of equity securitiesof the otherwise unaffiliated persons or itsaffiliates.In connection with unconsolidated financialstatements of a parent bank holdingcompany, the schedule requirements of Rule5-04 are applicable and the schedule prescribedby Rule 12-03 shall be filed.RUle 12-16. Supplementary Income StatementInformation.The totals shown in this schedule shouldbe .the amounts described by each caption7 h1Ch are included in the income statementOr the period covered.The rents applicable to leased personaliroperty to be included under Item 5 of Rule2-16, in accordance with Instruction 4, wouldbe rents for personal property which is usedfor an extended period of time (generallymore than one year) and which the companyelects to rent or lease rather than to buysuch as postage meters, computers andtrucks. The expected period of use of theasset rather than the legal term of the leaseshould govern. Temporary rentals such as adaily car rental or the rental of display spaceat a convention would be excluded.Instruction 5 explaining "AdvertisingCosts" calls for the inclusion of "all costsrelated to advertising the company's name,products or services in newspapers, periodicalsor other advertising media." Such costswould include the indirect cost expended insupport of advertising such as the cost of anadvertising department, a market researchgroup which specializes in evaluation of advertisingand promotional efforts (but not allmarket research), a media buying department,or a graphic arts department thatspecializes in the preparation of advertisingcopy, as well as the direct costs of advertisingspace. In addition, the cost of "otheradvertising media" would generally includeexpenditures for preparing and mailing salesbrochures and direct mail advertising materials.In cases where a company or division isprimarily in the mail order business, however,the costs of preparing a catalog wouldbe a selling cost similar to that of a salesmanin most industrial concerns, and such catalogcosts should not be included in "advertisingcosts." The cost of employing salesmen, preparingproduct display signs, printing pricelists and standard product catalogs, and reportsto stockholders should also not be consideredadvertising costs for purposes of thisrule.It is recognized that the distinction betweenadvertising costs and other sellingexpenses is frequently not clear cut. Wherethe guidance set forth herein is not sufficientto enable the registrant to determine theappropriateness of including or excludingcertain classifications of significant costs,disclosure of the type of costs included orexcluded from the captiOn will be a satisfactorysolution.Under Item 8, Research and developmentcosts, all costs charged to expense as in-

250 . SECURITIES AND EXCHANGE COMMISSION .curred in the current period for the benefitof the company in these account classifica~tions should be reported. These would in~elude company sponsored projects of pureand practical research as well as the develop~ment of new products or services or new orbetter production machinery and equipmentand for the improvement of existing productsand services. The amortization of deferredresearch and development costs should notbe included herein since this amount is de~scribed in Item 3 of the schedule.PART B-CORRECTIONS,CLARIFICATIONS AND EDITORIALCHANGES(The text of the amendments of Rules 1~02,3~15, 5~02~23, 5-03~17, 5-04, 9~05, 12~02, 12~04,12~06, 12~13, 12~16, 12-42 and 12-43 of RegulationS-X is omitted.)The amendments to Regulation S-X areadopted pursuant to authority conferred onthe Securities and Exchange Commission bythe Securities Act of 1933, particularly Sec~tions 6, 7, 8, 10 and 19(a} thereof; the SecuritiesExchange Act of 1934, particularly Sections12, 13, 15(d) and 23(a) thereof; thePublic Utility Holding Company Act of 1935,particularly Sections 5(b), 14 and 20(a)thereof; and the Investment Company Act of1940, particularly Sections 8, 30, 31(c) and38(a) thereof.By the Commission.RONALD F. HUNTSecretaryRELEASE NO. 142March 15, 1973SECURITIES ACT OF 1933Release No. 5377SECURITIES EXCHANGE ACT OF 1934Release No. 10041Reporting Cash Flow and Other Related DataIntroductionThe Commission has recently received preliminaryregistration statements which include"cash flow per share" data in the narrativesection of the prospectus. Use of suchdata has also been noted in annual reports toshareholders, particularly in the "FinancialHighlights" or "President's Letter" section.These and other means of presenting financialdata appear designed to decrease thecredibility of conventional financial statementsas a measure of business activity.The variation in form and purposes of such. data creates confusion. The term "CashFlow" and similar formulations such as"Earnings Before Non-Cash Charges," "AdjustedNet Income," "Net Operating Income"and "Operating Funds Generated" donot have precise definitions and may meandifferent things to different people. In additionto this definitional problem, there aredifferent purposes for presenting these data.One is to present an apparent alternative tonet income as a measure of performance. Asecond is to present information about liquidor near-liquid assets provided by operationswhich may be available for reinvestment ordistribution to shareholders.While differing definitions and purposesare basic sources of the confusion investorsand registrants are experiencing with "cashflow" data, the presentation of such data ona per share basis compounds this confusion.Numerous questions have been received inregard to the Commission's policy in thesematters. This release is being issued to out~line the Commission's views."Cash Flow" as a Proxy for IncomeMeasurementOne of the principal reasons given for presenting"cash flow" is that the income rnea s -

ACCOUNTING SERIES RELEASES 251urement model currently prescribed by generallyaccepted accounting principles doesnot accurately reflect the economic performanceof certain types of companies, typicallythose with substantial assets which arguablydo ·not depreciate or require replacement.While the Commission recognizes that thereare problems of income measurement forsome industries, the unilateral developmentand presentation on an unaudited basis ofvarious measures of performance by differentcompanies which constitute departuresfrom the generally understood accountingmodel has led to conflicting results and confusionfor investors. Additionally, it is notclear that the simple omission of depreciationand other non-cash charges deducted inthe computation of net income provides anappropriate alt'ernative measure of performancefor any industry either in theory or inpractice. This problem was recognized by theAccounting Principles Board in Opinion No.19 where it was noted that "the amount ofworking capital or cash provided from operationsis not a substitute for or an improvementupon properly determined net incomeas a measure of results of operations .... "If accounting net income computed in conformitywith generally accepted accountingprinciples is not an accurate reflection ofeconomic performance for a company or anindustry, it is not an appropriate solution tohave each corp.pany independently decidewhat the best measure of its performanceshould be and present that figure to itsshareholders as Truth. This would result inmany different concepts and numbers whichcould not be used meaningfully by investorsto compare different candidates for their investmentdollars.Where the measurement of economic performanceis an industry-wide problem, representativesof the industry and the accountingprofession should present the problemand suggested solutions to the Financial AccountingStandards. Board which is the bodycharged with responsibility for '-researchingand defining principles of financial measurement.Until new and uniform measurement~rinciples are developed and approved for anIndustry, the presentation of measures ofperformance other than net income shouldbe approached with extreme caution. Suchmeasures should not be presented in a mannerwhich gives them greater authority orprominence than conventionally computedearnings.Where management believes that the existingconventional income model does notpresent the results of operations realisticallyor fully, an explanation of the reasons and adescription of possible alternatives whichmight be used to. measure results may bepresented to shareholders and potentialinvestors to supplement conventional financialdata. The presentation of additional datain tabular form is also acceptable. Such tablesshould be accompanied by a careful explanationof the data presented. The addingtogether of figures derived by differentmeasurement techniques (such as net incomeand cash flow) should be avoided asshould per share data relating to measuresother than net income (see discussion below).In addition, when various measurementmodels are used for different lines of business,there should be a consistent applicationof such models to all similar segments of thefirm's operations. Also, results for all segmentsincluded in consolidated statements ofnet income should be included in any tabularor summary presentation.Annual reports to shareholders as well asfilings with the Commission should includeexplanations and data as discussed abovewhenever measurement models other thanconventionally computed income are used.Such additional information and data wouldtypically be presented in the "FinancialHighlights," the "President's Letter," or thetext of the report and should not be presentedwithout also presenting net income.Terms such as "N et Operating Income"which leave the impression that a figureother than net income is really incomeshould not be used.In cases where a measurement problemexists for an individual company rather thanin an entire industry, a solution already existsin the procedures of the accountingprofession. Under the newI.y adopted Code ofEthics of the American Institute of CPA's,an auditor is permitted to render an opinionapproving statements prepared even though

252 SECURITIES AND EXCHANGE COMMISSIONthey deviate from the principles adopted bythe Accounting Principles Board (or its successorbody) if he believes and can supportthe assertion that due to unusual circumstancesthe financial statements would otherwisebe misleading. Under such circumstances,full disclosure must be made by bothcompany and auditor, and the basic statementsmust be prepared in accordance withthe principles determined to present operatingresults most meaningfully. In suchcases, the staff of the Commission will naturallyconsider the circumstances which gaverise to the situation, but it will normally givegreat weight to the judgment of the registrantsand their independent accountants.The above discussion is designed to assistcompanies which believe the conventionalincome measurement model is unsatisfactoryin providing disciosure which is useful andnot misleading. This discussion is not intendedto support or reject any particularnew measurement model and the Commissionstrongly urges the accounting professionand other interested parties to considerthe development of new techniques for themeasurement of results in industries wherethe current model seems deficient."Cash Flow" as a Measurement of FundsGenerated from OperationsA second basic reason for highlightingcash or funds generated from operationsdata in financial summaries is to show theliquid or near-liquid resources generatedfrom operations which may be available forthe discretionary use of management. Analystshave suggested that this is a usefulmeasure of the ability of the entity to acceptnew investment opportunities, to maintainits current productive capacity by replacementof fixed assets and to make distributionsto shareholders without drawing onnew external sources of capital.While presentation of "funds generatedfrom operations" is useful, these data shouldbe considered in the framework of a sourceand application of funds statement whichreflects management's decisions as to theuse of these funds and the external sourcesof capital used. The implication of a presentationwhich shows only the funds generatedfrom operations portion of a funds statementis that the use of such funds is entirely atthe discretion of management. In fact certainobligations (e.g., mortgage payments)may exist even if replacement of non-depreciatingassets is considered unnecessary.Therefore presentation of one part of a fundsstatement should be avoided.The Commission has also noted situationswhere investors were misled by cash distributionswhich were in excess of net incomeand were not accompanied by disclosure indicatingclearly that part of the distributionrepresented a return of capital. To highlightthis fact in cases where funds distributedexceed net income, the Commission developedthe "Funds Generated and Funds Disbursed"statement in Form 7-Q which beginswith the caption "Income (Loss) Before RealizedGain or Loss on Investments." Fromthat amount the first deduction is "CashDistributed to Shareholders." The statementthen provides for adding non-cash chargesand deducting debt repayments to arrive atthe "Excess (Deficiency) of Funds GeneratedOver Distributions." This indicates whetheroperations generated the cash to make distributionsor whether distributions are madefrom borrowing or other sources.Cash flow presentations designed to reflectthe liquid assets or working capital generatedby the firm should be consistent withthe principles outlined in this section.Per Share InformationMany of the problems outlined above areaccentuated when "cash flow" data is presentedon a per share basis. Most importantly,such a presentation emphasizes theimplication that cash flow is more meaningfulthan net income as a measure of performance,particularly when a per share figure isincluded in the "Financial Highlights" sectionof a report".The first major problem in the presentationof cash flow per share data is that ofinvestor understanding. Investors overmany years have grown accustomed t~seeing operating per share data compu~eonly in the case of net income. AccountlDg

ACCOUNTING SERIES RELEASES25,'rauthorities have considered and largely settledthe measurement problems associatedwith the presentation of net income on a pershare basis. If other data are presented inthis way, there is a danger that the investorwill think .that what he is seeing is theconventional accounting measure of earningpower when in fact this is not the case. In anumber of reports, cash flow per share datahave been presented in such a manner as tolead to this inference despite the strong recommendationof the Accounting PrinciplesBoard in Opinion No. 19 that "isolated statisticsof working capital or cash provided fromoperations, especially per share amounts, notbe presented in annual reports to shareholders."Such presentations run a high risk ofmaterially misleading investors and companiesare urged to avoid this type of disclosure.Beyond the problem of understandabilityis the question of relevance. The investmentcommunity generally recognizes the relevanceof "earnings per share" as a measure ofthe historically achieved earning power of aneconomic entity in terms of a unit which isbeing bought, sold and quoted in the marketplace, the share of common stock. The earningpower represented by that share hasgenerally been considered a significant elementin the determination of its worth. Netincome, as a measure of ultimate result, mayreasonably be interpreted on a per sharebasis since no significant claims stand betweenit and the common stock owner. Wherethere are senior equity claims, these arededucted before computing the per sharefigure. Dividends are similarly logically presentedin terms of the individual share, asare net assets.Significant questions as to relevance arise,however, when other data are presented on aper share basis. Sales, current assets, fundsflow, total assets, cash and other similarfigures cannot logically be related to thecommon shareholder without' adjustment.These are aggregate data which are of greatimportance to analysts and managementalike in understanding the operations of thetotal economic entity, but they are not itemswhich accrue directly to the benefit of theowner of a part of the common equity.Charges and claims must be considered beforethe owner is benefited. To reflect suchitems on a per share basis may mislead theunsophisticated, since there is an implicationthat the shareholder is directly affected. Infact, such data are only meaningful from anoperating viewpoint and not from that of anexternal investment unit.Accordingly, per share data other thanthat relating to net income, net assets anddividends should be avoided in reporting financialresults.ConclusionIn this release, the Commission has reiteratedand explained its view as expressed toindividual registrants for many years thatcertain approaches to "cash flow" reportingmay be misleading to investors. All registrantsare urged to examine their reportingpractices in light of the problems and guidanceset forth in this release and to amendthem where appropriate.The Commission recognizes that reportingfinancial results cannot be a static phenomenon,and it continues to examine its viewsand policies to determine in what respectschange is desirable. In this connection, itwelcomes comments and suggestions regardingits policies from registrants and otherknowledgeable parties. If any parties havecomments on the views and policies set forthin this release, they should be addressed tothe Chief Accountant of the Commission.By the Commission.RONALD F. HUNTSecretary

254 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 143March 20, 1973Findings and Order imposing remedial sanction in the Matter of Robert Lynn Burroughs.In these proceedings pursuant to Rule 2(e)of the Commission's Rules of Practice to determinewhether Robert Lynn Burroughs,an accountant, should be temporarily or permanentlydenied the privilege of appearingor practicing before the Commission,l he submittedan offer of settlement.Under the terms of the offer, respondent,solely for the purpose of these proceedingsand without admitting or denying the allegationsof the order for proceedings, consentedto findings in accordance with the allegationsin that order and to the entry of anorder censuring him.After due consideration of the offer of settlementand upon the recommendation of itsstaff, the Commission determined to acceptsuch offer.On the basis of the order for proceedingsand the offer of settlement, it is found that: 21. Respondent, an employee of a publicaccounting firm, participated, under thesupervision of a partner in the firm, inthe audit of the records of a registeredbroker-dealer.1 Rule 2(e) provides in pOlrt that the Commission maydeny the privilege of appearing or practicing before it toany person who is found, after notice of and opportunityfor hearing, to have engaged in unethical or improperprofessional conduct.2 The findings herein are not binding upon any otherrespondents named in these proceedings.2. In connection with such audit and thecertification of the broker-dealer's financialstatement as of September 39,1971, which was filed with the Commissionon Form X-17a-5 pursuant to Rule17 a-5 under the Securities ExchangeAct of 1934, respondent failed to complywith generally accepted auditing standardsand the Commission's instructionsfor the Form. Respondent failed to evaluatethe effectiveness of the brokerdealer'sexisting internal controls to determinethe need for extending thescope of the examination, to inquire intomaterial poststatement events, and toobtain sufficient evidence to afford areasonable basis for the unqualifiedopinion given to the broker-dealer.Under the circumstances, it is appropriateto impose the sanction specified in respondent'soffer of settlement.Accordingly, IT IS ORDERED that RobertLynn Burroughs -be, and he hereby is, censured.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.RONALD F. HUNTSecretaryRELEASE NO. 144May 23,1973Order instituting proceedings and imposing remedial sanctions in the Matter of LaventholKrekstein Horwath & Horwath.Laventhol Krekstein Horwath & Horwath("LKH&H"), a partnership engaged in thepractice of accounting, has submitted an. offerof settlement for the purpose of dispOSIng

ACCOUNTING SERIES RELEASES 255of issues raised under Rule 2(e) of the Commission'sRules of Practice concerningLKH&H's right to appear and practice beforethe Commission, based upon the entryon May 23, 1973, of a consent judgment ofpermanent injunction against LKH&H in anaction commenced by the Commission. 1 TheCommission's complaint alleged, with respectto LKH&H, that it had participated in violationsof Section 17(a) of the Securities Act of1933, Section 10(b) of the Securities ExchangeAct of 1934 ("Exchange Act") andRule 10b-5 thereunder, and Sections 206(1)and (2) of the Investment Advisers Act of1940 ("Advisers. Act"), in that, in early 1970 itwas involved in the dissemination of falseand misleading certified financial statementsof Takara Partners, a limited partnershipengaged in investment activities, and inearly 1971-in the dissemination of materiallyfalse and misleading information concerningTakara's investment performance during1970. 2 The complaint also alleged thatLKH&H was not independent and was notqualified to certify the financial statementsof Takara because partners or employees ofLKH&H's East Brunswick, New Jerseybranch office, during the period of time whenthey were working on the preparation ofsuch financial statements, received paymentsfrom the general partners of Takaratotalling approximately $17,000 in the guiseof profits from participation in the purchaseand sale of "hot issues."LKH&H, without admitting or denying theallegations of the complaint, consented tothe entry of the permanent injunction enjoiningit from violating the cited provisionsof the Securities Act and the Exchange Actand rule thereunder in connection with thepurchase or sale of securities of Takara, andfr~m aiding and abetting any investmentadviser to Takara in violations of the citedprovisions of the Advisers Act, and ordering,S.~S.E.C. v. E!v.erest Management. f!0rJJ.0ration, et ai.,520·N. y ., 71 CivIl 4932. See SEC LItigatIOn Release No.2; (Novembe: 11, 1971).v'd he complamt also names as respondents three indit~~al_s Who were partners or employees of LKH&H, ande InJunctive action is still pending against them.it to adopt and maintain procedures to preventfuture violations of those provisionsand to take all reasonable steps to conductits professional practice in compliance withsuch procedures and ordering further relief.In view of the permanent injunction, andupon the recommendation of its staff, theCommission deems it necessary that proceedingsbe instituted against LKH&H pursuantto Rule 2(e) of the Commission's Rules ofPractice with respect to its qualifications toappear and practice before the Commission.Under the terms of its offer of settlement,LKH&H, without admitting or denying theallegations of the Commission's complaint inthe injunctive action and solely for the purposeof settlement, consented to a findingthat LKH&H has been permanently enjoinedas set forth above, and to the entry of anOrder:1. Requiring LKH&H to permit an investigation,within 15 months from the dateof the entry of the injunction, in orderto ascertain whether it is conducting itsprofessional practice in compliance withthe standards and procedures which itis required to adopt and maintain by theterms of the injunctive decree. This investigationis to be conducted in accordancewith methods and procedures generallyadopted or approved by theCommission for such investigations andat the expense of LKH&H. At the optionof the Commission, such investigation isto be conducted by:(a) A team of qualified professional accountantscomposed of persons selectedfor such purpose by the AmericanInstitute of Certified PublicAccountants (AI CPA); or(b) A team of qualified professional accountantscomposed of persons selectedfor such purpose by the ChiefAccountant of the Commission: (i)from among _ persons designated bythe AI CPA, or (ii) in the event thatthe AICPA does not designate suchpersons within 12 months from thedate of the injunction, from amongmembers of the AICPA; or

256 SECURITIES AND EXCHANGE COMMISSION(c) Members of the staff of the Commission.32. Prohibiting LKH&H, for a period of oneyear from the date of entry of the permanentinjunction, from effecting anymerger with or acquisition of any otheraccounting firm without first submittingto the Chief Accountant of the Commissionevidence that LKH&H's proceduresrespecting mergers oracquisitions adopted pursuant to the injunctionare being followed.3. Prohibiting it, for a period of 30 days,commencing five days after the datehereof, from accepting or undertakingany new professional engagement whichcan be expected to result, within oneyear from the date of such engagement,in filings, submissions or certificationswith or to the Commission. 4After due consideration, the Commissiondetermined to accept the offer of.settlenent.In arriving at this determination, the Commissionconsidered the facts that LKH&H, inorder to prevent a recurrence of the violativeactivity alleged, revised its supervisory and3 Pursuant to the judgment of permanent injunction,which includes similar provisions for an investigation ofLKH&H, in those instances where the persons conductingthe investigation are other than members of theCommission's staff, such persons shall be given a copy ofthat judgment and of the consent attached thereto, areto hold in confidence the fact that they are engaged insuch investigation as well as all information, books,papers, records, documents or other materials obtainedor utilized during the course of such investigation andrelating to the clients, procedures, systems or methodsof LKH&H, and shall submit their report of investigationto the Commission only, which report shall be thesole property of the Commission. It is understood thatLKH&H may have access to such a report on the premisesof the Commission.• For the purpose of this Order, "new professionalengagement" is defined to mean an engagement byclients, which include any persons or corporations subjectto the disclosure requirements of the Securities Act,the Exchange Act, the Investment Company Act, theAdvisers Act and the Trust Indenture Act of 1939, who,five days after the effective date of this Order, do notengage the services of LKH&H. LKH&H's right or obligationto perform its normal functions and services forexisting clients (including activities requiring filings;submissions or certifications with or to the Commission),shall not be affected during this period.control procedures, reviewed such procedureswith the Chief Accountant of the Commissionand, in order 0 insure that theseprocedures are being complied with, agreedto permit the above-described investigation.Further, the Commission noted that LKH&Hhad never before been a respondent in anadministrative proceeding instituted pursuantto Rule 2(e) of the Commission's Rulesof Practice or a defendant in an injunctiveaction brought by the Commission. In addition,the Commission considered sworn representationsmade by LKH&H that no partneror employee of LKH&H, other than thoselocated in the East Brunswick office of thefirm, participated in the activities alleged inthe Commission's complaint or received anydirect or indirect benefit from such activitiesother than such as pertain to fees chargedfor services rendered. LKH&H representedthat its East Brunswick office was acquiredon February 1, 1968, through a merger witha small certified public accounting firm inthat city which was merged intact intoLKH&H, and that LKH&H made an inquiryinto, among other things, the professionalcompetence and reputation of that firm priorto such merger.Accordingly, IT IS ORDERED that proceedingspursuant to Rule 2(e) of the Commission'sRules of Practice be, and they herebyare, instituted against LaventholKrekstein Horwath & Horwath.IT IS FURTHER ORDERED that, subjectto the terms and conditions provided in theoffer of settlement as set forth above, LaventholKrekstein Horwath & Horwath be, andit hereby is: (1) prohibited, for a period of 30days, commencing five days after the datehereof, from accepting new professional engagementsfor new clients which can be expectedto result, within one year from thedate of such engagement, in filings, submissionsor certifications with or to the Commission;(2) prohibited, for a period of one yearfrom the date of entry of the judgment ofpermanent injunction, from effecting anymerger with or acquisition of any other accountingfirm without first submitting to th~Chief Accountant of the Commission ev1-dence that its procedures respecting mergers

ACCOUNTING SERIES RELEASES 257or acquisitions are being followed; and (3)required, within fifteen months from thedate of entry of that injunction, to permit aninvestigation to ascertain whether it is conductingits professional practice in compliancewith the standards and procedureswhich it is required to adopt and maintain bythe terms of said injunction.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.RONAW F. HUNTSecretaryRELEASE NO. 146August 24, 1973SECURITIES ACT OF 1933Release No. 5416SECURITIES EXCHANGE ACT OF 1934Release No. 10363PUBLIC UTILITY HOLDING COMPANYACT OF 1935Reiease No. 18067INVESTMENT COMPANY ACT OF 1940Release No. 7955Effect of Treasury Stock Transactions on Accounting for Business Combinations 1In August 1970 the Accounting PrinciplesBoard (APB) of the American Institute ofCertified Public Accountants (AI CPA) issuedOpinion No. 16, "Business Combinations,"which identifies certain conditions whichmust be present (or in some cases absent) if abusiness combination is to be accounted foras a pooling of interests. Two of these conditions,which are set forth in paragraphs 47-cand 47-d, include provisions related to thereacquisition of voting common stock withintwo years prior to initiation and betweeninitiation and consummation of a businesscombination which is planned to be accountedfor by the pooling-of-interestsmethod. The Commission has observed thatthese provisions have been subject to varyinginterpretations in practice, and has conc~dedthat certain of these interpretationsare not compatible with concepts underlyingthe Opinion. Accordingly, this release setsforth the Commission's conclusions as to certainproblems relating to the eff~ct of treas­~ry. stock transactions on accounting forUSlDess combinations.Of'~e~ also Release No. 146A (April 11, 1974) StatementS .ohcy and Interpretations in Regard to Accountingenes Release No. 146.When cash or other assets are used orliabilities are incurred to effect a businesscombination, APB Opinion No. 16 concludesthat the combination should be accounted foras a purchase. This concept might be circumventedif cash or other assets were used orliabilities were incurred to reacquire commonshares and common shares were thenexchanged to consummate the combination.Therefore, for the pooling-of-interestsmethod to apply, paragraph 47-c of the Opinionrequires that "none of the combiningcompanies changes the equity interest of thevoting common stock in contemplation of effectingthe combination either within twoyears before the plan of combination is initiatedor between the dates the combination isinitiated and consummated; ...." Further,paragraph 47-d stipulates that "each of thecombining companies [may reacquire] sharesof voting common stock only for purposesother than business combinations ...."JIn some cases it is difficult to determinethe purposes of treasury stock acquisitions.An AICPA Accounting Interpretation ofOpinion No. 16 (No. 20 issued September1971) states: "In the absence of persuasiveevidence to the contrary, however, it shouldbe presumed that all acquisitions of treasury

258 SECURITIES AND EXCHANGE COMMISSIONstock during the two years preceding thedate a plan of combination is initiated (orfrom October 31, 1970 to the date of initiationif that period is less than two years) andbetween initiation and consummation weremade in contemplation of effecting businesscombinations to be accounted for as a poolingof interests. Thus, lacking such evidence,this compination would be accounted for bythe purchase method regardless of whethertreasury stock or unissued shares or bothare issued in the combination." The Commissionbelieves that this presumption and conclusionshould be followed.In determining the purposes of treasurystock acquisitions, it is ordinarily appropriateto focus on the intended subsequent distributionof common shares rather than onthe business reasons for acquiring treasuryshares. For example, shares may be reacquiredbecause management believes thecompany is overcapitalized or considers that"the price is right," but such reasons do notovercome the presumption that they wereacquired in contemplation of effecting businesscombinations to be accounted for aspoolings of interests. On the other hand, thepresumption may be overcome when sharesare acquired for a specific use unrelated tobusiness combinations such as stock optionor purchase plans or stock dividends, areassociated with a combination accounted foras a purchase, or are acquired to resolve anexisting contingent share agreement. However,the mere assertion that common sharesare reacquired for such purposes, evenwhere the assertion is formalized by actionof the board of directors reserving the treasuryshares, does not provide persuasive evidencethat they were not reacquired in contemplationof pooling-of-interests combinations.If a resolution of the board of directorsor -other statement of intent were sufficientto l;!,rovide persuasive contrary evidence, theresfrictions on treasury stock acquisitionswould be totally ineffective. Accordingly,while a board resolution made prior to acquisitionof treasury shares may be useful evidenceas to corporate intent, reference alsomust be made to the actual or probable issuanceof shares for purposes unrelated topooling-of-interests business combinations.When treasury shares are acquired duringa period beginning two years prior to initiationand ending at the date of consummationof a business combination to be accounted foras a pooling of interests (hereinafter referredto as the "restricted period") the issuance ofan equivalent number of shares prior to thedate of consummation would generally providepersuasive evidence that the treasuryshares were not acquired in contemplation ofthe combination. The shares issued may betreasury shares or previously unissuedshares since, with regard to the equity interestsof the common shareholders, there is nosubstantive difference between the two.Thus, a company might "cure" a conditionwhich would preclude pooling-of-interests accountingby selling common shares prior toconsummation of the combination. The"cure" could not be effected by merely retir-.ing treasury shares. .Paragraph 47-d of APB Opinion No. 16includes the statement that "treasury stockacquired for purposes other than businesscombinations includes shares for stock optionand compensation plans and other recurringdistributions provided a systematicpattern of reacquisitions is established atleast two years before the plan of combinationis initiated." Further, "a systematic patternof reacquisitions may be established forless than two years if it coincides with theadoption of a new stock option or compensationplan." In AICPA Accounting InterpretationNo. 20 of Opinion No. 16, no reference ismade to a systematic pattern of reacquisition,and some accountants have assertedthat this test has been . effectivelysuperseded. ·The Commission does not acceptthis assertion. Accordingly, the Commissionconcludes that treasury shares acquired inthe restricted period for recurring distributionsshould be considered "tainted" unlessthey are acquired in a systematic pattern ofreacquisitions established at least two yearsbefore the plan of combination is initiated (orcoincidentally with the adoption of a neWstock option or compensation plan) and thereis reasonable expectation that shares will beissued for such purposes.A systematic pattern of reacquisitionsmight be demonstrated by the reacquisition

ACCOUNTING SERIES RELEASES 259of a specified number of shares in successivetime periods, e.g., 1,000 shares per month. Asystematic pattern might also be demonstratedwhere, pursuant to a formal reacquisitionplan, shares are acquired based onspecified criteria such as the market price ofthe stock and cash availability. The criteriaof the reacquisition plan must be sufficientlyexplicit so that the pattern of reacquisitionsmay be objectively compared to the plan.Unanticipated interruptions caused by legalconstraints on a company's ability to reacquireshares would not upset an otherwisesystematic pattern of reacquisitions.The determination of whether there is reasonableexpectation that shares will be issuedfor the stated purposes of acquiring theshares is a matter of judgment. Generally,there would appear to be such reasonableexpectation where the following circumstancesexist at the time a reacquisition plan isadopted or shares are reacquired:1. As to stock option plans, warrants orconvertible securities, the quoted priceof the common shares is not less than 75percent of the exercise or conversionprice.2. As to stock purchase or bonus plans orstock dividends, either (a) shares arereacquired to fulfill existing commitmentsor dividends declared or (b) basedon a pattern of issuing shares for suchpurposes in the prior two years, theshares are reacquired to fulfill anticipatedrequirements in the succeedingyear.A systematic pattern of reacquisitions testwould not apply to treasury shares acquiredfor issuance in a specific "purchase" businesscombination or to resolve an existingcontingent share agreement from a priorbusiness combination, as these issuanceswould not be regarded as recurring distributions.Thus, shares acquired and reserved forthese purposes at the date a pooling-of-interestsbusiness combination

260 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 146-A'April 11, 1974SECURITIES ACT OF 1933Release No. 5416A.SECURITIES EXCHANGE ACT OF 1934Release No. 10363APUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 18067AINVESTMENT COMPANY ACT OF 1940Release No. 7955AStatement of ~olicy and Interpretations in Regard to Accounting Series Release No. 146On October 5, 1973, in Securities Act ReleaseNo. 5429, the COl'~mission requestedcomments on the substance of AccountingSeries Release No. 146 and stated that untilthese comments were considered the Comm!s,sion)Vould accept filings from registrantsusing. principles of accounting for businesscombinations in accordance with pra~ticed'eemed acceptable by public accountantsprior'to A.SR 146. Comments were. ~eceiv~d; ,from, num~rous. individuals, c()mpanies .. andgroups. , ... _. --Statement of PolicyAfter considering these comments, theCommission lias concluded that the statementof policy set forth in ASR 146 representsa proper interpretation of AccountingPrinciples Board Opinion No. 16 which dealswith accounting for business combinations.It has concluded, therefore, that it will applythis policy to all business combinations andtreasury stock acquisitions which occur subsequentto the date of this release. The policywill not apply in the case of subsequentbusiness combinations which are consummatedby companies which have acquiredtreasury shares' prior to the date of thisrelease so long as such shares are not"tainted" under the criteria deemed acceptableby public accountants prior to the issuanceof ASR 146 and so long as treasuryshares tainted under ASR 146 have not beenacquired subsequent to the date of this release.Several commentators were critical of thearbitrariness of some of the criteria set outin APB Opinion No. 16. The Commissionnotes that the subject of business combinationsaccounting is now on the agenda of theFinancial Accounting Standards Board, andit does not intend by adopting this release toprejudge the issues now being considered bythe Board. The Commission believes that theprinciples set forth in APB Opinion No. 16should not be eroded while the F ASB isconsidering this matter.Interpretations.A number of comment letters indicated aneed for the clarification of certain aspects ofASR 146. The following interpretive commentsare designed to guide registrants andtheir independent public accountants.1. Purpose of acquisition of shares" ,In determining the purposes, of treasurystock acquisitions, it is ordinarily appropriateto focuso~ the intended subsequent dis,­tribution of shares, e.g., exercise pf options,conversion of preferred stock, etc. APB OpinionNo. 16, AICPA Accounting InterpretationNo. 20 thereof, and ASR 146 all discussand emphasize subsequent distribution inassessing purpose of acquisition. It must berecognized, however, that . circumstancesmay exist where a co-mpany is obliged bycontract to reacquire specific shares or mustreacquire specific shares to settle outstandingclaims. For example, reacquisition mightbe made to (1) comply with an agreement topurchase stock upon the death of a stockholder,(2) settle a claim or lawsuit involvingalleged misrepresentation or other acts relatingto the original issuance of stock, (3)repossess stock pledged as collateral fo! areceivable or other contractual obligatIOn,and (4) repurchase stock from employees pu r -

ACCOUNTING" SERIES RELEASES 261suant to contractual rights or obligations.Such contracts or claims provide persuasiveevidence that resulting reacquisitions werenot made in contemplation of a business~ombination to be treated as a pooling ofinterests. ~ccordingly, unless it appears thatsuch rights or obligations are contrived toskirt the requirements of APB Opinion No.16, resulting reacquisitions would not resultin "tainted" shares.2. Reasonable expectation of reissuanceMany of those commenting on ASR 146expressed concern that the guidelines relatingto reasonable expectation of issuance ofshares for stock option plans, warrants orconvertible securities, i.e., the quoted price of" common shares is not less than 75 percent ofthe exercise or conversion price, would beapplied as an immutable rule. The Commissiondoes not intend that this guideline be arule. Reasonable expectation is a matter ofjudgment. Some of the other factors whichmay affect that judgment are the volatilityof quoted prices, the remaining time periodbefore conversion or exercise rights expire,and price and earnings trends. The Commissionintends that the 75 percent guideline beviewed as a presumption which may be rebuttedby relevant, probative evidence.3. Acquisitions subsequent to consummationSeveral of those commenting on ASR 146were concerned about the lack of specificguidelines for determining when there are"significant reacquisitions closely following acombination." The Commission does not intendto establish an additional criterion fordetermining the accounting treatment of abusiness combination. Rather, it intendedsimply to caution registrants and auditorsthat the substance of reacquisitions close.1Yfollowing consummation of a combinationshould not be ignored. For example, if acompany wished to replace untainted sharesissued in a purchase by acquiring an equivalentnumber of shares closely following ;itsconsummation, such shares would not" betainted. Conversely, if an enterprise were tocomplete a pooling and a very short timethereafter repurchase an equivalent numberof shares, such a purchase could affect thestatus of the combination and bar poolingaccounting.4. MaterialityAICPA Interpretation No. 20 of APB OpinionNo. 16 indicates that the presence of"tainted" treasury shares will not" precludepooling-of-interests accounting if the numberof shares is not material in relation to thetotal" number of shares issued to effect thecombination. In practice, "tainted" sharesare apparently being considered togetherwith other items under paragraph 47-b. Thiswould limit "tainted" shares to a maximumof 10% of the total number of shares issuedto effect the combination. ASR 146 does notaddress this matter because practice appearsreasonable and reasonably uniform.By the Commission.GEORGE A. FITZSIMMONSSecretary

262 SECURITIES AND EXCHANGE COMMISSIONSECURITIES ACT OF 1933Release No. 5428PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 1811JRELEASE NO. 147October 5, 1973SECURITIES EXCHANGE ACT OF 1934Release No. 10421Notice of Adoption of Amendments to Regulation S-X Requiring Improved Discl~sure of Le~~sA. INTRODUCTIONThe Securities and Exchange Commissiontoday adopted amendments to Rule 3-16 ofRegulation S-X which require increased disclosureof lease commitments by lessees inthe footnotes to financial statements filedwith the Commission. The proposal to amendRegulation S.:X for this purpose was pub­Ii.shed for comment in Securities Act ReleaseNo. 5401 (Securities Exchange Act· ReleaseNo. 10203, Public Utility lIolding CompanyAct Release.N"Q.17987).onJune 6,1973. Manyletters of comment have been received andconsidered.In its release proposing these amendmentsthe Commission noted that it was acting toprovide adequate information to investors inregard to an important and dramaticallygrowing form of asset acquisition and financing.It also observed that it had referred thebasic problem of accounting measurement ofleases to the Financial Accounting StandardsBoard in Accounting Series Release No.132.Subsequent to the date of the Commission'sproposal the Accounting PrinciplesBoard of the American Institute of CertifiedPublic Accountants reversed its previouslyannounced decision to take no action onlease disclosure and issued its Opinion No. 31d~aling with this subject. The disclosurecalled for in this Opinion was substantiallyless than that identified in the Commission'srelease as needed by investors. The Commissionhas carefu_lly considered the contents ofOpinion No. 31 to determine whether it providedfor sufficient disclosure to meet theneeds of investors and has concluded that itdoes not, although much of the disclosurecalled for by the Opinion will be useful toinvestors. Specifically, the Commission believesthat disclosure of the present value offinancing leases and of .the impact on netincome of capitalization of such leases, neitherof which is required by Opinion No. 31,are essential to investors. Accordingly, theamendments adopted herein require suchdisclosure. In other respects, the disclosurerequirements herein have been substantially. conformed to those in the Opinion so as tominimize duplication of effort by registrants.The additional disclosures required by theamendments are felt necessary to enableinvestors to compare meaningfully the capitaland asset structures and the operatingresults of companies making use of differentmethods of acquiring and financing assets.. The Commission does not intend by adoptmgthese amendments to prejudge the issuesof lease accounting now being considered bythe Financial Accounting Standards Board.At such time as that body develops improvedstandards of accounting for leases the Com-. . 'mISSIOn expects to reconsider the disclosurerequirements set forth herein.B. INTERPRETATIONS AND COMMENTSIn the comments received on the proposala number of questions were raised. Some ofthese were the basis for certain changes inthe proposals, while others seemed to call forclarifying interpretive comments which didnot warrant inclusion in the text of the rule.These items are discussed below in the orderin which they appear in Rule 3-16(q).1. Renewal options-It was pointed out bymany commentators that renewal op-

ACCOUNI:ING SE~IES RELEASES 263tions are generally a matter of prudentbusiness precaution by lessees and do'not necessarily constitute a"n assuredstream of financial payments to the lessor."The Commission "accepted thesecomments a.ud deleted renewal optionsfrom the period to be used in determiningwhether the lease covers 75 percentof the economic life of" the property.However, if the terms of the renewal'option (or the nature and useful life ofany lessee-provided improvements tothe leased property) are such that theprobability of the option being exercisedis extremely high, the renewal periodmay In substance be part of the noncan-, eel able period and it should be treatedas such in applying the 75 percent tef)t.In the normal case renewal options withsuch terms are likely to require capitalizationof leases under the ·building upequity test of APB Opinion N~. 5. ,2. Recovery of the lessor's investmerit-.:..Anumber of questions were' raised as t9whether it lease (such asa leveragedlease), where both the'lessor's recoveryof investment and his return are basedon the timing of tax benefits which he'receives as well as lease p~yp1ents,should be considered as one ,whichmeets the second criterion of a financinglease even though the lease paymentsalone would not have that effect.The Commission believes that such alease does meet the test set forth sinceit does have terms which assure thelessor a recovery of his investment andan economic return. In measuring thelessor's investment any investmentcredit received by him should be treatedas a reduction of investment.3. Fair market value of leased asset-Itwas pointed out that a lessor may sometimeshave acquired an asset at a datefar preceding the date a lease is enteredinto and, accordingly, his iIi'vestmentmay be an unrealistic basis for determiningwhether a financing lease isbeing entered into. Accordingly, the pro­POsed rule's definition' of a financinglease was changed to provide that thelessor should be assured recovery of thefair market value of the property. In thenormal case the lessor's cost will representfair market value unless a substantialtime period has passed between acquisitionand the date of lease except·that in the case of a manufacturerdealerlessor who meets the tests ofAccounting Principles Board OpinionNo. 27 for revenue recognition at thedate of lease, the amount of revenuerecognized may be used as a measure offair market v'alue.4. Minimum rentals-It was pointed outthat in a number of circumstances contractualminimum rentals were not agood measure of the cash inflows anticipatedby the lessor. In some such casescontractual minimum rentals would notrecover the lessor's investment, but contingentrentals are set at such a levelthat the lessor is virtually certain torecover his investment plus a fair return.While the rule adopted deals only, 'with minimum 'lease commitments, registrantsare urged to look at the economicsubstance underlying the leaseagreement. In cases where a lessor'srecovery is in fact but not contractuallyassured, present value computationsmay be most meaningfully made on the, basis of expected rental payments. Sucha practice would be consistent with therule adopted.Other cases were cited where no minimumrental was called for in the leaseagreement but the lessor's debt servicewas guaranteed by the lessee. In such acase it would normally be expected thatthe asset and related liability would bereflected on the balance sheet. If thet9tallease terms did not require capitalization,the guaranteed payments wouldconstitute the minimum rentals requiredto be disclosed at their presentvalue under this rule.5. Net lease payments-Many commentswere received as to the difficulty in determiningamounts included in leasepayments applicable to taxes, insurance,maintenance and other operatingexpenses. In the case of financingleases, these items are frequently ex-

264 SECURITIES AND EXCHANGE COMMISSIONplicitly set forth or excluded from lease -payments. The rule as adopted providesthat an estimate of such costs be subtractedif practicable. If costs cannot bereasonably estimated for some leases itis acceptable to disclose. the presentvalue of those lease payments on a grossbasis, with disclosure of the amount socomputed.6. Interest rate impli.cit in the terms of thelease-In most cases such interest ratesare explicitly negotiated in financingleases. Where this is not the case, interestrates applicable to the financing ofpurchases of similar types of propertiesby the lessees at the times of enteringinto the lease agreements may be indicativeof the interest rates implicit in theterms of the lease. Paragraphs 13 and 14of Accounting Principles Board OpinionNo. 21 also discuss this problem.In some cases interest rates negotiatedin leasing arrangements are variableand depend upon the rates for theshort-term paper used to finance leasedassets. In such situations present valuemust be calculated through the use ofan estimated rate over the life of thelease, but calculations of the currentimpact on net income should use thecurrent interest rate in determining theinterest charge.7. Materiality-Comments indicated thatthe originally proposed test of materialityfor present value disclosure whichwas based on debt and the present valueof leases discriminated against the companywith little or no debt. In response,the Commission has changed the test torequire disclosure of present value onlywhen the amount exceeds five percentof long-term capitalization (the sum oflong-term debt, stockholders' equity andthe present value of leases) or when theeffect on net income of capitalizingleases is greater than three percent ofaverage· net income for the most recentthree years. In calculating average netincome, loss years should be excluded. Iflosses were incurred in each of the mostrecent three years, the average lossshall be used for purposes of this test... ,c. AMENDMENTS TO REGULATION S-XThe following amendments to Rule 3-16 areadopted. The introductory paragraph of Rule3-16 is amended as follows:Insert at the end of the second sentence"and for item (q) as specified therein"Rule 3-16(i). Commitments and contingentliabilities.-(1) No change(2) Is deleted(3) Becomes (2)Rule 3-16(q). Leased assets and lease commitments.-Anycontractual arrangementwhich has the economic characteristics of alease, such as a "heat supply contract" fornuclear fuel, shall be considered a lease forpurposes of this rule. Leases covering oil andgas production rights and mineral and timberrights are not to be considered leases forpurposes of this rule .. For purpose~ of thisrule, a financing lease is defined as a leasewhich, during the. noncancelable lease period,either (i) covers 75 percent or more ofthe economic life of the property or (ii) hasterms which assure the lessor a full recoveryof the fair market value (which would normallybe represented by his investment) ofthe property at the inception of the leaseplus a reasonable return on the use of theassets invested subject only to limited risk inthe realization of the residual interest in theproperty and the credit risks generally associatedwith secured loans. The disclosuresset forth under sections (1) and (2) below areonly required if gross rental expense in themost recent fiscal year exceeds one percentof consolidated revenues.(1) Total rental expense (reduced by rentalsfrom subleases, with discl'"osure ofsuch amounts) entering into the determinationof results of operations foreach period for which an income statementis presented shall be disclosed.Rental payments under short-termleases for a month or less which are notexpected to be renewed need not beincluded. Contingent rentals, such asthose based upon usage or sales, shallbe reported separately from the basic

ACCOUNTING SERIES RELEASES 265or minimum ·rentals. Rentals on' noncapitalizedfinancing leases shall beshown separately for both categories ofrentals reported.(2), The minimum rental commitments underall noncancelable leases shall bedisclosed, as of the date of the latestbalance sheet presented, in the aggregate(with disclosure of the amountsapplicable to noncapitalized financingleases) for (i) each of the five succeedingfiscal years; (ii) each of the nextthree five year periods; and (iii) theremainder as a single amount. Theamounts so determined should be reducedby rentals to be received fromexisting. noncancelable subleases (withdisclosure of the amounts of such rentals).For purposes. of this rule, a noncancelablelease is defined as one thathas an initial or remaining· term ofmore· than one year and is noncancelable,or is cancelable only upon the occurrenceof some remote contingencyor upon the payment of a substantialpenalty.•(3) Additional disclosures shall 'be made toreport in general terms: (i) the basis forcalculating rental payments if dependentupon factors other than the lapse oftime; (ii) existence and terms of renewalor purchase options, escalationclauses, etc.; .(iii) the nature andamount of related guarantees made orobligations assumed; (iv)' restrictionson paying dividends, incurring additionaldebt, further leasing, etc.; and (v)any other information necessary to assessthe effect of lease commitmentsupon the financial position, results ofoperations, and changes in financial positionof the lessee ..(4) For all noncapitalized financing leasesthere shall be disclosed:(i) The present values of the minimumlease commitments in " the aggregateand by major categories of properties,such as real estate, aircraft, truckfleets and other equipment. Presentvalues shall be computed by discountingnet lease payments (after subtracting,if practicable, estimated, or actualamounts, if any, applicable to taxes,Insurance,' niaintenanceand other operatingexpenses) at the interest rateimplicit in the terms of each lease atthe time of entering into the. lease.Such disclosure shall be made as of thedate of any balance sheet presented. Ifthe present value of the minimum leasecommitments is less than five percentof the sum of long-term debt, stockholders'equity and the present value of the .minimum lease commitments, and ifthe impact on net income required to be. disclosed under (iv) below is less thanthree percent of the average net incomefor the most recent three years,this disclosure is not required.(ii) Either the weighted average interestrate (based on present value)and range of rates or specific interestrates for all lease commitments includedin the amount disclosed under (i)above.(iii) The present value of rentals tobe received from existing noncancelablesubleases of property included under(i) above based on the interest ratesimplicit in the terms of the subleases atthe times of entering into the subleases." (iv) The impact upon net income foreach period for which an income statementis presented if all noncapitalized. financing leases were capitalized, relatedassets were amortized on astraight-line basis and interest 'costwas accrued on the basis Of the out~standil1-g lease liability. The amounts ofamortization and interest cost includedin the computation shall be separatelyidentified. If the impact on net incomeis less than three percent of the averagenet income for the most recent·three years,' that fact may be stated inlieu 'of this disclosure. In calculatingaverage net income, loss years should. be excluded. If losses were incurred ineach of the most recent three years, theaverage loss shall be used for purposesof this test.*****

266 SECURITIES AND EXCHANGE COMMIsSIONThe foregoing amendments are. adoptedpursuant to Sections 6, 7;8, 10 a!ld, 19(a) ofthe Securities Act of 1933; .Sections 12, 13,15(d) and 23(a) of the Securities ExchangeAct of 1934; and Sections 5(b), 14 and 20(a) ofthe Public Utility Holding Company Act of1935. The amendments shall be. effectivewith respect to financial statements filedwith the' Commission subsequent to' November30, 1973.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 148November 13, 1973SECURmES ACT OF 1933Release'No.5436-SECURITIES EXCHANGE ACT OF 1934Release No. 10493PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 18168INvESTMENT COMPANY ACT OF 1940Release No. 8082Notice of Adoption of Amendments to Regulation SoX and Related Interpretations and GuidelinesRegarding Disclosure of Compensat~g Balances and Short~term Borrowing ArrangementsA. INTRODUCTIONOne of the amendments in Accounting SeriesRelease No. 125, adopted by the Commissionon June 23, 1972, changed Rule 5-02-1 ofRegulation S-X relating to .cash and cashitems to require disclosure of funds subjectto withdrawal or usage restrictions such ascompensating balances. Since then the Commissionhas received many inquiries concerningthe form of disclosure contemplatedby this amendment. Preliminary interpretationsand guidelines were drawn up and exposedin November 1972 to interestedgroups. Based on comments received fromindustry and professional groups at thattime, it became apparent that additionalamendments to the rules were required in~ddition to interpretations and guidelines.Accordingly, on April 12, 1973, proposed revisionsto Regulation S-X Rules 5-02-1, 5-02-25,5-02-29, 5-02-30 and 5-02-32 along with associatedinterpretations and guidelines were issuedfor public comment. These revisionsattempted to refine the requirements for,and to facilitate understanding and implementationof, disclosure relating to restrictedfunds and the effective cost of borrowing.Comments Received and Revisions AdoptedThe letters of comment received oil theApril 12, 1973, proposal raised a number ofproblems which have been carefully consideredin developing the final requirements,interpretations and guidelines set forth inthis release. The principal changes in theoriginal proposal that have been incorporatedinto the current release are as follows:1. Compensating balances are to be segregatedon the balance sheet only if theyare legally restricted under the terms ofthe arrangement while any oth~'r determinableamounts of funds which are heldas compensating balances are to be disclosedin the notes to the financial statements.Segregation recognizes that certaincash balances at the balance sheet dateare not readily available for discretionaryuse by management. Footnote disclos~reemphasizes information about finanCIalmanagement decisions which effectivelyrestrict the availability of cash funds over

AccouNTING SERIES RELEASEStime for alternative income yielding opportunitieseven though no legal restrictionsexist which preclude such use.2. The proposed requirement that the,effective int~rest rate (including the impactof compensating balances, fees, etc.)on borrowings be disclosed has been eliminated.Comments received indicated manypractical difficulties in determining such arate and the Commission has concludedthat such problems make it impractical torequire this disclosure' in financial statementsas a general rule although the Commissionencourages such disclosure whensignificant and practicable. The other proposeddisclosure requirements relating toshort-term borrowings have been adopted.In addition to these major changes, a numberof other technical changes' have beenmade in the rules, interpretations and guidelinesin response to specific substantive difficultiesraised or requests for clarifications ofterms used. None of these changes constitutesa substantive increas~ in previouslyproposed requirements. Specifically, Rules 5-02-1, 5-02-18, 5-02-25, 5-02-29 and 5-02-32 ofRegulation S-X are amended by this release.Reasons for RequirementsThe management of liquidity is an impor~tant part of the financial management of abusiness entity. The maintenance of shorttermborrowing capacity and the ability toobtain such funds at reasonable cost aremajor elements of Such a management responsibility.If investors are to understandthe financial policies of mariagement, disclosurerelative to these elements is necessary.It is generally recognized in the financialcommunity that one of the htajor elements inshort-term financing policy is the maintenanceof compensating balances supportingpresent and future credit from financial institutions.Such balances affect liquidity andt~e effective cost of borrowing. N~vertheless;dISclosure of the essential details of such:~angements has. been infrequent. WhenI~closure has occurred, the information sup­PI~ed has generally been insufficient to per­~lt stat~ment users to deal analytically withe subJect. Lack of disclosure of amountsaffecting liquidity such' as ~omp~~sati~g'balanceshas been justHi~don th~ grounds thats'uch arrangements were generally . unwritten,informal and riot subject to precisequantification. None of these' re"asonsaresufficient to support a policy of nondisclosureof situations which are recognized to be bothreal and significant. They do, however, supportthe need for rule changes and disclosureguidelines so that reasonably uniform andunderstood standards for disclosure can beapplied. They also indicate that disclosuremust be based in many circumstances onreasonable estimates and that precision ofmeasurement cannot be expected.The interest rate paid for short-term borrowingsis also of significance in appraisingthe financial policies and operating r~sults ofbusiness entities. Changes in this rate overtime may have a significant impact on profitability.The relationship of the rate paid atyear end to short-term rates generally beingcharged at that date to corporate borrowersmay be indicative of the future level of interestcosts to be incurred by the corporationunder varying conditions in the credit markets.In addition, information as to the magnitudeof such borrowings during a fiscalperiod should further assist investors in determiningthe impact of changing credit conditionsoil businessoperitions.it is recognized that disclosures such asthose set forth herein are of primary interestto those users of financial statements whowish to undertake detailed analysis of corporate'acti~ities and may not be required infinancial disclosure oriented solely to theneeds of the average investor.B. AMENDMENTS TO REGULATION S-XRules 5-02-1, 1>-02-18, 5-02-25, 5-02-29 and 5-02-32 are amended as follows:Rule 5-02-1. Cash and cash items.State separately (a) cash on hand and unrestricteddemand deposits; (b) restricted depositsheld as compensating balances againstshort-term borrowing arrangements; (c) timedeposits and certificates of deposit (excludingamounts included in (b) above or Rule 5-02-18(c) below); (d) funds subject to repaymenton call or immediately after the date of

268 SECURITIES AND EXCHANGE COMMISSIONthe balance sheet required to be filed; and (e)other funds, the amounts of which are knownto be subject to withdrawal or usage restrictions,e.g., special purpose funds. The generalterms and nature of such repayment provisionsin (d) and withdrawal or usage restrictionsin (e) shall be described in a note referredto herein. In cases wherecompensating balance arrangements existbut are not agreements which restrict theuse of cash amounts shown on the balancesheet, describe these arrangements and theamounts involved, if determinable, in thenotes to the financial statements. Compensatingbalances that are maintained underan agreement to assure future credit availabilityshall be separately disclosed in thenotes to the financial statements along withthe amount and terms of such agreement.Rule 5-02-18. Other assets.State separately (a) noncurrent receivablesfrom persons specified in captions 3(a)(1)and (4) above; (b) each pension or other specialfund; (c) deposits held as compensatingbalances ag~inst long-term borrowing arrangements;and (d) any other item not properlyclassed in one of the preceding assetcaptions which is in excess of five percent oftotal assets.Rule 5-02-25. Accounts and notes payable.(a) State separately amounts payable to(1) banks for borrowings; (2) holders of commercialpaper; (3) trade creditors; (4) parentsand subsidiaries; (5) other affiliates andother persons the investments in which areaccounted for by the equity method; (6) underwriters,promoters, directors, officers, employeesand principal holders (other thanaffiliates) of equity securities of the personand its affiliates; and (7) others. Excludefrom (6) amounts for purchases from suchp.erson subject to usual trade terms, for ordinarytravel expenses, and for other suchitems arising in the ordinary course of business.With respect to (4) and (5), state separatelyin the registrant's balance sheet theamounts which in the related consolidatedbalance sheet are (i) eliminated and (ii) noteliminated.(b) The average interest rate and generalterms (as well as formal provisions for theextension of the maturity) of each categoryof aggregate short-term borrowings (the sumof items (a)(l) and (a)(2) above) reflected onthe balance sheet at the end of the periodshall be disclosed along with the maximumamount of aggregate short-term borrowingsoutstanding at any month end (or similaraccounting period) during the period. In addition,the approximate average aggregateshort-term borrowings outstanding duringthe year and the approximate weighted averageinterest rate (and a brief description ofthe means used to compute such averages)for such aggregate short-term borrowingsshall be disclosed in the notes to the financialstatements.(c) The amount and terms (including commitmentfees and the conditions under whichlines may be withdrawn) of unused lines ofcredit for short-term financing shall be disclosed,if significant, in the notes to thefinancial statements. The amouJlt of theselines of credit which support a commercialpaper borrowing arrangement or similar arrangementsshall be separately identified.Rule 5-02-29. Bonds, mortgages and similar~M- .(a) State separately here, or in a note referredto herein, each issue or type of obligationand such information as will indicate(see Rule 3-13) (1) the general character ofeach type of debt including the rate of interest;(2) the date of maturity, or if maturingserially, a brief indication of the serial maturities,such as "maturing serially from1980 to 1990"; (3) if the payment of principalor interest is contingent, an appropriate indicationof such contingency; (4) a brief indicationof priority; (5) if convertible, the basis;and (6) the combined aggregate amount ofmaturities and sinking fund requirementsfor all issues, each year for the five yearsfollowing the date of the balance sheet. Foramounts owed to affiliates, state separatelyin the registrant's balance sheet theamounts which in the related consolidatedbalance sheet are (i) eliminated and (ii) noteliminated.(b) The amount and terms (including commitmentfees and the conditions under whichcommitments may be withdrawn) of unused

ACCOUNTING SERIES RELEASES 269com:mitment;::; for long-term financing arrangementsthat. woulq. pe disclosed underthis rule if used shall be disclosed in thenote!3 to the financial statements if siguificant.'Rule 5-02-32. Other long-term debt.(a) Include under this caption all amountsof long-term debt not provided for undercaptions 29(a) and 31 above. State separatelyallJ.ounts payable to (1) persons specified incaptions 25(a)(1), (2) arid (5); and (2) othersspecifying any material item. Indicate th~extent that the debt is collateralized. Showhere, or in a note referred to herein, theinformation required under caption 29.(b) The amount and terms (including commitmentfees and the conditions under whichcommitments may be withdrawn) of unusedcommitments fot: long-term financing arrangementsnot provided for under caption29(b) above shall be disclosed in the notes tothe financial statements if significant.C. GUIDELINES AND INTERPRETATIONSGuidelines and interpretations are presentedbelow to facilitate understanding andapplication of the revised rules as amended.Com~ensating Balances'Rules 5-02-1 and 5-02-18· have been expandedto require disclosure of compensatingbalances in order to avoid undisclosed comminglingof such balances with other fundshaving different liquidity characteristics andbearing no determinable relationship to borrowingarrangements. Rule 5-02-1 also requiresfootnote disclosure distinguishing theamounts of such balances maintained undera formal agreement to assure future creditavailability. While these rule changes eliminatecertain inconsistencies previously~~ted, comments received indicate consideraeuncertainty in the application of any rulereI . a t" mg to compensatmg .' balanees. Accord-~~gly, the Commission has 'concluded that. e following guidelines are necessary to as­SIS t registrants.DefinitionA compensating balance is defined as thatportion of any demand deposit (or any timedeposit .or certificate of deposit) maintainedby a corporation (or by any other person onbehalf of the corporation) which constitutessupport for existing borrowing arrangementsof the corporation (or any other person)with a lending institution. Such arrangementswould include both outstandingborrowings and the· assurance .of . futurecredit availability.Form of DisclosureThe manner of disclosure cannot be specifiedwith precision since it will vary accordingto the factual situation involved. Theserules call for disclosure of compensating bal~ance arrangements. Such disclosure will involvesegregation on the face of the balancesheet whenever such balances are maintainedunder an agreement which legallyrestricts the use of such funds. Examples ofsuch arrangements would include situationswhere a certificate of deposit must be heldwhile a loan is outstanding or where a minimumbalance must be maintained at alltimes while credit is extended or available.Footnote disclosure will be appropriate inother circumstances where such balancesare determinable amounts although not legallyrestricted as to withdrawal. Footnotedisclosure would be required. even thoughthe arrangement is not reduced to writing ifdeterminable amounts (e.g., a percentage ofshort-term borrowings, a percentage of unusedlines of credit, an agreed average balance)have been agreed upon by both partiesinvolved. An .arrangement where the balancerequired is expressed as an average overtime would ordinarily lead to additional footnotedisclosure of the average amount requiredto be maintained for arrangements inexistence at the reporting date since theamount held at the close of the reportingperiod might vary significantly from the averagebalance held during the period andbear little relationship to the amount requiredto be maintained over time. If arrangementsrequiring maintenance of compensatingbalances during the year werematerially greater than those at year endthat fact should be disclosed. Disclosure rna;

270 SECURITIES ANi> EXCHANGE COMMISSiONalso include a statement, if appropriate, thatthe amounts are legally subject to withdrawalwith or without sanctions, as applicable.If many banks are involved, the disclosureshould summarize the most commonarrangements and aggregate the compensatingbalances involved.Where a company is not in compliance witha compensating balance requirement, thatfact generally should be disclosed along withstated or possible sanctions whenever suchpossible sanctions may be immediate (notvague or unpredictable) and material.In determining whether compensating balancearrangements are sufficiently materialto require segregation or disclosure, variousfactors should be considered. Among thesemay be the relationship of the amount of thebalances to total cash, total liquid assets andnet working capital, and the impact of thebalances on the effective cost of financing. Inthe usual case, reportable compensating balanceswhich in the aggregate "amount" tomore than. 15 percent of liquid assets (currentcash balances, restricted and unrestricted,plu'3 marketable securities) wouldbe considered to be material. Lesser amountsmay be material if they have a significantimpact on the cost of financing.Compensating balances maintained by thecompany for the benefit of affiliates, officers,directors, principal stockholders or othersimilar parties may be of particular significanceto investors. Separate disclosure ofsuch balances may be required under otherCommission rules and regulations even ifthey are not of a magnitude such that theywould meet the materiality guidelines setforth above.Measurement ProblemsA number of problems arise in the processof determining the amount of compensatingbalances. It is recognized that precision ofmeasurement may not be practicable, butthat fact should not limit the disclosure ofmaterial arrangements since reasonable estimatescan be made. Since several of theproblems of measurement occur frequently,and since it is desirable that they be similarlysolved to assure uniformity of practiceamong companies, the following guidelineshave been developed to assist regIstrants. Itis recognized that every situation cannot beanticipated, and the need for judgment onthe part of registrants and their auditorscannot and should not be avoided.1. Minimum operating balance.-All corporationsrequire some minimum amount ofcash on "which to operate. The amount willdepend upon the extent of seasonal and randomfluctuations in short-term cash demandas well as management judgment regardingnecessary safety factors. It has been arguedthat, in those cases where" part of the" compensatingbalance reflects funds that wouldbe held anyway as a minimum operatingbalance, such funds should be subtractedfrom compensating balances since the maintenanceof such a compensating balance hasno incremental cost to the borrower .. Forpurposes of these disclosure requirements,such a subtraction is not appropriate. Theconcept of subtraction implies that the" com-"pensating balance" is of secondary "iniportanceand this is by no means apparent. Itwould be equally reasonable to contend thatoperating funds are free of cost because compensatingbalances must be maintai~ed. Inany event, the utilization of such amountsfor compensating balances precludes thesound cash management alternat"ive. of investingavailable cash in highly liquid interestbearing securities. It may be desirable,however, for companies to supplement disciosurewith statements regarding the dualpurpose of such amounts.2. Float.-The balance" shown on thebank's ledgers and the company's books willdiffer due to delays in presentment of checksand deposits in transit. In addition . someamounts included in the bank ledger' figuremay include funds subject to collection whichmay not be considered as meeting compensatingbalance requirements." These factorscomplicate the calculation of the amount ofcompensating balance to be disclosed bothconceptually and empirically. The compensatingbalance arrangements negotiated betweena company and its bank are normallyexpressed in terms of the collected bankledger balance, but the financial statements

ACCOUNTING SERIES RELEASES 271are pr:esented on the basis of the company'sbooks. hi order to make the disclosure ofcompensating balance amounts segregatedon the balance sheet consistent with thecash amounts reflected in the financial statements,the balance figure agreed upon by thebank and the company should be adjusted ifpossible by the estimated "float" so thatsuch an adjusted amount shown on the balancesheet will properly relate to companybook amounts for total cash. Both the agreedupon collected balance at the bank and theadjusted balance relating to the corporation'sbooks should be disclosed along with abrief description of the criteria used to makethe adjustment. Similar adjustments anddisclosure should be made for arrangementsdisclosed only in the footnotes if practicableand relevant to the arrangements described.A reasonable estimate of "float" based onthe information management uses to manageits bank relationships will be satisfactory.3. Compensation for other bank services.­Balances are maintained not only in connectionwith financing arrangements but also tocompensate the bank for its account handlingfunction and in some cases to· pay forother services such as lock boxes and accountreconcilement. Balances maintainedfor these purposes should not be included inthe disclosed compensating balances andwould not be construed as special funds per5-02-1(e) since such funds are available foruse upon payment of a service charge andwould not affect the cost of borrowing. If abank allows balances to serve both purposes,the balances should be' considered as a compensatingbalance and should be disclosed inaccordance with Rules 5-02-1 or 5-02-18 asappropriate. Supplemental', disclosure bycompanies of the dual purpose of suchamounts may be desirable.4. Reporting periods.-In general, com pens~tingbalance arrangements should only be?Isclosed for the latest fiscal year and laterInterim period for which statements are presented.If the terms of the arrangementsre .t

·272 SECURITIES AND EXCHANGE COMMISSIONlong- and short-term future credit availabilityin the notes to the financial statements.Separate disclosure provides important anduseful information to the investor about policiesregarding cash management and futurefinancing.. Commercial Paper and Debt Roll-OverRule 5-02-25 has been expanded to provideinformation to the investor regarding borrowingpolicies and their cost. The separate~tatement ~~ commercial paper outstandingIS a recogmtIon of the increasing importanceof this form Of short-term borrowing in corporate. financial management. Commercialpaper represents short-term unsecured notesissued for cash by the corporation, generallysupported in whole or part by outstandinglines of credit extended by financial institutions.Commercial paper and other short-termdebt should be classified as a current liabilityeven though the issuer's intention is toroll over such debt at its maturity. The factthat art issuer has both financial strengthand a past borrowing record such that sale ofnew paper appears reasonably assured doesnot constitute a basis for long-term classification,\since the power to terminate thecredit remains with the creditor. Only (1)when a borrower has a noncancelable bindingagreement from a creditor to refinancethe paper (or other short-term debt) and (2)when the refinancing extends the maturitydate beyond one year or the current operatingcycle of the business (whichever islonger) and (3) when the borrower's intentionis to exercise this right, should borrowingsunder such an agreement be shown as along-term liability (along with disclosure ofthe above facts). 1Unused Lines of Credit or CommitmentsRules 5-02-25, 5-02-29 and 5-02-32 also callfor the disclosure of the amount and terms ofunused lines of credit and commitments ifsignificant. Various factors should be consid-I This paragraph was subsequently rescinded in AccountingSeries Release No. 172, June 13, 1975.ered in determining significance such as totaldebt by term of such debt, total capital,total cash requirements, and the like.The disclosure of unused lines and commitmentssupplies the investor with informationregarding borrowing potential and futureliquidity under varying money market conditions.It is recognized that lines of credit orcommitments are frequently extended to aborrower subject to the condition that theborrower maintain certain standards ofcredit worthiness, and that the existence ofsuch lines or commitments therefore doesnot assure the availability of credit underconditions of deteriorating financial position.Accordingly, the rule provides that disclosurebe made of the conditions under whichlines or commitments may be withdrawn. Itis also recognized that such lines and commitmentsare occasionally offered by financialinstitutions as a marketing device andaccepted by corporations -without any intentionof use and not as part of their financingplan. Disclosure of such lines is not contemplatedby this rule.Unused lines disclosed as supporting commercialpaper or other debt arrangementsshould include only usable lines. For thispurpose usable lines are construed to betotal lines used to support commercial paperless lines needed to meet "clean-up" provis~o?sof a bo.rrowing arrangement. Such pro­VISIons reqUIre borrowers to retire credit ex­~ended at a bank or banks at some specifiedmterval for a specified period. Total linesoutstanding are therefore not necessarily ameasure of the total credit available on acontinuing basis. Similarly, if a corporationhas lines arranged with several banks whichin total exceed borrowing levels permittedunder existing lending agreement~, disclosureshould be limited to usable amounts.Rules 5-02-29 and 5-02-32 would includedisclosure of commitments such as standbycommitments, commitments for future disbursements,and unused revolving creditsmaturing after one year.ResponsibilitiesThe registrant is responsible for preparingfinancial statement disclosure of short-term

ACCOUNTING SERIES RELEASES 273interest rates, compensating balances, unusedconfirmed lines of credit, commercialpaper and other disclosures as specified inthese rules' and guidelines. The independentaccountant has the responsibility of satisfyinghimself that the disclosure is adequate.When arrangements such as" compensatingbalances and unused confirmed lines ofcredit exist, their determination and verificationwould be facilitated and more readilysubstantiated if the borrower set forth thebases of the mutual understanding in a lettersubmitted to the lender (or potentiallender) with a 'request for confirmation.* * * * *The amendmel)ts to Regulation S-X. havebeen adopted pursuant to authority conferredon the Commission by the SecuritiesAct of 1933, particularly Sections 6, 7, 8, 10and 19(a) thereof; the Securities ExchangeAct of 1934, particularly Sections 12, 13, 15(d)and 23(a) thereof; the Public Utility HoldingCompany Act of 1935, particularly Sections5(b), 14 and 20(a) thereof; and the InvestmentCompany Act of 1940, particularly Sections8, 30, 31(c) and 38(a) thereof.The above amendments to Rules 5-02-1, 5-02-18, 5-02-25, 5-02-29 and 5-02-32 of RegulationS-X shall be applicable to financialstatements filed after December 31, i973, forperiods beginning on or after December 30,1972. Requirements for disclosure of compensatingbalances as stated in Rule 5-02-1 priorto this release are deferred until December31, 1973, at which time these amendmentsshall take effect.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 149November 28, 1973SECURITIES ACT OF 1933Release No. 5441SECURITIES EXCHANGE ACT OF 1934.Release No. 10523PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 18190INVESTMENT COMPANY ACT OF 1940Release No. 8104Notice of Adoption of Amendment to Regulation S-X to Provide for Improved Disclosure of. Income Tax ExpenseThe Securities and Exchange Commissiontoday adopted amendments to Rule 3-16(0) ofRegulation S-X calling for improved disclosureof income tax expense in financial statementsfiled With . the Commission. Theseamendments were originally proposed on December18, 1972 (Securities Act Release No.5344) and then were reissued in revised formfor additional comment on September 12,1973 (Securities Act Release No. 5421).The final rule includes a number ofch~nges made in response to comments receIVedalthough the basic requirements ofthe ..orIgmal proposal which called for disclo-SUre of the components of tax expense, thereasons for timing differences between bookand tax reporting resulting in deferred incometaxes, and a reconciliation between theeffective income tax rate indicated by theincome statement and the statutory Federalincome tax rate have been retained and areadopted hereby. The proposal that theamount of deferred taxes shown on the mostrecent balance sheet which will be reflectedin tax expense reported in income statementsfor each of the next five years bedisclosed has been revised. The revision requiresd:sclosure of deferred tax reversalsonly in cases where the registrant expectsthat the cash outlay for income taxes with

274 . SECURITIES AND .EXCHANGE COMMISSION... - " . .r~spect to any of the succeeding three yearswill substantially exceed income tax expensefor such year. - . .The objectives of th~se disclosure requirementsare to enable users of financial statementsto' understand better the basis for theregistrant's tax accounting and the degree towhich and the reasons why it is able tooperate -at a different level -of tax expense~han that, which would be .incurred at thesta~utory tax rate. )3y developing such anunderstanding, users will. be able to distinguishmore easily between one time and continuingtaxadvantage~_ enjoyed by a companyand· to appraise the significance ofchanging effective tax rates. In addition,users wiUbe able to gain additional insightsinto the current and prospective cash· drainassociated with payment of income taxes.Discussion of Comments ReceivedNumerous comments were received in' responseto the exposure of this rule. I~ general,analysts and other users indicated thatthe required disclosure would,be very helpfulto them in the process of analyzing resultsand determining the earning power of a corporation.'Financial executives generally op:posed the disclosure on the grounds that itwould be costly to produce and would providedetails which would, be of little value- to theaverage investor. The Commission has concludedthat the benefits of the disclosure aresufficient to require. its presentation in financialstatements filed with the Commissionbut it recognizes that the detailed disclosureprovided herein will be primarily ofinterest to professional analysts who havethe obligation to develop an understandIngin depth of corporate results and may not berequired in financial disclosure designed forthe average investor. The Commission notes,however, that financial statements prepared. in conformity with generally accepted accountingprinciples as set forth in AccountingPrinciples Board Opinion No. 11 requiredisclosure of the "reasons for significant variationsin the customary relationships betweenincome tax expense and pretax accountingincome if they are not otherwiseapparent from the financial statements orfrom the nature of the entity's business" andit oelieves that m~ny of the disclosures requiredby Rule 3-16(0) may be necessary inorder to reflect the spirit of Opinion No. 1I.A number of commentators suggested thatthe Commission does not have the authorityto require disclosure of the information relatingto income taxes because such informationappears on the income tax returns of thecorporations and is therefore confidential.The Com!fiission finds no merit in this position.The requirements for full and fair disclosureof material information to investigatorsare a basic part of the Securities Act of1933 and the Securities Exchange Act of1934. Each Act proy-ides that. registrationstatements filed under the Act must contain,in addition to other information specified,such information "as the Commission may byrules or regulations require as being necessaryor appropriate in the public interest orfor the protection of investors."! Both Actsalso grant to the Commission the power toprescribe, w~th regard to documents requiredto be· filed, "the form or forms in whichrequireq information shall be set forth, andthe items or details to be shown in the balancesheet and earning statement. . . ."2 TheCommission believes that the amendmentsto Reguhitlon S-X adopted today are entirelyconsistent with its express authority underthe Acts. The type of information required tobe disclosed by these amendments is, in theopinion of the Commission, material to investorsas noted above.Other comments indicated that the rulewould require disclosure of informationwhich would be valuable to competitors sinceit would reveal tax strategy or which wouldlead taxing authorities to question tax de-I Section 7 of the Securities Act of 1933 (Act) andSection 12(g) and (b) of the Securities Exchange Act of1934 (Exchange Act). In addition, Section 13(a) of theExchange Act requires issuers of securities registeredunder that Act to file reports and information "in aCcordancewith such rules and regulations as the Commissionmay prescribe as necessary or appropriate f~rthe proper protection of investors and to insure fairdealing in the security."2 Section 19(a) of the Act and Section 13(b) of theExchange Act.

ACCOUNTING SERIES RELEASES . , 275ductions or assess claims based on amountsprovided' in computing tax expense whereitems subject to varying tax interpretationswere treated in a manner favorable to thetaxpayer~ Those who made such commentsdid: 'not provide specific examples of itemsand amounts involved, but the Commissionbelieves that most items of this sort would beof a size such that disclosure would not berequired under the significance criteria setforth in the rule. In those cases, if any,where the amounts involved are sufficientlylarge to require disclosure the needs of presentand potential investors in public corporationsare best served by providing such significantinformation even though there maybe an in~reased risk of adverse consequencesat the hands of competitors:Numerous commentators raised questionsabout the proposed requirement that disclosurebe made of the amounts of deferredincome taxes shown on the year-end balancesheet' which are expected to be reflected ascomponents of tax expense in each of thenext five years. It was pointed out that thisdisclosure would not achieve the stated objectiveof providing insights into potentialfuture cash outlays for taxes since in thenormal case one tax deferral is expected tobe replaced by another. Hence the data proposedto be required might lead to the misleadinginference that a substantial cashoutlay for taxes would be likely in the fiveyearperiod covered when such was not thecase. The Commission recognizes the validityo~ these comments and has revised this partIcularproposal. The revised requirement~a~ls for disclosure only in those cases whenIt IS expected that the cash outlay for incometaxes with respect to any of the succeedingthree years will substantially exceed incometax expense for such year. 'The Amended RulesInasmuch as certain of the ~~quirementsunder Rule 3-16(0) relate also to Rule 5-02-19Pto re Ifal 'd expenses and deferred charges, and 'h ule 5-02-35, Deferred credits, these rulese~"e been amended to include a cross-refereeto Rule 3-16(0).The text of amended· Rules 3-16(0) 5-02-19and 5-02-35 follows: '. :' '. "* * * * *Rule 3-16. General Notes to Financial Statements* * * * *(0) Income tax expense.-(I) Disclosureshall be made, in the income statement or anote thereto, of the components of incometax expense, including: (i) taxes currentlypayable; (ii) the net tax effects, as applicable,of (a) timing differences (Indicate separatelythe amount of the estimated tax effect ofeach of the various types of timing differences,such as depreciation, research anddevelopment expense, warranty costs, etc.Types of timing differences that are individuallyless than 15 percent of the deferred taxamount in the income statement may becomb~ned. If no individual type of differenceis more than five percent of the amountcomputed by multiplyii-tg the income beforetax by the applicable statutory Federal incometax rat~arid the. aggregate amount oftiming differences is less than five percent ofsuch computed amount, disclosure of each ofthe separate types of timing differences maybe omitted.) and (b) operating losses; and (iii)the net defe,rred investment tax credits.Amounts applicablE;! to United States Federalincome taxes, to foreign income taxes and toother income taxes shall be stated sepa~atelyfor each major component, unless' theamounts applicable to foreign and other incometaxes do not excee'd five percent of thetotal for the component.(2) If it is expected that the cash outlay forincome taxes with respect to any of the succeedingthree years will substantially exceedincome tax expense for such year that factshould be disclosed together with the approximateamount of the excess, the year (oryears) of occurrence and the reasons therefor.(3) Provide a reconciliation between theamount of reported total income tax expenseand the amount computed by mUltiplying theincome b~fore tax by the applicable statutoryFederal income tax rate, showing theestimated dollar amount of each of the un-

276 SECURITIES AND EXCHANGE COMMISSIONderlying causes for the difference. If no individualreconciling item amounts to morethan five percent of the amount computed bymultiplying the income before tax by theapplicable statutory Federal income taxrate, and the total difference to be reconciledis less than five percent of such computedamount, no reconciliation need be providedunless it would be significant in appraisingthe trend of earnings. Reconciling items thatare individually less than five percent of thecomputed amount may be aggregated in thereconciliation. The reconciliation may be presentedin percentages rather than in dollaramounts. Where the reporting person is aforeign entity, the income tax rate in thatperson's country of domicile should normallybe used in making the above computation,but different rates should normally be usedin making the above computation, but differentrates should not be used for subsidiariesor other segments of a reporting entity; Ifthe rate used by a reporting person is otherthan the United States Federal corporateincome tax rate, the rate used and the basisfor using such rate shall be disclosed.* * * * *Rule 5-02. Balance Sheets.* * * * *19. Prepaid expenses and deferredcharges-State separately any materialitems. Items properly classed as currentmay, however, be included under caption 8.(See also Rule 3-16(0).)* * * * *35. Deferred credits-State separ;,t.telyamounts for (a) deferred income taxes, (b)deferred tax credits, and (c) material items ofdeferred income. The current portion of deferredincome taxes shall be included undercaption 26 (see Accounting Series ReleaseNo. 102). (See also Rule 3-16(0).)* * * * *.. " '. ",' fIn order to clarify the rules' as adopted, anexample of disclosure and associated assumptiopsand computations h;,t.s been .attachedas an exhibit to thi!!l .release ..* * * * *The amendments to Regulation S-X havebeen adopted pursuant to authority. conferredon the Commission by the SecuritiesAct of 1933, particularly Sections 6, 7,,8, 10and 19(a) thereof; the Securities ExchangeAct of 1934, particularly Sections 12, 13, 15(d)and 23(a) thereof; the Public Utility HoldingCompany Act of 1935,· particularly. Sections5(b), .14 and 20(a) thereof; 'and the. InvestmentCompany Act of 1940,particuiarly Sections8, 30, 31(c) and 38(a) thereof.The above amendments to Regulation S-Xshall be applicable to financial statementsfor periods ending on or after December 28,1973. Such disclosure is recommended butnot required for financial statements of priorperiods included in filings with the Commissionsubsequent to December 31., 1973.By the Commission.GEORGE A. FITZSIMMONSSecretary .

ACCOUNTING SERIES RELEASES 277EXHIBITThe following example of the disclosure required under Rule 3-16(0) is provided to assist registrants in appraising·theproposal and in complying with it.I. AssumptionsThe following facts appiy to a hypothetical business corporation for the calendar year 1973 (all fi~res in thousands)Book income before tax _____________________________________________________________________________________ $15,000(1) Assets purchased at the beginning of 1973 at a cost of $10,000, eight year life, double declining balance.~~preciation for tax purposes, straight line on books, eligible for 7% investment credit. .(2) Research costs of $3,000 deducted on tax return but amortized over following years for book purposes.(3) Warranty reserve of $1,400 provided for book purposes is not deductible for tax purposes until warranty costsare incurred.(4) Income before taxes includes $2,000 related to construction-type contracts still in process which are accountedfor on the percentage of completion method for book purposes and on the completed contract method for taxpurposes.(5) Amortization of goodwill of $800 is not deductible for tax purposes.(6) Book income before taxes includes $2,400 which represents the net income of wholly-owned foreign subsidiariesthat are expected to indefinitely invest their undistributed earnings. Foreign Subsidiary A is permitted underits local tax laws to deduct a provision for an inventory reserve related to increased inventory levels. Thereserve would be reduced in periods of inventory decline. For consolidated financial statement purposes, nosuch accrual is made and the associated deferred tax expense is $420. The subsidiaries have reportable taxes intheir respective foreign jurisdictions as follows:Foreign ForeignSubsidiary A Subsidiary B TotalForeign Book Income before Taxes __________________________________ _ $2,100 $300 $2,400" . ~Foreign Jurisdiction TaX Rate ______________________________________ _ 30% 50%Currently Taxable Income __________________________________________ _ $ 700 $300 $1,000Current Tax Expense _"' _______________________ -: ___________________ ~210 150 360Deferred Tax Expense' ____________________________________________ _ 420 -0- 420Total Foreign Income Tax Expense _________________________________ _ $ 630 $150 $ 780(7) Investments sold during the year resulted in a gain of $1,000, which is taxed at capital gain rates of 30%.(8) Included in income is $1,500 of interest on tax exempt municipal bonds.(9) State and local income taxes amounted to $400.II. Illustrative NoteNote-Income tax expense (all data in thousands).Income tax expense is made up of the following components:U.S.State &Federal Foreign Local Total$2,312 $360 $400 $3,0722,328 420 -0- 2,748'.$4,640 $780 $400 $5,820

278 SECURITIES AND EXCHANGE COMMISSIONDeferred tax expense results from timing differences in the recognition of revenue and expense for tax and financialstatement purposes. The sources of these differences in 1973 and the tax effect of each were as follows:Excess of tax over book depreciation _______________________________________________________________ _Research and development costs expensed on tax return and deferred on books ____________________ _Revenue recognized on completed contract basis on tax return and on percentage of completion basison books __________________________________________________________________________________________ _Tax deductible inveritory reserve provided in foreign tax jurisdiction _______________________________ _Warranty cost charged to expense on books but not deductible until paid ___________________________ _$ 6001,440960420(672)$2,748Total tax expense amounted to $5,820 (an effective rate of 38.8%), a total less than the amount of $7,200 computed byapplying the U. S. Federal income tax rate of 48% to income before tax. The reasons for this difference are asfollows:% ofpretax$ Amount incomeComputed "expected" tax expense ____________________________________________________ _Increases (reductions) in taxes resulting from:$7,200 48.0%Foreign income subject to foreign income tax but not expected to be subject to U. S. taxin foreseeable future ($2,400 x 48%) - $780 = $372 ___________________________________ _ $ (372) (2.5)Tax exempt municipal bond income _______________________________________ 7~~ _________ _ (720) (4.8)Investment tax credit on assets purchased in 1973 ___________________________________ _ (700) (4.7)Goodwill amortization not deductible for tax purposes ________________________________ _ 384 2.6State and local income taxes, net of Federal income tax benefit* _____________________ _ 208 1.4,Benefit from income ta'xed at capital gains rate (1,000 x 48%) - (1,000 x '30%) = $180* (180) (1.2)Actual tax expense _______________________________________________________________ _ $5,820 ' 38.8%Based upon currently anticipated expenditures and operations, it is expected that the deferred income tax balancewill be substantially reduced in 1976 and the cash outlay for taxes associated with that year will exceed tax expenseby approximately $4,000, primarily due to the book amortization in that year of research and development expensepreviously deducted for tax purposes.III. Computational Guide(Furnished only to enable interested parties to determine source of numbers shown in above illustrative note; not tobe required of registrants in filings.)A. Tax computationsBook income before tax ___ ___________________________________________________________________________ $15,000State income tax ____________________________________________________________________________________ (400)Permanent differences:Goodwill amortization ______________________________________________________ -----------Municipal bond in come _____________________________________________________________ - __Foreign income, no domestic income tax ______________________________________________ _Capital gain ______________________________________________________ ---------------------* Since these amounts are less than 5% of the computed"expected" 'tax expense, they could be combinedwith any other items less than $360 into an aggregatetotal. For example, these items could be disclosed asfollows: "Miscellaneous items ... $28 ... 0.2%."If no single item had exceeded $360 in this case andthe total net difference of all items was also less than$360, this reconciliation would not have been required.800(1,500)(2,400)(1,000) (4,100)--$10,500

ACCOUNTING SERIES RELEASES279. Timing differences:Excess depreciation __________________________________________ ~ ___________________________________ _R&D deducted on tax return ____________________________________________________________________ _Warranty cost not deductible until paid __________________________________________________________ _Percen tag~ .of completion income _________________________________________________________________ _Tax income (excl. cap. gain) ___________________________________________________________________ _(1,250)(3,000)1,400(2,000)$ 5,650Tax to be pai4Tax on ordinary incomePlus' capital gain tax.Less investment credit.48 x 5,650 _______________________________________________________ $ 2,712.30 x 1,000_______________________________________________________ 300(700)Actual tax paid ________________________________________________________________________________ $ 2,312Tax expen8eper book8Tax expense on ordinary income .48 x 10,500 ______________________ _Plus capital gain tax _______________________________________________ _Less investment credit ____________________________________________ _$ 5,040300(700)Tax expense-Federal ________________________________________ $ 4,640Foreign tax___________________________________________________ $ 780State and local income tax____________________________________ $ 400B. Facts affecting disclosure of net deferred income taxes.Estimated Changes in Deferred Income Tax Accounts on Balance Sheets:197419751976Balance-beginning of year ____________________________________________ _Additions for timing differences in each year' ________________________ _Reversals of balances at beginning of each year ________ ~ ____________ _$10,0003,000(2,000)$11,0001,500(2,000)$10,500500(4,500)Balance--end of year __________________________________________________ _$11,000$10,500$ 6,500C. Computations of disclosure limits per Rule 3-16(0)Computed amount5% of computed amount15% of deferred tax15,000 x .48 = 7,200.05 x 7,200 = 360.15 x 2,728 = 409NOTE:, Includes effect of expected expenditures in each subsequentperiod which give rise to additional tax deferrals.

280 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 150December 20, 1973Statement of Policy on the Establishment and Improvement of Accounting Principles andStandardsVarious Acts of Congress administered bythe Securities and Exchange Commissionclearly state the authority of the Commissionto prescribe the methods to be followedin the preparation of accounts and the formand content of financial statements to befiled under the Acts and the responsibility toassure that investors are furnished with informationnecessary for informed investmentdecisions. In meeting this statutoryresponsibility effectively, in recognition ofthe expertise, energy and resources of theaccounting profession, and without abdicatingits responsibilities, the Commission hashistorically looked to the standard-settingbodies designated by the profession to provideleadership in establishing and improvingaccounting principles. The determinationsby these bodies have been regarded bythe Commission, with minor exceptions, asbeing responsive to the needs of investors.The body presently designated by theCouncil of the American Institute of CertifiedPublic Accountants (AICPA) to establishaccounting principles is the Financial AccountingStandards Board (F ASB). This designationby the AI CPA followed the issuanceof a report in March 1972 recommending theformation of the F ASB, after a study of thematter by a broadly based study group. Therecommendations contained in that reportwere widely endorsed by industry, financialanalysts, accounting educators, and practicingaccountants. The Commission endorsedthe establishment of the F ASB in the beliefthat the Board would provide an institutionalframework which will permit promptand responsible actions flowing from researchand consideration of varying viewpoints.The collective experience and expertiseof the members of the F ASB and theindividuals and professional organizationssupporting it are substantial. Equally important,the commitment of resources to theF ASB is impressive evidence of the willingnessand intention of the private sector tosupport the F ASB in accompIlshing its task.In view of these considerations, the Commissionintends to continue its policy of lookingto the private sector for leadership in establishingand improving accounting principlesand standards through the F ASB with theexpectation that the body's conclusions willpromote the interests of investors.In Accounting Series Release No.4 (1938)the Commission stated its policy that financialstatements prepared in accordance withaccounting practices for which there was nosubstantial authoritative support were presumedto be misleading and that footnote orother disclosure would not avoid this presumption.It also stated that, where therewas a difference of opinion between the Commissionand a registrant as to the properaccounting to be followed in a particularcase, disclosure would be accepted in lieu ofcorrection of the financial statements themselvesonly if substantial authoritative supportexisted for the accounting practices followedby the registrant and the position ofthe Commission had not been expressed inrules, regulations or other official releases.For purposes of this policy, principles, standardsand practices promulgated by the F ASBin its Statements and Interpretations! willbe considered by the Commission as havingsubstantial authoritative support,· and thoseI Accounting Research Bulletins of the Committee onAccounting Procedure of the American Institute of CertifiedPublic Accountants and effective opinions of theAccounting Principles Board of the Institute should beconsidered as continuing in force with the same degr~of authority except to the extent altered, amende,supplemented, revoked or superseded by one ormoredStatements of Financial Accounting Standards issueby the FASB.

ACCOUNTING SERIES RELEASES 281co~trary to such F ASB promulgations willbe considered 2 to have no such support.In the exercise of its statutory authoritywith respect to the form and content of filings"under the· Acts, the Commission has theresponsibility .'to assure that investors areprovided' with adequate information. A significantportion of the necessary informationis provided by a set of basic financial· statements(including the notes thereto} whichconform to' generally accepted accountingprinciples. Information in addition to thatincluded in' financial statements conformingto generally accepted accounting principlesis also necessary. Such additional disclosuresare required to be made in various fashions,such as in financial:' statements and schedulesreported on ~y independent public accountantsor as textual statements requiredby items in the applicable forms and reportsfiled with the Commission. The, Commissionwill continue to identify areas where inves-. ,.tor .information needs exist and will determineth~ appropriate methods of disclosureto meet these needs.It must be recognized that in its administrationof the Federal Securities Acts and inits review· of filings under such Acts, theCommission staff will continue as it has inthe past to take such action on a day-to-daybasis as· may be appropriate to resolve spe~cific problems of accounting and reportingunder the particular factual circumstancesinvolved in filings and reports of individualregistrants.The Commission believes that the. foregoing. statement of policy provides a soundbasis: for the Commission and the F ASB tomake significant contributions to meetingthe needs of the registrants and investors.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 151January 3, 1974'SECURITIES ACT OF 1933Release No. 5449SECURITIES EXCHANGE ACT OF 1934Releas~ No: 10580DisclosUre of Inventory Profits Reflected in Income in Periods of Rising PricesThe year· 1973 was a period of rapidly increasingprices in. the United States whencompared to historical economic norms forthis country. 'During the year consumerprices rose by about 8 percent, wholesale~rices by about 16 percent and the crudeIndustrial materials component of the whole-C 2 It sho).lld be noted th~t Rule 203 or,the' Rules ,oft~nd~c~ of the Code of Ethics of the AICP A providesat It IS necessary to depart from accounting principles~~omulgated by the body designated by the Council ofd e AICPA if, due to unusual circumstances, failure too so Would result in misleading financial statements. In~uCh a case, the use of other principles may be acceptedr required by the Commission.sale price index by about 30 percent. Therewere wide fluctuations in the prices of individualitems.Under such conditions the usefulness ofthe traditional accounting measurementmodel based upon historical cost is significantlyreduced. The process of matchingcosts against revenues is less likely to producemeaningful economic information if thecosts· were incurred at a time when the pricelevel associated with such goods and servicesdiffered significantly from that at the timewhen revenues were realized.While a continuation or acceleration of therate of price-level change might require a. fundamental change in the basic accounting

282 SECURITIES AND EXCHANGE COMMISSIONmeasurement. model used in preparing financialstatements, it would be premature forthe Commission to suggest such a change atthis time. Careful consideration of the manyimplications of such a major step would benecessary both by the Financial AccountingStandards Board and by the Commission. Atthe same time, it does not seem appropriatethat :registrants and accountants should simplyignore the impact of rapidly changingprices on financial statements.The most significant and immediate impactof price fluctuations on financial statementsis normally felt in cost of goods sold inthe income statement. In periods of risingprices, historical cost methods result in the'. inclusion of "inventory profits" in reportedearnings. "Inventory profit" results fromhoiding inventories during a period of risinginventory costs and is measured by the differ~ncebetween the' historical cost of 'anitem and its replacement cost at the time itis sold. Different methods of accounting forinventories, can affect the degree to which"inventory profits" are incIuded and identifiablein current income, but no method basedupon historical cost eliminl:!-tes or disclosesthis "profit" explicitly. Such "profits" do notreflect an increase in the economic earningpower of a business and they are not normallyrepeatable in the absence of continuedprice-level increase. Accordingly, where such"profits" are material in income statementspresented, disclosure of their impact on reportedearnings and the trend of reportedearnings is important information for investorsassessing the quality of earnings.In recognition of the need for additionaldisclosure in regard to inventories and costof goods sold, the CommIssion recently proposedamendments to RegulationS-X (SecuritiesAct Release No. 5427, October 4; 1973)which would require registrants to indicate"the' effect on net income, if significant, ofusing current replacement cost [for valuinginventories] in the computation of cQst . ofsales." To date the Commission has receiveda large number of comments on this proposed'disclosure' and the effectiveness of thatrequirement in eliciting information about"inventory profits." The comments also indicatedthat problems of implementation existed.The Commission has given careful con:sideration to these comments and hasconcluded that it would not be desirable 'toadopt final requirements in this area whichwould be effective for 1973 financial statements.At the same time, the Commissionrecognizes that the impact of "inventoryprofits" on currently reported earnings appearsto be significant in many cases andthat failure to make appropriate disclosuremay result in investors being inad~quatelyinformed as to the source and replicability ofearnings.The Commission therefore believes that itwould be in the best interest of both statementpreparers and users to' disclose theextent to which reported earnings are com- .prised of potentially unrepeatable and usuallyunsegregated "inventory profits." Accordingly,the Commission urges registrantsto make disclosure of such' amounts prior tothe . adoption of final requirements by the.Commission. Such disclosure may be made inthe financial statements, the notes thereto orin textual material accompanying financialstatements.The Commission recognizes that registrantsusually do not compute cost of goodssold on both an historical cost and currentvalue basis so that computation of suchamounts may often require estimation bythe registrant. It is also recognized thatcomputational methods or bases of valuationother than current replacement cost for 'eachitem sold might be used in developing usefulinformation about such "profits." FQr example,computing the cost of goods sold for eachmonth using a price-level adjusted inventoryamount might produce a reasonable and usefulestimate of such "profits" in some cases.Until final requirements are established, registrantsare. encouraged to use any methodor basis deemed appropriate by managementin exhibiting the impact of such "profits"along with a statement of the method orbasis used and the reasons for adopting it.The determination of cost of sales on acurrent replacement cost basis, howe,:er,provides only partial information regardIDgthe effects of inflation on a company's operations.A second factor is the responsivene~Sof a company's selling prices to changes In

ACCOUNTING SERIES RELEASE~ . 283C~:i)lts. If a comp~ny is able to raise sellingprices immediately upon realizing costs 'increases(or in anticipation of cost increases),its .net income in doiiar terms benefits frominflati~n. On the other hand,-as price in~creases lag behiitd cost increases the benefitof inventory "profits" is offset and the 'netinflation effect oil income may be negative.Because of various regulatory restraints o~pri~es, many companies may h~ve experiencedsignificant pricing lags In the currentyear.The impact of price-level changes does I.1otfall. equ~lly among companies. Some. firmsoper~te in sectors of the economy whereprices of goods purchased are more volatilethan selling priCes. Accordingly, the Commissionurges -.reiistrants to discuss the' rel;,l.­tionship of costs and prices experienced inthe current year in connection with disclosjnginventory profits.By the Commission.GEORGE A. FITZSIMMONSSecretarySECURITIES ACT OF 1933Release No. 5456SECURITIES EXCHANGE ACT OF 1934Release No. 10642,RELEASE ~O. 152 .', .. February 14; 1974PUBLIC. UTILITY HOLDING COMPANYACT OF 1935Release No. 18284INVESTMENT COMPANY ACT OF 1940Release No. 8232.',: :Notice of Adoption of Revision of Regulation s-x and Ainendment of Forms 10 and 10-K to ReviseRequirements as to Form and Content and Certification of Financial Statements of LifeI .. surance Comp.a~ies 'The Commission today adopted a generalrevision of its requirements as. to form andcontent of financial statements of life' insurancecompanies and also eliminated the exemptionfrom the certification requirementsapplicable to these companies. . Thesechanges were proposed on September 12,1973 and involve Article7A and relatedSchedules in Article 12 of Regulation S-X andInstructions 13 and 7 of Instructions as toFinancial Statements of Forms 10 arid 10-K,respectively.* Letters commenting on theproposal have been given consideration indetermining the form of the reVision of Article7 A and the timing of its adoption and of.. Nt' '.Se ~ ~ce of these proposed amendments was made inAc~u;:tIes Act Release No. 5420, Securities ExchangeAct ReI~ase No. 10381, Public Utility Holding CompanyReI e ease No. 18089 and Investment Company Actease No. 7988 (September 12, 1973). ,the elimination of the certification exemption.The revision reflects developments in accountingpractice during the past ten yearsincluding the publication in 1972 of an AuditGuide for life insurance companies by theAmerican Institute of Certified Public Accountants.This publication contains guidelines. f~r the preparation of life insurancecompany financial statements in accordancewith generally accepted accounting principles(GAAP) in place of the prescribed statutoryaccounting requirements followed bythese companies up to this time.As issued for comment the proposal wouldhave applied GAAP accounting to both stockand mutual life insurance companies. An~mber of comments were received from mutualcompanies concerning the need for andapplicability of GAAP to their financialstatements. The mutual companies stated

284 SECURITIES AND EXCHANGE COMMISSIONthat' because they have no stock ownershipinterest their operations were basically differentfrom those of stock companies. TheypOInted 'out that the American Institute ofCertified Public Accountants did not makethe GAAP requirements in its life insurancec6mpany Audit Guide applicable to mutualcompanies.' Filings by' mutual companieswith the Commissiori are generally in thecapacity of co-issuers of variable annuitycontracts and are included in prospectusesbecause of the guarantee of c~rtain liabilitiesof the· related variable annuity account. Inconsideration of the nature of the filings bymutual companies and the absence of a bodyof established generally accepted accountingprinCiples for them, an exemption from therequirement for GAAP financial statementshas been provided in Article 7 A. In addition,a similar exemption has been provided forwholly oWned· stock life insurance subsidiariesof mutual life insurance companies.In response to a number of comments con~cerhing' the problE~nis of meeting the newrequirements, the revised Article 7 A andrelated schedules have been made effectivefor financial statements filed after June 30,1974, since it may not be possible for somecompanies to prepare financial statementsusing GAAP by March 30,1974, the due datefor filing animal reports for calendar year1973. However, it should be recognized thatthe establishment of standards for reportingon a GAAP basis makes the disclosure ofresults of operations on that basis very importantand it is urged that companiesshould make every effort to follow the newrequirements in reporting for the year 1973.Those that cannot do this because of timepressures should consider filing amended 10-K or 8-K reports to disclose the effect ofus~ng GAAP as soon as they are in a positionto do so. Financial statements prepared on astatutory basis should include a note indicatingthe reasons why the GAAP basis was notadopted for 1973 and advising users that the1974 financial statements will be prepareddifferently. The requirements for certificationby independent accountants of financialstatements filed under the Securities ExchangeAct of 1934 will be applicable to statementsfor periods ending after November 30,1974.In 'addition to the new general' requirementthat the financial statements be preparedin accordance with generally accepted 'accounting principles, the following are themore significant specific changes from therequirements of the existing Article 7 A:1. Where appropriate, captions and in- 'structions have been conformed, withcorresponding captions of Article 5 ofRegulation S-X which applies to commercialand industrial companies. It isalso made clear that the general rulesin Articles 1, 2, 3 and 4 of Regulation S­X are applicable to life insurance financialstatements to the extent theyare pertinent (7A-02-1).2. It is intended that, in preparing consolidatedfinancial statements for an insuranceholding company whose consolidatedsubsidiaries are primarily lifeinsurance companies, considerationshall be given to utilization of the formatof the financial statements, notesand schedules in Article 7 A (7 A-01).3. A requirement for a statement as toaccounting principles (7A-05-1).4. Provision is made that a company mayfollow statutory accounting requirementsonly if the statutes of its state ofdomicile prohibit publication of its primaryfinancial statements on a basisother than in accordance with suchrequirements; however, in such eventthe statutory financial statementsshall be accompanied by supplementalGAAP statements (7 A-02-2, 3 and 5).5. The name of any person in which theinvestment exceeds two percent of totalinvestment. As originally proposedthis provision would have required reportingof an investment exceeding onepercent (7A-03-1). .6. In recognition of comments concernIngthe difficulty of ascertaining mar~etquotations for certain types of securItyinvestments particularly bonds and, b ennotes, the requirement has e fchanged so as to call for disclosure 0"value." Problems related to the deter-

ACCOUNTING SERIES RELEASES 285mination of value are discussed in Acc~untingSeries Release No. 118, issuedin December 1970 (7A-03-1, 7A-05-4 and12-27).7. In/ormation as to policy, nature andchanges in deferred policy acquisitioncosts (7A-03-6, 7A-04-7, 7A-05-1 and 12-31A).8. Reporting of aggregate amounts inseparate accounts as single items ofassets and liabilities (7A-03-9 and 19).9. A requirement that considerations forsupplementary contracts shall be reducedby the related amounts of deathand other benefits and increase in futurepolicy benefits (7A-04-1).10. Elimination from the income statementof details of sources of investmentincome. Such information maynow be stated separately in a note (7 A-04-2).11. Details of restrictions on stockholders'equity (7A-05-2).12. Revision of requirement relating to incometax disclosure. In addition to specificrequirements related to life insurancecompanies, the generalrequirements of recently amendedRule 3-16(0) are referred to (7A-05-3).13. An analysis of investment gains for theperiod consisting of a statement comparingrealized and. unrealized gains orlosses on investments in bonds andnotes and stocks (7 A-05-4).14. Information concerning the significanceof reinsurance ceded and assumed(7 A-05-6).15. Detailed schedules of bonds, stocks,mortgage loans and real estate, and asummary of realized gains or losses onsale of investments will 'no longer berequired. The schedules requiring asummary of investments (12-27) anddetails of future policy benefits andinsurance in force (12-31) have beencompletely revised. A schedule hasbeen added to provide details of deferred·policy acquisition costs (12-31A).Registrants with life insurance subsidiarieswhose financial statements for 1973will follow statutory accounting requirementsmay have special problems if theyhave any significant nonlife insur~nce act~~ties.Under those conditions the hfe SUbSIdIariesshould not be consolidated and theregistrant's equity in their stockholders' e­quity and net income or loss should be basedon GAAP. Separate statements (or groupstatements) of the life subsidiaries shouldaccompany the parent's statements.These amendments are adopted pursuantto authority conferred on the Securities andExchange Commission by the Securities Actof 1933, particularly Sections 6, 7, 9, 10 and19(a) thereof; the Securities Exchange Act of1934, particularly Sections 12, 13, 15(d) and23(a) thereof; the Public Utility HoldingCompany Act of 1935, particularly Sections5(b), 14 and 20(a) thereof; and the InvestmentCompany Act of 1940, particularly Sections8, 30, 31(c) and 38(a) thereof.(The text of the amendments, which includerevisions of Article 7 A and Rules 12-27and 12-31, new Rule 12-31A, all of RegulationS-X , and . revisions of Instructions 13 and 7 of.the Instructions as to Financial Statementsin Forms 10 and 10-K, respectively, is omitted.)These amendments shall be effectivewith respect to financial statements filedafter June 30, 1974, although they may beused in statements filed prior to that time~By the Commission.GEORGE A. FITZSIMMONSSecretary

286 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 153February 2~~ 1974SECURITIES ACT OF 1933Release No. 5459.SECURITIES EXCHANGE ACT OF 1934Release No. 10654Findings, Opinion and Order Accepting Waiver-and Consent and Imposing Remedial Sanctions inthe Matter of Touche Ross & Co.Information furnished to the Commissionin a non-public investigation into the affairsand financial reporting of U. S. Financial,Inc. ("USF")l for the' period 1969 to 1972indicated that financial reports issued byUSF and filed with the Commission includingthe annual financial statements for theyears ended 1970 and 1971 were false andmisleading. Touche Ross & Co. ("Touche"), apartnership engaged in the practice of publicaccounting, certified the annual financialstatements for those years. .It appears that as part of a scheme' tomislead the public by publishing false financialstatements reflecting fictitious earnings,USF and certain of its officers, directors· andassociates intentionally deceived Touche bymaking untrue representations and by furnishingfalse information in connection withits audits. The Commission has institutedlegal proceedings against these parties. 2Any such deception, however, did not relieveTouche of its responsibility to performits audits in conformity with generally acceptedauditing standards. The informationfurnished to the Commission indicated thatTouche's conduct of the 1970 and 1971 .auditsin a number of respects did not meet theprofessional standards required of public ac-1 Prior to 1969, USF was engaged in the development,COl'lstruction and sale of single family residential homesand home sites. During 1969, 1970 and 1971, USF'sreported income was derived primarily from real estatefinancing and the development and sale of multiplefamily and commercial real estate projects. USF's commonstock was listed on the New York Stock Exchangeon December 29, 1970 and was delisted on December 10,1973.2Securities and Exchange Commission v. U. S. Financial,[nc., et al., 74 Civil 92-S (S.D.Cal., February 25,1974).countants who practice before the Commission.Such information indicated that Touchefailed to obtain sufficient independent evidentiarymaterial to support its professionalopinion' in regard to a number of highlymaterial transactions which were constructedby management in such a way as tomake it appear that income had been earnedwhen in fact it had not been. In connectionwith these transactions it also appeared thatTouche failed to fully appraise the significanceof information known to it and toextend sufficiently its auditing proceduresunder conditions which' called for greatprofessional skepticism. These transactionsresulted in USF Improperly recognizing millionsof dollars of revenues and profits in1970 and 1971.Touche has submitted to the Commission awaiver of the institution of formal administrativeproceedings under Rule 2(e) and hasconsented to th~ entry of an order containingcertain findings, conclusions and remedialsanctions.Under the terms of Touche's waiver andconsent, Touche, solely for the purpose ofsettlement of this matter, and without admittingor denying any violations, and withoutadmitting or denying any fact except forthe purposes of this settlement, consented,among other things, to the entry of an appropriateorder.After due consideration of the consent andupon the recommendation of our staff, wehave determined that it is appropriate in thepublic interest to accept the consent.The Commission believes that the responsibilitiesof independent public accountantsare an essential part of our capital mark~tsystem, which is based upon investor confIdencein the reliability and fairness of fina n -

ACCOUNTING SERIES RELEASES 287. cial s~atements. Any lack of diligence andprofessionalism on the part of independentauditors seriously erodes confidence in thefinancial reporting of public companies andtends to impair the functioning of the capitaland trading markets with the result that oureconomy as a whole may suffer." By the ac-:ceptance of this consent, which includes thefollowing findings describing the facts andauditing deficiencies discovered as a result ofour staff· investigation, the Commissionhopes to reduce the likelihood of similar futurecases. 3The 1970 Audit -In the 1970 audit, Touche permitted UHF torecord profit on two major transactionswhere the evidence available to Toucheshould have indicated that no profit in facthad been earned.Burnham Management Corp.On August 27,·1970, USF purportedly soldthree properties to Burnham Management"Corp. ("BMC") for $5,399,000 and recognizedprofit of $550,000 from the transaCtion. Theletter agreement which covered the salecommitted USF to use its best efforts tosecure permanent financing on the propertiesfor BMG and to pay certain underwritingcosts upon BMC's syndication of' theproperties. Furthermore, the agreement providedthat upon final documentation, whichwas not prepared and executed, .USF was todeliver to BMC ·USF's guarantee that B~Cwould suffer no loss from operations of theproperties. The agreement was also subjectto an addendum which provided BMC withan absolute guarantee against. loss fromownership of the properties and a commit~ment by USF to complete co~struction of theproperties. The terms of this agreement~ade the recogniton of profit on the transactIonimproper in that as a result of the termsof the agreement and addendum USF hadnot shifted the risk of loss to BMC;3a-a 3 ?ur findings are not binding upon any other personst~al.nst Whom proceedings may be brought as a result of! Investigation.1962~ee Accounting Series Release No. 95, December 28,Shortly after year-end, BMC requestedUSf to,take back the properties or find otherbuyers pursuant to a' verbal _"put". agreemententered into with BMC by Robert Walter("Walter"); chief executive officer of US.F.In response, USF "found" two buyers whowere actually nominees of USF and one. ofwhom assumed BMC's interest with fundsprovided ,by USF.In connection with its review of the. BMCtransaction, Touche was aware that the finaldocumentation was not prepared and ,executed.Although Touche was delivered a copyof the above addendum with a confirmationletter from BMC, Touche failed to examineor review the ~ddendum. In addition, Touchedid n()t pursue the implications of the postyear-end. disposition of the properties byBMC. On th~ basis of the information in itsworking papers, Touche should have refusedto permit the recognition of profit on thistransaction: Additional investigation wouldhave developed further evidence as to thefmp~opriety .of the t~ans·action.Grubb & Ellis-GribbenIn late December 1970 a series of relatedagreements was entered into with Grubb &Ellis, Inc., an independent real estate enterprise,and with Walter P. Gribben ("Gribben").Grubb & Ellis purchased certain propertiesfrom USF for $13.2 million, resultingin a book loss of $532,000 to USF. Grubb &Ellis prepaid $855,000 interest on this transactionwhich was treated as deferred incomeon USF's books. USF leased the propertiesback for two years and retained Grubb &Ellis to manage them for that period. At thesame time, USF purportedly sold to Gribben,actually a USF nominee, its leasehold interestin the properties for $855,000 and recordedincome in this amount. To cover Gribben's$855,000 check dated December 31,1970, USF paid $855,000 to Gribben on J anuary4, 1971 allegedly to purchase Gribben'sinterest in the Grubb & Ellis managementagreements which interest Gribben neverowned.Touche did not obtain documentation towarrant the inclusion in USF's financialstatements of Gribben's purported purchase

288 SECURITIES AND EXCHANGE COMMISSIONof the lease interest. No confirmation wasobtained from Grubb & Ellis to support Gribben'spurported ownership of the managementagTeements or his participation in thetransaction. There was no confirmation fromGribben concerning his purported purchaseof the lease. The only independent documentationsupporting Gribben's purported pur~chase was his $855,000 check to USF. Touchewas aware of but did not attach appropriatesignificance to USF's $855,000 payment toGribben. Touche relied on a written representationof the principal financial officers ofUSF that Gribben was independent and onmisleading explanations of Walter and JohnB. Halverson ("Halverson") USF's executiveVice president4, that the USF-Grubb & Ellis-Gribbentransactions represented a complextransaction meant to satisfy everyone'stax objectives (which objectives were unspecified)and constituted an inseparable unit notsusceptible to separate analysis.Had Touche penetrated this' transactionrather than having' placed reliance uponmanagement's representations as to its purpose,the evolving pattern of manufacturingprofits wc;mld have been evident at an earlierstage.The 1971 AuditCircumstances surrounding the commencementof Touche's 1971 audit of USF shouldhave caused it to approach the audit withthe highest degree of skepticism. In October1971, at the time Touche was prepared tocommence the audit, Touche was terminatedby USF, which then engaged Haskins & Sells("H&S"). On January 21, 1972, Walter terminatedH&S5, and on the following day USF4 In December 1971, Halverson became USF's presidentand chief operating officer.S A report of USF's Audit Committee submitted to theBoard of USF in. mid-February 1972 stated: "2. TheJanuary 1972 termination of HS was motivated in partby the inability of HS to complete the 1971 audit by theend of February, in part by an incompatibility whichdeveloped between. management and HS and in part bypotential disagreements as to matters of accountingprinciples. 3. The potential disagreements as to accountingprinciples between the management of USF and HSinvolved the question of when income should be recognizedby USF in the following types of transactions: (a)re-engaged Touche. In addition, Touche's experienceon the 1970 audit indicated th!:J.tUSF was increasingly dependent on a relativelysmall number of large and complextransactions to achieve its income goals; Itwas also aware that management was aggressivelyseeking income to meet statedgrowth objectives. .In connection with the audit, Touche discoveredthat USF had structured a numberof year-end transactions to give the appearanceof income when in fact the income fromthese transactions could not properly be recognizedin 1971. Touche required USF todefer $13 million of profits which reduced itspreviously calculated unaudited net incomeby nearly 60%.The circumstances should have, requiredTouche to extend substantially its auditingprocedures in respect to the remainingtransactions and to regard management representationswith extreme care. Under suchconditions, it is the Commission's view thatTouche should have given closer considerationto criteria for revenue recognition includingevidence of the purchaser's financialstrength, effective control of the properties,control of the buyer by the seller and uncertaintyas to the amount of costs to be incurredby the seller. While Touche did preparea checklist with which. to review USF'sreal estate transactions, the guidelines onthe checklist, including a question regardingthe source of funds received by USF fromsuch transactions, were not consistently appliedin evaluating the transactions.Among the fraudulent real estate transactionson which USF improperly recognizedrevenue and profits in 1971 were the following:Commissions, fees, and financing-type income receivedin cash by USF in 1971 from joint ventures or partnershipsin which USF had an interest, where the cashreceived by USF came out of moneys loaned by USF. (b)Gains, profits and commissions income received by USFin 1971 where USF's profit or gain was represented atthe end of 1971 by notes rather than cash, or where USFhad a continuing cash investment in the transaction orhad a contingent obligation to supply funds." Touchereceived a copy of the Audit Committee Report shortlythereafter.

.Palm Springs Mobile Country Club("PSMCC")On March 26, 1971, US'F sold PSMCC toNational Community Builders ("NCB") for$5,750,000 in a '~8wap" transaction wherebyUSF also bought property from NCB. Becauseof the "swap;" of which Touche wasaware, USF could not recognize the $1.9million net profit realized on the sale in thefirst quarter of 1971. In an effort to perfectsuch profit, however, on April 13, 1971, USFcaused NCB to sell PSMCC to TSL, Inc.("TSL"),6,a USF nominee of which. Gribbenwas nominal owner, and USF then improperlyrecognized these revenues and profits inthe second quarter of 1971.TSL, on December 31, 1971, soid PSMCG toCarlsberg Resources Corp. ("Carlsberg")which had the right to "put" PSMCC back toTSL. At Carlsberg's insistence,. USF guaranteedTSL's performance under the agreement.Carlsberg had 120 days to examine thePSMCC property and books and decidewhether to put the property back to TSL. Ina separate agreement, USF agreed to' guaranteeCarlsberg a cash flow of $105,000 perannum on the property in the event the putwas not exercised. .It is the Commission's view that Toucheshould have determined from the evidenceavailable that TSL was in fact a nominee ofUSF without independent e~onomic substance.7 Such a determination would haveled to the conclusion that no profit shouldhave been realized on ,the transaction since a6 USF' could direct NCB to sell PSMCC to a buyerchosen by USF for the same sales price of $5,750,000pursuant to the March 26, 1971 sales agreement.7 Touche knew that a $375,000 note given by TSL toNCB as a part of TSL's down payment for the..purchaseof PSMCC was paid with a $375,000 advance by Walterto TSL, that the stock of PSMCC secured TSL's debt toDSF, assumed from NCB in connection with TSL'spurported purchase, that under a mana~ement agreementUSF was obligated to pay all operating expensesof PSMCC, and that TSL assumed BMC's "interest" in~wo o! the three properties purportedly sold to BMC asescnbed above. Touche also had in its possession TSL'sUnaudited balance sheet as of December 31, 1971, whichshowed that all of TSL's assets were acquired from USF .~~: all of TSL's liabilities were owed to USF. Touche1 not obtain TSL's income statement.ACCOUNTING SERIES RELEASES 289,put option to TSL remained outstanding onthe property at the date the auditor's opinionwas signed. 8Coastal Land Corporation ("CLC"). .On December 27, 1971 USF sold certainmobile home parks to CLC for approximately$19.2 million, receiving approximately $1.9million cash and the remainder in long-termnotes. USF improperly recognized approximately$3 million in profit in 1971 from thesale. USF had acquired the parks' from BoiseCascade Corp. ("Boise") in September 1971purportedly "in-trust" for CLC pursuant to aSeptember 10, 1971 agreement between CLCand USF which was contingent upon closingprior to year-end 1971. On November 24,1971USF and CLC purportedly rescinded the September10 agreement (but for one park whichwas syndicated to certain of USF's officersand directors) because of CLC's purportedinability to obtain the cash down payment. 9CLC thereafter obtained the requisite $1.9million cash down payment through a loan inthat amount from Union Bank of California,San Diego. The loan was nominally guaranteedby Bayview Investments ("BI"), a Walternominee, but was actually secured byWalter's pledge of 80,000 shares of USFstock.In connection with Touche's audit of the'CLC transaction, Touche made extensive inquiriesas to the source of CLC's $1.9 milliondown payment becaus~ ot" the following concernsTouche had regarding CLC's affiliates'other transactions with USF: that CLC wasowned by Richard W. Arneson, Jr., ("Arne-8 In any event, Touche did not contact Carlsberg todetermine the likelihood of the "put" being exercisedbut relied upon Walter's representation that exercise ofthe "put" was highly unlikely after April 15, 1972.T~uche issued its certificate on April 1, 1972, at aboutthe same time that Carlsberg indicated its intention toput PSMCC to TSL. .. .9The November 24 rescission letter was a fictIOn createdby Walter at year-end and back dated t? supportWalter's claim that USF be allowed to recogmze the $1·million commission paid USF by Boise in connectionwith the transaction as income rather than a reductionin cost basis, which sum USF improperly recognized inthe third quarter of 1971, and that USF be allowed torecognize an additional $3 million in sale income as aresult of the December 27, 1971 purported resale to CLC.

290 SECURITIES ANn EXCHANGE COMMISSIONson"); that Arneson together with Denhis P. -Hill ("Hill") were the nominal ownet~J>f A-HProperties ("A-H"), which entity -was indebtedto USF as -of Novem~er 1971 in theamount of approximately $15.2 million andwas in default on such debt"; that A-H and USFwere involved in a $4.5 million sale and leasebacktransaction whereby A-H sold to andleased-back from USF the land underlylngcertain A-H properties in December 1971 10 topartially fund the elimination of A-H's delinquentsecured debt and certain unsecured"advances" from USF; and that USF hadgiven A-H a guarantee against loss fromoperations. and other expenses until 80% occupancywas reached on the properties,which had not been -accomplished as of the1971 audit.Because of Touche's concern that CLC'sdown payment might have been funded indirectlyby USF through A-H, Touche determinedthat Union Bank had loaned the fundsto CLC, and that the loan was guaranteed byan un~amed corporation (BI) which purpOJ;tedlyused its undisclosed credit sources tosupport the guarantee. A Touche 'representativestated during the Commission's investigationthat Touche's concurrence with therecordation of the profits "realized" from thetr~nsactiori was conditioned on a negativedetermination of "no direct or indirect involvemen,t"-in the ~LC loan by USF, itsofficers or directors. ._ Touche requested from USF certain financialinformation concerning .CLC and A-Hbut was informed by Walter that such informationwas not available. Touche did notcontact Union Bank to inquire whether USFor any of USF's officers or directors weredirectly or indirectly involved in the CLCloan. Touche requested from Arneson a representationthat USF and its affiliated persQnswere not "directly or indirectly involved."Arneson stated in a writtenrepresentation that USF's officers "were notdirectly involved." While Arneson failed to10 The properties were sold to Equity InvestmentCorp., predecessor of A-H, a 35%-owned USF affiliate, onDecember 31, 1969. Arneson and Hill purportedly purchasedEquity Investment Corp. from that company'sstockholders in April 1970.disclaim in writing any indirect involveinent,Touche's representative -felt assured fromhis concurrent conversation with Arnesonthat there was also no indirect involvement.Touche received a representation letter fromcounsel to the unnamed corporate guarantorof the CLC loan (BI) which stated- that theunnamed corporation had undisclosed beneficialowners (who were in fact Arneson andHill) whom counsel refused to identify toTouche, and that the corporation used itscredit sources as a basis for its guaranty,which credit sources were not identified.Touche further received from Walter an intentionallyfalse and misleading written representationintended to deceive Touche that"neither USF ... nor any affiliated personshave guaranteed, either directly or indirectlyany obligation of CLC." Touche reliedupon the above representations and concurredin USF's profit recognition from theCLC transaction.It is the view of the Commission that hadTouche's confirmation procedures included adirect inquiry to Union Bank and hadTouche insisted upon knowing the identity ofthe corporate guarantor, it is likely thatWalter's involvement in the loan would havecome to light-despite Walter's express representationsto the contrary., .Relationship with Predecessor AuditorsAs previously noted, Touche succeededH&S in the 1971 audit. During the course ofTouche's audit it reviewed some of H&S'swork papers prepared during the course ofthe latter's brief engagement, but in theview of the Commission communication betweenthe firms was not as complete as itshould have been. When one auditor succeedsanother, be it on the same engagementor on a different one, it is important that thesuccessor obtain access to and carefully reviewthe results of the predecessor's work. Inmost instances, this will entail some reviewof the predecessor's work papers. In otherinstances, it may require discussions withthose responsible for the predecessor's work.If a client refuses to permit such discussions,such a refusal should constitute a reason forrejecting the engagement. It is essential

that, both the successor and the predecessorbe fully advised of the reasons surroundingthe termination and tb.e new engagement, ofany questions raised or· problems encountered'in the audit by the terminated firm,and, of any other relevant circumstances, sothat the public interest that the accountingprofession is supposed to protect will be properlyserved. No one's interests: are served byone, independent accountant not revealinginformation 'known to it which may bearupon the work of' another' independent accountantwho is examining financial ,statementswhich are destined to be disseminatedto the public or filed with the Commission.As the Commission has previously pointedout, the public accountant's first duty is tosafeguard the public interest, not that of hisclient. lOa'Summary.• I r ~,While it appears that Touche was deliber~ately misled in many respects by USF's managementin the course of the 1970 and 1971audits, Touche;s failure in a number of respectsto conduct these engagements in ac~cordance with generally accepted auditingstandards makes Touche responsible for cer~tifying financial statements' which proved tobe materially false and misleading. l1 As theCommission stated in its report on McKesson& Robbins, Inc~: 12 " ' ','lOa See, e.g., In the Matter of McKesson & Robbins, Inc.,Accounting Series Release No. 19 (1940).11 As stated in the AICPA's recently issued Statementon Auditing Standards §110.05 (1973), which was substantiallya restatement of existing practice, in makingan ordinary examination, the auditor must be alert toand recognize "the possibility that Jraud may exist" andthat fraud, "if sufficiently material, may affect his opinionon the financial statements .... " Accordingly, "hiseXamination, made in accordance with generally acceptedauditing standards, gives consideration to thispOSSibility," even though the ordinary examination isnot "primarily or specifically designed" t~ detect fraud.The failure, therefore, to conduct an examination inaccordance with generally accepted auditing standards~eans that' the auditor is responsible for his failure to;tect fraud when such failure results from a departure '~:n auditing standards., In the Matter of McKesson & Robbins, Inc., Account-Ing Series Release No. 19 (1940).'· ACCOUNTING SERIES RELEASES , 291! '" .. ~ . We believe. that ... [with respect :to]e~a,minations for corporations' whose' secur'hiesare held by the public" acc~un~tants can be expected to 'detect grossoverstatements of assets ~nd profits',whether resulting from fraud or, other~wise. We believe that aleJ:1;nes~ .on. thepart of the entire [audit] staff, coupledwith intelligent analysis by experiencedaccountants of the manner of doing busi.,ness, should detect overstatements.inthe accounts, regardless of their cause,long before they assume the magnitudereached in this case. Furthermore, anexamination of this kind should not, inour opinion, exclude the highest officersof the corporation from its appraisal ofthe manner in which the business underreview is conducted.... [W]e feel thatthe discovery of gross overstatements inthe accounts is a major purpose of ... anaudit ...."Although Touche's San Diego, California,, office was primarily responsible for the auditsin question, Touche partners from otheroffices, 'including the national office, alsoparticipated in and were consulted with respectto certain aspects of the audits. Theyalso planned and supervised a review of certain'USF audit programs and working-papers:as well as the findings; conclusions aridaccounting,- principles to be followed. Whileeve'ry firm is responsible for the opinionsissued by any of its partners, the involvementin this case of other partners and officesof Touche, as is customary and expectedof a national accounting firm, emphasizesthat the firm as a whole' must share theresponsibility.In accepting the offer of settlement, theCommission has considered the fact thatTouche, with one exception noted below, hasnot previously been'subject to disciplinarr orenforcement proceedings instituted by theCommission and that the one exception 13arose out of conduct which occurred in connectionwith financial statements for theyear 1947. In accepting Touche's undertakingto adopt certain procedures to13 In the Matter of Touche, Niven, Bailey & Smart, 37S.E.C. 629 (1957).

. :('292 SECURJT~ AND EXCHANGE CO~SIONstrengthen its existing ones, the Commissiondoes not contemplate that they will ~ncompasssteps which are other than required 'bygenerally accepted auditing standards.Rather, Touche and the Commission contemplatethat these procedures will improveTouche's ability to carry out its responsibilityto exercise due professional care in thec

, -'ACCOUNTING SERIES RELEASES 293not the transaction, including the gUarantee,will be properly reported.In view of the above findings, the Commissionconcludes that Touche engaged in improperprofession,al conduct.*' * * * *Under the terms of its offer of settlement,Touche, without admitting or denying theCommission's findings and solely for the purposeof settlement, consented to the entry ofan order embodying the following sanctions.Accordingly, IT IS ORDERED that proceedingspursuant to Rule 2(e) of the Commission'sRules of Practice be, and they herebyare, instituted against Touche Ross &Co.IT IS FURTHER ORDERED that, subjectto the terms and conditions provided in theoffer of settlement Touche Ross & Co., be,and it hereby is:A. Censured by the Commission.B. Required to adopt, maintain and complywith procedures which shall be submittedto the Commission for its review and approvalwithin thirty (30) days after the datehereQf, to prevent future violations of thefederal securities laws, which proceduresshall provide, among other things, as ameans of strengthening Touche's procedures1) That in all audit engagements specificreview shall be made which is designedto determine the management'sdirect or indirect involvementin material transactions which are includedin the financial statements;2) For the formulation and implementa- ,tion of qualitative office review proceduresrequiring periodic review atleast once every two years of allTouche offices under the control andsupervision of Touche's national staffto evaluate and ensure the quality ofthe audit engagements of such offices.C. In order to ascertain that Touche isc~~ducting its professional practice in comp;~nce with paragraph B above, an investigtlon, which shall be conducted at the ex­~:nse .of .Touche, shall be conducted by thetnmlSSIOn in accordance with methods andprocedures adopted or approved by it by the,use o( members of the profession in publicpracti~e selected or approved by the ChiefAccountant of the Commission or, at its. qp-. tion, by use of qualified professional accountantsdrawn from its own staff. Provided, 'however, that in those instances where. per-.sons conducting the aforesaid investigationare not members of the Commission's staffsuch persons (who shall be given a copy ofthese Findings, Opinion and Order and Consent)shall hold in confidence the fact thatsuch persons are engaged in such investig~tionas well as all information, books, paper~,records, documents or other materials o~tainedand/or utilized during the course ofsuch investigation and relating to theclients, procedures, systems or methods ofTouche. The report of investigation, in thoseinstances where the investigation is conductedby persons other than members of theCom~ission's staff, shall be submitted to theCommission only and shall be the sole propertyof the Commission and shall be maintainedin the Commission's non-public investigativefiles. Nothing herein is intended inany way to alter or amend the powers orjurisdiction of the Commission.D. For a period of tw-elve (12) monthsafter the date of this order, Touche's SanDiego, California, l?ranch office will not acceptor undertake any new professional engagementwhich can be expected to result,within twelve (12) months fj.~m the date ofsuch engagement, in filings, submissions orcertifications with the Commission. For thepurpose of such offer of settlement, "newprofessional engagement" is defined to meanan engagement entered into after five (5)days' subsequent to the effective date of thisorder between Touche's San Diego, California,branch office and any person or corporationsubject to the disclosure requirementsof the Securities Act of 1933, the &ecuritiesExchange Act of 1934, the Investment CompanyAct of 1940, the Investment AdvisersAct of 1940, the Trust Indenture Act of 1939and the Public Utility Holding Company Actof 1935. Nothing herein shall be construed toaffect the right or obligation of Touche's SanDiego, California, branch office during this

294 SECURITIES AND EXCHANGE COMMISSIONtwelve (12) month period to perform its. normalfunctions and services for existingclients (including activities requiring filings,submissions or certifications with the Commission),or to undertake engagements fornew clients which cannot be expected to result,within twelve (12) months from the dateof such engagement, in filings, submissionsor certifications with the Commission.E. Touche wiil not accept or undertakeany new professional engagement of anyclient whose business, revenues and netprofit (loss) is materially derived from realestate development or sales, including financingrelated thereto, as defined herein,which engagement can be expected to result,within twelve (12) months from the date ofsuch engagement, in filings, submissions, orcertifications with the Commission until theChief Accountant of the Commission is satisfiedthat adequate audit guides and programsfor application have been adopted,including appropriate. testing thereof as appliedto audits. For.the purposes of such offerof settlement, "hew professional engagement"is defined to mean an engagemententered into after five (5) days subsequent tothe effective date of this order betweenTouche and any person or corporation subjectto the disclosure requirements of theSecurities Act of 1933, the Securities ExchangeAct of 1934, the Investment Company'Act of 1940, the Investment Advisers Act of1940, the Trust Indenture Act of 1939 andthe Public Utility Holding Company of 1935.For the purposes of such offer of settlement,"any client whose business revenues and/ornet profit (loss) is materially derived fromreal estate development, or sales, includingfinancing related thereto," is defined to meanany client at least twenty-five (25) percent ofwhose gross revenues or pre-tax net profits(losses) were derived from real estate developmentor sales, including financing related·thereto, within two (2) of the preceding three(3) fiscal years. Nothing herein shall be construedto affect the right or obligation ofTouche during this twelve (12) month periodto perform its normal functions and servicesfor existing clients (including activities requiringfilings, submissions or certificationswith the Commission), or to undertake engagementsfoJ," new clients which, cannot beexpected to result, within twelve;(12) monthsfrom the date of such engagement, in filings,submissions or certifications with the Commission.F. The Commission shall retain jurisdictionof this matter pending final receipt of areport of investigation· referred to in para- .graph C above and thereafter for either thetaking, if necessary, of appropriate action toensure compliance, including but not limitedto the re-opening of these proceedings for theimposition of such other and further relief asmay be required under the circumstances, orthe approval of the report and termination,on notice,of this proceeding.By the Commission (Commissioner Pollacknot participating).GEORGE A. FITZSIMMONSSecretary

ACCOUNTING SERIES RELEASES 295 ,RELEASE NO. 154April 19, 1974SECURITIES ACT OF 1933Release No. 5483,,>SECURITIES EXCHANGE ACT OF 1934Relea~e 'No. 10746PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 18383INVESTMENT COMPANY ACT OF 1940Release No. 8315'Notice of Adoption of Amendments to Rule 4-02 and Rescission of Rule 4-07 of Regulation S-XRelating to Consolidated Financial StatementsThe Commission today adopted amendmentsto Rule 4-02 and rescinded Rule 4-07 ofRegulation S-X, both relating to requirementsfor consolidated and combined financialstatements. This 'action was originallyproposed on December 13, 1973, in SecuritiesAct Release No. 5445.The rescission of Rule 4-07 eliminates therestriction ,on consolidation of subsidiariesengaged in financial and nonfinancial activitiescontained in Rule 4-07(b). Consolidatedfinancial statements will now be subject tothe general provisions of Rule 4-02(a) that a"registrant shall follow ... principles of inclusionor exclusion which will clearly exhibitthe financial position and results ofoperations."The amendment to Rule 4-02 continues thepresent requirement of Rule 4-07 for supportingfinancial statements of consolidatedsubsidiaries engaged in certain financial activities.Consideration should also be givento improving the disclosure in annual reportsto stockholders by including this information,suitably condensed, as supporting financialstatements or as line of businessdisclosure. Although inform3:tion concerningnO~financial activities is not specifically reqUIred,such information may be given if?eemed appropriate for a better understand­~g of registrant's, business. The FinancialthCcounting Standards Board is c'bnsideringan~ m~tter of reporting by diversified comp­• l' es Including the extent of disclosure oflDJ.orm t'1'h a Ion about the different segments.wh ese requirements will be reconsideredbyethn a statement on this matter is adoptede FASB.A subparagraph added to Rule 4-02(a) isintended to prevent consolidation of subsidiariesof a registrant subject to the BankHolding Company Act of 1956 as to which adecision has been made requiring divestitureor in cases where there is a substantiallikelihoodthat divestiture will be necessary inorder for registrant to comply with provisionsof the Act.The following changes are made to Article4 of Regulation S-X:1. Rule 4-07 is revoked and reserved.2. Rule 4-02(a) is amended by addition ofthe following subparagraph (3)-(3) Any subsidiary or group of subsidiariesof a registrant subject to theBank Holding Company Act of 1956 asamended as to which (a) a decisionrequiring divestiture has been made,or (b) there is substantial likelihood, that divestiture will be necessary inorder to comply with provisions of theBank Holding Company Act.3. Rule 4-02 is amended by addition ofthe following paragraph (e)-(e) Separate financial statementsshall be presented for each subsidiaryor group of subsidiaries engaged inthe business of life insurance, fire andcasualty insurance, securities brokerdealer,finance, savings and loan orbanking, including bank related financeactivities; provided, however,that separate financial statementsmay be omitted:(1) For a consolidated subsidiary orgroup of subsidiaries in the same busi-

296 SECURITIES AND EXCHANGE COMMISSIONness in which the registrant's and registrant'sother subsidiaries' proportionateshare of total assets or totalsales and revenues (after intercompanyeliminations) exceeds 90 percentof consolidated assets or consolidatedsales and revenues.(2) For a nonsignificant consolidatedsubsidiary which is registrant's onlysubsidiary in a business, or for agroup of consolidated subsidiaries constitutingall of registrant's subsidiariesin the same business which ifconsidered in the aggregate would notconstitute a significant subsidiary.(3) For a consolidated subsidiary orgroup of subsidiaries in the same businessif in excess of 90 percent of theirsales and revenues are derived fromregistrant and registrant's other subsidiaries..The foregoing amendments are adoptedpursuant to Sections 6, 7, 8, 10 and 19(a) ofthe Securities Act of 1933; Sections 13, 15(d)and 23(a) of the Securities Exchange Act of1934; Sections 5(b), 14 and 20(a) of the PublicUtility Holding Company Act of 1935;, andSections 8, 30, 31(c) and 38(a) of the InvestmentCompany Act of 1940. The amendmentsshall be effective with respect to financialstatements filed with the Commission subsequentto May 31, 1974.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 155April 25, 1974SECURITIES ACT OF 1933Release No. 5488/PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 18392SECURITIES EXCHANGE ACT OF 1934Release No. 19754Notice of Amendments to Forms S-l, S-7, S-8, S-9, S-11, 10, 12, 8-K, 10-K, 11-K, 12-K and U5S, andRegulation S-XThe Securities and Exchange Commissiontoday adopted certain amendments of theinstructions pertaining to financial statements,summaries of operations and exhibitsin the above forms and amendments of arelated definition in Rule 1-02 and of Rule 5-02-39(d) of Regulation S-X. The instructionsin ·the forms are amended generally to conformthe terminology to that adopted in RegulationS-X in Accounting Series Release No.i25, to correct references to changed ruleand caption numbers in Regulation S-Xwhich were changed in Accounting SeriesRelease No. 125, to achieve consistencyamong similar requirements in variousforms, and to provide clarifications and modificationsof the instructions in some respects.The definition of the term "significant subsidiary"in Rule 1-02 of Regulation S-X isamended to achieve consistency with thebases and tests of significance of subsidiariesand other affiliates in the instructions to theforms, e.g., Instruction 8 of Form S-1. Theamendment to Rule 5-02-39(d), which was notincluded in the proposals that were publishedfor comment, reduces the requirementsspecified in that rule for summaries ofstockholders' equity accounts. .The amendments were proposed in~ SecurItiesAct Release No. 5405 (Securities ExchangeAct Release No. 10272, Public UtilityHolding Company Act Release No. 18025) onJuly 9, 1973. Forms S-l, S-7, S-8, S-9 and S-l1are used for registration of securities under

ACCOUNTING SERIES RELEASES ~97tne Securities Act of 1933; Forms 10 and 12are· used for registration of secu~ities underthe Securities Exchange Act of 1934; Forms8-K, -10TK, ll-Kand 12-K are used for specialor annual-report~ pursuant to the 1934 Act;and Fo'rm U5S is used for annual reports byholding companies registered under the PubliGUtility Holding Company Act of 1935.Regulation S-X states the requirements applicableto the form and content of fInancialstatements filed under the forms. .The 'comments received on the proposalswere given careful consideration in the -determinationof the defihitive - amendments.Numerous suggestions for changes in therules of an editorial or- clarifying naturewere adopted: The more significant or extensivechanges which were adopted are discussedbelow. Areas in the rules where sub-:stantive changes were· effected in - theproposals are underlined.In'the requirements for summaries' of operationsin Forms S-1, S-8, S-l1; 10 and 10-K -(e.g:, Item 6 in Form S-l) and for statementsof income in Forms S-7 and S-9 (e,g., Item 6in Form S-7), the format and the order of theinstructions were made consistent and theinstructions regarding the items of revenueand expense to be included in the summariesand regarding the computation of ratios ofearnings to fixed charges in the summariesand the statements were updated to reflectcurrent requirements. In this connection inthe specifications for "fixed charges" (e.g.,Instruction 5(c) of Item 6 of Form S-1), thecriterion for the interest factor of one thirdof all rentals has been deleted inasmuch asreliable estimates of the portion of rentalswhich represent interest can now generallybe made and there is considerable evidencethat one third of rentals is riot a reasonableapproximation of the interest factor today.~n Form S-9 the general instruction pertain­Ing to the use of the form is amended toconform the requirements relating to thefixed charge ratios to the comparable reqUirementsunder Item 3, Statements of Income.Comments were made that the requiretnhentsfor the ratios of earnings to fixedc arges andto combined fixed charges andpreferred dividends should be reconsideredin view of questions regarding whether thecriteria for the computations continue to beappropriate and whether the disclosureshave sufficient analytical value to readers towarrant their continuation. A further studyis planned in the light of these questions todetermine what, if any, additional amend-, ments would be appropriate. .The proposed clarification of the instructionsfor the furnishing of separate summariesOf operations of the registrant in additionto consolidated statements was deleted andthe original language in the instructions wasrestored, inasmuch as most commentatorsconsidered that the requirements for separateregistrant statements would be extendedby the proposal. Many also indicateda . belief that the general requirements forseparate financial statements of registrantsin addition to consolidated statementsshould be reduced. This matter will also begiven further consideration.- The'proposal to change the requirementsfor a summary of operations in Form S-8 torequirements for statements of income consistentwith Form S-9 was eliminated on thebasis of comments that this would be anextension of requirements which could notbe justified by the purposes of- Form S-8. Inthis form also the instructions to the summarywere clarified regarding the periods forwhich various statements are required.The instruction to the summaries (and thestatements of income) regarding reconciliationsof revenues and net income for differencesin reports previously issued (e.g., Instruction3 of Item 6 of Form S-1) has beenrevised to conform it closely to a comparablerule in Regulation S-X (Rule 3-07(b».One of the instructions to the summary ofoperations in Form 10-K (Instruction 5 toItem 2) which requires a statement by theregistrant and a letter by the independentaccountant regarding changes in accountingprinciples or practices, as amended in thisrelease, has been adopted in Form 12-K (Instruction7 as to Exhibits). This requirementwhich was adopted in Form 10-K in ReleaseNo. 34-9344 is considered to be applicable toutility company registrants who utilize Form12-K in filing their annual reports in lieu ofForm 10-K. The instruction has been further

298· SECURITIES AND EXCHANGE COMMISSIONamended to provide that the independentaccount's· letter regarding a specific changeneed be filed only one time.Certain of the instructions regarding financialstatements (i.e., Instructions 4, 6, 7and 8 as to Financial Statements of Form S-1and similar instructions in Forms S-7, S-9, 10and 10-K) were modified or clarified andmade consistent among forms with respect tothe requirements for financial statements, of. the registrant to be filed and for the filing oromission of financial statements of subsidiariesnot consolidated and of fiO percent orless owned persons. Similar instructions regardingthese latter requirements w~re alsoincluded for c~nsistency under Exhibits inForms 12 (Instructions 7 and 8) and 12-K(Instructions 4 and 5). A test relating toincome, which is considered an importanttest of sign'lficance of affiliates, is adopted'inthe instructions in the forms and in the,definition of "significant subsidiary" in Regulation. S-X as' an addition to the ~xistingtests reiating to assets and revenues. Thetests as propos~d have been modified to eliminatecertain exclusions in relation to theassets and income tests on the basis of commentsthat their effect would be minimal inmost instances. In Form 8-K the tests inInstructi9n 4 of Item ~ for ~etermining thesignificance of acquisitiol1s and dispositIonsof assets or businesses were conformed tothe tests in the definition in RegUlation S-X.,The instructions pertaining to succession~o and acquisition of other business (i.e.,Instructions 11 and 12 as to Financial Statementsof Form S-1 and similar instructionsin Forms S-7 and 10) have been updated toreflect current requirements and practicesand clarified, as between past and futuresuccessions. Further clarifications have beenmade in the instructions as proposed and therequirements for pro forma income statementshave been stated in accordance withsuggestions received. Comparable instructionshave been included in Form S-9 toachieve consistency with Form S-7.In Form S-l1 corrections of several referencesand requirements relating to RegulationS-X were made to reflect revisions of theregulation in Accounting Series Release No.125. Item 26 and special provision C-3 of theInstructions as to Financial Statements arereYised and' special provjsionE! C-5, 6' and 7'.are omitted to reflect the .~doption ~n RE,'!gula- ,tion S-X of new schedules as Rules 12-42 and12-43 in substitution for the schedules specifiedin Rules ,12-37 and 12-38 and new instructionsin Rule 5-04 for Schedules XVII,XVIII and XIX which were previously designatedas Schedules XVIII, XIX and XX inForm S-11:In Form U5S 'corrections of references tothe revised Regulation S-X were also made.Paragraphs l(c)(i) and (ii) of the Instructionsas to Financial Statements, which p:rovi~efor the omission of certain schedules specifiedin~ule 5-04 of Regtiiation S-X, are, revisedto provide for the omission also of newSchedule XVIII which was adopted' underRule 5-04. Schedule XVII, which is presentlyspecified for omission in paragrapJ:ts (c)(i) and(ii), formerly required compliance with Rule12-17 of Regulatio.n S-X, the requirelIlents ofwhich rule were combined with Rule 12-04and Schedule III unqer' Ii'ule 5-04. ScheduleXVII in Rule 5-04 now requii·es compliancewith new· Rule 12-42 and' it is consideredappropriate to continue to permit the omissionin F'orm U5S of Schedule XVII withregard to the new requirements as well asthe old by the continued' omission of ScheduleIII. New Schedule XIX, which requiresinformation r~garding certain oth~r investments,would be required if applicable. Alsoin Form U5S, the Instructions as to FinancialStatements are updated to make themconsistent with those 'of Form 10-K with respectto requiring statements of source andapplication of funds and the examination bythe independent accountant of the schedulesfiled in support of the financial stateme~ts.These amendments are adopted pursuantto authority conferred on the Securities andExchange Commission by the Securities Actof 1933, particularly Sections 6, 7, 8, 10 and19(a) thereof; the Securities Exchange Act of1934, particularly Sections 12, 13, 15(d) ~nd23(a) thereof; and the Public Utility Jlol~mgCompany Act of 1935, particularly Sections5(b), 14 and 20(a) thereof. 1(The text of the amendments to Forms S-iS-7, S-8, S-9, S-l1, 10, 12, 8-K, 10-K, ll-K, 12-and U5S and Rules 1-02 and 5-02-39 of Regu-

ACCOUNTING SERIES RELEASESlation S-X is omitted.) The amendments shallbe effective with respect to the applicablerules and forms on July 1, 1974.By the Commission.GEORGE A. FITZSJMll40NS .SecretarySECURITIES EXCHANGE ACT OF 1934Release No. 10756RELEASE NO. 156April 26, 1974Statement Regarding the Maintenance of Current Books and Records by Brokersand DealersInquiri~s have been received by the Commissionrequesting clarification of the requirementof Rule 17a-3(a) under the SecuritiesExchange Act of 1934 that every brokerdealershali "make and keep current" certainbooks and records enumerated in, the rule.Also, subparagraph (c) of Rule 17a-11' requiresthat telegraphic notice be given to theCommission when a' broker or dealer fails to·comply With the requirements of Rule 17 a-3to "make and keep current" books and recordsprescribed by the rule.Rule 17a-3(a) requires that registered broker-dealersprepare records of transactionsand dealings in securities for the accounts ofth~ firm's customers as well as for its ownrisk and account, and to prepare records ofother financial transactions related to thebusiness of the broker-dealer. These requirementsare intended to serve three basic regulatorypurposes. First, it is expected thatthe broker-dealer maintain current booksand records for the protection and convenienceof customers; that is, customers areentitled to prompt responses to inquiries andresolution of claims relating to their ac­Counts. Secondly, these requil'ements are intendedto enable a broker-dealer to be aware?f the extent of its compliance with the var­IOUS rules and requirements, particularly thenet capital and other customer Plotectionrules I, andbe able to demonstrate.complianceto the Commission and the' self-regula--1Includi Rioa n to ng u e 15c3-1 or comparable reqUIrements ofOdealera lOnal0secun°tIes exchange of whIch0the broker-IS a member and Rule 15c3-30tory authorities without the burden of bringingbooks and records up-to-date beingplaced upon the regulatory authorities.Third, a broker-dealer should have currentbooks and records to enable it to fulfill itsobligations and responsibilities to other broker-dealerswith whom business is transacted.Additionally, good business practicerequires timely information for effectivemanagerrlEint decisions. In order to servethese purposes, we discuss in the followingparagraphs general guidelines for the maintenanceof current books and records withrespect to the requirements of Rules 17a_3°(a)and 17a-11.2Order Tickets and ConfirmationsSubparagraphs (6) and (7) of Rule 17a-3(a)require the preparation of a memorandum ofeach brokerage order and each principaltransaction and subparagraph (8) requiresmaintenance of copies of confi·rmations oftransactions for the accounts of customersand partners. These are the basic sourcedocuments and transaction records of a bro:­ker-de.aler. By their nature the memorandaof brokerage and principal transactionsshould be prepared at the time of the transactions,and the confirmations, which areprepared from the memoranda, should beprepared and mailed on the day of the transactionor the following business day.2 Subsequent modification or change of applicablerules may result in the revision of the guidelines setforth herein (for example, see proposed revisions to Rule15cl-4, Securities Exchange Act Release Noo 10681, InvestmentCompany Act Release Noo 8275)0

300 SECURITIES AND EXCHANGE COMMISSIONRecords of Original EntryThe blotters or other records of originalentry described in subparagraph (1) of Rule17 a-3 itemize each day's transactions in aformat that facilitates posting to the generaland subsidiary ledgers. Blotter records relatingto securities transactions-e.g., dailypurchase and sale blotters-should reflect alltransactions as of the trade date and shouldbe prepared no later than the following businessday. Similarly, blotter records relatingto securities movements and the receipt alJ.ddisbursement of cash should reflect suchtransactions on the date they occur andshould be prepared no later than the followingbusiness day~General LedgersThe ledgers prescribed in subparagraph (2)of Rule 17a-3 are the general records, reflectingall asset, liability and capital accountsand all income and expense accounts andinclude control accounts ·for sitbsi.diary ledgers.The blotters and other records of originalentry should be maintained not only on adaily basis as discussed above, but in a formwhich will facilitate posting of the generalledger as frequently as necessary to enablethe broker-dealer to make the computationsnecessary to ascertain his compliance withthe net capital rule and the customers' reserverequirement rule. 3 For many brokerdealers,compliance with the customers' reserverequirement entails a weekly computationbased on updated general ledger accountbalances.A broker-dealer is required to be in compliancewith the net capital rule at all timesand the general ledger must be posted asfrequently as may be necessary to make thatdetermination. Compliance with this ruleand the concern for frequent computationsbecomes particularly important in periods ofsharp changes in securities prices and increasesin trading volume. Firms which arefrequent participants in underwriting syndicatesor which effect transactions in largeblocks of stock may also find it necessary topost their ledger on a daily basis because of3 Rule 15c3.3(e).the need for making frequent net capitalcomputations. If a broker-dealer effects onlya limited number of transactions during anaccounting period and it is clear from thenature of the business conducted that suchtransactions would have no material adverseeffect on the broker-dealer's financial andoperational condition, net capital or customer'sprotection requirements during theperiod it may be .appropriate to post thegeneral ledger on a monthly basis. 4Customer's Ledger AccountsTransactions involving the purchase andsale of securities should be posted to thecustomer's ledger accounts described in subparagraph(3) of Rule 17a-3 no later thansettlement date. Other customer transactionsrelating to securities movements andcash receipts and disbursements should bereflected as of the transaction date andshould be posted to, the 'accounts no laterthan the first business day following thetransaction.Subsidiary LedgersThe subsidiary ledgers and other records 5relating to securities in transfer, dividendsand interest received, securities borrowedand securities loaned, and monies loaned req~iredunder. subpar~graphs (4)(A)-(D)should be posted no later than two businessdays subsequent to the date of the securitiesor money movements. Transactions betweenbrokers not completed on settlement dateshould be posted to the appropriate fail todeliver or fail to receive ledger (or otherrecord) no later than the first business day4 In the course of posting the books at interim datesduring a month, it may not be necessary to makeadjustments for accruals and deferrals such as for depreciationor prepaid expenses if they would not materiallyaffect the financial condition of the broker-dealer.5 As used in subparagraph (4) and elsewhere in Rule17a-3, the term, "other records" should be construed toinclude, where appropriate, copies of vouchers, confirmations,or similar documents which reflect the informationrequired by the applicable subparagraph arrangedin appropriate sequence and in permanent for:~including similar records developed by the use of aU 0-matic data processing systems and produced or reprduced on microfilm.

ACCOUNTING SERIES RELEASES 301following settlement date; resolution of failtransactions should be recorded no laterthan the first business day following resolution.A broker-dealer who maintains his accountson the trade date basis of accountingand uses "fail" accounts to reflect transactionswith other brokers should post transactions~othe accounts no later than two business~ays subsequent to the transactiondate. In accordance with the provisions ofRule 17a-13(b)(5), long and short stock recorddifferences shall be entered in an appropriateledger account (subparagraph (4)(F» nolater than seven business days after the dateof a required quarterly securities examinationand verification. 6. Securities Position RecordThe securities record required by subparagraph(5) of Rule 17a-3(a) shall reflect thechanges resulting from purchase and saletransactions either as broker or dealer as ofclearance date, or settlement date, andshould be recorded no later than the followingbusiness day.1 In addition, other changesin securities positions should be reflected onthe date of the security movement or on thefollowing business day as of the date of themovement. Long and short securities recorddifferences shall be entered concurrentlywith their recording in the subsidiary ledgerrequired by subparagraph (4)(F). .Transactions in OptionsThe record of puts, calls, spreads, straddles,and other options described in subparagraph(10) should reflect transactions as ofthe date an option is written, guaranteedkdd a e or exercised and should be prepared 'no later than the business day following thetransaction.Wi:~f ~ounts are made on a cyclical basis in 'accordancerec or d edule 17a·13(c), 'thOany stock record difference shall beami' t' WI In seven business days subsequent to exnaIon and 'fi '7 Th veri lcatlOn of a particular security.secu 't'e reqUlrement'for current maintenance of thepre Parn lest'recordcan be met by broker-dealers throughmente: ~on of a. full securities record weekly, supplebalanc' y a daIly "takeoff" sheet summarizing andIng each day's securities movements.Trial Balances and Capital ComputationSubparagraph (11) requires the monthlypreparation of a trial balance of all ledgeraccounts and a computation of aggregateindebtedness and net capital as of the trialbalance date. These records should be preparedno later than 10 business days afterthe end of the accounting period, except inthose instances where the records must beprepared in a lesser period to satisfy anyreporting requirements established by anyself-regulatory authority of which the broker-dealeris a member. 8Other RecordsThe record of beneficial ownership of eachcash or margin account (subparagraph (9) ofRule 17a-3) should be prepared before transactionsare effected in an account. The employmentquestionnaire or application (subparagraph(12) of Rule 17a-8) should beprepared at or prior to the commencement ofemployment.Time Lag in Transmission of DataUnder certain limited circumstances theaccounting department of a broker-dealermay not be aware of a transaction until afew days after it occurs. T~ansactions 'suchas receipts and disbursements in out-of-townbranches' or by correspondents should be recordedno later than the day after the transactionis reported to the accounting department,and dividend and interest claims fromother brokers should be recorded no laterthan the day after the validity of the claim isestablished.Service BureausIf a broker-dealer hires or engages an outsideservice bureau or other recordkeepingservice to handle its records, the require-8 Although not specifically referred to in Rule 17a-3,the weekly or monthly computation of the amount to beon deposit under the customers' reserve requirementrule must be made in sufficient time to enable thebroker-dealer to make the required deposit no later thanone hour after the opening of banking business on thesecond business day following the date on which thecomputation is based, as required by Rule 15c3-3(e).

302 SECURITIES AND EXCHANGE COMMISSIONment to make and keep current the brokerdealer'sbooks and records is in no way diminished'and under such circumstances thebroker-dealer is responsible to the same degreefor maintaining current books and recordsas if he were maintaining them himself.Where a broker-dealer' undertakes to havehis books and records prepared and maintainedby'a service bureau or'record'keepingservice, he should assure himself that theservice will be provided in conformity withthe Commission recordkeepirig rules.By the Commission.GEORGE A. FITZSIMMONSSecretary .RELEASE NO. 157July 8, 1974SECURITIES ACT OF 1933Release No. 5512SECURITIES EXCHANGE ACT OF 1934Release No. 10906 -,Findings and Opinion Accepting Waiver and Consent and Imposing Remedial Sanctions inthe Matter of Arthur Andersen & Co. (Rule 2(e) of the- Rules of Practice)In May, 1973 information ,came to the attentionof the Commission ,which indicatedthat the Commission-and the public had notbeen fully informed of the facts relating to asettlement negotiated 'between WhittakerCorporation ("Whittaker") and its auditors,Arthur, Andersen & Co. ("Arthur Andersen")arising out of an audit performed by ArthurAndersen of the inventory of a subsidiary ofWhittaker. Accordingly, the Commission ordereda formal investigation into this matterwhich confirmed that public disclosure anddisclosure of this settlement to the staff hadbeen incomplete. As a result of this investigation,an injunctive proceeding was institutedon February 8, 1974 against Whittakerand 'the captioned proceeding pursuant toRule 2(e) of the Commission's Rules of Practicewas instituted thereafter.Since the proceedings were instituted, ArthurAndersen, solely for the purposes ofsettling this matter, and without admittingor denying any of the allegations, findings orconclusions has consented to the entry of anorder censuring the firm and to the publicationof certain findings and conclusions bythe Commission. For purposes of this settlement,Arthur Andersen has waived separationof functions and consented to the staff'sparticipation in the preparation of this orderand opinion.,The Arthur Andersen settlement withWhittaker arose out of its audit of the inventoryof Crown Aluminum Corporation, a majorsubsidiary of Whittaker, as part of itsexamination of the financial statements ofWhittaker Corporation for the fiscal yearended October 31, 1971. Subsequent to thisexamination, in connection with the pro-'posed sale of Crown, a physical inventorywas taken which indicated that inventory onthe books exceeded physical inventory onhand by approximately 100%. In the subsequentinvestigation, it was determined thatthe inventory overstatement resulted fromthe fraudulent alteration of inventory recordsby Crown management and otherCrown personnel. By recreation of inventoryrecords, it was calculated that the $9.2 millionbook inventories of Crown at October 31,1971 were overstated by approximately $4.4million, and that income for fiscal years 1970and 1971 was overstated. Of this total shortage,approximately $2.5 million occurred atCrown's Roxboro Plant. The Roxboro physicalinventory had been observed by ArthurAndersen.In connection with this observation, theArthur Andersen auditors did not adequatelycontrol inventory count tags even·ethough the firm's own procedures requlr Isuch control. Accordingly, Crown perso nne

ACCOUNTING SERIES RELEASES 303were able to alter certain tags and to createother' tags which were included with actualcount tags prior to the tabulation of theinventory. In addition, the fraudulent tagswere printed out in numerical sequence onthe inventory tabulation listing and indicatedquantities of aluminum coil in units of50,000 pounds per coil which are quantitiesin excess of that which could have beenreasonably expected to be physically containedin the Roxboro' plant' or any otherplant. The plant did not manufacture or purchasealuminum coils in excess of 5,000pounds. The auditors and any' reviewers ofthe inventory work papers did not notice thisblock of 100 tags which constituted a: substantialportion of the total inventory on thecomputer listing with quantities 10 times aslarge as the, largest actual inventory item.Normal inventory auditing procedures wouldrequire that special ,attention be paid to thelargest items in the inventory.'Further, this inventory observation tookplace under circumstances which shouldhave warranted special care. Arthur Andersenwas aware that in 1969 and 1970 certaininventory tags originally accounted for asunused were included as used by Crown' inthe computer runs.' Arthur Andersen alsoknew that Crown's system for accounting forthe inventory resulted, in differences betweenthe physical and book inventoriesamong various subcategories, though not innet amounts.! Further, the ,1971 audit tookplace in the context where an internal ArthurAndersen' memorandum'had expressedquestions concerning the "credibility" inother respects of Crown's management. 2, 1 Employees at Crown improperly prepared and/or recordedproduction and other accounting records so that~he overall book inventory was virtually equal to themflated physical accounts.M 2 An Arthur Andersen internal memorandum datedarch 14, 1970, expressed the following: ," ... There may be a question as ,to this client's[Crown] credibility as their position changes relativeto t~e net income they wish to report and pressuresWhlttaker is exerting on them.* * * * *"In ..k our opmIOn, the Crown personnel have not beenept fully informed by Whittaker on just what weIn the judgment of the -Commission, ArthurAndersen did not follow generally acceptedauditing standards in the audit ofCrown's inventory, and must share responsibilityfor the misstatements which resulted,even though it is apparent that the firm wasthe victim of a deliberate scheme. to defraudperpetrated by certain management, supervisoryand plant personnel of Crown.The Commission has been advised that ArthurAndersen has taken steps to preventthe recurrence of similar audit deficiencies.The firm has thoroughly reviewed the auditprogram used to audit Crown's inventory inorder to make the most constructive use ofits experience in this regard. While ArthurAndersen did not find that the programsthemselves were deficient within the parametersfor which they were designed, neverthelessit has revised its audit guides in sucha way as to enable reviewing personnel todetect breakdowns in audit procedures suchas occurred here. Further, Arthur Andersenis in the process of preparing a case study ofthe Crown Aluminum situation. This casestudy will be used in Arthur Andersen's stafftraining program in order to alert its professionalstaff to situations of this nature andto make its professional staff more aware ofthe areas in which a fraud can be perpetratedand the methods used to cover upsuch fraudulent conduct.In addition; the Arthur Andersen personnelinvolved in the audit on both a staff anda supervisory level have either left the firmor been reassigned to responsibilities notrelated to the firm's professional practice.The Commission believes that these correctivemeasures and the settlement negotiatedat arm's length with the party damagedmake unnecessary any further action by theCommission in regard to the inventory auditingdeficiency. Subsequent actions by ArthurAndersen in the disclosure of the settlementare doing in relation to the 8-1. It is their opinionthat we should pass adjustments so they can show avery favorable trend. They have told us that this iswhat our other offices are doing, and that you haveagreed that our treatment of the inventory and baddebt adjustments is not valid-they are definitelytrying to playoff you against us to get favorabletreatment."

304 SECURITIES AND EXCHANGE COMMISSION "and related matters require further discussionand action.Promptly following discovery of the inventoryproblem, Whittaker and Arthur Andersenagreed that it would be desirable toconduct a comprehensive review of the company'saccounting systems and internal controlsand an examination of its major inventoriesas well as to engage in a balance sheetaudit of expanded scope at the end of the1972 fiscal year in order to assure both Whittakerand Arthur Andersen that similarproblems did not exist at operating units inaddition to those discovered at Crown. Initially,Arthur Andersen offered to conductthis review, to assist in the implementationof any recommendations, and to perform theexpanded scope audit work at "loan staffrates," approximately one-half of Arthur Andersen'snormal billing rates, which wouldapproximate its out-of-pocket costs. At thetime, Arthur Andersen estimated" that thereview work, if billed at normal rates, wouldamount to approxi'mately $340,000. At Whitta~er'srequest Arthur Andersen agreed toperform the review at no charge. ArthurAndersen also said to Whittaker that itwould assist in performing any systems workrecommended in the review at "approximatelyon"e-half the normal billing rates.At about the same time, Whittaker retainedspecial counsel to determine whetherit had a cause" of action against Arthur Andersen.It did so because it was of the beliefthat Arthur Andersen had conducted an inadequateaudit in connection with Crown'sinventory. Because Whittaker's own investigationrelating to the cause of the inventorydiscrepancies was not then completed, it wasdecided that the company would defer determiningwhether it had a cause of actionagainst Arthur Andersen until the results ofinvestigation were known. Whittaker did notadvise Arthur Andersen that Whittaker wasevaluating its legal rights against ArthurAndersen. Following the conclusion of itsinvestigation into the cause for the inventorydiscrepancies, and in December 1972,after Arthur Andersen had completed itsreview of Whittaker's accounting systemsand internal control and issued a reportthereon, Whittaker was advised by its specialcounsel as well as its General Counsel that intheir opinion Whittaker had a cause of actionagainst Arthur Andersen. This conclusionwas" communicated to Whittaker's Board" ofDirectors, which decided that the compan.yshould pursue its claims against Arthur Andersen.However, because Arthur Andersenwas then in the process of completing itsaudit of Whittaker's 1972 financial statements,and Whittaker was concerned" thatthe assertion of a claim might jeopardize theability of Arthur Andersen to complete itsaudit, Whittaker intentionally withheld fromArthur Andersen any indication that Whittakerintended to assert a claim against ArthurAndersen. 3 On December 28, 1972, theboard of directors decided to assert a claimagainst Arthur Andersen but concluded thatit should not be brought to Arthur Andersen'sattention until Arthur Andersen hadcompleted its audit and" had signed its reporton Whittaker's financial statements whichwas to" be" included in a registration" statementto be filed with 'the Commission in afew days;On January 4,1973, Arthur Andersen executedits report on Whittaker's financialstatements for the fiscal year ended October31, 1972. The auditor's report and financialstateI1lents were contained in a registrationstatement filed with the Commission byWhittaker on January 5, 1973. On the sameday that the registration statement was filedwith the Commission, officers of Whittakeradvised Arthur Andersen that Whittaker feltit had a claim against Arthur Andersen. Atthat time, Whittaker asserted a claim of ap-3 At a board of directors meeting in early December,the topic of submitting the name of Arthur Andersen tothe shareholders for ratification as the auditors for thefollowing year was discussed even though Whittakerhad not previously submitted to their shareholders thequestion of ratifying the selection of auditors. At II.board meeting held on December 22, 1972, it was decidedthat Arthur Andersen would be recommended to theshareholders, provided that the claim Whittaker intendedto assert against Arthur Andersen could beresolved. However, when Arthur Andersen requested acopy of the minutes in connection with its audit, Whi~takerfurnished only a summary of the minutes of thISmeeting, claiming that the full minutes had not as yetbeen prepared. The summary made no mention of theclaim against Arthur Andersen.

ACCOUNTING SERIES RELEASES 305proximately $3' million against Arthur Andersen.During the month of- January 1973,there followed a number of meetings betweentop officers of Whittaker and seriiorpartners of Arthur Andersen. During thesemeetings, Arthur Andersen indicated thatthe pending claim against it jeopardized itsindependence and therefore that it would beunable to sign amendments to the pendingregistration statements. Whittaker told ArthurAndersen that if the issues were notsettled, Whittaker would not be able to recommendArthur Andersen to its shareholdersin connection with the next shareholder'smeeting. On January 30,1973 personnel fromWhittaker and Arthur Andersen met to see ifthey could resolve their differences.During the negotiations, Arthur Andersenmaintained that it would not settle for anyamount in excess of $1 million. Initially, theyoffered to settle by paying Whittaker $500,-000 in cash. They also proposed to establish aceiling of $250,000 at loan staff rates for theimplementation work relating to the recommendationsof the previous review in accordancewith the agreement made prior to thereview. At that time, they explained thatWhittaker was going to receive, almost $2million: $500,000 in cash, $250',000 in freeservices at loan staff rates equal to $500,000in normal billings, plus the $1 million in freeservices that had already been performed.This was the first time that Whittaker hadbeen advised that the review work ArthurAndersen had previously performed withoutcharge t9 Whittaker wauld have cost approx~imately $1 million at normal billing rates andnot the originally estimated $340,000. Whittaker,however, insisted upon a minimum of$1 million in cash in additiop. to the $250,000loan staff assistance which Arthur Andersenhad offered, for a total of $1,250,000. Afterseveral intermediate offers, Whittaker finallyoffered to settle on a cash payment of$875,000. Agreement was also reached on aceiling of $375,000 for the iinplementationprogram at loan staff rates. Whittaker executedand delivered to Arthur Andersen a";.ritten release of its claim in considerationo 1he pa~ment to it of $875,000.ced'Ccordmg to Whittaker,immediately pre-mg agreement to the terms of this finalproposal, Arthur Andersen inqUIred of Whi~~taker whether Arthur Andersen' woul~ berecommended to the shareholders at theforthcoming shareholders meeting and weretold they would be recommended.'According to Whittaker, Arthur Andersendesired to have disclosures concerning thesettleme~t li~ited to the $875,000 cash payment.4According to Arthur 'Andersen thesettlement amounted only to the cash paymentof $875;000 and, since the other factorswere not a p~u-t of the settlement, no disclosurewas necessary. 'Following the settlement, counsel for Whittaker'requested a meeting with the staff oftheCommissioU:; including the Chief Accountantof the Commission, in order to discussthe possib'le effect ,the settlement might haveon Arthur Andersen's independence. Thismeeting took place February 6, 1973 and wasattended by seni~~, management of Whittakerand senior partn'ers af Arthur Andersen,including on both sides persons who hadattended the negotiating meetings describedabove, and by their respective counsel. Atthat time, the $875,000 cash payment settlementwas described'to the Commissiop. as thesettlement. No mention was made of theearlier free review work that Arthur Andersenhild performed several months bEdore

deficiencies6 In September 1973, during the pendency of the Commission'sinvestigation which preceded the filing of theabove-mentioned complaint, Whittaker's board of directorsconcluded that the interests of the company reo306 SECURITIES AND .EXC~GE COMMISSIONany threat of suit: (which had been estimatedto have involved almost $1 million if billed atnorrn:~l rates), and no mention was made o~the additional agreement by Arthur Andersento' assist in implementing the reviewrecommendations at loan staff rates up to anamount of $375,000. In addition, no menti

ACCOUNTING SERiES RELEASES 307own rational decisions. The other rests., on the belief that appropriate publicity·ten~s to deter questionable practices andto elevate sta:rJdards of public conduct:"7The ultimate goal of the securities laws is,of course, shareholder and investor· protection.Effectivedisclosure is essentially ameans to that end and the entire legislativescheme can be frustrated by technical orformalistic attempts to .comply with the stat-1.ltes and rules involved without complyingwith the substance and hence the spirit andpurpose of the laws involved. The Commissionhas consistently attempted to achievedisclosurE;! in terms which are "clearly understandable."sUnfortunately, actual disclosures~ade have not always achieved theobjectives of the statute. As District JudgeWeinstein noted in this connection:"In at least some instances, what hasdeveloped in lieu of the open disclosureenvisioned by the Congress is a literaryart form calculated to communicate aslittle of the essential information as possiblewhile exuding an air of total candor.Masters of this medium utilized turgidprose to enshroud the occasionalcritical revelation in a morass of dull,and-to all but the sophisticates-uselessfinancial and historical ~ata. In t.heface of such obfuscatory tactics the commonor even the inoderately well informedinvestor is almost as much at the·mercy of the issuer as was his pre-SECparent."9In the instant case both Whittaker andArthur Andersen, in seeking 'the advice ofthe Commission's staff in the manner inwhich they did, not only frustrated the pur­Poses of the statute but imposed upon theC?mmission and its staff by seeking advicewIthout providing the staff with all of thematerial facts. The representativ~s of Ar-··t~ur Andersen in this regard emphasize thatt ey were acting in good faith and in reli-- h:rS~e F. Wheat, Disclosure to Investors, 10 (1969)8 elnafter referred to as the "Wheat Report").9 W~eat Report, at 78.F sFett v. Leasco Data Processing Equipment Corp., 332. upp 544, 565 (E.D.N.Y., 1971).ance on advice of several· counsel, and thatthey believed additional disclosure was ~otgermane or required. It should be· apparentto all, however, that the securities laws· andtheir administration by the Commission and·its staff cannot function well .if those whopractice before the Commission and thosewho file documents with it fail to operate inan atmosphere of unquestionable ·candor ~ndfull disclosure. Adequate disclosure does nottake place when there are salient facts be~r~ing on the merits of a negotiated settlementwhich are not disclosed.Whatever the merits of the argument thatdisclosure of the other aspect of the settlementwere not required to be made in theproxy statement, there is no excuse for theirnon-disclosure to the staff of the Commissionwhen its advice was being sought. The advicesought and the advice given are only as goodas the information upon which they are predicated.The limited review engaged in by thestaff of the Commission, whether it relates toregistration statements, proxy statements orother materials filed with the Commission,and the advice sought and the commentsgiven by the staff cannot take place consistentwith the objectives of the statutes in anadversarial atmosphere. The Commissionand its staff do not and cannot investig~terepresent~ti

308 SECURITIES AND EXCHANGE COMMISSIONlent of his or her reputation. Conferellceswith the staff of the Commission serve a­vital role in the administration of the securitieslaws, and ~uch conferEmces are predicated,for the most part, upon full disclosureby the professionals involved. It must beunderstood by all who practice before theCommission, lawyers and accountants alike,that the Commission and its staff cannottolerate less than full disclosure.By the Commission, Commissioner Sommernot participating.GEORGE A. FrrZSIMMONSSecretaryORDERUnder the· terms of its offer of.settlement,Respondent without ad:rp.itting or denyingthe Commission's findings and o"nly for thepurpose of settlement, consented to the" entryof an order embodying the folloWingsanctions.Accordingly, it is ORDERED that, subjectto the terms and conditions provided in theoffer of settlement, Respondent is censuredby the Commission.By the Commission. Commissioner Sommernot participating.GEORGE A. FrrZSIMMONSSecretaryRELEASE NO. 158July 19, 1974SECURITIES ACT OF. 1933Release No. 5514SECURITIES EXCHANGE ACT OF 1934Release No. 10921Order Accepting Sworn Undertaking Not to Engage in Practice Before The Commission in theMatter of Adolph F. SpearOn March 18,-1974, in an action brought bythe Commission, 1 the United States DistrictCourt for the Southern District of New Yorkentered an order permanently enjoiningAdolph F~ Spear, a Certified Public Accountant,from violating or aiding and abettingviolations of Section 17(a) of the SecuritiesAct.of 1933, and Section 10(b) of the SecuritiesExchange Act of 1934 and Rule 10b-5promulgated thereunder. The order, whichwas issued· with Mr. Spear's consent andwithout his admitting or denying the allegationsof the Commission's complaint, enjoinshim from, among other things, engaging inany act, practice or course of business whichoperates or would operate as a fraud ordeceit upon any person in connection with,but not limited to, the preparation and dis-I Securities and Exchange Commission v. World AcceptanceCorporation, et al., Civil Action No. 74-794(S.D.N.Y.).semination of false certified financial statementsof World Acceptance Corporation orany other issuer, the value and existence ofproperties owned by World Acceptance Corporationor any other issuer and the businessoperations of World Acceptance Corporationor any other issuer.At the same time that he consented to theorder of permanent injunction, Mr. Spear.executed a sworn statement stating that hehas no intention of resuming practice as aCertified Public Accountant and, in anyevent, that he will not perform any servicesas a Certified Public Accountant in connectionwith any administrative matter withinthe Commission's jurisdiction. 2After due consideration, and upon the rec-2 In the Commission's view, the language of Mr.Spear's undertaking would, at a minimum, encompas~practice before the Commission as defined in Rule 2(g) 0the Commission's Rules of Practice.

ACCQUNl'ING SERIES RELJi!ASESommendation of its. staff, the Commissionhas determined to accept Mr. Spear's swornundertaking not to practic~ before the Commission.A~~ordi~gly, IT IS ORDERED that thesworn undertaking ·of Adolph F. Spear not topractice before the Commission be, and herebyis, accepted; and it is further ORDEREDthat .the pr~vilege of appearing or practicingbefore the Commission be, and it hereby is,permanently denied him.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 159August 14, 1974SEcuRITIES ACT OF 1933Release No. 5520SECURITIES EXCHANGE ACT OF 1934Release No. 10961Notice of ~doption of Amendments to Guide 22 of the Guides for Preparation and Filing ofRegistration Statements under The Securities Act of 1933 and Adoption of Guide 1 of The GuidesFor Preparation and Filing of Reports and Registration Statements under The SecuritiesExchange Act of 1934 (Textual Analysis of Summary of Earnings or Operations)Effective Date: September 30, 1974The Securities and Exchange Commissiontoday authorized the adoption of amendmentsto Guide 22, "Summary of Earnings,"of the Guides for Preparation and Filing ofRegistrat~on Statements under the SecuritiesAct of 1933 ("Securities Act"). The Commissionalso. authorized the adoption ofGuide 1, "Summary of Operations," of Guidesfor Preparation and Filing of Reports andRegistration Statements under the SecuritiesExchange Act of 1934 ("Exchange Act").These Guides are not rules of the Commissionnor are they published as bearing theCommission's official approval; they representpolicies and practices followed by theCommission's Division of Corporation Fin.an?eand, in this instance, the Commis­SIon s Office of the Chief Accountant in administeringthe disclosure requirements ofthe federal securities laws. The proposals toamend Guide 22 under the Securities Act andad.opt Guide 1 under the Exchange Act wereorl .b gInalIy published for comment on Decema~~19, 1972 (Securities Act Release No. 5342)add. t.hen were reissued in revised form for(Sltlonal comment on December 12, 1973ecur·t·lIes Act Release No. 5442). TheseGuides will require disclosure to clarify and.explain the financial information called forby the Summary of Earnings and Statementof Income items of certain forms under theSecurities Act and similar summaries requiredby certain forms under the ExchangeAct.The relevant forms under the SecuritiesAct provide in part that, in addition to thecolumnar presentation of summary financialdata, registrants must supply information ofmaterial significance to investors in appraisingthe results shown. Securities Act Guide22, as .amended, indicates the type of supplementaryinformation needed to explain periodicchanges in financial data included in theSummary of Earnings. In order to applydisclosure standards similar to those requiredby Securities Act Guide 22, asamended, to filings under the Exchange Act,the new Exchange Act Guide 1 is adopted.In issuing the Guides for additional commentin December 1973, the Commissionpointed out that it has long recognized theneed for narrative explanation of financialstatements. Over the years the rules underthe various securities acts have beenamended a number of times to require addi-

310 SECURITIES AND EXCHANGE COMMISSIONtional narrative disclosure of complex financialtransactions. Securities Act Guide 22and Exchange Act Guide 1 require an explanationof the Summary of Earnings and Summaryof Operations to enable investors toappraise the quality of earnings. Investorsshould understand the extent to which accountingchanges, as well as changes in businessactivity, have affected the comparabilityof year-to-year data and should be in aposition to assess the source and probabilityof recurrence of net income (or loss). Thus,whenever there are material changes in theamount and source of revenues and expenses,including tax expenses, or changes inaccounting principles or methods or theirapplication that have a material effect onnet income, an appropriate analysis and explanationis required. In addition, this analysisshould include a discussion of materialfacts, whether favorable or unfavorable, re-.quired to be disclosed or disclosed in theprospectus, registration statement, or reportwhich in the opinion of management maymake historical- operations or earnings asreported in summary of earnings not indica~tive of current or future operations or earnings.Some commentators on the revised Guidesfelt that the standards for determining materialitywere too inclusive and that itemsthat were not material would still fall withinthe percentage test set forth in the Guides.The Guides, as adopted, provide that if inmanagement's opinion an explanation of achange is not necessary to an understandingof the summary of earnings even though thechange meets the percentage tests set forthin the Guides, the issuer should furnish theDivision as supplemental information, awritten statement of the reasons for suchopinion. On the other hand, if the issuerbelieves an explanation of a change is necessaryto an understanding of the summary, itshould be given· notwithstanding the factthat the change does not meet such percentagetests. For example, if sales and net earningsincreased only 2% in the most recentperiod after having increased by 10% ormore in previous periods an explanation ofthe 2% change would be appropriate. Also inresponse to comments, the Guides as finallya.dopted limit the issuer's explanation of ma- -terial . periodic revenue and expe~se itemchanges to changes beginning after the thirdmost recent fiscal year of the Summary ofEarnings (Summary of Operations) and providethat this explanation of material periodicchanges in revenues and expenses beincluded in a section captioned "Management'sDiscussion and Analysis of the Summaryof Earnings" immediately followingthe Summary of Earnings (Sull1mary of Operations)..A number of commentators also objectedto the requirement that management discussfacts that would indicate that historicalearnings were not indicative of present andfuture earnings. Difficulty in deciding what"facts" would have to be included and inpresenting forward looking information werecited. These comments have been take~ intoconsideration in revising the Guides, whichas· adopted require discussion of only materialfacts required to be disclosed or disclosedin the relevant document which, in management'sopinion, may make historical operationsor earnings not indicative of current orfuture operations or earnings. The discussioncalled. for would be in broad terms only;no specific quantitative estimates or projectionswould be required. Commentators alsoraised the question whether the Guide callsfor disclosure relating to anticipated changesin the trend of earnings or in absolute numbers.Depending on the facts and circumstances,discussion of material facts indicatingchanges in either absolute amounts or intrends would be required.It should be noted that the disclosuresproposed would be in addition to "Informationas to Lines of Business" called for byItem 9(b) of Form S-l and Item 5(b)(1) ofForm S-7 under the Secilrities Act and similardisclosure required by Item l(c)(l) ofForms 10 and 10-K under the Exchange Act.The text o(SecuritiesAct Guide 22 is setforth below. Exchange Act Guide 1 is also setforth below.* * *

ACCOUNTING SERIES RELEASES 311Guidi 22 Summary of Barnings. (Note: This Guide applies to the items ofthe registration forms under the Act thatprovide for a SU:tnmary of Earnings, Statementof Income, Summary Financial Data,or Condensed Financial Information, i.e.,Forms S-1, S-7, S-8, S-9, S-l1 and S-14).. (a) The content of the Summary of Earningsis specified in general in the instructionsto the pertinent items of the form. Thenecessity of disclosing items in addition tothose specified in such instructions will dependupon the circumstances. These instructionscannot, of course, cover all situationswhich may arise nor is it practicable to setforth a Guideline dealing specifically with allpossible situations. .(b) To enable investors to understand andevaluate material pedodic changes in thevarious items of the summary of earntngs, aseparately captioned section (entitled "Management'sDiscussion and Analysis of theSummary of Earnings") immediately followingsuch summary should include a state­. ment explaining (1) material changes fromperiod to period in the amounts of the itemsof revenues and expenses, and (2) changes inaccounting principles or practices or in themethod of their application that have a materialeffect on net income as reported. Thepurpose of this statement is to provide inves-. tors with management's analysis of the financialdata included in the summarythrough a discussion of the causes of materialchanges in the items of the summaryand of disclosure of the dollar amount ofea

312 SECURITIES AND EXCHANGE COMMISSIONclear' understanding by th,e investor of 'thefinancial results. Favo~able as, well as unfavorabletrends and changes s'hould be, discussed.Tables and charts may be used wher'eapprQPr:iate. A mechanistic approach to thisana\ysis -which uses ,boiler, plate or complianc~ja,rgon should be avoided. ,JO For purposes of this Guide discussion ofa: change in an item of rev~nue, or expensegen~rally is required when an item requiredto, be set forth in the summary or disclosedpursuant .to Rule 12-16 of Regulation S-Xin,c17e.ased or decreased by more than 10% ascompared to the prior period (but only if suchprior period is presented), and increased ordecreased by morethari 2% of the averagene~ income or. loss .for the most recent threeyears' presented. In calculating, average netin!!ome, loss years should be excluded.. Iflosl!l,~s were incurred in 'each of the mostrec~ntye~rs, the· average loss shall be usedfor purposes of this test. Should the issue~ be· ..of the opinion that, an explanation of' achange is not necessary to an understandingof the summary even though the changemeets the foregoing standards, the issuershaIi furnish the Division, as suppleme~ta]information, a written statement' of the reasonsfor the omission.Note: If an income statement in theform prescribed, by Regulation S­X is used in lieu of the summary,then the discussion should coverthe period to period changes inrevenue and expense items requiredby such Regulation.(g) 'Notwithstanding the fact that a changein an item of revenue or expense does notmeet the standards set forth in paragraph(0, .it should be discussed if the issuer believesan explanation 'of such a change isnecessar~ to an understanding of the summary.(h)' When. the text of the prospectus containsa discussion of factors indicating amaterial change in operating results,whether favorable or unfavorable subsequentto the latest period included in thesummary of operations, the management discussionand analysis should call attention tothe change and refer to the place in theprospectus where it is discussed. '., . ,* * * 'Guide 1 Summary of Operati~ns(a) The content of the sUnimary of'opera- 'tions is specified in general in the instructionsto the pertinent items of Forms '10 and10-K. 'The nece~sity ofdis~losing ite~s inaddition to those specified in such instruc-,tions will depend upon' the circumstances~These instructions cannot, of course, coverall situations which may arise nor -is it practicableto set forth a Guideline dealing specifically\vithall possible situations. .(b) To enable investors to unde~stand 'andevaluate' material periodic changes 'in thevarious items of the summary of operatioils,a separately captioned' section (entitled"Management's Discussion and Anaiysis' ofThe Summary of Operations") 'immediately:folloWing su,ch sUInmary, should .include astatement explaining, (1) material changesfrom period to period in the amounts of the'items of r~yenues and expenses, a,nd (2)changes in accounting principles or practicesor in the method of their application thathaye ,a material 'effect on net in~ome asreported. The pu:rpose of this' statement is toprovide investors with management's amilysisof the financial data included in the summarythrough a ,discussion' of the causes ~fmaterial changes in the'ite:pls of the summaryand of disclosure of the dollar amountof each such change and the effect of eachsuch change on the reported results for theapplicable periods. This discussion is necessaryto enable ipv!,!stors to compare periodicresults of operations and to assess the sourceand probability of recurrence of earnings(losses). The analysis should include a discussionof material facts, wheth~r favorable orunfavorable, required to be disclosed or disclosedin the registratIon statement or reportwhich, in the opinion of management,may make historical operations or earningsas reported in the summary of operations notindicative of current or future operations orearnings.(c) In' general, the discussion of materialperiodic changes should be limited to: (1) the

latest interim period presented and the com~parable interim period in the immediately .preceding fiscal year; (2) the most recentfiscal year presented and the fiscal year immediatelypreceding it; and (3) the secondmost recent fiscal year presented· and thefiscal. year immediately preceding it. Theremay be circum~tances, however, under whichan explanation of revenue or expense itemchanges. between two or more of the earlierperiods of the five year summary may be.material to an understanding of the summary.Further, to better explain revenueand expense item ch~nges for interim pe~riods it may be necessary to give an analysisof changes between consecutive· fiscal quarters.(d) While it is not feasible to specify .all .subjects which should be covered in the discussionand· analysis of the summary, thefollowing are examples which registrantsshould consider jn making disclosure:1. "Material changes in product mix or inthe relative profitability of lines ofbusiness;2. Material changes in advertising, research,development, product introductionor other discretionary costs;3. The acquisition or disposition of a materialasset other than in the ordinarycourse of business;4. Material and unusual charges orgains, including credits or charges associatedwith discontinuation of operations;5. Material changes in assumptions underlyingdeferred costs and the planfor amortization of such costs;6. Material changes in assumed investmentreturn and in actuarial assumptionsused to calculate contributionsto pension funds; and7. The closing of a material facility ormaterial interruption of business orcompletion ofa material contract.(e) The textual analysis should be presentedin a manner that will best communic~tethe significant elements necessary to acfi ear understanding by the investor of theIna .nClal results. Favorable as well as unfavorabletrends and changes should be dis-ACCOUNTING SERIES RELEASES 313cussed. Tables and cha~s may be used whereappropriate. A mechanistic approach "to thisanalysis which uses boiler,· plate or coinpli-'··ance jargon should be avoided.(f) For purposes of this Guide discussion ofa change in an item of revenue or expense .generally is required when an item requiredto be set forth in the· summary or disclosedpursuant to Rule 12-16 of Regulation S~Xincreased or decreased by more than 10% as·compared to the prior period (but only if such·prior p.eriod is presented), and increased ·ordecreased by· more than 2% as compared" tothe average net income or loss for the most·recent th.ree years presented. In calculatingaverage net income, loss years should beexcluded. If"losses were incurred in each "ofthe most recent years; the average loss shallbe used for purposes of this test. Should theissuer be of the opinion that an explanation·of a change is not necessary to an under~standing of the summary even through thechange meets the foregoing standards, theissuer sha]l furnish the Division, as supplementalinformation, a written statement ofthe reasons for the omission.Note: If an income statement in theform prescribed by Regulation S­X is used in lieu of the summary,then the discussion should coverthe period to period changes inrevenue and expense items requiredby such Regulation.(g) Notwithstanding the fact that a changein an item of revenue or expense does notmeet the sta~dards set forth in paragraph(f), it should be discussed if the issuer believesan explanation. of such a change isnecess~ry to an understanding of the summary.(h) When the text of the registration statementor report contains a discussion of factorsindicating a material change in operatingresults, whether favorable orunfavorable, subsequent to the latest periodincluded in the summary of operations, themanagement discussion and analysis shouldcall attention to the change and refer to theplace in the registration .statement or reportwhere it is discussed.* * *

314 SECURITIES .~. EXCHANGE COMMISSIONThe Commission has authorized ·the. adoptionof. Guide 22 and Guide 1 pursuant toauthority in Sections 6, 7, 10 and 19(a) of theSecurities Act, as amended, and Sections 12,13, 15(d) and 23(a) of the Exchange Act, asamended. The amendments will be effectiveSeptember 30, 1974 and will apply to registrationstatements under the Securities Actarid to reports and registration statementsunder the Exchange Act filed' on or afterthat date, but not to such registration statementsand reports filed before that date.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 160August 27, 1974Fbidings and Order Suspending From Commission Practice in the Matter of Loux, Gose & Co.and Galen Lloyd GoseThese are proceedings pursuant to Rule2(e) of the Commission's Rules of Practice todetermine whether Loux, Gose & Co. ("the(ihn"), a public accounting firm, and GalenLloyd ,Gose, a partner of the firm, should betemporarily or permanently denied the privilegeof appearing or, practicing before theCommission.Respondents have submitted an offer ofsettlement which the .Commission determinedto, accept. Solely for the purpose ofthese proceedings and without admitting ordenying the allegations of the order for proceedings,respondents consent to findings ofmisconduct as alleged in that order and to aspecified sanction.On the basis of the order for proceedingsand,the offer of settlement, it is found that:1. The firm audited the records of a thenregistered broker-dealer, and certifiedits firianciai statement as of September30,1971. Gose was the partner in chargeof the engagement.2. In connection with the audit and thecertification of the broker-dealer's financialstatement, which was filed withthe Commission on Form X-17a-5 pursuantto Rule 17a-5 under the SecuritiesExchange Act of 1934, respondentsfailed to comply with generally acceptingauditing standards and the Commission'sinstructions for the Form. Theaudit' was not adequately planned. Theaccountant conducting it lacked adequatetraining and proficiency as anauditor, and was not supervised properlyby respondents. In a-ddition, respondentsfailed to evaluate the effectivenessof the broker-dealer's existinginternal controls to determine the needfor extending the scope of the examination,to inquire into material post-statementevents, and to obtain· sufficientevidence to afford a reasonable basis forthe unqualified opinion given to the broker-dealer.Respondents consent to the entry of anorder suspending them from 'appearing orpractiCing before the Commission for 18months. They agree that prior to appearingor practicing before the Commission theywill request a quality review of their audit­~ng procedures under the quality review programof the American Institute of CertifiedPublic Accountants, correct any deficienciesso discovered, and submit the findings uponsuch review to the Commission's Chief Accountant'sOffice and Fort Worth RegionalOffice. In addition, the firm agrees to givenotice in writing of the findings in th;~t~proceedings to any client who requests au . Iing services for the purpose of registratIonwith or reporting to the Commission. . teUnder the circumstances, it is approprl a

ACCOUNTING SERIES RELEASES 315to ,i~pose the sanction specified in the offerof settlement.Accordingly, IT IS ORDERED that, subjectto the undertakings specified in the offerof settlement, Loux, Gose & Co. and. GalenLloyd Gose be, ·~nd they hereby are, suspendedfrom appearing or practicing beforethe Commission for a period of eighteenmonths, effective immediately.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 161August 29, 1974SECURITIES ACT OF 1933Release No. 5524SECURITIES EXCHANGE ACT OF 1934Release No. 10993Order Permanently Suspending Accountant from Appearance or Practice Before Commission inthe. Matter of Jerry A. McFarlandOn June 26, 1973, the Commission enteredan order, pursuant to Rule 2(e)(3)(i) of i~sRules of Practice, temporarily suspendingJerry A. McFarland, a certified public accountant,from. appearing or practicing beforeit. That order was based on the factthat, on February 25,1974, the United StatesDistrict Court for the Western District ofTexas granted the Commission's motion forsummary judgment and permanently enjoinedMcFarland from aiding or abettingfurther violations of Sections 5(a), 5(c) and17(a) of the. Securities -Act and Section .10(b)of the Securities Exchange Act and Rule 10b-5 promulgated thereupder (Securities andExchange Commission v. Bankers TrustCompany, Inc., et al., No. EP-73-CA-225).The complaint in the injunctive action alleged,among other things, that McFarland~ad violated those provisions by ~is preparatl~nand certification of materially false andnnsleading financial statements for BankersTrust Company, which were used by that, Company and others in connection with the~~fer and sale of unregistered securities toe pUblic.Rule 2(e)(3)(ii) of the Rules of Practice pro-. vides that any person temporarily suspendedin accordance with paragraph (i) may, within30 days after service upon him of the order oftemporary suspension, petition the Commissionto lift such suspension, but that if nopetition has been received by the Commissionwithin 30 days after such service, thesuspension shall become permanent. Mc­Farland was duly notified of this provision.The 30-day period has expired and no petitionto lift the suspension has been receivedby the Commission.Accordingly, IT IS ORDERED that JerryA. McFarland be, and he hereby is, permanentlysuspended from appearing or practicingbefore the Commission.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.GEORGE A. FITZSIMMONSSecretary

316 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 162September 27, 1974SECURITIES ACT OF 1933Release No. 5528SECURITIES EXCHANGE ACT OF 1934Release No. 11029Requirements for Financial Statements of Certain Special Purpose Limited Partnerships in- Annual Reports Filed with the CommissionIn recent years there have been an increasingnumber of registration statementsfiled with the Commission under the SecuritiesAct of 1933 for the sale to the public ofinterests in limited partnerships which areformed in connection with activities involvingincome tax shelter or deferral opportunities,as well as the opportunity for investmEmtgain in one form or another. Pursuantto Rule 15d-1 under the Securities ExchangeAct of 1934 registrants under the SecuritiesAct are required to file an annual report onForm 10-K for the fiscal year in which aregistration statement becomes effective andfor each subsequent fiscal year thereafterunless the registrant is exempt under Section15(d) of the Exchange Act from suchsubsequent filings. Many of these limitedpartnership registrants qualify for the exemptionfrom filing 10-K reports in subsequentfiscal years provided in Section 15(d)when securities to which the registrationstatement relates are held of record by lessthan 300 persons at the beginning of a fiscalyear.Some registrants, particularly those of thetype which develop and sell a single asset,have filed Form 10-K reports presenting therequired audited financial statements of thelimited partnership on a tax basis of accountingrather than on the basis of generallyaccepted accounting principles (GAAP). Historically,presentation of financial statementsof commercial and industrial companieson a GAAP basis has been consideredthe only acceptable basis for investors andpotential investors in a public company. Theindependent accountants' reports accompanyingthe financial statements presented ona tax basis acknowledge that the financialstatements do not purport to be in conformitywith GAAP, and an opinion is expressedon the fairness of presentation of the financialstatements on the tax basis. Heretofore,the staff has not, in general, requestedamendment of these financial statementspresented and audited on a tax basis. However,experience gained with the increasednumber of recent filings has caused a reconsiderationof this matter.One of the basic purposes of both the Securities'Actand the Exchange Act is to requireregistrants to provide full and fair disclosureregarding all- significant aspects and' activitiesof the business for the benefit of theinvesting public. The requirements for financialstatements under the Acts implementthis objective by causing disclosures regardingthe stewardship of financial resources ofthe company with respect to their utilizationand their condition. Since financial statementsprepared on a tax basis do not necessarilygive a complete presentation of thestewardship of the resources, they do not ingeneral meet the requirements for full andfair disclosure as envisioned in the Acts.Complete data relating to many aspects offinancial position and operations are frequentlynot included in financial statementsprepared on a tax basis and the scope of theindependent audit of such tax basis statementsalso may not be the equivalent of theusual audit of financial statements preparedon a GAAP basis. In addition, some problemareas arising out of relationships between, ageneral partner in the limited partners,h~and other related parties may cause p~rtIC Iflar accounting and auditing difficultIes. dthe financial statements of these hmI' 'te,partnerships are prepared on a GAAP ba~IS~it is likely that these factors would receIVt bearmoreattention and have an importan

, .ing on the determination of the scope of theaudit.'While it is contended that, in some instances,'investors in these limited partnershipsare primarily interested in the taxstatus of their investments and thus taxbasis financial statements are of more valueto them, the ultimate realization of the taxbenefits, as well as the ultimate recovery ofthe investment through sale of the project,depends on the proper utilization and stewardshipof the resources of the enterprise.Independent verification of the reporting onthese matters, can best be obtained fromaudited financial statements presented on aGAAP basis. Presentation of the financialdata on a tax basis may also be desirable butthe presentation should be in addition to thepresentation on a GAAP basis and shouldnot supplant it. It is common practice forcompanies to make adjustments to theirGAAP based account& for income tax reportingpurposes, and it is considered that theselimited partnerships can provide the tax basisfinancial statements in addition to theGAAP basis statements without undue difficUlty.In the rare instances where the sole10-K report required for the limited partnershipscovers a period near the start of theACCOUNTING SERIES RELEASES 317venture, the GAAP basis financial statementsserve a useful purpose by providingimportant information to the original investorson the custody of the funds received andwhether plans and commitments are beIngmade in conformity with the proposed scheduleof development of the project.The Commission has 'concluded that 'exemptionsshould not be granted to theselimited partnership registrants from thegeneral requirement that financial statementsshould be presented in conformitywith GAAP with the audit opinion renderedthereon on that basis in filings with theCommission. Accordingly, financial statementsin Form 10-K reports filed by limitedpartnership registrants for fiscal years endingon or after December 27, 1974, should bepresented on the basis of generally acceptedaccounting principles. Financial data presentedon a tax basis may be necessary infootnotes or supporting schedules to providedisclosures regarding tax aspects of the investments.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 163November 14, 1974SECURITIES ACT OF 1933Release No. 5540SECURITIES EXCHANGE ACT OF 1934Release No. III 00Capitalization of. Interest by Companies Other Than Public Utilities· The Commission has noted' with concern anl~crease in the number of nonutility companle~changing their accounting method to a~Ohcy of capitalizing interest cost.'·On June· 1 a proposed Accounting Series Release was~~ued for comm~nt (Securities Act Release· . 5505) proposmg a statement of account­~g policy on this issue and an amendment toegulation S-X requiring additional disclosureofSider .capl'tal'lzed·mterest costs. After conatlOnof the comments received, theCommission has determined to issue the followingstatement of policy and to adopt certainamendments to Regulation S-X as setforth below. In addition, the comments indicatedthe need for certain interpretive guidelinesand these are included as an appendixto this release.A. COMMENTARYThe conventional accounting model applicableto companies other than public utilities

..318 SECURITIES AND EXCHANGE COMMISSIONhas· not traditionally treated the cost of capitalas part of the cost of an asset and, exceptfor two specific industries, no authoritativestatement on this subject presently exists.Interest cost on debt is generally treated asa period expense of the period during whichqebt capital is use~, while the cost of equitycapital is reflected neither hi asset cost norin the in~ome statement.This approach has been adopted for a numberof reasons. First, it is impossible to followcash once it has been invested in a firm.Even when a loan is made for a designatedpurp~se and secured .by a li·en on specificassets, it can be argued that capital madeavailable for one purpose frees other capitalfor other purposes, and it is therefore unrealisticto allocate the cost of any particularfinancing to any particular asset. Thus, anyallocation of capital cost to particular assetsis based on allocation deCisions which areinherently arbitrary.Second, the cost o~ capital is extremelydifficult to measure. While interest ratesmay be associated with borrowings, any debtnormally rests in part on the existence of anequity base which provides borrowing capacity.Suppliers of debt capital almost inevitablylook to a borrower's overall economicposition in making credit granting decisions.In addition, restrictive covenants and otherterms such as compensating balance require-. ments may make the stated interest rate anunrealistic measure of capital. The cost ofcommon equity capital is even more difficultto measure since it represents the cost ofsharing an uncertain future earnings streamrather than a contractual out-of-pocket payment.Third, it has been felt that interest costswere generally costs of a continuing nature,usually fixed by contract, and that deferralof certain of these costs might leave an erroneousimpression as to the level of interestexpense (and the cash outlay for interest)that might be expected in the future. Interestwould not halt, for example, when anasset constructed with the use of capitalfunds was completed and placed in service.For these reasons, interest cost has generallybeen reflected as an expense of theperiod during which capital was used ratherthan associated with the assets acquired bythe use of the capital, even though it can beargued that interest cost is a cost whichshould be allocated to assets like other costsand that expensing interest as accrued is notconsistent with the matching model in generaluse. Two ex~eptions to this general ruleexist in the authoritative accounting literature.These are set forth in the Industry·Audit Guide issued by the American Instituteof Certified Public Accountants for"Savings and Loan Associations" and theAICPA Industry Accounting Guide "Accountingfor Retail Land Sales." In addition,electric, gas, water and telephone utilitieshave traditionally capitalized an allowancefor funds used in construction, includingboth interest and return on equity componentson the basis of rate-making considerations.The Commission has recently noted an increasingnumber of cases where interest hasbeen capitalized by registrants othe·r thanelectric, gas, water and telephone utilitiesand the exceptions noted above. This hascreated a source of incomparability betweenfinancial statements of companies followingdifferent practices in this respect.While the Commission recognizes that argumentscan be made for each of the accountingpractices in this area, it does notseem desirable to have an alternative practicegrow up through selective adoption byindividual companies without careful considerationof such a change by the FinancialAccounting Standards Board, including thedevelopment of systematic criteria as towhen, if ever, capitalization of interest isdesirable.Accordingly, the Commission concludesthat companies other than electric, gas,water and telephone utilities and those companiescovered by the two exceptions in the. authoritative literature described above, which had not, as of Jun~ 21, 1974, publiclYdisclosed an accounting policy of capitalizi~ginterest costs shall not follow such a po 1· ICY.Infinancial statements filed with the CommISsioncovering fiscal periods ending after June21 1974. At such time as the Financial A.dc-, t n -counting Standards Board develops s a hards for accounting for interest cost, t e

ACCOUNTING SERIES RELEASES 319Commission expects to reconsider this conclusion.Until such time, companies whichhave publicly disclosed such a policy maycontinue to apply it on a consistent basis butnot extend it to n~w types of assets. Returnon equity invested shall not be capitalized bycOIllpanies other than electric, gas, waterand telephone utilities.In addition, the Commission has amendedRegulation S-X to require that all companieswhich capitalize interest costs make disclosurein the face of the income statement ofthe amount capitalized in each year an in~come statement is presented and, in addition,that companies other than electric, gas,water and telephone utilities disclose theeffect on net income of this accounting policyas compared to a policy of charging interestto expense as accrued. This disclosure requirementincludes companies in the twoindustries mentioned above where there isan authoritative support for interest capitalization,since companies in those industriesare not capitalizing interest in reliance upona concept that recovery is virtually assuredthrough the rate-making process which isthe basis for capitalization by electric, gas,water and telephone utilities. Accordingly,interest capitalization in those industries resultsfrom an accounting variation· ratherthan a variation in the economic characteristicsof the assets involved, and disclosure ofthe impact of the accou;nting practice whichis peculiar to these industries is appropriateto facilitate comparisons with other industries.It is recognized that disclosure as requiredherein of the effect on net income of capitalizinginterest as compared to a policy ofcharging to expense as accrued is of primaryinterest to those users of financial statementswho wish to undertake a detailedanalysis of corporate activities and may notbe required in financial disclosure orientedSolely to the needs of the average inyestor.B. AMENDMENT TO REGULATION S-XR The following amendment to Rule 3-16 ofegulation S-X is adopted hereby:Rule 3-16.Statements.General Notes to Financial* * * *(r) Interest capitalized.,(1) The amount of interest cost capitalizedin each period for which an~in~come statement is presented shall-beshown within the income statement.Companies other than electric, gas~water and telephorie utilities whichfollow a policy of capitalizing interestcost (See Accounting Series ReleaseNo. 163) shall make the following additionaldisclosures required by'items(2) and (3) below. ,(2) The reason for the policy of interestcapitalization and the way in whichthe amount to be capitalized is determined.(3) The effect on net income for eachperiod for which an income statementis presented of following a policy ofcapitalizing interest as compared to apolicy of charging interest to expenseas incurred.* * * * *, This amendment shall be applicable to allfinancial statements filed on or after J anuary1, 1975.The above rule is adopted pursuant to authorityconferred on the Commission by theSecurities Act of 1933, particularly Sections6, 7, 8~ 10 and 19(a) thereof; and the SecuritiesExchange Act of 1934, particularly Sections12, 13, 15(d) and 23(a) thereof.By the Commission.GEORGE A. FITZSIMMONSSecretary

____________________320 SECURITIES AND EXCHANGE COMMISSION: - - .APPENDIXINTERPRETIVE COMMENTS AND GUIDELINES1. Calculation of Income EffectThe original proposal made by the Commission wouldhave required disclosure of the amount of Interest capitalizedin any balance sheets presented. In response tocomm~nts that questioned the need for such data thisproposal was,. riot· a:dopted. In calculating the effect ofinte!est capitalization on net income, however, it will benecessary to compute the amourit of amortization ofcapitalized interest which was charged against incomein .each year so that the net effect of an alternativeaccounting practice may be calculated. The effect of analternative policy on tax'expense should also be consid­.et:~d in 'calculating the net income effe~t. Di~closur~ ofthe elements of , the' coiriputt~d net income effect whilenot tequired, may be desirable'in some cases in o~der to, clarify the'pieselltation.2;.>.l\feaning of. "Publicly Disclosed"The release forbids companies other than electric, gas,water and telephone utilities and companies covered bythe two industry exceptions in authoritative accountingI~terature,to follow a policy of capitalizing interest ifsuch a policy had not been publicly disclosed prior toJune 21, 1974. Numberous questions were raised inletters of comment as to the meaning of "publicly disclosed."The Commission believes that any public disclosureof such a policy in any format will meet this .requirement. Formal financial statement disclosure,wouid not be necessary. If, for example, disclosure was'made in a supplemental document disseminated to ana­(ysts'on request, the test of public disclosure would bemet. ,If a company making an initial· filing with theCommission after June 20, 1974 had adopted such apolicy prior to, June 21, 1974 and discloses the policy inits initial filing, it will be considered to meet this requirement.. . .On the other hand, the mere filing of statementsfollowing such an accounting method with the' Commis­.sion without disclosure that the method. was being usedwoulci not constitute "public disclosure." ~ince AccountingPt:i!lciples Board Opinion No. 22 required disclosureof accounting policies anir emphasized that !;luch disclosureshould "ericompass those accounting principles andmethods that involve' ... a selection' from existing accep.tablealternatives ... (or) ... methods peculiar to theindustry in which, the reporting entity operates," itwoulq seem likely that any company which had capitalizeda material amount of interest woUld· have disclosedthis accounting policy. If a company has capitalized~nterest and not made disclosure of this accountingpolicy, but intends to continue' this policy, it shouldsupply full details to the staff for their consideration,including an explanation of. why disclosure was 'notmade in previous filings with the Commission.3. Meaning of "New Types of Assets"",The releas,e prohibits companie's who have a publiclydisclosed policy of interest capitalization from .applyingsuch' a policy to "new tyPes of assets." Comments requesteda clarification of this phrase. The Commissionbelieves that the phrase should not be interpreted toonarrowly in· order to maintain the present'level ofcomparability. For example, if a company had a policy· ofcapitalizing, interest on shopping centers, it would notbe prohibited from capitalizing'interest on residentialproperties 'if it expanded its lines of business. On theotherharid, if it were presently in two lines of bUSInessand capitalized inte'rest iIi only one, it would not bepermitted to' expand its interest capitalization policy tothe second line.4~ Income Statement p.:esEmtation of Capitalized Interest, CostA number of comments on the proposed release askedfor an illustration of the type of presentation contemplatedby the Commission when it required disclosure ofinterest cost capitalized "within th~ income statement."The following example provid~s suc~ an illustration:Sales __________________ ~ ______ ~-Cost of sales __ ~ ________________ _Selling; general and .administrative expense ______ _Interest cost accrued __________ _Less interest capitalizeq _______ _Income before income taxexpense ~ _Income t~x expense ___________ _Net Income ___ ~ ______ ~ ___ _1973.$10,0005,0002,0001,500. (600)7,9002,1001,000$ 1,1001974---$15,0007,0003,0002,000(800)11,2003,8001,825-$ 1,975

ACCOUNTING SERIES RELEASES 321SECURITIES ACT OF 1933Release No. 5542RELEASE NO. 164November 21, 1974SECURITIES EXCHANGE ACT OF 1934Release No. 11110Notice of Adoption of Amendments to Regulation S-X to Provide for Improved Disclosures ,Related to Defense and Other Long-Term Contract Activities " ,A. INTRODUCTIONThe Securities and Exchange Commissionhas long been concerned about the quality ofdisclosures made by registrants engaged indefense and other long-term contract activitiesbecause these activities involve inventoriesand receivables with unique risk andliquidity characteristics. After initially urgingcorporate managers to review their disclosurepolicies with respect to such contractingactivities, 1 the Commissionpublished for comment proposed amendmentsto Rules 5-02.3 a~d 5-02.6 of RegulationX_X.2As noted in its release proposing theseamendments, the Commission believes thatit is necessary and appropriate to expandthese Rules to require disclosure of greaterdetail in certain critical areas of long-termcontract activity, particularly with respect tothe nature of costs accumulated in inventories,the effect of cost accumulation policieson cost of sales, and the effect of revenuerecognition practices on receivables and inventories..The proposed amendments elicited numerousletters of comment which have been dulyconsidered by the Commission in the formulationof the amendmet)ts specificallya.dopted in this release. The following discus­SIOn outlines the Commission's responses tocertain of these comments as reflected in theadopted rules on receivables and inventories...Comments on Disclosure of Receivables-Rule5-02.3Paragraph (b). Several commentators----IActSecUritiR 1 esActRe1ease No. 5263, Securities Exchange2 S e e~se No. 9650, June 22, 1972.Act R ecurltie I s A c t R e 1 ease No. 5492, Securities Exchangee ease No. 10775, May 6, 1974.pointed out that the proposed amendment,could be broadly construed to requir'e additionaldisclosure for receivables' other thanthose arising from long-term contract activities.At the present time the Commissionintends only to improve disclosures relatedto long-term contract activities. Consequently,the amendment to this paragraphhas been deleted and the proposed disclosureof collection expectations has been incorporatedin the amendments addressed specificallyto receivables arising from such activities.Paragraph (e)., Some commentators suggestedthat the retain age disclosure shouldbe, limited to amounts not expected to becollected within one year. Due to the uniqueliquidity characteristics of retain age , theCommission. believes .. that any materialamount of retainage sho"!lld be disclosed nomatter when. such amount is expected to becollected. However, the Commission also believesthat. the significant uncertaintieswhich often affect the determination of amutually satisfactory contract completionmay cause the estimates of amounts to becollected within specific years to become progressivelyless reliable.· Consequently, theamet)dment as adopted requires the isolationof only the aggregate amount of retain ageexpected to be collected after one year. However,registrants are encouraged to provideestimated collections by year if their experienceor other factors enable them to do sowith reasonable accuracy.Several commentators suggested that theamendment should be modified to provide foramounts retained by contractors pursuant tothe provisions of subcontracts. The Commissionbelieves that this is unnecessary becauseRule 5-02.25 can be interpreted to requireseparate disclosure of significant

322 SECURITIES AND EXCHANGE COMMISSIONamounts of retentions payable to subcontrac-,tors.Paragraph (f). Numerous commentatorspointed out that a literal interpretation ofthe proposed amendment would call for disclosuresregarding all accrued receivablesrather than just those related to long-termcontracts and might also result in a duplicationof disclosures made under paragraph (g).The Commission recognizes the validity ofthese comments and the amendment hasbeen modified accordingly.The amendment as adopted also calls fordisclosure of the amounts of receivables notbilled or, billable that are expected to becollected after one year. The Commissionbelieves that disclosure of the timing of expectedcollections provides investors withmeaningful liquidity and risk information.It should be noted that the amendment isnot directed at items which are "unbilled" atthe, balance sheet date merely because thenecessary.paperwork has not been processedin accordance with the normal operation of abilling system. Such items would generallybe considered "billable" for purposes of thisRule.Paragraph (g). Many commentators arguedthat the proposed amendment was toobroad since it would require the disclosure ofamounts which could. be determined withreasonable certainty under express contractualescalation or change order clauses andwhich would be virtually assured of realization.The commission has concluded thatamounts due under routine change ordersand escalation features commonly found inthe terms of contracts are typically not subjectto such uncertainty that separate disclosureis required. On the other hand, it believesthat disclosure is necessary whenamounts are recorded which are not reasonablydeterminable under the specific terms ofexisting contracts. Accordingly, the text ofthis rule has been amended to require disclosurewhere the amounts included in receivableswhether billed or unbilled, are eitherclaims or other similar items subject to uncertaintyconcerning their determination orultimate realization.Several commentators questioned themeaning of the term "components" as usedin the requirement for footnote disclosure ofthe principal items comprising the 'aggregateof claims and other similar items subject ·touncertainties. In response, the Commissionhas used the terms "nature and status'" :tomore accurately reflect its' intentions andhas expanded the attached Exhibit to provide,examples of disclosure (-envisioned ·bythese terms. 'Comments on Disclosure of Inventories-Rule5-02.6 .Paragraph (b). In response to numerouscomments, this amendment has 'been modifiedin several significant ways. 'First, inrecognition of the recently adopted Statementof Financial Accounting Standards No.2, the Commission has deleted the require~ments for disclosure of the amounts of researchand development costs incurred dur:..ing the period or remaining in inveritory.Compliance with that Statement will obviatethe need for the disclosure of these amounts., However, the amendment still contemplatesa description of such costs being carried ininventory in compliance with the new Statement.Second, the Commission recognizes thatsome registrants may find it impracticable todetermine the actual amount of general andadministrative costs remaining in inventoryat the balance sheet dates. However; theCommission believes that registrants canprovide reasonable estimates of such remainingcosts determined, for example, on theassumption that costs related to a particularcontract or program have been removedfrom inventory on a basis proportional to thetotals of the various cost elements expectedto be charged to cost of sales for that contractor program. The assumptions used todevelop these estimates should be describedin a note to the financial statements.Third, the Commission expects that thedescription of the cost elements included ininventory will appropriately disclose t~eexistence of items not tYPIcally included Ininventoried costs in a usual manufacturingoperation. Described items may include, forexample, retained costs representing the e}Ccessof manufacturing or production costs

ACCOUNTING SERIES RELEASES 323over the amounts charged to costs of salesf~r delivered or in-process units, initial toolingand. other deferred start-up costs, generaland administrative costs, or researchand development ul)der contractual arrangements.In general, the Commission believesthat the accounting treatment of such costsis ,sufficiently unique to warrant the disclosureof their existence and, to the extentnoted below, their magnitude.Paragraph (c). This paragraph containsthe last sentence of Rule 5-02.6(b) as it existedprior to the amendments adopted inthis release. However, the requirements ofthis par,agraph may be amended by the proposalpublished in Securities Act Release No.5427. Comm~nts on that proposal are stillbeing considered.Paragraph (d).. Numerous commentatorspointed .out that the proposed definitionwould include supply or service contractsexpected.to be in process for more than oneyear even though such ~ontracts may notinvolve the unique risk and liquidity characteristics,associated with long-term manufacturing.and construction contracts or programs.The Commission believes that theproposed definition was susceptible to anoverly broad interpretation. Consequently,the Commission has modified ,the d~finitionto deal explicitly. with all contracts or programsaccounted for on either a percentageof completion or a completed contract basisprovided that any such contract or programhas associated with it material amounts ofinventories or unbilled receivables and hasb~en or is expected to be performed over aperiod of more than twelve months.Paragraph (d) (i). Many commentators arguedthat the amounts rep~rted under thisproposed amendment would not be mutuallyexclUsive from the amounts reported under~ubparagraph (iii). To eliminate this probem,the Commission has modifietl proposedS~:~aragraphs (i) and (iii) and now deals~. these matters in one subparagraphg t lCh requires disclosure of (1) the aggret.a e amount of (a) manufacturing or produc­IOn cost h'UndS w lch have been carried forwardreI ater a "Iearnmg.curve" concept and (b) anyallo ed. costs which have' been deferred forcatIon to future production, and (2) theportion of such aggregate 'amolint· w.hichwould not be absorbed in cost of sales basedon existing firm orders. The amendment alsocalls for the isolation of the cost elementsincluded in the costs carried forward, if it ispracticable for the registrant to provide thisdetail. The Commission believes that thesedisclosures will provide in'vestors with meaningfulinformation concerning the nature ofcosts accumulated in inventories.Paragraph (d) (ii). Many of the commentsnoted above under proposed Rule 5-02.3(g)were' also directed to this amendment. ,Thecommission has modified this subparagraphto reflect those comments. This amendmentrecognizes that certain registrants classifyamounts representing claims or other similaritems subject to uncertainties as inventoriesrather than as receivables reportableunder Rule 5-02.3(g). Regardless of wheresuch amounts are classified, the Commissionbelieves that material amounts must .be disclosedtogether with an appropriate descriptionof the nature and status of the principalitems comprising such amounts. In this connection,the Commission has expanded theaccompanying Exhibit to provide helpful examplesof the type of disclosure envisionedby this Rule.Paragraph (d) (v). Numerous commentatorsexpressed the view that the concept· of"title" is fraught with substantial difficultiesof legal interpretation and that in any eventit would be unduly burdensome to attemptsuch an analysis of the items included ininventory. The Commission accepts thesecomments and accordingly has deleted thisproposal.The subject rules, as amended herein, applyto disclosure in financial statements filedwith the Commission. Registrants and theirindependent public accountants must makethe determination as to what informationregarding such matters is required to constitutesatisfactory financial statement disclosureunder generally accepted accountingprinciples.8. AMENDMENTSRules 5-02.3 and 5-02.6 of Regulation S-Xare amended as follows:

324 SECURITIES AND EXCHANGE COMMISSIONRule 5-02.3. Accounts and notes receivable.­(a) through (d) (No change)(e) If receivables include amounts representingbalances billed but not paid by customersunder retain age provisions in contracts,state the amount thereof either in thebalance sheet or in a note to the financialstatements. In addition, state the amounts,if any expected to be collected after one year.If practicable, state by years when theamounts are expected to be collected._ (t) If receivables include amounts (otherthan amounts reportable under paragraph(g) below) representing the recognized sales'value' of performance under long-~erm contracts(see Rule 5-02.6(d» and such amountshad not been billed and were not billable tocustomers at the date of the balance sheet,state separately in the balance sheet or in anote to the financial statements, the amountthereof and include a general description ofthe prerequisites for billing. In addition,state the amount, if any, expected to becollected a-fter one year.(g) If receivables include amounts underlong-term contracts (see Rule 5-02.6(d»,whether billed or unbilled, representingclaims or other similar items subject to uncertaintyconcerning their determination orultimate realization, state separately in thebalance sheet or in a note to the financialstatements, the amount thereof and includea description of the nature and status of theprincipal items comprising such amount. Inaddition, state the amount, if any, expectedto be collected after one year.Rule 5-02.6. lnventories.-{a) State separatelyhere, or in a note referred to herein, ifpracticable, the major classes of inventorysuch as (1) finished goods; (2) inventoriedcosts relating to long-term contracts or programs(see (d) below and Rule 3-11); (3) workin process (see Rule 3-11); (4) raw materials;and (5) supplies.(b) The basis of determining the amountsshall be stated.If "cost" is used to determine any portionof the inventory amounts, describe themethod of determining cost. This descriptionshall include the nature of the cost elementsincluded in inventory.If "market" is used to determine any portionof the inventory amounts, describe themethod of determining "market" if otherthan current replacement cost.The method _ by which amounts 'are· removedfrom' inventory (e.g.; "average cost,""first-in, first. out," "last-in, first-out," "estimatedaverage cost per unit") shall be described.If the estimated aVerage CO$t· perunit is used as a basis 4> determine amountsremoved from inventory under a total programor similar basis of accounting, the prin--cipal assumptions (including, where meaningful,the aggregate number of unitsexpected to be delivered under the program,the number of units delivered to ~ate andthe number of units on order) shall be disclosed.-If any general and administrative costsare charged to inventory, state in a note tothe financial ·statements _ the aggregateamount of the general and administrativecosts incurred in each period, and th~ actualor estimated amount remaining in inventoryat the date of each balance sheet.(c) If the LIFO inventory method is use

ACCOUNTING SERIES RELEASES 325be stated in a note to the financial statements:: (i) . The aggregate amount of· manufacturingor production costs and any: related deferre'dcosts (e.g., initial tooling costs) whichexceeds the aggregate estimated cost of allin-process and .delivered units on the basis ofthe e'stimated average cost of all units expectedto be produced under' long-term contractsand programs not yet complete, aswell as that portion of such amount whichwould not be absorbed in cost of sales basedon existing firm orders at the latest balance'sheet date. In addition, if practicable, disclosethe amount of deferred costs by type ofcost (e.g., initial tooling, deferred production,etc.) ..(ii) The aggregate amount representingclaims or other similar items subject to uncertaintyconcerning their determination orultimate realization, and include a descriptionof the nature and status of the principalitems comprising such aggregate amount.(iii) The amount of progress payments nettedagainst inventory at the date of, thebalance sheet.* * * * * *The amendments to Regulation S-X havebeen adopted pursuant to authority conferredon the Commission by the SecuritiesAct of 1933, particularly Sections 6, 7~ 8, 10and 19(a) thereof and the Securities ExchangeAct of 1934, particularly Sections 12,13, 15(d) and 23(a) thereof.The above amendments to Regulation S-Xshall be applicable to financial statementsfor periods ending on or after December 20,1974. Such disclosure is recommended butnot required for financial statements for fiscalperiods ending prior to December 20,1974.By the Cemmission.GEORGE A. FITZSIMMONSSecretary

326 SECURITIES AND EXCHANGE COMMISSION. C. ~ EXHIBITThe following hypoth.etical example Js. fur~nished to illustrate the character and detailof the disclosures which might be furnishedin response to Rules 5-02.3 and 5-02.6 ofRegulation S-X as amended by the accompa-·nying release. The illustration is provided toassist in understanding and evaluating theamendments. .* * * * * * *XYZ Company and SubsidiariesConsolidated Balance SheetsAt December 31,ASSE:rs(000 omitted)CURRENT ASSETS:CMh ________________ __'Accounts receivable:Trade and other receivables, net of allowance for uncollectjble accounts of $38,000 in 1974 and$36,000 in 1973---,---~-----------------· 2,846 2,396Long-term contracts and programs (notes 1 and 2) ---- 18,985 19,036Total accounts receivable '--_~ __________ ~ _______ '-__ 21,~1 . 21,432Inventories and costs relating to long-term contracts and programs in process, net of progresspayments (notes 1 and 3)-,,··"---, _______________________ _ 6,278 6,257Prepaide~nses--------------'--------------- 46 27Total current assets _________ _--------_._---------- $28,593 $28,343Note 1. SUMMARY OF SIGNIFICANT AC­COUNTING POLICIESRevenue Recognition. Sales of commercialproducts under long-term contracts and programsare recognized in the accounts asdeliveries are made. The estimated sales valuesof performance under Government fixedpricedand fixed-price incentive contracts inprocess is recognized under the percentageof completion method of accounting whereunderthe estimated sales value is determinedon the basis of physical completion todate (the total contract amount multiplied bypercent of performance to date less salesvalue recognized in previous periods) andcosts (including general and administrative,except as described below) are expensed asincurred. Sales under cost-reimbursementcontracts are recorded as costs are incurredand include estimated earned fees in theproportion that costs incurred to date bear tototal estimated costs. The fees under certainGovernment contracts may be increased ordecreased in accordance with cost or performanceincentive provisions which measureactual performance against establishedtargets or other criteria. Such incentive feeawards or penalties are included in sales atthe time the amounts can be determinedreasonably.Inventories. Inventories, other than inventoriedcosts relating to long-term contractsand programs, are stated at the lower of cost(principally first-in, first-out) or market. Inventoriedcosts relating to long-term contractsand programs are stated at the actualproduction cost, including factory overhead,initial tooling and other related nonrecurringcosts, incurred to date reduced byamounts identified with revenue recognizedon units delivered or progress completed.General and administrative costs applicableto cost-plus Government contracts are alsoincluded in inventories. Inventoried costs relatingto long-term contracts and progra~Sare reduced by charging any amounts m

Amoun~billed ________________________________ACCOUNTING SERIES RELEASES 327excess of estimated realizable value to costof. sales. The . costs attributed to units deliveredunder long-term commercial contractsand programs are based on the estimatedaverage cost of all units expected to be producedand are determined under the learningcurve concept which anticipates a predictabledecrease in unit costs as tasks andNOTE 2-ACCOUNTS RECEIVABLEThe following tabulation shows the compo-production techniques become more efficient. through repetition.In accordance with industry practice, inventoriesinclude amounts relating to contractsand programs having production cycleslonger than one year and a portionthereof will not be realized within one year.* * * * * * *nent elements of accounts receivable fromlong-term contracts and programs:U.S. Government:__1974 1973(000 omitted)-------------- $ 7,136 $ 6,532Recoverable cos~ and accrued profit on progress completed-not billed ______ --------------- 4,173 3,791. U~vered cos~ and estimated profi~ subject to future negotiation-not billed ------- 1,468 1,73512,777 12,058Commercial Customers:Amoun~ billed ----------- 1,937 3,442Recoverable cos~ and accrued profit on uni~ delivered-not billed;..., _______ . ----------- 1,293 364Retainage, due upon completion of contracts , --------- 2,441 2,279U nrecovered cos~ and estimated profi~ subject to future negotiation - not billed 537 893$18,985 $19,036---The balances billed but not paid by customerspursuant to retain age provisions inconstruction contracts will be due upon completionof the contracts and acceptance bythe owner. Based on the Company's experiencewith similar contracts in recent years,the retention balances at December 31, 1974are expected to be collected as follows: $270,­?OO in 1975, $845,000 in 1976 and the balance. In 1977... Recoverable costs and acc:r:ued profit notbIlled comprise principally amounts of reve­~ue recognized on contracts for which bill­Ings had not been presented to the contractowners because the amounts were not billa-"ble at balance sheet date. It is anticipatedsuch unbilled amounts receivable from theU. S. Government at December 31, 1974 willbe billed over .the next 60 days as units aredelivered. Th~ unbilled accounts receivableapplicable to commercial customers are billableupon completion of performance testswhich are expected to be completed in September1975 .Unrecovered costs and estimated profitssubject to future negotiation, the principalamount. of which is expected to be billed andcoliected within one year, consists of thefollowing elements:

328 SECURITIES AND EXCHANGE COMMISSION1974 .. , ,1973., f .. l(000 ornit~) 'I1,u.s. Government Contracts:Excess of estimated or propOsed over provisional price _ , $ 190 $ 11>7:, .Amounts claimed for incremental costs arising from customer occasioned contract delays ____· __', 1,278 ' 1,578--,','1,468, 1,735Commercial Contracts:Unrecove~d costs and estimated profit relating to work not specified in express contract provisions __ 537 893.. , ,:.\.$2,005 $2,628NOTE 3-INVENTORIESInventories and inventoried costs relatingto long-term contracts and programs areclassified as follows:, DecelIl~r 31,1974 1973Fini$hed goods , , , ,', '.'Inventoried costs relating to long-term contracts and programs, net of amounts attributed to revenues~cognized to date .Work in proceSSI"-' '-,.:~___...;.-___________ ~~ __ ~~~ ____Rawnmre~'_'_'~' ____________ ~~ _______ ~~ __ ~_~~~~Supplies ___ ~~ ____ ~~ __________________ ~ ___ ~ __ ~~~~~..Deduct progresS payments related to long-term contracts and programs ____________ _(000 omitted)$3,562 $.?,4352,552; I '2,~,738" 947',·453 383, 112, 117,417 7,4741,139 1,217The f~llowing tabulation shows the costelements included in inventoried costs relatedto long-:-term contracts:$6,278 $6,257-- --December 31,1974 ~Production costs of goods currently in process, ''E?Ccessbeproducedof production___, _________________________cost of delivered units over the estimated___average cost of all units expected toUnrecovered costs subject to future negotiationGeneral and administrative costs ______ --' __fnitial tooling and other non-recurring costsThe inventoried costs relating to long-termcontracts and programs includes unrecoveredcosts of $280,000 and $310,000 at December31, 1974 and 1973, respectively, which are--(000 omitted)$1,184 $ 960647 893280 310260 270181 205-$2,552 $2,638--subject to future determination through ne~gotiation or other procedures not complete;balance sheet dates. Of such amounts, $26 r000 and $280,000 are in respect to contrac S

ACCOUNTING SERIES RELEASES 329under which all goods have been delivered atDecember 31, 1974 and 1973, respectively.The· unrecovered amount at December 31,1913. consisted of three items, one of which~as settled du:ring 1974. The amount remainingat December 31,1974 is represented princip'allyby. a· claim asserted against a customerfor amounts incurred as a result offaulty materials furnished by .the customerwhich in turn caused delays in performanceunder the contract. In the opinion of managementthese costs will be recovered bycontract modification or .litigation. It is expectedtha,t the negotiations which are beingconducted currently with the customer, willbe successfully concluded during the nexttwelve months. If this expectation is notrealized, the matter will be referred to theArmed Services Board of Contract Appeals,with the consequence that settlement couldbe delayed for an indeterminate period.Tne actu·al per unit production cost ·of theNX-4C aircraft produced during the mostrecent fiscal year was less than the estimatedaverage per unit cost of all. unitsexpected to be produced under the program.Prior to 1974, the Company's NX-4C commercialaircraft program was in the early highcost period. During the initial years of theprogram, the cost of units produced exceededthe sales price of the delivered units and theestimated average unit cost of all units to beproduced under the program. At December31, 1974, inventories included costs of $647,-000 representing the excess of costs incurredOVer estimated average costs per aircraft forthe 117 aircraft delivered through' the yearend. The estimated average unit cost is predicatedon the assumption that 250 planes willb~ produced and that production costs (prin­CIpally labor and materials) will decrease asthe project matures and efficiencies associ­~ted. with increased volume, improved prouctlOntechniques and the performance ofrep t't' e lIve tasks (the learning curve concept)are realized. (Note: The amount by which theprod-tOUc Ion costs of the equivalent finishedunits in process at the date of the latestba,lance sheet exceeds the cost of such unitson the basis of the estimated average unitcost of all units exp~cted to be producedunder the program should be stated. Since,as stated above, the actual per unit productioncost is currently less than the estimatedaverage per unit cost of all units expected tobe produced under the program, no suchexcess is assumed in this example.)Recovery of the deferred production, initialtooling and related non-recurring costs isdependent on the number of aircraft ultimatelysold and actual selling prices andproduction costs associated with futuretransactions. Sales significantly under estimatesor costs significantly over estimatescould result in the realization of substantiallosses on the program in future years. Realizationof approximately $421,000 of the gross. commercial aircraft inventories at December~1, 1974 is dependent on receipt of futurefirm orders. .Based on studies made by and on behalf ofthe Company, management believes thereexists for this aircraft a market for over 250units, including deliveries to date, with productionand deliveries continuing at a, normalrate to at least 1980. At December 31,1974, 117 aircraft had been delivered underthe program, and the backlog included 64firm unfilled orders and options for 43 units.The aggregate amounts of general and administrativecosts incurred during 1974 and1973 were· $2,251,000 and $2,238,000, respectively.As stated in Note 1, the Companyallocates general and administrative costs tocertain types of Government contracts. Theamounts of geJ).eral and administrative costsremaining in inventories at December 31,1974 and 1973 are estimated at $260,000 and$270,000, respectively. Such estimates assumethat costs have been removed frominventories on a basis proportional to theamounts of each cost element expected to becharged to cost of sales.* * * * * * *

330 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 165December 20, 1974SECURITIES ACT OF 1933Release No. 5550SECURITIES EXCHANGE ACT OF 1934Release No. 11147Notice of Amendments to Require Increased Disclosure of Relationships Between Registrants. and Their Independent Public Accountants !The Securities and Exchange Commissiontoday adopted certain amendments of Form8-K, Regulation S-X and Schedule 14A of theproxy rules. These amendments were originallyproposed on October If, 1974, in SecuritiesAct Release No. 5534. Based on thecomments received in response to that proposal,several modifications have been madewhich 'are discussed in this'release.One of the underpinnings of the Commission'sadministration of the disclosure requirementsof the federal securities la:ws isits reliance' on the reports Of indepep.dent.public accountants on the financial' statem'entsof registrants. These reports providethe assurance of an outside expert's examinationand opinion, thereby substantially increasingthe reliability' of financial statements.The decision that the Commission andinvestors should rely. on independent 'publicaccountants for the audit of financial statementswas made by Congress when it enactedthe Securities Acts forty years ago,and in the judgment of the Commission thissystem has worked effectively in the interestsof investors. The independence of theseprofessionals both iIi. fact and appearance isan essential ingredient in the system,. andthe Commission has taken a number of stepsto strengthen this independence. The amendmentsadopted herein are a further effort inthis direction.In recent years, the Commission has describedin several releases situations inwhich it concluded that the necess~ry independencedid not exist due to economic orpersonal relationships between accountantand client. In this way, it assisted the accountingprofession's own standard settingbodies in the creation of credible and usefulstandards of independence for the professionas a whole. This process is a continuing one.In addition, the Commission, starting in1971, has required specIfic disclosure in atimely Form 8-K filing of any change inprincipal accountants made by the registrant,including disclosure of any disagreementbetween the registrant and its principalaccountant in the eighteen months priorto the change which could have required ordid require mention in the accountant's report.This was designed to strengthen accountants'indepen

ACCOUNTING'SERIES RELEASES .' 331. '.It has noted with approval reports in whichthe accountants have evidenced their independenceby bringing sigriificant informationto the attention of investors. For example, inone recent case an independent accountantreported that its client's accounting procedures,while acceptable under generally accepted. accounting principles, were hot thosewhich the firm believed best reported financialresults under the particular factual circumstances.In another case, an· independentaccount while reporting on a five-year summaryof earnings noted in its report that theaccounting principles used to account for atransaction in an unaudited interim periodsubsequent to the five-year period were suchthat had the firm. been required to report onthis period an adverse opinion would havebeen required. After discussions with thestaff in this case, the registrant ultimatelyrevised the interim statements.,It i~ essential that both the fact and theappearance of independence be sustained sothat the confidence of the investing public inthe reliability of audited financial statementsand the integrity of the public accountingprofession will be maintained andenhanced. To this end, the Commission hasconcluded that it is desirable to increase thelevel of disclosure regarding relationshipsbetween independent accountants and theirclients.Accordingly, the Commission is adoptingherewith a number of amendments to itsforms and rules designed to enhance theaccountant's independence by increasing disclosureof auditor-client relation·ships.First, Item 12 of Form 8-K under whichchanges in accountants must currently bereported is amended to expand the disclosuresrequired and to clarify the intent ofthe item. The changes made and the reasonstherefor are as follows:1.TheresIgnatIOn..(or declination..to standfor re-election after completion, of thecurrent audit) and dismissal of accountantswould be reportable events as well~s the engagement of a new accountant.~ the past, when only the engagemento a new accountant triggered the re­Port·Ing requirement, there was sometimesconsiderable delay iIi bringing significantdisagreements' to the attentionof investors. Under the new rule, timelydisclosure is required. Tllis may meanon some occasions that two reports onForm 8-K will be required for a singlechange of accountants, the first on theresign~tion (or declination to stand forre-election after completion of the currentaudit) or dismissal of the previous. accountant and the second where a newaccountant is selected. In such a case,information filed in connection with thefirst report may be incorporated by referencein the second~A special variant of resignation, declinationto stand for re-election after completIonof the 'current audit, was notrecognized in Securities Act Release No.5534 which proposed these amendments.It is specified as a trigger' for reportingin .the adopted' amendments because of arecognition that, where an auditor declinesto stand' for re-election' after completionof his \ current audjt, such actionis the substantive act of resignation,rather than the later time when hiscurrent engagement is terminated.Changes in the independent accountantfor a significant subsidiary onwhom' the principal accountant expressedreliance also become reportableevents. The proposal did not restrictthis modification of existing rules to asignificant subsidiary and thus wouldhave required reporting of changeswhich are minor in relation to the consolidatedwhole and' of changes by noncontrolledinvestee companies. Forthese purposes, significant subsidiary isas defined in Regulation S-X Rule 1-02,except that a non-incorporated segm~ntsuch as a division which met the SIzetests of the definition would be included.In some circumstances, a report wouldbe required regarding an accountantwho did not report on financial statementsof the registrant. For example,where Accountant A reported on thefinancial statements of the prior year,Accountant B was engaged for the currentyear but was replaced by Accoun-

332 SECURrqES ,AND, EXCHANGE COMMISSIONtant C before he complet~d any examination,reports op Form 8-K would berequired, with respect to the ,changefrom,Accountant A to Accountant Bandfrom Accountant B to Accou'ntant C,2. The item would require disclosure as towhether the principal accountants' reportsfor either of the past two yearscontained an adverse opinion or 'a discl~imer'of opinion or was qualified as touncertainty, audit' scope or accounting, principles. B,ased on comments received,the language was modifie'd to makecl~~rt!tat' "consistency" exceptiopsneed not be reported in this item. Thisdisclosure Will assist users of Form 8-Kto determine' whether there were anyItems in the previous two years which, , were of such an unusual and materialnature'that disclosm;e was required inthe accountants' report. Although suchdata are Q'iJ. fIle elsewhere in most cases,including them in' the,8-K report willbring"t6gether'in one place informationwhich is relevant iIi the evaluation ofauditor-client relationships~ ,3. The period prior ~o the, date ,of, thechange of accountants for which disagreementsof sufficient importance towarrant mention in the accountants' reportif not resolved must be reported isextended from eighteen months to theperiod which includes the two most recentfiscal years and the subsequentinterim period. The previous requirementwas not sufficient to assure reportingof such disagreements in theprevious two audits, and since, two-yearcomparatjve statements are normallypresented this seems the minimum periodwhich should be covered.4. The item is amended to clarify the intentof the present item which: was torequire a description of all, disagreements,including those where, the disagreementwas resolved to the satisfactionof the accountant. This clarification, was necessary as a result of the experiencegained from analyzing 8-Ks fIled inwhich no description was given of disagreementsor in which a simple statementwas made that there were n'o un--' ',resolved disagreements and staff followupwas required to obtai~ the necessaryinfqrmation. Som'e commenta~ors on Sec'QritiesAct ~elease N o~ 5534 which proposedtheseamendm~nts requirestedclarification ()f 'whether disagreementsat lower 'staff levels are requested to 'bereported. Disagreeme~ts,' contemplated,by this rule occur a,t the decisiQn-mak-:ing level; i.e., between personnel of theregistrant responsible for 'presentationof itsfinanciai statements and personnelof the accounting' firm responsiblefor rendering its report.5. The term "disagreements" should be interpretedbroadly in responding to thisitem. For example, if' ali accountant resigned'or was dismissed' after advisingthe registrant that he' had concluded, - 'that internal controls necessary to develop,reliable statements did not exist,this ~ould constitute ,a reportable disagreementin the event of a change ofaccountants. Similarly, if an accountantwere to resign or be dismissed afterinforming the registrant that he haddiscovered'facts which led him no longerto be able to rely on management repre­'seIltatjons or which made him unwillingto be associated with statements preparedby management, such situationswould constitute reportabie disagreements.'' ' . '6. The item is amended to require that theregistrant's statement as to whether'any disa,greements existed be includedin the Form 8-K filing rather than in aseparate letter attached to the filingand to require that copies of the accoun-,tant's letter be filed as an exhibit withall 8-K copies filed. These changes areintended to simplify the filing procedureand to clarify the Commission's intentthat the registrant's description of disagreements,if any, and the accountant'sconcurrence or non-concurrence therewithbe included in the Form 8-K (orattached as an exhibit). Under the exi~tingrule, a few registrants have subrn~~ted letters separate from the For~ 8 10_filing with the result that the full dISC

ACCOUNTING SERIES RELEASES 333sure of any disagreement was not readilyavailable to the public.7. When a change in independent accountantsoccurs so that the accountantb~ing replaced is aware that a Form 8-Kshould be filed reporting the event, hemight well bring that reporting responsibilityto :'the attention of the registrant.If lie becomes aware that therequired reporting has not been'made,e.g., because' he has not been requestedto furnish a letter as required by Form, 8-K, Item 12 (d), he should' consider advisingthe registrant in writing' of thatreporting responsibility with a copy tothe Commission.Second, Regulation S-X is' amended to requiredisclosure in a, note to the financialstatements of any m~terial disagreement onany matter of accounting principles or practicesor financial st,atement disclosure reportedin Item 12 of Form 8-K withiri twentyfourmonths of the date of the most recentfinancial statements in' a fiiing. This disclosureis believed necessary to put readers ofthe financial statements on notice that sucha disagreement existed which could havesignificantly affected the statements.In addition, this amendment requires footnotedisclosure of any transactions or eventsoccurring during the fiscal year in which thechange of accountants took place or duringthe subsequent fiscal year which are similarto any transactions or events which gaverise to a reported disagreement and are differentlyaccounted for. This would includecases in which a disagreement arose duringthe year of change and the same transactionor transactions which gave rise to the disagreementwas accounted for in a differentmanner than that which the previous accountantconcluded was necessary.. If Such transactions which raise the same~~sues of accounting principle application orIsclosure are material and are 'accounted!~r in a manner different from that whiche former accountant apparently concludedWaseftreq·ulre,d d·Isclosure must be made of theect on the financial statements if the ac­C OUnt·co Ing method specified by the former acuntanthad been followed. Also, if disclosurewhich the former' acco~ntantapparep.tly concluded was required regardingsuch events or transactions has not beenmade elsewhere in the financial statements,it should be made in the footnote r~quired bythis rule. The proposal was modified to notrequire such disclosure where the methodasserted by the former accountant ce~ses tobe gener~lly accepted because ,of standardssubsequently issued. This disclosure willmake investors aware of situations wherealternative accounting approaches, may befollowed and are favored by at least oneprofessional accountant, and the effect of,such alternative approaches. In addition, itis believed that such disclosure requirementsmay have the effect of discouraging shifts inaccountants simply to obtain approval of analternative accounting approach. If registrantsand their present independentaccountants believe that the disclosure of theeffect of applying the alternative accountingapproach favored by the predecessor accountantwould not be significant to investors inthe circumstances, they may submit a statementto that effect to the staff which willconsider a waiver of the rule.Finally, a number of amendments aremade to Item 8 of Schedule 14A of the proxyrules to require additional disclosures in theproxy statement of the relationships betweenis!'!uers and independent public accountants.Since this disclosure is unlikely tobe relevant to other solicitations, it is requiredonly for annual meetings of securitiesholders or where financial statements arerequired pursuant to Item 15. These changesand the reasons therefor are as follows:1. Disclosure of the principal accountantselected or to be recommended to shareholdersfor election, approval or ratificationfor the current year. This requirementis designed to make stockholdersaware of the identity of the independentaccountant of record for the currentyear, even in cases when the shareholdersare not asked to take formal actionto approve his selection. The Commissionbelieves that such knowledge willenhance the stockholders' recognition ofthe role of the independent accountant.

334 SECURITIES ANi> EXCHANGE COMMISSION2. Disclosure is required of the name of the"principal accountant for' the previousyear if different from that selected orrecommended for the current year or ifno accountant has been selected for thecurrent year. This disclosure is designedto inform the stockholder when achange in accountants has occurred andwho the independent accountant of recordis in cases where no action hasbeen taken to select an accountant forthe current year.3. Disclosure of disagreements between accountantand issuer reported on a Form8-K filed to report a change in accountantduring the past year is required.The disclosure is designed to call disagreementsto stockholders' attention sothat they may be more fully informed ofthe relationships between accountantand issuer. Since any disagreementmust by its nature have two sides, itseems desirable that both sides have anopportunity to review its description inthe interests of obtaining a balancedand complete presentation. Accordingly,the issuer is required to submit the descriptionincluded in the preliminaryproxy material to the accountant, and ifthe accountant believes that the descriptionis incorrect or incomplete hemay include a brief statement, ordinarilyexpected not to exceed 200 words, inthe proxy statement presenting his viewof the disagreement. In recognition ofvalid comments received, the time forsubmitting such statement to the issuerwas extended to ten days and provisionfor flexibility in the number of wordswas made.4. Disclosure is required of whether or notrepresentatives of the principal accountantsfor the current year and the mostrecently completed fiscal" year are expectedto be present at the stockholders'meeting with the opportunity to make astatement and available to respond toappropriate questions. The Commissionbelieves that it is desirable for communicationbetween stockholders and theirindependent accountants to be encouraged.While the principal communicationis the accountant's report on financialstatements, there may be somematters which the accountants wish tobring to the attention of stockholdersand there "may be questions which stockholderswish to address to the accountants.This disclosure will emphasizethe existence of this opportunity forcommunication when it is available.5. Disclosure is required of the existenceand composition of the audit committeeof the Board of Directors. The Commissionhas already expressed its judgmentthat audit committees made up of outsidedirectors have significant benefitsfor a company and its shareholders (AccountingSeries" Release No. 123). Thisdisclosure will make stockholders awareof the exhrtence and composition of thecommittee. If no audit or similar committeeexists, the disclosure of that factis expected to highlight its absence.6. The current requirement in Item 8 fordisclosure of any finanCial interests ofany accountant who is being selected orapproved by stockholders of the issueror certain other relationships which existedduring the past three years is re~scinded inasmuch as the accountant,who must be independent of the issuer,is precluded from having such relationshipsby the accounting profession's(and the" Commission's) standards forindependence of accountants~The text of the amendments to Form 8-K,Regulation S-X and Schedule 14A of theproxy rules follows.Form 8-K. Item 12 and EXHIBITS are revisedas given below: "Item 12. Changes in Registrant's CertifyingAccountant.If an independent accountant who waspreviously engaged as the principal accountantto audit the registrant's financialstatements resigns (or' indicates he, . thedeclines to stand for re-electIOn after,completion of the" current audit), 0: l~dismissed as the registrant's prlllClpaaccountant or another independent aC-, , , I accouncountantis engaged as prlllcipa ntant or if an independent accountant 0, t e~whom the principal accountan

ACCOUNTING SERIES RELEASES 335pressed reliance in his report regardinga significant subsidiary resigns (or formallyindicates ,he declines' to stand forre..:election after the completion of thecurrent audit) or is dismissed, or anotherindependent accountant is engaged toaudit that subsidiary:(a) State the date of such resignation (ordeclination to stand, for re-election),dismissal or engagement.(b) State whether in connection with theaudits of the two most recent fiscal,years and any subsequent interimperiod preceding such' resignation,dismissal or engagement there wereany disagreements with the formeraccountant on any matter of accountingprinciples or practices, financialstatement disclosure, or auditingscope or procedure, which disagreementsif not resolved to the satisfactionof the former accountant would'have caused him to make referencein connection with his re'port to thesubject matter of the dis agreement(s);also describe each such disa-. greement. The disagreements requiredto be reported in response tothe preceding sentence include boththose resolved to the former ~ccountant'ssatisfaction and those not resolvedto the former accountant'ssatisfaction. Disagreements contemplatedby this rule are those whichoccur at the decision making level;i.e., between personnel of the registrantresponsible for presentation ofits financial statements and personnelof the accounting firm responsiblefor rendering its report.(c) State whether the principal accountant'sreport on the financial statementsfor any of the past two yearscontained an adverse opinion or a disclaimerof opinion or was qualified asto uncertainty, audit scope, or ac­COunting principles; also describe then~ture of each such adverse opinion,d.Isclaimer of opinion, or qualificatIon(d) 'rh· .e regIstrant shall request the fortneraccountant to furnish the registrantwith a letter addressed to theCommission stating whether :heagrees with the statements made bythe registrant in response to thisitem and, if not, stating the respectsin which he does not agree. The registrantshall file a copy of the formeraccountant's letter as an exhibit withall copies of the Form 8-K required tobe filed pursuant to General InstructionsF.* * * * *EXHIBITSInstruction 7. Letters from the independentaccountants furnished pursuant to Item12(d)* * * * *Regulation S-X. A new rule designated as (s)is added to Rule 3-16 as given below.* * * * *Rule 3-16(a) to (r) (No change)(s)~ Disagreements on accounting and financialdisclosure matters.-If, withinthe twenty-four months prior to thedate of the most recent financial statements,a Form 8-K has been filed reportinga change of accountants andincluded in such filing there is a reporteddisagreement on any matter ofaccounting principles or practices orfinandal statement disclosJ,lre, and ifsuch disagreement, if differently resoived,would have caused the financialstatements to differ materiallyfrom those filed, state the existenceand nature of the disagreement. Inaddition, if during the fiscal year inwhich the change in accountants tookplace or during the subsequent fiscalyear there have been any transactionsor events similar to those which involveda reported disagreement and ifsuch transactions are material andwere accounted for or disclosed in amanner different from that which theformer accountants apparently concludedwas required, state the effect onthe financial statements if the methodwhich the former accountant appar-

336 SECURITIES ANn EXCHANGE COMMISSION1ently concluded was required 'had beenfollowed. The effects on the financialstatements need not be disclosed if themethod asserted by the former accountaritceases to. be generally acceptedbecause of authoritative standards orinterpretations subsequently issued.* * * * *Regulation 14A. Item 8 of Schedule 14A isrevised as given below.Schedule 14A. Information Required InProxy Statement.Item 8. Relationship with IndependentPublic Accountants,If. the. solicitation is made on behalf of. management of the issuer and relates toan annual meeting of security holders atwhich directors are to be elected,· or ·financialstatementsare includ'ed p'ursuant-to Item 15, furnish the followinginformation describing the' issuer's 'rela~tionship. with its independent public accountants:...(a) The name of the principaiaccountantselected or' being recommended toshareholders for election, 'approval'orratification for the current: year. Ifno accountant. has been' .selected . orrecommended, so state and· briefly.describethe reasons therefor.(b) .Thename bfthe principal accountantfor the fiscal year most recently completedif different from the accoun-. tant selected or recommended for thecurrent year or if no accountant hasyet been selected or recommended forthe current year.(c), If a change or changes in accountantshave taken place since the dateof the proxy statement for the mostrecent annual meeting of shareholders,and if in connection with suchchange(s) a disagreement betweenthe accountant" and issuer has beenreported on Form 8-K or in the accoimtant'sletter filed as an exhibitthereto, the disagreement shall bedescribed. Prior to submitting preliminaryproxy material to the Commis-'sion which contains or amends such,description, the issuer shall furnishthe description of the disagreementto any accountant with whom a disagreementhas been reported.· If thataccountant believes that the descriptionof the disagreement is incorrector incomplete, he may include a briefstatement, ordinarily eXpected not toexceed 200 words, in the proxy statementpresenting his view of the disagreement.. This statement shall besubmitted to the' issuer within tenbusiness days of the· date the accountantreceives the issuer's description.(d) The proxy statement shall indicatewhether or not representatives of theprincipal accountants for the currentyear. and for the most recently completedfiscal year are expected to be'present at the stockholders' ·meetingwith the opportunity tomak'e a state-. ment 'if they desire·. to"' do : so andwhether 'or not such representativesare expected to' be available to respondto approp"riate questions.(e) If the issuer has an audit or similarcommittee of the Board of Directors,state the names of the members ofthe committee. If the Board of Directorshas no audit or similar committee,so state ...* * * * *The foregoing amendments are adoptedpursuant to authority in Sections 6, 7, 8, 10and 19(a) of the Securities Act of 1933; andSections 12, 13, 15(d) and 23(a) of the SecuritiesExchange Act of 1934. The amendmentsto Form 8-K and to Regulation 14A shall beeffective' for Forms 8-K and proxy statementsfiled subsequent to January 31, 1975.The, amendment of Regulation SoX shall beeffective with respect to financial statementsfiled for periods beginning on or after January1, 1975.By the Commission.GEORGE A. FITZSIMMONSSecretary

ACCOUNTING SERIES RELEASES 337RELEASE NO. 166December 23, 1974SECURITIES ACT' OF 1933Release No. 5551SECURITIES EXC~NGE ACT OF 1934Release No. 11150' .PUBLIC UTILITY HOLDING' COMPANYACT OF 1935Release No. 18723Disclosure of Unusual Risks and Uncertainties in Financial ReportingIn recent months, the Commission hasnoted with considerable concern a number ofsituations in which significant and increasingbusiness uncertainties have not beenfully reflected in the financial reporting ofregistrants. These have included cases inwhich unique or special circumstances havearisen which affect an enterprise's ability tomeasure current results, cases in whichchanging economic circumstances have sub':stantially changed the risk characteristics ofcertain assets and cases in which assumptionswhich underlie the use of certain accountingprinciples in certain situationshave become subject to substantial uncertainty.The Commission recognizes that a largenumber of estimates are required in thepreparation of all financial statements. Managementmust estimate the economic life ofassets, the magnitude of mineral resources,the outcome and timing of long-term contractingactivities, the outcome of legal andregulatory matters, the collectibility of receivablesand many others. Since investorsare aWare of the need for such estimates, inthe normal case it is not nece~sary for managementto point out that they have beenm~de and to indicate that some uncertaintyeXIsts as a result. Indeed, such disclosureWOuld amount to little more than\ "boilerptlate" which would not be' useful to invesors.st On the other hand, when unusual circumancesar'chan . Ise or werehthere are sIgnIficant. .taint ges ,In. the degree of business uncer­Y eXIstIng in a reporting entity, a registranthas the responsibility of communicatingthese items in its financial statements. Itis not sufficient to assume that the numbersshown in conventional fashion on the face ofthe financial statements will adequately informinvestors. The basic accounting modelis by its very nature a single valued one inwhich a single best estimate is reflected inthe face of the statements. While in mostcases, this presentation effectively communicatesbusiness financial position and resultsof operations, under some conditions of majoruncertainty it may not adequately informinvestors of the realities of a business beingreported. In such cases, registrants mustconsider the need for substantial and specificdisclosure of such uncertainties and, in extremecases, the' need for'deviation from, theconventional reporting model. In addition,independent public accountants must considerthe need for disclosure of such uncertaintiesin their report.A number of examples of such uncertaintiesand the kinds of disclosures which maybe appropriate are discussed below for illustrativepurposes. This list is not intended tobe all inclusive and could not be since changingconditions produce' new uncertaintiesand resolve old ones on a continuing basis.Loans and Loan Loss Reserves of FinancialInstitutionsIn several industries, severe economicproblems have developed in 1974. This hasbeen particularly true in the real estate areawhere high interest rates, increasing con-

338 SECURITIES AND EXCHANGE COMMISSIONstruction costs and difficulties in renting or .selling completed projec.ts.have threatenedthe survival of many enterprises. Companieswlt~ substantial equityipvestments in orcredit extensions to such enterprises havetherefore had to face. the problem of determ'iningthe value of such assets, and in mostcases a v.ery wide range of possible valuesexist depending upon various assumptionsabout the future.' ' .Companies, such as real estate investmenttrusts, which find themselves in such a positionshould make disclosures beyond the actualamount of loan l~ss reserve provided toenable investors to obtain a more' completepicture of uncertainties, involved. For example,in 'addition to' the disclosures requiredunder Rules 12-42 and 12-43 of Regulation S­X, narrative disclosures might' be made ofthe adequacy of any security interest held interms . of 'current realizable value, theamount' of loans delinquent and the extent ofthe delin'quencies, the concentration of theportfolio in particular markets and the economiccoiiditions in those m'arkets, the sensitivityof the portfolio to" specific economicvariables such as changing interest ratesand local employment conditions and the extentto which income continues to be accruedon various assets in the portfolio. To theextent possible; these disclosures should bespecific, not general. They should describeboth positive and negative factors.While the real estate industry has been aparticular problem area, loan loss reserveproblems of financial institutions are by nomeans limited to this area. Surveys of loan ,losses of banks; for example, have indicatedthat during the period 1969-1973, loan lossesas a percentage of loans outstanding havedoubled while the valuation portion of thereserve for loan losses has declined substantially.In addition, current economic conditionshave resulted in a substantial increasein borrowers who are experiencing financialdifficulties.A significant factor contributing to thedecline in reserves is apparently the solereliance by some registrants on the minimumprovision for loan losses resulting fromapplying regulatory formulae for minimumprovisions described in the regulations ofbanking authorities. It should be emphasizedth~( such formulae can:. only be viewed as,'a'starting point in determining the necess~ryprovisions 'to absor,b 'fu,ture Joan losees. :Asset forth in Regulation F of, the F,ederalReserve Board" an', estimated amoun~, forloan losses in excess of the minimum arp.ountshould be provided when judged appropriate.If, as may be the case with many registrantsin 1974, the minimum provisiori' r~stilts' in avaluation reserve balance' less ,than 'anamount adequate to reflect' the risks in, theyear-end loan portfolio, registrants must pr9-vide the amount necessary to insure theadequacy of the reserve.in additiori to the adequacy of valuationreserves, it is important that financial institutionsmake appropriate financi~l statemEmtdisclosures to enable investors to understandthe nature and current status oftheir portfolios. This should encompass a sufficientbreakdown of assets to giveth.e investorinfi!igh.t into investment policies~ l.endingp~a~tices and portfolio concentration. Banks,for' . example, have generally, disclosed"lo~ns" as a single item in the balance sheet,even though the item frequently amounts tomore than 50% of earning assets.' In suchcases, it would seem desirable to furnish in.," .-the balance sheet or the notes thereto anadditional analys,is of loan categories, perhapssuch as that required by Schedule III ofForm F-9 of Regulation F of the FederalReserve Board. ''Additional disclosures should also .be consideredin c~ses where there have been substantialchanges'in the risk characteristics ofportfolios, even when increased provisionsfor losses have been made. Where, for example,loans which are considered doubtful asto collectibility have materi~iiy increased, ?rwhere there have been large increases Indelinquencies, loans eXtende~ or renegotiatedunder adverse circumstances, or othe~evidences of changed risk, registrants shoulexpand on normal disclosures to hIg. hi'Ightsuch factors. 'Marketable Securities. .' th marketThe substantIal declIne In e dvalue of common stocks which has occur re

ACCOUNTING SERIES RELEASES 339in 1974 has resulted" in many companies holdingportfolios where the year-end marketvalue is below cost and hence where the risk'of investment ioss has materially increased.Generaily accepted accounting principles requirethat write downs to market be made bya charge in the income statement in caseswhere market declines are not due to a temporarycondition. Registrants and their independentaccountants must carefully reviewinvestm"ent portfolios to determine whetherevidence indicates that a provision for loss isnecessary.If registrants and their independent accountantsconclude that no provision for lossis required iIi the case of a portfolio wheremarket value is below cost at the balancesheet date, it is particularly important thatfull disclosure of the market decline and thepotential for loss on the basis of year-endmarket values be made. In such case, corisiderationshould be given to including disclosureon the face of the balance sheet (in theinvestment section) and the income' statement(in the investment income section). Inaddition, comments on market value changesshould be included in "Management's Discussionand Analysis of the Summary ofEarnings" described in Accounting SeriesRelease No. 159.Declines in the market value of commonstocks are particularly significant in the insuranceindustry. In this industry, currentpractice permits common stock portfolios tobe carried on the balance sheet at marketvalues with cost disclosed parentheticallyeven though gains and losses are reflected inthe income statement on a realized basis.Under current market conditions, it wouldappear desirable for all insurance companiesto consider adopting this approach.By making these comments the Commis­,sion does not intend to prejudge the manyco.mplex accounting issues in connectionwIth marketable securities which must bea.ddressed in a systematic way by the Finan­CIal Accounting Standards Board.Deferral of Fuel Costs by Public UtilitiesDu·Sub rmg. th~ past year, there have beenstantIal Increases in the fuel costs ofpublic utilities. In many cases, public' utilitycommissions have 'permitted these increasedcosts to be passed on to users through a "fueladjustment clause" under which increasedcosts paid in one period may be directlybilled to users in a subsequent period~ Thesecosts have in some cases been deferred asassets by utilities and matched against revenuesin the period when they are' billed.While such an accounting approach may notbe inappropriate" in circumstances where adirect right of pass through exists, uncertaintiesexist in some cases as to whetherpublic utility commissions will permit therecovery of these deferred costs at a timewhen full new rate schedules are adopted. Incases where public utility commission ordersdo not assure such recovery, registrantsshould make disclosure of the uncertainty asto recovery which may exist and the effecton the financial statements of a failure torecover these costs.Cost of Raw Materials Where Price is StillUnder NegotiationDuring the past year, companies in thepetroleum industry who source crude oil inforeign countries have had to deal with problemsof unusual uncertainties. Because ofuncompleted negotiations concerning thetake over of ownership by foreign governmentsand because crude oil acquired in 1974was expected to be subject to the price d'eterminationsof the finally negotiated agreement,such companies have had to estimatethe cost of crude oil currently being used inreporting results.Where such unusual circumstances existand where changes in estimates would havea significant impact upon reported results,expanded disclosure should be provided toenable investors to appraise the magnitudeof the risks involved. Such disclosure shouldbe highlighted in presentations of financialinformation.The disclosure should include a descriptionof the unusual circumstances involved, a descriptionof the types of assumptions madeby management when preparing financialreports, and an indication of the sensitivityof current and prospective earnings to

340 SECURITIES AND EXCHANGE COMMISSIONchanges in such assumptions caused eitherby changing circumstance~,or the final. determinationof the uncertainties involved.It would be appropriate to set forth suchnarrative discussions as part of the statementof accounting policies, as a separatenote to financial statements or by a parentheticalstatement on the face of the statements.Small Number of Projects with DominantEffect on ResultsIn some circumstances, registrants are ina position where the outcome of one or a verysmall number of projects will have a dominanteffect in determining. the company'ssuccess or failure. These, projects are frequentlysubject to substantial, uncertainties.Examples are major aircraft projects by airframe'manufacturers, major constructonprojects by a contractor, or major mineralexploration projects by an extractive industriescompany., In ,each case, .the individualproject is of an extremely large size relativeto the size of the company.In such cases, estimates of future successmay be necessary in order to pre'sent financialstatements on a going concern basis, andthe degree of that "future succe!'!s may haveto be predicted' to some explicit degree inorder to present an income statement coveringcurrent operations. In a major aircraftproject, for example, accounting .for the presentwill require some estimate of the totalnumber of units to be sold over the life of theproject and the length of time over whichthose units will be i:;old, since aggregate costs'must be spread over the units in the p:fo~gram. In addition, estimates must be made ofchanging levels of cost taking into accountproduction experience (the learning curve)and inflationary effe'cts.While the Commission has recentlyamended 'its financial disclosure ,requirements(in Accounting'Series Release No. 164)to obtain better disclosure of long-term contractactivities in all cases, those. situationsin which one or a few estimates subject tosubstantial 'uncertainty will have a' dominanteffect must be additionally considered.In such cases, disclosure of the sensitivityof results to 'estimates must be emphasized.This may be done in the face of the financialstatements by modifying appropriate captions.Another possible approach to be consideredin unusual circumstances is revisingthe basic format of conventional financialstatements to reflect a range of outcomes. Inaddition, substantial footnote discussion ofresults under alternative assumptionsshould be considered.The, Commission believes that the mostappropriate presentation in such cases willdepend upon the facts of the particular case,but feels that it should emphasize the needfor comprehensive and fully highlighted disclosure.By the Commission.'GEORGE A. FITZSIMMONSSecretarySECURITIES EXCHANGE ACT OF 1934Release No. 11153RELEASE NO. 167December 24, 1974Order Instituting Proceedings and Imposing Remedial Sanctions'in the Matter of Westheim er ,Fine, Berger & Co.Westheimer, Fine, Berger & Co. ("WFB"),a partnership engaged in the practice ofaccounting, has made an offer of settlement, " . f issuessolely for the purpose ~f dIspoSmg 0 2(e) ofraised with respect to It under R~le Thosethe Commission's Rules of PractIce.

issues relate ~o WFB'sright to appear andpractice before the Commission. They ariseout of the entry on November 14, 1974, of aconsent 'judgment of permanent injunctionagainst WFB in an action, brought by theCommission. 1 The Commission's complaint inthat action alleged, among other things, thatWFB had violated or aided and abetted violationsof Se~tions 19(b)a~d 13(a) of the ,SecuritiesExchange Act and Rules 10b-5 and 13a-1thereunder by permitting i~s audit reports,including its qualified opinion, to accompanythe financial statements of Realty EquitiesCorporation of New York ("Realty") forRealty's fiscal years. ended March3l, 1971and 1972. According to the complaint, thosefinancial statements reported certain transactionsinvolving Realty, Republic NationalLife Insurance Company and others as bonafide arms-length busi~ess transactions whensuch transactions were not so in fact. Thec~mplaint further alleged that, the results ofsome of those transactions were not as reportedin the aforementioned financial statements.Without admitting or denying the allegationsof the complaint, and solely for thepurpose of settlement, WFB consented to ajudgment of permanent injunction enjoiningit from violating the above-cited provisionsof the Exchange Act and the rules thereunderin connection with the purchase or saleof securities of Realty, any subsidiarythereof, or any other company which has orhas had securities registered pursuant to theSecurities or the Exchange Acts or for the~ecurities of which there exists a public trad­Ing market and which, within two of the lastpreceding three fiscal years (a) derived morethan 25% of its revenues or pre~tax net profit(loss) from the purchase, sale, trading, orother transactions involving the transfer of~eal estate properties or interests therein(~~her th~n personal residential uni~s), andp ~ecogDIzed material (in relation to pre-taxdl~O It (loss» gains from the sale, or other'----spo ·t·Sl Ion of interests in real estate proper-'set 1l1:~SCD v. Republic National Life Insurance Company,Releas ·N·N.y., 74 Civ. 1097 (MP). See S.E.C. Litigatione 0.6273 (March 8, 1974),3 S.E.C. Docket 684.ACCOUNTING SERIES RELEASES 341ties (other than personal residEmtiaI-units) (i)in which the purchaser made no significantinvestment in the property or (ii)' in whichthe seller has a continued involvement withthe property sold.In view of the permanent injunction, theCOl!lmission deems it necessary that proceed- 'ings be instituted against WFB pursuant toRule 2(e) of ' the Commission's Rules of Practicewith respect to its qualifications to appearand practice befo~e the' Commission.Without admitting or denying the allega-'tions of the Commission's complaint,' andsolely for the purpose of 'settlement, WFBhas submitted an offer of settlement inwhich it consents'to the entry of a,n order bythe Commission pursuant to Rule 2(e), whichprovides that:1. For at least one year from the date onwhich this order is entered, WFB willemploy the services of a special consultantsatisfactory to the, Commission.Such person shall be available to WFBfor consultation to the extent requestedby that firm. In addition to any specificrequests by WFB during the period ofsuch consultant's retention, the consultantshall select for review and review, tothe extent set forth below, the audits ofapproximately 15% of the publicly-heldcompanies for which WFB serves as independentauditor.2 The review to be conductedby the special consultant shall beperformed after WFB has completed itsaudit work and formulated its proposedaccountant's report on 'the financialstatements which include the transactionand/or occurrence occasioning his review,but before WFB has rendered itsreport on such statements.2. After the special consultant has completedhis review with respect to theprescribed number of public companies,,2 The audits which the special consultant may selectfor review shall be limited to those audits in whichcertain transactions and/or occurrences outside of theclient company's ordinary course of business are mate·rial to the audit. His review shall be limited to the auditwork performed, as reflected in the work papers, withrespect to such transactions and/or occurrences and theaccounting judgments made thereon." ,

342 SECURITIE.S AND EXCHANGE COMMISSION.he shall render a report to the Commissionas to his findings concerning' theadequacy of the audit work performed,as reflected in the work papers, withrespect to the transactions and/or occurrencesoccasioning his review and concerningthe reasonableness of the accountingjudgments made. thereon. Thereport shall inciude a description of thescope and nature of his review on whichsuch findings were based and shall befurnished to the Commission not later. than 90 days after the completion of the.-last review by the special consultantpursuant to paragraph 1 hereof. 33. -In addition, WFB shall adopt auditing.procedures to determi~e whether itsclients' have entered into . material_ transactions with related parties. 4. WIthin 90 days from the date of theentry of this order, WFB shall submit. such. proposed procedures to the Commission'sChief Accountant for his re­_ view and approval.4. Should WFB merge into another public_ accounting firm engaged in practice beforethe Commission and which. in terms'of. the number of its professional. employees,including partners, is at leasttwice' as large as WFB, the provisions ofparagraphs 1, 2 and 3 herein above shallterminate on the date of such merger.3 Such report shall not identify the clients' involved inthe special consultant's review. However, WFB shallretain in its files information as to such clients' identity.Should the Commission deem such information necessary,it will be made available to it.4 Among other things, such procedures shall include adefinition of the circumstances in which transactionsshall be deemed to be with related parties.. As expeditiously as possible thereafter,'- the combined accounting firm shaH applyits quality control standards to theaudits to be performed on the financialstatements of public companies thatwere for1p.erly clients of WFB. Furthermore,within 90 days from the date ofsuch merger' the combined firm shallreport to the Chief Accountant the statusof the Implementation of the applicationof such quality control standardsto such clients. And within 180 daysfrom .the date of such merger the combinedfirm shall submit· to the ChiefAccountant a final report confirmingthat the quality control standards havebeen adopted for use in all audits ofsuch clients.After due consideration, the Commissionhas determined to accept the offer of settlement.Accordingly, IT IS ORDERED that proceedingspursuant to Rule 2(e) of the Commission'sRules of Practice be, and they herebyare, instituted against Westheimer,Fine, Berger & Co.; it is furtherORDERED that Westheimer, Fine, Berger& Qo. be, and it is hereby is, censured; and itis furtherORDERED that" Westheimer, Fine, Berger& Co. comply with all of the terms of theoffer of settlement that the Commission hashereby accepted.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.GEORGE A. FITZSIMMONSSecretary

SEcuRITIES EX~HANGE ACT OF 1934Release No. 11176ACCOUNTING SERIES RELEASES 343RELEASE NO. 168January 13, 1975'Order Instituting Proceedings and imposing Remedial Sanctions in the Matter of BenjaminBotwinick & Co. and Alvin I.-Mindes 'Benjamin Botwinick & Co. ("BB"), a firmof certified public accountants, and' Alvin I.Mindes ("Mindes"), a certified public accountantand a partner in BB, have made anoffer of settlement for the purpose of disposingof matters raised with respect to themunder Rule 2(e) of the Commission's Rules ofPractice.' These matters arise out of the entryonJanuary 8, 1975 of a consent judgmentof permanent injunction against BB, andMindes in an action brought by the'Commission.1' '- ' ,The Commission's complaint in that actionalleged, among other things, that BB andMindes violated and aided and l abetted violationsof Sections 10(b) and 13(a) of the SecuritiesExchange Act arid the rules promulgatedthereunder. The complaint alleges,inter alia, that BB and, Mindes participatedin the filing with the Commission of an annualreport on Form lO-K for the fiscal yearended December 31, 1971 of Allegheny BeverageCorporation ("ABC"), which reportcontained consolidated financial statementsof ABC certified by BB.The complaint charged, inter alia, that inits consolidated statement of operations forthe year ended December 31, 197i, ABC materiallyoverstated net sales and net earningsby improperly accounting for sales ofVending machines by its wholly-owned sub­Sidiary, Valu Vend, Inc. ("VV"), because thesales transactions had not been substantiallycompleted as of December 31, 1971, andthe revenues reported as a result of such~~l.es Were substantially uncertain ~f collectithlty. The complaint alleged that many ofe sales were made in late 1971 to newly------'SEC932-73 v. Alle.g~eny Beverage Corporation, et at., D.D.C.1975).' See LItIgation Release No. 6677 (January 13,formed corporate purchasers with nominalassets, the principl:lls of which were inexperiencedin the vending or soft drink business,had made nominal or no downpay~ents toVV, had nominal or no cash invest,ment inthe business 'venture, and had not personallyguaranteed notes executed in conjunctionwith the sales of the machines. The complaintcharged that ABC or subsidiariesmade advance 'cash payments to severallarge purchasers of machines to enable thepurchasers to commence business operations.The complaint -further alleged thatpayment on the notes was dependent on thesale of beverage through the vending machines,that by the end of 1971 a, inaterialnumber of the machines reportedly sold hadnot been delivered and more than 75% of themachines were not on income-producing locations,and that moratoria on required notepayments of 'up to six months were granted.Finally, it was alleged that by the time BB'saudit of ABC was completed', ABC had beennoti:fi~d by a number of major purchasers oftheir 'inability to -make timely installmentpayments and rp,eet inflated beverage salesprojections that 'had been used by ABC toinduce purchases of vending machines.The complaint also alleged that ABC'searnings were materially overstated by theimproper capitalization of purported start-upcosts and test-market costs, and that ABC'sconsolidated balance sheet materially overstatedassets and retained earnings as aresult of the improper accounting of sales ofvending machines and purported start-upand test-market costs.The complaint also alleged that the opinionof BB contained in the ABC annual reportstated that "the Valu Vend, Inc. subsidiaryin its inception year reported income fromvending machine sales on the accrual

344 SECURITIES AND EXCHANGE COMMISSIONmethod," that "[n]otes receivable from suchsales will be collected over a four year periodfrom the date of the sale," and that "subjectto the collection of the aforementioned notesreceivable.... the financial statements containedin the annual report present fairlythe consolidated financial position and resultsof operations' ·of ABC and subsidiariesas of and for the year ended December 31,197.1,. and were prepared in conformity withgenerally accepted accounting principles.The complaint alleged that the opinion ofBB was materially false and misleading becauseABC's financial statements were notprepared in conformity with generally acceptedaccounting principles and did notpresent fairly the consolidated financial positionand results of operations of ABC andsubsidiaries as of and for the year endedDecember 31, 1971.Without admitting or denying the allegationsof the complaint and solely for thepurpos'e of settlement, BB and Mindes consentedto a judgment of permanent injunctionenjoining -them from violating theabove-cited provisions of the Exchange Actand the rules thereunder in connection withthe purchase or i;Jale of any securities.In view of the permanent injunction, theCommission deems it necessary that proceed~ings be instituted against BB and Mindespursuant to Rule 2(e) of its Rules of Practicewith respect to their qualifications to appearand practice before the Commission. Withoutadmitting or denying the allegations of theCommission's complaint and solely for thepurpose of settlemment, BB and Mindeshave submitted an offer of settlement inwhich they consent to the entry by the Commission,pursuant to Rule '2(e) of the Rules ofPractice, of an order imposing the followingsanctions. 2 After due consideration, the Commissionhas determined to accept the offer of, settlement.2 In connection with the offer of settlement, BB advisesthe Commission that it will resign as the publicaccountants for ABC on the completion of its audit forthe year ended December 31, 1974, and that it will notaccept any new engagements from ABC involving requiredfilings, submissions or certifications with theCommission.Accordingly, it·is hereby ORDERED1. That BB request the American Instituteof Certified Public Accountants todesignate one 'or two persons satisfactoryto the Commission's Chief Accountantto review the auditing procedures(including the application.' of 'generallyaccepted accounting principles) of BE. inconnection with clients· making filingswith the Commission; -that, in this connection,the designated reviewer or reviewersexamine the working papers ofaudits of companies for fiscal years endingbefore FebruarY 28, 1975, and havethe full scope and authority to communicatewith the Commission's staff toascertail1 its views and questions and toreview, as they deem appropriate, thepersormel and other records of BB, tothe extent reasonable and necessary todetermine whether the professional proceduresand practices. of BB are adequate;that at the conclusion of thisreview, and within 10 months from thedate hereof, the reviewer or reviewersreport conchisions to the Commissionand make recommendations if needed toBB for improvements; that these proceedingsremain open, and the Commission'retain jurisdiction of the matter, tothe extent reasonable and necessary toassure reasonable compliance with saidrecommendations; and that-BB not acceptengagements with any new clientsfor 10 months from the. date hereofwhere the engagement is expected toinvolve auditing or accounting servicesin connection with filing of financialstatements with, or submissions or certificationsto, the Commission.2. That Mindes complete a program of continuingprofessional education by attendingcourses or seminars for at lea: t100 hours in subjects relating to pub.hCaccounting or auditing; that this c~ntlnfuing education extend over a perIod 0not more than 10 months from the dateeminarshereof; that the courses or s theattended must be acceptable to dCommission's Chief Accountnt·a,anb-. M' d shall SUthat upon completIOn, In es atmit an affidavit certifying attendance

ACCOUNTING SERIES RELEASES 345said 100 hours of continuing education.3. That during the to-month period referredto hereinabove, Mindes engage inno practice before the Commission as anaccountant other than as an employeeor consuitant under supervision, and inno case act as and/or be a partner of BB.4. That BB have a policy that, for a fiveyearperiod, each of its partners shallattend courses or seminars in subjectsrelating to public accounting or auditingto the extent of at least 40 hours peryear.It is further ORDERED that proceedingspursuant to Rule 2(e) of the Commission'sRules of Practice be, and they hereby are,instituted against Benjamin Botwinick & Co.and Alvin 1. Mindes; and it is furtherORDERED that Benjamin Botwinick &Co. and Alvin 1. Mindes comply with all ofthe terms of the offer of settlement that theCommission has hereby accepted.For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 169January 23, 1975SECURITIES ACT OF 1933Release No. 5558SECURITIES EXCHANGE ACT OF 1934Release No. 11198Financial Disclosure Problems Relating to the Adoption of the Lifo Inventory MethodThe Commission today authorized the issuanceof the following exchange of correspondencebetween its Chief Accountant andthe Internal Revenue Service relating to discussionsheld in regard to financial disclosureproblems arising from the adoption ofLIFO accounting by many registrants andthe book-tax conformity requirements of theInternal Revenue Code.AttachmentsLetter to Internal Revenue Service,January 20, 1975"Letter.fl.rom nternal Revenue SerVIce,January 23, 1975SECURITIES AND EXCHANGE COMMISSION,WASHINGTON, D.C. 20549January 20, 1975MR. LAWRENCE B. Gnms,Assistant Commissioner (Technical)Internal Revenue ServiceRoom 30421111 Constitution Avenue, N.W.Washington, D.C. 20224DEAR MR. GmBS:As we discussed, this letter sets forth my

346 SECURITIES AND EXCHANGE COMMISSIONunderstanding of the solutions agreed uponto prevent possible conflicts between financialdisclosure principles and Revenue Ruling74-586.The Commission's Accounting Series ReleaseNo. 159 requires a public company toinclude "Management's Discussion andAnalysis of the Summary of Earnings" infilings with the Commission. The same analysismust be included in the annual report tostockholders, although its format may varysomewhat from that used in filings on Form10-K or in registration statements. The purposeof requiring this analysis, which underthe rules would include a statement explaining"changes in accounting principles or inthe method of their application that have amaterial effect on net income as reported," isto provide investors with a summary in oneplace bf the most significant elements ofreported results.In 'the case of companies which havechanged to LIFO accounting for inventories,an explanation of the change and its effect iscalled for by Accounting Series Release No.159. My understanding of our agreement onAccounting Series Release No. 159 reportingis that the Service would not terminate aLIFO election if the same language used inthe financial statements footnote to disclosethe effect of the change to LIFO is repeatedin management's analysis of operations. Thisis true whether such analysis is included as aseparate narrative or as a part of the president'sletter. You are agreeable to this positionbecause the change to LIFO would onlybe made where that method is preferable tothe one previously used. Thus the descriptionof the change would state the effect onincome but would be written in a mannerwhich conveys the message, that a summaryof operations using the LIFO method for thecurrent year is more meaningful in under­'standing the company's results of operations.A typical example relating to the impacton earnings might read as follows:Footnote A: The company has changed itsmethod of accounting for inventoriesto Last-in, First-out(LIFO) method. This was donebecause the rapid increase inprices during the year wouldresult in an overstatement ofprofits if use of the First-in,First-out (FIFO) method werecontinued since inventoriessold were replaced at substantiallyhigher prices. The effecton reported earnings for theyear was a decrease of$XXX,XXX, or $X.XX pershare.Excerpt from Man.agement's Analysis ofSummary of Earnings:In order not to overstate reported profitsas a result of inflation during the year, thecompany changed its method of accountingfor inventory from First-in, First-out toLast-in, First-out. This was necessary becauseof the rapid increase in prices in197X which caused inventories sold to bereplaced at substantially higher prices.The effect of the change was to decreasereported earnings by $XXX,XXX, or$X.XX per share.Your Rev. Proc. 73-37 has previouslystated that a company which changed toLIFO may make any disclosure which isrequired by Accounting Principles BoardOpinion No. 20 in its financial statements forthe year of the change without causing theService to terminate the LIFO election. Iunderstand that consistent with this positionand in recognition of new financial disclosureprinciples, the Service will amplify Rev. Proc.73-37 to allow the discl6sures required byAccounting Principles Board Opinion No. 28and Financial Accounting Standards BoardStatement No.3 in addition to the disclosurerequired in Accounting Series Release No.159. The amplified Revenue Procedure alsowould provide that the above disclosurescould be made in news releases, etc., in theyear of election.We believe that Rev. Proc. 73-37 amplifiedas discussed above will satisfactorily solvethe problem of permitting necessary disclosuresin the year in which a change to LIFOis made. The disclosures required to be madeunder our present rules and the other authoritativesources cited above are limited tothe income effects of the specific changes

ACCOUNTING SERIES REI$ASES 347made during the year and therefore wouldonly cover any segment of an inventory forwhich a change was made. If part of theinventory was changed to LIFO in one-yearand another segment was changed in thenext, the disclosures in the second yearwould only relate to the effect on overallearnings of the segment changed in thatyear and not to the effect of a differentinventory method on the inventory previmislychanged to LIFO.Rule 3-07 of Regulation S-X requires thatthe disclosure made in the year of change berepeated at any time the financial statementsfor that year are subsequently reported.Instructions to registration statementsand annual reports filed with theCommission require a summary of operationswhich includes information or explanationof material significance, including accountingchanges. Securities Exchange Actof 1934 Release No. 11079 requires that-a fiveyear summary of operations be included inthe annual reports to shareholders. We understandthat such a repetition of previouslymade disclosure will not cause conformityproblems. Our rules and the relevant authoritativeliterature do not presently requirethat any disclosure be made of the effect ofusing an alternative calculation of cost ofsales covering periods subsequent to theyear in which the change to LIFO is made.We do encourage but do not require registrantsto make disclosure of the pro-formaeffect on income if the LIFO system hadbeen used in the year prior to its adoption,but we understand that this disclosure wouldcause no conformity problems since the registrantwas not using the LIFO method fortax purposes in such previous year.We also considered Rev. Rul. 73-66 whichWas issued in part as a result of the 1972a~endments on Regulation S-X which re­~uIre (in Rule 5-02-6(b» that registrants uslngthe LIFO method disclose "the excess ofreplaLIF cement or current cost over statedcall 0, value" if material, either parenthetifiy In the balance sheet or in a note to thenan' IPro . ~Ia statements. The ruling presentlysta~ es that a footnote or parentheticalthe ement to the balance sheet could stateexcess of FIFO over LIFO cost. We understandthat the Service will amplify Rev.Rul. 73-66 so that the use of replacement orcurrent cost (which normally would not differsignificantly from FIFO) also would bepermitted in this note or parenthetically inthe financial statements.Sincerely,John C. BurtonChief AccountantINTERNAL REVENUE SERVICEWASHINGTON, D.C. 20224January 23, 1975.MR. JOHN C. BURTON,Chief AccountantSecurities and Exchange CommissionWashington, D.C. 20549DEAR MR. BURTON:I have received your letter dated January20,1975.Your letter is consistent with my understandingand the position of the InternalRevenue Service as set forth in RevenueProcedure 75-10, 1975-7 I.R.B. dated February18, 1975, and Rev. Rul. 75-50, 1975-7I.R.B., to be announced today in TechnicalInformation Releaseses, copies- of which areenclosed for your information.It is also my understanding that the abovementioned letter and this letter are beingpublished concurrently by the Securities andExchange Commission and the Internal RevenueService today.Sincerely yours,Lawrence B. GibbsAssistant Commissioner (Technical)Enclosures

348 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. 170January 27, 1975SECURITIES ACT OF 1933Release No. 5562SECURITIES EXCHANGE ACT OF 1934Release No. 11210Order Suspending Accountant from Appearance or Practice Before the Comission in the Matterof Tubber T. OkudaOn April 27, 1973, Tubber T. Okuda, anaccountant, was permanently enjoined fromviolating the antifraud provisions of the Securitiesand the Securities Exchange Acts bythe United States District Court for the WesternDistrict of Washington. 1 The courtfound that Okuda prepared two false andmisleading financial statements for NorthwestPacific Enterprises, Inc., only one ofwhich was certified. These statements werefound to have been used to induce persons topurchase the securities of Northwest Pacific.In a memorandum in support of its successfulmotion for summary judgment, the Commissionargued that (1) Okuda knew orshould have known these financial statementswere false and misleading in that theyfailed to disclose that principal assets (sixocean going vessels) were grossly overstated,and (2) Okuda failed to review sufficient competentevidentiary material to affQrd a reasonablebasis for the expression of his opinionon the certified financial statement ofNorthwest. The injunction led to Okuda'stemporary suspension from practice beforethe Commission. These proceedings were initiatedat Okuda's request to determinewhether or not that temporary suspensionshould be made permanent. 2The Commission has now determined toaccept Okuda's offer of settlement. On thebasis of that offer, it isORDERED that Tubber T. Okuda be, andhe hereby is, permanently suspended fromappearing or practicing before the Commission;but it is furtherORDERED that on and after September20, 1976, Okuda shall have the full right toapply for reinstatement;3 and it is furtherORDERED that any such application shallbe granted, if s'upported by an adequateshowing that:(A) Okuda has familiarized himself withthe registration and the disclosure provisionsof the federal securitiees statutes andwith the Commission's requirements with respectto accounting procedures, and(B) Nothing has occurred during the suspensionperiod that would be a basis foradverse action against Okuda under Rule2(e).For the Commission, by the Office of Opinionsand Review, pursuant to delegated authority.GEORGE A. FITZSIMMONSSecretaryIS.E.C. v. Northwest Pacific Enterprises, [nc., Civ. No.518-72C2.2 See Rule 2(e) (3) (ii) and (iii) of the Rules of Practice.ed on3The temporary suspension order was enterSeptember 20, 1973.

PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 18963ACCOUNTING SERIES RELEASES 349RELEASE NO. 171May 1, 1975Adoption of Revised Rule 26 Under the Public UtilitY Holding Company Act of 1935 andRescission of the Uniform System of Accounts for Holding CompaniesThe Securities and Exchange Commissiontoday announced the adoption of revisedRule 26 (17CFR 250.26) under the PublicUtility Holding Company Act of 1935, andthe rescission of the uniform system of a.ccountsfor holding companies ("uniform system").The purpose of the change is to facilitateadjustment of . registered' holdingcompany accounts to generally accepted accountingstandards.The revision was noticed for comment 'January23, 1975 (HCAR No. 18782, 6 S.E.C.Docket 169, 40 FR 5372). Six responses werereceived, all endorsing the change in substance.(The text of the amendment of Rule 26(17CFR250.26) is omitted.)Statutory BasisSection 15(a) of the Act authorizes theCommission to prescribe the records and ac~counts to be maintained and the periodsduring which they are to be retained forinspection and audit by every registeredholding company and every subsidiary. Section15(e) of the Act requires that only ~na~counting system approved by the Commis­SIOn be used. And Rule 28 prohibits, with thee~ceptions stated therein, the use of finan­CIal statements inconsistent with the bookaccounts so maintained.We hereby authorize, as a transitionalme .theasure, the adjustment of all ac£ounts forcalendar year 1975 to conform to the newaccOuntian ng system adopted in that year bySU:h Company subject to the rule, as thoughbe . S!stem had been in effect since thein ~~~?g of 1975. We have already grantedJanu lng Company Act Release No. 18782,ary 23, 1975, an exception from Rule 28,to permit companies which intend to adoptsuch accounting system in 1975 pursuant tothe amended rule to publish financial statementsfor the year 1974 on the new basis.This exception is hereby renewed and extendedto, financial statements for the year1975 or portions thereof. .. Background a .. d ~urpose. We have detertnined that the uniform system,prescribed in 1936, -has ·become obsoletein significant res'peets and that there is riblonger a need for a single' prescribed systemof accounts for holding companies'. . Thechange will aliow holding companIes to takethe initiative iIi developing accounting systemsadapted to their particular requirements.The rescission of the uniform system eliminates. discrepancies which have developedsince the uniform system was adopted betweenthe accounts prescdbed and generallyaccepted accoUliting principles. The principaleffects· are the use of the· equity method ofaccounting for investments in subsidiaries inplace of the cost method and the presentationof extraordinary gains and losses on theincome statement, rather than in retainedearnings.Record RetentionThe rule published herein differs from thatproposed in that it adopts rather than rescindsthe detailed schedule of record retentionrequirements which has been in effectsince 1959. It should be noted that, underparagraph (g) of the revised Rule 26, referencesin that schedule to the uniform systemof accounts noW are to be read as referencesto Rule 26. We are aware that this schedule

350 SECURITIES AND EXCHANGE COMMISSIONneeds some change and expect to publish' anamendment for comment.In reviewing the proposed rule in the lightof the 'comments' received, it became apparentthat the substitution of proposed paragraph(c) for the existing specific instructiorisas . to record retention createduncertainties and ambiguities which shouldbe avoided. It would not be appropriate todefer action on the basic accounting changeproposed for republication of record retentionrequirements, so it is necessary to retainthe existing requirements until the pro-,cedures necessary for change can becompleted'. .., .Other Changes From the Rule as ProposedTextual alterations have bee:p. made toclarify certain questions raised in the commentf'!.The second sel1tence. of p,aragraph(c)(2), which would have required that undistributed.ea~ings of SUbsidiaries be 'seg1-egated.on: tlleparent. company's' balancesheet, has been deleted. This conforms to ourbasic policy of leaving the form of fin,ancialstatements to Regulation 8-X. Although thelegal restrictions on ~lie lise of that portionof, the parent company's retained earningswill normally be material, that restrictionwIll usually overlap with similar restrictionsimposed by bond indentures Qr loan agreements,which are customarily described byfoot'note. A mandatory use of a balance ~heet'caption for one such restriction could complicatean already difficult problem of dIsclosure.',The final clause of paragraph (c)(3), whichreferred to a Section 12(c) application becomingeffective under Rule 23, is deletedbe~cause such an application can become effectivein more than one way.. Filing requirements, which originally appearedas subparagraph (b)(5), have beEmrestated in a separate paragraph (b). Eachexisting registered holding company shouldidentify the accounts to be used in its systemas part of its Form U5S for 1974, due May 1,1975, or by supplement thereto. A companyelecting to continue to use the old uniformsystem until January 1, 1976, should so statein that filing but must specify the accountsto beuse'd in a supplement thereto fiied' byDecember 1, 1975. This conforms to the 30~day advance filing requirement for' amendments.This portion of the rule has beeD: 'elabo'­rated to make it clear that the filing need notbe repeated' each year and that' copies' ofofficial charts of accounts, such as' thosepromulgated by the Federal Power Commis:­sion, need not be filed.Some companies subject to the rule maywish to adopt an official system used by theirsubsidiaries or associates, even though not. required to do so. The rule permits this choice.'Such companies are free to modify the systemso selected. Any variation from an officialsyste~ would, of course, preclude 'ine~tingthe' filing requirements' by a simplereference. However, official systems. are amatter of official notice and maY'be incorporatedby refere;nce in a filIng, as long as. thevariations therefrom are unequivocallystated.,Concern. has been expressed that. para­~aph (b)(9) of Rule 14 a-3 under the SecuritiesExchange Act of 1934 would requireinclusion of the entire chart of accounts inthe material which the issuer is required tofurnish on request to its security holders.That rule specifies the conditions on whichexhibits to such filings are to be furnished,and is fully adequate to cover the' contingency~Application of Rule 26Rule 26 is coextensive with Section 15(a) ofthe Act and applies, except 'as expressly limited,to every registered holding companyand every subsidiary thereof. The proposedtext has been rearranged to segregate inparagraph (c) the provisions dealing with theequity method of accounting for investmentsin subsidiaries, which are inherently limitedt

ACCOUNTING SERIES RELEASES ,. 351P9wer Commission or state commissions. Wedo not, at this time, see a need for additionalrequirements ,as to 'these companies. ' '"Subsidiary company" as used in this rulehas the specia~ meaning prescribed in Section2(a)(8) of the Act, and includes any companyregardless of form of organization inwhich 10% or more of the voting,securitiesare directly or indirectly owned, controlled orheld with power to, vote by a holding company.The rule does not prohibit use of theequity method of.accounting for investm~nts-- .in nonsubsidiaries. Its use for such investmentswould be governed by applicable accountingstandards. "Rule 26, is adopted pursuant to authority;conferred on, the Commissiort by the PublicUtility Holding Company Act of 1935, partic:ularly Sections 15 and 20 thereof, and shall. be effective forthwith. 'By the Commission.GEORGE A. FITZSIMMONSSecretary- . RELEASE NO~ 172JiI~e 13, 1975,-SECURITIES ACT OF 1933~elease No. 5590SECURITIES EXCHANGE ACT OF 1934Release No. 11470PUBLIC UTILITY HOLDING COMPANYACT OF.1935Rele,ase No. 19039INVESTMENT COMPANY ACT OF 1940Release No. 8819Notice of Rescission of Guidelines Set Forth i~ Accouniing Series Release No. 148 Pertaining toClassification of Short-Term, Obligatio~s Expected to be RefinancedAccounting Series Release No. 148 (33- business (whichever is longer) and (3)ends the maturity date beyond one yearGEORGE A. FITZSIMMONSor th e current operating cycle of the Secretary5436, 34-10493, 35-18168, IC-8082;' November13, 1973) set forth guidelines concerIiing.Jtheclassification of commercial paper' and shorttermdebt expected to be refinanced, as follows:"Commercial paper and other short-termdebt should be classified as a-currentliability even though the issuer's intention'is to roll over such debt at its maturity.The fact that an issuer has bothwhen the borrower's intention is to exercisethis right, should borrowings undersuch an agreement be shown as a longtermliability (along with disclosure ofthe above facts)."These guidelines are rescinded effectiveDecember 26, 1975 and financial statementsfiled with the Commission with balancesheets dated o~ or after that date shall followthe' criteria set forth in the Statement offinancial strength and' a ,past borrowing Financial Accounting Standards No. 6record such that sale of new paper appears("Classifi~ation of Short-Term Obligationsreason'ably assured does not con­Expected t9 Be Refinanced-An Amendments~itute a basis for long-termclassificatlon,of ARB No. 43, Chapter 3A") which wassince the power to terminate thecredit remains with the creditor. Only (1)issued by the Financial Accounting StandardsBoard in June 1975. Earlier application;he~ a borrower has a noncancelable of this new Standard in lieu of ASR No. 148mdmg agreement from a creditor to~e~nance the paper (or other short-termguidelines is encouraged.By the Commissiont e t) and (2) when the refinancing ex­

352 SECURITIES AND' EXCHANGE COMMISSIONSECURITIES EXCHANGE ACT OF 1934ReieaseNo. 11517: RELEASE NO. 173.: July 2, 1975, .Opinion and Order' iii a 'Proceediilg Pursuant to Rule 2(e) of the Commission's Rulesof Practice in the Matter of Peat, Marwick, Mitchell & Co.• ,.... f •Between February 1972 and March 1974the Commission filed four civil injunctivecomplaints against Peat, Marwick, Mitchell& Co. ("PMM") relating to' PMM's examinationsof financial statements of National StudentMarketing Corporation ("NSMC"), Tall~yIndustries, Inc. ("Talley"), Penri Central'Company ("Penn Central"), and Republic:! N a­tional Life Insurance Company ("RepublicNational"). In' addition, the Commission hascompleted an' investigation relating to StirlingHomex Corporation ("StIrling Homex")which"has also raised qu~stlons"coricerningPMM's ~~lldit of thj.~ ."CoII1panY!s fjnancialstatements. 1 in order to resolve thes~ ,c(mtro~versies, PMM has submitted an offer of settlement. which \s described in detail below,and 'which we have considered and,d~ter~ ;.::mined to' accept. As contemplated by thesettlement 9ffer, with~ut adniItting or denyingany of the statements a,nd, conclusionsset forth herein, P:M:M· has -;agreed ·to theinstitution of this Rule '2(e) 'proceeding andthe issuance of the order hereinafter setforth. 2The facts of these five matters, a/Sthey1 The first four matters have' been the subje~t ofinjun~tive actions brought by the Commission againstthe Companies involved, other persons and PMM. SEC v.National Student Marketing Corp., et at, Civil Action No225-72 (D.D.C.); SEC v. Peat, Marwick, Mitchell & Co.,instituted sub nom; SEC v. Talley'Industries, Inc., et al.,73 Civ. 4603 (S.D.N.Y.); SEq v. Republic National LifeI'I'I:surance Co., et. al., 74 Civ. 1097 (S.D.N.Y.); 'SEC v.Penn Central, Co., et al., 74.Civ. 1125 (E.D. Pa.). The fifth,matter has been the subject of an investigation of thecompany, other persons and PMM. This opinion, except.incidentally, does not attempt to deal with'. the other'persons involved in these various controversies.2 For purposes of this settlement and carrying out ofany procedures contemplated herein, PMM has waivedseparation of functions between the staff and the Commission.app~ar to the Commission, are set forth insom~ detail below, together with the Commission'sviews on the accounting and auditinglessons to be learned from them. Thefollowing highlights certain of the basicproblems which have been noted by the Commissionin these matters: '. The first set of problems relate to theprocess of taking on a new audit engagementand planning for the first audit. Three ofthese cases involved initial audits:In .the NSMC case, there was inadequatecommunication between' the predecessorauditor and PMM which resulted in, PMM'sbeing unaware of doubts wl.1ich the predecessorauditor had as to the integrity of manag~ment.In the Republic 'case, 'PMM was: aware of disagreements between their predecessorsand Republic's management regardingdisclosure of and accounting for investmentsin its major debtor, 'but PMM did notinvestigate these differen

ACCOUNTING SERIES RELEASES 353stance of the situation. In additiqn, in Stirlingthere was a division of ultimateauthority for the engagement between twopartners, one of whom operated out of anoffice far removed from the executive officesand the manufacturing facilities of Stirling,so that his abiiity to actively plan and supervisethis difficult first audit was substantiallyreduced.Another problem area highlighted by severalof the cases is the need for emphasizingthe importance of substance over form indetermining accounting principles to be appliedto particular transactions and situations.In addition to considering substanceover form in particular transactions, it isimportant that the overall impression createdby the financial statements be consistentwith the business realities of the company'sfinancial position and operations.In the Penn Central case, PMM did notplace sufficient emphasis on the economicsubstance of several transactions and hencepermitted these transactions to be accountedfor under principles which in our view werenot applicable in the circumstances. Moreimportantly, the inclusion of the sum of allthese transactions in financial statementsresulted in statements which, .taken as awhole, did not communicate to the user thebusiness realities of the company's financialposition and operations.We believe that an auditor must standback from his resolution of particular ac-.counting issues and assess the aggregateimpact of the particular issues upon a reasonableinvestor's perception of the economicsubstance of the enterprise for which financialstatements are being presented.In u~veral of these cases, serious problemsarose in the application of percentage ofcompletion accounting and its improper useto accelerate the recognition of revenue. Percentageof completion accounting is normallyUsed in SI 't ua t' Ions where the conventIonal .afProach of recognizing revenue at the pointIng? sale.and delivery would produce a misleadmllcture of business activity. This is norpra . y the case where there are substantialultioJects Iast'mg longer than a year, wherewh mate sales are assured by contract andere reasonable estimates can be made ofthe cost to complete the project. In theNSMC case, no firm sales had been madeand, in fact, the percentage of completionwas measured by the estimated percentageof sales effort expended. In addition, "projects"were of short duration and cost estimatesWere uncertain. Similarly, in Stirling,sales contracts were dependent on obtainingfinancing which was highly uncertain, andthe costs of completion were difficult to estimate.These cases emphasize that the use ofaccounting principles must be evaluated inthe light of their applicability to the facts ofthe particular case, and that professionalsmust exercise the greatest care and judgmentin appraising their applicability. Whilemanagement may initially select the principlesto be followed, the independent accountantmust be satisfied that in his professionalju~gment the principles selected arethose which appropriately describe the businessreality within the general framework ofthe accounting approach to economic measurement.Finally, in most of these situations, theauditors accepted the representations ofmanagement without obtaining independentaudit verification of the realities underlyingtransactions. While the Commission does notsuggest that management representationsare not a significant source of evidence, it isapparent that if the independent professionalisminherent in the auditor's role is to bemaintained, evidence beyond these assertionsmust be obtained in significant auditareas.In Talley, for instance, the auditors acceptedmanagement's estimates of contractsto be received despite the fact that Talleyhad to predict both total government contractsto be awarded and the company's expectationsof its share of such total contracts.These largely subjective judgmentswere based on various forms of "soft" dataand were not sufficient for the purpose ofassuming future orders. They also acceptedTalley's estimates of per unit cost reductionsdespite the fact that Talley's cost system wasnot capable of (and did not attempt to) monitordifferences between estimated and actualcost figures.

354 SECURITIES AND EXCHANGE COMMISSIONThe recognizing of revenue in· the NSMCcase depended in part on the firmness of the"contracts" with NSMC's customers. In that .regard the auditors relied heavily on management'srepresentations that oral contractswere not unusual· and were sufficientlyfirm to be a basis for recognizingrevenue. In the initial audit, they did notinsist on written confirmations from customers.In Stirling sales and income were recognizedin connection with the manufacturingand installation of modular housing for localhousing agencies although the agencies,themselves without funds, were dependentupon federal financing and binding commitmentsfor such financing were absent. In theCommission's judgment, PMM accepted representationsthat documentation from thelocal agency constituted or was the practicalequivalent of committed federal financing.Assignments of modules to specific contracts,ability to recover installation cost overrunsand the status· of particular projects wereother areas where PMM largely relied uponmanagement representations and did notperform appropriate audit steps.* * * * *The following is a description of the fivecases.NATIONAL STUDENT MARKETINGCORPORATIONPrior to discussing PMM's role as independentauditors for National Student MarketingCorporation ("NSMC") referenceshould be made to the circumstances underwhich the firm was engaged. In April 1968,N'SMC made a registered public offering of30,000 shares of its common stock. 3 At the 'time of this registered, stock offering,NSMC's independent auditors were ArthurAndersen & Co. and Covington & Burling3 NSMC's common stock was offered to the public at$6.00 per share. By September of 1968, the stock wasselling at $70 per share, about 350 times the last reportedaudited earnings per share.was its outside counsel. In July' of 1968,shortly before the close of NSMC's fiscalyear, Covington & Burling resigned as counselto NSMC and was succeeded by White &Case ("NSMC's outside counsel"). At approximatelythe same time, Arthur. Andersen advisedNSMC that it would not be available toundertake audit responsibilities for the fiscalyear ending August 31, 1968. Arthur Andersen'sdecision to resign apparently came as aresult of a'series of events which led ArthurAndersen and Covington & Burling to questionthe reliability of information which theyreceived fron NSMC's management.Upon being requested by NSMC to acceptthe audit engagement, PMM's Washingtonoffice inquired of the managing partner ofthe local Arthur Andersen office as towhether there was any professional reasonwhy PMM should not undertake to act asoutside autitors for the company. This limitedinquiry, which the Commission believesshould have been viewed as including questionsregarding management integrity, wasanswered in writing in the negative. PMMdid not ask for the reasons why Arthur Andersenhad resigned and -Andersen did notsupply any information in this regard. 4 TheCommission believes that information pertainingto the integrity of managementshould be communicated between predecessorand successor auditors. The resultingfailure of communication caused PMM toundertake this engagement at a distinct disadvantage.While the kind of informationArthur Andersen and Covington & Burlinghad did not necessarily go to the fundamentalintegrity of NSMC's management, it wasnevertheless significant information whichPMM should have sought more aggressively.The significance of the simultaneouschanges of the independent auditors and outsidecounsel also should not have been overlooked.This additional information mighihave added significantly to the nor~a"healthy skepticism" with which the audItorapproaches a professional engagement.I We4 Arthur Andersen acted on advice of counse.believe that at a minimum the fact that their respons~bommunlwas limited by such advice should have een ccated.

ACCOUNTING SERIES RELEASES 35~PMM's August 31,1968 Engagement­Accounting for Fixed Fee ProgramsNSMC was organized in 1966 to engage inthe development, marketing and implementationof various products and services of itsown and of its clients to high school andcollege students. At this time, it maintainedits executive offices in Washington, D. C.The clients of NSMC were companies wishingto sell their products and services in thestudent market. NSMC designed youth-orientedadvertising programs to fit the needsof individual clients and sold its ability toimplement those programs by distributingvarious materials - directly to the so-calledyouth market. Media used by NSMC in itsyouth marketing activities included campusposter advertising, handouts, direct mail,desk pads, college directories, newspaper insertions,films and product sampling. NSMCsold its services through account executiveswhose duties encompassed solicitation of prospectiveclients, explanation of NSMC's marketingcapabilities and development and designof specific programs to meet clients'marketing objectives. Posters, handouts,samples and other promotional materialsused in the marketing programs were oftenmade and delivered to the NSMC distributionnetwork by outside vendors and/or bythe clients themselves. NSMC's distributionnetwork consisted of part-time campus representativesemployed by NSMC who workedona commission basis.NSMC's revenues were generated oneither a commission or fixed fee basis, dependingupon the nature of the program. Anexample of a commission program was thedistribution of posters with tear-off couponsfor a magazine subscription. The clientwould pay a fee to NSMC per subscriptionapplication coupon received. An example of afi:xed fee type program was a direct mailingto a 'fi ~£ SpeCIIC number of addresses for a flat- ee. Fixed fee business first became signifi­~;~t for NSMC during the latter half of fiscal8.A.s described to the auditors NSMC's increasedf~ ,I e Lorts to obtain clients for particu-.,:r Inarketing programs on a fixed fee basisere centered on NSMC's recently expandednational sales operation centered in NewYork City. The company -had -hired severalaccount executives whose efforts involvedthe creation of an overall marketing program-marketingstrategy, media selection,art work, and the like-tailored to the needsof a particular client, its presentation to theclient, possible revisions and a new presenta- -tion, and ultimately acceptance by the client.The programs were directed to the studentmarket and thus were to -be implemented atvarious seasons during the academic year.The program effort was the resporisibility ofthe particular NSMC account executive whodrew upon and supervised the various necessarytalents of the New York Office staff. Asrepresented by NSMC's management, theonly remaining functions after acceptance bythe client were those of an essentially mechanicalnature such as printing, mailing,placing posters, and the like, with their costsbeing _susceptible to a reliable estimation. Asubstantial amount of firm commitments allegedlyhad been obtained for such fixed -feeprograms prior to August 31, 1968, and it wasrepresented that the creative effort had thusbeen largely accomplished, although implementationof the programs and billings wereto take place at a later date. It was explainedby NSMC to the auditors that, as was acommon practice in the industry, these commitmentswere for the most part not in writtencontract form.When PMM commenced its examination ofNSMC's financial statements for the fiscalyear ended August 31, 1968, it became immediatelyclear that NSMC's internal accountingbooks and records were in very poorcondition and that the journal entries were amonth or two behind. By early October apreliminary profit and loss statement hadbeen prepared by management which reflecteda loss of approximately $220,000 forthat year. It was at this time that the company'smanagement, principall~ its chief ~xecutiveofficer, advised the audItors that Itsbooks and records did not include substantialamounts of revenues generated by NSMC'sNew York office through the sale of fixed feeprograms. From the beginning of October tothe middle of November, additional informationwas supplied to the auditors by NSMC

356 SECURITIES AND EXCHANGE COMMISSIONwhich purported to show substantial commitmentswhich would result in income arisingout of the operations of this aspect ofNSMC's business. Approximately 96% ofNSMC's consolidated earnings before incometaxes and extraordinary items and forty percentof its assets resulted from the inclusionin NSMC's financial statements for 1968 ofrevenues, less the accrual of related costs,from these fixed fee programs described inthe financial. statements as "contracts inprogress." In our view, both this accountingtreatment and the auditing in respectthereof were inappropriate for several reasons.Of the $1.76 million in revenues fromunbilled receivables appearing in NSMC's1968 financial statements, only about $200,-000 was covered by written contracts fromNSMC's clients. 5 The rest was reported as"contracts in progress" but in fact consistedof what were said to be oral "commitments,"the sole written evidence of whose existenceconsisted in most part of one page commitmentreports of the NSMC account executives.All of these commitment reports fromthe account executives were dated in October,some six weeks after the close of thecompany's fiscal year. These reports gave noindication that the purported commitmentsexisted on August 31, 1968. The auditors'work papers do not reflect that efforts weremade to test whether they existed at August31, 1968 or not. 6Revenue should be recorded on a percentageof completion basis only in circumstanceswhere (1) the ultimate realization of therevenue is reasonably assured, (2) the completionof the contract requires a relativelylong period of time, (3) the partial performanceof the contract is a reasonable measureof business activity and (4) the cost of completioncan be reasonably estimated. In ourview, none of these criteria was met withrespect to the accounting for fixed fee programs,and the application of the percentageof completion accounting method to. thesecircumstances was inappropriate. In addition,the determination of percentage of completionon the basis of what, in our view, wasonly sales effort appears to us to be totallyinconsistent with the basic principles underlyingrevenue recognition. Furthermore, themethod used ignored all cost of implementingthe program in computing the percentageof completion, although such costs wereaccrued. Moreover, the company relied onlyon its account executives for their estimatesof the percentage of completion. Although theauditors claim, to have tested these representationsand estimates by the account executives,they did not document such testing intheir work papers. 7_The accounting method utilized for thefixed fee programs made no allowance for,and the financial statements made n.o referenceto, guarantee provisions in a substantialnumber of the programs by which, in theevent the response level did not reach astated mInImUm, NSMC was obligatedeither to accept a reduced fee or to rerun theprogram at no cost to the client. Since NSMChad had no significant past experience withthe fixed fee programs, its liability to makegood on these guarantees could not accuratelybe estimated.By way of summary, some measure of theinappropriateness of the percentage of completionaccounting applied to the fixed feeprograms in the company's 1968 financialstatements may be gleaned from the factthat during its 1969 fiscal year the companywrote off over 75% of the $1.76 million inrevenues ascribed to the fixed fee program~previously reported in the 1968 statements.5 It was NSMC's practice not to enforce even writtencontracts if the client never ordered implementation. Infact, the written contracts which they did have in 1968covering fixed fee programs included guarantees that acertain level of market performance would be achieved.6 See §338.02 of Statement on Auditing Standards No.1 (AICPA) on the form, content and nature of workingpapers.7 It is worth noting in this connection that least o~eaccount executive testified that he believed tha~ thl~percentage of completIOn . represente d NSMC's likehh ooof getting the commitment from the client. . ffs8 As discussed below, no disclosure of these wr~~-~erwas made in subsequent financial state.men.ts untl S~C'sthe Commission began its investigation mto Naffairs.

ACCOUNTING SERIES RELEASES 357In: addition to the. propriety of the accountingmethod is the question of appropriateauditing procedures with respect to fixed feeprOgI'ams. Standard of Field Work No.2 ofGenerally Accepted Auditing Standards requiresthe auditor to make "a proper study. and evaluation of the existing internal control[of his client] as a basis for reliancethereon." The 1968 audit was PMM's firstaudit of NSMC. Pmm's work papers containevidence that the audit was the beginning ofadequate record keeping for the fixed feeprograms. 9 In this respect, the workpapersthemselves were the principal records fromwhich the financial statements were' prepared.In light of the fact that the auditorsdid not consider NSMC to ,have a reliablesystem of recordkeeping, nor an adequatesystem of internal control, and that NSMChad no substantial prior experience withfixed fee commitments, the. extent of theauditors' reliance on information supplied byNSMC, we believe, was improper. For example,they accepted the percentages suppliedby NSMC's account executives of the amountof work that had ostensibly been completedon any particular commitment, even though,to their knowledge, NSMC had no written instructionsconcerning how this was to be computed.10 As noted earlier, although the auditorsclaimed to have examined the account executive'sfiles to verify and test the percent-·PMM's audit supervisor reported that NSMC's "accounting,bookkeeping and maintenance of files werealmost forgotten ... The net result is that our workingpapers represent the beginning of proper record keepingand accounting procedures for recording gross incomeon contracts."I·PMM'1969 s management letter to NSMC of January 2,s'd urged that these procedures be strengthened con­I erably:uDsal Ue to the nature of the activity of the company,sl'd es are recorded when a client commitment is coneredto . t Thbased eXIS. e amount of the sale recorded ismat d o~ the percentage of time incurred to the esti­OPine tIme to be incurred by the employees in develtimeg ~veral! programs for the client. Because thedevel~ . these employees is extremely important inPIng a systematic method of recording sales, it,age of completion figures utilized, such examinationwas not documented in the audit workpapers.Moreover, the auditors did not obtain writtenconfirmation from any of NSMC's clients.Company officers informed them that itsclients, not having been asked to formalize inwriting their acceptance of NSMC's 'programsin the first instance, did not expect tobe c;!alled upon to do so at a later date andmight well back off from doing business withNSMC if asked to do so. As a result, PMM didnot send written confirmations. The auditorsconcluded that the existence of these commitments.could be determined by telephoneconfirmation on a representative selection ofthe oral commitments and review of suchwritten commitment as existedY A number ofthe telephone calls were placed by NSMC'saccount executives and the auditors did notinsist on proper audit controls for these· oralconfirmations. Although there may be' verylimited situations where telephonic confirmationscan properly be utilized as an auditingtechnique, provided adequate controls areis imperative that the company adopt a policywhereby these employees report their time to theaccounting department on a weekly or other timelybasis, report in writing commitments obtained fromclients, and estimates of time to cOIllplete committedcontracts. In addition, preprinted forms should beused to obtain written confirmation of all client commit!JIents."Working with Mr. Kurek and Mr. Davies, we haverecently designed appropriate forms for use in theabove connection. We urge that implementation of therecently established program be followed up very closelyand that no wa'vering from the required proceduresbe permitted."11 For the fiscal year ended August 31, 1969, at theauditors' insistence NSMC recognized revenue only onfixed fee programs which were evidenced by a writtenletter of commitment by the client. These commitmentswere confirmed in writing by the auditors. Again theCommission believes that such commitments, even whenconfirmed in writing, should not have resulted in recognizedincome resulting from the application of the precentageof completion method, for the reasons previouslyspecified for the year ended August 31, 1968.Following the institution of the Commission's investigation,the company adopted' the completed contractmethod for the fiscal period ended December 31, 1969.

358 SECURITIES AND EXCHANGE COMMISSIONmaintained,12 in our view such a procedurewas inappropriate for NSMC.13NSMC's Pro~y StatementDuring the period from November 1968 toMay 1969, NSMC acquired additional companiesprimarily through the issuance of itscommon shares. In the Spring of 1969, PMMwas engaged to assist the company in consolidatingunaudited figures as at February 28,1968 to be used in a proxy statement toobtain authorization from its shareholdersfor the issuance of additional shares neededfor its acquisition program.Retroactive Adjustments. At about thistime, the auditors were informed that anaccount executive of the company had beenterminated for alleged unethical conduct andthat Ii subsequent review of the accountswhich this individual supervised disclosedthat four particular. client commitments forfixed fee programs which he had 'earlier reportedhad never in faCt existed. These commitmentsinvolved gross sales of approximately$750,000 which amounted toapproximately 43% of the fixed fee salesreported in the company's previously issuedfinancial statements for the fiscal yearended August 31, 1968. Costs of some $540,-000 had been accrued on these commItments,resulting in a net reduction on the, company'sincome before taxes for the prior periodof some $210,000. The auditors suggestedthat this income should be written offretroactive to August 31, 1968, and the companyadopted this procedure.About the same time that this retroactivewrite-off was being discussed with the company,PMM's tax department, which hadI: See, e.g., AICPA Industry Audit Guide, FinanceCompanies, p. 105, 1973.13 See Section 331.01 of Statement No.1 on AuditingStandards: ."Confirmation of receivables and observation of inventoriesare generally accepted auditing procedures.The independent auditor who issues an opinion whenhe has not employed them must bear in mind that hehas the burden of justifying the opinion expressed."The auditors did not satisfy this burden because noadequate documentation existed."been engaged in the preparation of the company'stax return, indicated that they believedthat the provision for deferred taxeswhich appeared in NSMC's 1968 financialstatements appeared to be in 'error as aresult of certain net operating loss carryforwardswhich the company was reportingon its tax retUI:ns. After being apprised ofthis, members of PMM's audit staff eliminateda portion of the 1968 provision fordeferred taxes in the amount of approximately$190,000, and a retroactive adjustmentof this effect was made on the company'sbooks as of August 31, 1968. 14Work on the proposed proxy statement wassuspended to facilitate shareholder approvalof several additional mergers that were thencontemplated. When preparation of theproxy statement was renewed, PMM personnelconsidered the question of whether theretroactive adjustments to the 1968 auditedstatements should be disclosed in a footnoteto the consolidated statement of earnings setforth in the proxy statement which was toreconcile the originally reported net salesand net earnings with the restated amountsresulting from pooled companies reflectedretroactively.The auditors took .the· position that thewrite-off of the previously erroneously reportedclient commitments and the extraordinaryitem which was a correction of the taxprovision error, both retroactively applied to1968, approximately cancelled each other outin their effect upon previously reported 1968net income. The difference, amounting toapproximately $21,000, was an amountdeemed by the auditors to be immaterial.They felt that the size and character ofNSMC had changed substantially throughacquisitions since PMM's report on the previousyear's audited statements had beenreleased. While the August 1968 financialstatements originally reported sales of $4.9million and net income of $388,000, the proxystatement reflected sales for that year of$11.5 million and net income of $773,000,after giving effect to pooled companies re-14 PMM later determined that this adjustment waS inerror.

ACCOUNTING SERIES REL~AS~S359flected retroactively, as well as the, retroactive'contract and tax adjustments.It is the Commission's view that what theauditOJ;s did had the effect of improperlynetting extraordi;nary and ordinary items ofincome and that' in any event; disclosure ofboth of these adjustments was required byparagraph 26 of Opinion No.9 of the Ac-,counting Principles, Board. None, of theseadjustments, moreover, were ~isclosed anywherein the proxy statement filed with theCommission and disseminated to stockholders;rather, they were improperly subtractedfrom the ~mounts shown for sales and earningsof pooled companies acquired by NSMCafter August 31, 1968 in the reconciliationfootnote., ,. .'About the same time that they were informedof the, four alleged nonexistent clientcommitments, the auditors _ were also informedthat the company was writing offagainst the current year's 'operating incomecertain other fixed fee programs whi~h hadbeen included in the 1968 statements butwere not being implemented for variou~ reasons.Despite this adverse experien~e, theauditors took no steps to reexamine or otherwisetake a fresh look at its 1968 audit or theprocedures and principles utiliz'ed thereinwith respect to fixe'd, fee programs, eventhough NSMC was utilizing the 1968 auditedstatements, which were being representedby NSMC to be true and correct, to acquireother companies. ISThe Commission believes that these Judgmentswere erroneous. The auditors wereaware that the company was experiencingcurrent difficulty with the implementationand realization of income from the' fixed feeprograms. Payments were not being received15 Fl' 'a t· 0 lOWIng the institution of the above injunctive" c Ion against PMM and others, the Commission relerredth t' 'a d' e ac Ions of PMM's engagement partner andu rtsupe . ,ary 17 rvlsor to the Department of Justice. On Janu-With '1974. an In. d'Ictment was returned charging theming maIring and causing to be made false and misleadstNSMC atementsWI'threspect to material.facts'In.theCon'" t~roxy statement referred to herein. Judgments of.. c IOn we t1974 Th re en eredagaInst.them on December 27States. oseN conVIctions'.are presently on appeal. United'v. atelli, Docket No. 75-10004.from these commitments in the ordinarycourse. Several of the commitments forwhich income was attributed in fiscal 1968were being' written' off currently and theultimate collectibilityof a substantial numberof other 1968 programs still on the company'sbooks was, at this time'; subject toserious question ...It is the Commission's vie'w tliat disclosureof these very' substantial write-om,; was essentia'lunder the circumstances. The writeoffsaffected what was represented by NSMCto be its Basic and unique line of business.The write-offs exposed the weakness of thatpart of the company's operations· which wasat the heart of Its entire acquisition program:The Nine MOl!th Statements 'The ,unaudited ~ine~month ea,rnings statementincluded in the proxY-statement wasco~piled ,by. NSMC with 'PMM;'s ,assistance,using the, same percentage ,of completion accountingtheory as in the 1968 figures. However,by the time the proxy statement wasissued, PMM knew not only that' a' materialamount of, the 19~8 commitments never existed,but that throughout fiscal 1969 thecompany wa§i writing off incurren,t periodsother commitment that had been recorded inthe 1968, figures that werenQt, implementedfor one re~son or another.Ip: compiling ,the nine-month financialstatements for the period whi~h ended May31, 1969, in at least one instance the Firmrefused to permit the inclusion of incomefrom commitments where there was no evidenceof a writing signed by the client. PMMdetermined to eliminate from' the ninemonthearnings statem.ent a purported commitmentfrom the Pontiac Division of GeneralMotors Corporation in an amount ofover $1 million because PMM was not satisfiedwith the written evidence supportingsuch commitment. However, NSMC substituteda commitment in a lesser amount fromEastern Airlines. This letter from the clientsupporting this commitment was produced inAugust 1969 at the printers by an NSMCofficial for the first time while preparation ofthe proxy statement was in process.

.360 SECl.JR1TIES AND EXCHANGE COMMISSIONTh~ appe8:ranc~ of this:~commitmeIl;t letterfoiiowed what had been, In QU,r vi~w, aS1,lspiciouspattern 9f.'P.ost-period. dis~~very,of inco~e,jtemsby NSMO manageme.nt. in October1968; as n9ted abc;>ve, folloWing a trialbalance which showed. a loss, .$1.7 million ofclient commitments was disclosed to PMMfor inclusion in the revenues for. the periodending August 31, 1968.:Although.a substantialport~on of these cQmmitQ1ents was writtenQ{f the. company~s bo()ks' du,ring the, sixmonth,period ending ,February 28, 1969,these, write-offs were, replaced· with the socall~dPontiac commitment, in the amount of$1.2 m~lion; wpich represented another matel':!ala~dition. to . NSMC . ' earnings twomonths after the fiscal period had. ended.'yet,: despite this experience, PMM did notobject to the recoxdingof the ,Eastern commitment.While . the Commission recognizes -that PMl\f was engaged in a proxy'reviewrather. than an' audit of these nine-monthfinan:cial statements, :J:lOnetheless, we beiievethat-urider 'all the 'circumstances then knownto' PMM, 'the 'ii,uditor's, should "not' have concurredin the deCision to recognize' incomearising out 'Of this commitment ·arid shouldnot have continued to be associated> with thefinancial statements. 'At the time the p~oxy statement was filed,NSMG and the auditors knew that of ,the$3,347,775 Of unbilled accounts receivable recordedin the 18-month period ended February28, 1969, some $2,055,523 (61%),had beenwritten off, 16' an additional $310,972 (9%) wasuncolleCtible or was to be written off andsome $123,006 (4%) was inactive and thebalance, some $858,274 (26%) had been billedorbille'd in part. None ofthese write-offs wasseparately disclosed. Despite the fact thatthe company had ostensibly changed its proceduresfor booking these' commitments andthat the size' and character of the company'hadch:a~ged through acquisitions, fixed feecommitments still accounted for a significantportion ()f the company's busiriess. Althoughthis method of accounting had proven to becompletely unreliable, revenues continued to16 Included in these amounts was the Pontiac commitmentof $1.2 million.,be accrued· in ·m:uch the same: fashioIl,through. August 31, '1969.'PM~'s ConuorlLetterThe approval of the shareholders' was solicitedon the basis of NSMC's August 31, 1968and May 31, 1969 financial statements. Theproxy statement was 'filed'with the Commissionon September 30,' 1969 and mailed toNSMC's shareholders. Among the mattersnoticed therein for actiori at a special shareholdersineeting to be held on October 8,1969was the approval of a merger of NSMC withInterstate National. Corporation ("Interstate"),a publicly owned company.Substantially the same proxy statementwasaiso mailed to Interstate's shareholders.The shareholders' of both companies voted toapprove the merger. Under the terms of themerge'ragree~ent', : which· was annexed to- the proxy statement PMM was' to deliver atthe time 'Of the closing, and before consummation',of' the' merger, what is, commonlycalled ,a "comfort letter," stating that: .'.. ~ ~ ...". '.."on the basis of a limited review, butnot an audit, of the latest available unaudited.'fnterim . financial statements ofNSMC and "It's subsidia:rie~~ consultations. with _ responsible officers of NSMC andother specified procedures and inquires (inchidingall such procedures as they 'considernecess,ary under the circumstances inconnection with such limited review), theyhave no reason to believe that the unauditedint~rim financial statements ofNSMG as of May 31, 1969, and for the ninemonths then ended, were not prepared inaccordance with accounting principles andpractices consistent with accounting printhepreparation of the August 31, 1968 aU-, dited . financial statements or that any materialadjustments of such unaudited interimfinancial statements are required fora fair presentation of the 'results of operationsof, NSMC and its subsidiaries or thatduring the' period from May 31, 1969. to a, ' b Inessspecified date not more than five usdays prior to the Effective Date there hfiRS. the 1-been any material adverse change m

ACCOUNTING SERIES RELEASES 361nancial position or results of operations ofNSMC and its subsidiaries taken as awhole".The.closing date for the Interstate mergerwas scheduled fer October 31, 1969. At thistime, PMM's Washington office was in themidst of its audit engagement for the fiscalyear ended August 31, 1969. In the course ofthis examination, the auditors determinedthat significant adjustments had to be madeto NSMC's financial statements. Certain ofthese adjustments were determined to beapplicable to the May 31, 1969 nine-monthfinancial statements-a subject of the requiredcomfort letter. The effect of the adjustmentsPMM considered applicable to thenine-month statements was to reduce netincome as set forth in the proxy statementfor the unaudited nine-month period from a$700,000 profit to a net loss of about $80,000.In light of the fact that PMM would not beable to give the "comfort" required by themerger agreement, the Firm's Departmentof Professional Practice in New York Citywas consulted on October 31, 1969, the day ofthe closing. An unsigned draft of PMM's lettersetting forth the adjustments considered bythem to be necessary was provided to the New,York office of NSMC's outside legal counsel,where the closing was to take place. Sometimeon the afternoon of October 31, before themerger was consummated, PMM informedNSMC and its outside counsel by telephonethat an additional paragraph would be addedto the letter which would state that if certainnecessary adjustments had been made at May31, 1969, the unaudited consolidated statementof earnings for the period would haveshown a net loss for the consolidated opera­~ions of the company and that the company' asIt existed on May 31 1969 was expected to"b reak even" for the fiscal ' year.. At this time, PMM (which was consulting~tsk own counsel as to what steps it shouldl a e) understood that the draft of~ts comfortpIettert'who h·lC It represented to be still incomorebe, Was being reviewed by representativessp O~h Interstate and NSMC and their reectlVePart. out·dSI e legal counsel and that allles Would await the delivery of a signed,final copy of the comfort letter' before consummatingthe merger.Later the same afternoon PMM calledNSMC's outside cou'nsel to state that thefirm was issuing a firial version of the letterto which had been added a further paragraphexpressing PMM's belief that the companiesshould consider submitting correctedfinancial information to the shareholders beforeproceeding with the merger. At thistime, contrary to its prior understanding,PMM was informed that the merger hadbeen consummated without awaiting the finaltext of PMM's letter.17 PMM delivered asigned copy of the final version to the officeof NSMC's outside counsel before the close ofbusiness on October 31, 1969. On the nextbusiness"day, November 3,1969, PMM mailedcopies of its final signed letter to each memberof the boards of directors of NSMC andInterstate (some of whom in both instanceswere outside directors) and NSMC's outsidecounsel which had represented NSMC at theclosing and to the law firm representingInterstate at the closing.PMM took no further action, believing thatit had satisfied its professional obligations bymanifesting its concern to management ofNSMC and to the directors and attorneys ofboth companies, and having been advised byits own counsel that further disclosure mightviolate state laws and the AICPA Code ofProfessional Ethics relating to auditor-clientconfidentiality.We recognize that the action taken by17 The comfort letter, after setting forth the basis onwhich it was issued and the adjustments PMM considerednecessary, stated in part:"Your attention is called, however, to the fact that ifthe aforementioned adjustments had been made atMay 31, 1969, the unaudited consolidated statement ofearnings of National Student Marketing Corporationwould have shown a net loss of approximately $80,000.It is presently. estimated that the consolidated operationsof the company as it existed at May 31, 1969, willbe approximately a break-even as to net earnings forthe year ended August 31, 1969."In view of the above-mentioned facts, we believethe companies should consider submitting correctedinterim unaudited financial information to the shareholdersprior to proceeding with the closing."

362 SECURITIES AND EXCHANGE COMMISSIONPMM was considerable, especially in the f~ceof what appeared to the Firm to be countervailingpositions taken by two prominent lawfirms. PMM's letter communication "to bothboards of directors was appropriate and putthem in a position to take necessary action.Nonetheless, we believe that independentauditors in such circumstances should insiston revised financial statements being sent toshareholders when they are professionallyassociated with such statements, whetheraudited or unaudited. Further, while we believethat primary responsibility rests withmanagement and directors of public companies,where they refuse to resolicit shareholders,under these circumstances, we believethat independent public accountantshave an obligation to notify the Commission.We believe that such action is protected bythe policies underlying the federal securitieslaws against any complaint that state statutoryor ethical confidentiality provisions hadbeen violated.1969 Financial StatementsOn or about December 1, 1969, NSMCmailed to its shareholders and others, andfiled with the Commission, its annual reportcontaining audited consolidated financialstatements for the fiscal years ended August31, 1968 and 1969. Although the auditingprocedures followed by PMM with respect tothe 1969 statements represented a changefrom 1968 in that the fixed fee programswere confirmed in writing with NSMC'sclients, accounting for the fixed fee programscontinued to be on the same percentage ofcompletion basis which the Commission, forthe reasons stated above, concluded was inappropriate.In addition, NSMC's 1969 financial statementsreflected extraordinary gains in theamount of $370,000 from the sale of twosubsidiaries. The transaction was describedin Note 3 to the company's financial statementsfor the fiscal year ended August 31,1969 as follows:"Subsequent to August 31, 1969, closingswere held with respect to the sale of all ofthe stock of Collegiate Advertising Ltd.and Compunjob, Inc., wholly-owned subsidiaries.The subsidiaries were sold to employeesof the respective companies. As toCollegiate, the consideration received was$220,000 represented by five-year 8% personalnotes;secured by 3,200 shares of thecompany's common stock, and as to Compujob,the consideration was $225,000, representedby one-year 5% personal notessecured by 4,500 shares of the company'sstock. The employees who purchas~d Compujobhad originally sold it to the company.In the opinion of counsel in both transactionsnegotiations and agreements of salewere in effect consummated prior to August31, 1969, and title to the stock and allof the risks and benefits of ownershipthereof passed to the purchasers on August29, 1969."The auditors were first informed of thesetransactions during their examination, wellafter the close of the fiscal year. AlthoughPMM knew the closings of these transactionsdid not take place until November of 1969, itwas represented to them that the basicterms had been agreed prior to August 31,1969. PMM was further aware that the partieswere considering several different methodsof structuring the transactions and, indeed,had been shown several different formsof agreement with respect to the sales priorto the November closing. In the auditors'view, the structure 0.£ the transaction wasmore a purchaser's problem and the auditors'concern was to assure them that risksand benefits of ownership passed fromNSMC to the purchasers prior to the end ofthe fiscal period in which the transactionwas to be recorded. Accordingly, the auditorssought and received legal opinions on theissue of passage of title from the attorneysfor the purchasers who, it was expected,would have had first hand knowledge of t~erelevant facts as participants in the neg~tladtions. In addition, PMM sought and recel~econfirmatory opinions from NSMC's outsld~legal counsel which stated that the effecupon NSMC and the purchasers of the t~Osubsidiaries was "as if" ownership of t eshares of the companies had been tra ns -

ACCOUNTING SERIES RELEASES 363felJ'ed thereunder prior to August 31, 1969. 18PMM was aware that each of these subsidiarieswas operating at a substantial loss andthat the purchasers were employees ofNSMC. In order.to alleviate their concern asto why the purchasers wanted to acquirewhat were in effect losing companies, theysought and received written representationsfrom the three principal officers of NSMCconfirming that there were no indemnificationor repurchase commitments given to thepurchasers.We believe that the auditors placed far toogreat a reliance on the opinions of counseland the representations of management withrespect to these transactions. Although theauditors were misled, such deception doesnot relieve the auditors of their professionalobligation to conduct their examination inaccordance with generally accepted auditingstandards ("GAAS"). As we said in a similarsituation in Accounting Series Release No.153, it appears that the auditors" ... failed to fully appraise the significanceof information known to [them] andto extend sufficiently [their] auditing proceduresunder conditions which called forgreat professional skepticism."We believe the "sales" of these subsidiarieswere, in fact, sham transactions. 19 We believethat if PMM had sufficiently extended itsaudit procedures it would have discoveredthat (1) in neither case had negotiations commenceduntil after the close of NSMC's fiscalyear;20 (2) in the case of one subsidiary,18 The engagement partner explained in a letter hewrote to NSMC's controller at the time that "we are'agreeing to the transaction being recorded as of August31, 1969 only in reliance upon legal opinion as to thepassage of title and the propriety of recording thetd'ransact·IOns atthat date. Furthermore, as we expressedun~g said meeting and in other occasions we willrequire ad t . . 'o . equa e disclosure of the transaction and ofa~~ relIance on the opinion of White & Case in the notes19 I~ro~ablY in our accountants' report." '.by th s ould be noted that the promissory notes givenrecou e purchasers clearly state that they are nonrsenote'on th s mvoI'vmg no personal liability therefor'0 T e purchasers' part.he minut fmeeting es 0 the NSMC Executive Committeethese tw S reveal that negotiations for the disposition of0O subs'd' .ctober 20 I lanes had not been authorized until.,1969.NSMC had, by various side agreements,agreed to assume all risks of ownership after"sale" and, with respect to the other subsidiary,NSMC had agreed to make various cashcontributions and to guarantee a substantialbank line of credit after sale; and (3) in bothcases the collateral to secure the notes hadbeen given to the purchasers by officers ofNSMC. 21 TALLEY INDUSTRIES, INC.This case arises out of a merger in May1970 of Talley Industries, Inc. ("Talley"), aMesa, Arizona bas.ed company engaged inthe manufacture and distribution of variousproducts, including products designed for theU.S. Armed Forces, with General Time Corporation("General Time"). In connectionwith such merger, Talley's financial statementsfor the year ended March 31, 1969(audited) and for the nine months endedDecember 31, 1969 (unaudited) were includedin a joint proxy statement mailed on orabout April 16, 1970 to shareholders of Talleyand General Time. PMM had examined and issueda qualified report on the 1969'statementsand consented to the inclusion of its report inthe proxy statement. Immediately prior to themerger, PMM also had issued a comfort letterdated May 10, 1970 with respect to Talley'sunaudited financial statements for the ninemonths ended December 31, 1969 which werecontained in the proxy statement. Informationobtained by the Commission in a non-pUblicinvestigation indicates that the foregoing financialstatements and comfort letter werematerially false and misleading. In ,addition,21 Another instance where we believe PMM shouldhave· extended its audit procedures to inquire furtherinto the substantive nature of the transaction relates tothe accounting for the acquisition by NSMC of Consultantsfor Market Isolation, Inc. This transaction, whichwas accounted for as a pooling of interest in NSMC'sfinancial statements for the fiscal year ended August 31,1969, involved the sale for a substantial purchase price(approximately $1,360,000 in NSMC stock) of a companywhich had little or no economic substance. In our view,this acquisition was a sham transaction entered into byNSMC and the sellers, who were employees and stockholdersof NSMC, in order to. avoid recording as expensespayments to which the sellers were entitledunder a sales representative agreement they had previouslyentered into with NSMC.

364 SECURITIES AND EXCHANGE COMMISSIONwe believe PMM's examination did not meetprofessional standards.Talley's financial statements were computedon the basis of: (a) Talley's projectionsof amounts of sales and expectation of newdefense contracts in future periods for significantportions of Talley's business at itsMesa, Arizona operations, and (b) Talley'sestimates of future production cost savings.In fact, Talley had no reasonable basis forexpecting receipt of new contracts for productionof its products in the amounts itprojected or for future production cost savingsin the amounts it estimated.In view of the foregoing, we believe thatboth Talley's March 31, 1969 and Talley'sDecember 31, 1969 financial statements improperlyreflect inclusion in inventory of substantialcosts in excess of those attributableto goods on hand at those dates ("excesscosts"). The aggregate of excess costsamounted to $8.9 million at March 31, 1969and substantially more at December 31, 1969.These excess costs (including those accumumatedin 1969) were written off as of March31, 1970 at the insistence of PMM.22 To theextent that such excess costs were improperlyincluded in inventory, cost of sales wasunderstated and net income was overstated.The write-off of excess costs at the end offiscal year 1970 was approximately $19 millionbefore anticipated tax effect. In ourview, under the circumstances present inthis case, Talley should have reflected excessinventory costs in its profit and loss statementsas incurred; the result of not havingdone so was to overstate Talley's earningsfor the year ended March 31, 1969. If all ofthe excess costs had been written off asincurred, Talley's earnings for the yearended March 31, 1969 would have been $.74per common share, compared to the reported. figure of $1. 71 per common share.Talley's Accounting SystemIn 1969 Talley accounted for its cost ofsales on a program basis ("program method")for fixed price U. S. Government contracts at22 We note that PMM's insistence on the write-off was. with the knowledge under the circumstances that such awrite~off would most likely lead to the civil and Commissionlitigation which in fact ensued.its Mesa, Arizona operations. Similar productswere grouped into a program. At fiscalyear end (March 31, 1969) a gross profit ratiobased on estimates was established and wasused in the following manner: actual salesfor the fiscal year were added to projectedsales for the following year as determined byknown backlog and projection by Talley'smanagement of anticipated contracts and actualcosts for the year's production wereadded to costs estimated by Talley's managementto complete the sales projected for thefollowing year. A gross profit ratio based ontotal estimated sales over total estimatedcosts was established and applied to the dollaramount of actual sales made in the audityear to determine the cost of sales for theyear. Any costs incurred in the audit year inexcess of the 'amount recognized as cost ofsales in that year by this computation werecarried forward as part of inventory. Thegross profit ratio so determined, adjusted foractual manufacturing overhead, was used byTalley throughout the following fiscal yearto compute cost of sales for unaudited interimperiods.In the financial statements examined byPMM for the fiscal year ended March 31,1969, Talley had projected total sales for theyear ending March 31, 1970 amounting toapproximately $100 million, of which onlyapproximately $24 million was backlog. Anticipatedsales contracts were primarily forprograms forpyrotechnics, starter cartridges,and bomb racks. Such treatment hadthe effect. of including in Talley's Mesa inventoryaccount at least $8.9 million of costsin excess of the projected total costs of contractson hand as of March 31, 1969.Talley's financial statements for the ninemonths ended December 31, 1969 (unaudited)showed nine months earnings computed onthe same basis of projected sales and estimatedproduction costs, which resulted in anoverstatement of inventory and of earnings;however, such financial statements werebased on:(1) $100 million of projected sales for theTalley Mesa operation for the fiscal yea~ending March 31, 1970, when actual sales 0only $18 million had been achieved for ~.~nine months ended December 31, 1969, an 1

ACCOUNTING SERIES RELEASES 365was, evident that the projected sales level of$100 million for the fiscal year 1970 wouldnot, be achieved; and(2) anticipated production. cost savingswhich had not been achieved as of December31, 1969. .Such, projections were made by Talleywithout adequate substantiation and lackedsufficient documentation.Talley's business at its Mesa operation wasobtained as a result of government contractsawarded for defense products. Talley, inmaking projections of future sales, had topredict: (1) total dollar amount of futurecontracts ,for a particuJar product· to beawarded by the defense agencies; and (2) thepercentage of the total market for that productthat Talley would be successful in capturing.,As to (1), although information was' availableconcerning future contracts to beawarded in the form of Advanced PlanningProcurement Information ("APPI") bulletinsfrom the Armed Forces, and in some tradepublications, projections were based largelyon subjective judgments by management asto 'future government purchases., Reliancewas not based solely on government accouncements,but also on a number of unofficialsources, such as reports from Talley'sfield representatives,' conversations withother individuals in government and industry,and in-house estimates of the government'sfuture purchasing plans. ComplicatingTalley's problems in making accuratesales projections was the fact that not allanticipated defense product requirementslisted by APPIs or reported in other tradesources available to Talley materialized into~ormal requests for proposals or bits. In someIn~ta?ces, reductions by Congress in approprIatIonscancelled programs in which Talley~ad projected it would secure contracts.th oreover, delays in approval by Congress ofe appropriations bills sometimes seriouslyun~ermined the accuracy of som~ of Talley'sprojections of future contracts to beaWarded.itsA:h to (2) above, i.e., Talley's projections ofthe p are. o~ the total market for a product,than ;~:I?tIons were even more subjectiveJudgments made in (1), because noofficial information was available as to anaccurate determination of those manufacturerswh~ would win bids .. As to certain ofthese projections, Talley had to estimate,among other things, whether it would be thelow bidder. As to certain others, Talley'sjudgment was based upon its belief that governmenthad desired and/or would d~sire tohave more than one source of supply ..Talley's production cost estimates of material,labor and overhead for the fiscal year1970, used in computing Talley's cost of salesfor its fiscal year ended March 31, 1969, werealso made without adequate substantIationand lacked sufficient documentation. Whilethe program method of accounting is acceptablein circumstances where contracts forfuture sales exist, or where the likelihood offuture contracts may be documented with asubstantial degree of assurance based onpast experience or other factors, we do notbelieve that either of these conditions existedin this case. 23In view of what PMM realized was thecrucial importance of the reliability and accuracyof Talley's projections of sales andestimates of production costs to a fair presentationof Talley's financial statements as awhole for the fiscal year ended March 31,1969, we believe that the auditors relied tooheavily upon the representations, projectionsand estimates made by Talley's management,and did not require sufficient documentationand evidential matter to enablethem to review adequately the sales projectionsand cost estimates for reasonableness.Accounting Controls and Use of Program CostMethodA physical inventory of goods-on-hand andZ3 Based upon our experience with respect to corporatedisclosure on defense and other long-term contractingactivities, we expanded the rules set forth in RegulationS-X to call for disclosure of greater detail in certaincritical areas, particularly with respect to the nature ofcosts accumulated in inventories, the effect of cost accumulationpolicies on costs of sales and the effect ofrevenue recognition practices on receivables and inventories.Such amendments to Regulation S-X wereadopted in Accounting Series Release No. 164, effectivewith respect to financial statements for periods endingon or after December 9, 1974.

366 SECURITIES AND EXCHANGE COMMISSION 'work~in-process was taken only once a year,at fiscal year-end, at Talley's Mesa operations,despite PMM's recommendation in1~68 to take inventory on a more frequentbasis for selected programs.No procedures or accounting, steps wereestablished by Talley or recommended by theauditors to adjust the cost of sales figures forinterim periods on the basis of variances ofactual' sales and cost experience from theprojections and estimates. Moreover, whileinformation was available throughout theyear. on both actual sales and actual costs,their variance from projections and estimateswas not computed as such by Talleyand, .in fact, Talley's management made noreView of their impact on the validity ofTalley's inte,rim cost of sales figures.The program cost method could be acceptedfor certain products with extendedproduction cycles and 'large start-up costsand : where' there is a reasonable basis toexpect the receipt of future or follow-on contracts.However, even assuming the predictabilityof such contracts, the use of estimatesinherent in this sytem requires strong accountingcontrols with constant monitoringand the recording of variances between estimatesand actual experience. However, Tal~ley's cost system lacked the sophistication tomonitor variances with respect to interimfinancial statements or, in, any event, wasnot utilized by Talley to do 'so. Also, therewas no documented evidence to substantiatethe large amounts of start-up costs (such asresearch and development costs and toolingcosts) expended by Talley to develop a majorportion of its products.In light of these facts, Talley should nothave employed the program cost method fora major part of their programs such as startersand pyrotechnics. Of the $19 million inexcess costs at March 31, 1970, $10.5 millionwas in the pyrotechnic program, $1.9 millionin the starter program and $3.3 million in thebom b rack program.Moreover, prior to April 16, 1970 whenTalley mailed its proxy statement, it wasknown that Talley's actual sales for its Mesaoperation for the nine months ended December31, 1969 were only $18 million and it wasthen evident that the projected sales level of$100 million for the year ending March 31,1970 would not be realized. Accordingly, evenassuming, arguendo,' that' 'ralley had beenjustified in embarking on use of the programcost method, by the date of the proxy statementit should have become quite obvious toTalley that the projections utilized in thecomputation of c"urrent earnings had provedso inaccurate and unreliable that continuedinclusion of excess costs in inventory wasclearly improper.The Role of PMMPMM's report on Talley's financial statementsfor the year ended March 31, 1969contained in the proxy statement is qualifiedas subject to the company's ability to obtainsufficient future contracts as referred to inNote 3. The relevant section of Note 3 states:"The Company .bases its calculation ofinventories and of cost of sales applicableto fixed price United States Government, contracts on the costs (including administrativeoverhead) incurred and estimatedto be incurred on the relative productionprograms. For the purpose of computingsales, these costs are prorated over theestimated total revenues for such programs.The estimates are based on actualcontracts on hand and future contractsexpected by management to be obtained.The resultant value of inventories on thisbasis at March 31, 1969 is approximately$8,900,000 in excess of the prorated cost ofactual contracts on hand and such excessis believed to be larger at December 31,1969 but management expects sufficientfuture contracts to be received to recoversuch excess." 'Although the auditors' report on Talley'sfinancial statements for the year endedMarch 31, 1969 included a "subject to" qualificationwith respect to Talley'S ability toobtain future contracts, the notes to Talley'sfinancial statements did not disclose:(1) The dollar amount of future contracts($100 million) which Talley's managementwas estimating would be obtained; and s(2) That recovery of the excess costs waf° to n 0also dependent upon Talley's reahza 10

ACCOUNTING SERIES RELEASES 367its projections of material amounts of savingsin production costs. Thus, the report didnot have a qualification that Talley's abilityto recover the excess costs was subject to itsability to perf

368 SECURITIES AND EXCHANGE COMMISSIONprepared in connection' with its then annualexamination of Talley's financial statementsfor Talley's March 31, 1970 fiscal year hadscheduled both the $100 million projectedsales and the $24.7 million actual sales forthe Mesa operations. The auditors knew theimportance of Talley's projections in Talley'scost of sales calculations for both fiscal year1969 statements and the '1970 interim statements.25 Knowing as it did by May 10, 1970that actual sales had fallen far short of projectedsales, the auditors should have insistedon amendment of the proxy materials,and, at a minimum, the comfort letter shouldhave disclosed:(1) that the actual sales for Talley's Mesaoperations for the fiscal year ended March31,1970 were only $24.7 million;(2) that computation of Talley's earningsfor the nine months ended December 31, 1969(unaudited) had been based on a $100 millionprojection of sales for the Mesa operations,which projection exceeded by a wide marginthe actual sales of $24.7 million for the fiscalyear ended March 31, 1970; and(3) that a write-off of Talley's accumulatedexcess costs (inCluded in inventory) would ormight be necessary, such Write-off resultingin material downward adjustment of earningsfrom those shown in Talley's financialstatements for the nine months ended December31, 1969 (unaudited), which financialstatements had been included in the April16, 1970 proxy statement furnished to shareholdersof Talley and of General Time.Prior to issuing the comfort letter for theinformation of the Board of Directors of GeneralTime Corporation, PMM'had had discussionswith Talley management in whichPMM inquired as to the status of the excess'costs in inventory. The auditors were informedthat, in the absence of a physical25 Both Talley and PMM personnel have testified that,in their view, Talley did not need to obtain all of the$100 million of sales during fiscal 1970 (i.e., in their viewthe sales could be obtained over more than one year) inorder to justify the carrying of the excess costs ininventory. We do not disagree. However, in the I,!ircumstanceswe believe a further review was necessary.inventory as at' December 31, 1969, Talleywas not able to determine with accuracy theamount of the excess costs as of December31, 1969. However, Talley's management estimatedthat the excess costs existing atMarch 31, 1969 had been substantially reducedand would be reduced to an immaterialamount by March 31, 1971. Talley's managementfurther informed PMM it ~stimatedthat as a result of additional programs institutedafter March 31, 1969, the aggregateamount of excess costs at December 31, 1969and March 31, 1970 was somewhat greaterthan at March 31, 1969 but no more than $12million in total (including the remainder ofthe excess costs existing at March 31, 1969).These representations by Talley's managementwere added to a letter which PMM waswriting to the Commission. PMM had not,verified such information' nor did it representthat it had done so. In fact the estimateswere unreliable and Talley's representationswere incorrect. We believe that suchuse of PMM's name was inappropriate inthese circumstances.On May 14, 1970 Talley'a acquisition ofGeneral Time was effected. In early June1970, subsequent to the merger, PMM discoveredduring its audit of Talley's 1970 fiscalyear-end financial statements that the excesscosts at March 31, 1970 were in factapproximately $16.5 million (an increase ofapproximately $7.6 million from the previousyear). Moreover, most of these costs did notappear to PMM to relate to new programsinstituted since March 31, 1969 contrary tothe represntations previously made by Talley.In mid-June 1970, PMM informed Talleythat it would be necessary to write off the$19 million of excess costs (discussed at page364, supra) that had been accumulated in inventory.ConclusionIn our View, . the au d" Itors uncn ·t·cal I reli- dance on Talley management's unven 'f' Ie danundocumented representations as to future. . t becausesales and costs was mapproprla e. of itsthey related to such a material portIonearnings for fiscal 1969. . b'ectWhile an opinion qualified as bemg sU J

ACCOUNTING SERIES RELEASES 369to the outcome of a particular uncertainty isdesigned to communicate that uncertainty toreaders of the report, it does not absolve theindependent accountant of the responsibilityfor performing adequate audit tests and obtainingdocumentation in regard to the matter.In this particular case, since Talley wasusing an estimate of future sales greater byseveral orders of magnitude than what thecompany had ever achieved on such productsand an estimate of reduced future costswhich was not supported by past experiencein computing cost of sales for fiscal 1969, webelieve, that absent substantial documentedevidential support for Talley's sales projectionsand cost estimates, the auditors shouldnot have accepted Talley's projections andestimates as a basis for even a qualifiedopinion.Furthermore, since at a date six weeksafter the close of the following fiscal year,the auditors' workpapers in the then ongoingexamination of Talley's financial statementsfor its March 31, 1970 fiscal year showed thatTalley had achieved less than 25% of the$100 million of sales which Talley had estimatedwould be achieved during that yearand which Talley had used as a crucial elementin estimating gross profit for 1969 andthe first nine months of fiscal 1970, we believethat the auditors should not have issueda comfort letter in which they said thatnothing had come to their attention whichwould cause them to believe that the financialstatements would require any materialadjustments. /We believe that in both the 1969 audit andthe issuance of the comfort letter, PMM'sprofessional performance in ~onnection withthe Talley engagement was deficient interms of the standards of the accountingprofession.REPUBLIC NATIONAL LIFE INStrRANCECOMPANYonP~M r:ndered unqualified audit reportsLif l~anclal statements of Republic National197~ ~~rance Co. ("Republic") for the yearsherein t~ and 1972. For the reasons set forth, e Commission believes that saidstatements were materially false and misleadingin that they misrepresented the incomeand financial condition of RepUblic andfailed to adequately diclose the nature andextent of transactions between Republic andRealty Equities Corporation of New York("Realty") and Realty-related entities 26 duringthis period. Moreover, .it is the Commission'sview that PMM failed to apply auditingstandards and procedures appropriateunder circumstances which should havecaused them to exercise a great degree ofcaution, particularly since during the time inquestion Realty was experiencing severe financialdifficulties and the prior auditorsalready had identified some of the problems.On May 10, 1971, PMM was engaged byRepulbic, a Texas life insurance companywhich then had about $10 billion of life insurancein force and over $400 million in netassets, to examine and report .upon Republic'sfinancial statements for the calendaryears ending December 31, 1970 and December31, 1971. Republic's prior independentauditor, Arthur Andersen & Co. ("Andersen"),had been terminated in late December1970 and its 1970 financial statements previouslyhad been issued in February 1971 withouta report by an independent public accountant.They were accompanied by an"Actuarial Certification" stgned by Neal N.Stanl~y, the company's actuary.PMM rendered an unqualified opiniondated February 18, 1972, on Republic's 1970and 1971 financial statements. PMM's reportstated that:". . . such financial statements presentfairly the statutory financial position ofRepublic National Life Insurance Companyat December 31, 1971 and 1970 andthe results of its operations and the sourceand use of funds for the years then ended,in . conformity with insurance accounting26 For purposes of this opinion, we consider transactionswith Realty-related entities to include transactionswith companies and individuals affiliated or associatedv-ith or otherwise related 1;0 Realty or involvingassets or properties at one time owned or managed by orotherwise connected with Realty or which came to Republicin a transaction in which Realty participated.

370 SECURITn;S AND EXCHANGE COMMISSIONprinciples prescribed or permitted understatutory authority applied on a consistentbasis. Insurance accounting pr~nciplesvary in some respects from generally acceptedaccounting principles (see Note 1 of.notes to financial statements)."PMM's report on Republic's 1972 financialstatements, dated February 6, 1973, was alsounqualified, and contained the same opinionconcerning the statutory financial position ofRepublic National Life' Insurance Company.27We take issue with PMM's audits of Republic'sfinancial statements. only with respectto treatment of Republic's transactions withRealty and Realty-related entities in 1970,1971, and 1972. For reasons stated hereafter,we believe that Republic's financial statementsfor 1970, 1971, and 1972 did not presentfairly the financial position of Republic,the results of its operations and the sourceand. use of funds during such periods. Itshould be noted that. our views as to theissues of adequate disclosure and "recognitionof income in these financial statements of27 On February 1, 1974 PMM withdrew its two reportson Republic's prior financial statements when, on thebasis of PMM's ongoing examination of Republic's 1973financial statements and information learned by PMMduring the Commission's private investigation, it appearedto PMM that a substantially greater reserve, theamount of which was then still undetermined, for lossesin Republic's investment portfolio would have to beestablished, and that the larger reserve would in partapply to earlier years since there was no basis fordetermining that all of these losses had been occasionedby events confined to 1973 alone. On February 4, 1974,PMM insisted that Republic issue a press release (revisinga press release previously issued by Republic on thatday) which stated that substantial adjustments to Republic'spreviously issued financial statements would ber.equired and that such prior financial statements andPMM's reports thereon should no longer be relied uponuntil the necessary adjustments were made. PMM subsequentlyissued its report, dated April 12, 1974, onRepublic's 1973 financial statements containing Ii substantialreduction of Republic's net gain from operationsand net gain from operations per share as previouslyreported for 1970, 1971 and 1972. This April reportstated that the financial statements had been preparedin accordance with statutory insurance accounting practices.In May 1974, PMM reported on Republic's financialstatements on the basis of generally accepted accountingprinciples.Republic do not turn on any distinctionsbetween statutory insurance accountingpractices and generally accepted accountingprinciples. Moreover, we believe PMM failedto gather sufficient competent evidentialmatter to determine the adequacy of thereserve for possible losses on mortgage loansand real estate for the years 1970, 1971 and1972.Republic's Realty-Related InvestmentsBeginning in January 1968, Republic madea series of investments in securities ofRealty and First National Realty' & ConstructionCorp. ("FNR"), a Realty-relatedentity, and made commitments to place andplaced mortgages on real properties ownedor operated by Realty and Realty-relatedentities. In addition, Realty and FNR purchasedreal properties from third partieswho owned the properties subject to Republicmortgages. Many of the mortgages withRealty and FNR thus assumed had a his'toryof late payments or other collection difficulties.On August 3, 1970, the American StockExchange suspended trading in Realty's securitiesand Realty publicly announced anexpected loss of $8.7 million for its fiscal yearended March 31, 1970. Shortly thereafter,Alexander Grant & Co., Realty's then auditors,disclaimed an opinion on Realty's consolidatedfinancial statements for the fiscalyear ended March 31, 1970, in part because ofuncertainties as to Realty's ability to meetfinancing requirements with respect to substantialamounts of short-term indebtedness.Realty's financial difficulties continuedthroughout the ensuing period covered bythe Republic financial statements discussedin this opinion.As of September 30, 1970, RepublIC 'ownedor was committed to purchase $24.6 millionof stock, bonds and notes of Realty, FNR andother Realty-related entities. In addition,Republic had over $33 million in mortgageloans outstanding on real properties owne~or managed by Realty or Realty-related er: t1 -ties. In view of Realty's financial difficultieS,Republic was thus faced with a serious qu~Stionas to its ability to recover in full ItS

ACCOUNTING SERIES RELEASES 371unsecured investment of $24.6 million. Atthis time, Republic apparently attempted torestructure its investments in a mannerwhich ga~e the investments the appearanceof greater security~' by removing itself fromthe position of a substantial unsecured creditorof Realty. It thereafter engaged in aseries of transactions with Realty which resultedin removing all of the bonds, notesand stock of Realty and FNR which Republicthen owned in exchange for notes of fourRealty-related' entities which held assetspurchased from Realty. These notes weresubsequently exchanged for mortgage loanson real estate properties and real estateitself. In these transactions significant additionalfunds were invested by Republic, thegreat portion of which was returned to Republicto pay prior obligations of Realty andRealty-related entities to Republic and inthe form of interest income.At December 31, 1971, Republic's financialstatements included $9 million of bonds andnotes of Realty-related entities, mortgageloans outstanding of $56 million on propertiesowned or managed by, or in some otherway connected with Realty or Realty-relatedentities and $31.5 million in real estate whichhad come to Republic as a result of Realtyrelatedtransactions.Republic's problems with its' Realty-relatedinvestments continued in 1972, and Republicinvested significant additional fundsin transactions with Realty and Realty-relatedentities. Republic's aggregate Realtyand Realty-related investments, contrastedto Republic's total reported statutory assets,Were approximately as follows at year end1970, 1971 and 1972:Realty andRealty- % To- Total Asrelatedtal setsYear1970$ 56 million 20.2 $277 million19711972$ 97 million 23.5 $412"million$110 million 24.6 $448 millionThis a .Re It ggregate amount of RepublIc'sno: l and Realty-related investments was. lll.ent IS~losed in Republic's financial stateaccoustor 1970, 1971 and 1972 or in PMM'sthat ~ a;:t~' reports thereon. We believeUc Information was material to Republic'sfinancial statements, particularlysince by September 1970 Realty was experiencingsevere financial difficulties whichcontinued throughout the period covered byPMM's 1971 and 1972 audits of Republic.N or did the financial statements or notesthereto or PMM's accountants' reports onsuch financial statements contain the materialinformation that at least 30% of Republic'sreported income in 1970 (31%), 1971(42%), and 1972 (30%) resulted from Republic'sRealty-related investments. Moreover,for reasons stated hereafter,· such incomeshould not have been recognized at all.In our view, PMM's auditors should haveinsisted that Republic make adequate disclosureconcerning such matters; failing that,disclosure of such matters should have beenmade in PMM's accountants' reports togetherwith appropriately qualified opinions.PMM's auditors had been aware of thesignificant transactions between Republicand Realty as a result of their own auditwork. Additionally, prior to issuance ofPMM's initial report (dated February 18,1972) on Republic's financial statements theauditors had reviewed workpapers preparedby Andersen, Republic's prior auditors, andhad reviewed a letter dated Nobember 6,1970, addressed by Andersen to Republic'sBoard of Directors. The letter noted that asof September 30, 1970, Republic's investmentsand commitments in Realty and FNRtotalled about $58 million, called to Republic'sattention recently available informationconcerning Realty's financial difficulties andinformed Republic that the ultimate recoveryin full of Republic's investments inRealty and FNR as of September 30, 1970was in doubt. In view of the above factorsand the likelihood of material effects thereofon Republic's financial positions at December31, 1970 and the results of Republic'soperations for the year then ending, the letterset forth Andersen's belief that Republic's1970 financial statements should include"complete and informative disclosure" ofthese matters. Examples of such disclosuresincluded:"Segregation within the balance sheet ofall investments in Realty and affiliates."

372 SECURITIES -AND EXCHANGE COMMISSION"Information regarding commitments toRealty and affiliates together with appropriatedescription as to Realty's currentfinancial condition.""Information relating to all significanttransactions between Republic and Realtyor its affiliates .... "'Andersen's letter also stated: ."Republic ha~ presently recorded approximately$2,000,000 of income from itsinvestments in Realty' and FNR during thenine months ended September 30, 1970.Although substantially all of such incomehas been' collected in cash, it neverthelesshas been offset by larger investments inRealty. Since realization of this income is· dependent upon the ultimate recovery ofRe'public's investments in Realty and· FNR, we do not believe current recognition· of such income is appropriate."In December 1970 Republicterminated Andersen's.engagement as Republic's auditors,and" Andersen did not audit the December1970 transactions between Republic andRealty nor did they report upon Republic'sfinancial statements for the year ended December31, 1970.In addition to the reserves discussedherein, Republic's 1970 and 1971 financialstatements reported upon by PMM containeda Statement of Source and Use of Funds, notrequired under" statutory life insurance accountingpractices but insisted' upon by theauditors as disclosure of investment portfoliodifficulties experienced by Republic which ina "Note" at the end of the text thereof,stated:"During' the years ended De

· ACCOUNTING ·SERIES.RELE,ASES 373insisted on establishment of a reserve forpossible losses on mortgage loans' and realestate of $7 million at· December 31, 1971(approximately $5 million of which was. attributableto Realty-related investments)and $7 million at December 31, 1972 (allattributable to Realty-related investments),it failed' to come to grips with the ba~icauditing questions. 29 PMMni.ade ·a juqgmentthat establishing the $7 million reserve forpossible losses on mortgage loans and' realestate essentially mooted· the disclosurequestion. We believe, however, that judgmentwas not correct in light of the thenknown circumstances. In our' view, theabove-quoted notes and the establishment ofthe reserves was not an a'dequate substitutefor disclosing Republic's relationsh~p· withRealty and the transact~ons. they had engagedin. No specific explanation was giventhat some or all of the reserve was attributablein the judgment of the audit()r~(t6 possiblelosses on 'Republic's' Realty-related investmentsand Realty's name w'as not evenmentioned in the financial statements. or inPMM's reports thereon ..: 'Although auditing of Republic's 1970 and1971 financial statements was accomplishedat the same time, PMM's examination ofRepublic's Realty-related investments f9-cused on the investments which Republichad on its books at December 31, 1971 as aresult of the numerous transictions betweenRepUblic and Realty in: 1970 and 1971. Sincethese remaining investments were in greatmeasure mortgage loans and real estate,PMM attempted to value the real estate andth: collateral underlying the loans to determInewhether Republic had sustained losses~ ~ result of the 1970 and 1971 transactions.t. hIle this examination 'included consulta­:.ons with Republic's managemEmt and a re­O~e~h of the appraisals, prepared by MembersA. e. American Institute of Real Estateppra1sers, which Republic had on the prop----.. In addition t thO 'Valuatio 0 IS reserve, a Mandatory.SecuritieslOSses onn t Reserve ("MSVR") applicable to possibleestate \V socks and bonds but not on mortgages or real1 as pr 'd d .971 and $5 8 O~I.e In the amount of $4.5 million for, mIlhon for 1972,erties in question, neither the appraisals norPMM's examination sought to asc~rtain thepurchase prices, paid, by Realty to,third'partiesfor these properties.- These propertieshad been purchased by Realty and simultaneouslysold or' mortgaged to Republic atprices far in excess of what Realty had paidfor them. Although PMM questioned the basisand validity of preparation of some of theappraisals (some of which were done on a"highest an~ best use" basis, assuming futuredevelopment), it did not obtain s~ficientevidence of the current value Of theproperties' in question. As 'one example;' inDecember 1971, Realty purchased a largetract of undeveloped land in the Adirondackregion of New York State for $3;150,000 andRepUblic placed a $13,450;000 mortgage onthis property at the same time. This was thelargest mortgage 9n Republic's books at bothDecember 31, 1971 and', 1972. Also ~nchided inthe 1972 financial' statements was a $5 millionleasehold' mortgage· to 'a·'Realty-relatedentity. This mortgag~ was secured by ,theleasehold interest in an 'aging industrialcomplex, the sole tenant of which had alreadygiven notice that it would not renewits lease. Also, the Commission's investigationrevealed that this transaction was contrivedby Republic and Realty so that theportion. Of the proceeds in .the amount of $1.7million of this loan could be used by Realtyand Realty-related entities to pay Republicthe principal and interest payments to becomedueo~ .two previously existing loanswhich had beep. grant~d by Republic toRealty-related. entities in late 1971. PMM'saudit procedures during their 1972 audit didnot reveal this design or alert them to all ofthe factors, surrounding the making of thisloan. Although PMM did raise questions concerni~gthe source of funds for the $1.7 millionprincipal and interest payments on thepre-existing loans, it did not learn that thenew $5 million loan by Republic had beenused for such purpose. Included in Republic's1971 and 1972 financial statements were theresults of several similar transactions. Consideringthe significant prior transactionsbetween Republic and Realty and Realty'sfailing financial condition, we feel that PMM

374 SECURITIES AND EXCHANGE COMMISSIONshould ~ave e.xtended its audit proceduressubstantially more than it did in this area.The result was that despite establishing areserve of $7 million for possible losses onmortgage loans and real estate, Republic'sRealty-related .mortgage loans and real estatewere substantially overvalued at December31,1971 and I)ecember 31, 1972. 30In this case, PMM was aware, or shouldhave been aware, of the significance of thesetransactions with Realty and Realty-relatedenti~ies. We consider it an auditors's duty todo more than just make a mechanical examinationof the data underlying a particulartransaction. The responsibility of the auditoralsoinvolves a duty. to investigate the totality.9f the circumstances surrounding materialtransactions, individually and in the aggrega~e;and to seek out the significantinformation that affects evaluation and decisions.In the instant case" PMM should haveexamine~ the circumstances under whichR~a~ty; and J~ealty-related. erititiesa

ACCOUNTING SERIES RELEASES 375million reserve and the MSVR, that therewas no basis for refusing to allow Republic torecognize income from such investments.This judgment, although having some theoreticalsupport,. was only as good as thevaluation of the investments that Republicheld. In our view of the circumstances in thiscase, the auditors did not sufficiently extendtheir audit procedures beyond their reviewof the appraisals referred to above to determinethe adequacy of the collateral for theRealty-related mortgage loans and, in fact,such collateral was substantially overvalued.Accordingly, we believe that in these circumstancessuch income should not have beenrecognized. Where interest is not being paidcurrently, it may be appropriate under someunusual circumstances to recognize interestincome currently on adequately collateralizedloans, but such circumstances generallywill be very exceptional.PMM's Review ProceduresIn late 1972, PMM instituted a procedurewhereby all of its reports on audited financialstatements issued after December 31,1972 would be reviewed by a second partnerprior to issuance, primarily to give additionalassurance of compliance with PMM policyregarding the form and content of the reportand the accompanying financial statements.Thus, the report dated February 6, 1973 withrespect of Republic's 1972 financial statementwas one of the first to be subject to thisso-called pre-issuance or "cold" review procedure.31.As part of the procedure, the ~ngagenientpartner was to prepare for the reviewer amemorandum regarding the potentially criti­~~l areas of the audit and an indication ofth e engagement partner's satisfaction withe aUdit in each of those areas. The proceuredby thd'dI not normally contemplate a reviewin e s.econd partner of any of tl\e underlyhi~---audIt workpapers, nor did it place uponany responsibility for the adequacy of3'Th' IS pre issWith a dif~ - uance review should not be confusede\ lerent rev" dsew her . lewmg proce ure of PMM referred toreView ofe here~n as "SEC review", which related to thecertam filings with the Commission.the audit or the appropriateness of the financialstatements and related disclosuressuchresponsibility remained with the engagementpartner who conducted the audit.In his memorandum in early 1973, the engagementpartner for the Republic auditidentified, as the "main problem" in the audit,Republic's investments ill Realty-rel~tedentities. In this connection, he stated:"The main problem area from an auditstandpoint is, investments. This companyhas some real ,problems in mortgage loans,certain bonds and real estate owned, mostof which arose through dealing ~thRealty Equities Corp. I not only reviewedthe investment workpapers' in detail butalso reviewed the loan files on new loansthis year, held lengthy discussions withVP-Investments'regarding problems andsolutions and personally directed the auditof investments."The memorandum did not mention, nor didthe second partner making the pre-issuancereview learn, that Realty was in severe financialdifficulties and that the prior auditorshad raised a number of questions withrespect to Realty-related investments. 32THE PENN: CENTRAL COMPANYOn February 1, 1968 the Pennsylvania andthe New York Central railroads merged andbecame the Penn Central TransportationCompany ("PCTC" or "Transportation Co.").PMM became the auditors of the merged, company and issued a report on the result ofPCT on both a consolidated and a "companyonly" basis for 1968. During 1969, Penn CentralCo., a holding company, was formed andacquired all of the stock of PCTC. For 1969,.PMM issued a report on the results of Penn'Central on a consolidated basis and PCTC ona "company only" basis. 3332 These questions are reflected in the prior auditor'sletter quoted above. The engagement partner apparentlydid not describe the differences the prior auditorshad with Republic because he thought he was confrontedwith a different situation.33 PMM's reports were dated March 7, 1969 and March12, 1970, respectively. Both reports were qualified as tothe failure to provide deferred income taxes and wereotherwise unqualified.

376 SECURITIES AND EXCHANGE COMMISSIONOn June 21, 1970, the Penn Central TransportationCo. filed· a petition for reorganizationunder the bankruptcy laws. An investigationconducted by this Commissionfollowing the filing of the petition revealedthat Penn Central management 34 had engagedin a program of concealing the deteriorationof the company which occurred in thepost-merger period and which led to the filingof the petition in reorganization. A detaileddescription of the transactions, eventsand activities preceding the filing of the petitionis contained in the Commission's StaffReport on the Financial Collapse of the PennCentral Company.35 Management's efforts involvedmisrepresentations as to the affairs,prospects, financial results, and value of assetsof the Penn Central complex. The misrepre!'1Emtationswere made in many. forms ofcommunications to the investing public andshareholders.While the financial statements upon whichPMM reported did show a declining trend in1969,36 'they substantially' understated themagnitude of the real decline in the economicfortunes of Penn Central and did notreflect the case drains which led to the col-34 Penn Central is used to identify the corporate complexin general without distinguishing the separateidentities of Penn Central Co. or the Transportation Co.Penn Central Co. was essentially a holding company andneither it nor PCTC had a separate management.35 The Financial Collapse of the Penn Central Company~taffReport of the Securities and Exchange Commissionto the Special Subco'mmittee on Investiga.tions ofthe House Interstate and Foreign Commerce Committee,August 1972. U. S. Government Printing Office, Washington,D. C.36 The consolidated results and the PCTC results werereported. Rail operations, which were most significantin appraising long run operating prospects, were notseparately reported. The data are as follows:Penn PennCentral Centralconsoli- Transpor- (Loss)dated tation on railearnings· operations· operations·Jan-Mar ($17)1970 $ 4 ($63) ($101)1969 $88 ($56) ($193)1968 $69 ($ 5) ($142)1967 $ 9 ($ 86)* In millionslapse of the railroad when PCTC could no'longer borrow funds.The financial statements did not ade:..quately present the financial condition ofPenn Central because the economic substanceof several transactions was· not properlyreflected therein and because there wasinsufficient attention given to the overallcondition of the Company and its operations.The principal means by which Penn Centralinflated financial results for 1969 includedthe failure to include charges arisingout of Penn Central's ownership of LehighValley Railroad Co., failure to reflect currentmaintenance expenses of the New York-NewHaven and Hartford Railraod Co. as chargesagainst income, the improper inclusion ofincome from large real estate transactionsby Great Southwest Corp. and the improperinclusion of dividends from certain subsidiaries.In 1968 the financial results were inflatedby the improper inclusion of profitsfrom the exchange of certain equity interestsin real property for the stock ownership inMadison Square Garden Corp., the improperinclusion of income of the purported dividendcomprising the common stock of a whollyownedsubsidiary of Washington TerminalCorp., the failure to record properly expensesconnected with mail and baggage handlers,charges arising out of Penn Central's ownershipof Lehigh Valley Railroad Co. and ExecutiveJet Aviation and the inclusion of purportedprofits from certain real estatetransactions of Great Southwest Corporation.By acquiescing in these improper accountingpractices, PMM, in our view, permittedPenn Central to misstate its financialposition and operating results for the years1968 and 1969.In some of the items discussed below,PMM's position is briefly described.Washington Terminal CompanyPCTC in 1968 included as part of its operatingincome"what they consIdered.tobe"dividend-in-kind" in the amount of $11,70 0 ,-000 declared by Washington Terminal CO.ffldpany ("ETC") a 50% owned company carrIeon the cost basis by PCTC. 37 This income waS37 The other 50% owner of the stock 0 f WTC waS theBaltimore & Ohio Railroad Company.

. ACCOUNTING SERIES RELEASES 377reflected in the results from ordinary operationsand was part of the consolidated earningsof Penn Central and also part of theTransportation Company's operating resultsfor the year. There was no separate disclosurein the financial statements or in thenotes thereto that informed the reader of thenature of this transaction or' of its magnitude.Absent this recordation as dividendincome, consolidated earnings would haveamounted to $78,753,000 as opposed to the$90,273,000 reported; and, PCTC's loss fromordinary operations would have amounted to$14,473,000 as opposed to the reported loss of$2,773,000~The "dividend~in-kind" which was declaredto its parent company was in the form of100% of the stockofa new company formedfor the purpose of receiving an undividedone-half interest in real property and airrights over the Union Station in Washington,D. C.38 Both before and after the transaction,Penn Central owned a 50% interest in theUnion Station property.The Union station property became thesubject of an agreement with the UnitedStates Government for development of a Visitor'sCenter and the leasing by the NationalPark Service of such Center. The deed conveyinglegal title and an undivided one-halfinterest provided that WTC would continueto control the property during the periodthat the Visitor's Center was under construction.39 The agreement provided that the N a-38 A similar dividend was paid in the form of 100% ofthe stock of a separate new company which was formedto receive B&O's 50% interest.~ a. The deed by which WTC conveyed (to the newly-.~rmed corporation) the undivided one-half interest incUd~~ th.e following reservation:ubject to the continued right of use possession°Per ti "Q '1 a on and maintenance of the Union Station""UI ding, concourse concession areas and relatedareas pr'Wa h' esently used for commercial operation by the\ices lngton Terminal Co., its lessees, concessionaries,nseesinvI't ' passengers, officers, employees, contractors,ees and " .and ' VISItors during the period of alterationity a~~nstruction of the Visitor's center parking facil­Law 90 ~ew passenger station contemplated by Publicthe Un~t64 and until the taking of full occupancy bycoverin~;~ States of America pursuant to a leasee property herein described."tional Park Service would lease the propertyfor 25 years, after the owners had madesignificant alterations and. improvements,which were expected to take two or threeyears. At the conclusion of the lease theproperty could be acquired by the NationalPark service for $1.PCTC recorded the $11,700,000 as its determinationof the value of the stock distributionreceived. 40 This amount was based on anappraisal of the underlying property and theair rights.PPM states that:Penn Central Transportation Company accountedfor its investment in WashingtonTerminal Company on the cost basis, an acceptablemethod of accounting and themethod most commonly followed in 1968.Since Penn Central Transportation Companyaccounted for its investment in WashingtonTerminal Company on the cost basis, inPMM's opInion any distributions from WashingtonTerminal Company necessarily wereproperly recorded in earnings when received;and since the distribution was a dividend-inkindthe proper method of recording it byPenn Central Transportation Company wasat fair market value under then currentaccounting literature. In PMM's view,PCTC's obligations under the lease contract. were fixed and accrued in its accounts, andtherefore, there was no uncertainty with respectto the value of this dividend and incomehad to be recognized in 1968 when thedividend was received.The Commission disagrees with PMM's positionthat all necessary elements were presentto permit the recordation of income in1968. In the Commission's view, this transactionwas, in substance, a write-up of thisasset on the books of the parent company.We believe that recognition by the TransportationCompany of income in the amount of$11,700,000 in the form of a 100% stock distri-40 McCandles Corporation had appraised the propertyand the air rights for the Baltimore & Ohio Railroad Co.at $27,000,000, so that based on that appraisal the valueof a 50% was $13,500,000. The figure of $13,500,000 wasreduced by PCTC to $11,700,000, to reflect its determinationof the fixed cost of improvements and a discount forthe period prior to commencement of rental payments.

378 SECURITIES AND EXCHANGE COMMISSIONbution was improper since in substance theposition of the consolidated enterprise was. unchanged with respect to the use, possession,operation, and maintenance of the underlyingsubject property after the receipt ofthe distribution. Generally accepted accountingprinciples do not permit recording atransaction based on form when its substanceis materially different.The substance of the December 18, 1968agreement was a promise on the part of theUnited States Government to purchase certainproperty after significant constructionand alterations had been made to transformsuch property into a National Visitor's Center.In the Commission's opinion, recognitionof income to PCTC under the circumstancesoutlined herein was inappropriate until theseller of Union Station had substantially performedits obligations.The Commission also believes that if incorriehi this amount was recorded in 1968,separate disclosure should have been made.Madison Square Garden TransactionPenn Central entered into a transaction in1968 which involved a nonmonetary exchangewithin its investment portfolio thatresulted in the company recording a gain inthe amount of $21 million. This gain wasreflected in income from ordinary operationsand was part of the consolidated earnings ofPenn Central and also part of PCTC's operatingresults for that year. There was noseparate disclosure in the financial statementsor in the notes thereto that informedthe reader of the nature or magnitude of thistransaction. Absent this gain, Penn Central'sconsolidated earnings from ordinary operationswould have amounted to $69,273,000 as. opposed to the $90,273,000 reported, andPCTC's loss from ordinary operations wouldhave amounted to $23,773,000 as opposed tothe reported loss of $2,773,000.This transaction represented the exchangeof Penn Central's 25% interest in MadisonSquare Garden Center ("Center") and its55% interest in the Penn Plaza office buildingfor a 25% interest in Madison SquareGarden Corporation ("Garden"). Before thetransaction, Garden owned 25% of the Center,20% of the office building, and real estateon which the former Madison SquareGarden had stood, and other minor assets. 41Penn Central, in its filing with the Commissiondescribing the transaCtion, indicatedthat its purpose was"to concentrate and unify Penn Central'sinterests in the new Madison Square GardenCenter and the office building-thoughthe ownership of a substantial equity interestin Madison Square (Garden Corporation)which will be the beneficial ownerand operator of those facilities." 42Penn Central, which received no cash, recordedthe gain of $21 million on this transactionby valuing the Garden Stock receivedat $25.7 million (based on its average marketprice on the NYSE of $11.078 per share atthe date of negotiations) and subtracting the$4.6 million carrying value of assets givenUp.43 ,It is PMM's position, as stated by it, thatthe exchange of PCTC's shareholdings andinterest in two corporations (privately held)which owned and operated an office buildingand a sports center, for shares of stock in41 Madison Square Garden Corp. was essentially aholding company whose major assets consisted of itsinterests in Madison Square Garden Center, which inturn had the exclusive right to the use of the franchiseand player contracts of the New York Rangers and NewYork Knickerbockers, and the Penn Plaza office buildingventure. The group 'of companies comprising the MadisonSquare Garden Corporation also owned a professionalice skating show and other real estate. The MadisonSquare Garden Corporation common stock hadregistration rights under the exchange agreement.42 Source-Schedule 13 D filed by Penn Central Companyreceived by the Commission April 1, 1969.43 This was based on an agreement dated December 18,1968. On the same date, Garden and Penn Central alsoentered into another agreement whereby Garden hadagreed to sell and Penn Central agreed to purchase at$11.078 per share up to 180, 538 shares of Garden'sdcommon stock. This sale and purchase agreement hathe effect of continuing Penn Central's undertaking toloan funds to cover costs of construction of the 29-s torYoffice building that would be in excess of the construCtionloan. This was to be accomplished by Garden loan!ing the funds that it would receive from the sale 0additional shares to Penn Central.ultPenn Central originally had a 23% interest as a re~ 1)'of the transaction which was increased to 25% malnnteeme .through purchases under the stock purchase agr

ACCOUNTING SERIES RELEASES 379. Ma~ison Square Garden Corporation, a diversifiedholding company with over 36,000shareholders, whose shares were publiclytraded, constituted a substantive exchangeof distinctly different kinds of assets and, inaccordance with accounting theory then inexistence, was an exchange of assets towhich gain or loss must have been recognized.If no recognition were m.ade of. theexchange, the 1968 financials would not haveshown the true results of management's de-. cisions in the handling of its stock ownershipin Madison Square Garden Corporation. InPMM's opinion, PCTC realized a gain of itsinvestment in 1968 as the financial statementproperly showed.It is the Commission's opinion that thetransaction represented .the substitution ofan investment in one form for essentially thesame investment in another form. There wasno change in economic interests in Center,the principal a~set involved, and Penn Central'sintent, as stated by it, was clearly notto dispose of its economic interest in thefacilities exchanged.We believe that PMM failed to recognizethat in substance there were not sufficientlysignificant changes from a business viewpointto warrant the recording of income onthis nonmonetary exchange. Furthermore, itis the Commission's view that PMM shouldhave required separate disclosure of the natureand amount of this transaction.Merger Reserve: Separation of Mail andBaggage HandlersIn 1968, Penn Central Transportation Companycharged against a $117,000,000 mergerreserve established in 1967, payments aggregating$4,672,000 made to certain mail andbaggage handlers upon 'their separationfrom employment with PCTC. 44.. The $117 million reserve was the pQ,tential cost ofrecalled I .tall'. emp oyees portIOn of an aggregate reserve toof~ng $275,421,985 for anticipated costs of the mergerres ennslyvania and New York Central railroads. TheRa:ll"Ve Was established in 1967 by the PennsylvaniaI road C .Corn ompany WIth the approval of the Interstatecharrnerce Commission. It was established by making atherebge to earn".mgs m.1967 m the amount of $275,421,985Y reducmg earnings in that year by that amount.The Penn Central's predecessor railroads,the Pennsylvania and New York Centralrailroads, and their labor unions had enteredinto a Merger Protective Agreement, datedJanuary 1, 1964, which provided that no oneemployed during the period from January 1,1964 to the effective date of the mergerwould be terminated after January 1, 1964. Asubsequent termination did not have to bemerger related for the agreement to apply.The $117,000,000 liability reserve whichwas established in 1967 was to provide onlyfor wages to be paid to 5,600 employees whohad been furloughed prior to the merger, butwho, due to the Merger Protective Agreement,had to be recalled to service upon theconsummation of the merger and had to beemployed or paid thereafter until they leftthrough natural attrition. 45Subsequent to the merger, Penn Centralearly in 1968 incurred a cost of $4,672,000 inseparation payments to mail and baggagehandlers made surplus as a result of curtailmentof use of Penn Central's services by theU. S. Post Office Department. The basic accountingquestion faced by PMM waswhether. the payment of $4,672,000 made tothe mail and baggage handlers, who hadbeen separated from employment withPCTC, was chargeable to the reserve previouslyestablished, or chargeable to expensesfor the period.PMM seriously questio.ned the use of theliability reserve for the payments to the mailand baggage handlers which questions mayhave led management of PCTC to petititonthe ICC for approval to charge this cost tothe reserve for ICC accounting purposes. 4645 There was another class of employees who wereexpected to be made surplus as a result of the merger.This group numbered about 7,800 employees and were tobe made surplus as a result of consolidations, coordinations,elimination of facilities, and so forth. It was madeup of employees who were working as of February 1,1968, and were to be subsequently made surplus. Allwages relating to such 7,800 employees were to becharged to current operations, no wages were to becharged to the liability reserve.46 By letter dated January 23, 1969, PMM advisedPenn Central Company with respect to this charge, inpart as follows:"We have reviewed the facts concerning the separa-

380 SECURITIES AND EXCHANGE COMMISSIONBy a letter to the ICC dated January 23,1969, Penn- Central argued that such . costsshould be charged to the merger reservebecause the payments to the mail and baggagehandlers were directly the result of thelabor agreements incident to merger, thatthey were unproductive of merger savings,and that the reserve was adequate in totalamount.PMM reviewed the letter to the ICC beforeit was sent and in the letter referred to inFootnote 46 above stated that if the ICC" ...in its judgment deems the separations to bemerger related and the costs incidentthereto chargeable against the reserve, wewould no longer have a basis for objection toa charge against the Merger Reserve for thispurpose."By letter dated January 29, 1969, the ICCreplied as follows:"This will advise that a majority of Division2 in conference today voted to grantthe letter request filed January 23, 1969,for authority to charge an amount of $4,-672,000 expended during 1968 in connectionwith separation of mail and baggagehandlers against the 'Merger Reserve' establishedin 1967."In our view, the $4,672,000 in separationpayments incurred during 1968 as a result ofthe curtailment in services of mail and baggagehandlers did not come within the originalmerger reserve criteria. The originalmerger reserve was created to provide forcharges for payments to employees who hadtion of these einplo'yees' and the 'dat'a,supplied to uswith respect to the costs, amounting to $4,672,000. It isour opinion that the Merger Reserve originally wasnot established to cover separations of this nature,and, accordingly, such costs would not constitute anappropriate charge against the reserve.·"We understand that you intend to petition theInterstate Commerce Commission to review the factsconcerning the separation of the mail and baggagehandlers and to rule on the question of whether suchseparations are, in fact merger-related. We have reviewedthe. letter addressed to the Commission by Mr.Saunders. Under the circumstances, if the Commissionin its judgment deems the separations to bemerger-related and the costs incident thereto chargeableagainst the reserve, we would no longer have. abasis for objection to a charge against the MergerReserve for this purpose."been furloughed prior to the effectiveness ofthe merger. The mail and baggage handlerswere not furloughed prior to the effectivenessof the merger. 47In the Commission's opinion, even thoughthe ICC was willing to permit the charge tothe reserve for ICC purposes, we believesuch amounts should have been reflected asa period expense during the year ended December31, 1968 in the financial statementsof the company issued to the shareholders.The accounting rationale for setting up theoriginal $117 million liability for the recall ofsurplus furloughed employees was thatsolely as a result of the effectiveness of themerger a liability had been created and thecombined railroads had therefore suffered anexpense (loss), unrelated to future operationsthat had to be recognized. This accountingrationale does not apply to the facts leadingto the $4,672,000 in payments. The liability,and hence the expense, did not exist as ofDecember 31, 1967 nor February 1, 1968. Norwas there a known contingent liability as ofsuch dates. It is the Commission's view thatPMM should have been more objective by. resolving this issue independently of the ICCand that initial resistance of PMM to chargingthe reserve for these payments reflectedthe proper accounting and auditing posture.Lehigh Valley Railroad CompanyPrior to 1962, the then PRR, through subsidiaries,owned 44.4% of the outstandingshares of Lehigh Valley Railroad Company("Lehigh Valley"). As a result of an exchangeoffer, PRR on February 28, 1963, became therecord or beneifical owner of 89.9% of thestock and this was incrased to 97.3% in 1964.Lehigh Valley remained a 97.3% ownedsubsidiary of PCTC at the time of the mergerof the PRR and NYC Railroads. In 1968, theLehigh Valley losses were $6 million, and ink eto PMM47 Penn Central had attempted to rna e a casdlt ally werethat these mail and baggage han ers ac u theintended to be furloughed prior to the date of enb funforesemerger and would have been ~t or some beenevents and administrative oversIght, and had they fte rfurloughed prIOr.to thatdate andrecalIed thereah rethepayments would have been chargeable to t e'serve.

ACCOUNTING SERIES RELEASES 3811969 the losses were $5.1 million, before anextraordinary charge of $1.2· million. Thefootnotes to the 1968 and 1969· FinancialStatements contained in the Aimual Reportto Shareholders ,separately disclosed theselosses. The Lehigh Valley results', however,were not consolidated with Penn Central'sresults during these periods. 48 Mariagement'sreason for not consolidating the operation ofLehigh Valley was' their position that PennCentral's ownership was temporary since theICC had required that Lehigh Valley be offeredfor affiliation with another railroadsYstem. 49 Penn Central apparently relied onthat ICC ruling as the basis for nonconsolidation,50apparently drawing its accountingsupport for nonconsolidation from the criteriaincluded in Accounting 'Research BulletinNo. 51. 51The Commission concluded, based upon itsinvestigatlen that neither, C&O/B&O norN&W ever had any interest whatso~:ver inacquiring Lehigh Valley; further, in the4. The operations of Lehigh Valley were not consolidatedin prior years; however, the financial state,mentsfor those years were not examined by independent publicaccountants.4' As noted in the footnotes to the 1968 and 1969financial statements contained in the Annual Reports toshareholders, Lehigh Valley was not included in consolidationbecause the Interstate Commerce Commission"has required [Lehigh Valley] to be offered for inclusionin another railroad system."50 The Interstate Commerce Commission, in approvingthe merger of the Pennsylvania and New York CentralRailroads in 1966, required PCTC to use its best effortsto offer Lehigh Valley to the C&O/B&O or to the N&WRailroads for inclusion in one of those systems, or absentsuch affiliation, for PCTC to continue to keepLehigh Valley operational and possibly be merged eventuallyinto Penn Central51 Th .e pertinent section of ARB No. 51 reads as fol­Iows:"Consolidation policy: 2. The usual condition for acon~rolling financial interst is ownership of a majorityvotIng' te h' In erest, and, therefore, as a general rule own-5~s Ip by one company, directly or indirectly of overco!ercen~ of the outstanding voting shares of anotherHo pany IS a condition pointing toward consolidation.Fo;ev er , there are exceptions to this general rule.whe eXample, a subsidiary should not be consolidateddoesre Contr I' I'k0 IS 1 ely to be temporary; or where itstanc~ot :es t with the majority owners (as, for in­Or in b' wkere the subsidiary is in legal reorganizationan ruptcy)."course of the investigation a managementrepresentative flatly stated that no one'wanted to acquire Lehigh Valley and that itwas not worth anything. In the Commission'sopinion, therefore, Penn Central'sownership in Lehigh Valley could not reasonablybe said to have been temporary, and,further, a significant' write-down in the investmentwas required.The Commission's investigation also includedinformation gathered from "Moody'sTransportation Manual" and from filings'made by Lehigh Valley and contained in thepublic dockets at the SEC. These sources ofpublic information revealed, among otherthings, that for a 13-year period from 1957through 1969, Lehigh Valley incurred consecutiveannual losses; whereas for the 13-yearperiod preceding 1957, Lehigh Valley hadonly two loss years. The trends as indicatedin this published data, as well as the currentamounts of advances being made to LehighValley, clearly supported PMM's questioningmanagement as to reasons why Penn Central'sinvestment in Lehigh Valley shouldnot be written down.The audit workpapers of PMM for 1969illustrate its awareness of the problem, theworkpaper stating "Lehigh Valley-to bewritten down or reasons must be supplied."As a result, at the request of PMM, PennCentral made the following written representationto PMM in a letter dated March 12,1970 concerning management's evaluation ofthis investment and their intention concerningits disposition."One of the roads to which Lehigh Valleymust be offered is the C&O and if themerger with the Norfolk and Western doesnot go through, the Lehigh Valley willhave great strategic value to the C&O andwe certainly should be able to come outwell on our investment."There are other alternatives we have inmind if this does not occur but it is tooearly and premature to determine to whatextent, if any, an impairment may result inthe investments."PMM states that, in its opinion: (1) LehighValley was properly not consolidated underthe provisions of ARB No. 51; (2) that the

Penn . Central could not readily expect tocover its lo-ans and advances to . Lehigh Villley;52It is our opInion that PMM should havemore critically examined management's as-surances given in support of their representationsthat Lehigh Valley could be disposedof to another railroad system and withoutincurring a loss.o38~ SECURITIES AND EXCHANGE COMMISSIONcarrying value of Lehigh was recoverableupon disposition; (3) that disdosu.re of thelosses in 1968 and 1969 were clearly set outin footnotes to fully' inform the r~ad~r; and(4) that the investment in and advances toLehigh Valley were included i~ consolidatedPenn Central investments and advanceswhich in the aggregate had a ~~rket valuewell in excess of their carrying value. For allof the (oreg~ing .t:easons,jn ·PMM's view, notconsoiidating .. Lehigh Valley was appropriateand no write-down would have been requiredC?f this asset either in 1968. or 1969.PMM further states that it was unawarethat Penn Central was not reasonably likelyto divest itself of Lehigh Valley in the foreseeablefuture and, therefore, accepted management'saccounting rationale in this regardand also accepted its reasons alS to whythe investment in Le4igh Valley' should notbe written down ..It is our vi~w that PMM~s ~uditingproceduresshould have· included its s~~king ade~quate eVidence to support management'swrittenr~epr~'~entationas to the likelihood ofdivestiture. In both 1968' and 1969 PMMshould have insisted that management furnishevidence .that. they had made offe'rs tothe C&O/B&O ahd to. N&W, or that they weregoing to do' so· within a specific time period.PMM should have satisfied itself by furtherinquiry as to whether management had evidenceof any. indications of interest fromthese two railroads or from any other potentialacquirer. We believe that PMM shouldhave insisted on additional representationsdescribing the specific alternatives thatmanagement had in mind in order for PMMto' satisfy itself whether it was too early todetermine, to what extent, if any, an impairmentof value existed or would result.In our view, Penn Central's ownership of~ehigh Valley was not temporary within themeaning of ARB No. 51 and, therefore, theoperating losses of Lehigh Valley shouldhave been reflected through consolidation.Failing such treatment, PMM should haveinsisted that the investments in, and/or advancesto Lehigh Valley be written downsince, in addition to Lehigh Valley's recordedlosses there was substantial evidence in theCommission's opinion, as early as 1968, thatExecutive Jet AviationIn 1965, as part of a diversification program,the Pennsylvania RailrC?ad ("PRR"),began investing in an air taxi service, ExecutiveJet Aviation, Inc. ("EJA").53 PRR lookedupon the investment as a means of enteringinto the air transport and air' cargo fields,even though it was aware that the FederalAviation Act prohibited railroads from engagingin such activities. PRR, however,made the investments in the" hope that itwould, be able to have the aeronautics laws.changed to permit it to engage in the air'cargo busiriess. . -" .In 1966 EJA applied to the Civil Aeronautics-Board for approval of its acquisition ofJohnson FlYirig Service, a supplemental aircarrier. In connection with this. application, aC.A.B examiner found that PRR controlledEJA . in violation of aeronautics laws. Pur­'suant to this finding, PRR submitted a planof financing and divestiture which contemplatedcontinued investment in ERA byPRR. In December 1967, the CAB held theplan to be inadequate, and ordered a completedivestiture.Up to 1966 PRR had advanced approxi-52 The investment and advances in Lehigh Valley byPenn Central at December 31, 1969 aggregated $49,493,-000. Of this amount, $23,025,000 was in capital stock,$4,125,000 in bonds, and $22,343,000 represented advancesand other sums due. Of the latter amount, $16,-395,000 represented advances made in 1968 and 1969.53 In 1965, as part of its diversification program, PRR,through a wholly-owned subsidiary, American Contr~etCorp., acquired 655,960 shares of class B, nonvot~ngcommon stock of EJA at a cost of $327,980, representJn~a 58% interest in the company's combined class A antclass B shares outstanding. AmerIcan. Contraet'slarges" . f of loansInvestment m EJA, however, was m the orm II"n Uand .advances. Between 1964 and 19 691, oans. w~Ief nds$21 million were made by American Contract WIth Uprovided to it initially by PRR, and later by Pen neo .

ACCOUNTING SERIES RELEASES383mately $14,000,000 to EJA. These advancesco~tinued at a rate of approximately $2.5million a year during 1967, 1968 and 1969. Inthe last half of 1967, EJA embarked on aprogram of quietly acquiring interest in severalforeign supplemental carriers. At thesame time, Penn Central also was purportedlytrying to find a buyer for its interest inEJA, although its desire to retain some sortof "buy-back" rights was making this moredifficult.In mid-1968 U. S. Steel Corp. and BurlingtonIndustries, Inc. entered into a memorandumof understanding with Penn Centralwhereby they agreed to purchase Penn Central'sequity and debt interest in EJA, subjectto EJA's receiving CAB approval to acquireJohnson Flying Service. However,Burlington withdrew from the agreement inDecember 1968 and U. S. Steel followed.On June 4, 1969, the CAB instituted proceedingsto determine whether EJA aridPenn Central· had violated provisions of theFederal Aviation Act: In October 1969, theCAB issued a cease-and-desist order, towhich Penn Central and EJA consented. Inaddition to levying fines against both, theorder directed EJA to divest itself of controlof foreign air carriers and Penn Central todivest itself of control of EJA.EJA had sustained losses since it beganoperation. 54 EJA was unable to obtain outsidefinancing unless Penn Central was willingto subordinate its investment. EJA'sauditors, Lybrand, Ross Bros. & Montgomery(now Coopers & Lybrand), were unableto complete audits in .1968 and 1969 becauseof major problems. EJA's financial and operatingcondition was continuously adverse~nd,. in the opinion of the Commission, the. kehhood of Penn Central's recovery of itsInv~_s~ments was highly unlikely.Despite this situation, Penn Central'sstated t. POSl't'lOn, as reflected in a represental\~~nletter addressed to Peat \. MarwickJ.YJ.ltch II "f~ll e & Co., dated March 12, 1970 was as---OWs:"Pursuant to order of the Civil Aeronau-.. 1965 10 .$869,000' l;s. $992,000; 1966 loss: $2,214,000; 1967 loss:, 68 loss: $3,830,000; 1969 loss: $4,101,000.tics Board we must dispose of our investmentin Executive Jet Aviation by March1, 1971. Consequently, we are at this timecarrying on negotiations with a number ofinterested parties with a view of disposingof our hold,ing just as soon as practicable.It 'is a complicated situation and consequentlynegotiations as between interestedparties vary widely. We anticipate that ourholding will be disposed of in the relativelynear future but only at that time will it bepossible to evaluate intelligently the considerationto be received for our investment.It is almost certain that we willreceive various types of securities in exchangefor our stock."PMM states that in its opinion it was notunusual: (a) for a company the size of PCTCto invest approximately $21,000,000 in whatamounted to an experiment for expansionand for the investee company to suffer lossesduring its initial years; and (b) for a companywhich had suffered losses still to be consideredto have substantial value to anothercompany thereby enabling the investor companyto recoup its investment or incur only aminor loss upon sale, this being particularlytrue of a start-up company possessing operatingrights. The investment in EJA of approximately$21,000,000 was among total investmentsand advances of Penn Central of$453,239,000 in 1968 and $535,711,000 in 1969.In PMM's opinion investments and advancesto consolidated subsidiaries and miscellaneousinvestments are to be considered as agroup in determining whether a write-downshould be made. The total market value ofthe investments and advances, includingEJA, was in excess of the carrying value,and, therefore, in PMM's view there was noreason to write down the group of investmentsnor to write down any individual investment.Moreover, PMM states that it didnot believe that management's representationwas unreasonable and considered that itwould have been improper to require thatthe investment be written down by an arbitraryamount when, in PMM's opinion, anestimate of the loss, if any, was not determinable.EJA eventually was sold in 1970 ata considerable loss, but in PMM's view thisloss is not a true measure of the loss, if any,

384 SECURITIES AND EXCHANGE' COMMISSIONthat .would have been experienced had thesale occurred under normal circumstancesprior to commencement of reorganizationproceedings.The Commission believes PMM did not gofar enough in its examination to evaluatethis asset. It was known to Penn Central andto PMM that EJA had been continually inneed' of operating funds; PMM was alsoaware' of the CAB's order to Penn Central todivest itself of control of EJA, and it alsoknew of certain prior unsuccessful attemptsby Penn Central to dispose of this investment.Under the circumstances describedabove, in the Commission's view the investmentin EJA was seriously impaired andPMM should have viewed this investmentdifferently from other Penn Central investments.. The Commission's investigation revealedthat PMM was not furnished with financialstatements of EJA. PMM, however, requestedPenn 'Central management to representto ,PMM its evaluation of Penn Central'sposition in this investment and. its intentionconcerning the disposition of EJA.Penn· Central's March 12, 1970 reply toPMM made no mention of any possible loss inthis investment.The Commission feels that since PMM wasaware of EJA's financial difficulties, itshould have insisted that management ofPenn Central require EJA to prepare financialstatements for PMM's review, and alsoshould have insisted that Penn Central includein its representation letter the numberand identities of the parties interested inacquiring EJA .. Further, PMM should alsohave insisted that this representation letterinclude the status of the various negotiationsin support of management's statementthat they had anticipated this investmentwould be disposed of in the relatively nearfuture. In addition, PMM should have requiredmanagement to represent to them thepossible range of any gain or loss that couldresult from the nature and status of thenegotiations with interested parties.We believe that PMM should have expandedits auditing procedures in 1968 and1969 to obtain the necessary competent evidentialmatter to enable it to conclude thatthis investment was fairly stated. In 'outopinion, based on all available evidence, itappears the loss in this investment shouldhave been recognized in 1968 and 1969, andthat PMM failed to exercise proper judgmentin this regard.Great Southwest Real Estate ActivitiesGreat Southwest Corporation ("GSC") is amajority-owned (approximately 91 %) real estatedevelopment subsidiary of Pennco asubsidiary of PCTC, which is in turn a s~bsidiaryof the Penn Central Company. 55 In1968 and 1969 GSC management effected severalincome tax oriented syndications whichwere described as having included thereincertain tax advantages to investors. Thesesyndications resulted in large reported earningsby GSC and were reported to shareholdersof GSC in its annual report to its shareholdersand to the extent. of Penn Central'sownership, they were also included in Penn~entraVs consolidated earnings and inPCTC's reported results Of operations. 56At issue in this case were GSC's accountingtreatment and financial reporting ofthree real estate transactions which werepart of the 1968 and 1969 tax syndications. Inone transaction in 1968 GSC sold a parcel ofraw land known as the Bryant Ranch whichwas suitable for holding for subsequent saleor development and sale. In the other twotransactions GSC sold in'1968 an operatingamusement park known as Six Flags OverGeorgia, and in 1969 an operating amusementpark known as Six Flags Over Texas.In December 1962, the Commission issuedAccouriting Series Release No. 95 ("ASR-95")to provide guidance in the application ofgenerally accepted accounting princ~ples toreal estate transactions reported in financialstatements to be included in documents filed55 Pennsylvania Railroad Company, through Pen nc ?,acquired the majority interest in GSC in the mid-1960 sas part of the diversification program of PRR. Forconvenience, any reference to GSC includes Macco cor P , , h' h s mergeda 100% owned SubSIdIary of Pennco w IC wainto GSC in March 1969,56 PMM was the auditor of GSC as well as Penn CentraL

ACCOUNTING SERIES RELEASES 385under the federal securities laws. In thatrelease we stated:. "The recognition of profit at the time ofsale, in accordance with generally acceptedaccounting principles, is appropriate if it isreasonable to conclude, in the light of allthe circumstances, that a profit has beenrealized."We also indicated, in that release, thatmere formal compliance with the technicallegal requirement of a sale is not necessarilysufficient to justify revenue recognition, andthat the substance of a transaction is thecontrolling consideration. In our opinion, thereal estate transaction in question in thiscase involved circumstances of the type discussedin ASR-95 arid were governed by theprinciples set forth therein dictating thatthere be no recognition of profit. 57In 1968 GSC sold the Bryant Ranch for$31,0.0.0.,0.0.0. to a limited partnership formedto purchase the land. GSC reported thetransaction as a sale and recorded a profit inthat year of $8,558,176 and deferred $827,833as a reported profit in 1969. The purchasermade a cash payment of $6,0.0.0.,0.0.0. of which$60.0.,0.0.0. was assigned to principal and $5,-40.0.,0.0.0. to prepaid interest. A note for $30.,-40.0.,0.0.0. at a 7% annual rate was given forthe balance, and under the terms of the noteno principal payments were to be paid for thefirst 15 years after the transaction through1983. There was no personal liability on thenote and as required by California law, theon~y recourse was against the land. DuringthIS 15-year period, interest in the flatamount of $1,0.0.0.,0.0.0. per year (less than that~ed for by the 7% rate) was to be paid.er,1984, principal payment plus accruedas well as current mterest.payments.were tobth e made 0ver a f· Ive-year period to amortizee note. Among other aspects of the terms- ---"fu rsuant to d" . •Matter of G an a mlnIstratIve proceeding In theRelease No. ~e9~t Southwest Corporation, Securities ActSection 15(c) (4)4, dated January 15,1973, brought underand consent d of the Securities Exchange Act of 1934GSC for 196~ to by GSC, the financial statements ofre~orts the reo and 1969 have been restated and newtamed in th n have been issued by PMM. PMM mainforth eSe . tr ese new repo r t sat th t h e orlO"lnal " accountingansact'Ionshad been proper..,"of the transaction, GSC was obligated undercertain conditions to make certain improvementsand also pay certain other costs.In 1968, GSC sold its amusement parkknown as Six Flags Over Georgia for $22,-980.,157 and recorded a profit of $4,813,40.0. onthe transaction. In the Georgia park transaction,the purchaser, a limited partnership,made a cash payment of $2,970.,0.0.0. of which$1,50.0.,0.0.0. was assigned to principal and $1,-470.,0.0.0. prepaid interest. The purchaser alsogave a mortgage note for $21,0.0.0.,0.0.0. at 7%interest. Principal payments in the amountof $70.0.,0.0.0. yearly were to begin in 1975. In1969, it sold its other amusement park knownas Six Flags Over Texas for $40.,0.0.0.,0.0.0., andrecorded a profit of $17,530.,170. on the transaction.As to the Texas park, the purchaseralso a limited partnership, made a cash pay~ment of $5,432,670. of which $1,50.0.,0.0.0. wasassigned to principal and $3,932,670. to prepaidinterest. The purchaser also gave amortgage note for $38,30.1,585. There wereother aspects to the structure of these twotransactions which included continuing exclusivemanagement of the am:usementparks by GSC as well as GSC's retention ofcertain risk of loss and opportunity for gainfactors. 58 Except for a few differences bothamusement park transactions were substantiallysimilar.In ASR-95, we stated that a prerequisite torevenue recognition is an effective exchangeor conversion. The Commission finds thatapplying the text of ASR-95 to the BryantRanch transaction, there was not a sufficientconversion of either GSC's or the purchaser'sinterest in the property to justify treatmentof the transaction as a sale; and despite theformal aspects of the transaction, GSC immediatelyafter the sale had essentially thesame type and degree of control as it hadprior to the transaction.The Commission finds that one of the aspectsof an exchange missing from theamusement park transactions, but necessaryfor an effective economic conversion, was thetransfer of control.58 Moreover, GSC could not be removed as generalpartner prior to 1997 except under certain limited circumstances.

386 SECURITIES AND EXCHANGE COMMISSIONThe Commission finds that the other critIcalaspect of an exchange absent from thetransactions was the transfer to the purchaserof the risk of loss and opportunity forgain. Upon the transfer of the amusementparks, GSC continued to have, in a functionalsense, essentially the same type of degree ofcontrol over the business and managementas it had before. 'GSC also continued to bearsubstantially all of the opportunity for gain.When the elements of control and retentionof risk and opportunity for gain are consideredtogether, it becomes apparent thatGSC's position with respect to the amusementparks did not substantially change becauseof the sale transfers. As to these twotransactions, the Commission believes thatin economic 'terms, true exchanges did nottake place, and therefore, it was not properfor financial reporting purposes to record thetransactions as sales and recognize revenuethereon. 59PMM states that in 1968 and 1969 it was itsopinion and still is that the three transactionsmentioned above were bona fide salesand, in its view, met the criteria of ASR-95,which was an important consideration inPMM's decIsion that it was appropriate torecognize income on these transactions.PMM believes that these transactions involvedsubstantial cash outlays by the purchasersand resulted in the transfer of thereward or burden of ownership from theseller to the buyer. It also believes that therewas no continuing involvement on the partof the seller, except to make certain improvementson Bryant Ranch for which estimatedcosts were taken into account and to becomethe operator of the two amusement parksunder a management contract with the purchasers.Moreover, aside from ASR-95, it isPMM's view that other then current accountingliterature required that income berecognized in 1968 and 1969 when thesetransactions occurred.In the Commission's opinion these threereal estate transactions were structured byGSC with the concurrence of Penn Central's59 See Securities Exchange Act Release No. 9934, supra,dated January 15, 1973, for the Commission's descriptionand views of the three real estate transactions.management in an unsuccessful attempt to ,meet the criteria contained in ASR-95.' Tlie'Commission believes these transactionsfailed to meet the criteria of ASR-95 since, j.n 'substance, nothing happened from a businessviewpoint to warrant the recording ofsales and profits on these transactions. PMMshould have recognized the attempts bymanagement to structure transactions in acontrived manner to meet the technical criteriaof existing accounting literature, whenin the Commission's view, they did not. It isour opinion that PMM in its 1968 and 1969audits of GSC and of Penn Central' failed toexercise critical and independent judgmenton this very important issue.New York, New Haven and Hartford RailroadAs a condition of the merger of the PennsylvaniaRailroad and the N ew York CentralRailroad, substantially all of the propertiesand investments of the New York, New Havenand Hartford Railroad Company ("N:ewHaven") were acquired by Penn Central as ofDecember 31, 1968. In our view Penn Centralin 1969 improperly accounted for New Havenmaintenance costs thereby obscuring thetrue dimensions of New Haven's operatingloss. As a result, there was a significantdifference between the results of operationsreported to the ICC and those reported to thepublic in 1969. Footnote 14 to the financialstatements contained in the 1969 AnnualReport to Shareholders discloses this difference.6060 Footnote 14 reads as follows:"(1) Shares issued in December 1968 in connectionwith the acquisition of New Haven properties havebeen reflected in the accompanying financial statementsat $41.125 per share, the average fair marketvalue of the stock during the period of negotiation ofthe acquisition agreement; whereas the Commission[ICC] has ruled that such shares be valued at $87.50per share, the value determined by the Commission[ICC]. The difference in purchase price has been re~fleeted partly as a deferred credit of $23,077,000 a~P artly as additional paid-in capital of $21,284,000 . bTt !D 0 freports to the Commission [ICC]; whereas a lIa 1 1 Yapproximately $40 000 000 for rehabilitation and oth er ' , . 't' n 0 fcosts assumed in connection with the acquls 1 10d · the ae-New Haven properties has been reflecte lD .companying [GAAP] financial statements, but not !D

ACCOUNTING SERIES RELEASES 387Penn Central asserted that the state ofNew Haven's equipment was very poor andhad to, be rehabilitated. On this basis, substantiallyall of the costs attributable to theupkeep of the road in 1969 were written offagainst a liability for rehabilitation cost establishedin connection with the purchase ofthe New Haven properties. .To charge the rehabilitation liability, accountwith items charg~able as period expenseswould be improper. As a result ofmaking such charges Penn Central recorded .total maintenance expenses in 1969 for NewHaven which were significantly lower thanthose recorded by New Haven in the prioryears.Care must be taken to distinguish genuinerehabilitation charges from ordinary maintenancecosts which may be incurred at aboutthe same time. We believe that in this caseinsufficient attention was given to this distinction.The Commission is of the opinionthat it would have been necessary to approximatethe amount of expenditures deservingcapitalization by comparing the total ofmaintenance and restoration costs incurredwith the record of normal up keep incurredin prior years. The historical record of approximateexpenditures by 'New Haven fornormal maintenance and capitalizationitems, as compared with 1969, follows (inmillions of dollars):61Expense Capitalized Total1969 $ 1.6 $35.9 $37.51968 34.6 0.6 35.21967 335 . 1.3 34.8196619633.3 0.5 33.85 31.7 4.7 36.5th~S a result of the staff's investigation ofI~. area, the Commission believes that thea? It examination by PMM was not suffi­CIent to come to a conclusion that the $1.6-'.forreportsth tto the CommlSSlon"[ICC1. In 1969, the net losshOlde: ransportation company, as reported to sharetheC s, w~s $21,986,000 less than the loss reported tothe li:~~llssion [ICC] because of charge-offs against61 Fro 1,Ity for rehabilitation and other costs."(N o.m Infor t'10) f rna IOn contained in "Verified StatementInterstateO C Stanley G. Jordon, Bureau of Accounts,ommerce Commission, Docket No, 35291",million was all of the general maintenanceand. repair costs. that were to be chargedagamst 1969 earmngs.Trucking Company DividendsIn 1969, PCTC caused one of its truckingcompany subsidiaries, New York CentralTransport Co. , to declare cash dividends of$12,000,000 to PCTC. PCTC also caused twoother trucking companies to declare cashdividends in the aggregate of $2,000,000 to anintermediate subsidiary which then declareda dividend in a like amount to PCTC.The Commission's investigation revealedthat none of the trucking company subsidiarieshad sufficient cash funds to meet thesedividend declarations. As to the $12,000,000in purported dividend payments from NewYork Central Transportation Co., PCTC instructedoneof its banks to charge PCTC'saccount and credit the account at that bankof New York Central Transport Co. Simultaneously,New York Central Transport Co. instructedthe same bank to charge it's accountfor that amount and credit the account ofPCTC. The bank followed the instructions.At the time when rCTC w~s allegedly loaningfunds to its subsidiary, PCTC did nothave the necessary cash funds in that bankto cover the amounts transferred. N ew YorkCentral Transport Co.'s books of accountthen reflected "advance payable" in theamount of $12,000,000 and its equity accountwas reduced by a like amount. While advancespayable were substituted for equitybelonging to the sole shareholder on thebooks of New York Central Transport Co.,the Commission concludes that the end result,in effect, did not give the 100% stockholder(PCTC) entity anything more than ithad before, and the $2,000,000 dividend paymentby an intermediate subsidiary was thesame, in practical effect as N ew York CentralTransport dividend payment.Notwithstanding the fact that these dividenddeclarations had no effect whatsoeveron the consolidated earnings of Penn Central,the "company only" (PCTC) financialstatements did include this dividend declarationin reported income.

388 SECURITIES AND EXCHANGE COMMISSIONPMM disclaims knowledge of the instructionsgiven to the bank by PCTC or the NewYork Central Transport Co. However, PMMstates that its view was, and is, that a subsidiarymay make a dividend payment aslong as it has accumulated earnings availablefor such dividend, even if no cashchanges hands at the time and the parentcompany simultaneously or subsequentlyrecords advances to such subsidiary. Withrespect to intercompany transactions of thisnature, it is PMM's opinion that such transactionsare by their nature not arm's-lengthand that, therefore, in "company only" statementsthe important factor is disclosure.These dividends were included in a separateline item entitled "Dividends and interest­Consol~d~ted Subsidiaries" which totalled$44,324,000 in the separate "company only"financial statements for 1969. .. In the Commission's opinion, though PMMdif!c~aJms knowledge of the instructionsgivento t,he bank by PCTC or the New YorkCentral' Transport Co., PMM should havefollowed the procedure of tracing cash transfersin. support of these transactions and ,had it done so, it would have discovered thebank statements, and the bank's debit andcredit memoranda accompanying such statements.This, in turn, would have led PMM tomake further inquiry of management as tothe factual circumstances underlying thesetrans~ctionl:!.In the Commission's view, PMM's auditprogram should have been expanded in orderto test intercompany transactions in greaterdepth. Such expanded testing was desirablesince PCTC, the entity purportedly benefitingfrom this transactions, had it separatefinancial statements, which were reported onby PMM, included in the annual report furnishedto shareholders by Penn Central.In the Commission's view, since no cashchanged hands and the dividend, though de~elared from retained earnings, was supportedonly by entries on the books of the bank, thesubsidiary and the parent, and since cashfunds were not available to support the entriesof the bank or the companies, there wasno basis for recognizing the dividend as income.ConclusionIn this case, Penn Central managementwas engaged in an attempt to conceal theextent of the deterioration of the company.One of the elements in this program was thepresentation of financial statements whichdid not reflect the adverse results of railroadoperations and which minimized adversetrends in the total business. PMM shouldhave understood what management wasdoing and, rather than acquiesce, shouldhave resisted management's efforts.Auditors should be alert for the kinds ofwarnings present in this case indicating thatmanagement seeks to conceal a deteriorationin the affairs of the company.One major warning given was management'seffort to record income from transactionswhich were structured to give an appearanceof being bona fide but which did notreflect. a business or economic change whichwould justify the recording of income. TheWashington Terminal dividend, the MadisonSquare Garden exchange, the trucking companydividends and the Great Southwestproperty sales illustrate this development.In a period of crisis, management maystructure transactions or seize upon opportunitieswhich may serve as a vehicle forrecording a gain in a particular period butwhich do not require that a company changeits fundamental interest in the asset. Auditorsmust not allow their skepticism as to theessence of transactions to be undermined.Instead, auditors should increase their vigilancewhen the proposal of such transactionsraises questions as to management's intentionsand as to the condition of the company.Attempts by management to shift expensesfrom current accounts to reserve accountsor to capital accounts is also a cautionarynote to accountants. In the itemSabove, PMM allowed Penn Central to shiftexpenses under highly unusual circumstances,as in the case of New Haven maintenancecosts and the mail and baggage handlers.Auditors also should be alert to the factthat where a company is experiencing a deteriorationin its financial condition and results,it may seek to avoid writing down loSS

ACCOUNTING SERIES RELEASES 389operations or investments and might seek to ,keep the current losses from such operationsout of the consolidated financial statements.The Lehigh Valley Railroad and the ExecutiveJet A viatioI1 situation described aboveare 'illustrations of that kind of desire bymanagement, which must be resisted by auditors'.The' time when write-downs may bemost needed is when a company is deterioratingand it is that very time when managementwill be particularly likely to want toavoid write-downs and will be willing tomake representations to auditors to avoidthe write-downs or to avoid consolidation ofloss operations.Another element in attempts by managementto conceal in the financial statementsthe deteriorating condition of a company isthe timing of recording large transactions.Some of the transactions described abovewere rushed to completion in the final momentsof the financial period. Although thisis not always a sign of improper managementconduct, auditors should pay particularattention to such last minute transactionswhere the results of the company are decliningor at a breakeven point as to profit andloss as in the Penn Central situation.When faced with the possibility that managementmay be attempting not to revealmajor adverse business trends, auditorsmust recognize this and review accountingmatters with a particularly critical outlookto make certain that the financial results donot obscure the adverse business trend. Theaccountant must be certain that the treatmentof all items fully conforms with theapplicable principles. Moreover, the ac

390 SECURITIES AND EXCHANGE COMMISSIONAct. Thereafter the Commission began aninvestigation of the affairs of the Company.Information obtained by the Commissionin that investigation into the affairs andfinancial reporting of Stirling Homex for theperiod 1970 to 1972, indicates to us that aregistration statement and certain reportsissued by Stirling Homex and filed with theCommission included audited financial statementsfor the seven-month period endedFebruary 28, 1971 and for the fiscal yearended July 31, 1971 which were false andmisleading and did not present fairly theconsolidated financial position and results ofoperation of the Company in conformity withgenerally accepted accounting principles.The consolidated statements of income ofStirling Homex for the seven-month periodended February 28, 1971 included in the registrationstatement for the. preferred stock 63and the consolidated statements of income ofStirling. Homex for the year ended July 31,1971 contained in the Annual Report toShareholders and Annual Report on Form10;.K for such fiscal year were false and misleadingin that among other things:all modular sales of $12,493,000 for theFebruary 28, 1971 period and $25,292,600out of total modular sales of $29,482,271 forthe July 31, 1971· period were improperlyrecorded in that the purported sales werenot supported by required financing commitments;installation sales were overstated by approximately$3,723,000 out of a total reportedinstallation sales of $5,137,000 forthe February 28, 1971 period and $2,443,-000 out of total installation sales of $7,200,-000 for the July 31, 1971 period through theinclusion of sales from projects for which.there were no commitments of financingand through Stirling Homex's improper re-63 Also included in the registration statement wereunaudited financial statements for the nine-month periodended April 30, 1971. Such unaudited financialstatements were false and misleading in that all modularsales of $18,183,000 for the April 30A971, period andapproximately $4,656,000 out of the total installationsales of $6,382,000 for such period were improperly recorded.porting of approximately $1,000,000 as ofFebruary 28, 1971 and approximately $2,-000,000 as of July 31, 1971 of excess installationcosts as "cost overruns" reimbursableto the Company64; andgeneral administrative and other: expenseswere materially understated byapproximately $832,000 as of February28, 1971 and approximately $1,000,000 asof July 31, 1971, as a result of the impropercapitalizing of such expenses. Additionally,certain other expenses andconstruction costs were improperly capitalized.PMM examined and issued unqualified reportson these financial statements. Althoughit should be noted that it appearsthat officers and other representatives ofStirling Homex, as well as others, intentionallydeceived PMM by misrepresentation andconcealment of material information andeven the creation of a forged or spuriousdocument, our investigation causes us to believethat PMM's examinations were not conductedin accordance with generally acceptedauditing standards and we believe, asis detailed within, that the accounting methodsfollowed by Stirling Homex were not inaccordance with generally accepted accountingprinciples.Stirling Homex accounted for its sales byseparating the manufacturing and installationfunctions and by recording sales andincome on the manufacturing aspect of thetransaction upon the supposed assignment ofmanufactured units to the requirements of aparticular housing agency customer. Thiswas supported by a commitment of fundingwhich was supposedly evidenced by receiptof a letter of designation, feasibility letter orother similar document from the localagency. Stirling Homex treated the letters or. asother documents from the local agenCIeSthe equivalent of a financing commitment,and PMM accepted this concept. d. te aIn determining whether there eXIS" italized64 Had Stirling Homex not Improperly cap" of. 11 t" n portIonthese costs overruns from the msta a 10 b ta I1 -certain of its projects, it would have incurred su stiallosses on completion of these projects-

,commitment of Federal financing, PMM relied.on representations of Stirling Homexmanagement, the Company's supposed experts,on governm~nt housing programs, anopinion of outside counsel furnished by management;apparent concurrence of other reputabl~organizations dealing with the Company,':and the belief that local housingauthorities would not enter into contractsfor projects without reasonable assurancethat funding would be available. In fact, aswe think PMM should have understood, inalmost all, cases the letters or other documentswere not a commitment for Federalfinancing and without Federal financing therevenue from the project was not assured. 65The acceptance of these representationswithout further auditing' work, particularlyin the light of PMM's lack of experience inthis area, resulted in improper recognition ofsales revenues ...In summary, the Commission believes that. the registration statement, reports and thefinancial 'statements contained therein portrayedStirling Homex as a healthy, prosperouscompany with increasing sales and earningswhen, in fact, that company wasexperiencing serious business problems andfinancial difficulties. Moreover, nearly all ofStirling Homex's sales and resulting accountsreceivable were either improperly recordedor fictitious, and the ConsolidatedBalance Sheet included in the Annual Reportsmaterially overstated assets by ap­~roximately $36,400,000 as a result of theInclusion in accounts receivable of sales fromprojects improperly recorded in th~ currentand prior fiscal year.' .Stirling Homex Revenue Recognit'ion Policiest Stirling Homex contracted with its customers,primarily public housing authorities,o ~anufacture and install modular housingUDlts resulting in a housing-development-"" some p , tand th rOJec s went forward to completion. Others,reSUlte~Yf Were larger, did not. The lack of completionhOOd 0 r~~ a number of factors, including neighborinabill·tPPo:;ntlOnto housing at particular sites and the, Y of St' rlng Which I lr l?g Homex to continue to obtain financedto Its Ultimate collapse.AeCOUNTING SERIES RELEASES 391ready for occupancy. Modules were manufacturedon an assembly line at StirlingHomex's manufacturing facility in Avon,New York. The modules were later to beshipped to a construction site where theywould be assembled into two, three and fourbedroom apartments. The apartments, inturn, woul,d be assembled into larger structuresconsisting of two to five apartments,depending upon the requirements of an individualizedsite plan. The completed modulescontained wall and floor coverings, draperyfixtures and all other necessary appurtenancesin order to make the multi-mod~ledwelling unit ready for occupancy when assembled.The Company purported to follow a revenuerecognition policy whereby revenuewould be recognized on the sale of eachmodule when manufacture of the modulewas completed and other events had occurred(including an irrevocable assignmentof the modules to a specific contract and afirm commitment of funding for the project)which reasonably assured the ulti~ate collectibilityof the sales price. For purposes ofrevenue recognition, Stirling Homex madean allocation of the contract price as betweenmodule manufacture and module installationsegments and, upon the manufactureand assignment of modules to acontract, the Company normally recorded asmodular manufacture sales approximately55% of such total contract price. The accountsreceivable resulting from the recordingof sales upon completion of the manufactureof modules were carried on the books ofStirling Homex as unbilled (not invoiced tocustomers) receivables. The portion of thetotal 'contract price allocated by the Companyto module installation was recognizedon the percentage of completion basis as sitepreparation and installation work was performed.During the period relevant here, StirlingHomex's customers consisted primarily ofpublic housing authorities who looked toFederal government housing programs assources of financing for their proposed projects.The programs involved were low renthousing programs under the turnkey programof the Department of Housing and

392 SECURITIES AN~ EXCHANGE COMMISSIONUrban Development ("HUD") and a subsidizedhousing program under Section 236 ofthe National Housing, Act administered bythe Federal Housing Administration("FHA;~). In addition, Stirling Homex hadone project under the rural housing programof the Farmers Home· Administration("Farmers Home") of the Department of Agriculture.Mosiof Stirling Homex'sprojects in theperiod under co'nsideration were under theHUD turnkey program. The initial step inthis program, following the receipt of proposalsincluding proposed prices from a numberof applicants, was the issuance by a localhousing authority ("LHA") of a letter of designation,designating an applicant, such asStirling Homex, as the developer of a specifiedprojectsubject to specified conditions.Subsequently, if the specified conditionswere met, the letter of designation would befoliowed by a contract of sale between, theLHA and the developer, countersigned byHUD to evidence tts commitment to financethe project. Until HUD countersigned thecontract of sale, there was no legally bindingcommitment of governmental funds by HUp.Stirling Homex, however, began to manufacturemodules and recognize income with respectthereto prior to the countersigning ofthe contract of sale by HUD and in mostcases recognized income upon receipt of aletter of designation.Commencing in the last quarter of the 1971fiscal year, Stirling Homex recognized revenueson modules manufactured in connectionwith three projects which were intended tobe financed under the Section 236 program ofthe FHA. The inItial step in this programwas the issuance by the FHA of letters offeasibility. These letters, although indicatingth~ FHA's determination that the project'was economically feasible and evidencing anintent to participate in the projects upon thesatisfaction of certain conditions, did not infact represent a legally binding funding commitment.66 Stirling Homex, however, began66 In addition to representations by Stirling Homexthat the feasibility letters were a commitment of financing,PMM relied upon an opinion of counsel experiencedin FHA matters, furnished to them by Stirling Homexto manufacture modules and recognized incomewhen a letter of feasibility was· 'received.-The third governmental program involvedwas the rural housing program of FarmersHome Administration, a branch of the· Departmentof Agriculture. The one projectpurportedly financed under this programwas the Greater Gulf Coast Housing'DevelopmentCorp. project in Mississippi which isdiscussed below. Since the only purportedcommitment on the part of Farmers Homewas a forged or spurious document committing$15 million, it is unnecessary to discussthe normal operation of this program. 67While reviewing $tirling Homex's 1971 registrationstatement, the staff of the Commission'sDivision of Corporation Finance questionedthe reasonableness of recogriizingsales revenues in advance of the date onwhich the Company was able to validly invoicea customer.68 The staff requested thatStirling Homex revise its financial statementsto defer recognition of income to thatpoint' at which the amount recorded wasvalidly billable to a customer.69 Had Stirlingmanagement, which stated that, "In the trade andwithin the FHA organization, the feasibility letter isconsidered a binding, firm and reliable document" and"In summary, it is our opinion that the feasibility lettermay reasonably be treated for accounting purposes as abasis for recognition of projected projects." The auditorsdid not fully relate the existing facts to this opinion.67 The materiality of this one project to the financialstatements of Stirling Homex is vividly illustrated bythe fact that sales on this project represented in excesSof 60% of all module sales for the seven month periodreflected in Stirling Homex's 1971 registration statement.68 Stirling Homex's unbilled receivables grew rapidly.On December 31, 1969, unbilled receivables were $6.4 4 ,-918. At the end of the 1970 fiscal year, unbilled receIvablesincreased more than seven-fold to $4.6 million. ByJuly 31, 1971, the unbilled receivables were to inc:-e.as eby over $25 million bringing the total to $29.5 ,mIlllOndThis increase of unbilled receivables created a dIstortedbalance sheet since the current assets were composeprimarily of these unbilled receivables. 0 197169The relevant paragraph from the June 3, theletter of comment reads as follows: "It is n?te~ t~~~1 isnumber of modules installed through AprIl 3, h thefar less than the number manufactured throug Divifiscalyear ended July 31, 1970. It appears to thegnizesion that the registrant's account'mg practicesb'llingreCOtoincome too far in advance of the date of 1

ACCOUNTING SERIES RELEASES 393H6mex complied with this request, its financialstatements would have shown substantiaLlossesfrom operations.Instead, Stirling Homex requested a meetingwith the Division of Corporation Financeto discuss its accounting practices. Duringthis meeting,70 and in a written statementsubmitted shortly after the meeting, StirlingHomex set forth its rationale for the allocationoLthe total contract price between themodule manufacturing phase and the installationphase and represented that no saleswere recognized with respect to module manufacturingunless the following five conditionswere met:"(1) The Company must be designated bythe LHA non-profit sponsor or other agenciesas the contractor for the project. Thisdesignation is supported' by a formal commitmentfrom the customer to the Company.(2) The customer must have obtained andsubmitted evidence to the Company that acommitment of monies to fund the projecthas been obtained from the appropriategovernmental agency under which the projecthas sponsorship. 71(3) The numbers and types of modulesand the general site plan and improvementsmust be identified and be the subjectof the agreement between the Companyand its customers.(4) The Company must assign the manufacturedmodule to a specific projectand physically identify the module asbeing assigned to and reserved exclusivelyfor the specific project and customer.(This identification was to be~ustomers. It is requested that the' financial statements. or the current year be revised to defer recognition ofincomev I'dat I'east to a pomt no sooner than the amount IS.~oI ly billable to the customer."pa~t this meeting, which is discussed iii/ra, a PMMmad er responsible for the Stirling Homex accountRome ,a number of statements regarding Stirlingbeen'ex s account'mg practIces.WhICh.we belIeve.to have" In error.In its s b . .sented t u mISSIon, Stirling Homex falsely repredesi...... t~ the staff-as it had to PMM-that a letter of.,.. a Ion frepresent d rom an LHA under the turnkey programe Such a commitment.physically attached at the earliest stageof the manufacture of the module.)(5) The module must be completed and beready for shipment to the customer."In short, it was represented- to the Commissionby Stirling Homex that before incomewas recognized in connection with modulemanufacture all events had occurredwhich reasonalby assured the ultimate collectibilityof the sales price properly allocableto such manufacture.This representation was false and theCommission has concluded that with respectto virtually every project as to which theCompany recognized income at the point ofmodule manufacture, one or more of the fiveconditions stated above had not in fact beensatisfied at the time of income recognition.General site plans were rarely in existenceat the time sales and income were recognizedfrom the manufacture of the modules. Becauseirrevocable assignment of modules to aparticular project was, in many instances,largely impossible until such site plans weredeveloped, the purported assignment of modulesto projects indicated in the computerruns and other records of the Companyshown to PMM, was essentially a sham. Infact, the modules were maintained for themost part on an unsegregated basis andshifted and reassigned from project to projectwhere the need arose. 72More importantly, in virtually every instancethere did not exist a firm and legallybinding commitment of Federal funds to financethe project. The non-profit entities(some of which were "shells") and the LHA'sdoing business with Stirling Homex did nothave substantial funds of their own. Theletter of designation and feasibility lettersdid not represent legally binding commitmentsof funds to purchase the projects andwere subject to a number of stated conditions,such as selection and approval of a72 For example, on the RIT project, which StirlingHomex included in sales for the nine months periodended April 30, 1971, Stirling Homex "assigned" modulesto the project for the purpose of recognizing incomebut they were not the type called for by the project. Itwas not until May, 1971 that the Company began manufacturingthe appropriate modules.

394 SECURITIES AND EXCHANGE COMMISSIONsite, satisfaction of various zoning and buildingcode requirements· and agreement on anultimate contract price. In almost all casesthere was no commitment of funding to financethe projects at the time income wasrecognized.In constrast to its representations to PMMand the staff of the Commission, that theseconditions would routinely be satisfied, theCompany, in practice, experienced great difficultiesin finding acceptable sites (becauseof local opposition to the projects and otherpolitical and social problems) and in obtainingthe zoning and building code variancesnecessary for its projects. In some instancesit also had difficulties in reaching agreementon the ultimate contract price.Moreover, the Commission believes thatthe allocation of the contract price as betweenmodule manufacture and installationwas arbitrary and did not accurately reflecteither the relative costs of each segment ofthe total sales price nor the relative profitabilityof the two segments. In fact, the actualcosts of installation in most of the projectscompleted by the Company substantially exceededthose portions of the applicable totalcontract prices that Stirling Homex allocatedto the installation work-at least, whenthere is taken into consideration the costoverruns improperly classified by the Companyas accounts receivable.Stirling Homex's accounting policy withrespect to the recognition of sales and incomeupon completion of the manufacture ofmodules, which permitted the Company to·front-end and prematurely report sales andearnings, was not in accordance with generallyaccepted accounting principles. 73 Follow-73 In 1970, the Accounting Principles Board issuedAPB Statement No.4 which stated the general view onincome recognition as follows:"Revenue is conventionally recognized at a specificpoint in the earning process of a business enterprise,usually when assets are sold or services are rendered.This conventional recognition is the basis of the pervasivemeasure of principle known as realization."'" * *"Revenue is generally recognized when both thefollowing conditions are met: (1) the earnings processis complete or virtually complete, and (2) an exchangehas taken place."ing the manufacture of a modular hoqsing-.unit for sale to an LHA, Stirling Homex stillowned the modules and bore the risk ofaloss. ,The Commission believes that the percentageof completion method of income recognitionwas inappropriate with respect to theinstallation portion of the projects 74 since,among other things, the total time requiredfor manufacture of the modules, prepar.~tionof the site and installation of the modules didnot require more than a few months....,-;assumingsite selection, funding approv~ls andother local approvals were in fact in handand,therefore, the contracts probably couldnot be properly considered as Ion&,. term contracts.Retention of PMMStirling Homex began to search for a newaccounting firm in January of 1971 afterencountering resistance to certain of its accountingpractices on the part of Harris KerrForster and Company ("HKF"), its auditorsfor the fiscal year ended July 31, 1970.* StirlingHomex apparently contracted a numberof accounting firms, including members of theso-called "big-eight." In late February of1971, PMM was retained by Stirling Homex.PMM was not aware of the approaches bythe Company to other accounting firms or ofthe disagreements between HKF and theCompany.7S PMM was informed that theprincipal reason for the change in auditorswas purportedly the Company's desire andthat of its investment banker to obtain a"big eight" firm. PMM also asked KHF ifthere . were any professional reason whyPMM should not accept the engagement. Inaddition, PMM made inquiries concerningStirling Homex and learned that the Corn-7. While there are some exceptions to this rul~, t~enecessary criteria for such exceptions did not eXIst Inthis case. This method, as indicated above, differed fr?~the method Stirling Homex utilized in connection WItrecording sales on the manufacture of the moduleswhereby Stirling Homex recorded sales and in~meupon the completion of the manufacture of the mod es.See Accounting Research Bulletin No. 45.d'd75 Although PMM reviewed HKF workpapers, t,heY t~enot learn of questions raised by HKF regardIng hicbincome recognition policies of Stirling Home:: 17tate-HKF had reported on in the prior years' finan c1aments.

ACCOUNTING SERIES RELEASES 395pany' had 'reputable outside' directors, legalco'uDsel and bankers. *PMM was retained to perform an audit ofStirling Homex's financial statements forthe seven months of the Stirling Homex fiscalyear ended February 28, 1971. PMM wasinformed that such financial statementswere '"to be included in their registrationstatement to be filed by Stirling Homex withthe Commission. The account was assignedto a partner in PMM's Newark, New Jerseyoffice. The audit work, however, for the StirlingHomex account was to be performed bythe PMM staff located in Rochester, NewYork, working under the direciton of a PMMpartner in that office.PMM assigned an SEC reviewing partnerfrom the New York office to the StirlingHomex audit who participated in severalmeetings where significant decisions weremade concerning unresolved audit questions.However, the .SEC reviewing partner wasunfamiliar with the. income recognition policiesof Stirling Homex and the governmenthousing programs, being utilized by customersof Stirling Homex. He did not reviewthe audit workpapers and, in connection withthe February 28, 1971 audit, met only oncewith the other PMM auditors for face-to-facediscussion of the audit.The Financial Statements of Stirling HomexReported on by PMM .There is set forth below analyses of specificaspects of PMM's audit of the ConsolidatedFinancial Statements for the seven monthperiod ended February 28, 1971 and for thetwelve month period ended July 31, 1971. Inthe view of the Commission, these analysesdemonstrate that in a number of respectsPMM's conduct of the audits was not inaccordance with generally accepted auditingstandards.I~ a number of important areas, PMM~~ uly relied on the representations andn erpretations of Stirling Homex managelIlentd .ul ,an on management-prepared schedre~isand workpapers. It appears that thisof t~nc; was. due in part to the inexperience~M personnel and their unfamiliareeAccou t' S 'the Corn ,n, lUg enes Release No. 174 issued today byrnlSSlOn with respect to the activities of HKF,ity with government housing programs, governmentcontracting or construction companies.Many such managementrepresentations were intentionally false andmisleading and constituted part of a deliberateeffort by management of the Company todeceive PMM, among others, as to the truestatus of a number of significant affairs.However, in the Commission's view, PMMaccepted uncritically the representations ofStirling Homex with respect to these mattersand did not take those steps which wererequired under the circum stan aces in orderto verify the accuracy of the Company's assertions.Thus, PMM's personnel relied on management'srepresentation that a letter of designationrepresented a firm commitment offinancing for a HUD turnkey project. Asdiscussed above, letters of designation didnot constitute a commitment of governmentfinancing and, should not have been reliedon for that purpose by PMM. Documentationevidencing a legally binding commitment ofgovernmental financing rarely existed priorto the reporting of income by StirlingHomex.In several instances Stirling Homex obtainedfrom the LHA contracts of sale onwhich the required HUD signature evidencingthat funds had been authorized and reservedfor the purchase of the developmentwas missing. Absent such signature, therewas no assurance that the project was eligiblefor financial assistance, that the fundshad been properly authorized or that fundshad been reserved by the government andwere available to effect payment and performanceby the purchaser LHA.76 Despitethe fact that these documents should havebeen recognized as being incomplete, PMM'spersonnel relied on the oral representationsof Stirling Homex management that in practicaleffect financing had been committed tothese projects. In the Commission's view thisreliance was improper.Similarly, PMM's personnel relied on the76 In some cases, Stirling Homex did not actually havea letter of designation but only a preliminary, nonbindingletter of intent.

396 SECURITIES AND EXCHANGE COMMISSIONrepresentations of management and an opin~ion of outside counsel expert in FHA mattersfurnished by management that letters of fea~sibility in. practice represented financingcommitments by the FHA. Although a feasi~bility letter was an important first step inobtaining FHA financing and indicated astrong interest in the project, feasibility let~ters in general, and· the feasibility lettersinvolved here in particular, were subject tospecified conditions and, in the Commission'sview, they did not represent a binding commitmentof funds for the project for incomerecognition purposes.The obtaining of a commitment of fundingwas an especially serious matter since theLHAs and other nonprofit entities doingbusiness with Stirling Homex were withoutfinancial resources and any agreements theyentered into with Stirling Homex requiredfinancial backing of the Federal government.However, the auditors did not adequatelyfamiliarize themselves with the governmentalhousing programs despite their lack ofprior experience with these programs anddid not contact any Federal agency in orderto verify the existence of commitments to_finance the housing projects involved. Theauditors' assumption that the LHAs wouldnot enter. into agreements with StirlingHomex without reasonable assurance of gov~ernment financing was, in the Commission'sview, unwarranted.PMM's peronnnel relied on management~prepared schedules and workpapers, includ~ing computer runs of module assignment toprojects, without adequate independent veri~fication of their accuracy. As it turned outsuch schedules were essentially meaninglessunless a final site plan for the project existed.Such a site plan did not exist in manycases. They did not perform the extendedaudit steps which the Commission believeswere called for with respect to the accountsreceivable resulting from the improper andpremature recording of module sales fromperiods preceding its engagement by StirlingHomex, carried on the books of StirlingHomex as unbilled accounts receivable.In the Commission's opinion, the confirma~tion procedure used by PMM with respect tounbilled receivables was inadequate. The con~firmations which were sent to the LHA'ssought, for the most part only confirmationof the existence of a letter of designation orcontract and the basic terms of the agreement,i.e., the number of housing units andprice. In the Commission's view, informationon the status of the project should also havebeen sought from the LHA's and, although itwas perhaps reasonable to assume that anLHA would not confirm a project unless governmentalfunding was in fact available, theconfirmations should have specifically requestedconfirmation of a funding ·commitment.The Commission also believes that thehandling of the confirmations by the auditstaff was faulty in that they failed to takeextended audit steps to evaluate the signifi~cance of remarks written on certain of theconfirmations or deviations from normal confirmationpractices, such as, in one case, thereturn of a confirmation to the companyrather than to the auditors.February 28, 1971 AuditListed· below is a schedule of projects forwhich Stirling Homex, in the Commission'sview, improperly recorded sales during theseven months ended February 28, 1971.Portland ProjectRochesterIthacaWashington, D. C.Mississippi GGCAdditional salesrecognized on projectspreviouslyPercentModule Sales Total Sales$ 569,200 4.51,200,400 9.5721,600 5.7678,400 5.47,916,000 62.8recorded in the1970--fiscal year 2,522,400 12.1$12,608,000 100.0(a) Mississippi GGC Projectf theThis project accounted for 62.8% 0 n­th sevemodule revenue reported for . e 971 andmonth period ended February 28, 1

ACCOUNTING SERIES RELEASES 397represented over .44% of the total revenuereported for the period.In December, 1970, Stirling Homex enteredinto'a contract (subsequently amended) withthe Mississippi Greater Gulf Coast HousingDevelopment Corp; ("GGC"),77 a non-profitcorporation with no financial substance, forthe construction of 800 modular units for$15,000,000 with the funding to be providedby the Farmers Home Administration, anagency of the Department of Agriculture("Farmers Home").As evidence of the financing commitmentnecessary for the inclusion of sales and earningsfrom this project in the financial statements,PMM's personnel relied on a letter toGGC from Farmers Home dated February 22,1971 which purported to represent a commitmentof government financing for $15 million.78 This letter was a forged or spuriousdocument, on the stationery of FarmersHome. 79 GGC had 'neither a history of operations,nor any' financial substance. Sincethere was no funding for the project, itshould not have been included in sales.The contract with GGC was subject toagreement on acceptable sites for the projectsconditioned upon the approval of theappropriate governmental funding agencyand the obtaining of financing from the appropriategovernmental funding agency. Nosite plans or proposed site plans existed. Nomodules were ever shipped to Mississippi forthis project, and the project was never built.Because of the magnitude and effect onthe Stirling Homex financial statements ofthe sales and earnin:gs of this project, it'7 Although PMM was not aware of this fact, thisroup was formed at the behest of Stirling Homex solely~cause of the necessity to have such a corporate vehi­C e to ostensibly negotiate and contract with Federalagencies for the funding of housing projectsaT .IIhe limit of funding on any individual FarmersMiss'orne pr',oJ,ect··IS restrIcted by statue to'$750,000. Thehad ~~SIP~1 GGC contract provided that Mississippi GGCOne 0 e rIghts to assign its rights under the contract toprova~ rnore non-profit corporations subject to the apinvolvsdofthe appropriate governmental funding agency.e .'·PMM d'spurio Id not know that the document was forged orus and 'tCorn mit I was presented to PMM as representing ament of funding by Farmers Home.should have been audited with greater carethan PMM exercised. 80 PMM's personnel,without 'knowing even the general guidelinesof the Farmers Home program, acceptedtheir reading of the February 22, 1971 letterand the oral representations of StirlingHomex management at a meeting describedbelow as a sufficient basis to conclude thatthere was a firm commitment of financingfor this project.On March 19, 1971, three PMM auditors,including the client partner and the SECreviewing partner, visited the offices of StirlingHomex to discuss with Stirling Homexmanagement problem areas of the audit thenbeing conducted. Among the areas discussedwas the absence of evidence of such financing.81At this meeting the management of theCompany submitted th'e $15 million commitmentletter for the inspection of the PMMauditors. These auditors requested a copy ofthe letter for their files, but the managementof the Company stated they could not provideone at that time, stating that there was"political reasons" for keeping the letter confidentialuntil .local announcements weremade by the sponsor of the project. No copyof the letter was subsequently obtained, nordid the auditors make an abstract of itsterms or attempt to verify the authenticityof the document through direct communicationwith the Farmers Home. There was noother documentary support in PMM's workpapersdemonstrating a firm commitment of80 The confirmation received by the auditors as ofFebruary 28, 1971 in connection with GGC confirmed "acontract dated February 28, 1971 providing for totaldevelopment and construction cost of fifteen milliondollars," whereas in fact the contract for which confirmationwas being sought was dated December 28, 1970.Although this was treated as a clerical error (and theJuly 31, 1971 confirmation subsequently received referredto the appropriate contract date) and we do notsuggest that this contract was not in fact validly executed,we nevertheless believe that under the circumstancesfurther inquiry should have been made concerningthe date of the contract.81 PMM's workpapers contain a notation by a PPMpartner stating that absent such financing "the incomerecognition on the sale of the financed modules could bejeopardized."

398 SECURITIES AND EXCHANGE COMMISSIONfinancing necessary to justify recording theMississippi GGC project in sales.Under the GGC contract the non-profitgroup was responsible for obtaining 100%financing from a government agency. Thefinancing provision was later modified andU. S. Shelter ("USS"), a wholly-owned subsidiaryof Stirling Homex, was to arrangefinancing and receive a 2% financing fee($300,000) upon acceptance of this provisionby the GGC.The financing fee of $300,000 was reflectedin the Consolidated Statement of Incomecontained in Stirling Homex's 1971 registrationstatement. The footnotes to the financialstatements dis(!lose that this fee wasearned under an agreement with a non-affiliatedcustomer whereby USS had renderedcertain services to the customer which includedthe obtaining of a commitment from a. Federal agency for permanent financing of ahousing project. This income was improperlyrecognized. This footnote is false and misleadingin that although this agreement, asshown to PMM, was dated February 15, 1971,it was in fact signed in March- after thebalance sheet date-and thus the non-affiliatedcustomer had not retained USS's servicesas of the balance sheet date and asindicated above, USS had not obtained anycommitment of permanent financing from aFederal agency nor rendered any other servicesto this customer.Although PMM mailed a confirmation toGGC concerning this USS financing fee, theconfirmation was not returned. PMM did receive,however, a letter from the GGC's attorneywho stated that USS's proposed financingcommitment to GGC on February 15,1971 had been accepted by GGC, but thatsuch fee was subject to certain terms and.conditions of the agreement dated February15, 1971 and that payment of the fee was tobe deferred until the date of any loan closings.The letter did not state when the proposedfinancing agreement had been acceptedby GGC.The auditors had a copy of the February15, 1971 agreement in their workpapers.They questioned the recognition of incomeby USS of this fee since there was no indicationthat USS had obtained any commitmentfor financing. To profide evidential matter.tosupport this financing fee, PMM obtainedfrom Stirling Homex a copy of an ambiguousletter from Stirling Homex's bank which,-stated that the bank had approved an unsecured$15 million line of credit, but. alsostated that borrowing under the line was tobe limited to $3 million outstanding at anyone time. Despite the obvious ambiguity inthe letter, the auditors did not confirm thecommitment's existence or its terms with thebank.(b) Rochester, New York ProjectIn late 1970, Stirling Homex submitted aproposal to the Rochester Housing Authority("RHA") to develop a turnkey project of 91units .on four scattered sites for approximately. $2.3 million. No contractor agreementwas executed for this project. StirlingHomex recorded $1.2 million in modular saleson this project on the basis of a letter ofdesignation from the RHA dated February26, 1971. These sales constituted a materialportion of total sales for the seven-monthperiod.PMM sent a letter to the RHA requestingconfirmation that RHA had accepted StirlingHomex's proposal for the 91 units. The letterwas returned to PMM marked correct withan attached copy of the letter of designationfor 91 units that the RHA had sent to theCompany.The designation letter, while tentativelydesignating Stirling Homex as developer ofthe project, set forth a schedule of events. and approvals including site approval by variousauthorities, negotiation of the ultimateprice that would have to be effectuated priorto the execution of a firm contract of sale,and a commitment of Federal assistance infinancing the purchase of the projects b! ~heRHA. PMM also obtained from Stlrhn:Homex a copy of a letter dated February 2 f1971 to the RHA from the Area Director. 0HUD which authorized the RHA to deslg-. d lopernate Stirling Homex as the turnkey eve fof the project, subject to the RHA's !,ett~~ ~tdesignation containing the phrase su~;to site approval by the City of Rochester. toThe auditors established no procedures ntsmonitor the accomplishment of the eV~ar_outlined in the designation letter. The

ACCOUNTING SERIES RELEASES 399ious problems of rezoning, adequate sewagesystems, and local governmental approvalswere never resolved. The proposed Rochestersites were found unacceptable by HUD andthe project was never constructed.There was no le'gally binding contract ineffect between the RHA and liUD or otherevidence of financial commitment for thisproject. Therefor.e, sales and income in thisprojec~ should not have been recognized.(c) Washington, D. C. ProjectA proposal was made to the National CapitalHousing Authority ("NCHA") in the fallof 1970, to develop this turnkey project whichwould consist of 51 dwelling units for a proposedpurchase price of .$1,217,640. No contractwas obtained by Stirling Homex on thisproject at any time. For the seven monthperiod ended February 28, 1971 StirlingHomex recorded modular sales of $678,400for the project ..PMM work papers contain only three documentsto support recognition of $678,400 ofmodule revenues on this project. One documentwas a copy of an undated letter proposingtwo possible housing developments to theNCHA. Another was· a letter dated- February26, 1971 from the· NCHA to Stirling Homexinforming the Company that it had beenselected as the turnkey developer for a particu1arsite and' additionally informing theCompany that approval by the community aswen·' as by the Board of Directors of theDistrict of Columbia Redevelopment LandAgency ("RLA") was required for the development.The third letter from the RLA, also datedFebruary 26, 1971, indicated that the RLAapproved the selection of Stirling Homex asthe developer of the site but that final ap­~rovalcould only be given after public hear­~n~~ before the RLA's Board of Directors. No: It procedures were undertaken by theqs ~ff of PMM to determine whether the reulreda I . . .de 1 pprova was ever obtamed for thISVe opment.'A lette dthe NC r, ated March 12, 1971, was sent toconti HA by PMM requesting that theyProp rID I the acceptance of the Company'sopm~~: fo r . a 51 dwelling unit housing devel­Signed b ThIs lett.er was returned to PMMy an offiCIal of the NCHA indicatingthe information was essentially correct. Atypewritten note on the returned NCHA confirmationinformed PMM that: "Before theproposal is finalized the Authority, RLA andthe HUD Regional Office must. review andapprove construction and financial details."82The Commission believes that, in the circumstances,there did not exist evidence of acommitment by NCHA to purchase the hou~ingunits, or a commitment by HUD to financethe project and this income should nothave been recognized.(d) Portland, Main ProjectAt the time of income recognition, therewas no firm commitment of funding for thisproject although a subsequent commitmentwas later obtained in July of 1971 and theproject was completed. PMM received fromStirling Homex a copy of a turnkey agree-. ment dated January 28, 1971 entered into byStirling Homex and the Portland HousingAuthority ("PHA") for the sale of a 50 dwellingunit housing development for $1,280,662.Stirling Homex included in sales $569,200from this project. There was no funding forthis project identified in the space providedin the contritct. Further, the agreement wasnot signed by HUD. Consequently, there wasno evidence of a legally binding commitmentof federal monies to fund the purchase of theproject at the time of the completion of theaudit field work.As late as June 25, 1971 Stirling Homex,PHA and HUD were still negotiating overprice and speCIfications for the project, and itwas n.ot until July 22, 1971 that a firm contractwas executed by the PHA, HUD andStirling Homex.(e) Ithaca, New York ProjectPMM obtained from the Company as evidencethat a contract,of sale existed a documentdated March 3, 1971 by which the IthacaHousing Authority ("IHA") contracted topurchase from Stirling Homex a completedhousing development' consisting of 54 dwellingunits for $1,233,050. Although the developmentwas to be purchased and funded82 In connection with the July 1971 audit, the confirmationreturn did not contain any such typewrittennote.

400 SECURITIES -AND EXCHANGE COMMISSIONunder the turnkey program of HUD, noturnkey contract in the required HUD formwas executed. There was no formal commitmentof Federal funding as of the February28, 1971 period although a formal commitmentwas subsequently obtained and theproject was completed. Sales of $721,600 fromthis project were included-improperly inthe Commission's view-for the February 28,1971 period.(f) Accounts Receivable at February 28,1971In addition to the newly recognized salesduring . the period under audit, StirlingHoinex carried ~ substantial amount of accountsreceivable and cost overruns on projectsrecorded as sales during the 1970 fiscalyear, which were also audited by PMM duringits audit of the seven-month period.Listed below are some of the projects and theamounts of the accounts receivable whichthe Commission believes were improperly recordedas· of February 28, 1971:Hillwood, AkronHighland, AkronBridgeport Street,Worcester-Providence Road, Worcester. Bird and Pearl, EriePittsburgh, ErieGrandview, ErieNorth Street, WorcesterAccountsReceivable$4,470,000 833,352,020329,500416,1001,283,000444,4001,174,600469,000All the above accounts receivable recordedon Stirling Homex's financial statements asof February 28, 1971 were recorded, althoughin several instances in substantially smalleramounts, during the 1970 fiscal year of StirlingHomex ended July- 31, 1970. The delaysin payments and progress on these projectshad continued as of February 28, 1971 andshould have prompted extended audit procedures.With certain exceptions, these projectswere in essentially the same posture as theywere in the prior fiscal year in that therehad been little installation work accom~plished, no money collected and no formalcommitment of funds by any governmentagency.84 The terms of some of the agreementsthemselves, had expired, such as the120 day completion clause. All of these projectswere HUD turnkey projects. The supportingagreements were not executed byHUD and therefore not backed by a fundingcommitment.During the . audit, PMM's personnellearned that the proposed site for theBridgeport project had to be abandoned.They received the following statement on areturned confirmation from the WorcesterHousing Authority that referred to StirlingHomex's dealings with them on the Bridgeportproject:"In July 1970 this Authority and KabethProperties, Inc. ·were in the p.rocess of negotiatinga contract for the purchase of 25units to be erected on Bridgport Street inWorcester, Massachusetts for the sum ofapproximately $563,350.00. !lecause ofproblems involving site location, the proposedsite had to be abandoned. At thepresent time, the Authority is awaitingsubmission by Kabath Properties, Inc. of aset of contract documents for approximatelythe same number of units on asuitable site in Worcester, Massachusetts."July 31,1971,. AuditListed below is a schedule of projects forwhich the Commission believes StirlingHomex improperly recorded sales during thefiscal year ended July 31, 1971:"" Stirling Homex recorded accounts receivable of $6,-818,000 during this period on this project against which$2,348,000 was purportedly received by the Company,leaving a net receivable of $4,470,000. In fact the $2,348,-000 which related to three other Akron projects waserroneously applied to this receivable and the figureshould have been $6,818,000.S t t and84 The Providence Road, Bird & Pearl ree $2 _North Street projects representing approximately ;t170,000 out of a total accounts reveivable figu~e toFebruary 28, 1971 of $26,960,000 were paid for prI~r ctsJuly 31, 1971. However, cost overruns on the yroJeaccumulated in excess of $326,000 upon completIOn.

ACCOUNTING SERIES RELEASES 401RochesterWashington, D. C.Mississippi GGCSt. Thomas, V. 1.St Croix, V. I.Clay"MorgantownStanley SimonGrandviewHiIlwoodHighlandTotal SalesPercentTotalModule Sales Sales$1,200,400678,0008.520,0001,360,0001,360,0001,951,0002,418,0006,282,500317,60086,8001,118,000$25,292,600$29,482,2714.12.328.94.64.66.68.221.31.10.33.885.8(a) Virgin Islands Proy"ectsThe documentation in PMM's workpapersfor the two projects was identical and thecontracting entity was the same, QuantumDevelopment Corporation ("Quantum"), anon-profit corporation sponsoring the· housingdevelopment pursuant to the FHA's Section236 program., The earliest dated contracts were purchaseagreements executed September 22, 1970.The terms of purchase agreements called forthe sale of 200 dwelling units for a totalpurchase price of $2,720,000 for each of thelocations. Stirling Homex was to pay for theshipment of the modules to their respectivelocations and only to supervise their installation.PMM's workpapers also contained a feasibilityletter dated January 8, 1971 addressed~o ~he Virgin Islands Foundation for HouslDgand Economic Development ("VIFHED")St . C rOIX, . V'ex .lrgin Islands. This letter had anPlration date of 30 days and had not been~~newed. PMM's personnel did not know ofQ y relationship between the VIPHED andc~antum, nor did they do any follow-up prolettures to determine whether the feasibilityIter had been renewed.and S~~cond agreement between Quantumalso . lrling Homex, dated June 1, 1971, wasagree 1n PMM's workpapers. This purchasement called for the purchase by Quantumof 100 dwelling units for a price of$1,360,000 for each of the two sites or a totalof $2,720,000 for 200 dwelling units. Accordingto the terms of this contract, paymentwas to be in the form of an irrevocable letterof credit to be issued by the First PennsylvaniaTrust Company of Philadelphia. Otherconditions set forth in the agreement were:(1) Approval of the modules by the FHA;(2) Payment was to be made on the issuanceof an appropriate bill of lading; and(3) The modules were to be constructed inaccordance with the plans and specifications.The workpapers of PMM indicate thatreliance for the commitment to fund theproject was placed on the expired feasibilityletter and on oral representations by theCompany that a bank letter of credit hadbeen furnished to Stirling Homex. In fact, aletter of credit had not been obtained byStirling Homex at the time of PMM's auditand neither this letter of credit nor otherfinancing was subsequently obtained.On July 31, 1971, PMM sent a confirmationto Quantum to confirm information concerningits contract with Stirling Homex datedSeptember 22, 1970 of 400 dwelling units for$5,400,000 with the terms of payment 10% ofthe units upon approval and acceptance ofplans and specifications by mortgagee and thebalance upon acceptance of modules at thefactory. The confirmation was returnedmarked incorrect and there was a letter attachedwhich said there was a new contractdated June 1, 1971 for 200 dwelling units at$2,720,000. In addition, the letter indicatedthat 10% of the contract price was to be paidupon approval and acceptance of the plansby the mortgagee and the balance upon acceptanceof the modules at Stirling Homex'splant.Moreover, in a note to its workpapers inthe July, 1971 audit, PMM indicated the followingas to this project:"FHA financing being processed by theLHA there so Stirling does not keep up ontheir progress. Stirling and PMM are relyingon the bank letter of credit for thecredibility of financing monies."(b) Clay, New York ProjectThis project involved an application with

402 SECURITIES AN]) EXCHANGE; COMMISSIONFHA under a Section 236 program of 150dwelling units for a total price of approximately$3.5 million. The . applicant· on theproject for which Stirling Homex was to bethe builder was Clay Development Corp.("Clay"), a wholly-owned Stirling Homex subsidiary.Clay, in turn, had an agreement witha non-profit sponsor under which the projectwould be purchased by thespo~sor uponcompletion. In the closing days of the 1971fiscal year, Stirling Homex recorded about $2million of modular sales on this project'.Sales were recognized on the basis of afeasibility letter dated July 30, 1971 from theFHA. The letter by its terms specified thatits Issuance was subject to receipt of anallocation of Federal funds. Further, the letterindicated that prior to the commencementof subsequent processing, a municipaltax abatement for the prc;>ject would be. required.Thus, the letter did not evidence afirm commitment of financing. Had they extendedtheir audit procedures, the auditorscould. have discovered that no cmmitment offederal funds had been made.Additionally the purported arr~ngementbetween Clay and the non-profit sponsor forthe resale of the project was a sham. 85 Thereforethe purported sale was only to Clay, awholly-owned subsidiary of Stirling Homex.As such it should have been reflected in thefinancial statements as a sale to an affiliatedcompany.(c) Morgantown, West Virginia ProjectThis project involved an application withFHA under Section 236 for 200 units for atotal price of approximately $4.3 million.During the fourth quarter of the 1971 fiscalyear ended July 31, 1971, Stirling Homexrecorded approximately $2.5 million of modularsales on this project, using as a basis forevidence of firm commitment of financing onthe project a letter dated July 30, 1971 fromthe FHA to Aquarius Development Corp.("Aquarius"), a wholly-owned subsidiary ofStirling Homex. The project was the result ofa contract between Aquarius and a nonprofitentity.85 The non-profit sponsor for the project in fact hadwithdrawn at the time of the July 1971 audit. PMM wasnot aware of this fact.Th.e letter, while cast in the form ofafeasibility letter, was in fact merely an offerto Aquarius to submit a revised applicationfor a feasibility letter. It was not a firmcommitment of financing and the Commissionbelieves should not have been relied onas evidence of such a commitment. The modulesthat were supposedly manufactured forthis project were structurally unsuitable becausethey were over two feet short of therequired length. This proposed project waslater abandoned for this reason and becauseof inability to obtain financing.Moreover, as in the case of the Clay project,the purported agreement to sell theproject to a non-profit sponsor was a sham.(d) Stanley Simon ProjectIn the 1971 fiscal year ended July 31, 1971modular manufacturing sales of nearly $6.3million were recorded on this project on thebasis of an agreement dated April 23, 1971between Stirling Homex and Stanley Simonand Associates ("Simon") acting on its behalfand behalf of limited partnerships to beformed in the future. The agreement providedfor the purchase of 1,000 modules at$11,000 per module for a total price of $11,-000,000. It called for a $25,000 down paymenton each site with the projects to be financedconventionally rather than through governmentprograms. Each site for the moduleswas to be approved by both parties. For themost part, there was no commitment of financingon the project and there was noassurance that Simon would be able to arrangesuch financing. s6 In early July, 1971Stanley Simon and Stirling Homex begandrafting a contract to cover the 1,000 moduleunits pursuant to the terms set forth in the. PMM that86 The only evidence that was submItted to. d waS aany permanent financing had been obtaIlle, . gsh D' SaVIncommitment dated July 19, 1971 by t e Ime ort-Bank of Williamsburg (UDSBW") to make a firs:2munitgage loan in the amount of $825,000 for a 1 k Thedevelopment to be constructed. U' N w Yor .III tIca, e nt ofh rt · the amoucommitment by the DSBW was s 0 III 'ce ($1,232.-$283,000 required to make up the full sale prI ted as000). As for the remaining module sales repor hou1denues s fattributable to the Simon contract, no rev 'dence 0have been recognized because of the lack of eVlpermanent financing.

ACCOUNTING SERIES RELEASES 403April 23rd letter of understanding but thiscontract was never finalized.During the July 31, 1971 audit, PMM'sperson,nel realized that a firm commitmentof financing wa~ unavailable inasmuch asthey specifically' noted in their workpapersthat financing for this project was "pending".The review notes compiled by the PMMaudit manager indicate that as late as September23, 1971, subsequent to the date ofPMM's report, PMM should "obtain proof of100% permanent financing."A PMM partner was aware that financingwas not commited for the sales recorded onthe Simon project by the close of the 1971fiscal year and not obtained during the auditperiod. He was not concerned with the absenceof any firm commitment because herelied on the reputation of Simon personally. and the fact that Simon was known to be aman of considerable wealth. The partner feltthat this was sufficient reason to permitincome recognition on the project.(e) Stirling Homex Accounts Receivable asof July 31,1971Receivables associated with revenues recordedin fiscal 1970 on many of the projectsdiscussed above were still carried as receivablesat the end of fiscal 1971. 87 There isevidence in the PMM workpapers that therewere substantial problems with respect tomany of these projects. The Commission believesthat PMM failed to take adequateaudit steps to assess the significance of theseproblems, relying on optimistic representationsof Stirling Homex management which~er~ received in response to the auditors'InquIries.Listed below are several examples:(1) Pittsburgh Project Receivable of $444,­~~o. PMM was informed by Stirling Homexth at Hl!D had expressed reservations aboute project site and Stirling Homex had indicatedit Could substitute another site if neceeSsary . There is no indication that PMM----Jeaminedany correspondence or other docu-87 Approxim telOut of $37 85 a y $36,400,000 of accounts receivableerly includ' 0,000 total accounts receivable were impropedas assets.mentary support for this statement by management.(2) Washington Project Receivable of $678,-400. PMM was informed during the 1971 fiscalyear audit of the substantial delays beingexperienced with respect to this project becauseof the necessity of obtaining numerousapprovals.(3) Grandview, Erie Project Receivable of$1,269,600. During the 1971 fiscal year thisproject was substituted for the 37th andTuttle Street Project in E:rie, Pennsylvania,on which sales were recorded during StirlingHomex's 1970 fiscal year pursuant to anagreement with the LHA. As noted in theirworkpapers, the auditors were aware of the"political and community entanglements"being experienced by 'Stirling Homex.(4) Bridgeport Project Receivable of $329,-500. PMM knew that this receivable wastroublesome because no new replacementsite had been located for the previouslyabandoned site and any replacement sitewas subject to HUD's approval.(5) Mississippi GGC Receivable of $8,520,-400. PMM learned during the 1971 fiscal yearaudit that Stirling Homex was making applicationand seeking approval for several sitesthrough the' Farmers Home. PMM learnedthat a $750,000 "prototype" project proposalfor 50 out of the 800 units had not receivedfinal approval by the time the audit wasbeing performed. 88 Moreover,' the moduleshad not been shipped to Mississippi.(6) Hillwood Project Receivable of $7,240,-000. This project, which had been carried asa receivable by Stirling Homex since Octoberof 1969, had almost no site work accomplishedand was encountering zoning problems.Stirling Homex had reduced the numberof modules for this project. Despite thesize and age of this proposed project PMMtook no extended audit steps with respectthereto.(7) Highland Project Receivable of $3,352,-000. At the close of the 1971 fiscal year ofStirling Homex, there had been no progress88 In fact, by the time of the PMM audit, the projecthad been rejected by the Farmers Home, This was notknown to PMM.

404 SECURITIES AND EXCHANGE COMMISSIONon this project even though it was a largereceivable and had been recorded in the 1970fiscal year· of Stirling Homex. The projectsite had been switched from the HighlandStreet, Akron location to a completely differentsite in East Barberton, Ohio. The salesthat had supposedly represented the Highlandproject were not reversed on this projectbut merely switched to the BarbertonProject. However, in October of 1971, StirlingHomex entered into an entirely new contractof sale which was approved by HUD and theproject was ultimately completed and paidfor.Cost Overruns on Stirling Homex ProjectsBy the close of its 1971 fiscal year, StirlingHomex had incurred over $1 million of costoverruns on various projects, which werecarried on its books as receivables. Further,Stirling Homex carried an additional $1,000,-000 of cost overruns as Contracts in Progress.89 These cost overruns represented additionalcosts incurred by Stirling Homex inexcess of that portion of the contract priceallocated to installation sales, which additionalcosts had not been and were not reimbursableunder the terms of the applicablecontracts. The existence of these cost over-K9 Stirling Homex improperly classified as an assetcertain costs and expenses amounting to approximately$832,000 for the seven months ended February 28, 1971and $1 million for the fiscal year ended July 31, 1971which related to the construction of a proposed Mississippiplant to be financed by a $5 million industrial bondoffering. This classification permitted these amounts tobe capitalized rather than expensed during the period inwhich they were incurred, and resulted in an overstatementof net income for said periods. PMM's acceptanceof this classification was inappropriate in that reimbursementwas unlikely under the terms of the trustindenture, a substantial portion of the expenses were. general and administrative expenses, and the reimbursementof the $1 million in intangible expenses fromthe offering proceeds was highly unlikely since theyrepresented 20% of the total proceeds. Stirling Homexincurred these cost overruns because of delays causedby Stirling Homex's premature manufacture of modules,which were in large part motivated by the Company'sincome recognition policies. These delays caused increasedexpense such as storage costs, module refurbishment,and dissatisfaction with the Stirling Homexproduct by some customers.runs was not properly accounted for in Stir~ling Homex's financial statements nor dis-·closed in the accompanying footnotes.Despite the unusual nature and size ofthese cost overruns PMM did not undertakeadequate audit steps in that it failed to obtainreliable support for their collectibility.Subsequent Discovery of Improper BusinessActivitiesAfter being shown Stirling Homexis Form10-Q for the period ended October 30, 1971,. PMM personnel learned that the $2,720,000in modular sales for the Thomasville and St.Croix projects had been reversed, that themodules had been reassigned to another projectand that these facts were not publiclyknown. The Company advised PMM that thiswas an unusual nonrecurring transaction occasionedby events which took place afterJuly 31, 1971.Even though PMM personnel knew ofthese reversals and their possible effect onthe audited financial statement for the July31, 1971 period, they failed to follow auditingprocedures that should be complied with insuch circumstances to determine whetherthese reversals required modification orwithdrawal of PMM's report on the July 31,1971 financial statements. 90During March of 1972, PMM objected tothe Company's recognition of a very largeamount of income on two newly begun projectsinvolving private financing. As a consequence,income from these projects was notreflected in Stirling Homex's financial statementsfor the period and the Company reporteda substantial loss from operations forthe quarter. 91In May of 1972 PMM auditors were told bymanagement th~t Stirling Homex's financial. condition was deteriorating rapidly and t~atit would report a $20 million lo~s for ~he ~~~months ended April 30, 1972, mcludmg1 t sections90 See Statement on Auditing Standards a. ting at561.01 ff. ("Subsequent Discovery of Facts EXISthe Date of the Auditor's Report"). . of events9J This announcement started the cham nY inC mpllwhich led to the ultimate bankruptcy of the 0July 1972.

. ACCOUNTING SERIES RELEASES 405stantial charges agail,1st income for the periodresulting from a reduciiion in the salesprice of modules on certain projects uponwhich reve~ue had been recognized in priorfiscal periods, a provision for the repair andrefurbishing of 10,000 uninstalled modules instorage areas of the company, a provision forestimated additional costs of construction onthe Stanley Si:qlon :project, a: provision fordoubtful accounts with respect to the costoverruns which were included in accountsreceivable and a provision for various overruncosts incurred in connection with theconstruction of several projects.The auditors were completely "dumbstruck"by this recital by Stirling Homexmanagement. They failed to' undertake anyreview or investigation to ascertain whetherthe newly discovered facts existed at thedate of their report on Stirling Homex's financialstatements. Due to the nature ofthese extraordinary charges, it should havebeen clear to them that the previous financialstatements of Stirling Homex were seriouslydeficient.Statements to the Commission StaffOn July 7, 1971 a meeting was held at theCommission in connection with the thenpending registration statement of StirlingHomex to discuss the Division of CorporationFinance's letter of comments. Present at thismeeting were representatives of StirlingHomex, its outside counsel, underwriters andpartners of PMM.. The meeting began with a general discus­SIon concerning the staffs letter of comments.92 Then a more particularized discus-.. .land One of the matters under discussion was a certainthe t sale. PMM originally advised Stirling Homex thatOPini:ansacti~n as originally structured would not, in itsthat .nr' qualIfy for income recognition but. indicatedIWithin ththe transact'Ion were restructured to brmg.It.generall ~ real estate guidelines then being appliedThe traY Y PMM, income would properly be recorded.nsactioadvised b P n Was then restructured along the linesliolllex illY MM, and PMM gave its opinion to StirlingDUring th:nage~ent that income could be recognized.ration Fl' Ille e tmg the Commission's Division of Corpov'nance . d' '.lews and th m Icated Its dIsagreement with PMM'se sale was reversed.sion took place concerning- Stirling Homex'sincome recognition policies, with the clientpartner of ·PMM asking whether the staff ofthe Commission desired Stirling Homex to.recognize on the completed contract method.·He questioned this method and stated thatunder the circumstances this method wouldnot be in accord with generally acceptedaccounting principles.The PMM partner stated that the realquestion was not a matter of mechanicalapplication of accounting theory but ratherat what point in time sales should be recognizedand what event should have transpiredprior to recognition. He then outlined fourevents that had occurred prior to recognitionof income by Stirling Homex, which in effect,would remove any credit risk. The most importantof these events that he outlined wasthat there was· a commitment of permanentfinancing to purchase the project.A number of statements by the partnerwere largely inaccurate. Very few of StirlingHomex's projects were covered by permanentfinancing. Had he made appropriateverification during the earlier audit periodor prior to the Commission meeting, hewould have known that these statementswere not true.The oral statements of the partner weresubsequently confirmed in the supplementalsubmission submitted by Stirling Homex inJuly 1971. The purpose of this submissionwas to outline Stirling Homex income recognitionpolicies for the staff of the Commissionin an attempt to dissuade the staff frominsisting on the completed contract methodof income recognition.93It contained numerous false statements,including misrepresentations concE.'1"ning theturnkey and other government programs asutilized by Stirling Homex and the fact thatStirling Homex had fulfilled certain conditionsprecedent before including its projectsin sales.CONCLUSIONSAs illustrated above, the Commission be-93 These elements are substantially the same elementsdiscussed in connection with Stirling Homex's accountingmethods. See discussion above.

406 SECURITIES AND EXCHANGE COMMISSIONlieves that PMM failed in a number of materialrespects to conduct the February 28,1971 and July 31, 1971 audit engagements inaccordance with generally accepted auditingstandards.Valuable lessons can be derived fromPMM's conduct, which, if focused upon, willhopefully prevent similar occurrences in thefuture. The facts of this case suggest that fora new and unknown client, some independentinvestigation should be made of the company,its customers and methods of doingbusiness. When a client extensively utilizesgovernment programs and contracts, it isexpected that the auditors will have a thoroughand complete familiarity with the programs.In~ddition,care should be given to theorganization of the "audit team" so thatresponsibilities are clearly defined. With respectto the Stirling Homex audit, the presenceof two partners operating out of differentoffices supervising the same audit workgave rise to a situation where importantdecisions were deferred and the division ofresponsibility was not clear. As a result, itwas difficult to coordinate effective controlover the audit and the decision making processwith respect thereto. This situation permittedvacillation on major decisions whichultimately were never satisfactorily resolvedby either partner.During the audit of Stirling Homex, theSEC review by PMM's SEC reviewing partnerwas superficial although the audit wasone where it had been determined that an"in depth" review was required.A successor auditing firm should reviewthe working papers of the predecessor auditors.Such review should cover critical auditareas and unusual accounting matters. Itshould also cover disagreements between thepredecessor auditors and management,whether or not they are satisfactorily resolved,which relate to accounting principles,auditing procedures, and the predecessor'sunderstanding regarding the' reasons for thechange of auditors. Further, successor auditorsshould always be alert to factors bearingon the integrity of management.A major deficiency of the Stirling Homexaudit was PMM's reliance on the unsupported,undocumented representations ofmanagement. An, auditor should not relysolely on the representations of management,but satisfy themselves as to such mattersby other means consistent with the circumstancesof the 'particular transaction,such as independent documentary verification.Auditors should be wary when sales andincome are sought to be recogn'ized on thebasis of assumptions and projections as tofuture events necessary for the ultimate realizationof such income. In this case, salesand income were recognized on governmentfinancial housing, projects at an early stagein the processing of the projects and at apoint where the essential commitment ofgovernment financing was not in existenceand where the projects were still subject to avariety of conditions such as the politicallyexplosive issue of site selection of low incomehousing. The auditors, in part because oftheir unfamilarity with government housingprograms, accepted optimistic and in somecases deceitful representations ',of the companyand others regarding the programs andprojects in question. The Commission believesthat in cases such as these whereincome recognition occurs well before thepoint at which the custo'mer is normallybilled, auditors should exercise a high degreeof caution and skepticism.A~so we believe that auditors have a dutyto disclose subsequently acquired informationwhich existed at the date of the auditor'sreport and establishes that previouslyreported upon financial statements are materiallyfalse and misleading. On two occasionsduring the 1972 Stirling Homex fisc~lyear, PMM learned information, which IfPMM had investigated as they should ha~e,would have disclosed to PMM that earlIerprepared financial statements of StirlingHomex were materially false.teFinally,it must be' noted that the stat - h ements made by the PMM partner t~ _, , , t' ith dISCUSCommISSIOn staff III connec IOn w t' n' tra 10sions of the Stirling Homex regis feSstatementconstitute unacceptable pr~OJllsionalbehavior in practice before the ou n -i: 'mission. Independent proJ.ess IOn al aCCb halfd t On etants should not act as avoca es

ACCOUNTING SERIES RELEASES 407of their clients before the Commission, especiallywhen the accountant is making factualstatements about a particular client's businesswhich have not been verified. As theCommission rec~ntly stated:"The Commission and its staff do not andcannot investigate representations madeto it, but must be abl~ to rely on theircompleteness if this process is to work. Theobjectives of the securities laws can onlybe achieved when those professionals whopractice before the Commission, both lawyersand accountants, act in a mannerconsistent with their responsibilities.Professionals involved in the disclosureprocess are in a very real sense the representativesof the investing public servedby the Commission, and, as a result theirdealings with the Commission and its staffmust be permeated with candor and fulldisclosure. It cannot resemble an adversaryrelationship more appropriate to litigantsin court, because the Commission isnot an adverse party in this context. Allwho are familiar with the Commission'spolicies know that too much importance isattached to the word of the professional to. 'permIt his or her word to become the subjectof question. A professional's word is. often the functional equivalent of his orher reputation. Conferences with the staffof the Commission serve a vital role in theadministration of the securities laws, andsuch conferences are predicted, for themost part, upon full disclosure by theprofessionals involved. It must be underst?O~by all who practice before the Com­~IssIon, lawyers and accountants aliket tt the Commission and its staff cannoto erate less than full disclqsure." 94* * *CONCLUSIONAs Cont I~ent, PMe;P ated by PMM's o~fer,of settle-Into the has a~eed ~o an mvestigation----audit p m.anner m WhICh it conducts itsractlce WI 'th respect to clients whose"'See IExchangenActthe MatteR I r'''AOJ rthur Andersen, ASR No. 157,e ease No. 10906.financial statements, reported upon by PMMare filed with the Commission. That comprehensiveexamination is to be carried out by acommittee . whose compensation and expenseswill be borne by PMM. Members ofthe committee will be agreed upon by PMMand the staff of the Commission. The natureand scope of the examination is outlined in amemorandum addressed· to the committeewhich has been agreed upon by the Commissionand PMM and which is annexed to theoffer of settlement. It is contemplated thatthe examination can be completed and thereport of the committee submitted to theCommission within approximately sixmonths. PMM also has agreed to the entry ofan order by the Commission requiring it toadopt and implement any reasonable recommendationsthe committee may make withrespect to PMM's SEC audit practice andprocedures. 95 The offer of settlement alsocontemplates that two annual reviews ofPMM's audit practice, will be conducted in1976 and 1977 at firm expense, and the resultsof these reviews will be reported to the. Commission and PMM.96PMM has agreed to the entry of an orderby the Commission prohibiting it from acceptingaudit engagements for new SECclients for the six-month period beginning onMay 1, 1975 and terminating on October 31. '1975. Durmg that period, with certain exceptions,PMM will not accept or negotiate forthe acceptance of new SEC clients. 97 This six-95.In the event that PMM demonstrates to the satisfactionof the Commission that a recommendation of thecommittee is not reasonable or need not be implementedeither in the form recommended or with reasonablemodifications, then it has been agreed that such recommendationneed not be adopted.96 Since it is contemplated by all concerned that thisexamination and two subsequent reviews are designedto serve the purposes embodied within Rule 407 of theFederal Rules of Evidence, the parties have agreed toan order which the court has entered requiring that thedetails of the examination and reviews, the workingpapers and other documentation other than the reportsof the committee and the reviewers and the deliberationsof the committee and reviewers are to be heldconfidential.97 For the six-month period from May 1, 1975 throughOctober 31, 1975, PMM has not accepted and will notaccept audit engagements from new audit clients whichcontemplate the issuance by PMM of an auditor's opin-

408 SECURITIES AND EXCHANGE COMMISSIONmonth restriction does not affeCt in any wayPMM's ability to service its existing clientsnor does it affect other aspects· of PMM'spractice such as tax and management consultiilg._PMM has also agreed to the entry of finaljudgments of permanent injunction in eachof the four injunctive actions the Commissionhas instituted against the firm. Theseinjunctions, among other things, prohibit thefirm from engaging in specified violations ofthe federal securities laws with respect tothe financial statements of the companiesthat gave rise to these proceedings. One ofthe injunctions formalizes certain PMM proceduresand requires that they be followedwith respect to accepting new audit clientsgenerally and special procedures when a newengagement follows a resignation by a predecessorauditor which has resulted in the filingof a Form 8-K with the Commission reflectingidentified professional disagreementsbetween the predecessor auditor and theclient.Further, PMM has agreed to revise andimplement certain procedures with respectto (i) its existing preissuance review of reportsby a second partner not otherwise associatedwith the engageinent in that the secondpartner will evaluate theappropriateness of financial statement disclosuresand the accountants' report relatingto- material discussed in the engagementpartner's memorandum; that memorandumwhich will be prepared following a review ofion, in respect of financial statements which it is expectedby PMM will be filed with the Commission withinthe next succeeding twelve-month period_ Such limitationshall not inclqde an audit client (i) in which asignificant equity or debt interest is held or acquired bya present client of PMM, (ii) for which PMM has providedprofessional services since January 1, 1974 andprior to May 1, 1975, (iii) which is controlled by a foreignentity provided the financial statements of the clientare not separately filed with the Commission, (iv) whichis a client or a subsidiary or division of a client of aforeign affiliated firm of PMM, (v) which since July 1,1974 and prior to May 1, 1975 has communicated withPMM concerning the possible engagement of PMM as itsauditor (the Commission having been advised of thenumber of such instances), or (vi) if its acceptance byPMM as an audit client is approved in the particularcircumstances by the Chief Accountant of the Commission.the working papers, . and will identify anddiscuss the critical audit areas and unusualaccounting matters encountered .during tpecourse of the -audit; (ii) its existing review -bya second partner of specified types of engagementswhich will include an in depth revIewof the appropriateness of judgments and theworking papers· in the critical audit areasand unusual accounting -matters, and (iii) ascertainingthat engagement partners or, -if necessary,others associated with them are adequatelyinformed with respect to anyunusual or abnormal practices peculiar tothe industry and circumstances involved inthe engagement. PMM has also agreed toconduct a study of the use of the percentageof completion m~thod of accounting and toestablish guidelines in this area for its auditpractice, which guidelines are to be appliedin the conduct of its audits for fiscal yearsbeginning on or after December 27,1975. Theprocedures and the study and the implementationthereof, including the guidelines, arethe subject of this order as set forth below.In determining to accept PMM's settlementoffer, we have taken into account thefact that these controversies relate to auditengagements for five clients out of a largenumber of audit engagements conducted byPMM over the years in question going backto 1968, and that, based upon informationsubmitted by PMM and otherwise known tous, their overall audit practice appears to beconducted in a competent and professionalmanner. Moreover, we believe that the provisionsof the settlement offer will providePMM· and the Commission with independentassurance of the quality of PMM's auditpractice before the Commission. While theCommission continues to retain jurisdictionover this proceeding, this settlement resolvesthese existing disputes between PMMand the Commission.For the foregoing reasons, it is herebyORDERED,e1. This proceeding under Rule 2(e) of th. . ·nstitute. dCommission's Rules of PractIce IS 1 5PMM's offer of settlement, dated June ,1975, is hereby accepted. f the2. An investigation will be made 0

ACCOUNTING SERIES RELEASES 409manner in which the audit practice of PMM isconducted with respect to audit clientswhose financial statements reported upon byPMM are filed with the Commission.a. That examination will be carried out bya committee (the "Committee") whose compensationand expenses will be borne byPMM. The members of the Committee will bechosen by PMM from a list of persons acceptableto the staff of the Commission.b. The joint understanding of the Commissionand of PMM concerning the examinationis outlined in a memorandum addressedto the Committee. The memorandum is AnnexB to PMM's offer of settlement.c. It is contemplated by the Commissionand by PMM that the examination can becompleted and. the report of the Committeesubmitted within six months.d. PMM will promptly take all steps reasonablynecessary and appropriate to adoptand implement any reasoIl:able recommendationsthe Committee may make with respectto the manner in which such audit practice isconducted, provided, however, that, if PlV[Mdemonstrates to the satisfaction of the Commissionthat a recommendation of the Committeeis not reasonable or need not be implementedeither in the form recommendedor with reasonable modifications, such recommendationneed not be adopted.e. The contents of the investigation, theworking papers and other documentation(except the Committee's report) and the deliberationsof the Committee will be heldconfidential except from PMM and the Commission..3. PMM will promptly take all steps reason­~bly necessary and appropriate to adopt andImplement the procedures contaIned in AnnexC to PMM's offer of settlement. PMMwill notify the Chief Accountant of the Com­Il}' •ISSlon prior to any amendment of suchpr~cedures ~ithin the next five years.th . PMM wIll conduct a study of ~he use ofe percentage of completion metnod of ac­~~unting and establish guidelines in thisap;~. fo~ its audit practice, which will bevear~e~ In .th~ conduct of its audits for fiscal1975. egInnmg on or after December 27,5. For the six-month period from May 1,1975 through October 31, 1975; PMM has· notaccepted and will not accept audit engagementsfrom new audit clients which contemplatethe issuance by PMM of an audit()esopinion, in respect of financial statementswhich it is expected by PMM will be filedwith the Commission within the next succeedingtwelve-month period. Such limitationshall not include an audit client (i) inwhich a significant equity or debt interes~ isheld or acquired by a present client of PMl\:f,(ii) for which PMM has provided profess,ionalservices since January 1, 1974 and prior toMay 1, 1975, (iii) which is controlled by aforeign entity provided the financial statementsof the client are not separately filedwith the Commission, (iv) which is a client ora subsidiary or a division of a client of. aforeign affiliated firm of PMM, (v) whichsince July 1, 1974 and prior to May 1, 1975has communicated with PMM concerning thepossible engagement of PMM as its auditor(the Commission having been advised of thenumber of such instances), or (vi) if its acceptanceby PMM as an audit client is approvedin the particular circumstances bythe Chief Accountant of the Commission.·6. A review will be conducted in 1976 and.in1977 at PMM's expense of the matters consideredunder the AICPA program for thereview of quality control procedures of multiofficefirms and ,to determine whetherPMM has taken all steps r~al?onably necessaryand appropriate to adopt and .implementthe procedures described in Annex C toPMM's offer of settlement and any recommendationof the Committee (subject to theproviso stated in paragraph 2.d.).a. Each review will be conducted by apanel operating under the AICPA program,or (if such a panel is not prepared to act) bythe Committee or not less than three accountantmembers thereof, or (if the Committeeor three of its members are not prepared toact) by a group of not less than three certifiedpublic accountants chosen by PMM froma list acceptable to the staff of the Commission.b. The results of each review will be reportedto the Commission and to PMM.c. The contents of each review, the workingpapers, other documentation (except the re-

410 SECURITIES AND EXCHANGE COMMISSIONport of its results), and deliberations of thereviewers will be held confidential exceptfrom PMM and the Commission.7. The Commission retains jurisdiction ofthis proceeding.By the Commission.GEORGE A. FITZSIMMONSSecretary.SECURITIES EXCHANGE ACT OF 1934Release No. 11514RELEASE NO. 174July 2, 1975Opinion and Order instituting proceedings and imposing remedial sanctions in the Matter of. Harris, Kerr, Forster & Co.RULE 2(e) OPINIONI. INTRODUCTIONThis opinion under Rule 2(e)(1) of the Commission'sRules of Practice (specifically, Section201.2 (e)(l) (ii) and (iii) of Title 17, Code ofFederal Regulations) arises out of the conductof Harris, Kerr, Forster & Co. ("HKF"),a partnership of independent public accountants,in its audit engagement and unqualifiedreport upon the financial statements ofStirling Homex Corporation ("StirlingHomex") for the fiscal year ended July 31,1970. 1 These financial statements and HKF'sunqualified report on them were included inStirling Homex's (1) 1970 Form 10-K filedwith the Commission; (2) 1970 Annual Reportto Shareholders; (3) 1971 Registration Statementfor offering of 500,000 shares of StirlingHomex cumulative convertible preferredstock;2 (4) 1971 Form 10-K filed with the1 §201.2(e) (1) provides as follows: The Commission mayde,ny temporarily or permanently, the privilege of appearingor practicing before it, in any way to any personwho is found by the Commission after notice of and theopportunity for hearing in the matter . . . (ii) to belacking in character or integrity or to have engaged inunethical or improper professional conduct, or (iii) tohave willfully violated, or willfully aided and abetted theviolation of any provision of the Federal securities laws(15 U.S.C. secs. 77a to 80b-20), or the rules and regulationsthereunder.2 HKF was not Stirling Homex's independent auditorat the time of the offering by Stirling Homex of itspreferred stock. The independent auditing firm of Peat,Commission, and (5) 1971 Annual Report toShareholders. It is our opinion that thesefinancial statements were false and misleading.While it is our opinion that HKF's executionof its 1970 Stirling Homex engagementwas not performed in accordance with generallyaccepted auditing standards ("GAAS"),HKF appears to have been a victim of adeliberate scheme to defraud, including themisrepresentation and concealment of certainmaterial facts, perpetrated by certainmanagement and supervisory personnel ofStirling Homex and others. *HKF has submitted to the Commission awaiver of the institution of formal administrativeproceedings under Rule 2(e) (1) andhas consented to the entry of an order con-Marwick, Mitchell & Co., which replaced HKF, reportedon the financial statements of Stirling Homex and consolidatedsubsidiaries for the seven months ended February28, 1971, the most current audited financial statementsincluded in the 1971 Registration Statement o~Stirling Homex. The conduct of the accounting firm 0Peat, Marwick, Mitchell & Co., with respect to S~irlin~Homex is discussed in ASR Release No. 173 also ISSUeby the Commission today. ' . fa* Today the Commission also announced the filIng 0 "civil injunctive complaint in this matter entitled SCecu~,ties and Exchange" St'r g Homex 011'Comm~sswn v. ~r ~n . . d pur -ration et al. In addition, the CommiSSIOn Issue A t of, S T Exchange csuant to Section 21(a) of the ecun les f St'rling1934 a "Report of Investigation in the Matter °h BloardHomex Corporation Relating to ACtlVI 'T~es of t eof Directors of Stirling Homex CorporatiOn.

SECURITIES AND EXCHANGE COMMISSION 411taining certain findings, conclusions and remedialsanctions.. Under the terms of HKF's waiver and consent,HKF solely for the purpose of settlementof this mat~6!r, and without admittingor denying the Commission's findings of law,and without admitting or denying any factexcept for the purpose of this settlement,consented, among other things, to the entryof an appropriate order. .After due consideration of the offer of consent,we have determined that it is appropriateand in the public interest to accept thisconsent.II. BACKGROUNDStirling Homex was in the business ofmanufacturing and installing modular dwellingunits in low-to-moderate income housingdevelopments under the sponsorship of a localpublic housing authority. During fiscal1970, a rapid expansion in Stirling Homex'smodular housing manufacturing capacity occurred.This expansion was accompanied bywidespread publicity and a volatile stockprice movement. During this period, StirlingHomex's management sought to maximizeincome in hopes of supporting and maintainingan inflated price/earnings ratio. StirlingHomex attempted to progress from a smallconstruction company to a leader in the nascentmodular housing industry.Stirling Homex's reported sales of modularhousing were $5.4 million in 1969 and $16.5million in fiscal 1970. The apparent impetusto this revenue growth was the recognitionof modular sales attributable to "turnkey"projects which, under certain conditions,qualified for financial assistance from theDepartment of Housing and Urban Development("HUD"). Stirling Homex achieved. t~ese increased sales, in the Commission'sVIew, through the improper recognition ofrevenues and realization of profits with re­Spect to the manufacture and installation ofiOdular dwelling units. In 1972, Stirlingomex Was declared bankrupt.III. 1970 AUDITA.IIKF'Bus' s Understanding of Stirling Homex'sIness.In its review of the turnkey contracts,HKF considered only the relationship betweenStirling Homex and the local housingauthorities ("LHAs"). HKF's concern centeredaround Stirling Homex's ability to performunder the contracts with the LHAs andnot with the LHAs' ability to fulfill theirfinancial obligations, nor with the commitmentof financing by HUD. HKF, in theopinion of the Commission, did not fully understandthe funding provisions applicable toStirling Homex's operations under the HUDturnkey program and did not seek expertadvice.In addition, HKF did not determinewhether financial responsibility existed onthe part of Stirling Homex's customers topurchase the completed turnkey projects. Infact, the LHAs did not have the necessaryfinancing to carry out these turnkey housingprograms without massive HUD assistance. 3Moreover, the terms of the turnkey contractsbetween Stirling Homex and the LHAs werespecifically conditioned upon HUD's approval,which approval had not been obtained:"The approval of this Agreement by theGovernment signifies that the undertakingby the Purchaser of the acquisition of theproperty constitutes a project eligible forfinancial assistance under the Annual ContributionsContract 4 identified in Exhibit'C'; that said Annual Contributions Contracthas been properly authorized; thatfunds have been reserved by the Governmentand will be available to effect paymentand performance by the Purchaserhereunder; and the Government approvalof the terms and conditions hereof."3While Note 3 to the Company's financial statementsfor the fiscal year ended July 31, 1970 indicates that thehousing projects purchased by the LHAs were Federallyfinanced and because of this "no provisions for doubtfulaccounts was considered necessary," this footnote wasmisleading because it failed to disclose that no firmcommitment for funding of any Stirling Homex projecthad been made by any Federal agency responsible forfunding Stirling Homex's projects.'The Annual Contributions Contract is the documentwhereby HUD guarantees a commitment of funds to theLHAs.

412 SECURITIES AND EXCHANGE COMMISSIONRevenues from these turnkey projectswere included in sales during the 1970 fiscalyear, although the required HUD approvalwas absent from most of the turnkey contracts.These contracts were available to,and were reviewed by, HKF and were maintainedin HKF's workpapers. HKF did notconsider HUD's. approval necessary to therec.ognition of Stirling Homex revenues.HKF was aware of the existence of a largenumber of modules reflected in sales toLHAs under turnkey· contracts which hadnot been installed on the project sites as atJuly 31, 1970. HKF was also aware that theturnkey contracts ,provided that the risk ofloss remained' with Stirling Homex until theproject was completed and contained no provisionfor payment until such time. In theCommission's view, the recognition of revenueunder these circumstances was inappropriate.B. HKF Procedures Employed on StirlingHomex ~rojectsToward the end of fiscal 1970, HKF establishedcertain criteria pertaining to turnkeycontracts that had to exist before HKFwould acquiesce to revenue recognition byStirling Homex on the modules manufacturedand assigned to specific projects. Thesecriteria were established by HKF because itwanted reasonable assurance that theturnkey contracts would, in fact, be completedby Stirling Homex. HKF made thejudgment that the LHAs would meet theirfinancial obligations when a certificate ofoccupancy was issued.Therefore, during the period, HKF requiredthat the following criteria be met byStirling Homex in order to recognize revenueon the projects: (1) Stirling Homex own or"control" the land upon which the projectwas to be constructed; (2) any of the following:(i) construction on the project site; or (ii)possession of a building permit; or (iii) reasonableassurance that a building permitwould be forthcoming; and (3) in certain instances,modules be turned over to a commoncarrier.The focus of these elements was unfortunatebecause it turned on Stirling Homex'sability to perform under the turnkey contractsand not upon the ability of the LHAsto' pay. However, the LHAs' ability to paywas totally dependent on the commitment ofHUD financing and, as previously indicated,this was not adequately considered by HKF. 5c. Projects1. General DiscussionDuring fiscal 1970, Stirling Homex iniproperlyrecognized revenue of 'approximately$3.7 million on 8 turnkey projects, 6 located inErie, Pennsylvania; Worcester, Massachusetts;and Sanford, Maine. None of the contractsfor these projects had been countersignedby HUD as at July 31, 1970, asrequired by the contracts and the applicableHUD guidelines.At no time did HKF make inquiry regardingthe existence of HUD funding. This lackof inquiry, in the opinion of the Commission,did not meet the requirements of GAAS.72. Worcester, Massachusetts, ProjectStirling Homex executed four contractswith the Worcester Housing Authority inJuly of 1970, in the closing days of the 1970fiscal year. These contracts involved fourseparate projects to be financed under theHUD turnkey program. These contracts accountedfor over $1 million in sales improperlyrecognized in fiscal 1970.The Worcester contracts do not containany HUD approval. None existed. The engagementsenior indicated this in HKF's5 Almost no documentary evidence exists in HKF'sworkpapers demonstrating a commitment for financingby HUD to support income recognition by StirlingHomex on its turnkey projects.6 In addition, two Akron, Ohio projects, Hillwood andHighland, on which Stirling Homex recognized revenueof $6,900,000, were being processed under the tumkeyprogram. HKF did not determine whether the AkronMetropolitan Housing Authority had HUD approval forthese projects, though such approval was required;~the terms of these agreements. In fact, no such Happroval existed.. s7The third standard of Auditing Field Work reqUlr e, 'd t' I matter asathe examination of suffiCIent eVl en la " Thepredicate for the expressIOn,of th·e aud'tI or's opmlOn ., . . "due pro""eSthirdgeneral standard of audltmg reqUlreS t (See.' f engage men .slOnal care" m the performance 0 an , bed bYStatement on Auditing Standards No . . 1, pub~~, contheAICPA.) In the Commission's opinIon,.~ alSstanduct,in this instance, fell below these mInImdards.

ACCOUNTING SERIES RELEASES 413workpapers prepared during the 1970 auditof Stirling Homex: , . .It ~~s apparent from con~ersations thatHUD is the financier of the Worcester developments.My question is that if HUDhas not yet approved said contracts whatwill happen if such approval is not given .... Who would. pay for the .developments[?] Iwould say that HUD's approval could notbe obtained until the following comes topass (none of which happened until Septemberor October).. Yet Stirling Homex' recognized revenueand income on these Worcester projects. Therequired HUD approval in"\ some instancesnever occurred, and in others occurred wellafter the' close of the 1970 fiscal year .. Moreover,HKF's own revenue recognition criteriawere not satisfied in one instance. Oneproject site had been rejected by the zoningboard as unacceptable. and ~o new replacementsite was ever found. Thus, StirlingHomex n~ither' owned nor controlled theland on this project. The HKF workpapersindicate that HKF was aware that the modulesassigned to the Worceste~ ~rojects (assignmentto a project was the basis for revenuerecognition) were being stored atlocations other than the project sites.As late as September 1970, -the HKF engagementaudit senior visually inspected thefour Worcester project sites' and found thattwo of the sites were only vacant lots. Thethird site had been rejected by the City ofWorcester zoning board,S and the fourth wasapproximately 95% complete.'~he HKF workpapers indicate that the senior on theaud~t learned the following, ", , . the Bridgeport Streetr::e,ct was killed due to local oppo.:;ition to developing aIncome project. He [Stirling Homex's legal representat''t Ive, WIn orcester] says presently there are four~I e: under consideration as substitutes for the Bridgeo;rStree~ project, the selection of a final site is stillar: n . I .raised the possibility that since these mattersnew Subject to public hearings (as evidenced by local8Ub8~~t~er :eports on Providence and North Street), ano ba ' e Stte may never be found. Therefore, I can seeBridg Sts under our present thinking for includingeport St t . .uncritj II ree S tn sales." (EmphasIs added.) HKFincomeca Y accepted Stirling Homex's recognition ofassuran on the Bridgeport street project because ofStirling ~s by the Worcester Housing Authority andOInex that a substitute site would be found.3. Erie, Pennsylvania, ProjectsStirling Homex entered into tl~ree contractswith the Housing Authority of theCity of Erie o'n the very last business day offiscal 1970. These agreements covered threeprojects to be financed under the HUDturnkey program and accounted for approximately$1.7 million in revenues recognized infiscal 1970. As was the case with the Worcesterprojects, there was no evidence of a HUDfinancing commitment, and in fact, none existed.4. Notes to 1970 Financial StatementsFootnote 3 to the Stirling Homex fiscal1970 financial statements, captioned, "Receivablesand Unbilled Amounts on Contracts,"states the following:The Company enters into various modularhousing sale contracts with local housingauthorities. These contracts contain an allocationof the sales price as between modularunits, site development and installation,land and other reimbursables. Theterms of' certain sales contracts("Turnkey") provide for payment andtran~fer of title upon completion and receiptof all approvals necessary for occupancy.The Company records sale of modularunits after they have been manufacturedand assigned to specific contracts.The notes and accounts receivable fromaffiliated companies represent sales tocomp~nies in which certain officers anddirectors of the Company or members oftheir immediate families have an equityinterest.The Company's sales to local housing authoritiesare for Federally financed housirigprojects which qualify for financial assistancefrom the Department of Housingand Urban Development. Due to the natureof these sales, no provision for doubtfulaccounts is considered necessary.This note contained inaccurate and misleadingstatements in that the turnkey contractsentered into by Stirling Homex did notprovide for an allocation of the sales pricebetwe~n modular and installation portions,although Stirling Homex submitted its proposalson such a basis. In order to obtain the

414 SECURITIES AND EXCHANGE COMMISSIONconcurrence of the LHAs with, the allocation,HKF suggested to Stirling Homex during its1970 fiscal year audit that Stirling Homexhave the LHAs execute addenda to theturnkey contracts which would provide for abreakdown of modular and installation sales.However, Stirling Homex refused to submitthe addenda to the local housing authoritiesfor their signatures.Once HKF determined that Stirling Homexwould not submit the addenda to the LHAsfor their signatures, HKF decided on an alternativeapproach. In this regard, HKF senttwo confirmation letters to the local housingauthority on each project. One confirmationrequested a verification of information regardingits contracts with Stirling Homex,including the date of contract, a breakdownof the total sales price between olOdular andinstallation sales, the terms of payment, andthe number of dwelling units received by thehousing authority through July 31, 1970. Thesecond confirmation requested a verificationof the amount of apartment dwelling unitscompleted and assigned by Stirling Homex toa project with the particular local housingauth'ority, as well as the amount billed byStirling Homex through July 31, 1970.By structuring the confirmations in thisfashion, HKF was attempting, to confirm theinformation contained in the Stirling Homexaddendum. However, HKF did not receive asigned confirmation from all of the housingauthorities verifying such information;rather, certain of the housing authoritiesreferred HKF back to the contracts for confirmationof the contract terms themselves.HKF's attempt to confirm the breakdown ofthe total sales price and the dollar amountand number of modules completed and assignedto a project, the Commission believes,was inappropriate., Further, the last paragraph of Footnote 3set forth above leaves the impression thatHUD funds had been committed to the projectsand thus there was no necessity for anallowance for doubtful accounts. In fact,there were no Federal funds committed tothese projects. Additionally, during thecourse of its audit engagement, HKF did notconcern itself with this question.5. ConclusionIn the Commission's opinion, HKF's auditwas not performed in accordance with generallyaccepted auditing standards in that,among other things, it failed to acquire andexamine sufficient competent evidential materialconcerning firm commitments of HUDfinancing to the projects.In accepting HKF's offer of settlement, theCommission has considered the fact thatHKF has not previously been subject to disciplinaryor enforcement proceedings institutedby the Commission, that the conductoccurred in 1970, that HKF was subsequentlyterminated by Stirling Homex be~cause of disagreements with Stirling Homexover matters of accounting principles 9 andthat HKF was the victim of a deliberatescheme to defraud. Further, the Commissionhas considered the professional conduct ofHKF with respect to transactions and eventsthat occurred after HKF issued its report onStirling Homex's'1970 financial statements,especially HKF's insistence' that StirlingHomex give full and complete disclosure inits 1971 Registration Statement concerningtwo transactions that were recognized inincome in' finanCial statements that HKFwas not reporting upon and at a time whenHKF was no longer serving as independentauditor for Stirling Homex.In view of the above findings, the Commissionconcludes that HKF's audit of StirlingHomex's 1970 financial statements was notconducted in accordance with generally acceptedauditing standards.* * * * *Under the terms of its offer of settlement,Harris, Kerr, Forster & Company, withoutadmitting or denying the Commission's findings,and solely' for the purpose of settlement,consented to the entry of an orderembodying the following sanctions.9 Accounting Series Release No. 165, adopted D7c~:~ber 20, 1974, after HKF was terminated by StIr 'reHomex, would, in circumstances such as these, requ~e_disclosure of the substance of the disagreements gistweenthe mdependent,publIc'accountantand the retrant.

ACCOUNTING SERIES RELEASES 415Accordingly, IT IS ORDERED that proceedingspursuant to Rule 2(e) of the Commission'sRules of Practice be, and they herebyare, instituted against Harris, Kerr, Forster& Company.; and Harris, Kerr, Forster &Company hereby is censured by the Commission.By the Commission.GEORGE A. FITZSIMMONSSecretarySECURITIES ACT OF 1933Release No. 5596SECURITIES EXCHANGE ACT OF 1934Release No. 11529PUBLIC UTILITY HOLDING COMPANYACT OF 193'5Release No. 19083INVESTMENT COMPANY ACT OF 1940Release No. 8848RELEASE NO. 175July 10, 1975Notice of Adoption of Amendments to Rule 4-02 of Regulation S-X Relating to ConsolidatedFinancial StatementsThe Commission today adopted an amendmentof Rule 4-02(e) of Regulation S-X relatingto separate statements of subsidiariesincluded in consolidated financial statements.The amendment clarifies the requirementsfor separate statements of consolidatedsu bsidiaries engaged in certainfinancial activities. Revision of the rule wasoriginally proposed on December 11, 1974. 1ConSideration of comments has resulted inre~sions of the proposal so that the rule nowbeIng adopted will be more understandableand easier to work with. -thThe December 1974 release observed thate proposed amendment resulted from ourexperience in examining financial statementsfiled by registrants and 'also from---current·economlC and finanCIal.develop-I Securiti AAct ReI es ct Release No. 5548, Securities ExchangeAct Ret ase No. 11132, Public Utility Holding Companylease N eass e No. 18705, Investment Company Act Reo.612.ments. At that time we noted concern overdevelopments in banking and other regulatedfinancial businesses in which there isregulation for the interests of depositors andinsureds apart from the interest of stockholders.The need for disclosure of informationconcerning subsidiaries in these highlyleveraged areas is no less necessary today.The revisions to the proposed amendmentsof Rule 4-02(e) are as follows:The provision of subparagraph (e)(2) requiringfinancial statements for a registrant'snonsignificant subsidiaries when theinvestment in them exceeds 10 percent oftotal assets on registrant's balance sheet hasbeen transferred to paragraph (e). The remainderof subparagraph (e) (2) has beeneliminated since it provided for omission ofnonsignificant subsidiaries whose exclusiongenerally would be appropriate because oflack of materiality. The former subparagraph(e) (3) has been renumbered (e) (2) butis otherwise unchanged.

416 SECURITIES AND EXCHANGE COMMISSIONThe inclusion of leasing, as part of thefinance line of business has been modified toinclude subsidiaries engaged in finance leasingand to ,exclude subsidiaries with onlynonfinancing leases.The proposed subparagraph 4-02(e) (1) providedfor exclusion of supporting statementsof a consolidated significant subsidiary or ofa significant group of subsidiaries if theirassets, sales and income each exceed 90 percentof the correspohding amounts on theconsolidated statements. In response to severalcomments these provisions have beenrevised so that in making this test averageconsolidated income (or loss) may be substitutedfor the current year's income (or loss).This is comparable to a provision in thedefinition of significant subsidiary in Rule 1-02 of Regulation SoX.Under the rule one or more sets of financialstatements may be required in supportof the basic consolidated statements, andunder certain unusual circumstances asmany as four separate sets 'of statementsmay be needed. 2 While this requirement mayappear to place an onerous burden on aregistrant, it is a reflection of the involvedand complicated nature of business and isnecessary to provide the investor with sufficientinformation on which to base investmentdecisions. In its project on "FinancialReporting for Segments of a Business Enterprise,"the Financial Accounting StandardsBoard is considering the reporting problemsof diversified companies including the matterof disclosure of information about differentsegments. Rule 4-02 will be reconsideredwhen the F ASB issues a statement on thissubjeCt.The following is the text of Rule 4-02(e) asrevised:(e) Separate financial statements shall bepresented for each significant consolidatedsubsidiary or each group of consolidated subsidiarieswhich in the aggregate meets the2 For example, a holding company 'with bank and'finance company subsidiaries might have to present thefollowing sets of financial statements: (1) consolidatedstatements; (2) parent company statements; (3) combinedstatements of bank subsidiaries; and (4) combinedstatements of finance company subsidiaries.tests of a significant subsidiary en'gaged inthe business of life insurance, fire and casualtyinsurance, securities broker-dealer, finance(which group includes similar activitiessuch as factoring, mortgage banking andleasing, exclusive of subsi?iaries with onlynonfinancing leases), savings and loan orbanking (including all subsidiaries of banks),and for all nonsignificant consolidated subsidiariesnot otherwise included in groupsabove, combined when registrant's investment(including current and not current advances)in all such subsidiaries exceeds 10percent of total assets on registrant's balancesheet. N otwiihstanding the foregoingrequirement, separate financial statementsmay be omitted:(1) For a consolidated subsidiary or groupof consolidated subsidiaries in the same businessif the registrant's and registrant's othersubsidiaries proportionate share (based ontheir equity interests) of (i) total assets (afterintercompany eliminations), (ii) total salesand revenues (after intercompany eliminations),and (iii) income (or loss) before incometaxes and extraordinary items of such subsidiaryor group of subsidiaries each exceeds90 percent of the corresponding amounts onthe consolidated financial statements. If theproportionate share of income (or loss) under(iii) above and the corresponding amount onthe consolidated financial statements are notboth income or both loss, then separate financialstatements may not be omitted. Ifthe average income before income taxes andextraordinary items on the consolidated financialstatements for the last five fiscalyears is less than such consolidated incomeon the most recent annual financial statementsor if the average consolidated loss fO.rthe last five years is less than such consolIdatedloss on the most recent annual financialstatements then such average amountsmay be substit~ted in the determination under(iii) above. . . oup(2) For a consolidated SUbSIdIary or gr .. 'd' . . the same bu SI -of consolIdated SUbSI Iarles m . lesness if in excess of 90 percent of theIr sa t. f .nstranand revenues are derIved rom ret:>andregistrant's other subsidiaries. d tedThe foregoing amendments are d;9~~) ofpursuant to Sections 6, 7, 8, 10 an

ACCOUNTING SERIES RELEASES 417the Securities Act of 1933; Sections 12, 13,15(d) and 23(a) of the Securities ExchangeAct qf 1934; Sections 5(b), 14 and 20(a) of thePublic Utility ~olding Company Act of 1935;and Sections 8, 30, 31(c) and 38(a) of theInvestment Company Act of 1940. Theamendments shall be effective with respectto financial statements filed with the Commissionsubsequent to September 30; 1975.By the Commission.GEORGE A. FITZSIMMONS,Secretary.SECURITIES EXCHANGE ACT OF 1934Release No. 11543RELEASE NO. 176July 22, 1975Findings. and Order imposing remedial sanctions in the Matter of Hertz, Herson & Co.These are proceedings pursuant to Rule2(e) of the Commission's Rules of Practice todeter~in~ whe.ther Hertz, Herso~ & Company("Hertz, Herson"), a partnership engagedin the practice of acco·unting, shouldbe denied the privilege of appearing or practicingbefore the Commission.Respondent, without admitting or denyingany of the Commission's findings and solelyfor the purpose of settlement, has submittedan offer of settlement in which Respondentconsents to the institution of proceedingsunder Rule 2(e) of the Commission's Rules ofPractice and to the entry of an order containingcertain findings and remedial sanctionsas set forth below.1. For the fiscal year ended August 31,~971, Drew National Corporation ("DN") andIts then approximately 80%-owned subsidiary,Drew National Leasing Corporation('~DNL"), issued false and misleading finan­CIal statements. Respondent, independentaccountants for DN and DNL rendered un­~ua1i.fied opinions with respe~t to those fianclalstatements.!-~--'The Com ..settled I miSSion has instituted and simultaneouslyof th . egal proceedings against DN, DNL, and certainelrCom_ .offi. cers and directors,.Secunttes. .and Exchange".188ton v D ..1141). Th . :ew Nattonal Corp., et al. (DDC 75-leges . e Commission's complaint in that action al-, tnter al"mentsh 'f ta, t at ON sand ONL's financial statemislead.orthe years 1970 and 1971 were false andIng because inadequate allowances and provi-2. DNL was engaged in the business ofequipment leasing. At the fiscal year endedAugust 31, 1971, there were at least twomillion dollars of leases on which there weredelinquent lease payments out of a totallease portfolio of approximately twelve milliondollars. During 1971, DNL wrote off$134,000 against the allowance for doubtfulaccounts (which had an opening credit balanceof $131,000) and charged income by anadditional provision of $193,000, bringing theallowance for doubtful accounts to. $190,000at August 31, 1971. .3. The provision and allowance were inadequateunder the circumstances since a significantportion of the leases were uncollectible,for among other reasons, the leases wereseriously delinquent and the value of theunderlying collateral was insufficient. Thiswas particularly true since the condition ofmany of the leases which were delinquent in1970 deteriorated further during 1971. Inaddition, DNL continued to recognize revesionswere made for DNL's doubtful lease receivables.The complaint alleges that by the end of fiscal year 1970,many lease receivables were delinquent and otherwisedoubtful of collection.In the conduct of its audit for 1970, Respondent reliedto a great extent upon management's representationsas to the collectibility of delinquent leases, the value ofthe collateral and reliability of third party guarantors.While the delinquencies were less serious and materialin 1970 than in 1971, the Commission believes that amore diligent audit might have uncovered the problems.

418 SECURITIES AND EXCHANGE COMMISSIONnues on these leases. As a consequence,DNL's 1971 financial statements materiallyunderstated net loss and were false and misleading.4. In connection with the audit of DNL's1971 financial statements, Respondent, inmany instances, relied upon the representationsof DNL's management as to the collectibilityof, and the status of collection effortswith respect to, the lease receivables. In theperformance of the audit, Respondent failedto use due professional care in that it did notsufficiently extend its audit tests by obtainingand examining adequate, competent evidentialmatter to determine the veracity ofmanagement's representations. In other instances,documentation was available whichwas not properly evaluated.Thus, Respondent failed to appraise thesignificance of information known to it andto extend sufficiently its auditing proceduresin circumstances calling for professionalskepticism.While" the adequacy of an allowance fordoubtful accounts is inevitably a matter ofjudgment and no one precise amount is appropriatein each situation, auditors have anobligation to bring together as much relevantinformation in this connection as isnecessary so that a reasonable judgment canbe made. In this case, the auditors failed toaccumulate sufficient information. Furthermore,they formed a judgment on the informationobtained which clearly fell outsidethe realm of reasonableness.5. As a result of the inclusion of a provisionfor doubtful accounts more appropriate foran earlier year, DNL's 1972 financial statements,concerning which Respondent renderedan unqualified opinion, ipso facto werefalse and misleading in that the company'snet loss was materially overstated." 6. To the extent that they incorporatedapproximately 80% of DNL's understatednet loss of 1971 and overstated net loss for1972, DN's financial statements for 1971 and1972, concerning which Respondent renderedunqualified opinions, were false and misleading.After due consideration, the Commissionhas determined to accept the offer of settlement.In arriving at its determination, the. Commission considered the fact that Respondent,in order to insure that it performsits audits in accordance with generally acc~ptedauditing standards, has agreed to thereview described in the order.Accordingly, IT IS ORDERED· that proceedingspursuant to Rule 2(e) of the 'C~mmission'sRules of Practice be, and they herebyare, instituted against Respondent.. IT IS FURTHER ORDERED that, uponthe terms and conditions provided in theoffer of settlement, Respondent consents tothe entry by the Commission of an orderwhich provides that: ..1. Respondent shall employ as consultants,two certified public accountants who are satisfactoryto the Chief Accountant of the Commissionto review and evaluate the auditingprocedures and professional practice of Respondentin coimection with its audits ofpublicly-held companies. The review shall belimited to the audit work performed, theelements of .quality control and the auditprocedures employed by the firm as reflectedin the. relevant working papers and to ananalysis of the application of generally acceptedaccounting principles. The consultantsmay communicate with the Commission'sstaff to ascertain its views. The reviewshall be performed after Hertz, Herson hascompleted said audits, but in no event shallthe review commence later than two weeksfrom the date the consultants are retained.2. At the conclusion of the review andevaluation, but in no event later than eightweeks 2 from the date of this order, the consultantsshall report their conclusions to theOffice of the Chief Accountant of the Commissionand shall make recommendations, if3needed, to Respondent for improvements.Respondent shall have a reasonable opportunityto reply in writing to the review a~devaluation results to the staff of the Commlscision, and to institute any recommendechanges.k s3. Respondent represents and underta e. . b granted at2 A reasonable extenSIOn of time may e isthediscretion of the Chief Accountant of the Com msion.din. . h I· ts involve3 Such report snail not Identify t e c lenthe review.

ACCOUNTING SERIES RELEASES 419not to accept engagements with any newpublic clients from date of entry of the Commission'sOrder until one month after thesubmission by the consultants to the Commissionof their report where the engagementis expected to involve· filings with, orsubmissions or certifications to, the Commission.4. The Commission shall retain jurisdictionof this matter pending final receipt of thereport referred to above, and thereafter forthe taking of appropriate action, if necessary,for any purposes relevant to this orderor the report, after notice and an opportunityfor an evidenciary hearing.After due consideration, the Commissionhas determined to accept the offer of settlement.By the Commission.GEORGE A. FITZSIMMONSSecretary._ RELEASE NO. 177September 10, 1975SECURITIES ACT OF 1933Release N.(). 5611PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19162SECURITIES EXCHANGE ACT OF 1934Release No. 11641Notice of Adoption of Amendments to Form 10-Q and Regulation S-X Regarding InterimFinancial ReportingA. General StatementIn Securities Act Releases No. 5549 andNo. 5579, the Commission proposed alternativemethods of increasing disclosure of interimresults by registrants. More than 700letters of comments have been received inresponse to these proposals. In addition, theCommission held public hearings on the proposalsand heard testimony from 14 witnesses.The Commission has given carefulconsideration to all comments and to the~vidence received in the public hearings. Itas now determined to adopt certain of the~~Oposals, to modify others and propose red1sed rUles for further comment and to withrawothe r proposa I s, all as dIscussed " below.1'hl"n eSproposals for revised rules are containedSe ecu rIles "t" Act Release No. 5612 datedPternber 10, 1975.A.doPtion foAmendments to Regulation S-XThe Corn " "SUbsta t" mISSIOn has determined to adopt,n lally as proposed, a new rule [Rule3-16(t)] which will require disclosure of selectedquarterly financial data in notes toannual financial statements of certain registrants.In making this determination, theCommission has concluded that footnote disclosureof net sales, gross profit, income beforeextraordinary items and cumulative effectof a change in accounting, per sharedata based upon such income, and net incomefor each quarter within the two mostrecent fiscal years and any slibsequent fiscalperiod for which income statements are presented,is appropriate for the protection ofinvestors in the case of large companieswhose shares are actively traded. The Commissionbelieves that the greatest investorneed for these data exists in the case of suchcompanies whose activities are most closelyfollowed by analysts and investors. Accordingly,registrants whose shares are not activelytraded or whose size is below certainlimits have been exempted from this rule atthe present time. In making this judgment. the Commission also recognized that the

420 SECURITIES AND EXCHANGE COMMISSIONcosts of such disclosure would be relatively agreater burden to smaller companies. N evertheless,the Commission urges -registrantswho are exempt from the rule to consider thedesirability of including such data in theirannual reports. The exemption applies to allregistrants who do not meet the followingcriteria:'A. I. The registrant has securities registeredpursuant to Section 12(b) of the ExchangeAct; or2. The registrant has securities registeredpursuant to Section 12(g) of the ExchangeAct that are quoted on the National Associationof Securities Dealers Automated Quotation-'Systeinand these securities meet theRegulation T requirements for continued inchisionon the list of OTC margin stock; and, B. -The registrant and consolidated subsidia~ieshadincome after taxes but' before extraordinaryitems and cumulative effect of achange in accounting of $250,000 for each ofthe last three fiscal years or had total assetsat the- last fiscal year end of $200,000,000 ormore. 'The Commjssion believes' that such .disclosureswill materially assist investors in 'understandingthe pattern of corporate activitiesthroughout a fiscal period and' it' feelsthat such an understanding is important iffinancial statements are to serve their objec'­tive of allowing investors to develop reasonableexpectations about the future prospecfsof enterprises in which they are investing orconsidering investment. 1 Presentation ofsuch quarterly data will supply informationabout the trend of business operations oversegments of time which are sufficiently shortto reflect business turning points. Annualperiods may obscure such turning points andmay reflect a pattern of stability and growthwhich is not consistent with business reality.In addition, quarterly data will reflect seasonalpatterns which are of signific:ance toan investor's understanding of the businessoperations of a reporting entity.Numerous commentators took issue withI See the report of the Trueblood Committee appointedby the American 'Institute of Certified Public Accountantsto study the objectives of financial statements.the Commission's view that the footnote informationproposed to be required by theproposals' and adopted herein was necessaryfor investors. They- suggested that interimresults are materially affected by rand·omevents, that short period estimates are' bytheir nature imprecise and that putting suchdata into annual financial statements 'willmislead by lending them an appearance ofreliability which cannot in fact exist. In addition,numerous respondents suggested thatif the Commission did believe that quarterlydata should be presented to investors at theend of the year, this could best be achievedby including the quarterly data in management'sanalysis of the summary of operationsor elsewhere in' the annual report, butnot in the notes to financial statements.The Commission has concluded ,that itshould not a~end its proposal in response tothese comments. While 'it recognizes thatrandom events 'can materially affect quarterlyresults, it believes that Section (3) ofRule 3-16(t), which requires disclosure in thenote of any unusual items occurring in' anyquarter disclosed, 'will emible investors toascertain the effect of such items and hencenot be misled. It also recognizes that' shortperiod estimates are- imprecise, and it emphasizedin Securities Act Release No~ 5549that it was not proposing any change In thetraditional accounting practice' of makingthe best estimate practicable at the time theestimate must be made, and then'reflectingsubsequent adjustments in the estimate insubsequent periods as the need became apparent.Estimates are a necessary part of allfinancial reporting, and since registrantshave had many years experience in makingthe estimates required in quarterly reportingand investors have had equivalent experiencein using the reports encompassingthese estimates, the Commission is not preparedto conclude that including quarterlYdata in a footnote to the financial stateme~t~will create an impression of reliability wh~c nwill mislead investors. In addition, sectloof(3) of Rule 3-16(t) requires the disclosure rthe aggregate effect and the nature of ye·~lend or other adjustments.WhICh.arematerl"ThiSto the results of each quarter presented. inedisclosure will permit investors to deterIll

ACCOUNTING SERIES RELEASES 421the nature and effect of substantial changesin estimates~. The Commission also does not agree thatthe required disclosure sho~ld only be madeoutside the financial statements. In general,it believes that significant financial disclosuresabout business operations during aperiod shoul4 be included in the financjalstatements for that period. The burden istherefore on those who believe that significantfinancial data should be outside thefinancial statements to demonstrate the reasonfor its exclusion. Commentators did notoffer any compelling reasons to support theirposition in this. regard. Accordingly, the·Commission believes that it is appropriate torequire disclosure in the notes to financialstatements. of those companies in whichthere is the most substantial public investorinterest., .Involvement of Independent PublicAccountantsThe inclusion of interim data in the footnotesto annual financial statements necessarilywill associate the independent publicaccountant with these data in some fashion.In its initial proposal in Securities Act ReleaseNo. 5549, the Commission indicatedthat it was not prepared to have these datalabeled "unaudited." After receiving manycomments and estimates of cost which suggestedthat an audit of interim data would bevery costly to registrants, the Commissionpublished an additional set of proposals (inSecurities Act Release No. 5579) which wouldpermit this note to be labeled "unaudited"and at the same time would set forth as anamendment to Rule 2-02 of Regulation S-X a~et o~ limited review procedures which audiorswould be expected to follow when theyWere associated with a set of financial state­;noetnts which included such an unauditedo note.'.he~: careful consideration of costs andsio n ~ s of auditor involvement, the Commisn~tet: s b de~ermi~~d to permit the requiredthough t:' IdentIfIed as "unaudited." EvenP~ndentSUchIS note will not be audited, indeaccountantswill be associated witha note when they report on financialstatements which include such a note. The.Commission does not believe it is appropriatefor independent accountants to be subjectf1dto unknown responsibilities in connectionwith their association with this note. Accordingly,the Commission is proposing, in SecuritiesAct Release No. 5612, dated this date, aslightly amended set of review and reportingprocedures which the Commission believeswill satisfactorily set forth its expectation asto the responsibilities of independent accountantswho report on financial statementsfiled with it which include such a note. TheCommission plans to adopt final standardsfor auditors' reports which spell out theseexpectations prior to the effective date of theamendment to Rule 3-16 adopted hereby.The Commission notes, however, that thesubject of auditor involvement with interimfinancial data has been under active considerationby the Auditing Standards ExecutiveCommittee of the· American Institute ofCP As (AudSEC). It also notes that historicallythe Commission has not been requiredto set forth the standards and procedureswhich underlie an independent public accountant'sreport because the public accountingprofession has developed appropriatestandards and procedures to provideprotection to the investing public who relyupon such reports.The Commission believes. that it is preferableto continue its past policy of permittingthe accounting profession to determine theauditing standards and procedures underlyingaccountant's reports as ~ong as this policyis consistent with the interests of investors.Accordingly, it urges AudSEC tocontinue its study of auditor involvementwith Interim financial data in the light of theCommission's determination that certain interimdata shall be included in annual financialstatements of certain registrants in anote labeled "unaudited" and the Commis-·sion's further determination that auditor associationwith these data will necessarilyoccur and the responsibilities for such associationmust be satisfactorily defined. IfAudSEC adopts a Statement on AuditingStandards prior to December 10, 1975 whichsets forth the standards and procedures tobe followed by independent accountants in

422 SECURITIES AND EXCHANGE COMMISSIONconnection with the data in the unauditednote required by Rule 3-16(t), and the Commissionis satisfied that these standards andpr~cedures adequately protect the interestsof investors, it is the intention of the Commissionto withdraw the proposed sections ofRule 2-02(e) which set forth specific .proceduresof review and reporting and to indicatethat the AudSEC statement identifies the"appropriate professional standards and procedures"presumed to have been followed bythe reporting independent public accountantunder Rule 2-02(e).The Commission received many commentson the subject of auditor involvement, nearlyall of which raised questions as to whetherthe benefits of such involvement would warrantthe cost. The Commission has consideredthese comments with great care since itbelieves that it should not lightly imposeadditional costs on registrants and that thebenefits of new requirements to present andprospective investors should outweigh anyadditional costs involved. Since the benefitsof the increased involvement of independentaccountants in interim reporting are notsubject to quantification, and· the measurementof costs includes many variables whichare highly uncertain, the weighing of costsand benefits will inevitably require the exerciseof subjective judgments rather than a­rithmetical computations.In its releases proposing increased auditorinvolvement, the Commission specifically invitedcomments on the cost of its proposals toregistrants. Many responses were received,but relatively few indicated that the respondenthad undertaken any systematic researchinto the costs involved. Those that didreport a systematic study of costs reportedthat the costs would vary depending on thenature of the registrant, but the most commonestimates indicated that a quarterlyreview following the procedures set forth inthe proposal would cost between 5% and 25%of the current annual audit fee. In the Commission'shearings, several of those makingsuch estimates were asked whether the studiestook into account any savings in year-endaudit time which might result from quarterlyreviews and they responded that nosuch savings had been included. In addition,several witnesses stated that current auditingprocedures frequently included analyticalreviews of results of time periods withinthe year in searching for unusual itemswhich would require additional auditingsteps, even though these reviews did notfocus specifically on quarterly periods. '.The Commission believes that as· reViewsof quarterly information become a regularpart of the audit examination of public companies,auditors will revise the timing oftheir audit examinations so that they willperform procedures related to the testing ofinternal controls and the analytical review ofinternal financial reports on a regular basisthroughout the year. In addition, programsencompassing regular analytical reViewshould increase the efficiency of auditors infinding and focusing promptly on potentiallytroublesome areas in the audit. The Commissionbelieves, therefore, that many of thecosts included in the studies reported to theCommission will not prove to be incrementalcosts but will reduce the cost of the year-endaudit examination. In addition, it is the Commission'sview that many of the costs will beof a one time rather than a continuing naturesince audit programs and corporate controlsystems will be improved promptly tokeep costs at a minimum. The Commissiond'oes not suggest that the cost of auditorinvolvement in quarterly data will be trivial,but it does believe that some of the higherestimates supplied to it will not prove to becorrect.The benefits resulting from such increasedcosts cannot be quantified, but the Commissionis satisfied that they will be substantial.While the new rules will not mandate thetimely involvement of the independent aCcountantwith quarterly reports, the Commissionbelieves that it is likely that suchinvolvement will occur so that managemen~will be less likely to face the necessity °drevising quarterly data at the time year-enstatements are published. Either timely orretrospective involvement s hou idI·ncreaselythe care and attention devoted to ~ua~erodreports which will increase the hkel~ :dthatmanagement will disco.ver ne:~~ition,justments on a timely baSIS. I~ ro b1eJ1'lmanagement may be able to identify P

ACCOUNTING SERIES RELEASES 423areas more promptly so that unusualcharges and credits are not made so frequentlyin the last month of a fiscal year.finally, the involvement of independent ac-: countants w.ill add the expertise of profes­. sional accountants with wide experience inreporting problems to the quarterly reportingprocess. This should improve individual. company reporting and direct greater professionalattention to the general problems ofinterim reporting.. The Commission has brought a number ofenforcement actions involving quarterly reportsand it has observed other cases wherequarterly reports have required correction.In addition, it has noted the preponderanceof Form 8-K filings covering unusual chargesand credits to income being made late in theyear. While these are not suggested to beevidence of systematic abuse in quarterlyreport~ng, they do indicate that deficienciesexist. Although auditor involvement will notprevent all deficiencies, the Commission doesbelieve that it will enhance the reliability ofinterim reports and reduce the likelihood ofabuse. In the final analysis, however, thebenefits of auditor involvement in quarterlydata are expected primarily to result fromimprovement in the quality of interim reportingand the annual auditing process andonly secondarily from the prevention of specificabuses currently perceived.After appraising the costs and benefits,the Commission has determined that thebenefits of mandatory involvement of independentaccountants in quarterly data onthe basis set forth in the rules adopted herebysubstantially outweigh the costs thereof~nd that such involvement is required in theInterests of investors.In exempting certain registrants fromthese rules, the Commission has noted that~~e cost of auditor involvement will fall with. e greatest relative severity on smaller re­~~trants in which public investor interest isC~ of.gr.eat magnitude. In these cases, theth m:;lISSlOn believes that it is less clear thatte:. enefits of auditor involvement with init~rn data outweigh the costs. Accordingly,SUch aSren~t required such involvement forthough .g!st.rants at the present time, al-It wIll continue to study the questionas it evaluates the experience gained fromthe rules adopted here by.Effective Date of Amendments to RegulationS-XBecause quarterly data have not previouslybeen included in financial statementsfor a year and because the Commission recognizesthat specific implementation of auditorinvolvement and improved systems ofinternal control relative to quarterly datamay take time to achieve, the Commission isnot requiring the inclusion of such data infinancial statements for fiscal periods beginningprior to December 26, 1975. In addition,quarterly data will not be required for quarterlyperiods beginning prior to that date.Earlier implementation of the requirementsby registrants is encouraged.Inclusion of Quarterly Data in FinancialStatements Included in Annual Reports toStockholdersThe rules adopted hereby require thatlarge companies whose shares are activelytraded include the disclosure of certainquarterly data in financial statements filedwith the Commission. The Commission believesthat these companies also should includethis disclosure in financial statementsfurnished to stockholders.Adoption of Amendments to Form lO-QThe Commission has determined to adoptsubstantially increased requirements for thecontent of quarterly reports on Form 10-Qwhich will be applicable to all registrants.These requirements include condensed financialstatements, a narrative analysis ofresults of operations, the approval of anyaccounting change by the registrant's independentpublic accountant, and a signatureby the registrant's chief financial officer orchief accounting officer. In addition, the revisedform permits additional financial disclosuresdeemed appropriate by managementand permits management to state thatfinancial data in the form has been reviewedby independent public accountants and toinclude as an exhibit to the form a letter

424 SECUR~TIES AND EXCHANGE COMMISSIONfrom the independent I?ublic accountant inregard to this review. ,The Commission originally proposed to requirefinancial statements prepared in accordancewith Regulation SoX except for theexclusion of certain footnote disclosure. Anumber of commentators suggested thatstich statements would be more detailedthan required by investors and would becostly' to prepare. Accordingly, the ruleadopted provides that the financial statementsfurnishedneed only include the majorcaptions 'set forth in RegUlation SoX andpermits the 'combination of such captionswhen certain materiality tests are met. Theonly subcaptions required by the nile arethose which set forth the components of inventory(raw materials, work in process andfinished goods), if applicable, since users offinancial statements have indicated thatthese subcaptions are of considerable import~ncein evaluating the significapce ofchanges in inventory. In addition, the rulepermits a" suinmarizedstatement of sourceand application of funds. The rule retains theoriginal proposed provision that rules includedin Regulation SoX which call for detailedfootnote disclosures and schedules donot apply to financial statements filed inForm 10-Qs. A number of commentators indicatedthat the proposed language Was notsufficiently specific since all footnote disclosuresrequired in annual financial statementscould be said to meet the test of beingnecessary to preverit the statements frombeing misleading. The Commission did notintend this interpretation, since it believesthat detailed footnote disclosures requiredannually need not be updated quarterly inthe absence of highly unusual circumstances.It has attempted to clarify the languageto make its intent clear although it has retainedin the rule the general obligation to'make disclosures adequate to make the informationpresented not misleading. This is arequirement for all filings with the Commissioriand has been included in Form 10-Qsince the time of its adoption.The new rules require income statementsfor the most recent quarter, the equivalentcalendar quarter in the preceding year andyear-to-date data for both years. Condensedfunds statements are required on a year:-to",date basis for the current and prior year. inaddition, registrants ~re p~.rlp.itted to showincome statement data and funds statement1 .' •qata for the twelve month per~od end~ng atthe interim reporting date for both years ifthey elect to do so. Balance sheets are requiredas of the end of the most recentquarter. and at the same date, in the precedingyear.In addition, the new rules require increasedpro forma information in the case ofbusiness combinations accounte~ for as pl,lr-.chases, conformity with the principles of ac~:counting measurement set forth in the Acc

ACCOUNTING SERIES RELEASES 425"Guides for Preparation and Filing of Reportsand Registration Statements under theSecurities Exchange Act of 1934." Commentatorspointed out that this Guide was designedto apply to a summary of earningscovering a period of several years and thatsome of the tests set forth in that Guide werenot precisely applic~ble to interim reportingoriForm iO-Q. While the Commission believesthat the general principles set out inGuide 1 would be relevant to a quarterlyanalysis, it recognizes that certain quantitativetests are inapplicable,· and that theshorter period covered by interim reportsmay have an impact on the types of analysiswhich will be most meaningful to investors.Accordingly, this instruction has been redraftedto make it specifically applkable toForm 10-Q and to give more general guidanceto registrants rather than setting clownquantitative tests. The new instruction requiresexplanation of the reasons for materialchanges in the amount of revenue andexpense items from one quarter to the next(even though the preceding quarter may notbe reported as such in the Form 10-Q), betweenthe most recent quarter and theequivalent quarter in the preceding year,and between the year-to-date data and comparabledata for the prior year. While suchexplanations are to be presented in narrativeform, it is expected that they will includequantitative data In explaining thereasons for changes. In addition to requiringan analysis of operations, the new form inc~udesan instruction which permits the re­~strant to furnish any additional inform a­t~on which management believes will be ofsIgnificance to registrants. This same in­~ruction requires the registrant to indicatehether a Form 8-K was filed during theqUarter reporting either unusual charges orcreditU st " "0 mcome or a change of audItors.Sign nder th~ new rules, Form lO-Q must beth ed by eIther the chief financial officer ore ch" ftion T~~ acco~.mting officer of the corporaniti~. IS requIrement was included in recogweren o~ the" fact that the data in the formapPro P~lInaMly financial, and that it wasof thePrhl?'te to emphasize the responsibilitycthe releffmancial or accounting officer forpresentations explicit and implicit inthe filing. This signature will not relieveother corporate officers of their responsibilities.Rescission of Form 7-QSince the rules and instructions adoptedherein for Form 10~Q require a condensedquarterly statement of source and applicationof funds for all companies, the separateform (Form 7-Q) which sets forth this requirementfor certain real estate companiesis rio longer required. Accordingly, Form 7-Qand the rules specifying its application arerescinded.Review of Form lO-Q Data by Independent. Public AccountantThe financial information included inForin 10-Q need not be reviewed prior tofiling by an independent public accountant.However, ~ertain registrants will be requiredto include certain data contained in theForm lO-Q in·an unaudited note to financialstatements for the year. Such a note must bereviewed by an independent public accountantin· accordance with prescribed professionalstandards in connection with the annualaudit. Since review procedures must beapplied to quarterly data ,in connection withthe annual audit of such registrants in anyevent, the additional cost to these registrantsof having a review made on a timelybasis should be small, particularly jf theannual audit is planned with such a reviewin mind.The Commission· believes that all registrantswould find it useful and prudent tohave independent public accountants reviewquarterly financial data on a timely basisduring the year prior to the filing of FormlO-Q arid it encourages registrants to havesuch a review made. While such a reviewdoes not represent an audit and cannot berelied upon to detect all errors and omissionsthat might be discovered in a full audit ofquarterly data, it will bring the reporting,accounting and analytical expertise of independentprofessional accountants to bear onfinancial reports included in Form lO-Q andtherefore should increase the quality and the

426 SECURITIES AND EXCHANGE COMMISSIONreiiability of the data therein in a cost-effectiveway.Instruction K of Form 10-Q permits registrantsto state that an independent accountanthas reviewed the financial informationincluded therein if the accountant has reviewedthe data in accordance with establishedprofessional standards and proceduresfor such a ·review. In Release No. 33-5612 ofthis date the Commission has proposed forcomment such professional standards andprocedures and it plans to adopt such standardsprior to the effective date of the Form10-Q revisions~ The Commission notes, however,that AudSEC has issued for exposure aset of proposed standards and procedures 'forsuch a review, and if professional standardsare adopted which the Commission believesare satisfactory to protect the interests ofinvestors, it is the intention of the Commissionto withdraw its proposed standards andr~ly on . the standards. established byAudSEC.If the registrant has the independent publicaccountant perform such a review andelects to state this fact, the statement mustalso indicate whether all adjustments or additionaldisclosures proposed by the independentaccountant have been reflected inthe data presented, and if not, why not.In addition, if the registrant states thatsuch a review has been made, there may (butneed not be) included as an exhibit to theform a letter from the registrant's independentaccountant conforming or otherwise commentingupon the registrant's representationsand making such other comments asthe independent accountant deems appropriate.A number of commentators have indicatedthat they do not believe that independentaccountants should be permitted to associatetheir names with data on the basis of limitedreview procedures. This position is alsotaken in the AudSEC exposure draft on interimreviews referred to above. This view isbased on the concern that users of the accountant'sreport will not be able to distinguishbetween a report covering an auditconducted in accordance with generally ac-.cepted aUditing standards and a report on alimited review following specified procedures,and hence will be misled. The Commissionhas considered these comments, but isnot prepared to conclude that investors willbe unable to distinguish appropriately betweendifferent types of reports. It believesthat an accountant's report on a limited reviewmay provide significant and useful informationto investors and that such reportsshould be encouraged. At the present time,however, the Commission does not propose torequire such reports in connection withForm 10-Q filings.In Securities Act Release No. 5579, theCommission proposed to amend the facingsheet of Form 10-Q to require registrants toindicate by check mark whether or not financialstatements required by the form hadbeen reviewed by independent public accountants.A number of commentators suggestedthat such a requirement would imply that areview was mandatory and that a "no" answerwould indicate a deficiency in the form.Others commented that a simple yes or noanswer on the front of the form would oversimplifya complex matter and would increasethe likelihood of investors being misled.The Commission has concluded that at thepresent time, the proposed check mark onthe facing sheet of Form 10-Q is not necessaryand it has determined not to adopt theamendment 'to the facing sheet.Amendments to Forms S-7 and S-16In Securities Act Release No. 5579 theCommission proposed amendments to FormsS-7 and S-16 which would have had the effectof permitting the use of Form S-7 by registrantsnot presently qualified to do so if thefinancial information included in their Form10-Q filings was reviewed by indepenent publicaccountants and this fact was stated o~Form 10-Q. Many commentators Sugg estethat the involvement of public accountant~on a review basis was not an equivalent t~s 1as compared to the current tests. of finan~~estrength and stability now reqUlr~d for theyuse of Form S-7. With few exceptIOnS, t berecommended that the amendments noadopted.t tbeThe Commission is concerned abou

ACCOUNTING SERIES RELEASES i!27cost of registering securities for sale and it isdesirous of keeping such costs at a minimumconsistent with the protection of investors.'Accordingly, the Commission has approvedpublication fO'!" comment amendments toForms S-7 and S-16. While such proposedamendments do not include timely auditorinvolvement as one of the criteria for use ofthe forms, they are designed to broaden theavailability of the use of the forms by alarger number of companies.Effective Date of Form 10-Q AmendmentsThe Commission has determined to makechanges in Form 10-Q adopted hereby effectivefor Form 10-Q reports filed coveringperiods beginning after December 25, 1975,but in no event shall disclosure of comparativebalance sheet data and source and applicationof funds data be required for interimperiods beginning prior to that date.B. Amendments AdoptedThe text of the amendments to RegulationS-X, Form 10-Q and Form 7-Q and relatedrules follows.I. Regulation S-XRule 2-02. Accountants' Reports.(a) through (d) (No change)(e) Association with unaudited note coveringinterim financial data.If the financial statements covered by theaccountant's report designate as "unaudited"the note required by Rule 3-16(t), itshall be presumed that appropriate professionalstandards and procedures with respectto the data in the note have been~ollowed by the independent accountant whol~ associated with the unaudited footnote byVlltue of reporting on the financial statelllentsin which it is included.* * * * *,,Rule 3-16. General Notes to FinancialStatements. (See Release No. AS-4.)(t)cial dD'* * * * *t~closure of selected quarterly finan-E: ata tn notes to financial statements.~emption. This rule shall not apply toany registrant that does hot meet thefollowing conditions:(a) The registrant (1) 'has securitiesregistered pursuant to Section 12(b) ofthe Securities Exchange Act of 1934. or(2) has securities registered pursuant ~oSection 12(g) of that Act which also (i)are quoted on the National Assoditiim,of Securities Dealers Automated QuotationSystem and (ii) meet the requirementsfor continued inclusion on the listof OTC margin stocks set forth in Section220.8(i) of Regulation T of the Board ofGovernors of the Federal Reserve System;and(b) The registrant and its consolidatedsubsidiaries (1) have had a net incomeafter taxes but before extraordinaryitems and the cumulative effect of achange in accounting, of at least $250,000for each of the iast three fiscal years; or(2) had total assets of at least $200,000,-000 for the last fiscal year end.(1) Disclosure shall be made in a note tofinancial statements of net sales, gross profit(net sales less costs and expenses associateddirectly with' or allocated to products sold orservices rendered), income before extraordinaryitem and cumulative effect of a changein accounting, per share data based uponsuch income, and net income for each fullquarter within the two' most recent fiscalyears and any subsequent interim period forwhich income statements are presented.(2) When the data supplied in (1) abovevary from the amounts previously reportedon the Form 10-Q filed for any quarter, suchas would be the case when a pooling ofinterests occurs or where an error is corrected,reconcile the amounts given withthose previously reported describing the reasonfor the difference.(3) Describe the effect of any disposals ofsegments of a business, and extraordinary,unusual or infrequently occurring items recognizedin each full quarter within the twomost recent fiscal years and any subsequentinterim period for which income statementsare presented, as well as the aggregate effectand the nature of year-end or other adjustmentswhich are material to the results ofthat quarter.

428 SECURITIES AND EXCHANGE COMMISSION(4) Where this note is part of financialstatements which are presented as audited,it may be designated "unaudited."* * * * *Article llA. Statement of Source and Applicationsof Funds.Rule i1A-01. Application of Article llA.This article sh~ll be applicable to state:ments of source and application of funds 'filedpursuant to requirements in registrationand reporting forms under the Securities Actof 1933 and the Securities Exchange Act of1934. .II. Rule 13a-13. Quarterly Reports on Form. 10-Q.(a), (b)(l), (c) and (d) (No change)(b)(2) (Deleted)(b)(3), (4) and (5) become (b)(2), (3) and (4),respectively.III. Rule 13a-15. Quarterly Reports of Cer­. tain Real Estate Companies on Form7-Q.(This rule is rescinded.) .IV. Rule 15d-13. Quarterly Reports on Form. 10-Q.·(a), (b)(l), (c) and (d) (No change)(b)(2) (Deleted)(b)(3), (4) and (5) become (b)(2), (3) and (4),respectively;V. Rule 15d-15. Quarterly Reports of CertainReal Estate Companies on Form7-Q.(This rule is rescinded.)VI. Form 7-Q. For Quarterly Reports ofCertain Real Estate Companies UnderSection 13 or 15(d) of the SecuritiesExchange Act of 1934.(This form is rescinded.)VII. Form 10-Q. For Quarterly Reports UnderSection 13 or 15(d) of the SecuritiesExchange Act of 1934 .. Instructions A through G (No change)H. Financial Statements(a) The registrant shall furnish an incomestatement, balance sheet and statement ofsource and application of funds for the periodsset forth in (b) below. These statementsshall follow the general form of presentationset forth in Regulation S-X with the followingexceptions:(1) Balance sheets and income statementsshall include only major captions (Le.,numbered captions) set forth in R:egulati.onS-X, with the exception of Inventories wheredata as to raw materials, work in process andfinished goods shall be included, if applicable.Where any major balance sheet captionis less than 10% of total assets, and theamount in the caption has not increased ordecreased bY.more than 25% since the previousbalance sheet 'presented, . the captionmay be combined with others. When. anymajor income statement caption is less than15% of average net income for the mostrecent three years and the amoun't in thecaption has not increased .or decrea~ed bymore than 20% as compared to the nextpreceding comparable income statement, thecaption may be combined with others. Incalculating average net income, loss yearsshould be excluded. If losses were incurred ineach of the most recent three years, theaverage loss shall be used f9r purposes ofthis test. Notwithstanding these tests, Rule3-02 of Regulation S-X applies and de minimU8amounts therefore need not be shownseparately~. (2) The statement of source and 'applicationof funds may be abbreviated, startingwith a single figure of funds provided byoperations and showing other sources andapplications individually only when they exceed10% of the average of funds provided byoperations for the most recent three years.Notwithstanding this test, Rule 3-02 of RegulationS-X applies and de minimu8 amountstherefore need not be shown separately.(3) Rules 3-08 and 3-16 of Regulation S-Xand other. requirements which call for de-'tailed footnote disclosure and schedules shallnot apply .. As with all information filed withthe Commission, however, disclosures mustbe adequate to make the information presentednot misleading. .A company in the promotional or developmentstage to which paragraph (b) of Ru~e5A-01 of Article 5A of Regulation S-X. 15applicable shall furnish the informatlo~specified in Rules 5A-02, 5A-03, 5A-04 bane5A-06 of Regulation S-X in lieu of the a OVfinancial statement requirements. ts(b) The condensed financial statem~nw·shall be provided for periods set forth be 0 .

ACCOUNTING SERIES REJ;.EASES 429(1) The condensed income statementshall be presented for the most recent fiscalquarter, for the period between the end ofthe last fiscal year and the end of the mostrecent fiscal quarter, and for correspondingperiods of the preceding fiscal year. It alsomay be presented for the cumulative twelvemonth period ended during the most recentfiscal quarter and for the corresponding periodof the preceding fiscal year.(2) The balance sheet shall be' presentedas of the end of the most recent ,fiscalquarter and for the end of the correspondingperiod of the preceding fiscal year. However,balance sheets for dates prior to December26, 1975, are not required.(3) The statement of source and applicationof funds shall be presented for the periodbetween the end of the last. fiscal yearand the end of the most recent fiscal quarter,and for'the corresponding period of the precedingfiscal year. It also may be presentedfor the cumulative twelve month periodended during the most recent fiscal quarterand for the corresponding period of the precedingfiscal year.(c) For registrants engaged in the seasonalproduction and the seasonal sale of a singlecropagricultural commodity, the incomestatement may be presented for the twelvemonths ended with the current interim quarter,with comparative data for the correspondingperiod of the preceding fiscal year inplace of the current quarter and year-to-dateInformation specified by (b)(1) above.-. (d) If, during the current period specifiedIn (b) above, the registrant or any of itsconsolidated subsidiaries, entered into abusiness combination treated for accountingPurposes as a pooling of interests the inte'. 'rIm fInancial statements for both the cur-~ent year and the preceding year shall rebec~ the combined results of the pooleds USInesses. Supplemental disclosure of thep:p~rate results of the combined entities forgi;lods prior to the combination' shall be(:)' with appropriate explanations.any .In .c~se the registrant has disposed ofany ~~~~flcan~ portion of its business duringeffect th e perIods covered by the report, the- ereof on revenues and net incometotaland per share-for all periods shall bedisclosed. In addition, where a material businesscombination accounted for as a purchasehas occurred during the current fiscalyear, pro forma disclosure shall be made ofthe results of operations for the current yearup to the date of the end of the most recentfiscal quarter (and for the comparable periodin the preceding year) as though the companieshad combined at, the beginning of theperiod being reported on. This pro formainformation should as a minimum show revenue,income before extraordinary items andthe cumulative effect of accounting changes,such, income on a per share basis and netincome.(f) The fin,ancial statements to be includedin this report shall be prepared in conformitywith the standards of accou'nting measurementset forth in Accounting PrinciplesBoard Opinion No. 28 and any amendmentsthereto adopted by th~ Financial AccountingStandards Board. In addition to meeting thereporting requirements for accountingchanges specified therein, the registrantshall state the date of any change and thereasons for making it. In addition, in thefirst Form 10-Q filed subsequent to the dateof an accounting change, a letter from theregistrant's independent accountants shallbe filed as an exhibit indicating whether ornot the change is to an alternative principlewhich in his judgment is preferable underthe circumstances; except that no letter fromthe accountant need be filed when thechange is made in response to a standardadopted by the Financial Accounting StandardsBoard which requires such change.(g) (Formerly paragraph k) If appropriate,the income statement shall show earningsper share and dividends per share applicableto common stock and the basis of the earningsper share computation shall be stated togetherwith the number of shares used in thecomputation. The registrant shall file as anexhibit a statement setting forth in reasonabledetail the computation of per share earnings,unless the computation is otherwiseclearly set forth in the report.(h) and (i) (No change)(j) (~eleted)

430 SECURITIES AND EXCHANGE COMMISSION(k) (Now becomes (g»1. Management's Analysis of Quarterly IncomeStatements.The registrant shall provide a narrativeanalysis of the results of operations explainingthe reasons for material changes in theamount of revenue and expense items betweenthe most recent quarter and thequarter immediately preceding it, betweenthe most recent quarter and the same calendarquarter in the preceding year, and, ifapplicable, between the current year to dateand the same calendar period in the precedingyear. Explanations of material changesshould include, but not be limited to, changesin the various elements which determinerevenue and expense levels such as unitsales volume, prices charged and paid, productionlevels, production cost variances, laborcosts and discretionary spending programs.In' addition, the analysis shouldinclude an explanation of the effect of anychanges in accounting principles and practicesoro-in the method of tl~eir applicationthat have a material effect on net income asreported.J. Other Financial Information.The registrant may furnish any additionalinformation related to the periods being reportedon which, i.n the opinion of management,is of significance to investors, such asthe seasonality of the company's busine'ss,major uncertainties currently facing thecompany, significant accounting changes underconsideration and the dollar amount ofbacklog of firm orders. In addition, the regis-, trant shall indicate whether any Form 8-Kwas required to be filed reporting any materialunusual charges or credits to incomeduring the most recently completed fiscalquarter or whether any Form 8-K was requiredto be filed during that period reportinga change in independent accountants.K. Review by Independent Public Accountant.The financial information included in thisform need not be reviewed prior to filing byan independent public accountant. If, however,a review of the data is made in accordancewith established professional standardsand procedures for such a review, the registrantmay state that the independent accountanthas performed such 'a review. Ifsuch a statement is made, the registrantshall indicate whether all adjustments or.additional disclosures proposed by the independentaccountant have been reflected inthe data presented, and, if not why not. Inaddition, a letter from the registrant's independentaccountant confirming or otherwisecommenting upon the registrant's rep~esentationsand making such other comments asthe independent accountant deems appropriatemay be included as an exhibit to theform.L. Filing of Other Statements in CertainCases. (Formerly Instruction I) (Nochange) .M. Sales of Unregistered Securities (Debtor Equity) (Formerly Part C)The information called for herein shall begiven as to each "security" as defined inSection 2(1) of the Securities Act of 1933.. Ifthe information called for has been p'reviouslyreported on another form, it 'may beincorporated by a specific reference to theprevious filing.Give the following information as to allsecurities of the registrant sold by the registrantduring the fiscal quarter, which :werenot registered under the Securities Act of1933, in reliance upon an exemption fromregistration provided by Section 4(2) of thatAct. Include sales of the registrant's reacquiredsecurities as well as new issues, securitiesissuedin exchange for property, servicesor other securities, and new securitiesresulting from the modification of outstandingsecurities:(1) Give the date of sale, and the titleand amount of the registrant's securitiessold;(2) Give the market price on the date ofsale, if applicable;(3) Give the names of the brokers, underwritersor finders, if any. As to any securitiessold but which were not the subject of./public offering, name the persons or ident~ ythe class of persons to whom the securitIeSwere sold;'t te(4) As to securities sold for cash, s agretheaggregate offering price and the ag fllgateunderwriting discounts, brokerage CO rimissions,or finder's fees. As to any secu

ACCOUNTING SERIES RELEASES 431ties sold otherwise than for cash, state thenature of the transaction and the nature andaggregate amount of consideration receivedby the .. registrant; .(5) Indicate the section of the Act or ruleof the Commission under which exemptionfrom registration was claimed, and statebriefly the facts relied upon to make theexemption available; and (6) State whetherthe securities have been legended and stoptransferinst~~tions given in connectiontherewith, and if not, stat~ the reasons whynot ..N. Signature and Filing of Report. (FormerlyInstruction J)Eight copies of the report. shall be filedwith the Commission. At least one copy ofthe report shall be filed with each exchangeon which any class of securities of the registrantis listed and registered. At least onecopy of the report filed with the Commissionand one copy filed with each such exchangeshall be manually signed on the registrant'sbehalf by a duly authorized officer of theregistrant and by the principal financ,ial officeror chief accounting officer of the registrant.Copies not manually signed shall beartyped or· printed signatures.A. Summarized Financial Information(Existing Part A 'deleted)B. Capitalization and Stockholders' Equity(EXisting Part B deleted)C. Sales of Unregistered Securitjes (Debt orEquity)(Part C becomes General Instruction M)SIGNATURES~ursuant to the requirements of the Securi­~es EXchange Act of 1934, the "registrant hasuly caused this report to be signed on itsbehalf by the undersigned thereunto dulyauthorized.Date ______ _Date ________ _(Registrant)(Signature)*(Signature)** Print name and title of the signing officer under hissignature.* * * * *These amendments are adopted pursuantto authority in Sections 6, 7, 8, 10 and 19(a) ofthe Securities Act of 1933; Sections 12, 13,15(d) and 23(a) of the Securities ExchangeAct of 1934; and Sections 5(b), 14 and 20(a) ofthe Public Utility Holding Company Act of1935.The amendments of Rule llA-Ol of RegulationS-X, Exchange Act Rules 13a-13, 13a-15,15d-13, 15d-15 and Forms 7-Q and 10-Q will beeffective for reports filed for periods beginningafter December 25, 1975, but in no eventshall comparative balance sheet data orsour~e and application of funds data be requiredfor interim periods beginning prior toDecember 25, 1975. Rules 2-02(e) and 3-16(t)of Regulation S-X shall be applicable to financialstatements for all fiscal periods beginningsubsequent to December 25, 1975,but in no event shall disclosure of quarterlydata be required for quarters beginningprior to that date.By the Commission.GEORGE A. FITZSIMMONSSecretary

432 SECURITIES AND EXCHANGE COMMISSIONRELEASE NO. ·178October 9, 1975SECURITIES ACT OF 1933Release No. 5625PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19203SECURITIES EXCHANGE ACT OF 1934Release No. 11721Notice of Adoption of Amendments to Regulation S-X with Respect to Accounting for Researchand Development CostsThe· purpose of these amendments is toconform the requirements pertaining to theaccounting and reporting for research anddevelopment costs in Regulation SoX, Formand Content of Financial Statements, andthe standards established by the FinancialAccounting Standards Board in Statement ofFinancial Accounting Standards No.2, Accountingfor Research· and DeelopmentCosts-, iri October 1974. Differences exist betweenthe requirements in Regulation SoXand FASB Statement No.2 in that StatementNo.2 specifies in summary that researchand development costs shall becharged to expenses as incurred" whereasvarious rules and items in Regulation S-Xrelate to the recordation and amortization ofdeferred research and development expenses.The Commission stated, in Accounting SeriesRelease No. 150, that the pronouncementsof the F ASB will be considered toconstitute substantial authoritative supportfor accounting and reporting procedures andpractices used in preparing financial statementsfiled with the Commission. In accordancewith this policy, the Commission issuedon November 21,1974, Securities Act ReleaseNo. 5541 (Securities Exchange Act ReleaseNo. 11109, Public Utility Holding CompanyAct Release No. 18667) which contained proposalsto amend the affected rules and itemsin Regulation S-X, including Caption 20 inRule 5-02, Schedule VII in Rule 5-04, Rule 12-08, and Items 3 and 8 in Rule 12-16, toeliminate the differences, and to add a newcaption in Rule 5-03 to provide for disclosurein the financial statements of the researchand development costs charged to expense asspecified in Statement No.2.Comments received from the public indicatedgeneral agreement with the proposedamendments. Minor technical changes whichwere' suggested- in the' ¢omments on the proposalsare reflected in these amendments.An instruction is added to the proposed newcaption ,in the incom~ statement (Caption 3Aof Rule 5-03) for research and developmentexpenses to permit the alternative of disclosingthe amount of such expenses in a note tothe financial statements. The interpretationand guideline in Accounting Series ReleaseNo. 141 which pertains to Item 8, Researchand development costs, under Rule 12-16 ofRegulation S-X, is rescinded inasmuch asItem 8 is rescinded and because a definitionof research and development is provided inF ASB Statement No. 2 that is consideredapplicable to that term where it appearselsewhere in Regulation S-X. A reference toresearch and development expense in Rule 3-16(0)(1) of Regulation S-X is deleted.The Commission hereby adopts (1) amendments-of Regulation S-X revising paragra p :(1) of Rule 3-16(0), Caption 20 of Rule 5-~,the title of Schedule VII of Rule 5-04, tietitle and instruction Nos. 1, 3 and 7. of ~~p~12-08, and Item 3 of Rule 12-16~ addIng 8 oftion 3A to Rule 5-03, and deletmg Ite~ Ac­Rule 12-16· and (2) an amendment ? dOngcounting S~ries Release No. 141 re~c~n 1 toan interpretation in Part A pertaIDI~gItem 8, Research and development cos 5,Rule 12-16 of Regulation S-X.in

ACCOUNTING SERIES RELEASES 433(The text of the amendments is omitted.) .The amendments are adopted pursuant toauthority in Sections 6, 7, 8, 10 and 19(a) ofthe ~ecurities Act of 1933; Section 12, 13,15(d) and 23(a) .• of the Securities ExchangeAct of 1934; and Sections 5(b), 14 and 20(a) ofthe Public Utility Holding Company Act of1935. The amendments are effective on November15, 1975, for financial statements forfiscal years beginning on or after January 1,1975.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 179ANovember 24, 1975SECURmES ACT OF 1933Release No. 562~ASECURITIES EXCHANGE ACT OF 1934Release No. 11 736AAmended Order Suspending Accountant from Appearance or Practice Before the Commission in. the Matter of Thomas R. Mathews. 1On October 31, 1974, an or.der was enteredby the Commission pursuant to' Rule2(e)(3)(i)(a)of the Rules of Practice temporarilysuspending respondent Thomas R. Mathews,a certified public accountant, fromappearing or practicing before the Commission.These proceedings were instituted pursuantto respondent's petition to lift thetemporary suspension. See Rule 2(e)(3)(ii) ofthe Rules of Practice.The Commission's order of October 31,1974, was based on the fact that in Securitiesand Exchange Commission v. Harold L.Fisher, et al., S.D. Ohio, Civil Action File No.8~76, respondent had previously consented,WIthout admitting or denying any of theallegations of the Commission's complaint, to~~e entry of an order permanently enjoiningSun f:~m violations of Section 17(a) of thet~CurItzes Act of 1933, and Section 10(b) ofIt e Securities Exchange Act of 1934 anda ~~e lOb-5 thereunder. The complaint in that('~r:on alleged that Harmony Loan Company~Y")' a small loan and con~umer fl-''0issue~ ~tober 15, 1975, the Qommission inadvertently1933 ReI e text of an order, designated Securities Act ofItelease ~se No. 5628, Securities Exchange Act of 1934179. l'h t o. 11736 and Accounting Series Release No.shoul" a border is hereby rescinded in its entirety and• \t e co 'dIII stant a llSI ered to have no force or effect. TheIllended order is issued in its stead.nance company incorporated in Kentucky,was the subject of a fraudulent schemewhereby control of the company was transferredin October 1971, and that in thistransaction the sellers received valuable corporateassets which the purchasers replacedon the books of the company with certaingrossly overvalued assets. The complaintfurther alleged that after the transfer ofcontrol, the company, in February 1972, beganselling a new issue of debentures to thepublic by' means of a prospectus filed withthe State of Kentucky which contained falseand misleading statements and omissions ofmaterial facts, and that over $110,000 wasobtained from investors before the KentuckySecurities Division suspended sales onMarch 13, 1972.The Commission's complaint alleged thatrespondent performed accounting services forHarmony and further alleged that in November1971 he was responsible for making certainentries on Harmony's books in order toconceal the method by which control of Harmonyhad been transferred. According to theCommission's complaint, these entries wereallegedly made with the knowledge and expectationthat they would be reflected in flnancLlIstatements prepared for the companywhich would be distributed to the investingpublic. The complaint also alleged that the

434 SECURITIES AND EXC.HANGE COMMISSIONentries concealed .the fact that as of Octoberai" i971, Harmony was insolvent. , , 'According to the Commission's compl~int,respondent was alleged,.to be responsible formaking the following' entries, which werereflected in financial statements preparedfor the company as of October 31, 1971:(1) The complaint alleged that certain revenuebonds, transferred to. ~armony wererecorded as "Marketable Securities" at theirface value of $341,000, when in act there wasno market for the bonds and their originalcost was only $132,000. The complaint alsoalleged that at the same time "appraisalsurplus" was falsely recorded on the books toreflect the difference between the cost of therevenue bonds and the valuation placedupon them as a current asset of Harmony.(2) The complaint also alleged that the intereston the bonds was recorded as an assetentitled "Accrued Interest Receivable-MarketableSecurities" despite the fact that intereston the bonds had been in default foralmost two years., ' .(3) The -complaint further ~ alleged that, iIiorder to inflate the value of Harmony's assets,treasury stock was 'improperly recordedon Harmony's books as an asset in theamount of $226,520, and that the recordationof treasury stock as an asset under suchcircumstances was not in accord with generallyaccepted accounting principles. See, e.g.,Rule 3-14 of Regulation S-X.The Commission believes the effect of theforegoing entries was to conceal the lootingof valuable corporate assets from Harmony.The financial statements of October 31, 1971were included in a prospectus filed with theState of Kentucky. In that prospectus, theseunaudited financial statements were referredto as having been prepared by respondent'sfirm. As noted above, in Februaryand March 1972, Harmony began selling anew issue of its debentures to the public bymeans of this prospectus.It appears to the Commission that due tohis prior association with Harmony, respondentknew that Harmony had on several occasionsobtained money from the public by saleof its securities and would continue to do soand that in the offer and sale of such securities,prospectuses would be used which containedfinancial statements. reflecting his entrieson the boo~s 9f the company. TheCommission is o( the opinion that, in thesecircumstances, respondent would be responsiblefor such violatIons of the antifraudprvisions of the federal securities laws asmay be proven to result from such entries. 2Since these proceedings were instituted,respondent, solely for the purpose of settlingthis matter, and without admitting or denyingany of the allegations of the Commission's'complaint, or the statements herein,submitted an offer of settlement consentingto the order set forth below, which the Commissionhas determined to accept. Such consentis given on the understanding that theorder is not and shall not be evidence of anyviolation of or compliance with any statuteor law, or an admission or denial of thewrongdoing or liability by respondent in any2 T'he financial stateIlJents prepared for Harmonywere unaudited. A,ccotding to the American Institute ofCertified Public Accountants' Committee on AuditingProcedure Statement on Auditing Standards, §516.01, (see prior Statement of Auditing Procedure No. 38):"This type of an engagement is an accounting serviceas distinguished from an examination of financial statementsin accordance with generally accepted auditingstandards. *** [T]he [unaudited fmancial] statementsare representations of management, and the fairness oftheir representation is management's responsibility."However, the Commission believes an accountant is, not excused from compliance with generally acceptedaccounting principles merely because he does not expressan opinion with respect to representations containedin financial statements. The Commission furtherbelieves §516.03 of Statement of Auditing Standards,supra, makes it clear that the Certified Public Accountantis "associated with" unaudited financial statementsin a situation such as this, and that in such cases,§516.04 requires the practitioner to disclaim an opinio?on such financial statements with which he is aSSOCIated.See also, Opinion No. 8 of the Committee on Pr~fesdsional Ethics of the American Institute of CertlfiePublic Accountants (entitled: "Denial of the opini~nDoes not Discharge Responsibility in All Cases"). nthat Opinion, the Committee stated: . s the"In a circumstance where a member beheve I, . I d' as a whO efinancial statements are false or mls ea m~ . f theor in any significant r!,!spect, i~ is tl1,e OpID10n ~f thecommittee that he should reqUire adjustments asethe Cpaccounts or adequate disclosure of the facts, as tantmay be, and failing this the independent a.cco~n withshould refuse to permit his name to be aSSOCiatethe statements in any way."

ACCOUNTING SERIES RELEASES 435action now or hereafter pending against respondentor any other person. On the basis ofrespondent's offer of settlement, it isORDERED that Thomas R. Mathews be,and he hereby is, suspended from appearingor practicing before the Commission;and it is furtherORDERED that on and after October 30,1977, Mathews shall have the right to applyfor reinstatement of his privilege toappear and practice, and any such applicationshall be granted if supported by ashowing that:(A) Mathews has enrolled in and attendeda total of 100 or more hours of professionalseminars or college courses dealing with theregistration and disclosure requirements ofthe federal securities laws and generally acceptedaccounting principles and auditingstandards during the period of his suspension;and(B) Nothing has occurred during the suspensionperiod that would be a basis foradverse action against Mathews under.Rule2(e).By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 180November 4, 1975SECURITIES ACT OF 1933Release No. 5640PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19235SECURITIES EXCHANGE ACT OF 1934Release No. 11790Notice of the Institution of a Series of Staff Accounting BulletinsThe Securities and Exchange Commissiontoday announced the institution of a series ofStaff Accounting Bulletins intended toachieve a wider dissemination of the admini~trativeinterpretations and practices uti­~zed ~y the Commission's staff in reviewingr n~nclal. statements. The Division of Corpo­;t lon Fmance and the Office of the Chiefcco.untant began the series today with therU~Ication of Bulletin No.1 (S.A.B. ReI. No.BUllov.ember 4, 1975). The statements in thethe ~~n a~e .not rules or interpretations ofbea' mmiSslOn nor are they published asthe rIng the Commission's official approval;fOll~ represent interpretations and practicesCOUntWed by theD'IVlSIon. .and the Chle. fAcantin adQUirern mIDIS.. termg.the dIsclosure.reentsof the federal securities laws.Description of SeriesThe process of financial reporting is dynamicand evolutionary. Consequently, newor revised administrative interpretationsand practices must be implemented in responseto changes in the reporting process.While large accounting firms who practicebefore the Commission have many opportunitiesto exchange information and views withthe staff, the Commission has been concernedabout comments that small accountingfirms have fewer such opportunities andmay be at an unfair competitive disadvantagebecause there has been no formal disseminationof staff positions.The announced series of bulletins attemptsto curtail these problems by making avail-

436 SEClJRITIES AND EXCHANGE COMMISSIONable to tl1e public a ,compilation of certainexisting st~f( interpretations and practicesand by providing a means by which new orrevised interpretations and practices can bequickly· and easily cC)mmunicated to· registrantsand their advisors. Thus, this seriesshould not only reduce the staff's workloadby eliminating repetitive comments and inquiries,but 8:1so save registrants both timeand mo~ey in the registration and reportingprocess.It is anticipated that the bulletins will beprepared for publication from time to timeand will be collated periodically, but notmore frequently than on a quarterly basis.The new bulletins would keep the series currentby stating staff positions on specific newproblems that may be of general interest andon matters which are arising frequently inletters of comment. Each bulletin would contain. material organized according to th~broad topics specified in Staff Acco~ntingBulletin No.1. New topics maybe added··toaccom-niodiite material not readily assoCiatedwfth existing t(jpics~Two indices have been provided. to assistregistrants in ascertaining information rele~\rant to their particular· needs. The first indexpresents a comprehensive listing of allsubject m~tters discussed. in the bulletins.The second index lists the published rules,regulations, forms, releases and opinionsspecifically' cited in the bulletins .. These indicesshould facilitate (a) the use of the bulletinsby. registrants and their . professionaladVisors and (b) the periodic revision andupdating of the bulletins n~cessit~ted by theevolutionary process discussed above.All interested persons are invited to submittheir views and comments oil the administrationof these interpretations and practicesto Howard P. Hodges, ChiefAccountant, Division of Corporation Finance,and on the policies reflected thereinto John C. Bu~ton, Chief Accountant of theCommission.By th¢ .Commission.GEORGE A. FITZSIMMONS· .SecretaryRELEASE NO. 181November 10, 1975SECURITIES ACT OF 1933Release No. 5642SECURITIES EXCHANGE ACT OF 1934Release No. 11817Notice of Amendments of Regulation S-X and of Certain Filing Forms with Respect to FinancialReporting Requirements for Companies in the Development Stage .The Commission hereby amends Article 5Aand certain rules of Regulation S-X whichspecifies the requirements for the form aridcontent of the financial statements andschedules to be included in registrationstatements and periodic reports filed withthe· Commission by certairi commercial, industrialand mining companies in the promotional,exploratory or other stages of development;amends instructions in variousregistration and reporting forms regardingthe applicability of Article 5A requirementsto the financial statements to be included inthose forms filed by the development stagecompanies; and amends other references toArticle 5A iri forms and rules.Article 5A, prior· to these amendments,contained specialized requirements for thefinancial statements of development stag~companies meeting specified standards, a~they differed in several significant respe~ ~from the requirements for financial stt:_rments in Regulation S-X which are apP p_ble to companies which are not in a de~ ~tsment stage, particularly for balance s e t teandincome statements (Article t,), s a

ACCOUNTING SERIES RELEASES 437ments' of other stockholders' equity (Article11), and statements of Source and applic.ationof funds (Article 11A). Whim these specia1-ized require'ments for the form and contentof the financial statements of certain compa:nies in the development stage were adoptedby the Commission, there were no authoritativestatements of the accounting professionregarding the' appropriate accounting andfinancial reporting directly applicable tosuch companies. ' "In June 1975 the Financial AccountingStandards Board issued Statement of Fin~ncialAccounting Standards No.7, "Accountingand Reporting by Development StageEnterprises," which specifies in summarythat financial statements issued by a developmentstage enterprise shall conform togenerally accepted accounting principles applicableto established operating enterprises,and that certain additional information shallbe disclosed in the financial stateritents. ThisF ASB Statement relates to ali of the types ofcompanies to which Article 5A and the relatedrules in Regulation S-X were applicable,as well as to other development stagecompanies which did not meet the standardsfor utilization of the Article 5A requirements.The Commission stated, in Accounting SeriesRelease No. 150, that the pronouncementsof the F ASB will be consfdered toconstitute substantial authorij;ative supportfor accounting and reporting procedures andpractices used in preparing financial statementsfiled with the Commission. Therefore,the Commission considered that it shouldrevise its requirements for the presentationof financial statements by developments~age companies in filings with the Commis­~~on to conform them to the requirements ine F ASB Statement. Proposed amendmentsWere is d .1975' sue for publIc comment on July 31,rn lU Securities Act Release No. 5601. Comw~~t~;eceivedindicated general a~eementWeI' e proposals. Minor technical changesthe e Suggested which have been effected inIn a~endments.'~ionS~~ ~men~ments, Article 5A in RegulalZedf' IS reVIsed to eliminate the speciallUanc'laIstatement requirements for allcompanies 'to which :A.rti~~e 5A wis _a.p~~ic~~ble and to prescribe additional ihfor~~t,itm,as specified in F ASB StateInEmt' No. 7, t~ beincluded in financial statements in registrationstatements and periodic reports filed byall companies in the development stag~. Allother rules and instructions in Regulation, S,.X ,relating to the prior Art'ic~e 5A 'r~qu,ire'~'ments are also eliminated. The instructio'nsas to financial statements applicable to thedevelopment stage companies in FormsS-2,8-3, I-A, 10 and 10-K are amended to conformthe requirements for the form and content offinancial statements applicable to those prescribedfor established operating companiesin Article 5, 11, and 11A of Regulation S-X torequire the additional financial informationspeclfied in revised Article 5A. General InstructionH(a) in Form 10-Q and Rules 13a-13and 15d-13 under the Exchange Act whichcontained references to Article 5A are revised.The exemption in Form 10-K from the requirementsfor audit€:d' financial statementsfor development stage companies qnder certain'conditions, which was proposed to berescinded, has been retained. However, thatexemption' and the exemption from requirementsto file quarterly reports on Form 10-Qprovided for certain mining companies in thedevelopment stage in Rule 13a-13 and 15d-13wiil be restudied to determine whether suchexemptions continue to be appropriate.Form S-1 is the general form used forregistration of securities under the SecuritiesAct; For~ S-2, is used by commercial an,dindustrial companies in the developmentstage and Form S-3 is' used by mining companiesin the development stage for registrationof equity securities for sale for cllsh underthe Securities Act; 'Form' I-A is used forfiling the notification and offering circularfor securities pursuant to Regulation A underthe Securities Act; Form 10 is the generalform used for registration of securitiesunder the Exchange Act; Form 10-K is usedfor annual reports and Form 10-Q is used forquarterly reports pursuant to the ExchangeAct.(The text of the amendments of Article 5Aand Rules 12-01, 12-06, 12-06A and 12-07 of

438 SECURITIES AND EXCHANGE COMMISSIONRegulation S-X, of Forms S-2, S-3, 1-A, 10and 10-K, and of Exchange Act Rules 13a-13and 15d-13 is omitted.)The amendments are adopted pursuant toauthority in Sections 6, 7, 8, 10 and 19(a) ofthe Securities Act of 1933; and Sections 12,13, 15(d) and 23(a) of the Securities ExchangeAct of 1934.The amendments are effective for fiscalperiods beginning on or after December 26,1975. When financial statements, or financialsummaries or other data derived therefrom,for periods prior to·. the effective date areincluded with such financial statements ordata for periods after the effective date infilings with the Commission, they shall be. resta~ed, where necessary, to conform to theamended requirements for financial statementsof development stage companies.By the Commission.GEORGE A. FITZSIMMONSSecretarySECURITIES EXCHANGE ACT OF 1934Release No.. 11821RELEASE NO. 182November 12, 1975No.tice o.f Permanent Disqualificatio.n fro.m Appearance or Practice Before the Comrttission in the., Matter of Charles H. Southerland "On June 24, 1975, the Commission enteredan order, pursuant to Rule 2(e)(3)(i) of itsRules of Practice, temporarily suspendingCharles H. Southerland, a certified publicaccountant, from appearing or practicing beforethe Commission. The order was based onthe fact that on April 23, 1975, Southerlandwas permanently enjoined by the UnitedStates District Court for the Northern Districtof Texas, Dallas Division, in a suitbrought by the Commission,l from violatingSection 17(a) of the Securities Act, Section10(b) of the Securities Exchange Act, andRule 10b-5 thereunder. Southerland consentedto the injunction without admittingor denying the allegations in the Commission'scomplaint.The complaint in the injunctive action allegedthat Southerland violated the aboveprovisions of the federal securities laws, inthat he prepared a certified financial state-I S.E.C, v. Sports International, Inc., et al. (N.D. Tex.,Dal. Div., Civ. Action No. 3-75-0371-C).ment for Sports International, Inc. which containedfalse ana misleading in~ormation.Rule 2(e)(3)(ii) of the Commission's Rules ofPractice provides that any person temporarilysuspended in accordance with paragraph(i) may, within 30 days after service uponhim of the order of temporary ~uspension,petition the Commission to lift such suspen~sion, but that if no petition has been receivedby the Commission withiil'30 days after suchservice, the suspension shall become permanent.Southerland was duly notified of thisprovision. The 30 day period has expired andno petition to lift the suspension has beenreceived by the Commission.Accordingly, notice is hereby given th~tthe temporary suspension of Charles tSoutherland has become permanent and thaSoutherland is therefore disqualified fr~rnappearing or practicing before the CommISsion.GEORGE A. FITZSIMMONS, Secretary

ACCOUNTING SERIES RELEASES 439RELEASE NO. 183November 14, 1975SECURITIES ACT OF 1933Release No. 5644SECURITIES EXCHANGE ACT OF 1934Release No. 11827PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19243INVESTMENT COMPANY.ACT OF 1940Release No. 9031Notice of Adoption of Revision of Regulation S-X to Revise Requirements as to Form and Contentof Financial Statements of Insurance Companies Other Than Life and Title Insurance CompaniesThe Securities and Exchange Commissiontoday adopted a general revision of Article 7of Regulation S-X which contains .requirementsas to form and content' of financialstatements for insurallce ~ompanie~· otherthan li(e and title ,companies. The revisionreflects changes in financial reporting bythese companies since 1961 when Article 7was last revised. In addition to revising Article7, the schedule prescribed by Rule 12-29 isrevised and the schedules' prescribed byRules 12-17, 12-23, 12-24,·12-25, 12-26, 12-28and 12-30 are revoked. The revision was proposedon July 11, 1974, 1 and letters of commenthave'been received and have beengiven consideration in determining the formof the revision herein adopted.The most significant change adopted is arequirement that' the . statements be preparedin accordance with generally acc~ptedaccounting principles (GAAP).. (7-02-1). Thisreplaces the existing requirement of Article 7that the financials· follow statutory accountingrequ.irements and that they be accompaniedby supplemental statements reconCilingnet income and stockholder'sequity on the GAAP and statutory bases. In:ecent years we have observed that a major­Ity of the financial statements of fire and~asualty insurance companies included in fil­~ngs and annual reports to stockholders were---repared on the GAAP basis as against theI Notice f thSeCUliti 0 e proposed amendments was made inA.ct ReI es Act Release No. 5513, Securities ExchangeAct Re~ase No. 10912, Public Utility Holding CompanyRelease e;se No. 18490 and Investment Company Acto. 8422 (87-528) dated July 11, 1974.r~quired statutory statements with supplementalreconciliations. The adoption of therequirements for GAAP statements reflectsthis development in reporting practices.'. Statutory accounting requirements may befollowed by those companies domiciled instatel'J whos~ statutes prohibit publication ofan insuror's primary financial statements onanother basis; however, in such situationsthe statutory.statements shall be accompanieqby supplemental QAAP statements (7-02-2). Whether th~ basic statements are preparedon the GAAP or. statutory basis, theymust be accompanied by supplemental reconciliationsof in~terial differences betweenGAAP and statutory accounting (7-02-3).Inasmuch as Regulation S-X has for manyyea:r;-s classified title iI:1surance companieswith commercial and industrial companieswith an i~plicit requirement that. their financialstatements be prepared in accordancewith ,GAAP, it appears to be inappropriateat this time to make them subject tothe requirements of Article 7. The provisionthat these companies shall comply with Article5 will be· retained (7-01).The revised article permits mutual insurancecompanies and wholly owned stock subsidiarie.sof mutual insurance companies toprepare financial statements in accordancewith statutory accounting requirements (7-02-4). However, these companies are encouragedto prepare their filings in accordancewith GAAP if they desire and to includethem in filings.Consistent with the requirements for lifeinsurance companies in Article 7 A, investmentsof fire and casualty companies may bestated on the balance sheet at cost or value

440 SECURITIES AND EXCHANGE COMMISSIONprovided that the .alternates to the amountsat, which bonds and stocks are stated aredisclosed parenthetically (7-03-1). Realizedprofits. or losses on investments are to beincluded as a component of net income (7-04-13), 2 while appreciation or depreciation ofinvestments carried on the balance sheet atvalue is reflected, in a stockholders' equityaccount (7-03-20(3». This presentation is notviewed as a final resolution of the accountingand reporting problems associated with investmentsbut rather as a temporary solutionwhich provides for similar treatment bylife and fire and casualty insurance companies.Many of the insurance company groupsand holding company groups filing with theCommission include both life and fire andcasualty subsidiaries. In connection with thereporting of realized investment profits orlosses on the income statement, the changein value of marketable equity securities duringthe period. is to be disclosed parentheticallyor on a line immediately following theincome' statement. ,(See Accounting" Series'Release No. 166.) An adoitioifal requirementin a note calls for an analysis of realized and .unrealized gains and losses on· bonds andstocks (7-05-3). This analysis is required regardlessof whether bonds and stock arestated at cost or value on the balance sheet.Prior to its dissolution' the AccountingPrinciples Board considered the problems relatedto accounting for marketable securitiesbut was unable to reach conclusions as toappropriate treatment. While the matter isnot presently on the agenda of the FinancialAccounting Standard Board, 3 it is one whichwill have to be addressed in due course. Atsuch time as new accounting principles areprescribed, the Commission will considerwhat changes are necessary in its requirementsfor insurance company and other financialstatements., The revised requirements are substantiallysimilar to those proposed in July 1974.2 Under statutory accounting requirements for fireand casualty insurance companies such profits or lossesare included in net income. GAAP as applied generallywould include such profits' or losses in net income."The Board's exposure draft on marketable equitysecurities deals only with a limited part of this problem.Wherever' appropriate, captions and, instructionsconform with corresponding· ones inArticle 5 which applies to commercial andindustrial companies or in Article 7A. Theorder of the items of the financial statementsis generally similar to the order of items inour life insurance company requirements.The following are' a number of additionalrequirements which are specific in nature:1. To the extent that they are pertinent,the general rules in Articles 1, 2~ 3 and4 of Regulation S-X are applicable (7-02-1).2. In preparing consolidated' financialstatements for an insurance holdingcompany whose consolidated subsidiariesare primarily insurance companiesother than life insurance companiesconsideration shall be given toutilization of the format of the finan-. cial statements, notes and schedules inArticle 7 (7~Ol).3. 1\. . statement of accounting. principlesand practices· reflected in the statements(7-05-1).. 4. The name of any person in which theinvestment exceeds two percent of totalinvestments (7-03-1(6».5. Information as to policy, nature andchanges in deferred policy acquisitioncosts (7-03-S, 7-04-5, 7-05-1 and 12-29).6. Elimination of details of sources of in~vestment income from the incomestatement. Such information would bestated separately in a note (7-04-2).7. Details of restrictions on stockholders'equity (7-05-2).S. Information concerning the signifi~cance of reinsurance ceded (7-05-4).9. Rule 12-29, a schedule which is con~cerned with premiums, losses and pol~icy acquisition costs, has been exten~sively revised.10. The' summary of investments containedin Rule 12-27 is made applicableto insurance companies covered by Ar~ticle 7.t11. The detailed schedules of investmen Swhich have been the subject of R~le:12-23, 12~24, 12~25 and 12~26 are ehm ~nated.

ACCOUNTING SERIES RELEASES. 44112. The schedule requirement for a summaryof realized gains or losses on saleor maturity of investments is elimi­. nated (12-30).13. In view ot: the application of the schedulerequired by Rule 12-04 concerninginvestments in and earnings of affiliates,the similar schedule required byRule 12-17 is no longer necessary andis eliminated.These amendments are adopted pursuantto authority conferred on tl1e Securities andExchange Commission by the Securities Actof 1933, particularly Sections 6, 7, 8, 10 and19(a) thereof; the Securities Exchange Act of1934, particularly Sections 12, 13, 15(d) and23(a) thereof; the Public Utility HoldingCompany Act of 1935, particularly Sections5(b), 14 and 20(a) thereof; and the InvestmentCompany Act of 1940, particularly Sections8, 30, 31(c) and 38(a) thereof.(The text of the amendments is omitted.)These amendments shall be effective withrespect to financial statements filed afterDecember 25, 1975, although they may beapplied in statements filed prior to that time.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 184November 26, 1975SECURITIES ACT OF 1933Release No. 5648SECURITIES EXCHANGE ACT OF 1934Release No. 11878PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19267INVESTMENT COMPANY ACT OF 1940Release No. 9057Minor Amendments to Sections of Regulation S-X Which Were Originally Revised by AccountingSeries Release Nos. 147, 148 and 149I. IntroductionSince the issuance of Accounting SeriesRelease (ASR) No. 147 (October 5, 1973) reqUiringadditional disclosure about leases,~SR No. 148 (November 13, 1973) regardingdIsclosure of compensating balances andshort-term borrowing arrangements, and~SR No. 149 (November 28, 1973) setting.orth improved disclosure requirements forIn~ome tax expense items, registrants havePOInted out certain editorial inconsistencies~~Xambiguities in the associated Regulational rule changes and guidelines. Registrants14~o noted th~t a materiality test in ASR No.atn results In disclosure of de minimusareOunts and that ASR No. 148 disclosuresnies not required for several types of compa­Regulco:,ered by separate rule sections inatlon S-X.On May 27, 1975, rule changes were proposedto correct such items as well as makingan editorial change in one of the ASR No. 148guidelines (Securities Act ReI. No. 5587, SecuritiesExchange Act ReI. No. 11442, PublicUtility Holding Company Act ReI. No. 19005,Investment Company Act ReI. No. 8801).Based on letters of comment some modificationsof the proposals have been made asnoted below. None of the modifications constitutesubstantive changes from those originallyproposed.II. Discussion of the AmendmentsMost of the amendments constitute minoreditorial changes of existing requirements.However, the following amendments constitutechanges in the substance of such requirements.

442 SECURITIES AND EXCHANGE COMMISSIONA. Rule 3-16(0)(1) has been amended toavoid disclosure of immaterial componentsof deferred tax expense. Changesmade to the proposal based on the lettersof comment will now meet thisobjective. Also, Rule 3-16(0)(3) has beenamended to call specifically for reconciliationsin loss situations. Mosi registrantshave been providing such reconciliationsbut the amendment nowresolves any ambiguity about this issue.B. Proposed changes in Rule 3-16(q)(2)have been modified to eliminate therequirement to disclose mInImUmrental commitments for more than thedate of latest balance sheet required.C. The last sentence of Rule 5-02-1 hasbeen amended to eliminate the unintendedrequirement for separate disclosureof a compensating balance relatedto an unused portion of a regularline of credit when a total compensatingbalance amount, covering bothused and unused lines of credit, is presented.D. Rule 5-02-25 has been amended to. requireseparate disclosure of borrowingsfrom factors and other financialinstitutions in. addition to banks andcommercial paper' holders as presentlyrequired. Combined information about. short-term borrowing rates frombanks, factors or other financial institutions,and commercial paper holdingswill now be required.E. Article 6 (Management InvestmentCompanies), Article 6B (Face AmountCertificate Investment Companies),and Article 7 A (Life Insurance Companies)of Regulation S-X have beenamended to include many of the disclosuresnow required by ASR No. 148 forother types of companies. Rules 6-03-1and 6-22-1 have been modified to includespecific reference to time depositsas part of cash on hand and demanddeposits. Although the Commission is. concerned about ~he classification ofsuch items for purposes of meeting therequirements of a "diversified company"under Section 5(b)(1) of the InvestmentCompany Act of 1940, it hasdetermined not to conclude on thismatter at this time.F. The guidelines and interpretations sectionof ASR No. 148 contains a paragraphdealing with criteria for classifyingshort-term debt which is intendedto be rolled over at maturity. Since theissuance of ASR No. 148, the FinancialAccounting Standards Board issuedStatement of Fina~cial AccountingStandards No. 6 ("Classification ofShort-term Obligations Expected to BeRefinanced," May 1975) which establishedstandards in this area. Accordingly,this paragraph was rescinded.(ASR No. 172, June 13, 1975.)G. As noted above, Article 6, Article 6Band Article 7 A have been amended toinclude for other types of companiesmany of the disclosures now requiredby ASR No. 148 for Article 5 companies.The Guidelines and Interpretationsset forth 'in Section C of ASR No.148 are now applicable to companiescovered by Articles 6, 6B and 7 A ofRegulation S-X to the extent thatequivalent rules have been amended,insuch Articles.III. Amendments to RegUlation S-X andModifications of ASR No. 148 GuidelinesRules 3-16(0), 3-16(q), 5-02-1, 5-02-18, 5-02-25, 6-03-11, 6-03-12, 6-03-16, 6-22-1, 6-22-15, 6-22-17 , 6-22-19 , 6-22-21 , 7A-03-2 , 7 A-03-8 and7 A-03-17 are amended as follows:* * * * *Rule 3-16(0). Income tax expense.(1) Disclosure shall be made, in the incomestatement or a note thereto, of the comp~nentsof income tax expense, including (1)taxes currently payable; (ii) the net tax effects,as applIcable, " . f ( ) t"" d"fferences0 aImIng 1 esti-(Indicate.separately the amount of"thetypesmated tax effect of each of the varIous" "h d reclatlon,of timing differences, suc as ep t ofwarranty.costs, etc", wheretheatmounofeach such tax effect excee d s f lve " percen " thethe amount computed by multiplyxngtatu_income before tax by the applicable s

ACCOUNTING SERIES RELEASES 443tory, Federal income tax rate; other differencesmay be combined.) and (b) operatinglosses; and (iii) the net deferred investmenttax credits. Amounts applicable to UnitedStates Federal ,income taxes, to foreign incometaxes and to other income taxes shallbe stated separately for each major component.Amounts applicable to foreign or otherincome tax'es each of which is less than fivepercent of the total of the major componentneed not be separately disclosed.(2) If it is expected that the cash outlay forincome taxes with respect to any of the succeedingthree years will substantially exceedincome tax expense for such year, that factshould be disclosed together with the approximateamount of the excess, the year (oryears) of occurr~nce and the reasons therefor.(3) Provide a reconciliation between theamount of reported total income tax expense(benefit) and the amount computed by multiplyingthe income (loss) before tax by theapplicable statutory Federal income taxrate, showing the estimated dollar amount ofeach of the unde.rlying causes for the difference.If no individual reconciling itemamounts to more than five percent of theamount computed by multiplying the incomebefore tax by the applicable statutory Federalincome tax rate, and the total differenceto be reconciled is less than five percent ofsuch computed amount, no reconciliationneed be provided unless it would be significantin appraising the trend of earnings.ReconCiling items that are individually lessthan five percent of the computed amountmay be aggregated in the reconciliation. Therecon CI '1' la t' Ion may be presented in percent-~es rather than in dollar amounts. Wherein:o;:porting person is a foreign entity, thedo . ~ tax rate in that person's country ofth mlcIle should normally be used in makingsh:u~~ove computation, but different ratessegm not be used for subsidiaries or otherrate ents of a reporting entity. When thethe U Used 't by a repo rt' mg person .IS other thantax 1lI ed States Federal corporate incomeUSingrate, htherate used and the basis' forSUc rate shall be disclosed.* * * * *Rule 3-16(q). Leased assets and lease commitments.. Any contractual arrangement which hasthe economic characteristics of a lease suchas a "h ea t supply contract" for nuclear ' fuelshall be considered a lease for purposes ofthis rule. Leases covering oil and gas productionrights and mineral and timber rightsare not to be considered leases for purposesof this rule. For purposes of this rule afinancing lease is defined as a lease whichduring the noncancelable lease period eithe;(i) covers 75 percent or more of the ec~nomiclife of the property or (ii) has terms whichassure the lessor a full recovery of the fairmarket value (which would norm all be representedby his investment) of the property atthe inception of the lease plus a reasonablereturn on the use of the assets investedsubject only to limited risk in the realizationof the residual interest in the property andthe credit risk generally associated with securedloans. The disclosures set forth undersections (1) and (2) below are only required ifgross rental expense in the most recent fiscalyear exceeds one percent of consolidated revenues.(1) Total rental expense (reduced by rentalsfrom subleases, with disclosure of suchamounts) entering into the determinationof results of operations for each periodfor which an income statement isrequired shall be disclosed. Rental paymentsunder' short-term leases for amonth or less which are not expected tobe renewed need not be included. Contingentrentals, such as those· based uponusage or sales shall be reported separatelyfrom the basic or minimum rentals.Rentals on noncapitalized financingleases shall be shown separately for bothcategories of rentals reported.(2) The minimum rental commitments underall noncancelable leases shall be disclosed,as of the date of the latest balancesheet required, in the aggregate (withdisclosure of the amounts applicable tononcapitalized financing leases) for (i)each of the five succeeding fiscal years;(ii) each of the next three five-year periods;and (iii) the remainder as a single

444 SECURITIES AND EXCHANGE COMMISSIONamount. The amounts so determinedshould be reduced by rentals to be receivedfrom existing noncancelable subleases(with disclosure of the amounts ofsuch rentals). For purposes of this rule, anoncancelable lease is defined as one thathas an initial or remaining term of morethan one year and is noncancelable, or iscancelable only upon the occurrence ofsome remote contingency or upon thepayment of a substantial penalty.(3) (No change.)(4) For all noncapitalized financing leasesthere shall be disclosed:(i) The present values ,of the minimumlease commitments in the aggregate andby major categories of properties, such asreal estate, aircraft, truck fleets and.other equipment. Present values shall becomputed by discounting net lease payments(after subtracting, if practicable,estimated, or actual amounts, if any, appiicableto taxes, insurance, maintenance. and other operating expenses) at the interestrate implicit in the terms of eachlease at the time of entering into thelease. Such disclosure shall be made as ofthe date of any balance sheet required. Ifthe present value of the minimum leasecommitments is less than five percent ofthe sum of long-term debt, stockholders'equity and the present value of the minimumlease commitments, and if the impacton net income required to be disclosedunder (iv) below is less than threepercent of the average net income for themost recent three years, this disclosure isnot required;(ii) (No change.)(iii) (No change.)(iv) The impact upon net income for eachperiod for which an income statement isrequired if all noncapitalized financingleases were capitalized, related assetswere amortized on a straight-line basisand interest cost was accrued on the basisof the outstanding lease liability. Theamount of amortization and interest costincluded in the computation shall be separatelyidentified. If the impact on. netincome is less than three percent of theaverage net income for the most recentthree years, that fact may be stated inlieu of this disclosure. In calculating averagenet income, loss years should beexcluded. If losses were incurred in eachof the most recent three years, the averageloss shall be used for purposes of thistest.* * * * *Rule 5-02-1. Cash and cash items.State separately (a) cash on hand and unrestricteddemand deposits; (b) legally restricteddeposits held as compensating balancesagainst short-term borrowingarrangements; (c) time deposits and certificatesof deposit (excluding amounts includedin (b) above or Rule 5-02-18(c) below); (d)funds subject to repayment on call or immediatelyafter the date of the balance sheetrequired to be filed; and (e) other funds, theamouilts of which are known to be subject towithdrawal or usage restrictions, e.g., specialpurpose funds: The . general terms and natureof such repayment provisions in (d) andwithdrawal or usage restrictions in (b) or (e)shall be described in a note referred toherein. In cases'where compensating balancearrangements exist but are not agreementswhich legally restrict the use of cashamounts shown on the' balance sheet, describein the notes to the financial statementsthese arrangements and the amountsinvolved, if determinable, for the most recentaudited balance sheet required and for anysubsequent unaudited balance sheet requiredin the notes to the financial statements.Compensating balances that aremaintained under an agreement to assu: efuture credit availability shall be disclosed IIIthe notes to the financial statements alongwith the amount and terms of such agreement.* * * * *Rule 5-02-18. Other assets.t receiva-State separately (a) noncurre~ )(1)bles from persons specified in captIOns 3(a _. ther speand (4) above; (b) each pe~SIOn or 0 . s heldcial fund; (c) legally restrIcted depoSIt t rillas compensating balances against long~t~erborrowing arrangements; and (d) anh pr e-item not properly classed in one of t e

ACCOUNTING SERIES RELEASES 445ceding asset captions which is in excess offive percent of total assets.Rule 5-r02-25. Accounts and :"'otes payable.(a) State separately amounts payable to(1) banks for borrowings; (2) factors or otherfinancial institutions for borrowings; (3)holders of commercial paper; (4) trade creditors;(5) parents and subsidiaries; (6) otheraffiliates and other persons the investmentsin which are accounted for by the equitymethod; (7) underwriters, promoters, directors,officers, employees and prindpal holders(other than affiliates) of equity securitiesof the person and its' affiliates; and (8) others.Exclude from (7) amounts for purchasesfrom such person. subject to usual tradeterms, forordi~ary travel expenses and forother . such items arising in the ordinarycourse of business. With respect to (5) and (6),state separately in the registrant's l;>alancesheet the amounts which in. the related consolidatedbalance sheet are (i) eliminated and. (ii) not eliminated.(b) The weighted average interest rateand general terms (as well as formal provisionsfor the extension of the maturity) ofeach category of aggregate short-term borrowings(the sum of items (a)(l), (3.)(2) and(a)(3) above) reflected on each balance sheetrequired shan be' disclosed along with themaximum amount of aggregate short-termborrowings outstanding at any month end(or similar time period) during each periodfor which an end-of-period balance sheet isrequired. In addition, the approximate averageaggregate short-term borrowings outstandingduring the period and the approxim~teweighted average interest rate (and abrIef. description of the means used to computeSuch averages)· for such aggregateShort-term borrowings shall be disclosed inthee notes to the financial statements.c) (No change.)* * * * ~RUle 6-03-1. Cash and cash items., Statestl"' t separately (a) cash on hand, unre"-(b) Ie ~? demand deposits, and time deposits;hel~a loans; (c) legally restricted depositsas compensating balances againstshort-term borrowing arrangements; (d)funds subject to repayment on call or immediatelyafter the date of the balance sheetrequired to be filed; an

446 SE€PRITIES'AND EXCHANGE COMMISSIONRule 6-22-1. 'Cash,and' cash:.items.. ",. ' ~ _ .' . .' f'""." . : _' ,~ .State separately, (a) ca~h' on hand, ,unrestricted.demand d~posits; 'and! tim~ deposits;(b) 'call.'loans; (c) legally restricted depositsheld 'as 'compensating b~la'ncesagainstshort-term borrowing' arrangements; (d)funds subject to'repayment on call or immediatelyafter the date of the . balance' sheetreq~lred to be filed; and (e)' otherfuhds, 'theamounts 'of which are known to be subject towithdrawal or usage restrictions, e.g., specialpurpose funds. The general terms and natureof such repayment provisions in (d) andwithdrawal or usage restriction in (c). or (e)shall be described in a note referred toherein (see Rule 5-02-1).,!,. .* * " *,.'\ .Rule 6-22-15. Other assets... " -', State, separately (a) amounts, du~ froIll'di­'rectors and officers, (b) legaUy restricted depositsheld a~c~mpensatitigb~la'rices'againstlong-term borrowing , arrangements, 'and ,(~),any other items iti eXcess, of five percent ofthe amoutlt ,of all assets other than qualifiedassets. " "" ,:~ '," , :r" ':.' .: .* '*Rule 6-22-17(a). 1':tlotes payable.' ':(i) State separately' amounts ,payablewithin one year (1) to banks and (2) to others,and (ii) provide in a note to the financialstatements 'the' information required underRule 5-02-25(b) and (c);* * * * *Rule 6-22-19. Funded debt.(a) (First sentence unchanged.)(b) The amount and terms (including commitmentfees and the conditions under whichcommitments may be withdrawn) of significantunused commitments for long-te'rm debtthat would be disclosed under: this rule ifused shall- b~ ,disclosed in the note's to thefinancial statements.* * * *Rule 6-22-21. Other long-term .debt.(First three sentences unchanged.)~ The amount and t~rms (including commitmentfees and thEl conditions' 'under whichcommitments'Illay be withdrawn) of significantunused commitments'. for long,-term debt,that w04ld be,' disclosed under, this rule ifused shal~ be dil:;c1osed in the notes to thefinancial statements.: "* ' - *', - *".. *... ~... 'Rule 7A-03-2~ "Cash and cash: items; ,State separately (a) cash on hand and un~restricted 'demand deposits; (J» legally· restricteddeposits held as compensating balancesagainst' short-term . borrowingarrangements; (c) funds subject to repay:'fuent on call or immediately after the date ofthe haiance sheet ,required to pe filed; and (d),other funds,'iheamounts of which are knownto be' subject to withdrawal' or usage restrictions;e.-g.;, special purpose furids. The' generalterms and natl.lre of stlch rep~y~ents provi­~ions ih.(e:) and Wj.thdrawa1'or us~ge -restrictionsin'(J» ,or.(d) shall be describe.d iIi a notedr~ferred to h~rei:!l (see Rule 5-02-1).* *Rule 7A-03-8.' Othe~'assets;Amend last sentence as follows:.' . Include legally ,restricted deposits held ascompensating' balances· 'against" long-termborroWing arrangements., .'. - .,* *' * *Rule 7A-03-17~'- Other liabiliti~s.(First sentenceurichanged.)The amount and terms (including commitmentfees and the' conditions under whichcommitments may be withdrawn) of unusedcommitments for long-term financing arrangementsnot provided for under Rule 7A-03-14shalI be disclosed in the notes to thefinancial statements if significant.* * * * *In the third full paragraph of the gui~elinesset f~rth in ASR No. 148 concernltn~'t"Unused Lines of Credit or Comml men sdthe'definition.of "usable'.lInes". the seconIIIsentence is modified as follows:are co tl -For this purpose usable lines

ACCOUNTING SERIES RELEASESsirued to be total lines used to supportcommercial' paper and other debt arrangementsless lines needed to meet"clean-up" provisions of a borrowing arrangement.~IV. Effective DateThese amendments are adopted pursuantto authority in Sections 6, 7, 8, 10 and 19(a) ofthe Securities Act of 1933; Sections 12, 13,15(d) and 23(a) of the Securities ExchangeAct qf 1934; Sections 5(b), 14 and 20(a) of thePublic Utility Holding Company Act of 1935;and Sections 8, 30, 31(c) and 38(a) of theInvestment Company Act of 1940.These amendments. shal~ be applicable toall financial statements filed with the Commissionfor all fiscal periods ending subsequentto December 25, 1975.·Ea.rlier applicationis encouraged. .":1.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 185December 11, 1975SECURITIES ACT OF 1933Release No. 5654SECURITIES EXCiIANGE ACT OF 1934Release No. 11917PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19296INVESTMENT COMPANY ACT OF. 1940 :Release No. 9080Notice of Adoption of Amendments to Article 9 of Regulation S-X Relating to FinancialStatements of Bank Holding Companies and BanksIn Securities Act Release No. 5620* theCommission proposed amendment of Article9 of Regulation S-X to conform certain reportingpractices of bank holding companiesand banks to generally accepted accountingprinCiples as practiced in other industries.C~mments on the proposal have bee~ rec~lVedand considered and with one modificatIonthe proposed a~endment is now~doPted. Regulation S-X which specifies theorm and content of financial statements is~;nended by adding to the provisions applicare~~~ banks (Rule 9-05) three subparagraphs1 a Ing to reporting of reserves for loan08ses cl 'fi . .cl. ' aSSl lCatIon of unearned income and---80Inasslfi t· 't~ca Ion of certain debt in~truments,e lInes referred to as capital debt.• Notice of thSecUritl' A e proposed amendments was made inA.... ct ReI es ct R e IN' ease o. 5620, Secunties . ExchangeAct Re~ase No. 11672, Public Utility Holding Companyltelease ;se No. 19186 and Investment Company Acto. 8951, dated September 24, 1975.As noted in Release 33-5620 these changeshad been discussed from time to time withrepresentatives of the panking community,Federal bank regulatory authorities, theAmerican Institute of Certified Public Accountants,and the Internal Revenue Service.In addition, because of concerns thatthe change in reporting loan· loss reserveswould adversely affect the reserve accumulatedfor tax purposes, the Chief Accountantrequested and received from the InternalRevenue Service a letter which said, in part:The Service has no requirement that thefinancial statements conform to the booksin the case of additions to the bad debtreserves for banks already on the reservemethod. We would deem it appropriate,however, that, if material, the disparitybetween the amount shown on the booksand the amount shown on the financialstatements be disclosed to the shareholderby way of a footnote or other method andthe two amounts reconciled on the books.

SECURITIES AND EXCHANGE COMMISSIONThe letters commenting .on the pr.oP.osalwere' fav.orable. It was suggested ~hat ther:ule sh.ould pr.ovide f.or discl.osure .of the difference,between the l.oan l.oSS reserve stated.on the financial statements and the reserveaccumulated f.or tax purp.oses if material andsuch a change has been made. In additi.onthe pr.oP.osal t.o reclassify capital debt hasbeen' changed t.o make it clear that it includessub.ordinated indebtedness.In c.onnecti.on with the pr.ovisi.on thatb.onds" n.otes and debentures be rep.orted asliabilitie.s- rather than capital, the recent pr.o­P.osal .of the Fede'ral bank regulat.ory auth.oritiest~ amend their peri.odic Rep.ort of Conditi.on(Call Rep.ort) reclassifies such debt in asimilar manner. The descripti.on .of that pr.o­P.osed revisi.on states that the change "doesnot necessarily imply any supervis.orychange .in the treatment .of these n.otes bythe banking agencies.'The f.olI.owing is the text .of. the three subparagraphshereby added t.o Rule 9-05 .ofRegulati.on S-:x:-- - .(e) ·The'valuati.on P.orti.on .of the reserve f.orI.oan losses shall be reported as a deducti.onfr.om l.oans receivable, the deferred tax P.ortionas a deferred tax item, and the c.ontingencyporti.on as a part .of undivided profits.If' materia1~r different . from thevaluation P.orti.on, the reserve accumulatedunder the Internal Revenue C.ode . pr.ovisi.ons'shall be discl.osed in a n.ote and the, tW.o am.ounts rec.onciled.(0 B.onds, n.otes, debentures, and similardebt (including sub.ordinated indebtedness)shall be rep.orted as liabilities. Debt instrumentsmay n.ot be gr.ouped with st.ockh.olders'equity under the capti.on "Capital."(g) Unearned inc.ome shall be rep.orted as adeducti.on fr.om l.oans receivable.These amendments are ad.opted pursuantt.o auth.ority c.onferred .on the Securities andExchange C.ommissi.on by the Securities Act.of 1933, particularly Secti.ons 6, 7, 8, 10 and19(a) thereof; the Securities Exchange Act .of1934, particularly Secti.ons12, 13, 15(d) and23(a) there.of; the Public Utility H.oldingC.ompany Act .of 1935, particularly Secti.ons5(b), 14 and 20(a) there.of; ,and the InvestmentC.ompany Act .of 1940,'particuhir1y Secti.ons8, 30, 31(c) and 38(a) there.of.These amendments shall be effective withrespect t.o financial statements' filed afterJanuary 15, 1976, alth.ough they may be appliedin statements filed pri.ort.o that time.By the Commissi.on.GEORGE A. FITZSIMMONS. SecretarySECURITIES EXCHANGE ACT OF 1934Release N .o. 11906RELEASE NO. 186December 5, 1975Order Instituting Pr.oceeding and Imp.osing Sancti.ons Pursuant t.o Rule 2(e) .of the C.ommissi.on'sRules .of Practice in the Matter .of R.obert L. Ingis.The Securities and Exchange C.ommissi.on("C.ommission") deems it appr.opriate t.o institutepr.oceedings against R.obert· L. Ingis("Ingis"), a C.P.A., pursuant t.o Rule 2(e) .ofthe C.ommissi.on's Rules .of Practice, 17 CFR201.2(e).1 Acc.ordingly, IT IS HEREBY OR-1 Rule 2(e)(3), 17 CFR 201.2(e)(3), provides in part:"(i) The Commission, with due regard to the publicinterest ... may by order temporarily suspend-from appearing or practicing before it an: (~)accountant .. , who .. , has been by nam tentpermanently' enjoined by any court of com~e anjurisdiction by reason of his misconduc~ ::tiOnaction brought by the Commission from VlO ro"+or aiding and abetting the violation of ar;; Prulession of the Federal securities laws or ~ ~Y anYand regulations thereunder; ... (b) .foun actioncourt of competent jurisdiction 1D ~n a partY, h' h he 15 ..brought by the Commission to w IC tted tpe... to have violated or aided and abe

ACCOUNTING SERIES RELEASES 449DER~D that such proceedings be, and theyhereby are, instituted.Ingis has submitted an offer of settlementin this proceeding. Under the terms of hisoffer of settlement, Ingis, without admittingor denying the factual assertions set forthherein, consents, solely for purposes of thisproceeding and any other proceeding thatthe Commission may institute against him,to the entry of the findings and the ordersmade herein.I. BackgroundKalvex, Inc. ("Kalvex") is a Delaware corporationthe common stock of which is registeredwith the Commission pursuant to Section12(b) of the Securities Exchange _ Act of1934, 15 U.S.C. 781(b). It is engaged, throughits wholly-owned and majority-owned subsidiaries,in the distribution of drugs, consumerproducts, and motor homes as well asthe manufacture and distribution of graphicarts and commercial printing. Among itsother holdings, Kalvex is the owner of approximately23,971 shares, or about 52 percent,of the preferred stock of Allied ArtistsPictures Corporation (,'Allied")2. The commonstock of Allied is also registered withthe Commission pursuant to Section 12(b) ofthe Securities Exchange - Act of 1934, 15U.S.C. 78J(b).II. The Relationship of IngisIngis is a certified public accountant whoserved as the executive vice-president andchief operational officer of Kalvex until September10,1974, when he was removed as anofficer and employee by the board of directors.Ingis was also a director of Allied and:erved as its chief financial ~fficer until Sept~mber,1974, when he was removed fromese Positions.- ~~------------~----viOlation of an .. f h F d '. I- ••I y prOVISIOn 0 tee era secuntiesd aws ... or of the rules and regulations thereunber (unless the violation was found not to have• een Willful) ". Pursuant . .. .tlon of All" to a p:ovlslon of the ArtIcles of Incorpora--Shares ar .led ArtIsts, if the dividends on preferredera, the e In arrears for six consecutive calendar quartpreferenpreferred shareholders are accorded a votingCe oVer the common shareholders of Allied Art-III. The Violations by IngisIn March 1973, Ingis was approached by afriend with the idea of starting a computerfirm that would provide computer services toKalvex, Allied and other companies. Subsequently,on April 2, 1973, the computer company,which was known as Shared Computerand Personnel, Inc. ("SCP"), was incorporatedin Delaware, and Ingis was elected asone of its directors. Thereafter, Ingis suggestedto Emanuel L. Wolf ("Wolf"), the presidentand chairman of the board of directorsat both Kalvex and Allied, that Kalvex invest$150,000 as "seed money" in SCPo Ingisrepresents that he was told by Wolf thatWolf would approve the investment by Kalvexin SCP only if certain concessions weregiven to Wolf. 3 Ingis accordingly asked thatSCP, as a condition to receiving investmentcapital from Kalvex, agree to a kickbackarrangement to Wolf that envisioned the deliveryto Wolf of 10 percent of the monthlybillings received by SCP from Kalvex andAllied', $23,000 of the monies to be receivedby SCP from Kalvex and Allied for originalsystems design to be furnished by SCP and a10 percent equity interest in SCPoThereafter, Ingis demanded a partial paymentfrom SCP, and, accordingly, he receiveda check from SCP in the amount of $3,000.Pursuant to Ingis' instructions, the payee ofthis check was left blank. The $3,000 SCPcheck was later co-signed by Ingis becauseall checks in excess of $2,500 had to be jointlysigned by the president of SCP and Ingis oranother officer of Kalvex. In order to depositthis check, Ingis inserted the name RoyaltyManagement Corp. ("RMC") as payee andendorsed the check. RMC was an inactivecorporation that was originally intended tobe used to perform audits and facilitate venturecapital investments by Ingis and others.Ingis was later advised by SCP that a second$3,000 check was ready. Pursuant to Ingis'instructions, the check was made payable toists. During the relevant period, forty-six (46) quarterlydividends had not been paid to the preferred shareholdersof Allied Artists and were in arrears. As a result,Kalvex was, and still is, able to elect and control amajority of the board of directors of Allied Artists.3 Wolf denies that he made any such demands.

450 SECURITIES AND EXCHANGE COMMISSIONRMC as payee and Ingis co-signed the secondcheck and deposited it in the RMC account.Finally, on May 7, 1974, a third check in theamount of $2,500 was given to Ingis by thepresident of SCPo The check was likewisedeposited by Ingis in the same manner asthe previous checks. Subsequent to the deliveryof the third check, SCP did not have thefunds to make further payments and Ingisadvised its President on May 10, 1974 tocease making any more payments and not toissue the stock. 4 Thus, the shares demandedas pa·rt of the scheme were in fact neverissued or delivered.Ingis then discovered that Wolf had engagedin double-billing of expenses and reportedit to the board of directors of Kalvex.Shortly after Ingis' participation in the kickbackscheme was exposed by Wolf, Ingis demandedthat the board of directors of Kalvexinstitute an outside audit for the purposes ofverifying the double-billing of expenses byWolf. The board decided to conduct an internalaudit, rather than the outside audit demanded5 by lii.gis~' and ultim'ately dischargedIngis as an officer and employee of the companyby virtue of his participation in thekickback scheme. 6 The Allied board also declinedto institute an outside audit demandedby Ingis. Thereafter, Ingis advisedthe Commission's staff of the activities discussedabove.The Commission instituted proceedingsagainst Ingis and others arising out of thekickback scheme described above and otherrelated events. 7 The Commission alleged that4 SCP had agreed in writing, however, to the kickbackarrangements, including the issuance and delivery beforeApril 1, 1974 to RMC of 15,000 shares of SPC'scommon stock, or about 15 percent of the equity interestin SCPo5 In Securities and Exchange Commission V. Kalvex,Inc., Civil Action No. 74 CIY 5643, CCH Fed. Sec. L. Rep.. (Current) 11 95,226 (S.D.N.Y., 1975), in which Ingis was adefendant, the district court found, however, that anoutside audit, even if conducted would not have exposedIngis' kickback scheme. Id. at p. 98,189.6Ingis has instituted a civil action against Kalvexalleging that he was wrongfully and maliciously discharged.1 Securities and Exchange Commission V. Kaivex, Inc.,Civil Action No. 74 CIY 5643, CCH Fed. Sec. L. Rep.(Current) 11 95,226 (S.D.N.Y., 1975). In addition to theIngis violated and aided and abetted viola.:.tions of Section 14(a) of the Securities' ExchangeAct of 1934,15 U.S.C. 78n(a) and rules14a-3 and 14a-9 promulgated thereunder, 17CFR 240.14a-3 and 240.14a-9. In particular,the Commission contended that both Kalvexand Ingis, as a person standing for electionas a director, were subject to the proxy disclosurerequirements of Section 14(a) and therules promulgated thereunder. In its opinionrendered on July 1, 1975, the United StatesDistrict Court for the Southern District ofNew York found thatIngis knew that he was standing forelection as a director; he knew that theproxy statements which had been filedand distributed were false and misleading.Securities and Exchange Commission V.Kalvex, Inc., Civil Action No. 74 CIV 5643,CCH Fed. Sec. L. Rep. (Current) §95,226 atpage 98,187 (S.D.N.Y. 1975). Accordingly, thedistrict court held that "Ingis' violated andaided and abetted violatio~s of Section 14(a)of the, Exchange Act and Rules 14a-3 and14a-9 thereunder .... " I d.The Commission also alleged that Ingisaided and abetted violations of Section 13(a)of the Securities Exch~nge 'Act of 1934, 15U.S.C. 78m(a) and Rules 13a-1 and 13a-13promulgated thereunder, 17 CFR 240.13a-1and 240.13a-13. In particular, the Commissionalleged that the quarterly and annualreports filed by Kalvex were false and misleadingby failing to accurately reflect thekickback scheme discussed infra, the Commission allegedthat Wolf submitted duplicate expense vouchers toboth Allied and Kalvex, which resulted in filing of falseand misleading reports with the Commission in violationof Section 13(a) of the Securities Exchange Act of 1934,15 U.S.C. 78m(a) and Rules 13a-1 and 240.13a-13. Wolf,without admitting or denying the factual assertionsmade by the Commission, consented to the entry of apermanent injunction against future violations of Sec;tions 13(a) and 14(a) of the Securities Exchange AC1t3~_1934, 15 U.S.C. 78m(a) and 78n(a), and Rules 13a-l, CFR13, 14a-13 and 14a-9 promulgated thereunder, 17 ddi-240.13a-1, 240.13a-13, 240.14a-3 and 240.14a-9. I~ : thetion, Kalvex consented to a final judgment by WhlC doptfirm agreed to appoint an audit committee and .t~ ~ s inprocedures to avoid the repetItIOn. . f"1 actJVltle0 sImI arthe future.

ACCOUNTING SERIES RELEASES 451accounts of the company, falsely stating theinc'ome and expenses of tile company, andfailing to disclose that Ingis had caused themaking of false entries which permitted himto receive improper reimbursements by submittingfalse e-xpense vouchers. In addition,it was argued that the quarterly reports forthe quarters ending March 29, 1974, andJune 28, 1974, were fals~ and misleading inthat the reports failed to disclose that RMC,a corporation under Ingis' control, had receive,d,$8,500 in kickbacks from SCPo Thedistrict court held: ~As a person who provided assistance andencouragement to conduct patently inviolation of the securities laws, defendant[Ingis] must be held responsible forsuch conduct as an aider and abetter.Id. at page 98,188.The district court permanently enjoinedIngis from future violations of the Federalsecurities laws.I d. at page 98,189.IV. Finding. 'The Commission finds that Robert L. Ingis'is subject to sanction under Rule 2(e)(3) ofthe Commission's Rules of Practice, 17 CFR201.2(e)(3) by virtue of his having been foundto have violated and aided and abetted violationsof the federal securities laws and therules promUlgated thereunder and havingbeen permanently enjoined fr~m future violationsof Sections 13(a) and 14(a) of theSecurities Exchange Act of 1934, 15' U.S.C.78m(a) and 78n(a), and Rules 13a-1, 13a-13,14a-3 and 14a-9 thereunder, 17 CFR 240.13a-1, 240.13a-13, 240.14a-3 and 240.14a-9.V. Offer of Settlement£ In his offer of settlement, Ingis makes th~ollowing statements which he asks the Commissionto consider, viz: ,j \ Ingis has never previously be~n the sube~of a~y other Commission proceeding;C' IngIs initially apprised Kalvex and theomm' .hle-bi l~SIon of the facts relating to the douilydlh~g of expenses by Wolf and voluntaramItted .to the Commission his own participationin the acts subsequentlycomplained of by theCommission;83. Ingis voluntarily assisted the Commissionin its investigation; .4. Ingis has placed into an interest bearingtrust account $7,409.78 of the $8,500 thathe deposited into the RMC account and hasinstructed the trustees to deliver the $7,-409.78 to SCP, Kalvex or such other personwho is determined to be the rightful owner ofthese funds. 95. Ingis did not personally benefit from the$8,500. deposited in the RMC account; and6. The activities charged by the Commissiondid not involve a report filed by Ingis asa CPA. to7. Ingis represents that all of the actsrelating to the kickback scheme were basedon Wolfs instructions.VI. SanctionAfter due consideration of all the circumstances,and upon the recommendation ofthe staff, the Commission has determined toaccept Ingis' offer of settlement. In arrivingat this determination, the Commission hastaken into consideration the statementsmade by INGIS in his offer of settlement.Accordingly, IT IS FURTHER ORDEREDTHAT: .1. ROBERT L. INGIS, a CPA, be and hehereby is prohibited from appearing or practicingbefore the Commission as an accountB:ntother than as an employee of an account;;lntor consultant under supervision of anaccountant.2. After twenty-two months, Ingis may applyfor permission to resume appearance and8Ingis came to the Commission, however, only afterKalvex decided to conduct an internal audit but refusedto institute the outside audit which he had requestedand after he had been removed from his positions atKalvex and Allied.,9 Ingis represents that RMC incurred expenses in theamount of $200 for secretarial work and $890.22 in legalfees and expenses which were paid out of the $8,500deposited in the RMC account. The remaining $7,409.78was retained in the RMC account since June, 1974,which was under the control of Ingis as a signatory.10Ingis was, however, the chief financial officer atAllied and the chief executive officer at Kalvex.

452 SECURITIES AND EXCHANGE COMMISSIONpractice before the Commission as an accountant,provided that if during the pendingof the prohibition:A. Ingis has been employed by an accountantor as a consultant under the supervisionof an accountant, then he willsubmit an affidavit from a partner of eachaccounting firm in which he was employedor which supervised him attesting to hisprofessional competence as an accountant;B. Ingis commences an independent accountingpractice, then Ingis will requestthe AICPA to review his auditing proceduresas to clients whose audits were supervisedor conducted by Ingis and to rendera report on his professionalcompetence to the Chief Accountant of theCommission; andC. Ingis becomes a partner of an accountingfirm, he will not handle a certifiedaudit unless it is reviewed by anotherpartner of such accounting firm who willattest in writing to Ingis' professional competenceas an accountant.3. Before applying for permission to resumepractice and to appear before the Commission,Ingis shall submit satisfactory proofthat he has attended courses or seminars insubjects relating to public accounting or auditingto the extent of at least 40 hours forthe twelve months immediately precedinghis application for readmission.By the CommissionGEORGE A. FITZSIMMONSSecretaryRELEASE NO. 187December 15, 1975SECURITIES ACT OF 1933Release No. 5655SECURITIES EXCHANGE ACT OF 1934Release No. 11923Order Accepting Resignation from Commission Practice as an AccoUntant in the Matter of Bill D.Steele (Rules of Practice-Rule 2(e))On March 5, 1974, the Commission institutean injun,ctive action in the UnitedStates District Court for the Central Districtof California alleging, among other things,that Bill D. Steele, an accountant and formerlythe chief financial officer of the SeaboardCorporation, violated the anti-fraudprovisions of the Securities Act of 1933 andthe Securities Exchange Act of 1934. 1 Withoutadmitting or denying the allegations in.the Commission's complaint, Steele consentedto entry of a permanent injunction inthat action enjoining him from fraudulentconduct in connection with the offer, purchaseand sale of securities. 2I S.E.V. v. The Seaboard Corporation, et al ... CivilAction No. CV 74-567-MML.2 The injunction was entered on July 31, 1975.Having been advised that the Commissionwas contemplating the institution of administrativeproceedings pursuant to Rule 2(e) ofits Rules of Practice, based on the allegationsin the injunctive action, to determinewhether he should be temporarily or permanentlydenied the privilege of appearing orpracticing before it as an accountant, Ste~leagreed to resign from Commission pract~ceas an accountant on condition that no admInistrativeaction be brought against him. lIefurther agreed that if he subsequently appliesfor readmission to such practice, ~er-. .' .' t' e actlon,tam allegatIOns m the InJunc IV • 3-which are specified in his letter of resl~a._tion, shall, for purposes of any suc~ 3P~ Intion only, be deemed true and cor~~c tionaddition, he agreed that any such apP lC(3) heshall be supported by a sowIng h. that·.a.

ACCOUNTING SERIES RELEASES 453has fa:miliarized himself with the registrationandthe disclosure provisions of the federalsecurities statutes and with the Commission'srequirements with respect toacco'Unting procedures, and (b) nothing hasoccurred during the intervening period thatwould be ,a basis for adverse action againsthim pursuant to Rule 2(e).After due consideration, and upon the recommEmdationof its staff, the Commissiondetermined to (accept Steele's resignationfrom Commission practice as an accountant.Accordingly, IT IS ORDERED that resig.:.nation of Bill D. Steele from appearing orpracticing before the Commission be, and ithereby is, accepted, and he shall no longerhave the privilege of so appearing or practicing.For the Commission, by its Secretary, pursuantto delegated authority.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 188January 7, 1976SECURITIES ACT OF 1933Release No. 5667SECURITIES EXCHANGE ACT OF 1934Release No. 11985INVESTMENT COMPANY ACT OF 1940Release No. 9115Interpretive Statement by the Commission on Disclosure by Registrants of Holdings ofSecurities of New York City and Accounting for Securities Subject to Exchange Offer andMoratoriumThe Commission has noted developmentswith respect to the financial problems of theCity of New York~ inCluding the moratoriumimposed by' the state legislature on the enforcementby holders of the terms of certainoutstanding short-term obligations of theCity of N ew York; 1 recent amendmentsadop,ted by the legislature to the Local FinanceLaw (Title 6-A), the creation of the~unicipal Assistance Corporation for theCIty of New York ("Municipal Assistancet orporation"), the enactment by the legis lafi\nan'CIaure of statutes providing for a three-yearIplan for the.City and the enactment-~-- "'The leg l"tin liti ,a 1 y of the moratorium has been challengedYork r:;lOn, and upheld in the Supreme Court of NewCorp. for~~h,tng, National Bank v. Municipal Assistance22, 1975 b e Ctty of New York, et al., decided DecemberSUpreme 6 Judge Harold Baer, Index No. 20245-1975,an intent' ourt, New York). The plaintiff has indicatedIOn to appeal.by Congress of The N ew York City SeasonaiFinancing Act of 1975 (Public Law 94-143).These developments have created significantquestions with respect to disclosure and accountingby registrants who are holders ofNew York City securities. In light of thesedevelopments, the Commission has determinedthat it would be helpful to investorsand to registrants and independent publicaccountants to publish its views on someaspects of these problems.The Commission's present rules requirecertain specific disclosures of the cost andmarket values of investments in securities.Commercial and industrial companies are requiredto state the cost and market value ofmarketable securities and other securitiesinvestments, either by setting forth eachissue separately or by the use of reasonablegroupings. 2 Management investment compa-2 Regulation S-X, Rules 5-02-2, 5-02-12, 12-02.

454 SECURITIES AN]) EXCHANGE COMMISSIONnies, are required to state the cost and valueof each issue held. 3 Insurance companies andbanks are required to state the 'cost andvalue of the aggregate holdings of bonds. andnotes issued by states,' municipalities andpolitical subdivisions, and in the case of insurancecompanies, corporate securities. 4In addition to these specific rules; the Commissionhas long required registrants to includein filings "such further material informationas is. necessary to make the requiredstatements, in light of the circumstances under'whichthey are made, not misleading .."5In interpreting this requirement, the Commissionhas from time-to-time issued statementswhich call attention to particularproblems where disclosure beyond the specificrequirements of rules may be necessary.In view of the circumstances referred' toabove, the Commission believes that certaininformation in regard to holdings of NewYork City securities set forth below is materialand should assist investors in makingtheir own judgments about the effects, ifany, on'the income arid business of registrantsof the developmeJlts referred to abovewith respect to the financial situation of NewYork City.Accordingly, registrants who hold NewYork City notes that are in moratorium;other securities issued by the City ~f NewYork that will mature within three years;securities of the Mutlicipal AssjstanceCorporationthat were issued in exchange for NewYork City notes in moratorium; or securi~iesof the Municipal Assistance Corporation thatwere made subject to an agreement modifyingtt;!rms, should make the following disclosuresin notes to financial statements (and, ifappropriate, in m~~agement's analysis of thesummary of earnings) if the book value ofsuch securities in the aggregate amounts tomore than 10% of stockholders' equity:~ RegUlation S-X, Rules 6-02-7, 12-19.4 RegUlation S-X, Rules 7-03-1, 7a-03-1, 12-19, 9-05(b)(2)and Regulation F, Form F-9A-2(a)(3) of the FederalReserve Board.S Regulation S-X, Rule 3-06; also Rule 408 under theSecurities Act of 1933 and Rule 12b-20 under the SecuritiesAct' of 1934.(1) The total cost and carrYing value (ifother than cost) of the above described'securities which were held at the end of1975, and the income on such securitiesrecorded in 1975.(2) Of the total amount included in (1),identify separately the cost an( carrying. . '/value of those securItIes .Ca) issued by New York City in~ moratorium,(b) other securities issued or guaranteedby or otherwise obligating theCity of New York which will maturewithin three years,(c) issued by the Municipal AssistanceCorporation in exchange for theNew York City notes in'moratorium,and(d) issued by the Municipal AssistanceCorporation and subject to anagreement modifying terms.(3) A discussion of the effect of the moratorium,exchanges or agreements on futureiricome in' comparison' with theincome recorded in 1975.This disclosure reflects the fact that NewYork City has encountered an acute financial,problem which has required certainemergency measures. On the other hand, inthe light of the measures referred to theredoes not appear to be any adequate basis atthis. time for cori~luding that the long termrisks involved are uilique, and, therefore, theCommission beiie'ves the existing provisionsof Regulation S-X whjch require, in additionto disclosure of the aggregate cost, disclos~r~of the aggregate market value of all mumCIpalsecurities, including those of New YorkCity, should adequately reflect the long termrisks. The Commission has therefore determined,after consultation with the bank r:fulatory authorities, not to mandate specl ~cally at this time disclosures beyond thospresently required and those stated abov~. tThe disclosures referred to above re le~the Commission's conclusion that devbe oms. 1 pro 1ments with respect to the financlaeatof the City of New York call for disclosu~orlcthis time of significant holdings o.f ~e~y af­City securities which are pa~tIc~:raffairsfected by recent developments III t

ACCOUNTING SERIES RELEASES 455of the City. The Commission recognizes, however,t}:~at other issuers of securities maysuffer financial difficultIes that could adverselyimpact holders of material investmentsin such. securities. As a part of alonger term and more generalized effort todeal with the· fact that significant concentrationof holdings in any security may warrantdisclosure,the Commission is proposing anamendment to Rule 3-16( ) of Regulation S-Xwhich would require footnote disclosure byall registrants of certain concentrations insecurities holdings. (See Securities Act ReleaseNo. 5668, dated January 7, 1976).In addition to the questions of disclosurediscussed above, questions have arisen as tohow holders of securities subject to the moratoriumor securities into which they havebeen exchanged should. account for thosesecurities in their financial statements atDecember 31, 1975. Various views have beenexpressed, and it is apparent from the diversityof reaction to the factual circumstancesset forth herein that there is no single answerto the questions within the currentlyexisting body of authoritative accountingpronouncements.Because there are differing opinionsamong accountants as to the 'proper accountingtreatment under existing authoritativepronouncements, and in view' of the fact thatthe Financial Accounting Standards Boardhas agreed to undertake a study of the accountingproblems raised by the moratoriumand exchange with the intention of dev~lop,ing standards' which can be applied to yearendstatements in 1976, the Commission isnot prepared at this time to require the useof any particular accounting method to a~countfor holdings of such securities at December31, 1975. It believes that the disclosuresset forth above, together with adescription of the accounting methods followed,should assist investors in evaluatingthe impact of the moratorium and exchangeon registrants and to estimate the amountswhich might have been recorded under alternativeaccounting methods.By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 189February 9, 1976SECURITIES ACT OF 1933Release No. 5684SECURITIES EXCHANGE ACT OF 1934Release No. 12081PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19379Notice of Withdrawal of Release No. 33-5612 Which Proposes Amendments to Form 10-Q andRegulation S-X,Regarding Interim Financial Reporting"is~n d September 10, 1975 the Commissionado;t. Accounting Series Release No. 177Regut~ amendments to Form 10-Q andl'epOrt~tlon S-X regarding interim financialadoPt:~g· In that release, the CommissionSubstantially increased requirementsfor the content of quarterly reports onForm 10-Q by all registrants now reportingon Forms 7-Q and 10-Q and a new rule [Rule3-16(t)] which requires disclosure of selectedquarterly financial data in notes to financialstatements of certain registrants whose

456 SECURITIES AND EXCHANGE COMMISSIONshares are actively traded and whose size isabove certain limits. Reference is . made toAccounting Series Release No., 177 for a discussionof ~he new reporting requirement onForm 10-Q and applicability of Rule 3-16(t) toregistrants.The Commission noted in ASR No. 177 thatthe inclusion of interim data in an unauditedfootnote to the financial statements will associatethe independent ac~ountant withthese data. Therefore, the Commission simultaneouslyissued for comment Release No.5612 in which it proposed review and reportingprocedures which set forth its expectationsas to the responsibilities of independentaccountants who are associated withinterim financial data. The purpose of theproposal was to provide the profession withappropriate "professional standards and pro­(!edures" to protect the interests of inv.estors.The Commission noted in ASR No. 1,77 thatthe subject of auditor involvement with interimfinancial data has been under activeconsideration by the Auditing Standards ExecutiveGommittee (AudSEC) of the AmericanInstitute of Certified Public Accountants.The Commission urged AudSEC tocontinue its study of auditor involvement inthe interim reporting process. It. indicatedthat if AudSEC adopted a statement whichsatisfactorily defines the standards and proceduresto be followed by auditors for suchinvolvement, it would withdraw Release No.5612.In December 1975 AudSEC issued Statementon Auditing Standards No. 10 entitled"Limited Review, of Interim· Information."The' standards and procedures set forth inthat statement appropriately define the roleof the auditor in the interim reporting process.Accordingly, the Commission is withdrawingthe proposed rules set forth in ReleaseNo. 5612 and intends to rely on thestandards adopted by AudSEC., By the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 190March 23, 1976SECURITIES ACT OF 1933Release No. 5695SECURITIES EXCHANGE ACT OF 1934Release No. 12240PUBLIC UTILITIES HOLDING COMPANYACT OF 1935Release No. 19437Notice of Adoption of Amendments to Regulation S-X Requiring Disclosure of CertainReplacement Cost DataA. General StatementIn' Securities Act Release No. 5608 issuedAugust 21, 1975, the Commission proposedfor comment amendments to Regulation S-Xwhich would require footnote disclosure ofcertain financial data regarding current replacementcost. These proposals were de-SIgned.to enable mvestors.tobt in more0 arelevant mformatlon. .about the current.eCO-t1 _, . . an In anomics of a business enterprIse I~ solelYtionary economy than that provIded babyfinancial statements prepared on tteer s of thsis of historical cost. More than 350 Ie oposcommenthave been received on the pr

- ACCOUNTING SERIES RELEASES 457als and after giving these comments carefulconsideration, the Commission has determinedto adopt the proposals in somewhatrevised form. In addition, the Commissionhas decided to create an advisory committeeto assist its &taff in providing guidance toregistrants in the problems of implementingthis new rule.The new rule as adopted requires registrantswho have inventories and gross property,plant and equipment which aggregatemore than- $100- million and which comprisemore than 10% of total assets to disclose theestimated current replacement cost of inventoriesand productive capacity at the end ofeach fiscal year for which a balance sheet isrequired and the approximate amount of costof sales and depreciation based on replacementcost for the two most recent full fiscalyears. In addition, registrants are requiredto disclose the methods used in determiningthese amounts and to furnish any additionalinformation of which management is awareand believes is necessary to prevent the informationfrom being misleading. This informationmay be presented either in a footnoteto the financial statements or in a separatesection of the financial statements followingthe notes. In either place, the informationmay be designated as "unaudited."In requiring these data, the Commission isaware that it is requiring companies to makedisclosures of costs which cannot be calculatedwith precision. They must be estimatedon the basis of numerous assumptions whichmay vary over time and from company tocompany and through the use of techniqueswhich are not so fully developed that theycan be standardized at the present time, ifever, This is because estimates of current;':Placement cost must be made within thea~ework of each registrant's economic situatIonc t an db'ecause there are dIfficult conbep ual and empirical jUdgments which mustf:ct made ,in the light of different specificdat Ual cIrcumstances in developing thetha~' Nevertheless, the Commission believesinves~uch data are important and useful toIt fe ~rs and are not otherwise obtainable.P1ain:d s t?at imprecision, if properly exl'heC ' will not make the data misleading.omm' .ISS Ion encourages registrants tosupplement the required disclosures with informationwhich management believes willbe helpful to investors in understanding theimpact of price changes and other currenteconomic conditions on reported- results.In recognition of the imprecise nature ofthe data, the Commission is proposing forcomment a "safe harbor" rule designed -torecognize in a rule the Commission's viewthat if such data have a reasonable basis, areprepared with reasonable care and in goodfaith and are presented with adequate disclosurethe data do not constitute an "untruestatement of a material fact" or a "manipulative,deceptive or fraudulent device."Decision not to DelayThe Commission was urged by many commentatorsto delay the adoption of rules (orat least the effective date) until the means ofcompliance with the rules could be spelledout with precision~ The Commission has concludedthat such delay is not appropriate ingeneral, although it has permitted a oneyear delay in effectiveness of the rule formineral resources in the extractive industries.This was done in recognition of theparticularly severe implementation problemsfor such assets and in the light of the expressedwillingness of a leading trade associationin the largest of these industries toundertake a major research - effort withinthis year to resolve such problems. In- addition,a one year delay has been permitted ineffectiveness for foreign assets located outsidethe North American continent and theEuropean Economic· Community if certainspecific disclosures relating to such assetsare made.The Commission's judgment that delay isnot appropriate is based on a number offactors. First, it believes that under currenteconomic conditions, data about the impactof changes in the prices of specific goods andservices on business firms is of great significanceto investors in developing an understandingof the current operations of anyfirm. While the current general rate of inflationhas been reduced from 1974 levels, it isstill at a level such that unsupplementedhistorical cost based data do not adequately

458 SECURITIES AND EXCHANGE COMMISSIONreflect current business economics. Further,in any inflationary economy specific costsand prices which may affect a businesschange more rapidly than the general pricelevel. These factors make the impact of delaymore severe than would be the case in a timeof price stability.In addition, as a practical matter, it wouldnever be possible for the Commission to anticipateevery possible circumstance thatmay be faced in the application of this newdisclosure rule. This is particularly truesince the rule covers new ground and requiressubjective judgments in its. application.Accordingly, the Commission believesthat various approaches taken in implementingthe rule should be viewed as experimental,and that alternative approaches will beacceptable as long as the methods used arefully described and are applied in good faithand with reasonable care. There does notseem to be any persuasive reason, therefore,to deny these data to investors while experimentation.in alternative techniques takesplace.By r~quiring full disclosure of the . approaches. used and permitting considerableflexibility in the way in which the data aredisplayed, the Commission is confident thatit has provided -sufficient latitude so thatregistrants will be abl,e to communicate effectivelythe meaning 'of the data to investors.Registrants may, for example, presentthe data in supplemental financial statements,show estimates in terms of rangesrather than single figures, and discuss theimprecisions inherent in the data. They maydescribe historical relationships betweencosts and selling prices, point out the costsavings and any incremental costs andchanged economic lives associated with newequipment, indicate their plans for the replacementor non-replacement of assets, andpresent any other information which theybe,lieve will assist investors in understandingt1'!e i~pact of changing prices and inflationin general on the registrant. This may includea discussion of possible favorable effectsof inflation on the firm, such as thebenefits from repaying debt in less valuabledollars and the possible benefits of operatingleverage in an inflationary environment.While certain standards and guidelines forapplication of this rule may be developedafter experimentation has taken place, it ishighly unlikely that a totally uniform set ofprocedures can ever be developed which willmake the implementation of the rule a mechanicalprocess.Creation of Advisory Committee to Assist inImplementation 'Nevertheless, the Commission recognizesthat it is important that registrants receiveguidance on implementation problems andthat experience in this regard is shared.Accordingly, it has determined to appoint anadvisory committee composed of personsworking with the problems of implementationto meet on a regular basis with the staffof the Commission to consider problemsraised by registrants in complying with therule. The composition and procedures of thiscommittee will be announced shortly. Fromthese meetings and from its other experiencesin dealing with registrants; the staffwill publish staff accounting'bulletins whichset forth its judgments. The first staff accountingbulletin on this subject which respondsto questions raised in letters of commenton the proposal and to problems arisingfrom the staff's experience in participatingin pilot programs by business firms is beingpublished simultaneously with the issuanceof this release.In addition to its own efforts, the Commissionbelieves that it would be useful forindustry groups and associations to considerspecialized problems in the application ofreplacement cost concepts to their areas ofinterest. In this connection, such groups mayundertake to develop specific price indicesapplicable to particular classes of assets andsuggest uniform industry-wide reporting approaches.The Commission staff would bewilling to lend such assistance as it can tosuch efforts.Analysis of Costs and Benefits. d the pro-The release which accompame toposed rules specifically requested data ;sn tsthe cost of compliance. Many respon e

ACCOUNTING SERIES RELEASES' 459expressed concern about -costs, but only asmall number made specific estimates. Thoseestimates varied widely, and iri general thecost· estimates supplied by companies whichhad implemented replacement cost systemsor undertaken _pilot studies were substantiallybelow those which had not. This suggeststhat as companies take steps to implementthe rules' adopted herein, they will findthat the cost of compliance will be less thanthat estimated. 'Nevertheless, the Commissionrecognizes that the cost of implementingthis rule will be significant, particularlyin the first year of preparing the necessarydata. It also seems clear that the cost will beproportionately higher for small companieswith less sophisticated accounting systems.The Commission has carefully consideredthe cost of implementation and weighed itagainst the need of investors for replacementcost information. It has concluded thatin the case of companies of large size whichgenerally have' the largest· public investorinterest, the data are of' such importancethat the benefits of disclosure clearly outweighthe costs of data preparation. In thecase of smaller companies where the costburden is proportionately greater and thee:ctent of public investor interest is proportIonatelyless, the balance between economiccosts and benefits is less clear. Accordingly,the Commission has determined initially toexempt from the rule companies whose inven~oriesand gross property; plant andeqUIpment aggregate less than $100 million.While it urges such companies to make appr?priatedisclosure of the effect of specific~~l~e changes and inflation in general on. elr operations, it is not at this time requir­In~ them to make the spe~ific disclosure re­!~~~ed by this rule. As experien,ce is' gainedth b the ~osts of implementing the rule andth: C enefl~ ~f the information to investors,of el' o~nm~slOn will consider the desirabilityIn u~n.a~mg or amending the exemption.that a dItIon, the Commission has concludedprope~~panies whose inventories and grossassets les comprise less than 10% of totalthe c need not make the disclosure since inSUch a~~WOUldof such companies the effects oflsclosure on financial statementsgenerally be immaterial.Inclusion of Data in Financial S~atements andAuditor ResponsibilityThe Commission also asked for specificcomment on whether the required datashould be audited. Most commentators suggestedthat due to both cost considerationsand the Jack of articulated standards, itwould be undesirable to require the replacementcost information to be audited. Manyadvocated that the data be removed from thefinancial statements and included elsewherein annual reports and filings.In response to these comments the Commissionhas concluded that the re~uired dataneed .not be audited and it accordingly willpermIt the required information to be labeled"unaudited." It does not believe, however,that the information should be removedfrom the financial statements. As ithas previously stated, 1 it believes that significan~financial disclosures about business operatIonsduring a period should generally beincluded in the financial statements for thatperiod, and it does not see any compellingreasons for excluding this information. In a?u~iness world characterized by uncertainty,It IS necessary to recognize that many estimatesbased on subjective judgments must'be included in financial statements and thatappropriate means of describing the uncertaintiesand the lack of precision in the datamust be found. 2 -. While the original proposal required thatthe data be displayed in a footnote, the Commissionrecognizes that in some circumstancesthe required data when supplemented byadditional disclosures explaining the basisfor its preparation and other informationdeemed appropriate by management may beof considerable length and include substantialdata. Both because of its length arid itsnature registrants may feel that it shouldnot be included in the notes to the financialstatements. Accordingly, the adopted rulepermits the disclosures either in the footnoteor in a separate section of the financial statementswhich follows the notes and is appropriatelylabeled. If such a separate section isI Accounting Series Release No. 1772 Accounting Series Release No. 166

460 SECURITIES AND EXCHANGE COMMISSIONused, a brief cross reference in the notes(such as in the note on accounting policies)would be appropriate.. The unaudited footnote or separate sectionof the financial statements containing thedata will be a part of financial statementsreported on by independent accountants: Accordingly,the independent accountant willbe associated with the replacement cost informationeven though it is unaudited. TheCommission urges the Auditing StandardsExecutive Committee of the American Instituteof Certified· Public Accountants to developappropriate standards applicable to theauditor in the case of such association.Non-Preemption of Financial AccountingStandards BoardA number of those commenting upon theproposal expressed concern that the rules ifadopted would preempt. the Financial AccountingStandards Board (F ASB) and possihlythe conclusions of the Commission's generalstudy of financial disclosure now underway. The CommissIon does not believe thatthese concerns are merited.In December 1974, the FASB issued anexposure draft of a statement which wouldrequire financial statements to include supplementaldata in which historical costs wereadjusted for changes in the general pricelevel. In the Commission's proposal, it notedthat general price level adjustments mightbe used either with historical cost or currentreplacement cost financial data. Accordingly,it did not and does not view its proposal ascompetitive with that of the F ASB. In fact,in implementing the Commission's rule, someregistrants may wish to use data regardingchanges in the general price level as part ofthe analysis of reasons for changes in replacementcosts. At the present time, how-. ever, the Commission does not propose torequire the presentation of data restated forchanges in the general purchasing power ofthe monetary unit.Similarly, the Commission does not believeits new requirements prejudge any conclusionswhich may arise from the F ASB'sstudy of the conceptual framework of financialstatements. As it noted in its originalproposal, the Commission believes that fundamentalchanges in the basic accountingmodel should come about only after carefulstudy by the F ASB. It believes that experi7mentation with replacement cost informationof the sort that will result from theimplementation of this rule will m~teriallyassist the F ASB in its study as well. asproviding meaningful supplemental disclosureto investors in the interim.Finally, the Commission does not feel thatadoption of this rule will have any adverseeffect on its own broad study of financialdisclosure. One of the reasons for the studywas the concern expressed by some tp,at theCommission's requirements emphasized objectivedisclosure to the exclusion of relevantinformation .. Certainly this rule will give thestudy group the opportunity to observe theresponse of registrants and investors to arequirement for non-precise subjective disclosure.The rule will of course be part of thetotal framework studied and its adoption atthis time does not exclude it from considerationin the study.Non-Inclusion of Other Current Cost andValue DataSome commentators on the proposed ruleobjected to its partial approach. They suggestedthat data be required concerning thecurrent value of other assets' and liabilitiesand the effect of inflation on monetary itemsheld by the company. The Commission recognizesthat its rule is a limited one and doesnot deal either with all effects of inflation onfinancial position and operations, or with thecurrent value of all assets and liabilities. Itsprimary objective, as articulated in ~headopted rule, is to provide investors WIthmeaningful additional information not oth~rwiseavailable about the current econo~Icslof a business as a supplement to h IS· t rIca0 .cost data. A secondary objective is to proV'I.d edata about the current cost f · entorles0 IllV' tand productive capacity at the balance sheet' g asdate.These are the principal oper~ l~ thatsets of many businesses. It is recognIze urereplacement cost does not always meaS tsthe current economic values of such as se ,

ACCOUNTING SERIES RELEASES 461but in m'ost cases it is a reasonable approximation.The Commission views its rule as a firststep'in a process of providing more meaningfuldisclosure .about current economic costsand values to investors. It believes that therule will encourage meaningful experimentationwith the various approaches to providingsuch information, and as noted above itwill assist the F ASB in addressing the broadconceptual and practical issues involved.The Commission also believes that the rulewill provide investors' with significant datanow unavailable about the effect of currenteconomic conditions on the bllsiness. Theeffect of inflation on mOl'1:eta'ry assets andliabilities can be approximated from datanow publicly available, and the current marketvalue of marketable securities portfoliosis required to be disclosed. With the additionaldata provided as a result of this rule,analysts and investors should be able to developa. number, of different methods of analyzingeconomic results, such as estimatingthe return on new investment, calculatingrates of return on capital based on varyingassumptions and developing alternativemeasures of economic results.The Commission cautions investors andanalysts against simplistic use of the datapresented. It intentionally determined not torequire the disclosure of the effect on netincome of calculating cost of sales and depreciationon a current replacement cost basis,both because there are substantial theoreticalproblems in determining an income effectand because it did not believe that users~hould be encouraged to convert the dataInto a single revisE;!d net income figure. Thedata are not designed to pe a simple roadmap to the determination of "true income."~n addition, investors must understand thatUe to the subjective judgments and thelllany different specific factual circumstances. . ,Involved, the data will not be fully comrarableamong companies and will be subjecto errors of estimation.Legal Exposure of RegistrantsFinanabout y, commentators expressed concernthe possible legal liabilities to whichthey would be exposed as a result of includingdata based on subjective judgments andestimates. While the Commission believesthat registrants are protected under the lawas it now exists if such data have a reasonablebasis, are prepared with reasonable careand in good faith and are accompanied bydisclosure of the basis of their calculationand the imprecisions inherent therein, it hasdetermined to propose an amendment toRule 3-17 to make this clear. This proposal isbeing issued for comment (in Securities ActRelease No. 5696) simultaneously with theadoption of these amendments to RegulationS-X.Effect on CompetitionThe Commission has considered the impactwhich the foregoing amendments to RegulationS-X would have upon competition andhas concluded that the preparation and discloslire'of replacement cost information ofthe type in question to the public, includingregistrants' competitors, will not significantlyburden competition. In addition, theCommission has concluded that requiringth~se disclosures only by those companieswhose inventorIes and gross property, plantand equipment aggregate $100 million ormore, and whose total inventories and grossproperty, plant and equipment are 10% ormore of its total assets, will not significantlyburden the ability of such companies to competewith those which do not meet thesecriteria. In' any event; the Commission hasdetermined that any possible resulting burdenwill be far outweighed by, and is necessaryand appropriate to achieve, the importantbenefits to investors discussed herein.Effective Date of Regulation S-X AmendmentsThe ,CommIssion has determined to makeRule 3-17 of Regulation S-X effective forfinancial statements covering fiscal yearsending on or after December 25, 1976, withthe exception that it shall not apply to themineral resource assets of companies engagedin the extractive industries prior tofiscal years ending on or after December 25,1977, nor shall it apply to the assets located

462 SECURITIES AND EXCHANGE COMMISSIONoutside the North American continent andthe countries of the European EconomicCommunity prior to fiscal years ending on orafter December 25, 1977, provided that thehistorical cost and a description of any suchassets excluded from the supplemental replacementcost data are disclosed.B. Amendments AdoptedRegulation S-X.* * * * *-Rule· 3-17. Current Replacement Cost Information.Statement of ObjectivesThe purpose of this rule is to provide informationto inve~tors which will assist them inobtaining an understanding of the currentcosts of operating the business which cannotbe obtained from historical cost financialstatements taken. alone. Such informa,tionwill necessarily include subjective estimatesand it ·-may be supplemented by· additionaldisclosures to assist investors in understandingthe meaning of the data in particularcompany situations. A secondary purpos~ isto provide information which will enableinvestors to determine the current cost ofinventories and productive capacity as ameasure of the current economic investmentin these assets existing at the balanc~.sheetdate.Exemption. This rule shall not apply toany person where the total of inventoriesand gross property, plant and equipment(Le., before deducting accumulated depreciation,depletion and amortization) asshown in the consolidated balance sheet atthe beginning of the most recently completedfiscal year is less than $100 millionor where the total of inventories and grossproperty, plant and equipment is less than10 percent of the total assets of the personas shown in the consolidated balance sheetat the beginning of the most recently completedfiscal year.The information set forth below shall beshown in a note to the financial statementsor as part of a separate section of the financialstatements following the notes. "The noteor the separate section may be designated"unaudited." ,. .."..(a) The current replacement 'cos~of inventoriesat each fiscal year end for which abalance sheet is required shall be stated. 'Ifcurrent replacement cost exceeds netrealiz':,able value at that date, that fact shall bestated and the amount of the excess disclosed..(b) For the two most recent fiscal years,state the approximate amount which ,cost ofsales would have been if it had been calculatedby estimating the current replacementcost of goods and services sold at the timeswhen the sales were made. .(c) State the estimated current cost of replacing(new) the productive capacity togetherwith the current depreciated replacementcost of the productive capacity on handat the end of each fiscal year for which abalance sheet is required. For purposes ofthis rule, assets held under financing leasesas defined in Rule 3-16(q) shall be included inproductive capacity. In the case of any majorbusiness segments wl1ich the company doesnot intend to maintain beyond the economiclives of existing assets, the disclosures setforth in Rules 3-17(c) and (d) are not requiredprovided full disclosure of the facts, amountsand circumstance;; is made.(d) For the two most recent fiscal years,state the approximate amount of .depreciation,depletion and amortization which wouldhave been recorded if it were estimated onthe basis of average current replacementcost of productive capacity. For purposes ofthis calculation, economic lives and salv~g~values currently used in calculating hist?rIcalcost depreciation, depletion or amortI~ationshall generally be used. For assets be.1Dgdepreciated, depleted or amortized on a tlml~expired basis, the straight-line method sha _be used in making this calculation. For assets deprecIated,.'depletedor amortized. shallonany other basis (such as use), that baSISbe used for this calculation. . erJllin-(e) Describe the methods used In det (0). 'temS ..ing the amounts disclosed m 1 . derathrough(d) above. Describe wha~ consl·ternstion, if any, was given in respondmg to 1

ACCOUNTING SERIES RELEASES 463(a) and '(b) . to the related, effects on directlabor costs, repairs and maintenance, utilityand other indirect costs as a result of theassumed replacement of productive capacity.Where the economic lives or salvage valuescurrently used in historical cost financialstatements are not used in (d) above, anexplanation of other bases used and the rea­,sons therefor shall be disclosed. If depreciation,depletio~ 'or amortization expense is acomponent of inventory costs or cost of sales,indicate' that fact and cross-reference theanswer' for this item in item (b) in order toavoid, potential' duplication in the use ofthese data.(0 Furnish any additional informationsuchas the historical customary relationshipsbetween cost changes' and changes inselling prices, the difficulty and related costs(such as those related to environmental regulations)which might be experienced in replacingproductive ca'pacity-of which managementis aware and which it believes isnecess~ry to prevent the above informationfrom being misleading., * * * * *This amendment to' Regulation SoX isadopted pursuant to Sections 6, 7, 8, 10 and19(a) of the Securities Act of 1933; Sections12, 13, 15(d) and 23(a) of the. Securities ExchangeAct of 1934; and Sectio~s 5(b), 14 and20(a) of the Public Utility Holding CompanyAct of 1935.Rule 3-17 of Regulation S-X is effective forfinancial statements for fiscal years endingon or after December 25, 1976" except t~atthe rule shall be initially applicable to themineral resource assets of registrants engagedin the extractive industries and toregistrants' assets located outside the NorthAmerican continent and the countries of theEuropean Economic Community in financialstatements for fiscal years ending on or afterDecember 25, 1977; provided that the histori-: cal cost and a description of any such assetsexcluded from the supplemental replacementcost data are disclosed.. B~ the Commission.GEORGE A. FITZSIMMONSSecretaryRELEASE NO. 191March 30, 1976 'Findings, Opinion and, Order Imposing Remedial Sanctions in the Matter of Rudolph, Palitz & Co_and Harvey B.. Spiegel'These are proceedings pursuant to Rule2(e) of the Commission's Rules of Practice todetermine whether Rudolph', Palitz & Co.("the firm"), a public accounting firm, and:arvey B. Spiegel, a former partner of thet~, should be temporarily or permanently. enled the privilege of appearing o'r practic­Ing before the Commission.s ~esPondents have submitted an offer of.:. tlelllent which the Commission has deter­"llned tth 0 accept. Solely for the purpose ofde~s~ proceedings and without admitting orceellng the allegations of the order for prolllgS,respondents consent to institutionof proceedings under Rule 2(e)' of the Commission'sRules of Practice and to the entryof an order containing certain findings andremedial sanctions as set forth below.On the basis of the order for proceedingsand the offer of settlement, it is found that:1. Capital Corporation of America (CCA), aPennsylvania corporation, has been registeredwith the Commission as a management,closed-end, non-diversified investmentcompany pursuant to Section 8 of the InvestmentCompany Act of 1940 (1940 Act) sinceMarch 30, 1967. CCA is also a small business

464 SECURITIES AND EXCHANGE COMMISSIONinvestment' company, licensed as such onAugust 9, 1962 under the Small BusinessInvestment Act of 1958.2. CCA filed with the Commission a registrationstatement on June 28, 1967 under theSecurities Act of 1933 (1933 Act) which registrationstatement became effective September17, 1970. CCA also filed reports and proxysolicitation materials as required by Sections20 and30(a) and (b) of the 1940 Act.3. Respondent Spiegel was CCA's auditorfrom prior to March 31,1967 through October31, 1968. Respondent Rudolph,Palitz wasCCA's auditor from November 1, 1968 toMarch 31, 1974. From November 1, 1968through February 28, 1972, respondent Spiegelwas a partner of respondent Rudolph,Palitz and was the partner in charge of theaudit of CCA.l4. Subchapter M of the' Internal ~evenueCode of 1954 enables an investment companyto enjoy certain favorable tax treatment providedthat, among other things, at the end ofeach fiscal quarter of the investment company,the values and distribution' of certainsecurities owned by the investment companydo not exceed specified percentages of thetotal assets of the investment company.5. From sometime prior to March 31, 1967continuing beyond March, 1972, CCA hadestablished lines of credit with variousbanks. On or about March 31, 1970, CCAborrowed $500,000 against such lines ofcredit, issuing notes therefor, payable April1, 1970. On or about March 31, 1971, CCAborrowed $740,000 against such lines ofcredit, issuing its notes therefor bearing adue date of April 1, 1971. On or about March30; 1972, CCA borrowed $200,000 issuing itsnote payable April 3, 1972. April 3, 1972 wasthe first banking day following March 31,1972. Each note was repaid on the due date.6. Respondents knew that the purpose ofthe aforesaid borrowing was to increase theamount of cash of CCA at the end of thefiscal quarters ended March 31, 1970, March31, 1971 and March 31, 1972, 2 so as to enableCCA to show the requisite ratios and thereby1 Respondent Spiegel has not practiced as a publicaccountant since March 1, 1972.2The fiscal year of CCA ends on March 31.to qualify for the favorable tax treatmentafforded investment companies under SubchapterM of the Internal Revenue Coqe.Respondents knew or should have knownthat eCA did not intend otherwise to use theproceeds of the loans made on or aboutMarch 31, 1970, March 31, 1971 and March31, 1972 in the operations of CCA.7. Respondents, in auditing and reportingon the financial statements for the fiscalyears ended March 31~ 1970, March 31, 1971and March 31, 1972, acquiesced in the followingtreatment of the transactions for balancesheet purposes: The proceeds of the borrowingswhich occurred on or about March 31 ofeach year were included as cash on the assetside of the balance sheet. The amounts of theborrowings were included under liabilitiesand capital under the caption "Notes payabledue within 90 days-unsecured."8. The balance sheet of CCA dated March31, 1970 showed cash in the amount of $533,-105. Of this amount, $500,000 represented theproceeds of the note dated March 31, 1970payable April 1, 1970. The balance sheet ofCCA dated March 31, 1971 showed cash inthe amount of $859,619. Of this amount,$740,000 represented the proceeds of the notedated March 31, 1971 payable April 1, 1971.The balance sheet for March 31, 1972 showedcash in the amount of $448,393. Of thisamount, $200,000 represented the proceeds ofthe note issued March 30, 1972 payable April3,1972.9. The borrowings referred to above representedapproximately 53 percent of the notespayable shown in the balance sheet datedMarch 31, 1970, approximately 50 percent ofthe notes payable shown in the balance sheetdated March 31, 1971 and 50 percent of thenotes payable shown in the balance sheetdated March 31, 1972.10. Because of the "one-day" nature of the. purnotes,the uniqueness of the busmess dpose for which the transactions were enter Ie. . re a-into and the size of the transactIOns In htionship to the aggregate amounts of ht e~cash and notes payable on the balan~: ~ e bydates, respondents should have clarIfIe 'tafinancialstatement notes or other a~~e~tesble methods, the Items . "h" cas and n ts topayable" on the year-end balance shee

ACCOUNTING SERIES RELEASES 465reflect the effect on those items of theseborrowings and their repayment. Respondents,by failing to so clarify those items,failed .. to properly give effect to generallyaccepted accouflting principles in reportingon the financial statements of CCA for thefiscal years referred to above.11. The statement of consolidated incomefor the year ended March 31, 1971 containedin the annual report dated March 31, 1971 ofCCA reflected $90,000 as a gain on investmentresulting from the purported sale ofproperty owned by CCA. This property hadbeen acquired by CCA through foreclosureon 27 acres of land which had a cost basis toCCA of $60,000. On September 28, 1970, CCAsold its 27 acres to Affiliated Associates for$150,000. Affiliated· Associates made no downpayment on this purchase. CCA received· atwo-year, 6 percent purchase. money mortgagein the principal amount of $150,000 withboth principal and interest due and payabletwo years from the date. CCA further receivedwarrants. to purchase a 50 percentinterest in Affiliated Associates stock at $.10per share. Respondents knew that AffiliatedAssociates was not an operating company.At the time of the' audit, the property wasappraised at $250,000.12. The $90,000 gain shown in the statementof consolidated income for the yearended March 31, 1971 referred to above,should not have been so reflected in suchperiod and should have been deferred. Intheir weighing of the factors to determinewhether the gain should or should not havebeen recognized, respondents failed to employgenerally accepted accounting principlesand auditing standards. 3h After due consideration, the Commissionas determined to accept the offer of settlement.In arriving at its determination, theCommission considered the fact that RespondentRudolph, Palitz & Co., in order toinsure that it performs its audits in accordancewith generally accepted auditing standards,has agreed to the review described inthe order, and likewise that RespondentHarvey B. Spiegel has agreed to participatein a program of continuing education.Accordingly, IT IS ORDERED that proceedingspursuant to Rule 2(e) of the Commission'sRules of Practice be, and they herebyare, instituted against Respondents.IT IS FURTHER ORDERED that, uponthe terms and conditions provided in theoffer of settlement, Respondents consent tothe entry by the Commission of an orderwhich provides that:1. Respondent Rudolph, Palitz & Co. iscensured.2. Respondent Harvey B. Spiegel is suspEmdedfrom practice before the Commissionas an accountant for a period of sixty (60)days.Respondent Rudolph, Palitz & Co. hasagreed that it will participate, after May 1,1976 in a local firm quality peer review programconducted by the American Institute ofCertified Public Accountants.Respondent Harvey B. Spiegel has agreedthat he will undertake a program of continuingprofessional education consistent withthe guidelines recommended by the AmericanInstitute of Certified Public Accountantson continuing education for professionalmembers of said association.IT IS FURTHER ORDERED that AdministrativeProceeding Number 3-4402 is herebydismissed.By the Commission.GEORGE A. FITZSIMMONSSecretary----3see Ac .ber 28 19 COuntmg Series Release No. 95, dated Decem-El(cha~ 62, Securities Act Release No. 4566, Securitiesge Act Release No. 6982.

SECURITIES ~D EXCHANGE COMMISSIONSECURITIES EXCHANGE ACT OF 1934Release No. 12629RELEASE NO. 192July 14, 1976Notice of permanent disqualification from appearance or practice before the Commission in the" . Matter of Archie S. Barnhill, On April 6, 1976, the Commission enteredan order, pursuant to rule 2(e)(3)(i) of itsRules of Practice, temporarily suspendingArchie S.· Barnhill, a certified public accountantfrom appearing or practicing before theCommission. The order was based on the factthat on January 16, 1976, Barnhill was permanentlyenjoined by the United States DistrictCourt for the Northern District. ofTexas, Dallas Division, in a suit brought bythe' Commission 1 from violating Section 5(a),5(c) and 17(a) of the Securities Act of 1933and Section 10(b) of the. Securities ExchangeAct or1934 and Rule lOh .. 5 thereunder. Barn ..l).il1 consented to the injunction without admittingor denying the substantive allega ..tions in the Commission's complaint.The complajnt in the injunctive action allegedthat Barnhill violated the above provisionsof th~ federal securities laws in that,among other things" he certified a financialstatement of Tex-A-Chief, Inc. following apurported audit, when in fact Barnhill's auditconsisted mainly of discussions with thatcompany's president and did not include independentverification of Tex-A-Chiefs assetsand liabilities.Rule 2(e)(3)(ii) of the Commission's Rules ofPractice provides that any person temporarilysuspended in accordance with paragraph(i) of that rule may, within 30 days afterservice upon him of the order of temporarysuspension, petition the Commission to liftsuch suspension, but that if no petition hasbeen received by the Commission within 30days after such service, the suspension shallbecome permanent. Barnhill was duly notifiedof this provision. The 30-day period hasexpired and no petition to lift the suspensionhas been received by the Commission.Accordingly, notice is hereby given thatthe temporary suspension of Archie S. Barnhillhas become permanent and that Barnhillis, therefore, disqualified from appearing orpracticing before the Commission.GEORGE A. FITZSIMMONSSecretary'S.E.G. v. Tex-A-Ghie'" Inc. Civil Action No 3-75-1478D. 'J" •

ACCOUNTING SERIES RELEASES 467RELEASE NO. 193July 27, 1976SECURITIES ACT OF 1933Release No. 5729'SECURITIES EXCHANGE ACT OF 1934Release No. 12662PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19629INVESTMENT COMPANY ACT OF 1940Release No. 9369Request by Arthur Andersen & Co.-Partial Response and Solicitation of Comments on CertainQuestionsOn June 15, 1976, the public accountingfirm of Arthur Andersen & Co. ("Andersen")filed a "petition" with the Commission requesting,essentially, that we considerwhether to:(1) revoke Instruction H(f) of Form 10-Q[17 CFR 249.308a] which requires that independentaccountants express their judgmentregarding the preferability of an accountingprinciple adopted when accounting principlesare changed at the discretion of a registrant.(2) withdraw the statement of policy embodiedin Accounting Series Release No. 150[39 FR 1260] in which the Commission statedthat it would consider accounting principles,standards and practices promulgated by theFinancial Accounting Standards Board(FASB) as having substantial authoritativesupport and those contrary to such F ASBpromulgations as having no such support. 1(3) define the current meaning of the term"substantial authoritative support."PreferabilityInstruction H(f) to Form 10-Q was adopted~Y the Commission in Accounting Series Re-5e5~se No. 177 on September 10, 1975 [40 FR37]. It was originally proposed for com-----'The Com ..203 of th miSSIOn noted in this connection .that RuleArneric e Ru!:s of Conduct of the Code of Ethics of the\'ides t~n I~st~tute of Certified Public Accountants pro­PrinCiple at It IS necessary to depart from accountingCouncil ~ promulgated by the body designated by thefailure :0 ~he AICPA if, due to unusual circumstances,8t~tements ~ so would result in misleading financial. P.tJnciPles nd that, in such a case, the use of otherilIon. may be accepted or required by the Commismentin essentially the same form on December19, 1974 2 and comments were received onit and carefully considered by the Commission.In addition, the issues regarding thisinstruction were presented at public hearingsheld in 1975 on the Commission's interimreporting proposals.Subsequent to adoption of Instruction H(f),the Auditing Standards Executive Committeeof the AICPA (AudSEC) requested thatthe Commission reconsider the instructionand, in response, the Commission held a publicmeeting with the Committee on April 23,1976 at which the issues were discussed andat which time several submissions were received.On April 30, 1976, the Commissionadvised AudSEC that, after further consideration,it saw no reason to change its conclusion.The substantive issues involving InstructionH(f) therefore have been thoroughlyaired and the reasons for the Commission'sconclusions have been fully set forth. In theabsence of any showing by Andersen that ithas presented any new substantive reasonsfor reconsideration of our action, the Commissionhas no basis before it warrantingfurther reconsideration of the matter.Establishment of Accounting PrinciplesThe second and third actions requested byAndersen raise fundamental issues of importanceupon which the Commission has concludedit wishes to have the benefit of publiccomment before determining what action, ifany, it may be appropriate to take. In addi-2 Release Nos. 33-5549, 34-11142, 35-18718 [40 FR 1079].

468 SECURITIES AND EXCHANGE COMMISSIONtion, the Commission expects to hold a publicmeeting on the issues with invited representativesof persons With significant interestsin financial·reporting.A cornerstone of the disclosure processenvisioned by the securities laws is the financialinformation included in audited financialstatements. Since 1933, when Congressdetermined to rely on independentaccountants to provide assurance of reliabilityin financial statements, the Commissionhas relied upon the judgments of the accountingprofession both in individual factualcircumstances and in the establishmentof principles of general acceptance. In 1938,the Commission stated its administrativepolicy with respect to financial statements inAccounting Series Release No. 4 [11 FR10913]:"In cases where financial statements filedwith this Commission pursuant to its rulesand regulations under the Securities Act of1933 or the Securities Exchange Act of1934 are· prepared in accordance with accountingprinciples' for which there is nosubstantial authoritative support, such financialstatements will be presumed to bemisleading or inaccurate despite disclosurescontained in the certificate of theaccountant or in footnotes to the statementsprovided the matters involved arematerial. In cases where there is a differenceof opinion between the Commissionand the registrant as to the proper principlesof accounting to be followed, disclosurewill be accepted in lieu of correction ofthe financial statements themselves only ifthe points involved are such that there issubstantial authoritative support for thepractices followed by the registrant andthe position of the Commission has notpreviously been expressed in rules, regulationsor other official releases of the Commission,including the published opinionsof its Chief Accountant."In. 1973, various private sector groups concernedwith financial reporting establishedthe' Financial Accounting Standards Boardand this body was designated by the accountingprofession as the entity having the responsibilityfor considering and promulgating. accounting standards andinterpretations. Following this action, theCommission issued a Statement of Policy(ASR 150) reflecting its recognition of th~F ASB's role in the setting of accountingprinciples, standards and practices. ASR 150reflected an explicit statement of the Commission'sadministrative practice in carryingout its responsibilities under the securitieslaws. Historically, the Commission has acceptedas having substantial authoritativesupport those practices which have beenidentified by the accounting profession asstandards to be followed by members of theprofession. With. the creation of the F ASB,the Commission believed that it should publiclyindicate that it viewed the standards,practices and interpretations issued by theF ASB as constituting those practices havingsubstantial authoritative support.Andersen requests that the Commissionwithdraw these policies which have governedthe manner by which it has determinedwhether financial statements meet the requirementsof the Securities Acts. Beforeresponding to Andersen's request, the Commissionhereby solicits public comment onthe following basic issues raised:1. Should the Commission continue its pol~icy of recognizing the pronouncementsof the Financial Accounting StandardsBoard as providing a frame of referencefor publicly held companies to satisfytheir statutory disclosure obligations'?2. Should the Commission further definethe phrase "substantial authoritativesupport"'?3. Should the Commission further definethe phrase "accounting principles andpractices" used in Rule 2-02(c) of RegulationS-X [17 CFR 210.2-02(c)]? dComments in triplicate should be ~ -dressed to the Secretary, Securities and 05:~change Commission, Washin~on, D.C. ~OJJlandshould be referenced to FIle S7-647. 15ments should be received by S eptemberub-'1976. All comments will be available for Plic inspection.By the Commission.GEORGE A. FITZSIMMONSSecretarY

SECVRITIES ACT OF 1933Release No. 5730PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19630ACCOUNTING SERIES RELEASES 469RELEASE NO. 194Aprjl 29, 1976SECURITIES EXCHANGE ACT OF 1934Release No. 12663Reporting Disagreements with Former Accountants-Adoption of Amendments of RequirementsIn Securities Act Release No. 5701 issuedon April 29, 1976, [41 FR 19132] the Commissionproposed an amenqment of RegulationS-X [17 CFR Part 210] which modifies previouslyexisting requirements for disclosure ina note to the financial statements of certaindisagreements with former accountants regardingaccounting. and financial disclosurematters. Nine letters of comment, all favorable,were received in response to the proposal.The Commission has ·determined toadopt the amendments substantially as proposed.BackgroundIn Accounting. Series Release (ASR) No.165, December 20, 1974, [40 FR 1010] theCommission announced adoption of certainamendments of Form. 8-K, [17 CFR .249.308]Regulation S-X [17 CFR Part 210] and Schedule14A [17 CFR 240.14A-I01] of the proxyrules~ The amendments then adopted· wereoriginally proposed on October 11, 1974, inSecurities Act Release No. 5534 [39 FR37999].Among other matters, Rule 3-16(s) of Regu­~ation S-x [17 CF.R210.3-16(s)) was adoptedy that release.· That rule called for disclo­Sur ." e lD a note to financial statements of twod 1St' .1 lDet matters, as follows:. The fact of a reported disagreement.~he first sentence of the rule stated:If, within the twenty-four mo,pths priorto the date of the most recent financialstatements, a Form 8-K has been filedrep rt', 0 lDg a change of accountants andIncluded in such filing there is a re-Ported d'lsagreement on any matter.of~ecO~nting principles or practices or fianclalstatement disclosure, and if.such disagreement, if differently resolved,would have caused the financialstatements to differ materially fromthose filed, state the existence and natureof the disagreement."In connection with this portion of the rule,the text of ASR 165 states:"This disclosure is believed necessary toput readers of the financial statementson notice that such a disagreement existedwhich could have significantly affectedthe statements."2. The effect on financial statements ofchanging accountants as regards a reporteddisagreement. The second sentenceof the rule stated:"In addition, if during the fiscal year inwhich the change in accountants tookplace or during the subsequent fiscal. year ·there have been any transactionsor events similar to those which involveda reported disagreement and ifsuch transactions are material and wereaccounted for or disclosed in a maimerdifferent from that which the formeraccountants apparently concluded wasrequired, state the effect on the finan­Cial ·statements if the method which theformer accountant apparently concludedwas required had been followed."In connection with this portion of the rule,the text of ASR 165 states, in part:"This disclosure will make investorsaware of situations where alternativeaccounting approaches may be followedand are favored by at least one professionalaccountant, and the effect of suchalternative approaches. In addition, it is

470 SECURITIES AND EXCHANGE COMMISSIONbelieved that such disclo.sure requirementsmay have the effect o.f disco.uragingshifts in a.cco.untants simply to. obtainappro.val o.f an alternativeacco.unting appro.ach."It sho.uld be no.ted that the fact o.f a disagreementwith a fo.rmer acco.untant is requiredto. be repo.rted in co.nnectio.n withrules o.f the Co.mmissio.n o.ther than Rule 3-16(s) o.f Regulation SoX [17 CFR 210~3-16(s)Jspecificallyin Fo.rm 8-K fo.llo.wing the resignatio.no.r dismissal o.f the fo.rmer acco.untanto.r the engagement o.f a new accountant, andunder Item 8 o.f Schedule 14A o.f the proxyrules. On the o.ther hand, disclosure of theeffect on financial statements o.f changingaccountants as regards a disagreement repo.rtedin Fo.rm 8-K is required o.nly by Rule3-16(s) o.f Regulation SoX [17 CFR210.3-16(s)].Objections to Existing RuleSeveral o.bjectio.ns had been raised to. continuillK.the requirel!i~nt fo.r disclosure infinancial statements o.f the fact of disagreementin circumstances where disclosure regardingthe effect o.n·financial statements isno.t required.1. In the vast majo.rity o.f cases, disagreementsregarding matters of acco.unting princ;ipleso.r practices o.r financial statement disclo.surE:are resqlved to. the satisfactio.n o.f thefo.rmer accountant and the same kind o.ftransactio.ns o.r events continue to. be acco.untedfo.r o.r disclo.sed consistent with whatthe fo.rmer acco.untant apparently co.ncludedwas required. In such circumstances thefinancial statements have no.t been affectedby a treatment different fro.m that which thefo.rmer acco.untant apparently co.n~luded wasrequired. Thus, while a different reso.lutio.nof the matter o.f disagreement co.uld haveaffected the financial statements, the statementshave no.t been so. affected..2. Many believe the requirements o.f Fo.rm8-K and the pro.xy rules pro.vide adequateno.tificatio.n to. tho.se users o.f financial statementswho. may deem the disclo.sure materialto. their co.nsideratio.ns.3. D.isclo.sure o.f o.nly the fact o.f a disagreementm a note to. financial statements wasintended only to. . info.rm readers that . thefinancial statements might have been prepareddifferently if the matters o.f disagreementhad been reso.lved differently and no.tto. raise questio.ns abo.ut the a·dequacy o.rfairness o.f the statements presented. Thismay be misundersto.o.d.4. Audito.r changes that precipitate the repo.rtingo.f disagreements on Fo.rm 8-K areno.t numero.us and o.nly a small portio.n o.ftho.se cases is expected to. invo.lve circumstanceswhere the successo.r. acco.untantdeems accounting principles o.r practices o.rfinancial statement disclo.sures acceptablewhich the fo.rmer acco.untant fo.und unacceptable.Thus, if the vast majo.rity o.f no.testo. financial statements regarding "disagreementson acco.unting and financial disclo.surematters"··do. not require any disclo.sure o.f theeffect o.n the financial ~tatements, there maybe ~ tendency fo.r readers to. give less attentio.nthan warranted to. tho.se which do. co.ntaindisclo.sure·s abo.ut the effects.Amendment of Ruie 3-16(s) [17 CFR 210.3-16(s)JThe Co.mmissio.n has co.ncluded that theseo.bjectio.ns have substantial validity. Accordingly,it is ado.pting the amendment to. Rule3-16(s) o.f Regulatio.n SoX [17 CFR-210.3-16(s)]to. require disclo.sure in a no.te to. the financialstatements o.f .the existence and natureo.f a previo.usly repo.rted disagreement o.nlywhen disclo.sure is also. required o.f the effecto.n financial statements if the metho.d whichthe fo.rmer acco.untant apparently co.ncludedwas required had been follo.wed, i.e., o.nly intho.se cases when the successo.r acco.untantfo.und acceptable what the fo.rmer acco. un -tant fo.und unacceptable.Pursuant to. Sectio.n 23(a)(2) o.f the ExchangeAct the Co.mmissio.n has carefullyco.nsidered the impact which the fo.regoin~rule amendment wo.uld have upon co.mpetl~tio.n and has co.ncluded that, to. the exte n .the amendment impo.ses burdens o.n compe t1 -d pro.­tio.n, such burdens are necessary an ap hepriate in furtherance o.f the purposes of tsecurities laws.PART 210-FORM AND CONTENT OF FI-

ACCOUNTING SERIES RELEASES 471NANCIAL STATEMENTS, S'E­CURITIES ACT OF 1933, SE­CURITIES EXCHANGE ACTOF 1934, PUBLIC UTILITYHOLDING .cOMPANY ACT OFt{}35, AND INVESTMENTCOMPANY ACT OF 1940* * * * *§210.3-16. General notes to financial statements.(See Release No. AS-4.)* * * * *(s) Disagreements on accounting and financialdisclosure matters.-If, (1) within thetwenty-four months prior to the date of themost recent financial statements, a Form 8-K has been filed reporting a change ofaccountants,(2). included in the Form 8-"K therewas a reported disagreement on any matterof accounting principles or practices or financialstatement disclosure, (3) during the fiscalyear in which the change of accountantstook place or during the subsequent fiscalyear there have been any transactions orevents similar to those which involved thereported disagreement, and (4) such transactionsor events were material and were accountedfor or disclosed in a manner differentfrom that which the former accountantsapparently would have concluded was' required,state the existence and natur~ of thedisagreement and also state the effect on thefinancial statements if the method had beenfollowed which the former accountants apparentlywould have concluded was required.These disclosures need not be made if themethod asserted by the former accountantsceases to be generally accepted because ofauthoritative standards or interpretationssubsequently issued.* * * * *These amendments are adopted pursuantto authority in Sections 5, 7, 8, 10 and 19(a)[15 U.S.C. 77f, 77g, 77h, 77j, 77s] of the SecuritiesAct of 1933; Sections 12, 13, 15(d) and23(a) [15 U.S.C. 781, 78m, 78o(d), 78w] of theSecurities Exchange Act of 1934; and Sections'5(b); 14 and 20(a) [15 U.S.C. 7ge, 79n,79tl of the "Public Utility Holding CompanyAct of 1935. .This amendment shall be effective withrespect to financial statements filed afterAugust 31, 1976. .By the Commission.GEORGE A. FITZSIMMONS',SecretaryRELEASE NO. 195August 6, 1976SECURITIES ACT OF 1933Release No. 5732PUBLIC UTILITY HOLDING COMPANYACT OF 1935Release No. 19642SECURITIES EXCHANGE ACT OF 1934Release No. 12694Minor Amendments to Regulation S-Xad The . Commission announces herein the02~Ptton of minor amendments to sections 2-

472 SECURITIES AND EXCHANGE COMMISSIONchanges in amounts of depreciation charges,resulting from changes .. in' estimates of re-.maining useful lives of fixed assets, ratherthan from a change in accounting principles.Since these changes have long been requiredto be disclosed in a note to the financialstatements under §210.3-07(a) and morerecently have been required to be disclosedin the section of financial reports devoted tomanagement's discussion and analysis of operations,it no longer is considered necessaryto require a specific comment on thesechanges by accountants in their audit reports.This requirement is eliminated bydeletion from §210.2-02(c) of the words "asrequired to be set forth in §210.3-07(a)" whichheretofore have linked the reporting requirementin, §210.2-02(c) to the changes in accountingpractices specified in §210.3-07(a).Section 210.5-02-32 is amended to correctreferences therein to captions in §210.5-02;.25to reflect revisions in those captions whichwere recently adopted in Accounting SeriesRelease No. 184 [40 FR 59340].Section 210.12-08 is' amended to reinstatethe last three sentences that were in Instruction3 of that section prior to the adoptionof Accounting Series Release No. 178 [40FR 48359] wherein the sentences were inadvertentlydeleted.Commission action: The Commission herebyamends sections 2-02(c), 5-02-32 and Instruction3 of section 12-08, all of Part 219 ofChapter II of Title 17 of the Code of FederalRegulations, to read as set forth below:PART 210--:-FORM AND CONTENT OFFINANCIAL STATEMENTS, SECURI­TIES ACT OF 1933, SECURITIES EX­CHANGE ACT OF 1934, PUBLIC UTIL­ITY HOLDING COMPANY ACT OF 1935,AND INVESTMENT COMPANY ACT OF1940.* * * * *§210.2-02. Accountants' Reports* * * * *(c) Opinion to. be expressed.-The accountant'sreport shall state clearly: (1) The opinionof the accountant in respect of the financialstatements covered by the report andthe accounting, principles and practices reflectedtherein; and (2) the _ opinion of theaccountant as to the consistency of the applicationof the accounting principles, or as toany changes in such principles which have amaterial effect on. the financial statements.* * * * *§210.5-02. Balance sheets.* * * * *32. Other long-term debt.---(a) Include underthis caption all amounts of long-termdebt not provided for under captions 29(a)and 31 above. State separately amounts payableto (1) persons specified in captions25(a)(1), (2), (3) and (6); and (2) others, specifyingany material item. Indicate the extentthat the debt is collateralized. Show here, orin a note referred to herein, the informationrequired under caption 29.(b) * * ** * * * *§210.12-08 Intangible assets, preoperatingexpenses and similar deferrals. 1.2.7* * * *(Instruction) 3. Show by major classificationsin each part, such as franchises, goodwill,etc. If such classification is not present orpracticable, each part may be stated in oneamount. The additions included in columnC shall, however, be segregated in accord­'ance with an appropriate classification.Items of minor importance may be includedunder a miscellaneous caption ineach part.* * * * *The amendments are adopted pursuant toauthority in Sections 6, 7, 8, 10 and 19(a~ ~15U.S.C. 77f, 77g, 77h, 77j, 77s] of the Sec~r~i(:~Act of 1933; Sections 12, 13, 15(d) an .[15 U.S.C. 781, 78m, 78o(d), 78w] 0: the S~CU~~ties Exchange Act of 1934; SectIOns 5(/theand 20(a) [15 U.S.C. 7ge, 79n, 79t] 0 1935'Public Utility Holding Company A~i:~.s.c:and Sections 8, 30, 31(c) and 38(a) f the In-80a-8, 80a-29, 80a-30(c), 80a-37(a)] 0vestment Company Act of 1940.

ACCOUNTING SERIES RELEASES 473Inasmuch as the amendments reduce therequirements of section 210.2-02(c) and correctminor errors in other sections the Commissionfinds that, for good cause, the noticeand procedures. specified in the AdministrationProcedures Act of 1946 are unnecessary,and accordingly the foregoing amendmentsare adopted effective immediately upon publicationin the Federal Register.By the Commission.GEORGE A. FITZSIMMONSSecretary

SUBJECT INDEXACCOUNTING SERIES RELEASESReleaseNo.PageNo.ACCOUNTANTS' CERTIFICATEACCOUNTANTS' REPORT[See CERTIFICATE OF ACCOUNTANTS and CERTIFICATION)ACCOUNTING PRINCIPLES[See also ~ENERA~LY ~C~EPTED ACCOUNTING PRINCIPLES)Changes m accountmg pnnClples .•.. ~ ........•••..•.........••.....•...•.....•...•....•..•.....•..•Change to an alternative accounting principle ......••....•••.........•.••..••...••••.•..............Disagreement regarding accounting principles ••••.•••••....•....•......•.........•..•••..•...................................................................................................................................................................................................Exceptions to accounting principles ..•......•...............••..........•..-.......•................Leadership in establishing and improving. by the accounting profession ......••.. ~ .•...•••..•.•...••..•No substantial authoritative -support for ...•......•...........•....••..•.•••..••....•-••...•.....•............ ~ ................................................................................................................................................................................ ..Plans for following .••••...••.....•••.•.••.............•....•...••......•...••....•...............Requirements for a statement of ••.....•......••....••....•••..... : ..••.••..•.....••.•..•.....••...Requirements for limited partnerships •....•......•.....•.....•....•.....•....•..........••.....•..Review by independent public accountants ......•.•......•...............•.....•....•...............~ubstantial authoritative support for •••......• -.•....•....•.•..........•..............•............Summary ofaccounting principles and practices ......•••.................••..••.................•...ACCOUNTS RECEIVABLEClassification of installment receivables and related deferred income taxes .........•.............•.....COnfirmation of receivables endorsed as normal auditing procedure .••.......•.....•.•..•...........•..Funds improperly classified as accounts receivable .•.............•.............•......•.•......••••..Independent confirmation for earlier years .......................................................... .ADVERTISING COSTSAdoPtion of . ts I d' II requU'emen lor ISC osure ...•.......•....•...........................................nterpretation of term ..........•.............•.....••.....•............•..............•..........ANNUAL REPORTS TO STOCKHOLDERS \~ash now da~ in annual reports to shareholders ••••....••....•••.....•.•..••.•.•.........•.....•....onditions under which c~pies of regular annual reports to stockholders may be rued in place of certainDis financial statements required in Forms 10-K and N-30A·1 (N-1R).....••..............················closure concerning restricted securities by registered investment companies required in reports toIlDshareholders •................••..•.•......•....•...............................................In PlrO~ing disclosures in annual reports to stockholders .......•........•.............................e uSlonof quarterly data m . annual reports to stockholders ........••.•..............................12515919517719316519421150415019~15315216219415017819312510219289012514114241116154177226310471424467333469132802280467286284317103280432468225179102016022624925034210295423475

476 SUBJECT INDEXIAPPRAISAL SURPLUSReleaseNo.PageNo.Creation by promotional companies ............................................................... .Falsely recorded ........•........................................................................8 3179A 433AUDIT COMMITTEESComposed of non-officer members of the board of directors ........................................... .Composed of outside directors ...........................•.........................•.•..•..........Disclosure of the existence and composition ......................................................•..Should strengthen accountants' independence ...................................................... .Would lessen the accountants' direct reliance on management ...........................•.........•...19 6123 221165 334126 228165 330AUDITORS' CERTIFICATEAUDITORS'REPORT[See CERTIFICATE OF ACCOUNTANTS and CERTIFICATION]AUDIT REQUffiEMENTSAdherence to generally accepted standards and reqwrements of audit procedure ............•...........Auditing requirements omitted .....••..................••.........................................Auditing valuations of securities held by investment companies ................. , .................... .Certain replacement cost data may be designated as unaudited ••....................•................•Change in requirements for comments by accountants regarding changes in accounting practices •.•.•....Comment by accountant regarding preferability of management's change to an alternate accounting"principle ....................•.......•..•.......•.......•......•.....•.......•......•.•....• , . 0"................................................................................................Failure to audit or examine registrant's books and statements ........................................ .Failure to comply with generally accepted auditing standards ..............•............•..........•.•""Failure to employ necessary degree of vigilance and inquisitiveness .....................•......•......•..Failure to meet minimum audit requirements of Form X-17 A-5 ......... " ........... : ................ .Familiarization with registration and disclosure provisions of federal securities statutes required ........ .Impracticable to require alternative auditing procedures ........................................... .Improper to attest that balance sheet was prepared from the books and records when it was preparedon basis solely of information supplied by telephone which was false and misleading .................. .Inadequate audit with respect to work-in-process inventories ...............•.........................Independent accountant associated with interim data included in an unaudited footnote in annual financialstatements ............................•......•...............•.................................................................................................................................Independent accountant associated with unaudited replacement cost data .................•.........•.•Inspection by independent auditors of data supporting valuation of restricted securities ..........•.......Lack of adherence to generally accepted auditing standards and Commission's minimum audit requirements.......................•...............•...................................······;······ ................................................................................................................................................................................................Lack of adherence to auditing standards ........................................................... .Limitation on examination of balance sheet inappropriate ............................................ .Need for more thorough auditing procedures ....................................................... .19 421 12118 215190 457195 471177 424193 46748 4159 4873 10391 16197 17299 177105 182143 254157 303160 314174 414192 46619 964 6851 45187 45390 16192 1656777177 421189 456190458113203108109110104197719719719818110106

SUBJECT INDEX477Physical examination and confirmation of securities held by investment adviser ..•....•.••..•...........ProfessiOnal standards and procedures for review of interim financial data proposed in Release No.33-5612: ..........• ~ ..•......•.................•.........•.....................................Proposal for professional standards and procedures for review of interim financial data withdrawn ....... .Reduction ofthe cost of year-end audit examination .................................................•Reliability of audited financial statements .......................................................... .Requirement for a certificate of an independent accountant based on an audit conducted in accordancewith generally accepted auditing standards .......•.........•........•............................Requirements for comments in Form l().Q regarding change of auditors reported in Form 8-K ...•..•...•..Requirements for a quality review of auditing procedures or professional practice ...................... ................................................................................................................................................................................................." ...............................................................................................""Responsibility of independent accountant for review of financial statement disclosures of compensatingbalances. commercial paper and related items •......•......•......•.••.........•..............•...Responsibility to perform audits in conformity with generally accepted auditing standards .............. .Revision of requirements for reporting changes in accountants ....•..•••....•....•.......•.........•...Safe harbor rule relating to estimates of replacement costs proposed in Release No. 33-5696 ....•.........Special requirements for opinion of accountant rued with annual report or Form N-1R .....•......... __ ...Verification of inventories of prior years in first audits ......•.•........ _ .. _ ....••.......•........... _Waiver of audit requirements ..................................................................... .ReleaseNo.1031771891771659017714415316016716817317618619114815316519419012090141PageNo.180426456422330159425255293314342344409418452465273286330469457218159247BALANCE SHEETClassification in. of deferred income taxes arising from installment sales ............................... .Communication of business financial position: .................•.....................................Compensating balances segregated •............................................................•...Consolidated. to reflect financial condition of a parent company and its subsidiaries ..................... .Creation of surplus by appraisal .................................................................... .Criteria for condensation of balance sheet items .................................................... .Disclosure of deferred taxes ......................•..............................................•.Disclosure of market decline in securities .......................................................... .Limitations on examination of. inappropriate .......••................................•...............~isleading balance sheets ..........................•.........................•....................R;~·tin·g· ·t· ·b·· ·k· ·h· ·l·d·:·········.-···············································,············ .. ······o an 0 mg companies ............................................................... .ReviSion of requirements for companies in the development stage .................................... .Requirements for investments of fire and casualty insurance companies ............................... .Requirements for quarterly balance sheets .................•..•.....••..............................BANKSAccounting A f· or mves t men t securl ·t· les .........•: ..•...•.....•.........••.....•.•...............- .....mendments of rules in Article 9 to conform certain reporting practices of bank bolding companIes andbanks to generally accepted accounting principles ................................................. .Clnte ompen sa t· 109 b alances with ............................•...........................•..............r~retation regarding the reporting of aggregate indebtedness of holders of equity securities in con-8?lidated group of banks and the holding company and application of schedules in unconsolidated finan-N:~~ :tat~ments.................................................................'............... .Item or disclosure of uncertainties by banks ....................................................... .Itev.o~al of exemption from certification offinancial statements ...................................... .1810n8 of Article 9 of Regulation SoX applicable to bank holding companies and banks ..•..............1021661483841149166~9679212818118317718818514814116612112817833727113352733391077165239436439424454447270249338220238

478 SUBJECT INDEXBONDSComputation of ratio of e~gs to fixed charges when debt securities are registered ......' .~ ..• ~ •... : .. ...Treatment by investment company of interest collected on defaulted bonds applicable .to Pllriod priorto purchase date .....•....••.............•...................................•.. : ...•.. ' ... ' .. ' •.•BROKER-DEALERSAccountant as broker-dealer .....•..•...........•.......••...•....................• .' .....• : : ...... .Maintenance of current books and records ........•......•..•...•............... > ••••••••••••• ; ••• : •Maintenance of records of transactions by broker.dealers acting as underwriters of investment companyshares .. : ..........•...........................•.........••...........•..•••.•••.....••....•..Quotations for unlisted securities •....•.•.•...... , ...•.............................................Situations in which accountant held to be not independent with respect to a broker-dealer client. ......... ~BUSINESS COMBINATIONSEffect of treasury stock transactions on accounting for business combinations ...••.•....•....•..•.•.•••.Guidelines for pooling-of-interests accounting ..•.••.•..•.....•.......••.•.•• ' ....•....•......•.•..•. :,Statement of policy and interpretations regarding ASR 146 and business combinations ............••.••.... ,CAPITALIZED INTEREST CqSTStatemen~ of policy •......•..•.•..•.......•.......•..••..••..•..•.•....•.. : ..•.•• ' ...• '. : ............. 'ReleaseNo.. '''.119122.:361261569811881126., -,146130146AIf;3PageNo.217",221"31235299176214145235257240260317CAPITAL STO~KAccounting for pro rata stock distributions to shareholders .•..•..•.......•.....•.............•.......Treatment Of dividends when applicable to corporation's own capital stock held in sinking fund ..•........Reacquisition of voting common stock ........•.. ; .........•....••.....••.... :: ...................... .CASH FLOW~porting cash flow and other data ..........•.......................•..•.......•.•..•....•..••....•CERTIFICATE OF ACCOUNTANTSAccountants' report containing an adverse opinion or a disclaimer of opinion •..........•......•..•..•••.Audit report accompanying financial statements which were misleading ..•....•..............•...•.•...Certificate by non-independent accountants .•.•....•••..•.••...•....•.......•. , .•...•..........••.....Certificate required to conform to Rule 2"()2 of Regulation S-X •.....•.............•....•.........•.....Certificate should be addressed to stockholders .•..............•..•......•.........•.................Change in requirements for accountants' reports .•....•........•.........•.•.........................Circumstances for expression of an opinion with respect to summary earnings tables ..•..•..............Comments in audit reports regarding changes in accounting practices .•.............•.............•....Contents of the accountant's certificate ......•..•...•....••........•..•....•... , .......••. : ........ .Disclosures contained in the certificate of the accountant ............................................. ................................................................................................................................ ~ .......................................................... ..False and misleading financial statements and certificate ..•..........•..........•......... , .•.......... .................................................................................................................................................................................................................................................................................................Firm accountable for its certificate ...................•...................•.....•.........••......•.1245146142165167286882144621912312562'195214193889914418667223325725033234119801482555472222245147111346715517725545079

SUBJECT INDEX479ReleaseNo.PageNo.Inju~ctive complaints reiating to examinations of financial statements ........•........................Nature of examina~ion and certificate required where registered management investment companiesretain custody of portfolio investments or place them in custody of national securities exchangemember ... '., ..•............. '" ......•...•...•.. '" .•..•..........................•............Nature of examination and cert;ificate required for yearly review of all funds and securities of client heldby investment adviser ........•. ; ..•.......................................................•.•..Need for disclosure of uncertainties in accountants' repOrts .•..•...•......••..••....•.•.....•..•...•..Opinion eXpressed on the presentation of financial statements on tax basis ................••.•...•.•.•••Opinion qualified as to procedures followed in valuation of securities by investment companies .•..••.•....Opinion q!1alified as to survival of registrant ........• t .......................................... ' ....•Opinions qualified in regard to audit scope or account~g principles .............•....•....•........................................................... j •••••••••••••••••••••••••••••••••••••••••••••••.................................................................................................Outside experts' examination and opinion ..•..•...•. : •..•.•....•.•••.•....•.......•.•.•.............Standards for auditors' reports relating to limited review procedures ................................. .Statement in certificate regarding adequacy of scope of audit ........................•.•..•. ; ......... .Statement in certificate unjustified ........•...•...•.................................................... , ........................................................................................... .Studies of accountants' certificates ..•...•........... : .................•.................•..........Unqualified opinion supported by alternate procedures.-....................................••.. ; .• ; ..Unqualified opinions with respect to false financial statements ..............................•.•.•.•.•.Variations' fu certificates of accountants •.•...•...•...• : ......•...•.....•.....••...•.•.•.•.•....... :. '173 35227. 18103 180i66 337162 316118 216115, -209:77 10690 161165 330165 330177 42119 964 6767 7721 1190 ·161176' 41790 159103 180CERTIFICATES OF DEPOSITConditions for sepl1rate disclosure •.....•.....•.•.......•.........•..•..............................CERTIFICATIONAlleged unethical or improper professional conduct in certification of financial statements ............... .Broker-dealer financial statements, certification of ................................................. ..Certified financial statements contained false anc:! misleading information .............•...............•................................................................................................................................................................................................................................................................................................Certifications with or to the Commission prohibited .... : .......•................•...•................Elimination of exemption from certification requirements for financial statements of life insurancecompanies ..•....•.•.............•...............•............•.................. ·.········•·• .Elimination of exemption from certification requirements for financial statements of banks .............. .False certification of financial statements ..........................•.•................................ .................................................................................................................................................................................................................... ~ ..............................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................F~···:····,································"·········· ...................... , ................... .I nC1a1 statements, certification of ....•............................................................ neoDie statements, certific;ation of ......................................'.......................•...~ .. : .......................................................................................... .I\e qU~e~ent for certification by independent public accountants ................................... .V :tl")ctlon on certifications by accounting firm .............•........................•...•...........V:l Ue of certification by independent accountants .........................•..•.......................Ue of review of system of internal control in certification of financial statements ..................... .148 271105 182143 25464· . 68. 73 8778 106110 198182 438144 256152 283121 22048 4168 8088 15591 16199 177158 308161 315168 344170 348192 466115 20962 5490 15981 140153 29479 13719 7

480 SUBJECT INDEXReleaseNo.PageNo.COMMERCIAL PAPERInterpretation and guidelines for reporting .•.••....•................................................Rescission of guidelines on classification ......•.....................•..........•.....•..............Revision of rule to require additionalseparate disclosures .....•..................•...................COMPENSATING BALANCESInterpretations and guidelines for disclosure .•.....•...........•..•....•..•.......•...•.........•. ' ..Revision of rule regarding disclosures ....................................................•.........COMPANIES IN THE DEVELOPMENT STAGEAmendments of finaneisl reporting requirements .•..•..........•...•..........................•..•..CONSOLIDATED FINANCIAL STATEMENTSConsolidation of financial statements of registrant and its subsidiaries engaged in diverse financialactivities .................................................... '.' ....................••..........Disclosure of aggregate indebtedness of holders of equity securities in consolidated group .of registrantbank holding company ............ ~ •..•..•.••.•..•....•..•.......•.......•..•..•. '.' .•..•........Group financial statements of unconsolidated subsidiaries and 50 percent or less owned persons ..•........Revisions of rules in Article 4 of Regulation S-X regarding consolidated financial statements ...•................................................................................................................................................................................................................................................................................................... ,...~Revisions of rules in Article 9 of Regulation S-X regarding consolidated financial statements of bankholding companies .....•..........•.•.•.••"....•.............................•........•...•••...•Separate registrant summaries in addition to consolidated statements ........•...................•....Treatment of investment in subsidiaries in consolidated fin8jDcial statements ..•.....................•..CONTRACT ACTIVITIESDefense and otherlong-term contract activities .•....•........•..•..........•.........•..............Dis~osure of losses on long-term contracts •......•..•...•..•....•.............•.....................COST OF CAPITALArbitrary bases for allocation ..•..........•....•.....................•...............•......•......DEFERRED INCOME TAXESBalance sheet classification of deferred income taxes arising from installment sales ...........•.......••.Interpretation regarding disclosure of deferred income taxes in the balance sheet ...................... .DIVIDENDSAccounting for pro rata stock distributions to shareholders ...............•...•.......................Interpretation regarding dividends paid to shareholders of consolidated group ..•.......................Interpretation regarding presentation of dividends ...•............................................•.Procedures management investment companies may follow in allocating past dividends to arrive atbalance of undistributed net income and accumulated net realized gain or loss on investments .•.........Treatment of dividends when applicable to corporation's own capital stock held in sinking fund .•.........EARNINGS PER SHAREInterpretation of the significance of ..........•..•................................•.................148172184148184181141141141" 1251541751281553164138163102149124141142665142272351442266442436248249248225295415238297132124531817827346:3

SUBJECT INDEX 481ReleaseNo.PageNo.EARNINGS TO FIXED CHARGESComputation of .ratio .•....•..•............................................•............•..........Coverage of fixed charges ....•....................................................................Requirements for computation of ratio updated. • . . . . . . . . . . . . . .. . .................................. .EXTRAORDINARY ITEMSRequirements for increased disclosure .•..•..••..............FAIR VALUEBasis of valuation ofsecurities held by investment companies ...•............................•........Capitalization of fair value of shares issued in a stock distribution or dividend ...........•...............Recovery of fair market value of a leased property •..................................................FINANCING LEASESInclusion as a part of finance line of business ...•...................................•...............•.Requirement for disclosure of present value and impact on net income of their capitalization .....•........FIXED CHARGESComputation of ratio of earnings to fixed charges, guideline for ....................................... .Presentation of ratio ofearnings to fixed charges, guideline for ....................................... .Requirements for computation of ratio of earnings to fixed charges updated ............................ .FLOATConsideration of, in determining compensating balance .............................•.................FOREIGN CURRENCIESAmendment of rule regarding translation .......................•....•....•.......•.•..•.......•....FORMS, Amendments-Securities Act of 1933-S-l •.....•..•.•...••........•......•............................ ~ •..........................8-2 ..........•...•..•....•.........•..............•....................................•....8-3 •.•••••••••••••••••••••••••••••••.•.••.•••••••••••••••••.•.•••.••••••••••••••••••••.•••••8·7 ............. '" ............... '" ...................................•.........•....................................................................................................8-8 .•..••.•.•.•...•••••..•.•.•..•....•.•..•...•..•..•.•.•..•.•..•...•.......•....•..••••...... ............................................................................................8·9 J, •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••~.ii·::::::::::::::::::::::::::::::::;:::::::::::::::::::::::::::::::::::::::::::::::::::::: :I-A··················································· ..................................... ..........................................................................................SecurTlIes Exchange Act of 1934-10 ., .. .......................................... : .........................................................................................................................................119122155138113118124147175147119122155148125138155181181138155138155138155138155181121138217221297244201214223263416262217221297270225244296437437244296244296244296244296437220244

482 SUBJECT INDEX12 ..........................•................•...•..........•...............................8-K ..•••••.•••.•..•••••..•••.•.•....•....••...•..•.••..••.•••.••.•..•..••..••.••..•.•••..•..•lo-K .........•.•.....•••...........•...............•........•............••.••..•.••........................................ : ......................................................... .11-K .••........•.........•.........•...•.••..................•.............•..•.............12-K .•...............................................•••........•...........................7-Q ..•...••.•...•..••..•...•••...•••••..••.•••••••.••...••..•....•..•...••.••..•.•.•.•...•••lo-Q ..........•....................••..•.........•.•............•....•.••....•.....•.•......Schedule 14A of Regulation 14A ............••................•........•...•••....•..•.....•.......Public Utility Holding Company of 1935-U58 ................................................................. ; ........................ .Investment Company Act of 1940-N-IR.: .................................................. , ...................... : ... ~ ......... .FUNDSGuidelines for disclosure of special purpose funds and funds maintained for further credit availability ••.•..FUNDS STATEMENT, SOURCE AND APPLICATION OFAdoption of requirements for the form and c~ntent of ststements of source and application of funds ......••Improper implication when cash flow data presented outside the statement ..........................••.Revision of requirements for banks ......•.....•....••.....•.....•...........••.............•.....•.Revision of requirements for companies in the development stage ............... , ...................•.Varistion permitted in disclosure offunds statement data ......•..•..............•......•..........••.GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)Amendments of rules in article 9 to conform certain reporting practices of bank holding companies andbanks to GAAP ......................................•.................•.......•.....•.......•.Application of G AAP to the recognition of gain on sale of real estate ..................................•Determination of satisfactory disclosure under GAAP ......................•..........•..... ; ....... .Discussion of problems if accounting net income is not computed in accordance with G AAP ..•............Failure to properly give effect to GAAP in reporting on financial statements .•..•..•..........•......••.................................................................................................False certification that financial statements conformed to GAAP .•....•••....•••....••.....••....••.•............................................................................................ ~ .............................................................................................. ..Generally accepted accounting practice pertaining to accrual of Federal income tax by investment companieswho elect to retain realized capital gains .....•......••......••.•...••..•..•.•.•.............Generally accepted accounting rules applicable to pro rata stock distributions to shareholders ....••.•...•Provision of information in addition to that included in financial statements cOnformin, to GAAP .•••.....Reconciliations of material differences between GAAP and statutory accounting •... : .•.••••••.•..••....References to guidelines for preparation of financial statements of stock life insurance companies in conformitywith GAAP .....••.••......••................••......••.........•.•.......•••..........Rescission of Uniform System of Accounts for registered public utility holding companies to facilitateadjustment of their accounts to GAAP ......••.....••......•...........•.................•........Requirement for a review and analysis of the application of GAAP .•.............••...••.•....•.......•Requirement for enrollment in seminars or courses dealing with GAAP and auditing standards .......... .ReleaseNo.152155181138155138155"165121138152155181155138155177177181165:155120148117142128Ui1177185951641427819168168114124150188152171176179APageNo.285" 296437244296244296334220244'28529643729624429642541943733429621827121125223943742444716932325110646580344207223281439283349419435

SUBJECT INDEXRequirement for GAAP basis financial statements for limited partnerships .•...•..•••....•••...•..••...Requirement that financial statements of insurance companies other than life and title companies be preparedin accordance with GAAP ..••...•..•..••..•.•...•....•.•.••.....•.•.•.••..•••...•.•.••...•Variations under .authoritative accounting pronouncements regarding accounting for securities subjectto moratorium ....•.............•••...•.•••........•....•.......••.•..•...•..•..•.•....•..•....Write-downs in accordance with GAAP •.•..•••••.••.•..• ; •.••.•..•..•.••.•.. : .•......•.....•......•GENERALLY ACCEPTED AUDITING STANDARDS (GAASIDistinction' between a report of audit conducted in accordance with GAAS and a report on a limitedreview ....................................................................................... .Extent of adherence to GAAS by accountants .....•••......•..•.•........•.•....•..•....•...•....•..Failure to comply with G AAS .................................................................... .GAAS ign~red and disregarded .................................................................. ~ .Lack of adherence to GAAS .......................... '.' .......................................... .Procedures to insure thst audits will be performed in accordance with GAAS .........................•.................................................................................................Requirement that audit be conducted in accordance with GAAS ..•..•.............•...............•...Requirements under GAAS .••..•...•....•.....................................•....•.............Responsibility to perform audits in accordance with GAAS .......................................... .INCOME STATEMENTCertification of income statements in first-time audit situations ....•.•..•......•.......................Communi~tion of business results of operations in income statement ...........•...........•....•....•Criteria for condensation of income statement items ................................................. .Disclosure of capitalized interest in income statement .•...•..........••...•.•....•..•...•............Disclosure of potential for loss on securities in income statement .•......•.....•...........•....•.......Guides for explanation of items of financial information in summary of earnings or statement of income ... .Impact of price fluctuations in income statement .................................................... .Reeoneilistion of effective income tax rate indicated by income statement and the statutory Federal Taxrate .............................. ~ ........................................................... .Reporting of realized investment profits or losses by insurance companies subject to revised Article 7 ofRegulation S·X •.•..•.•••••.••.•..•....••....••...•....•.••.•..•..............•.......•.........Requirement for management analysiS of results of operations in Form 1().Q ••••••••••••••••••••••••••••Requirements for certification of profit and loss or income statement applicable to summary earningsRe table. ........................................................................................ .Re vision of requirements" for companies in the development stage ............••.........••.........•.... vision of rule regarding supplementary inco!,De statement information •.....•.•......•............•..~ ............................................................................................. .s~n of rule relating to income statements of bank holding companies .•...........................•.V . . ty ofsummary earnings table to profit and loss statement •.•..•..•..•..........•...............&riatlon permitted in disclosure of income statement data " ........•.....•.............•.•..........~COMETAXESClasSification of deferred income taxes ............................................................ .ReleaseNo.16218318816617719597391979910514315716017419267108109110170176191902115390166411631661591511491831776218112512812862177102483PageNo.3164394553394264481031611721771822543033144144667719719719834841846515913286159337353193393092822734404245443622623923951424178

484 SUBJECT INDEXDisclosures required for income tax expense ........................................................ .Interpretation regarding separate disclosure of state and foreign income taxes ..............•........•..Revision of rule regarding disclosure of income tax expense ...........•.•.........•....' ....: ••........Revision of rules regarding provisions for Federal income taxes by registered investment companies ..... .SEC/IRS agreement regarding disclosure of book/tax conformity requirements ........................ .Ultimate realization of tax benefits ..........................•••.....................•.... ~ ...... : . :INDEPENDENCE OF ACCOUNT ANTSAccountant as attorney .................................................•.•..........•......•.....Accountant as broker-dealerAccountant as commercial competitor ............................................................. .Compilation of representative rulings in cases involving accountants' independence .................... .Guidelines "and examples of situations involving accountants' independence ............................. .Summary of past releases and compilation of unpublished cases arising under Acts administered by Com·mission relating to independence ofaccountants .................................................. .Acting as custodian of securities portfolio of registered investment company ....•.......................Business relationships with clients· ................................................................ .Examination of a nonmaterial segment of an international business ..•........••...•................•.•Family relationships with registrant ....•••....••...•.•......•••..•••..•..•.•...••......•••....•...Financial interest in registrant •.•......•......•....•...•......••.....•.....•.......••....•........Indemnification by registrant •.............•......•........•......••......•••......•...............Lack of independence by accountants .............................................................. .Loans to registrant .........•....................•.....•..•.....•......•...•.......•..•..........•Member of "operating committee" established by board of directors of registrants ...•.•..••...•..•......Occupations with conflicting interests .......................•.......................•..............Performing EDP and bookkeeping services .......•................................•................Principles applicable to determination of independence .....•..........................•..............Registrant's securities pledged as payment for audit services ...•........•...•.....•.....•............Relationship to registrant ..•...•....•...•...•..............................•.......•..............Relationships between registrants and their independent public accountants •...•................•......Relationships with broker-dealers ..........................•..........•..........•..........•......"Requirement for certification incorporated in law ...•.........••.....•....•.•....••...........•......Serving as trustee, officer, director or employee of registrant ........................................ ." ..............................................................................................................................................................................................Situations where there may not be lack of independence ............................................. .Steps to strengthen independence ....•........... : ......•.....................•.....................Stipulated fee paid for advice and services •......•.........•••................................•.....Trading account in securities of registrant ..........•..•......................•..............•......ReleaseNo.149'141125149184114169'162126126126811264781478112611247811262284781112126227882919710811014447.471261263744472165811268124781791654728PageNo..273248225273442. 20734531723523523613922737139391422331994014223211939141200231141061481611721971982553940235229323639..13301452351401391411373304119

SUBJECT INDEX 485.. Account· mg f or mvestment . securities . . ................... ;.......................................... ....... .........................................................................................Release PageNo. No.INSTALLMENT SALESUse of installment method of reporting gross profit for income tax purposes ........•......•.......•....INSURANCE COMPANIES102 179~Accounting for investment securities ............................................ ~ .................. .Amendments of rules in Article 7 A (Life Insurance Companies) pertaining to cash and cash items. otherassets. and other liabilities ..•......•...•......•......•......•......•....................•......•Deferral of proposed rule regarding examination of policy reserves of life insurance companies •...•.......Reference to retention of exemption of life insurance companies from certification of financial statements..................•....•..•.•....•........•.........•..••••.••.•••..••.•...........••.•... Removal of exemption of life insurance companies from certification of financial statements ......•.•.....Requirement that financial statements of insurance companies other than life and title companies beprepared in accordance with generally accepted accounting principles .....•.....•....•............•..Requirements of revised Article 7 of RegulationS-X not applicable to title insurance companies.; •.••..•..Requirements for investments of fire and casualty insurance companies in balance sheet ................ .Revised Article 7 of Regulation S-X permits mutual insurance companies and wholly owned stock subsidiariesto prepare financial statements in accordance with statutory accounting requirements .. ~ •.....Revision of Article 7 A of Regulation S-X applicable to life insurance companies •........•..•.•...••.••...Revision of Article 7 of Regulation SoX applicable to insurance companies other than life and title companies....................................................................................... .INTERESTCapitalization of interest ......................................................................... .Disclosure of short-term interest rates ...................................................•........•.Interest on bonds improperly recorded ..........•..................................•....•.•........Interest ra~e implicit in terms of a lease ....................................................•.....•..Reduction of fixed charges by amounts representing interest income in the computation of earnings tofixed charges •.................•...............................................•......•........Treatment by investment company of interest collected on defaulted bonds applicable to period prior topurchase date ........•..................................•......................................'188184125121'IQ218318318318315218316314.8179A14711936"'45444222522028343943943943928343931727343426421731INTERIM FINANCIAL REPORTS [See REPORTS. INT~RIM] .INVENTORIESDetermination of replacement or current cost for disclosing excess over stated LIFO value .........•..... 141 248Disclosure of inventory profits .....................•......•......•...............................•. 151 281Disclosure problems relating to adoption of LIFO inventory method and SEC/IRS agreement relatingthereto ...•...................... :............................................................ . 169 345Inadequate audit with respect to work-in-process inventories ........................................ . 67 77Inspection of inventories endorsed as normal auditing procedure .........•............................ 19 10Merchandise inventories substantially overstated .•....................•............................ 105 182Nature of costs accumulated in inventories ............•.....•............•...•....................... 164 321Requirement for footnote disclosure of estimated current replacement cost of inventories ...........•.... 190 457Settlement relating to an audit ofan inventory ..................................................... . 157 302Verification of inventories of prior years in first audits .............................................. . 90 159INVESTMENT ADVISERVariations in examinations of funds and securities of clients held by investment adviser ................. .INVESTMENT COMPANIES103 ISO118188212453

486 SUBJECT INDEXAcquisition of restricted securities .............•........................... ; ...........•...........Amendments of Rule 6-02.()9 of Regulation S-X and Rule 2a-4 under the Investment Company Act of--~ 1940 ................•....•...................•....•..........•..•..... ; ....................... .Amendments of rules in Articles 6 and 6B Unvestment Companies) pertaining to cash and cash items.other assets, notes payable. funded debt. and other long-term debt •...............................•..Auditing security valuations ............................................•..............•...•.......Conditions imder which copies of regular annual reports to stockholders may be filed in place of certainfinancial statements ..... ; ; '" ; .•............................... '.' •..................•. , ...••....Disclosures regarding securities ......................................•............................Maintenance of records of transactions by broker-dealers acting as underwriters of investment companyshares .................................................................................. .Portfolio management of securities ...•....................... ~ ....................•...•......•....•.................................................... ; ... ; ... ; .................................... .Procedures for allocating past dividends to arrive at balance of undistributed n"et income and accumulatednet realized gain or loss on investments .........•...........•..............................•... ' ...Revision of annual report Form N-IR ...•....................................................•......Standards followed in retaining custody of portfolio investments or placing them in custody of nationalsecurities exchange member ....................... ' ......... ; ........... ' ..•.......................Treatment of interest collected on defaulted bonds applicable to period prior to purchase date .. , ....•...•Valuation of securities ....................•............•......................................... __................................................................................................ ,ReleaseNo.113'11;4184V 8"",:._: 41113.11611898113118561202736l13118.. 1PageNo.200,206442215.35·205210216176203212·462181831201213INVESTMENT SECURITIES.J'Accounting for. by investment companies ........•...•...........•...... :. ; ..........•...•........•.Auditing valuations of securities of investment companies ..........••.•............•...•.. ,: ....•... ; •Disclosure of income from dividends and interest from investment securities ......... ; .......•.....•. ; ..Disclosure of investments in affiliates ......•......... : .........•....•....... : ...•.......•........•.Di$closure of the cost and market values of investments in securities ..•..... ' ...........•.......•.......Examination of securities of investment company by independent accountant ...•........•...•...•....•.Information on securities to be provided by banks ... " .•.................••...................•....•.Physical examination and confirmation of securities held by investment advisers •..................•....Treatment of investments in subsidiaries in consolidated statements ........•...................•..•...11811841118188190'2712810332122153521645346118238ISO1KEY EMPLOYEESInterpretation of the term ................................•..............................•..•......141LEASESFinancing and non-financing leases in relation to a financing line of business ............••...............Impact on net income of capitalization of financing leases .•..•...................•......•...•........•Increased disclosure oflease commitments by lessees ......•..........•..•.........•....... : ...•....•Interpretation of.disclostire required for noncancelable leases •........•.......................•......•Interpretation of disclosure requirement for rents applicable to leased personal property ............... .Lease transaction to be accounted for as a purchase .....•.•.........................................••Present value of financing leases .•....................•..•..•............•...•..........•.......•..Reduction of requirements for disclosure of minimum rental commitments .....••..•......••...•.•......175147147141141132147184416262262248249242z64442LIQUIDITYDisclosure of management policy •...••.............................................................Presentation of information about liquid assets ..................••....•......•........•.....••......148142'/;672fjO

SU&JECT INDEX 487,MATERIALry'YCombination of captions in quarterly financial statements when inateriality tests are met .•......••...•..Conforming definiticJn to Rule 1-02 of Regulation S-X .................•.......•.....•.................Guidelines for determination of materiality of compensating balance arrangements ....•..•...•.....•...•Interpretation of tests of significance in definition of significant subsidiary .................••.....•......Materiality criteria for condensation of financial statement items ...........•••...••••..........••... : . ~.Materiality test pertaining to tainted treasury shares ....•...•.....................•............ .' ... .Standards for determining materiality ............................................................. .Test for materiality of present value of noncapitalized financing leases .............................. : ..ReleaseNo.177.13814814~41146A159147PageNo.'. 42124ii270• .248'. 34.261310 .264MINIMUM OPERATING BALANCESInterpretation regarding relationship to compensating balances .•..•..•..•.....•.•....•......•..•.• '. : .'- ~148, . 27.0OPINIONS OF ACCOUNTANTS [See CERTIFICATE OF ACCOUNTANTS and CERTIFICATION]OTHER STOCK:HOLDERS' EQUITYAmendment' of rules relating to the account. Surplus. including redesignation as, Other stockholders'equity •....•••......•...........•........................•. ~ ........................•......•..Creation of surplus by appraisal in balance sheets of promotional companies ......•..................•..Disclosure regarding undistributed earnings ........•...•..•.•........•..•.......•...•.........•.•..Earned surplus account established for accumulation of earnings subsequent to effective date of quasi·reorganization .•••........•.....•.........••.•.............•.•......•..•.......................Revision of requirements for companies in the development stage •.•....•.......•.•......•...........•Transfers from retained earnings in connection with pro rata stock distributions to shareholders ......... .POOLING.()F-INTERESTSAccounting guidelines ..•.•......................• ' .....••....•..•.................•...............EHect of treasury stock transactions on accounting for business combinations as poolings-of-interests .... .Statement of policy and uiterpretations regarcnng ASR.I46 and poolings-of-interests ................... .PRICE LEVEL CHANGESImpact on financial statements ............•....•......... '.' .......•...•...' •.....•..................PROCEEDINGS PURSUANT TO RULE 2(e) OF ~ULES OF PRACTICE (See TABLE OF CONTENTS)PROFIT AND LOSS STATEMENT [See INCOME STATEMENT]PRO RATA STOCKAccounting for distributions to shareholders ..................•...•.•...•...........................QUARTERLY FINANCIAL DATA [See also REPORTS. INTERIM]?isclosure of quarterly financial data in notes to annual financial statements ............................ .'" ..................... .o ............ '" ...................... : ............................................................................................................. ..QUASI-REORGANIZATIONApplication to corporate procedure and conditions for ......•..........................................ItATIOSCOlIlputat' .!tat' Ion of ratio of earnings to fixed charges .................................................... .l\e 10. of earnings to fixed charges for total enterprise .............................................. ..qUlrelIlents for computation updated ....•. ' .................•................................•....125814125181124130146146A1511241771892511912215522532481743722324025726128122341945517217221297

488 SUBJECT INDEXReleaseNo.PageNo.REAL ESTATEAccounting for transactions where circumstances indicate profits were not earned at time transaetio~s. were recorded .. •. . •. . . •. •••••••. . •. . ••. •. . . •. . •••••. . . . ••. ••••. . . . . ••••••••. . . . •••••. . . . . ••••. ' 95 169Adoption ofschedules for real estate •...••.••..•.........•.••.•••.•..••..... ;'....••.••....••.•• ~ . . . 125 226Amendment ofschedules. for real estate. ••. . •. •. . . ••. . •. . •••. . ••. •••. •. •. . ••••. •••. ••. . •. . . •. •. ••. . . 'J .J41 250Need for disclosure of uncertainties in real estate industry ...••••••••....•..•.....•...........••.••..' . • 166 338REGULATION S-X. AmendmentsArticles 1: 2. 3. 4. 5. 11 and 12 - General revisions .•.•••.•.••••••••.••.•.•..•..•......•••.•••••••....•Interpretations and minor amendments •••••••.•.•.••..••.••••.•••.••••.•••.••••.••••••..•.••.•..•Article 5A~ Amendments •••.•.•....•..........••.....•...•........•........................... ,.Article 7 - General revision •••••••••••••••••••••••••••••••••••.•••••.•••••••.••••••••..••••.•••••.Article 7 A - General revision .•••....••.•.........•.....•••••....••••.•...•......•.................Article 9-Amendments ••.•.•••••...............•••••.....••••...•.••...•.••. , .••.....•• , .•.•...•General revision •••...•••.•..•••.•••••••....•.•••••••.••••...•.••••..••..•...•....•.••....•..•.Article 11A-Adoption •.•...•.•..•..••.•••••....•••.....•••......••••..•••....•••...•.••....••••.Rule l-02-Amendments ..••••••.•••......•••••••••••..•••••..••••• , ...••.•...•••..••....••••.•.•." " " " " " " " . " " " " " " " " " " " . " " " " " . " " " " " " " . " " " . " " " " " . ,. " " " ,. " " " ~ " " " " " " " " " " .. " " " " " " ,. " ,. " " " " " " " " " " " " " " " " " " " " "~u1e 2-01;... Amendment ••.••.•......•••••...••••.••••••.•.••.....•• : •...•••••••. ~ •••...•••..••••••."Rule 2-02-Amendments •.••• .-••... ~ •••••....••'••••••••••••••••••••••••••••••••••••••••.• ; •• ; ••• '., ,H, """.".,.""""",..""""""""".".""""."""".""""".""""",.""""""""""",..""""""",."."".""""""""•• """"".".,, .i. ~ft .•• """".,, .:."""""."""""".""".""".""""",.",.""""""""""""""" •• """"""."",.""""""" .. """"".""""".""".-." .~-.""" " ",," " """ ,. ,. " "" ".,," "." "". " """ ",." " "" "" .,," " "" ,. "" " " " " "" "" " " " ,." " " "" " " .. "" " " "" " " ";,, " " "" " "" ,.,. " " " ... " " "Rule 3-01-Amendment •••.•.•••••.••.••....•.........•.••.•.•.•......••...••.•• ' ...••••...•.••...•Rule 3-08~ Amendment •..••••••••••••••••••••••.••••••.••••••••••••..•••••.•.••••.•••••..••••••••Rule 3-09-Amendment •.•••••••.••.••••••••••••...••••.•..•.•...•••••...••.••...••.....••.......•RUle 3-15-Amendment ••••••••••••••••.••••..•••••....••••...••••••.••••....••••.•.•••.....•••••.Rule 3-16-Amendments ••.••••••.••••••••..••••.•..•••••..••••..•.••••.•..•••••...•••••...••••...Rule 3-17 - Adoption ••••.•.•••••..••.•••••....•••..••••....••.••.•..••..••••...••..•••.•• ' ••....•••Rule 4-02-Amendments •.••.........••....•..•....•••.•......•.....••....••...••..••...••.••.••••Rule ~5- Amendment ••••.•••..•••••••..•••••..••....••....•••....•.....•••..••..•.•...•..... : .•Rule ~ -Amendment ...••••.••.....••••.•..•.•...•.....••...••.•..•••...••••...••...••. , ...... .Rescission ••..•.•.••••••••••..••••••..••••..•.••..••...••••.•.•.••..••.•.•••.•.•••••••••.......Rule 5-02-Amendments ..••••••••..•.••...••.•..•.•..•••...••.....••.....•...••.•....•••.•...•..•Rule 5-03-Amendments .•••••••••••••••.•..•••...••••....••......••..•..••.....•••.•.....•.......125141181183152-121128-1171251553744792112517719521125125141125147149163165177.17818419419012;515417512512515412514114814915516417818419512514117822624743743928522023821122429632361371122443147111225225250225262275319334431432442470461225295415225225295225250'/fJ72'752963234324424'712262504S2

SUBJECT INDEXRule !HI4-Amendments •..............•..•..•...........•...•.........•••...•.•.•......••.•..•••.................................................................................................................................................................................................Rule ~-Amendm~nt .............•..........•..........••........•....••...........•.•..•.••.••Rule 6-08-Amendment .•.....•..•.......•........•...•....•..•....•..••..........•..••.•••.••••••Rule 6-22-Amendment .••.•..•.•.....•..................................•........•.....•.•...•.•.Rule 7A-OS...!,.Amendment ..•....................•.•.....•................•.... ' ..•....•............Rule 9-05"": Amendments •..•.......•........................•..•..•.....••...••......•.•...•..••.•...................... ., ......................................................................... .Rule llA-OI-Amendment •.•......•...•...•.............•...............•.....•.••..•...•...••.••Rule 12-01-Amendment ....••..•....•.•...•.•..•.•.•..............•..•....••..•.•..•...•...•.....Rule 12-02-Amendment ...........................................•.....................•.•.•...•Rule 12-04-Amendment ................................•.......•....••.........•.•....•..•.......Rule 12-06-Amendments .....................•.....•......•..........•....•......•.....••..•...•., Rule 12-06A - Rescission .........................•..•.•••....•.......•..•.....•..•..•.••.•...•....Rule 12-07 - Amendment ............................•..••.•.....•.......•.•..••.......•.....•.....Rule 12-08-Amendment .............•..•.....•..•........•.................•..•..•..•....•..•.............. .: .................................................................................... .Rule 12-lS-Amendment ..... _ .............•..•..•.........•..•....•........•.....•.......•.......Rule 12-16 - Amendments ...............•..•.........•..•..•............................•.•..•..•.Rules 12-17. 12-28. 12-24. 12-25. 12-26. 12-28. 12-30-Rescissions •....................•........•...•..•.•Rule 12-27 --Amendment .•..•..•..•..•..•.•.................•..•........•.....•....•..•..•..•.•...Rule 12-29-Amendment .....•..................•.... : ..•..••........................••.....•.....Rule 12-31-Amendment ...........................•...............................•.....•.......•Rule 12-31A - Adoption .......•......•..•.•..............•........•...••.•.•.•.••.••.••....••.•..•Rule 12-42-Adoption .••..•....•.........•..............•.....................••..•...•...•..•..•Amendment .....•.................................................•..•......•..•.......•...•..Rule 12-43 - Adoption ....................................................•...................•...Amendment .•..•......................................•.........•.............................RENTSApplicable to leased personal property .....•.......•..•..•.............•........•..••.••.....•..•..Disclosure of minimum rental commitments .•.......•..•..•.•.......................................REPLACEMENT COSTReplacement cost data useful in evaluating profits ., ....................•...••.•...•......•.•..••..•.Requirement for footnote dise10sure of estimated current replacement cost of inventories and productivecapacity ........•.....•.......................•.•............•......•..••..•..••.•....•.••.REPORTS. ACCOUNTANTS' OR AUDITORS' [See CERTIFICATE OF ACCOUNTANTS and CERTI­FICATION]REPORTS. INTERIMFalse and misleading quarterly and annual reports ............................ ,.••........••....•....ISsuance of quarterly earnings reports .........., ..........•...•..•.........•• ~ ..•......•...•......•.~ar~rlY reports on Form 1O-Q ...•........•..•...........•.••.....•...•..................•.....•..qUIrements for increased disclosure of interim results .....•..•.....................•......•........ItESEARCH AND DEVELOPMENT COSTS~losure of deferred research and development cost .. , ......•...................................•..~erpretation of the term ...........•.••...................•.............'...............•.•.......It qu.u-ement for disclosure •.•.......•..•...•........•..........•...••...•.•••...••..•..•..•..•.•••eSClSsion ores f ul re la tmg . to d elerra ~ I ...•........•....................•...........•...•.....•.•...•ReleaseNo.125141178114184184184141185177181141141141181181181178195141125141178183152183152,152125141125141141184151190186130189177138141125178489PageNo.226250432206442442442250447431437250250250437437437432471250226250432439285439,285285226250226250249442282457450241455419244249225432

490 SUBJECT INDEXReleaseNo.PageNo.RESTRICTED SECURITIESAcquisition •.•••••.••••..•..•.......•.....•...•............•.•..••.....••.....•••....•...•.•....•.Determination of value ••..•.•..••..•.•••.••.••••••.•.•••.•••.••.••..•.••••••••...•••••..•••..••••.................................................................................................Disclosure problems .................................................................. -.•..•..•••.•...............................................................................................Portfolio management ........................................................................... .Private placement exemption .•••••••.•••••..•.•.•.•..••••...•••••..•..••...•••...••.••.•...••.•••.Expansion of reporting requirements in Form N-1R ••....•.•••.••.•........••.•.••........•....•••.••RETAINED EARNINGS [See OTHER STOCKHOLDERS' EQUITY]REVENUEGross profits on real estate transactions ............................................................ .Method of determining accumulated net realized gain or loss on investments •....••...•..•..........••.•Reeoneiliation of revenues and net ineome ...•••••.•••••.••.•••••••••••.•••••..••.•••••••.•••..• ; •••.Revenue and expense changes ................. '.' ................................................. .Revenue reeognition practices related to receivables and inventories .••.•••..•••.•....•..••..•••...••.RULES [See also REGULATION S-X]Securities Act of 1938-"Rule408 .......•.....•••....•..•...........•....••.....•....•..•.••...••....•..••......•••••. ~Securities Exchange Act of 1934-Rule10b-5 ..•••••...•••••.•.•••.....•••.•••••.•••••.••••••..•••••.•...•••..•.•...••..•••••.••... ......................................................................................................................................................................................Rule 12b-2O ....•.••...••....•••••••.•••...•••.•.•••....••••...•••...••.•..••...•••.•••••.•.••Rule 13a-l ..• : ••.•..••••.••••....••••..•.••..••••...•••....•••••..••..•.•••..••..••••••••••••Rule 13a-13 •.....•••....•.••••••....•••....•.•....••.••...•••..•••..••.....••.•••..•••••...•................................ (, .......................................................... .Rule 13a-15 •.•...•••......••....••...•••.•.•..•...•••....••...•••..••...••..•.•••..•.••••••••Rule 14&-3 ................................................................................... .Rule 14&-9 •••.....•.•.•....•..•..•••..•••.....•.••...•.....••....•...•...•...•...•..••..••....Rule lSd-I ....•••••...••••.•••.•••••..•••...••••.•••••...••.•••..•..•.•••••.••••.••••••.••••••Rule lSd-13 •••.•.....•••••.•...•.•...••.•...••...••••.•••...••..••...•.....••••.....•••......Rule lSd-15 .....••.•.•.••..••..•...•.•....•...•..•..••...••....••.••..•.••.•.••...••..•.••.••Rule17a-3 .................................................................................. ............................................................................................Rule17a-5 .................................................................................. .Rule 17a-ll ••.•...••••..••••....••••...••••..••••..•••..••••....••...••••....••.....••.••• ••·Public Utility Holding Company Act of 1935-Rule26 .................................................................................... .. 113113118'113116 .113113. i209566155177164188113124158161167179A1821881671861771811861771~1571861621771811779816616015617120020121220521020020421816946297425321206224308315341433438454341451431437451431451306451316431437431176299314299

SURJECT INDEX 491ReleaseNo.PageNo.Inv~stment Advisers Act of 1940-Rule 204-2(b): : .....................................•........•.....••.••......•.••.••.••..•.••Rule 206(4)..2 ...•.............••.......•..•.......•...........•....••..•..•.•..•..•.•••.•.•.•.1Investment.Company Act of 1940--

492 SUBJECT INDEXReleaseNo.PageNo.TREASURY STOCKEffect of treasury stock transactions on accounting for business combinations ......................•....Statement 'of policy and interpretations regarding ASR 146 and treasury stock acquisitions ............. .Treasury stock improperly recorded .............................................................. .UNDISTRIBUTED INCOMEAppropriate provision by investment companies for taxes on realized undistributed capital gains ........ .Method of determination of undistributed net income of investment companies after allocation of pastdividends ............••....•..•................•..............................................UNIFORM SYSTEM OF ACCOUNTSRescission of. for registered public utility holding companies .......................................•..UNUSUAL CHARGE AND CREDIT ITEMSRequirement for disclosure of unusual items occurring in a quarterly period ..........................•.Requirements for increased disclosure ..........•...................................................UNUSUAL RISKS AND UNCERTAINTIES146146A179A1145617117713825726043420746349420244Disclosure in financial reporting ......••..•..•...•...••..••..••.•••..•••..•...••....•.•..•.....•.. ; i166, 337