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Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Portfolio Description Jack W. Paul, Ph.D., CPA Professor of Accounting Lehigh University Jack W. Paul, B.A. (Economics), Cornell University, MBA, Ph.D., Lehigh University. Dr. Paul is a licensed CPA in the State of Florida. He is a professor of accounting at Lehigh University and has taught financial and intermediate accounting, auditing, advanced auditing, information systems, CPA review, and managerial and cost accounting. He is former director of the MS in Accounting program at Lehigh University and teaches the capstone course in that program. He has obtained several grants for conducting accounting research and has published in a number of academic and practitioner journals. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Portfolio Description

PORTFOLIO DESCRIPTION SHEET


BNA Tax and Accounting Portfolio 5148-2nd, Related Party Transactions (Accounting Policy and Practice Series), represents the first of two anticipated Portfolios dealing with related party transactions. This Portfolio discusses the pervasiveness of related party transactions throughout a wide spectrum of business dealings. The Portfolio analyzes the nature of related party transactions and discusses how these transactions are treated under generally accepted accounting principles. The Portfolio also reviews the applicable corporate governance features pertaining to related party transactions. The Portfolio surveys the history and concepts pertaining to related party transactions and the rather considerable pertinent accounting literature, including Financial Accounting Standards Board pronouncements, Securities and Exchange Commission rules and regulations, stock exchange listing requirements and AICPA and PCAOB auditing pronouncements. This Portfolio discusses in detail the accounting and disclosure requirements pertaining to a number of topics dealing with asset transfers among related parties, including sales, purchases, nonmonetary transactions, lease arrangements, and transfers of financial instruments. Although generally accepted accounting principles contain guidance concerning the disclosure of related party transactions, the accounting standards are mainly silent when it comes to accounting for these transactions. This Portfolio analyzes when related party transactions should be accounted for differently from transactions between unrelated parties. The Portfolio offers suggestions regarding possible approaches to the accounting for related party transactions under differing circumstances. This Portfolio may be cited as BNA Tax and Accounting Portfolio 5148-2nd, Paul, Related Party Transactions (Accounting Policy and Practice Series). Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis I. Introduction, Background, and Scope of Portfolio

A. Perspective
This Portfolio focuses on accounting for transactions between or among related parties and covers

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topical areas most significant and of broadest application to related party transactions. To this end, the Portfolio analyzes the treatment of related party transactions under significant accounting and disclosure requirements, including Financial Accounting Standards Board (FASB) pronouncements, Securities and Exchange Commission (SEC) regulations, stock exchange rules, pronouncements of the Public Company Accounting Oversight Board (PCAOB), and auditing standards. 1
1 Worksheet 1 provides a glossary of abbreviations and acronyms used in this Portfolio.

1. Treatment of Related Party TransactionsGeneral


A significant number of enterprises enter into transactions with related parties. These parties include employees, subsidiaries, affiliated organizations, stockholders, directors, executive officers, and stock promoters, among others. From an accounting perspective, related party transactions are recorded similarly to transactions between unrelated parties. However, these transactions have broad disclosure requirements because of their potential impact on financial statement transparency. While the definition of related party is fairly uniform throughout the accounting literature, the disclosure requirements vary depending on the context. Nevertheless, some transactions with related parties do not require disclosure. Most notably, related party transactions that are immaterial to a company's financial statements are not subject to the disclosure rules under FASB Accounting Standards Codification (ASC) 850 (based, in large part, on FASB Statement No. 57, Related Party Disclosures). 2 Likewise, SEC Regulation S-K does not require disclosure of transactions with related parties when those transactions are under a certain dollar amount and the related parties do not have a direct or indirect material interest. 3
2 FASB ASC 850-10-50-1; FASB Statement No. 57, Related Party Disclosures, 2. 3 17 C.F.R. 229.404 (a), 369.

2. Why Related Party Disclosures?


All business enterprises possess a unique risk profile resulting from their specific financing and operating strategies. Internal forces, such as management's talents, their proclivity toward transparency and risk aversion, as well as external forces, including industry competition, macroeconomic trends, the industry life-cycle, and global dynamics, all contribute to enterprise risk. These internal and external forces interact to form the portrait of risk that is visible from an outsider's perspective. Related party transactions have the potential to distort this picture. Related parties may enter into transactions that give the appearance of having been conducted on an arm's-length basis in order to misrepresent the actual risk of the enterprise. As such, the potential for fraud is significant because related party transactions provide an excellent opportunity to hide malfeasance. By failing to record related party transactions or reveal their related party nature, insiders can easily use these transactions as vehicles for disguising compensation, misappropriating assets, and/or misstating financial statements. Even if misrepresentation is not intended, the nature of related party transactions is such that their terms may be more favorable than those attainable by an outside party. As a consequence, the economic reality of a particular business event may not be apparent without complete disclosure.

3. The Many Varieties of Related Party Transactions


As related party transactions are pervasive, they may enter into almost every facet of business. The scope of these transactions has led to a vast array of rules, regulations, pronouncements, and standards dealing primarily with disclosures necessary for reporting many related party transactions. Related party transactions may appear in a variety of circumstances, including: purchases and sales of merchandise and services (merchantable assets); purchases and sales of productive (capital) assets; indebtedness and guarantees; investments in the securities of the enterprise or affiliated entities; leases; off-balance sheet financing; use of company assets and personnel; compensation arrangements, including stock options and employee pension trusts; inappropriate commingling of company assets; services rendered

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or received; asset transfers; and investments in other entities, including special purpose entities (SPEs). This Portfolio discusses a number of these items in light of significant accounting and disclosure requirements, in an effort to convey the correct accounting and reporting treatment for such related party transactions.

4. Authoritative Literature
In the United States, the accounting treatment of related party transactions is governed by three main authoritative sources; these are: (1) SEC Regulation S-X, 4 (2) SEC Regulation S-K, 5 and (3) FASB ASC 850. The SEC is charged with assuring that public companies provide full disclosure in their financial reporting. Although the SEC does not issue accounting standards per se, it provides oversight by governing the broader framework for preparing public companies' financial statements. 6
4 SEC Regulation S-X, Rules 4-08(k) (1) and (2). 5 17 C.F.R. 229.404, 369. 6 See generally Securities Act of 1933, 15 U.S.C. 77a, et seq. (1933); Securities Act of 1934, 15 U.S.C. 78a, et seq. (1934).

Regulation S-X prescribes the statutory requirements for preparing the financial statements and related footnotes in filings with the agency. Regulation S-K, on the other hand, governs the non-financial portions of these filings. While the footnote disclosures required by Regulation S-X are substantially consistent with the FASB rules under FASB ASC 850, Regulation S-K requires additional, and often more extensive, disclosures than those required by FASB pronouncements. It is important to understand the differences between Regulations S-X and S-K. As indicated, the requirements under Regulation S-X regarding the financial statement footnotes in filings are generally consistent with requirements in accounting standards, which often allow considerable discretion in terms of the wording, scope, and coverage of footnote information. On the other hand, supplemental information required by Regulation S-K is highly prescribed and allows little leeway in terms of scope and specificity. Although the SEC retains the legal authority to prescribe accounting procedures, 7 the agency has generally left this task to FASB, which is the authoritative body given jurisdiction over accounting standards that govern the preparation of financial statements. 8 These standards collectively are referred to as generally accepted accounting principles (GAAP).
7 Id. 8 FASB ASC Term Related Parties; FAS 57, 24(f).

5. Summary of Related Party Transactions and Key Terms


The usual assumption under which business is conducted is that transacting parties are independent and act in their own best interest. This assumption is invalid when transacting parties are related. A related party is one with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. 9 Control is defined as the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an enterprise through ownership, by contract, or otherwise. 10 Interestingly, U.S. GAAP does not explicitly define the term related party transaction. IASC International Accounting Standards No. 24, Related Party Disclosures, does so, but in somewhat nebulous terms. It describes a related party transaction as a transfer of resources, services or obligations between related parties, regardless of whether a price is charged. 11 This latter notion is corroborated by FASB ASC 850, which indicates that a lack of accounting recognition does not mitigate the necessity to disclose material

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related party transactions. 12


9 FAS 57, 24(f). See also FASB ASC Term Related Parties, paragraph (f). 10 FASB ASC Term Control (as used in FASB ASC 850-10); FAS 57, 24(b). 11 IASC International Accounting Standards No. 24, Related Party Disclosures, 9. 12 FASB ASC 850-10-05-5; FAS 57, 1.

FASB ASC 850 calls for the disclosure of material related party transactions but excludes, compensation arrangements, expense allowances, and other similar items in the ordinary course of business. Also excluded are those transactions eliminated in the preparation of consolidated or combined financial statements. 13
13 FASB ASC 850-10-50-1; FAS 57, 2.

Comment: The phrase, in the ordinary course of business, is taken to mean daily transactions that are carried out in a more or less routine fashion. For example, in addition to compensation and travel arrangements, a home mortgage obtained by a bank officer from his or her employer, on terms no more favorable than any other mortgager, is considered to be in the ordinary course of business. 14 Similarly, if executive officers of a retail chain and their families are allowed to purchase consumer goods from their employer under terms comparable to those of coworkers, the transactions are deemed to be in the ordinary course of business. 15
14 FAS 57, 19 (background information not codified). 15 See id. (stating the following, Disclosure of compensation arrangements, expense allowances, and other similar items in the ordinary course of business is not necessary for a user to understand the financial statements.) Accordingly, such items may be excluded. See also 17 C.F.R. 373.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis I. Introduction, Background, and Scope of Portfolio

B. Background and History


Accounting pronouncements and literature first referenced related party transactions in June 1953, with the issuance of Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins. In describing related party transactions, the Bulletin states, [n]otes or accounts receivable due from officers, employees, or affiliated companies must be shown separately and not included under a general heading such as notes receivable or accounts receivable. 16 This reference was included among a set of rules that the American Institute of Certified Public Accountants (AICPA) recommended to the New York Stock Exchange in 1933, rules formally adopted by the membership of the AICPA in 1934. 17 Thereafter, standards dealing with various types of related party transactions burgeoned, and have since become commonplace and pervasive in GAAP, Generally Accepted Auditing Standards (GAAS), and International Accounting and Auditing Standards.
16 Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, ch. 1, A, 5; FASB ASC 850-10-50-2. 17 ARB 43, ch. 1, A (historical information not codified).

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In 1969, a case involving the criminal indictment of auditors dramatically thrust related party transactions to the forefront. Three auditors were found guilty of filing false statements in violation of the Securities Exchange Act of 1934 in the notorious, so-called Continental Vending case. 18 Harold Roth, president of Continental Vending Company, directed funds to be diverted to Valley Commercial Corporation, an affiliate. The auditors were aware that a footnote in Continental's financial statements did not disclose that Roth had borrowed approximately the same amount, which he was unable to repay, forcing Continental into bankruptcy. In July 1975, six years after the resolution of the case in 1969, the AICPA issued AICPA Statement on Auditing Standards 6, Related Party Transactions. 19 This Statement was superseded in 1983 by AICPA Statement on Auditing Standards 45, Omnibus Standard on Auditing Standards (codified as AU Section 334, Related Parties). 20 With the publication of FAS 57 in 1982, FASB finally issued a pronouncement covering the disclosure of related parties.
18 U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969). 19 AICPA Statement on Auditing Standards 6, Related Party Transactions (July 1975). 20 AICPA Statement on Auditing Standards 45, Omnibus Standard on Auditing Standards (Aug. 1983).

Comment: The issuance of SAS 6 was unusual in that this auditing standard effectually promulgated accounting rules for the disclosure of related party transactions, standards which did not exist prior to the date of issuance. No accounting pronouncements on related parties were extant, except for the rules concerning the classification of receivables described in ARB 43. This situation existed until 1982, when FASB issued FAS 57. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis I. Introduction, Background, and Scope of Portfolio

C. Concepts Related to Financial Statement Disclosure


The requirements to disclose the nature of related party transactions stems from several basic qualitative features that FASB believes financial statements should possess. Those accounting qualities, discussed below in the context of related party transactions, are relevance, reliability, comparability, consistency, and materiality.

1. Relevance
To be useful for decision making, accounting information should be relevant. FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, indicates that, to be relevant, information must be timely and have predictive or feedback value, or both. 21 Accounting pronouncements over the year have required specific undisclosures regarding related-party transactions for the very reason that such disclosures are expected to provide the requisite predictive and confirmative information that readers of financial statements require. In particular, related party disclosures possess predictive value in that they provide financial statement users with a clearer picture of the nature of business transactions that were not carried out at arm's-length in the ordinary course of business. Without a clear picture provided by disclosures, predictive models used by analysts and investors may prove useless as investment tools. Capital markets and resource allocations may be distorted, often with dire consequences.
21 Feedback value refers to the ability of information to confirm or correct earlier expectations. FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, 51 (May 1980).

Comment: The damaging effect of lack of adequate disclosures about related party

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transactions was evident in the collapse of Enron. The abuse of special purpose entities (SPEs) by Enron has been widely reported. By not disclosing the nature of its dealing with SPEs, Enron's management was able to portray asset transfers and liability transactions as sales, and thereby conceal substantial amounts of off-balance sheet debt. 22
22 Cecil W. Jackson, Business Fairy Tales (Thomson 2006), at 179.

The Enron situation illustrates that financial statement numbers alone may provide an incomplete picture of enterprise risk. Comment: The sheer volume and complexity of financial statement disclosures exact significant costs for extracting the information that often is used as input for predictive models. Given these not insignificant costs, anecdotal evidence suggests that some analysts may bypass disclosures and simply enter the financial statement numbers into their models. The consequences of doing so can be disastrous, however. For example, Enron's related party transactions footnote in the 1999 financial statements reported the following: A senior officer of Enron is the managing member of LJM's 23 general partner LJM2, which has the same general partner as LJM, acquired, directly or indirectly approximately $360 million of merchant assets from Enron, in which Enron recognized pretax gains of approximately $16 million. 24 The 2000 annual report's related party footnote hinted at the extent of Enron's dealings with SPEs: Enron contributed to newly-formed entities assets valued at approximately $1.2 billion, including $150 million in Enron notes payable, [and] 3.7 million restricted shares of outstanding Enron stock. 25 Although Enron did not reveal the full nature of its dealings with SPEs, the magnitude of the transactions should have at least alerted analysts and sophisticated investors to its misrepresentations.
23 LJM was a special purpose entity set up by Andrew Fastow, Enron's CFO. 24 Jackson, Business Fairy Tales, above, at 189. 25 Id. at 190.

Through feedback and confirmation, disclosures aid prediction by reducing uncertainty and providing a springboard to the future, thereby providing more assurance for making sound judgments. In addition, relevant information should be timely, i.e., available soon enough to influence decisions that financial statement users make.

2. Reliability
Another described qualitative characteristic of accounting information is reliability. Reliability refers to the representative faithfulness of information, that is, the degree of correspondence between information and the actual events and transactions. 26 Reliable information is verifiable. 27 As more and more estimates enter into accounting data, these data may become less verifiable. Reliable information is also neutral. Neutrality refers to the ability of standards to avoid favoring special interests. 28
26 CON 2, 59, 63-64. 27 Id. 81-89. 28 Id. 98-110.

As related party transactions may conceal fraud, representative faithfulness becomes a concern whenever these types of transactions occur and require reporting in financial statements. Related party transactions can easily masquerade as arm's-length transactions entered into in the ordinary course of business, making it simple to perpetrate a fraud and then cover it up. Fraud concerns are heightened

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when related party transactions involve members of management, since management is in a position to override internal controls.

3. Comparability and Consistency


Comparability and consistency are two additional qualitative characteristics that accounting information should possess. Comparability measures the degree to which enterprises can be compared, while consistency refers to the application of methods over time. 29 Greater comparability and consistency improve the ability to make informed investment decisions. Because risk profiles vary considerably from one enterprise to the next, related party disclosures are especially useful for analyzing the unique risk characteristics of an enterprise, thereby aiding the decision process and facilitating informed judgments.
29 Id. 111-122.

4. Materiality
Even though reporting entities should strive to present accounting information that possesses the qualitative characteristics of relevance, reliability, comparability, and consistency, it need not strive for these goals when presenting information that is not material to financial statement users. 30 Determining whether an item may be material to financial statement users requires an accountant to evaluate both quantitative and qualitative considerations. 31 If magnitude alone were the only criterion for judging materiality, many related party transactions would not need to be disclosed. Because these transactions may be indicative of second, underlying dealings, related party transactions require disclosure when other transactions of similar magnitude would not. As CON 2 notes for example, [a]mounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions. 32
30 Id. 129, 130. 31 Id. 131. 32 Id. 128d.

Comment: Because many related party transactions are abnormal or unusual transactions, they may have considerable ability to dissuade or entice decision makers. As a consequence, preparers of financial statements should employ a lower materiality threshold when dealing with related party transactions. As indicated at Section I.A.1, above, FASB ASC 850 calls for the disclosure of related party transactions that are material. Given that magnitude should not be the sole criterion for judging the materiality of a related party transaction, an interesting question arises: What qualitative characteristics distinguish a related party transaction that is material from one that is clearly not? Courts have customarily used the prudent or reasonable man concept to distinguish material from immaterial items. For example, in TSC Industries, Inc. v. Northway, Inc., 33 a case dealing with a proxy statement, the Supreme Court indicated that information omitted from such a statement can be considered material even if its inclusion would not have altered a shareholder's vote. The Court noted:
33 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. What the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of a reasonable shareholder. Put another way, there must be a

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substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having altered the total mix of information made available. 34
34 CCH Federal Securities Law Reports 95,615 (U.S. Sup. Ct. June 14, 1976) as quoted in CON 2, 164.

Accordingly, to be considered material, there must be a substantial likelihood that the disclosure is an important piece of information in the decision making process. Many if not mostrelated party transactions, other than those in the ordinary course of business, would fall into this category. Comment: Clearly, these kinds of materiality judgments can be difficult. For example, closely held companies may engage in various transactions with family members. Deciding which, if any, of these relationships and transactions to disclose may be difficult. Moreover, it may not always be necessary to reveal the names of individuals. FASB ASC 850 indicates that, In some cases, aggregation of similar transactions by type of related party may be appropriate. 35 For example, a company that leases storage facilities from company officers may simply disclose that fact without naming individuals. In certain cases, it may be necessary to actually name the related party if it would be difficult to understand the nature of the relationship without doing so. 36 In other cases, the effect of the relationship between parties may be so pervasive that disclosure of the relationship alone may be sufficient. 37 This situation may occur, for example, when a mobile home manufacturer distributes completed homes exclusively through captive retail outlets.
35 FASB ASC 850-10-50-3; FAS 57, 2 n.3. 36 FAS 57, 2 n.3 (not codified). 37 FASB ASC 850-10-50-3; FAS 57, 2 n.3.

Planning Point: Judging the adequacy of related party disclosures is problematic. For example, FASB ASC 850 calls for recording material related party transactions to which no amounts or nominal amounts were ascribed. 38 One might argue that transactions recorded at a nominal amount are not considered material. Judgments concerning the materiality of related party transactions should, however, turn on an as if comparison with similar, market-based transactions. In each such case, the following question may be posed: If the transactions were consummated between unrelated parties, what would the amounts have been? If the answer is that the amounts would have been material, then the transactions should be disclosed under FASB ASC 850. Even then, related party transactions do not have a one-to-one equivalency with market-based transactions. As mentioned, the qualitative aspects of materiality must also be examined, even if the transactions are not considered material from a strictly quantitative point of view. For example, if officers, employees, or family members are party to transactions with the enterprise, other than amounts for normal compensation and similar such items in the ordinary course of business, disclosure is warranted to forestall the appearance of undisclosed remuneration at the expense of shareholders/owners.
38 FASB ASC 850-10-50-1(b); FAS 57, 2.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis I. Introduction, Background, and Scope of Portfolio

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D. Fraud Concerns
One concern about related party transactions is the possibility that the parties are committing fraud. As seen below, the instances of fraud are very low, but the possibility of fraud remains a concern nonetheless. 39
39 This section is based on Elaine Henry, Elizabeth A. Gordon, Brad Reed, and Tim Louwers, The Role of Related Party Transactions in Fraudulent Financial Reporting, Working Paper (University of Miami 2006).

1. Frequency of Fraudulent Related Party Transactions


Related party transactions appear to be commonplace. In one study, 80% of the companies studied had disclosed at least one related party transaction. 40 Another study indicated that 75% of companies polled had disclosed a related party transaction. 41 Despite the common occurrence of related party transactions, studies indicate that the overall occurrence of fraud, at least that which has been detected, is low. For example, one study of federal class action suits, covering the period 1996 to 2001, reported only 100 incidences annually of inappropriate financial reporting out of approximately 15,000 audits of public companies. 42 Reported frauds involving related party transactions are fewer still in number. For example, the percentage of improprieties involving related party transactions ranged from a low of 10% 43 to a high of 21% in an earlier study. 44
40 Elizabeth A. Gordon, Elaine Henry, and D. Palia, Related Party Transactions and Corporate Governance, 9 Advances in Financial Economics 1-28 (2004). 41 Many Companies Report Transactions With Top Officers, Wall St. J., Dec. 29, 2003, at A1. 42 Baruch Lev, Corporate Earnings: Fact and Fiction, 17(2) J. Econ. Perspectives 27-50 (2003). 43 Securities and Exchange Commission, Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002 (2003). 44 S. Shapiro, Wayward Capitalists: Targets of the Securities and Exchange Commission (Yale University Press 1984).

2. Related Party Transactions as a Fraud Risk Indicator


While few related party transactions are fraudulent, perhaps more significant is the relative magnitude of the ones that are fraudulent. Several high-profile cases, including Enron 45 and Tyco 46 have highlighted concern over the use of related party transactions as a clever means to obscure fraudulent financial reporting. AICPA Statement on Auditing Standards 99, Consideration of Fraud in a Financial Statement Audit, lists as a fraud risk factor, [s]ignificant related party transactions not in the ordinary course of business or with related entities not audited or audited by another firm. 47
45 In re Enron Corp. Secs., 235 F. Supp. 2d 549 (2002). 46 Securities and Exchange Commission v. L. Dennis Kozlowski, Mark H. Swartz and Mark A. Belnick, Civil Action No. 02 CV 7312. 47 AICPA Statement on Auditing Standards 99, Consideration of Fraud in a Financial Statement Audit (Oct. 2002), Appendix.

Nevertheless, evidence regarding the weight to be given to the significance of these transactions in elevating the risk of fraud is inconclusive. In one study, the authors found that reported fraud cases had approximately the same proportion of significant and unusual related party transactions as non-fraud cases. 48 The authors concluded that the mere presence of significant and unusual related party

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transactions did not appear to increase the risk of fraud. Although some studies found similar results, others came to a different conclusion. In one such study, internal auditors viewed related party transactions as a significant factor in assessing the risk of fraud. 49 And in yet another study, the authors found that the SEC had ranked the failure to recognize or disclose related party transactions as one of the top 10 audit deficiencies. 50 Thus, the evidence is mixed concerning the weight to be given to related party transactions as a fraud risk indicator.
48 Timothy Bell and J. Carcello, A Decision Aid for Assessing the Likelihood of Fraudulent Financial Reporting, 19(1) Auditing: Practice and Theory 169-184 (2000). 49 G. D. Moyes, P. Lin, and R.M. Landry, Raise the Red Flag, 62 Internal Auditor 47-51 (2005). 50 M. Beasley, J. Carcello, and D. Hermanson, Top Ten Audit Deficiencies-SEC Sanctions, 191(4) Acct'g. 63-67 (2001).

3. The Role Related Party Transactions Play in Fraud Cases


An extensive study, published in 2006, examined the role that related party transactions play in fraud cases. 51 The authors cataloged 48 instances of fraudulent or improper reporting, significant aspects of which involved related party transactions. After gleaning these cases from SEC Accounting and Auditing Enforcement Releases (AAERs) the authors cataloged them by type of transaction. 52 Their compendium of cases is instructive since it provides an idea of the means concocted by a host of perpetrators to conceal improprieties through the use of related party transactions. As the cases reveal, insiders used various means to conceal the misappropriation of assets, to cover up fraudulent financial reporting, and/or to disguise compensation. 53 In each of the following categories, the term related parties refers to individuals or affiliates that are counterparties to transactions with the subject entity:
51 Henry, The Role of Related Party Transactions in Fraudulent Financial Reporting, above. 52 These AAERs covered the period 1980 to 2005. 53 For a detailed account of the cited cases, see Henry, The Role of Related Party Transactions in Fraudulent Financial Reporting, above, at 12-23 and Table 1.

Sales of Goods or Services to Related Parties Ten companies were found to have recorded fictitious sales or were cited for improper revenue recognition. 54 Purchases of Goods or Services From Related Parties In five cases, the subject companies failed to disclose the related party nature of the transactions. 55 In seven cases, the companies recorded purchases of merchandise that was non-existent, not needed, or above market. 56 Sales of Assets to Related Parties Four companies were found to have overvalued assets sold to related parties, 57 while one company, Tyco, failed to disclose the related party nature of the transaction. Yet another, Hollinger, sold assets at below market prices for the enrichment of a related party. Purchase of Assets From Related Parties Five companies overvalued the purchases, either to overstate the assets recorded on the books, 58 or in the case of Tyco, to transfer wealth to a related party. Borrowing From Related Parties Nine companies were found to have understated liabilities in conjunction with loans from related parties. 59 Loans to Related Parties Six cases involved companies understating liabilities because

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they did not record the loans. 60 In six other instances, the related party feature was not disclosed. 61 Three companies understated loan losses. 62 In one case, the CEO received cash, but the company, Cronos, recorded the disbursements as unsecured loans without divulging the related party nature of the transactions. In two instances, the companies were lending at below-market rates. 63 Purchase of Equity Securities by Related Parties Two cases dealt with companies that used related party transactions to inflate their statutory capital. 64 Two companies recorded the consideration received at inflated values to overstate assets. 65 One company, Altratech, used the transactions to circumvent regulations. 66 Another company, Hollinger, did not disclose the related party characteristics of the transactions. 67 In another instance, assets of Tonka Corporation were diverted to the CFO through Tonka's investments in an entity he owned. 68 Issuing Securities to Related Parties Two of these cases dealt with companies not identifying related parties who purchased and subsequently sold securities of the registrant.
69 In two other cases, the SEC found that the companies had sold equity securities to related parties at prices that were below market. 70

54 These companies are Softpoint, Itex, NetEase.com, Horizon, Ciro, Livent, Humatech, C.E.C., Swisher, and FastComm. Id. 55 These companies are Madera, Tyco, Rite Aid, Pace American, First Humanics. Id. 56 These companies are PNF, Chancellor, Livent, Hollinger, Enron (Chewco SPE), ZZZZ Best, and Biomaterials. Id. 57 These companies are MCA, Enron (the LJM SPE), Wilshire, Horizon. The asset values were inflated to record higher gains. Id. 58 These companies are STDO, Great American, G. C. Tech, and ZZZZ Best. Id. 59 These companies are Adelphia, Novaferon. Enron, Refco, ESM, Tri-Corp Services, Pantheon, First Humanics, and Endotronics. Id. 60 These companies are Adelphia, Novaferon. Enron, Refco, ESM, and Tri-Corp Services. Id. 61 These companies are Rite Aid, Adelphia, ESM, Puryear, BBS, and Printonthenet.com. Id. 62 These companies are Convenient Food, MCA, and Oiltech. Id. 63 These companies are Rite Aid and Adelphia. Id. 64 These companies are Dixie National and Trademark USA. Id. 65 These companies are Pacific Waste Management and PNF Industries. Id. 66 Id. 67 Id. 68 Id. 69 These companies are Swisher and Softpoint. Id. 70 International Teledata and Enron dealt with the special purpose entities known as JEDI, Chewco, and LJM in order to conceal wealth transfers to Andrew Fastow, Enron's CFO, and members of his family.

4. Conclusions
The incidence of fraudulent financial reporting is low, and the use of related party transactions to

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perpetrate a fraud is lower still. Despite this low rate of occurrence, the significance of high-profile cases involving related party transactions cannot be ignored. Fraudulent reporting has a chilling effect on capital markets by engendering a lack of faith in financial reporting and the credibility of the accounting profession. Nevertheless, the evidence is inconclusive as to whether auditors perceive significant and unusual related party transactions to be a substantial fraud risk factor. The frauds enumerated in the previous section indicate the variety of artifices that insiders have used to conceal the misappropriation of assets, cover up fraudulent financial reporting, and/or disguise additional compensation. Knowledge of these frauds can help auditors detect future improprieties. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis I. Introduction, Background, and Scope of Portfolio

E. Scope of Portfolio
This Portfolio focuses on the accounting treatment and disclosure requirements for related party transactions. It analyzes the treatment of each covered category of transactions under significant accounting and disclosure requirements, SEC regulations, stock exchange rules, PCAOB pronouncements, and auditing standards. Section II, below, discusses the accounting literature relevant to related party transactions. Section III, below, comprehensively covers: (1) sales and purchases of merchandise and services; (2) nonmonetary transactions; (3) transfers of financial instruments; and (4) lease arrangements. Section IV, below, reviews corporate governance features as they pertain to related party transactions and dealings with corporate insiders in general. Finally, Section V, below, discusses the auditing literature relevant to related party transactions. Fraud issues are discussed as they pertain to covered categories. A subsequent Portfolio will cover: (1) indebtedness, debt arrangements, and guarantees; (2) maintenance of compensating balances; (3) investments in other entities, including special purpose entities; (4) investments in the equity or other securities of the enterprise; and (5) compensation arrangements, stock options, and employee pension trusts. This Portfolio does not cover items that are immaterial to a proper understanding and presentation of financial statements. Nor does the Portfolio deal with issues concerning minor defalcations. Also excluded are those transactions in the ordinary course of business that have no impact on financial statement presentation. These transactions include normal compensation 71 and items such as the routine sale of merchandise or services on terms no more favorable than those attainable by unrelated parties.
71 Compensation and items such as travel expense allowances are explicitly excluded by FASB ASC 850. However, SEC regulations require disclosure of compensation arrangements with the principle executive and financial officers, regardless of income level, and for other highly compensated executive officers, subject to a $100,000 threshold. SEC Release Nos. 33-8732a and 34-54302a, Final Rule, Executive Compensation and Related Disclosure (2006).

This Portfolio does not merely catalog, compile, and paraphrase applicable rules. Rather, the Portfolio analyzes the rules and explains how they apply to the covered transactions. The information is presented in a manner that is both comprehensive and designed to serve the practical needs of accounting policymakers and technicians in companies, public accounting firms, and other professional environments. Examples and planning points are integrated into the text. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis II. Authoritative Literature and Guidance Related party transactions are addressed not only in GAAP literature but also by the SEC and certain stock exchanges. Accordingly, a company may have to follow several sets of rules. This section

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addresses the reporting rules pertaining to the disclosure of related party transactions, as well as their accounting treatment. GAAP pronouncements apply to the preparation of financial statements that are prepared for shareholders on a quarterly and annual basis. Statements filed with the SEC are to be prepared in accordance with GAAP 72 and also conform to SEC Regulation S-X. Accordingly, financial statements filed with the SEC cannot differ substantially from those included in annual reports to shareholders. SEC Regulation S-K governs the form and content of the supplemental, non-financial information that is to be included in registration and other forms filed under the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as certain aspects of annual reports issued to shareholders. 73 Stock exchanges typically specify that their required disclosures be included in the reporting entity's Form 10-K or proxy statement.
72 SEC Regulation S-X, Reg. 210.4-01, Rule 4-01(a) (1). 73 SEC Regulation S-K, Reg. 229.10.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis II. Authoritative Literature and Guidance

A. Accounting and Disclosures: U.S. GAAPFAS 57


The authoritative rules regarding related party transactions under U.S. GAAP are in FASB ASC 850, which is based on FAS 57. According to these rules, related parties include: 74
74 FASB ASC Term Related Parties; FAS 57, 24(f).

Affiliates of the enterprise; entities for which investments are accounted for by the equity method by the enterprise; trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; principal owners of the enterprise; its management; members of the immediate families of principal owners of the enterprise and its management; and other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. Another party also is a related party if it can significantly influence the management or operating policies of the transacting parties or if it has an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. 75
75 This and other definitions for the terms used in the FASB Codification are found in Worksheet 2.

Accordingly, parties that are related to a given reporting entity include: Principal owners and management, as well as members of their immediate families; The parent company, when applicable; Any subsidiaries; Affiliates, i.e., entities that: 76

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Directly control or are controlled by the reporting entity; Indirectly, through one or more intermediaries, control or are controlled by the reporting entity; Are under common control with the reporting entity; and Employee trusts, including pensions and profit sharing trusts managed by or under the trusteeship of the reporting entity's management.

76 FASB ASC 850-10-05-3; FAS 57, 24(a).

Also included are any other parties who either directly or indirectly possess the power to direct or cause the direction of management and policies of the enterprise through ownership, by contract, or otherwise. 77
77 FASB ASC Term Control (as used in FASB ASC 850-10); FAS 57, 24(b).

Examples of related party transactions include: sales, purchases, transfers and leases; services received or rendered; investments in off-balance sheet entities known as special purpose (or variable interest) entities; guarantees; maintenance of compensating balances; use of company assets; compensation, including stock options; and employee pension trusts. How wide a net should be cast in making a determination as to the individuals or entities that are related to a particular reporting entity? Correspondingly, what qualifies as a related party transaction? In many situations, the answer is obvious. Management, subsidiaries, and so on, are undoubtedly related parties. In other cases, it is not so obvious. For example, assume Mrs. Y sits on the boards of both Company D and Company E. Mrs. Y and Company D are related parties. Likewise, Mrs. Y and Company E are related. Are Company D and Company E related parties? Does it matter if there are no transactions between these two companies? In another example, the CEO of Company P sells real estate in a series of transactions to the president of Company S, a major supplier of Company P. Are the purchase transactions between Company P and Company S related party transactions? Are the real estate deals related party transactions? A related party can significantly influence the management or operating policies of the transacting parties to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. 78 Accordingly, making a determination as to which of these entities or individuals constitute related parties turns on two major considerations: (1) the degree of influence or control that is present, and (2) any difference in actions taken from what they would be if the parties were independent.
78 FASB ASC Term Related Parties; FAS 57, 24(f).

In the case of Mrs. Y, it would seem that Company D and E would not be related parties simply because Mrs. Y sits on both boards whether or not transactions occur between the two entities. The presumption is that one director typically could not influence transactions between these two entities. However, if Mrs. Y is in a position to influence transactions between these entities to such an extent that transactions would differ because of her influence, the two entities and Mrs. Y would be related parties. She is able to significantly influence the management or operating policies of the transacting parties to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. 79
79 FASB ASC Term Related Parties; FAS 57, 24(f).

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In the second example, Company S and Company P are not related parties in the absence of common control or influence. A determination as to whether the purchase transactions between Company S and P are related party transactions would depend on the degree of influence exerted by the CEO of Company P, as well as whether the actions of Company S's president were different from what they would have been were it not for the real estate deals. One would have to examine the circumstances and delve further into the real estate transactions themselves. Were these purely private transactions? Were they at market value? If the transactions were at less than market value, they are likely related party transactions because they presumably were effected to influence the president of Company S and, in turn, the purchase transactions between S and P. Under these circumstances, the purchase transactions between S and P are related party transactions. If the real estate deals were consummated at market value, the purchase transactions between S and P would likely not constitute related party transactions assuming the real estate dealings were purely private and did not alter the behavior of Company S's president or the purchase transactions between the two entities. 80
80 For a more thorough discussion of the limits of related party transactions, see Mason, Alister, K., Related Party Transactions (The Canadian Institute of Chartered Accountants 1979), at 28-46.

1. Accounting Recognition
How should related party transactions be recorded? Although the accounting treatment of related party transactions is not usually different from those between or among unrelated parties, the position in FASB ASC 850 is that, since the parties are not acting independently, one cannot presume that related party transactions are consummated on an arm's-length basis. 81 Accordingly, such transactions are recorded according to their form, that is, using the stated exchange price and other such terms. However, the form of a transaction may differ from its substance. 82 This consideration is a primary reason for requiring the disclosure of related party transactions. Moreover, if the form of the transaction differs substantially from its substance, FAS 57 requires the disclosure of, such other information deemed necessary to an understanding of the effects of the transactions on the financial statements.
83 81 FASB ASC 850-10-50-5; FAS 57, 3. 82 SAS 45; AICPA Professional Standards, Related Parties, 344.02. 83 FASB ASC 850-10-50-1(b); FAS 57, 2.

The next section explains the disclosure requirements under U.S. GAAP for related party transactions.

2. Disclosures Required by FASB ASC 850


FASB ASC 850 requires the following disclosures for material related party transactions: 84
84 See Section I.C.4, above, for a description of the term material.

The nature of the relationship(s) involved. 85 A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements. 86

85 FASB ASC 850-10-50-1(a); FAS 57, 2(b). 86 FASB ASC 850-10-50-1(b); FAS 57, 2(b).

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Comment: The additional information might, for example, include what the exchange price would have been if the parties were independent and the transactions had been consummated at arm's-length. Depending on the type of transaction, other disclosures may be required, for example, those concerning loss allowances or contingencies, or information pertaining to normal industry practices. The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period. 87 Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement. 88

87 FASB ASC 850-10-50-1(c); FAS 57, 2(b). 88 FASB ASC 850-10-50-1(d); FAS 57, 2(b).

Financial statements and disclosures are ordinarily required for the current year and one or more preceding years. 89 An example of these disclosures is found in Worksheet 3, which shows excerpts from McKesson Corporation's March 31, 2007 Form 10-K.
89 FASB ASC 205-10-45-1 and 45-2; ARB 43, ch. 2, A, 1, 2; FASB ASC 250-10-45-5; FASB Statement No. 154, Accounting Changes and Error Corrections, 7.

There are two decision points when determining which transactions to disclose. The first is deciding if a related party transaction is a type of transaction subject to the FAS 57 disclosure rules. The second is deciding whether a related party transaction that is the type subject to the disclosure rules is material and, thus, must be disclosed. Regarding the first decision, FASB ASC 850 exempts only a few related party transactions from the disclosure rules. Specifically, disclosure is not required for compensation arrangements, expense allowances, and other similar items in the ordinary course of business. Comment: The phrase and other similar items in the ordinary course of business may appear to allow some leeway for items that are conducted among entities on a routine basis, such as sales of inventory or purchases of supplies. However, this exception appears to be fairly narrow and confined to transactions occurring when related party individuals are acting in their capacity as employees of a reporting entity. Items similar to the cited examples would be those transactions that are routinely consummated by employees on a daily basis. Under this interpretation, other similar items would include, for example, purchases of merchandise made by executive officers of a retailer, and their families, when such sales are transacted on terms no different from those applicable to other employees or customers. The second decision involves a determination of materiality. The materiality standards for related party transactions are not different from those pertaining to other financial statement components. Materiality has both a quantitative and qualitative dimension. 90 Perhaps more so than other transactions, the qualitative dimension weighs heavily in judging materiality for related party transactions because underlying dealings may not be evident from an examination of the financial statements. The position of the individual involved is an important consideration, as well as the appearance of impropriety even if none exists in fact.
90 CON 2, 31.

3. Transactions Reported in Separate Statements of Affiliates

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FASB ASC 850 does not require disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements. However, the related party disclosures (listed in Section II.A.2, above) are required, including dollar amounts, when presenting the separate statements of affiliates, that is, subsidiaries, corporate joint ventures, and 50%-or-less-owned investees. 91 In contrast, when separate financial statements are presented with those of the parent company in the same report, duplicate disclosures are not required. 92
91 FASB ASC 850-10-50-4; FAS 57, 2 n.2. 92 Id.

Comment: Although GAAP prohibits the issuance of parent-only financial statements, it does not preclude the issuance of subsidiary-only financial statements without accompanying consolidated statements. However, the related party disclosures need to be included. Thus, when affiliates' separate financial statements are presented, transactions that were eliminated for presentation of the consolidated group are restored to afford full disclosure. 93
93 AICPA Technical Practice Aids/Technical Questions and Answers, TIS 1400.27 (not codified).

Worksheet 4 provides an example of the related party footnote disclosures found in Hurco Companies, Inc. October 31, 2006 financial statements on Form 10-K.

4. Management Representations of Equivalency


At times preparers of financial statements and reports may wish to include statements to the extent that related party transactions were entered into under terms equivalent to those prevailing in arm'slength transactions. If these representations are included, the preparer must be able to substantiate them. 94 In this regard, FASB ASC 850 states the following:
94 FASB ASC 850-10-50-5; FAS 57, 3.

Transactions involving related parties cannot be presumed to be carried out on an arm's-length basis, as the requisite conditions of competitive free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm's-length transactions unless such representations can be substantiated [emphasis added]. 95
95 Id.

The Enron debacle is a classic example of a company that made representations concerning related party transactions that could not be substantiated. Enron's proxy statements and financial reports included representations describing related party transactions as being equivalent to those conducted on an arm's-length basis. For example, the 2000 proxy statement included the following claim: [M]anagement believes that the transactions were reasonable and no less favorable than the terms of similar arrangements with unrelated third parties. 96 Similar wording is also found in the 1999 and 2000 Forms 10-K and 10-Q. The Powers Report, an investigation of the debacle by a committee of Enron's Board of Directors, noted that the company lacked the factual basis required by GAAP to make these assertions. Indeed, the Report adds that the transactions were structured in such a way that many of the dealings, in all likelihood, could only have been transacted with Enron insiders. 97
96 Report of Investigation by the Special Investigative Committee of the Board of Directors of

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Enron Corp., William C. Powers, Jr., Chair, 185 (2002). 97 Id. at 199.

Planning Point: Because of notorious accounting scandals, such as Enron, it is ever more likely that authoritative bodies will closely scrutinize related party transactions. A prudent course of action would be to include representations regarding comparability only when a well-established market exists for a given product or service. Otherwise, it is best to avoid these kinds of representations.

5. Disclosure of Control Relationships


The FASB Codification defines control as [t]he possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an enterprise through ownership, by contract, or otherwise. 98 If a control relationship exists, disclosure of that relationship may be required. The conditions for disclosure are as follows: (1) an enterprise is a reporting entity, that is, it issues its own financial statements, (2) the enterprise is under common ownership or management control with one or more other enterprises, and (3) the enterprise's operating results or financial position are different from what they would have been absent the control relationship. 99 Disclosure is not necessary if the reported financials do not differ despite the existence of the control relationship. However if the financials are impacted, disclosure is required even if there are no transactions between or among the related parties.
98 FASB ASC Term Control (as used in FASB ASC 850-10); FAS 57, App. B. 99 FASB ASC 850-10-50-6; FAS 57, 4.

Planning Point: An extensive search of SEC filings revealed no reported instances of control relationships of the type under consideration. It may be that there are very few of these relationships. On the other hand, this is one of the more onerous requirements found in FASB ASC 850 and proper implementation is difficult. The question, of course, is how to determine whether operating results would differ in the absence of a control relationship. One way to determine whether disclosure is required is to examine the degree of autonomy enjoyed by affiliates and the effect that membership in the affiliated group has on their operations. This may prove an easier call if transactions exist. In either situation, one might consider proceeding in the following manner if: (1) an affiliate operates in a fashion completely independent of other entities within the related group, and (2) its operations are not impacted in some fashion by the parent or other affiliates, disclosure would normally not be required. On the other hand, if operations are affected in some way due to group membership, for example, sales or production are restricted by the parent or an affiliate, the subsidiary could then not be considered autonomous and disclosure of the control relationship is therefore required. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis II. Authoritative Literature and Guidance

B. SEC Regulations for Public Companies


1. Financial Statement Disclosures: Regulation S-X Requirements
SEC Regulation S-X governs the reporting of financial information in reports filed with the SEC. For related parties, this regulation requires the following disclosures in financial statements filed with the SEC: Related parties should be identified and the amounts stated on the face of the balance sheet, income statement, or statement of cash flows. 100

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In cases where separate financial statements are presented for the registrant, certain investees, or subsidiaries, separate disclosure shall be made in such statements of the amounts in the related consolidated financial statements which are (i) eliminated, and (ii) not eliminated. Also, any intercompany profits or losses resulting from transactions with related parties and not eliminated and the effects thereof shall be disclosed. 101

100 SEC Regulation S-X, Rule 4-08(k)(1), 17 C.F.R. 210.4-08(k)(1); FASB ASC 235-10S99-1. 101 SEC Regulation S-X, Rule 4-08(k)(2), 17 C.F.R. 210.4-08(k)(2); FASB ASC 235-10S99-1.

The term certain investees refers to 50%-or-less-owned entities over which control is exercised (e.g., SPEs and investments accounted for under the equity method). The SEC requires the presentation of consolidated balance sheets for the two most recent fiscal years and consolidated income statements and statements of cash flows for three fiscal years. 102 The related party disclosures are included in the footnotes to these statements. Although the Regulation S-X requirements are similar to those of FASB ASC 850, Regulation S-X is more succinct, stating only that, Related parties should be identified and the amounts stated on the face of the balance sheet, income statement, or statement of cash flows. 103 FASB ASC 850 is more explicit, requiring disclosure of: (1) the nature of the relationship(s) involved; (2) a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; (3) the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; (4) amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement. 104
102 SEC Regulation S-X, 17 C.F.R. 210.3-01, 210.3-02. 103 SEC Regulation S-X, Rule 4-08(k)(1), 17 C.F.R. 210.4-08(k)(1); FASB ASC 235-10S99-1. 104 FASB ASC 850-10-50-1; FAS 57, 2.

Planning Point: The practical approach is to include the more detailed FASB ASC 850 requirements in the footnotes of financial statements filed with the SEC.

2. Non-Financial Statement Disclosures: Regulation S-K Requirements


In addition to the financial statement footnote disclosures set out in Section II.B.1, above, the SEC requires registrants to include certain related party disclosures in the non-financial statement portions of SEC filings. 105 The disclosures are to be included in registration statements filed under the Securities Act of 1933 and filings under the Securities Exchange Act of 1934. The latter includes annual reports, proxy statements, registration statements, and all other forms required to be filed pursuant to the 1934 Act. 106 Item 404 of Regulation S-K, Transactions with Related Persons, Promoters and Certain Control Persons, outlines the disclosures required for related party transactions and covers disclosures pertaining to the following: 107
105 See generally, SEC Regulation S-K, Item 404, Reg. 229.404. 106 SEC Regulation S-K, Reg. 229.10(a). 107 SEC Regulation S-K, Reg. 229.404.

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Transactions with related persons Item 404(a); Review, approval or ratification of transactions with related persons Item 404(b); Transactions with promoters and certain control persons Item 404(c). The pertinent disclosure requirements for each of these are covered in the sections that follow.

a. Transactions With Related Persons: Item 404(a)


(1) Covered Transactions According to Item 404(a), related persons include executive officers, directors, nominees for director, significant shareholders, and the immediate families of these individuals. 108 If the registrant, including its subsidiaries, has entered into related party transactions with any of these individuals and the amount exceeds $120,000, the company must disclose the transactions if it determines that the related person had or will have a direct or indirect material interest. 109 The disclosure requirements pertain to any:
110 108 A detailed discussion of related persons is set out in Section II.B.2.a.(2) below. 109 SEC Regulation S-K, Reg. 229.404(a). 110 Id.

Financial transaction, arrangement, or relationship, or Series of similar transactions, arrangements, or relationships, including indebtedness or guarantees of indebtedness. A direct interest involves entering into transactions with the registrant, or one or more of its subsidiaries. For example, holding an equity interest by purchasing shares of the registrant's common stock and engaging in loan transactions with the registrant or its subsidiaries constitute direct interests. An indirect interest typically involves an intermediary. For example, an individual is a related party if he or she engages in loan transactions with the registrant and has an investment in a company that holds a substantial equity interest in the registrant or its subsidiaries. The $120,000 is not a bright-line threshold. It is, however, the starting point for making a determination as to whether the related party has a material interest and whether the transaction is to be tracked for disclosure purposes. In deciding whether a party's interest is material, the following factors should be considered: 111
111 17 C.F.R. 149-50.

The significance of the information to investors, given all the circumstances; The importance to the related person; The nature of the related party relationship; and The dollar amount of the transactions. For purposes of Item 404(a), the term, transaction includes, but is not limited to, any financial transaction, arrangement or relationship, including indebtedness or guarantees of indebtedness, or any series of similar transactions. 112 If the individual has a material direct or indirect interest that exceeds

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$120,000, then the transaction, or series of similar transactions, must be disclosed. Similar or like transactions pertaining to a specific party should be aggregated to ascertain whether the $120,000 limit is exceeded. A transaction or series of similar transactions should be separately disclosed for each counterparty. If the related party's interest in a particular transaction, or series of related transactions, is not a direct or indirect material interest, disclosure is not required. 113
112 SEC Regulation S-K, Reg. 229.404(a). 113 17 C.F.R. 150.

Planning Point: Much has been written about the way Enron used special purpose entities (SPEs) to manipulate earnings. Two SPEs set up by Andrew Fastow, Enron's CFO, were dubbed LJM1 and LJM2. As general partner of LJM1, Fastow bought and sold Enron assets at prices more favorable to LJM1 than to Enron. By using Enron's loan guarantees, LJM1 acquired huge sums of cash that Fastow used for personal gain. All of Enron's transactions with the LJM partnerships met the materiality threshold. Although disclosure regarding these transactions was included in the 2001 proxy statement, the information omitted facts that were crucial to understanding the transactions. Indeed, the mindset at Enron was one of obfuscation and avoidance. 114 Of course, Enron was not alone. Other companies have used similar ploys. A study published in 2003 found that corporations entering into related party transactions are more likely to be associated with fraudulent financial statements. 115 Given the high probability that related party transactions will be closely scrutinized, full disclosure becomes increasingly important.
114 Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp., William C. Powers, Jr., Chair, 201 (2002). 115 Lotfi Geriesh, Organizational Culture and Fraudulent Financial Reporting, 73 CPA J. 28 (Mar. 2003).

(2) Categories of Related Persons The disclosure requirements under Item 404(a) differ somewhat depending upon the classification into which a related person falls. There are two distinct classifications of related persons: (1) directors and executive officers, and (2) significant shareholders. (a) Directors and Executive Officers The first classification includes: 116
116 SEC Regulation S-K, Reg. 229.404(a).

Directors and executive officers; Nominees for director when the required disclosures are presented in a proxy or information statement that provides information regarding the nominee's election; The immediate family members of these individuals. The following are deemed to be immediate family members: children, stepchildren, parents, stepparents, spouses, siblings, mothers-in-law, fathers-in-law, sons-in-law, daughters-in-law, brothersin-law, and sisters-in-law. Also included are individuals sharing the household of the related person, excluding tenants and employees. 117 The disclosures set out in Section II.B.2.a.(3), below, are necessary if any of these persons entered into transactions with the registrant during any part of the year. Disclosure is also necessary for transactions that were proposed during the fiscal year.

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117 Id.

(b) Significant Shareholders (Certain Beneficial Owners) The second classification of related persons comprises significant shareholders (certain beneficial owners) and members of their immediate families. Significant shareholders are individuals beneficially owning more than 5% of any class of the registrant's voting securities. 118 When a significant shareholder is a counterparty to transactions involving the registrant, the disclosures set out in Section II.B.2.a.(3), below, are required. However, unlike officers and directors, the disclosures are necessary only for the time period during which the transaction(s) existed or occurred.
118 SEC Regulation S-K, Reg. 229.403(a).

Example: An individual not yet a significant shareholder sells assets to the registrant in January. Later, in June, this person becomes a significant shareholder. Disclosure of the January asset purchase is not required since the individual was not a significant shareholder at the time of the asset purchase. On the other hand, if a transaction begins before the individual becomes a significant shareholder and continues after that event, disclosure is required. The following example illustrates this point. Example: An individual not a significant shareholder in Year A loans funds to the registrant in that year. In Year B, that person becomes a significant shareholder. If the funds are not repaid prior to the individual becoming a significant shareholder, disclosure is required. 119
119 17 C.F.R. 157.

Note that indebtedness disclosures are not required unless the individual is also an executive officer, director, or director-nominee. In addition to the disclosures found in the next section, Regulation S-K, Item 403(a), requires the registrant to provide the following information pertaining to all significant shareholders: The title of the class of stock; The name and address of the beneficial owner; The amount and nature of the beneficial ownership; and The percentage of the class of stock. 120

120 SEC Regulation S-K, Reg. 229.403(a).

(3) Item 404(a) Disclosures The following disclosures are required if the registrant or its subsidiaries enter into material transactions with any of the persons identified in Section II.B.2.a.(2), above: executive officers, directors, nominees for director, significant shareholders and the immediate family members of these individuals: 121
121 SEC Regulation S-K, Reg. 229.404(a).

The name of the related person; The basis on which the individual is a related person: title, position and so on;

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The individual's interest in the transaction with the registrant (and/or subsidiaries), including: The person's position(s) or relationship(s) with the entity that is a counterparty to, or has an interest in, the transaction; The person's ownership interest in the counterparty entity, or in the entity having an interest in the transaction; The approximate dollar value of the amounts involved in the transactions; The approximate dollar value of the related person's interest in the transactions, computed without regard to profit or loss; and Any additional information about the transactions or the related person that is required to make the transactions understandable, i.e., any information that would be material to investors, given the circumstances of the particular transactions or series of transactions. Comment: This last requirement is the result of a 2006 revision of Regulation S-K. The revision was intended to impart a principles-based approach. The belief is that preparers are more inclined to provide full disclosure under this approach because the required information is not circumscribed by overly prescriptive wording more indicative of the competing rules-based approach. The contention is that a rules-based approach develops a mind-set whereby preparers try to omit as much as possible if the rules do not explicitly state that the information is required. Much of this development was in response to insider dealings at Enron and other companies. For example, Enron's management and in-house counsel worked diligently to shoehorn insider dealings into the existing Regulation S-K rules while revealing as little as possible. In this regard, the Powers Report, an investigation into the debacle by a committee of Enron's board of directors, noted: Enron's disclosures and the information we have about how they were drafted reflect a strong predisposition on the part of at least some in the Company to minimize the disclosures about the related-party transactions. Fastow [Andrew Fastow, CFO] made clear that he did not want his compensation from the LJM partnerships to be disclosed, and the process reflected a general effort to say as little as possible about these transactions. While we recognize that Enron was not alone in seeking to say as little as the law allowed, particularly on sensitive subjects, we were told by more than one person that the Company spent considerable time and effort working to say as little as possible about the LJM transactions in the disclosure documents. It also appears that Enron Management structured some transactions to avoid disclosure 122
122 Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp., William C. Powers, Jr., Chair, 201 (2002).

The newer requirement to ensure that transactions are understandable should make it more difficult to claim that the information was omitted because it was not specifically called for. Worksheet 5 provides an example of the Item 404(a) disclosures that are included in Atmel Corporation's July 9, 2007 proxy statement on Schedule 14A. Regulation S-K requires the registrant to report Item 404 transactions occurring since the beginning of the registrant's last fiscal year, as well as any currently proposed transactions. 123 For the following SEC filings, disclosures are to be included for the current year and the two preceding fiscal years: 124
123 SEC Regulation S-K, Reg. 229.404(a).

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124 SEC Regulation S-K, Reg. 229.404. See also 17 C.F.R. 151, n.416.

Form S-1 or Form SB-2 pursuant to the Securities Act of 1933; Form 10 or Form 10-SB pursuant to the Securities Exchange Act of 1934. Accordingly, disclosure is required for three years in registration statements filed under the 1933 Act and the 1934 Act, i.e., for the period specified in Item 404, which is one year, and for two additional years. If, however, information is being incorporated by reference into a registration statement on Form S-4, the additional two years of disclosure is not required. In this situation, the necessary disclosure is for only one year, the period specified in Item 404. 125
125 Form S-4 is submitted to the SEC when a merger or an acquisition occurs. The form is also used for exchange offers when securities are provided for similar securities at less demanding terms, typically to avoid bankruptcy.

In the case of arrangements calling for periodic payments or installments, such as leases, disclosure of the aggregate amount of all periodic payments or installments is necessary. The dollar amount is the aggregate of all payments due on or after the beginning of the fiscal year, including any required or optional payments due during, or at the conclusion of, the lease or other transaction requiring the periodic payments or installments. 126 Worksheet 6 provides an example of the required disclosures for leases as reported in Frozen Food Express Industries' 2006 proxy statement on Schedule 14A.
126 SEC Regulation S-K, Reg. 229.404(a).

(4) Additional Disclosures for Transactions Involving Indebtedness Indebtedness transactions between the registrant and related persons require disclosures over and above those outlined in the previous section. For indebtedness transactions, the following additional items are to be included for the period during which disclosure is required in the filing: 127
127 SEC Regulation S-K, Reg. 229.404(a)(5).

The amount of principal outstanding as of the latest practicable date; The amount of principal paid; The amount of interest paid; and The rate(s) or amount(s) of interest payable. Furthermore, the information regarding a related person is to include the largest aggregate principal amount of all indebtedness outstanding at any time during the fiscal year, along with all amounts of interest payable on that aggregate amount. Worksheet 7 provides excerpts from Amgen's 2006 proxy statement on Schedule 14A illustrating disclosures pertaining to indebtedness transactions with related persons. As indicated in Section II.B.2.a.(3), above, disclosure is required for one year, unless the registrant is filing a registration statement, in which case three years of disclosure are required. Disclosures regarding indebtedness pertain only to those individuals included in the first classification listed in Section II.B.2.a.(2), above; executive officers, directors, and nominees for director. Disclosures regarding material indirect interests in indebtedness transactions by these individuals are also required. As indicated in Section II.B.2.a.(5)(a), below, indebtedness disclosures pertaining to individuals falling into the second classification of related persons (significant shareholder) are expressly excluded. 128

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128 SEC Regulation S-K, Reg. 229.404(a).

Comment: The Sarbanes-Oxley Act of 2002 (SOX) amended the Securities Exchange Act of 1934, 13, Periodical and Other Reports, by prohibiting issuers from making loans to executive officers and directors. 129 SOX defines an issuer as a company that issues or proposes to issue securities, if the securities are registered under section 12 of the Securities Exchange Act of 1934, or if the company is required to file reports with the SEC under section 15(d) of the Securities Exchange Act (or will be required to file those reports at the end of the fiscal year in which a registration statement for the issuer's securities has become effective under the Securities Act of 1933). 130
129 Sarbanes-Oxley Act of 2002 (SOX), Pub. L. No. 107-204, 116 Stat. 745, 402. 130 SOX 2. Section 12 of the 1934 Act pertains to registrants that are not investment companies. The latter are covered by Section 15(d).

(5) Exclusions Section II.B.2.a.(3), above, enumerates the disclosure requirements when the registrant or its subsidiaries enter into material transactions with related persons, while Section II.B.2.a.(4), above, sets out additional requirements for indebtedness transactions. There are a number of exclusions to these requirements as they pertain to the following: Indebtedness; Employment relationships; Directors' compensation; Certain indirect material interests; Other exclusions: Determination by competitive bid or governmental authority; Certain financial services; The ownership of equity securities. The following subsections cover each of the foregoing categories. (a) Exclusions Pertaining to Indebtedness Indebtedness incurred for the following types of transactions entered into in the ordinary course of business are excluded from the disclosure requirements: 131
131 SEC Regulation S-K, Reg. 404(a).

Purchases of goods or services that are subject to normal trade terms; Ordinary business travel and expense payments; Other transactions in the ordinary course of business. Comment: The phrase in the ordinary course of business is taken to mean those

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transactions of daily living that are carried out in a more or less routine fashion. For example, in addition to compensation and travel arrangements, a home mortgage obtained by a bank officer from his or her employer, on terms no more favorable than any other mortgager, is considered to be in the ordinary course of business. Indebtedness disclosures pertaining to significant shareholders, i.e., those persons who beneficially own greater than 5% of any class of the registrant's voting securities, are expressly excluded; 132 Disclosures by banks, savings and loans, and broker-dealers extending credit under Federal Reserve Regulation T 133 for loans that are not categorized as: 134 Nonaccrual; Past due; Restructured; or Potential problem loans. 135

132 SEC Regulation S-K, Reg. 404(a). 133 See Federal Reserve System, Title 12, Banks and Banking, Chapter II, Federal Reserve System, Part 220, Credit by Brokers and Dealers (Regulation T): 12 C.F.R. part 220. 134 SEC Regulation S-K, Reg. 229.404(a). 135 See Item III.C.1. and 2. of Industry Guide 3, Statistical Disclosure by Bank Holding Companies (17 C.F.R. 229.802(c)).

If these loans do not fall into any of the foregoing categories, the disclosure may consist of a statement that the loans to the related persons: 136
136 SEC Regulation S-K, Reg. 229.404(a).

Were made in the ordinary course of business; Were on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with non-related persons; and Did not involve more than the normal risk of collectibility or present other unfavorable features. (b) Employment Arrangements Disclosures of employment relationships are not required to be duplicated under Item 404 if the information is provided elsewhere pursuant to Regulation S-K. Since executive officer compensation is reported under Item 402 of Regulation S-K, Executive Compensation, the disclosures need not be repeated if the following conditions prevail: 137
137 SEC Regulation S-K, Reg. 229.404(a).

The executive officer is not an immediate family member as enumerated in Section II.B.2.a.(2), above;

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The compensation is such that it would be reported as being earned for services to the registrant under Item 402, Executive Compensation; The executive officer is a named executive officer, as defined in Item 402; 138 The compensation was approved by the compensation committee of the board of directors (or equivalent), or recommended to the entire board by the compensation committee (or equivalent).

138 SEC Regulation S-K, Reg. 402(a)(3), Item 402(a)(3) defines named executive officers as those individuals in the following categories: (1) principal executive officer (PEO); (2) principal financial officer (PFO); (3) the three most highly compensated executive officers, other than the PEO and PFO serving at the end of the fiscal year; (4) up to two individuals who would be in the previous category, except that they were not serving at the end of the fiscal year.

(c) Directors' Compensation Disclosure of compensation paid to directors need not be reported under Item 404(a) if the compensation is disclosed pursuant to Regulation S-K, Item 402(k), Compensation of Directors. 139
139 See generally, SEC Regulation S-K, Reg. 229.402(k).

(d) Certain Indirect Material Interests An individual who holds a position with an enterprise that enters into a transaction with the registrant or its subsidiaries has an indirect interest in the transaction. Even if material, such an interest is excluded from the disclosure requirements of Item 404(a) if the interest arises: 140
140 SEC Regulation S-K, Reg. 229.404(a).

Exclusively from the individual's position as a director of the enterprise doing business with the registrant or its subsidiaries (however, disclosure is required if the individual is an executive officer of the enterprise); From holding less than a 10% equity interest, whether direct or indirect, in an entity, other than a partnership, that is party to the transaction with the registrant or its subsidiaries; or From both of the foregoing. Comment: To determine whether the 10% equity interest has been exceeded, the individual must aggregate his or her equity holdings with those of all other individuals enumerated in Section II.B.2.a.(2), above. These persons include all executive officers, directors, director-nominees, significant shareholders, and immediate family members. If the combined direct or indirect equity holdings of these individuals exceeds 10% of the ownership in an enterprise that is a counterparty to transactions with the registrant or its subsidiaries, disclosure of the related party transactions is required. 141
141 Id.

If the indirect material interest stems from the registrant's transactions with a partnership in which the individual is a limited partner, disclosure is not required unless:

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The 10% aggregate threshold is exceeded; or The person holds another position in the partnership. In contrast, disclosure is required if the individual is a general partner. Comment: The ownership test pertaining to a partnership is analogous to that mentioned in the previous comment. The direct or indirect ownership interests of all persons enumerated in Section II.B.2.a.(2), above, are combined. If the aggregate direct or indirect ownership exceeds 10%, disclosure of the related party transactions is required. 142
142 Id.

(e) Other Exclusions 143


143 Id.

Certain other exclusions apply to the Regulation S-K requirements for disclosing related party transactions. Disclosure is not required under the following circumstances: The rate or charges involved in the transactions are determined by competitive bids; The transaction(s) involve services as a common carrier or contract carrier; The rates are fixed in conformity with law or governmental authority (e.g., energy costs paid to a regulated electric utility); The transactions involve services as a bank depository; Transactions involving certain financial services including entities serving as a transfer agent, stock registrar, trustee under a trust indenture, or providing similar types of services; Where the related person's interest arises solely from his or her investment in the registrant's securities on terms that are no more favorable than those enjoyed by other investors in those same securities. 144

144 But see SOX 403 for enhanced disclosure requirements for directors, officers, and principle stockholders who purchase or sell a registrant's securities.

b. Disclosure of the Process for Review, Approval or Ratification of Transactions With Related Persons: Item 404(b)
Regulation S-K, Item 404(b), requires disclosure of the process for providing assurance that transactions with related persons are reviewed, approved or ratified. Although the SEC recognizes that the characteristics of such a process can vary, Item 404(b) offers examples of the types of features envisioned, including: 145
145 SEC Regulation S-K, Item 404(b)(1), Reg. 229.404(b)(1).

The types of transactions covered by the policies and procedures incorporated in the process;

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The standards to be applied in accordance with the stipulated policies and procedures; The persons or groups of persons on the board of directors, or others, responsible for applying these policies and procedures; and A statement describing whether the policies and procedures are in writing and, if not, how the policies and procedures are evidenced. Planning Point: A practical way of assuring that the policies are communicated and followed is to fold this process of identification, review and transaction approval into management's annual assessment of internal control as stipulated by SOX Section 404(a). 146 The requirements for management's assessment of internal control can be found in 5402, Internal Controls: Sarbanes-Oxley Act 404 and Beyond (Accounting Policies and Practice Series).
146 See SOX 404(a).

Worksheet 8 shows excerpts from General Electric Company's 2007 proxy statement on Schedule 14A. The disclosures illustrate GE's process for providing assurance that transactions with related persons are reviewed, approved, and ratified. If any related party transactions requiring disclosure under SEC Regulation S-K, Item 404(a), as set out in Section II.B.2.(a), above, were excluded from the registrant's review, approval, or ratification policies, or if these procedures were ignored, the omissions are to be disclosed. 147 This disclosure is not required for transactions occurring before an individual became a related person. 148 If, however, the transaction(s) continue(s) after the individual becomes a related person, disclosure of the omissions are necessary. 149
147 SEC Regulation S-K, Reg. 229.404(b)(2). 148 The categories of related persons under Regulation S-K are set out in Section II.B.2.a.(2) above. 149 SEC Regulation S-K, Reg. 229.404(b).

c. Transactions With Promoters and Certain Control Persons: Item 404(c)


(1) Promoters A promoter is a person who individually, or with others, takes the initiative in founding or organizing a business. Also deemed a promoter is an individual who receives consideration amounting to 10% of any class of securities of a registrant or 10% of the proceeds from the sale of those securities. Underwriters are excluded, as are individuals who receive 10% of the securities or proceeds in exchange for property but do not take part in founding or organizing the business. 150
150 SEC Regulation S-X, Reg. 210.1-02.

If the registrant had a promoter within the past five fiscal years and is filing a registration statement on (1) Form S-1 or Form SB-2 under the Securities Act of 1933 or (2) Form 10 or Form 10-SB, certain disclosures are required. Anything of value provided to or by promoters within the previous five years requires disclosure. As indicated in Section II.B.2.a.(3), above, Item 404 disclosures on registration statements are required for a period of three years. Comment: There is no materiality test. Disclosure is required when anything of value changes hands, including money, property, contracts, services, options, and rights of any kind. 151

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151 SEC Regulation S-K, Reg. 229.404(c)(1)(i).

When such exchanges take place, the following are to be disclosed: 152
152 SEC Regulation S-K, Reg. 229.404(c)(1)(ii).

The name(s) of the promoter(s); The nature and amount of anything of value received by, or to be received by, each promoter, either directly or indirectly; and The nature and amount of any assets, services, or other consideration received, or to be received, in exchange by the registrant. Additionally, for any assets acquired, or to be acquired, from a promoter, the following disclosures are required: 153
153 Id.

The amount at which the assets were acquired, or at which they are to be acquired; The accounting principle(s) followed in determining the amount at which the assets were recorded on the registrant's books; The name of the person(s) determining this amount, as well as the relationship, if any, to the registrant or any promoter; and The cost of the assets to the promoter if acquired within two years of their transfer to the registrant. Worksheet 9 provides excerpts from 21st Century Telesis' Form 10, which discloses transactions with promoters. (2) Certain Control Persons The disclosures set out in the foregoing section are also required for any control person, defined as: 154
154 SEC Regulation S-K, Reg. 229.404(c)(2).

An individual who has acquired control of a registrant that is defined as a shell company; A person who is part of a group of individuals acquiring such control, where a group is defined as two or more individuals who agree to act together to acquire, hold, vote, or dispose of the equity securities of a registrant that is a shell company. A shell company has the same meaning as used in Rule 405 under the Securities Act of 1933 and Rule 12b-2 of the Securities Exchange Act. 155 A shell company is:
155 Id.

A registrant, other than an asset-backed issuer as that term is defined in Item 1101(b) of Regulation AB, that has: 156

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156 Rule 12b-2, Securities Exchange Act of 1934 (17 C.F.R. 240.12b-2).

1. No or nominal operations; and 2. Either: i. No or nominal assets; ii. Assets consisting solely of cash and cash equivalents; or iii. Assets consisting of any amount of cash and cash equivalents and nominal other assets. For purposes of this definition, the determination of a registrant's assets (including cash and cash equivalents) is based solely on the amount of assets that would be reflected on the registrant's balance sheet prepared in accordance with generally accepted accounting principles on the date of that determination. 157
157 Id.

An asset-backed issuer means an issuer whose reporting obligation results from either the registration of an offering of asset-backed securities under the Securities Act, or the registration of a class of assetbacked securities under Section 12 of the Exchange Act. 158 An asset-backed security is one that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that, by their terms, convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders; and provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases. 159
158 SEC Regulation S-K (Regulation AB), Reg. 229.1101(b). 159 SEC Regulation S-K (Regulation AB), Reg. 229.1101(c)(1).

Comment: A foreign private issuer is deemed to have complied with Item 404(c) if it provides the information required by Item 7.B of Form 20-F. 160
160 Securities Exchange Act of 1934, Form 20-F, Registration of Securities of Foreign Private Issuers Pursuant to Section 12(b) or (g), Annual and Transition Reports Pursuant to Sections 13 and 15(d), and Shell Company Reports Required Under Rule 13a-19 or 15d-19 17 C.F.R. 249.220f.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis II. Authoritative Literature and Guidance

C. Stock Exchanges
Various stock exchanges also have rules concerning related party transactions. This section covers New York Stock Exchange and NASDAQ requirements.

1. New York Stock Exchange a. Rules Pertaining to Related Party Transactions


Since the late 1950s, the New York Stock Exchange (NYSE) discouraged material related party

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transactions. When a listed company entered into such a transaction, the Exchange typically made an agreement with the company to rectify the situation within a reasonable period of time, typically within three to five years. 161 Several developments brought about a modification of this policy. In particular, audit committees were increasingly prevalent due to various mandates, including a 1978 NYSE rule requiring virtually all listed companies to establish audit committees. In the meantime, the SEC promulgated rules requiring the disclosure of related party transactions. 162 As a consequence, it is no longer the policy of the NYSE to discourage related party transactions, although the NYSE still maintains the position that large, publicly held corporations can operate effectively without related party transactions. 163 The current view is that properly constituted audit committees and independent, objective directors can be expected to distinguish between beneficial transactions and those that raise the suspicion of exploitation by insiders. The NYSE Board of Directors adopted the following statement regarding related party transactions: 164
161 New York Stock Exchange, Listed Company Manual, 307.00. 162 See Section II.B, above. 163 New York Stock Exchange, Listed Company Manual, 307.00. 164 Id. This statement was adopted in March 1983.

The NYSE believes that the review and oversight of such situations is best left to the discretion of listed corporations and corporations applying for listing on the NYSE. While no particular method of resolution is suggested, the Audit committee or a comparable body could be considered as the forum for review and oversight of potential conflicts of interest situations. The NYSE expects listed corporations and those applying for listing to monitor and review related party transactions. Additionally, the NYSE requires companies that apply for listing to confirm that they will appropriately review and oversee related party transactions on an on-going basis. 165 The rules also indicate that the NYSE will review disclosures in proxy statements and other SEC filings and send reminder notices when warranted. 166
165 Id. 166 Id.

b. Shareholder Approval Policy: Issuance of Stock


Under NYSE rules, related parties include: 167
167 Id. 312.03(b).

Directors; Officers; and Substantial security holders. A substantial security holder is a person owning 5% or more of the common shares or voting power.
168 The concept is similar to that used by the SEC in defining certain beneficial owners (significant

shareholders) as set out in Section II.B.2.a.(2).(b), above. Whereas the SEC definition pertains to those owning more than 5% of any class of the registrant's stock, the NYSE contemplates a scope that is less broad: those owning 5% or more of the outstanding common shares, or voting power. Voting power outstanding is defined as the aggregate number of votes that may be cast by holders of those

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securities outstanding that entitle the holders thereof to vote generally on all matters submitted to the company's security holders for a vote. 169
168 Id. 312.04(e). 169 Id. 312.04(f).

(1) Issuances to Related Parties Shareholder approval is required in any transaction, or series of related transactions, in which related parties (directors, officers, and substantial security holders) are the recipients of common stock, including those securities convertible into common stock or exercisable for common shares. 170
170 Id. 312.03(b). Equity compensation plans also require shareholder approval. For additional information on related party transactions as they pertain to compensation, see id. 312.03(a) and 303A.08.

There is an exception to this approval policy if the individual to whom shares are issued is a substantial security holder but not also a director or officer. When a listed company issues common stock to the security holder (1) in a cash sale, and (2) at a price that is equal to or greater than both the book value and market value of the stock, a 5% threshold comes into play. Approval is only required if the number of shares of common stock, including the number of shares into which the securities may be convertible or exercisable, exceeds, before issuance of the shares, either 5% of: 171
171 Id. 312.03(b).

The number of shares of common stock outstanding, or The voting power outstanding. (2) Issuances to Related Entities Shareholder approval is required when the reporting entity issues shares to entities with which the reporting entity's directors, officers, and substantial security holders are associated. Stockholder approval is required when common stock, including those securities convertible into common stock or exercisable for common shares, are issued in any transaction or series of related transactions to: 172
172 Id.

A subsidiary, affiliate or other closely related person of a related party; and Any company or entity in which a related party has a substantial direct or indirect interest. In the latter situation, issuance to an entity in which a related party has a substantial direct or indirect interest, shareholder approval is only required if the shares to be issued by the listed company or the number of shares of common stock into which the securities may be convertible or exercisable exceeds, before issuance of the shares, either 1% of: 173
173 Id.

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The number of shares of common stock outstanding, or The voting power outstanding. A substantial interest in a company or entity is defined as 5% or greater of the company's common shares or voting power outstanding. 174
174 Id. 312.04(e).

In computing the 1% and 5% thresholds, only shares actually issued and outstanding are used. The following are excluded: (1) treasury shares, (2) shares held by a subsidiary, and (3) unissued shares reserved for issuance upon conversion of securities or upon exercise of options or warrants. 175
175 Id. 312.04(d).

(3) Exception to Shareholder Approval The NYSE allows an exception to the foregoing approval procedures if delay would jeopardize the viability of the company. Any exception has to be approved by the audit committee of the board. The issuer is required to mail a letter to shareholders alerting them to the fact that these equity securities are being issued without the approval required by the NYSE but with audit committee approval. The mailing deadline is 10 days prior to the issuance of the securities. 176
176 Id. 312.05.

2. NASDAQ a. Audit Committee Approval of Related Party Transactions


NASDAQ requires each issuer to review, on an ongoing basis, all related party transactions for potential conflicts of interest. Additionally, all related party transactions require approval by the audit committee or another independent body of the board of directors. 177 Rather than devising yet another definition, NASDAQ simply defines related party transactions as those targeted for disclosure by the SEC under Regulation S-K, Item 404: 178 those related party transactions exceeding $120,000 when the related person had or will have a direct, or indirect material interest. The requirements pertain to any financial transaction, arrangement, or relationship, or series of similar transactions, arrangements, or relationships, including indebtedness or guarantees of indebtedness.
177 NASDAQ Manual, 4350(h). 178 Id.

b. Shareholder Approval Policy 179


179 Equity compensation plans also require shareholder approval. For additional information on related party transactions as they pertain to compensation, see NASDAQ Manual, 4350(i) (1)(A).

(1) Related Persons Defined According to NASDAQ rules, related persons include directors, officers and substantial shareholders. A substantial shareholder is a person owning 5% or more of the common shares or voting power of the listed company. 180 The concept is similar to that used by the SEC in defining certain beneficial owners (significant shareholders), as set out in Section II.B.2.a.(2), above. Voting power outstanding is defined

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as the aggregate number of votes that may be cast by holders of those securities outstanding which entitle the holders thereof to vote generally on all matters submitted to the company's security holders for a vote. 181
180 Id. 4350(i)(4). 181 Id. 4350(i)(4).

(2) Issuances Resulting in Change of Control NASDAQ rules require shareholder approval when the issuance, or potential issuance, of the stock of the listed company will result in a change of control. (3) Share Transactions Consummated by Related Parties NASDAQ uses a 20% threshold to flag issuances of stock when related parties are involved. When a listed company issues common shares, or securities convertible into or exercisable for common stock and the issuance is not a public offering, shareholder approval is required if the issued shares, together with sales by officers, directors, or substantial shareholders, equal or exceed (or will equal or exceed) 20% of the outstanding shares or voting power before the issuance. The approval is required when the price is less than the greater of book or market value. 182
182 Id. 4350(i)(1)(D)(i).

(4) Related Persons Having an Interest in a Target Company NASDAQ also requires shareholder approval when: (1) a listed company issues stock to purchase the shares or assets of another company, and (2) related persons have an interest in the target company. Specifically, approval is required when: 183
183 Id. 4350(i)(1)(C)(i).

A related person has a 5% or greater direct or indirect interest in the target company, the assets to be acquired, or consideration to be paid in the transaction or series of transactions; Related persons collectively have a 10% or greater direct or indirect interest in the target company, the assets to be acquired, or consideration to be paid in the transaction or series of transactions; or The present or potential issuance of common stock, including securities convertible into or exercisable for common stock, could result in a 5% or more increase in the outstanding common shares or voting power of the listed company. Only shares actually issued and outstanding are used to compute the threshold. Excluded are: (1) treasury shares, (2) shares held by a subsidiary, and (3) unissued shares reserved for issuance upon conversion of securities or upon exercise of options or warrants. 184 This approval is necessary since the related person(s) could influence the way the target company votes its shares of stock in the listed company.
184 Id. 4350(i)(3).

(5) Exceptions to the Shareholder Approval Policy NASDAQ allows an exception to shareholder approval when delay in securing shareholder approval would seriously jeopardize the financial viability of the enterprise. The exception must be expressly

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approved by the audit committee or a comparable body of the company's board of directors comprised solely of independent, disinterested directors. 185 The issuer must seek prior written approval from NASDAQ's Listing Qualifications Department. The company is required to mail a letter to all shareholders not later than 10 days before issuance of the securities informing them of the omission to seek shareholder approval. The letter must disclose: 186
185 Id. 4350(i)(2). 186 Id.

The terms of the transaction, including the number of shares of common stock that could be issued and the consideration received; The fact that the issuer is relying on a financial viability exception to the stockholder approval rules; and That the audit committee, or comparable body of the board of directors comprised solely of independent and disinterested directors, has approved the exception. The issuer is also required to promptly make a public announcement through the news media disclosing the same information, but no later than 10 days before the issuance of the securities. 187
187 Id.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis III. Sales, Purchases, Transfers, and Leases Between Related Parties This section covers accounting and disclosure requirements pertaining to related party sales, purchases, transfers, and leases of goods and services. Also included are the sales, purchases, and transfers of financial instruments. First, GAAP accounting and disclosure rules are discussed, next SEC rules and regulations, and finally New York Stock Exchange guidance related to the sales and purchases of company securities. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis III. Sales, Purchases, Transfers, and Leases Between Related Parties

A. GAAP Accounting and Disclosures


Since related parties are not acting independently, there is the presumption that related party transactions are not conducted on an arm's-length basis. 188 Nevertheless, the accounting treatment afforded related party transactions usually does not differ from that used for transactions between unrelated parties. An exception arises when related parties are under common control, a consideration impacting sales, purchases, transfers, and leases among related parties.
188 FASB ASC 850-10-50-5; FAS 57, 3.

Related party transactions are typically recorded according to form, using the stated exchange price and terms, although there are exceptions to this principle. Because the form of a related party transaction may differ from its substance, full disclosure is required when the transactions are material. 189

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189 SAS 45 (AICPA AU 334.02).

1. Accounting TreatmentRelated Parties Not Under Common Control


When parties are not under common control, transactions between or among related parties should be recorded according to their form. When substance differs from form, FASB ASC 850 requires the disclosure of, such other information deemed necessary to an understanding of the effects of the transactions on the financial statements. 190
190 FASB ASC 850-10-50-1(b); FAS 57, 2.

2. Accounting TreatmentRelated Parties Under Common Control


The accounting treatment of sales, purchases, transfers, and leases between or among related parties under common control differs from the accounting treatment of other related party transactions because of the presumption that transactions among entities within a control group lack substance. 191
191 FASB Technical Bulletin No. 85-5, Issues Relating to Accounting for Business Combinations (background material not codified).

a. Definition of Under Common Control


Although the issue is unsettled, the term under common control usually means that a common owner holds greater than 50% of two or more entities. The common owner may be an individual, another enterprise, immediate family members voting as a bloc, or a group of shareholders acting in concert. According to the SEC, parties are under common control in the following four situations: 192
192 See generally Donna L. Coallier, Professional Accounting Fellow, Office of the Chief Accountant, SEC, Remarks at the Twenty-Fifth Annual National Conference on Current SEC Developments (Dec. 9, 1997). EITF Issue No. 02-5, Definition of Common Control in Relation to FASB Statement No. 141 (not codified), provided guidance on the definition of common control in relation to FAS 141, which was superseded by FAS 141(R). Given that FAS 141 is no longer authoritative guidance, the related EITF Issue 02-5 is not codified.

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(1) An individual holds greater than 50% of the voting ownership interest of each entity; (2) An enterprise holds more than 50% of the voting interest; (3) Immediate family members hold greater than 50% of the voting ownership interest of each entity (with no evidence that those family members will vote their shares in any way other than in concert); Immediate family members include a married couple and their children, but not the married couple's grandchildren; Entities might be owned in varying combinations among living siblings and their children; Such situations require careful consideration regarding the substance of the ownership and the voting relationships; and (4) A group of shareholders holds more than 50% of the voting ownership interest of each entity, and there is contemporaneous written evidence of an agreement to vote a majority of the entities' shares in concert. Comment: FASB's Emerging Issues Task Force discussed the meaning of the term common control but came to no consensus. This conclusion was published in EITF Issue No. 02-5, Definition of Common Control in Relation to FASB Statement No. 141, which noted that the SEC Observer indicated SEC registrants should continue to follow the guidance set out in the preceding paragraph. EITF Issue 02-5 is reproduced in Worksheet 10.

b. Accounting Treatment
The SEC's view is that when related parties under common control exchange assets, transfers should be recorded using carry-over amounts except in limited circumstances. 193 Exceptions turn on: (1) the frequency of the transactions (recurring versus infrequent) (2) the asset time horizon (current versus long-term) and (3) valuation uncertainty, i.e., whether the exchanged property is objectively and readily determinable. Thus, an exception is made when the transactions are (1) recurring, (2) the transferred assets are short-term (current assets), and (3) valuation is not an issue. 194 For example, market exchange prices would be used for short-term sales and purchases of inventory and the like when a ready market is available. Long-term assets, intangibles, and transfers of net assets, as in a business combination, present a different sort of problem in that there is usually no readily determinable exchange price. In such instances, transfers are effected at carry-over (recorded) amounts. 195 These considerations are applicable to the presentation of separate affiliate statements. When financial statements are consolidated or combined, all intercompany transactions, including intercompany gains and gross profit remaining, are to be eliminated. 196 Disclosure is not required for transactions so eliminated. 197
193 EITF Issue No. 85-21, Changes of Ownership Resulting in a New Basis of Accounting. The EITF, however, could not reach a consensus on how privately held companies should record such transactions. 194 Id. 195 Id. 196 FASB ASC 810-10-45-1; Accounting Research Bulletin No. 51, Consolidated Financial Statements, 6. 197 FASB ASC 850-10-50-1; FAS 57, 2.

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Comment: FASB's Emerging Issues Task Force discussed the level of ownership required to recognize a new basis of accounting. The SEC Observer expressed the view of the SEC staff that transactions among parties under common control should be recorded using carry-over amounts. However, the Emerging Issues Task Force was unable to reach consensus on this issue. This conclusion is reflected in EITF Issue No. 85-21, Changes of Ownership Resulting in a New Basis of Accounting, which is reproduced in Worksheet 11. There are two important arguments in favor of the SEC viewpoint. The first stems from the basic accounting precept relating to revenue recognition: revenue should only be recognized when realized. Affiliates transacting among themselves leave a control group no better or worse off. As there is no outside counterparty, the earnings process is not complete. Accordingly, an exchange is deemed not to have taken place. The second reason stems from concerns about fraud. If gains are recognized when assets are transferred within a control group, income could be boosted simply by moving assets around. These considerations point toward recording transactions at existing carrying amounts.

3. Sales
When parties are unrelated, revenue is recognized when a sale is consummated with appropriate recognition of an estimate for uncollectible accounts. For the most part, sales between related parties are not accounted for differently from sales between unrelated parties. However, as indicated in Section III.A.2.b, above, there are certain differences that turn on whether the related parties are under common control.

a. Sales Between Related Parties Not Under Common Control


Related parties not under common control should record recurring sales of nonfinancial assets consummated in the ordinary course of business at terms equivalent to those that would prevail between unrelated parties the historical exchange price, i.e., the value settled upon by the transacting parties. 198
198 FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, 69.

In unusual situations or when valuation is not reasonably determinable, it may be more appropriate for related parties to record sales using carrying amounts, that is, the historical cost reflected in the transferor's financial statements. Whether under common control or not, related parties exhibit certain influence and control characteristics differentiating them from unrelated parties. Specifically, related parties have the ability to, significantly influence the management or operating policies to the extent that one of the transacting parties might be prevented from fully pursuing its own separate interests.
199 Where market measures are readily available and there is no compelling evidence that transactions

have been contrived to arrive at the results desired by the parties, the use of prevailing market prices is appropriate. However, in cases where there is no arm's-length market in the commodities or financial instruments under consideration, the use of historical cost is more prudent to preclude recording gains that subsequently prove to be illusory. In all cases, material related party transactions require disclosure. 200
199 FASB ASC Term Related Parties; FAS 57, 24(f). 200 FASB ASC 850-10-50-1; FAS 57, 2, 15.

Although not entirely analogous, standards covering nonmonetary transfers provide some insight. The FASB Codification states the following in regards to measuring transfers when fair values are not readily attainable: 201

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201 FASB ASC 845-10-30-8; APB Opinion No. 29 Accounting for Nonmonetary Transactions, 26.

If neither the fair value of a nonmonetary asset transferred nor the fair value of a nonmonetary asset received in exchange is determinable within reasonable limits, the recorded amount of the nonmonetary asset transferred from the enterprise may be the only available measure of the transaction. Accordingly, when long-term nonfinancial assets are sold, historical cost may be the only objective measure. Planning Point: When related parties are involved, measurements having little or no objectivity may raise a question as to whether a sale is in the best interest of shareholders. For example, assume that Corporation A, which deals in art treasures, sells a painting to Corporation R. The CEO of Corporation A owns less than 1% of the outstanding shares of A but is the majority shareholder of Corporation R, whose other shareholders are relatives of Corporation A's CEO. Corporation A bought the painting last year for $150,000 on speculation. The artist is not well known and there is no ready market for the painting. Corporation A and Corporation R are contemplating a sales price of $65,000. In this situation, the preferred course of action is to record the sale at the carrying amount on the books of Corporation A: $150,000. If the sale is recorded at $65,000, the form of the transaction is not indicative of its substance, which is not determinable due to the lack of an arm's-length basis for the transaction. In such instances, FASB ASC 850 requires disclosure of such other information deemed necessary to an understanding of the effects on the financial statements. 202 Whichever amount is used to record the sale, full disclosure in A's financial statements would necessitate revealing the transaction details and identifying the related parties. For example, if the sale is recorded at $65,000, the disclosure should include the amount that Corporation A paid for the painting and the amount of the resultant loss. Depending on the eventual value of the painting, this sale may not be in the best interest of Corporation A's shareholders. A definitive determination depends on the eventual selling price of the painting to an independent third party.
202 FASB ASC 850-10-50-1(b); FAS 57, 2.

b. Sales Between Related Parties Under Common Control


The treatment of sales between related parties under common control depends on: (1) the frequency of the transactions (recurring versus infrequent); (2) the asset time horizon (current versus long-term); and (3) valuation uncertainty (i.e., whether the exchanged property is objectively and readily determinable). (1) Recurring Sales of Short-Term Assets Objective Valuation As indicated in Section III.A.2.a, above, the term under common control usually means entities whose common owner holds more than 50% of both enterprises. A common owner may be: 203
203 EITF Issue 02-5 (not codified). See also generally, Securities Exchange Commission, Office of the Chief Accountant, Donna L. Coallier, Professional Accounting Fellow, Office of the Chief Accountant, Twenty-Fifth AICPA National conference on Current SEC Developments (1997).

An individual; Another enterprise; Immediate family members voting as a bloc; or

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A group of shareholders acting in concert. When parties are under common control, recurring sales of short-term nonfinancial assets in the normal course of business are typically recorded using prevailing market prices if available. 204 A typical example is the sale of inventory by one affiliate to another.
204 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer).

Example: A bauxite extractor sells aluminum ore on a recurring basis to an affiliated company that processes the bauxite ore and extrudes aluminum tubing to be used in various manufacturing processes. Since these sales are recurring and there is a ready market for the price of the bauxite ore, the sales would typically be recorded at prevailing market prices. If the tubing manufacturer has minimal inventories, the effect of using market prices is likely immaterial. When separate statements are presented, intercompany gross profits that are material require disclosure. If the statements of the two affiliates are consolidated or combined, accounting standards require the elimination of material intercompany gains or losses, as well as gross profit remaining in inventory. 205
205 FASB ASC 810-10-45-1 and 45-10; ARB 51, 6, 23.

(2) Sales Using Carry-Over Amounts When parties are under common control, non-recurring sales of short-term assets, sales of short-term assets when valuation is in question, and most sales of long-term assets should be transferred at carry-over amounts without recognition of a gain or loss. 206 When a gain or loss is indicated because a cash sum is paid that differs from the recorded amount of the assets, alternative treatments depend on whether the affiliates are combined or whether separate statements will be presented.
206 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies.

Comment: Although there are some exceptions, GAAP rules generally require the consolidation of majority-owned subsidiaries. 207 Accordingly, if combined statements will be presented, each company can record a normal gain or loss entry, which will be eliminated when the statements are combined. When the separate statements of affiliates will be presented or the affiliates in a control group will not be combined, an alternative is to include the gain or loss in an equity account, such as accumulated other comprehensive income.
207 FASB ASC 810-10-15-10(a); ARB 51, 3, as amended by FAS 94, 13.

Example (Affiliates Combined): Company L and Company D are each greater than 50% owned by Mr. B. Accordingly, these two companies are affiliates under the common control of Mr. B. Combined statements will be presented for the group of related enterprises. Company L sells land, for which it paid $40,000, to Company D for $72,000 cash. The separate financial statements of these companies prior to the land sale appear as follows:

L Company: Condensed Financial Statements Before Land Sale Transaction Balance Sheet

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Liabilities & Equity Liabilities Stockholders equity Capital stock Retained earnings Assets Land Other assets Total Assets $40,000 Beginning balance Current net income 700,000 400,000 2,500,000 $4,000,000 1,400,000 $1,500,000

Total stockholders 3,960,000 equity $4,000,000 Total liabilities & equity Income Statement Revenues Expenses Net income

$10,000,000 9,600,000 $400,000

D Company: Condensed Financial Statements Before Land Sale Transaction Balance Sheet
Liabilities & Equity Liabilities Stockholders equity Capital stock Retained earnings Beginning balance Assets Other assets Total Assets Current net income $1,200,000 Total stockholders equity $1,200,000 Total liabilities & equity Income Statement Revenues Expenses $3,600,000 3,420,000 220,000 500,000 $300,000

180,000 900,000 $1,200,000

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Net income

$180,000

Company L would make the following journal entry to record the sale: Entry Recorded by L Cash Land Gain on sale of property Company D would record the following entry: Entry Recorded by D Land Cash DR 72,000 72,000 CR DR 72,000 40,000 32,000 CR

When the statements are combined, the gain is eliminated and the land restored to its original carrying cost to avoid recognizing gains by simply transferring assets within a control group. The following working paper presents the condensed combined balance sheets and income statements after the land sale transaction and the elimination entry:

L and D Companies: Condensed Combined Financial Statements Working Paper


Adjustments and Balance Sheet Land Other assets Total Assets Liabilities & Equity Liabilities Stockholders Equity Capital stock Retained earnings Beginning balance Current net income Total stockholders equity Total liabilities & equity Income Statement 700,000 432,000 2,532,000 220,000 180,000 900,000 32,000 920,000 580,000 3,400,000 1,400,000 500,000 1,900,000 $1,500,000 $300,000 $1,800,000 $4,032,000 L Co. D Co. Eliminations $72,000 1,128,000 $4,032,000 $1,200,000 32,000 Combined $40,000 5,160,000 $5,200,000

$4,032,000 $1,200,000

32,000

32,000

$5,200,000

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Revenues Expenses Operating income Gain - sale of land Net income

$10,000,000 $3,600,000 9,600,000 400,000 32,000 $432,000 3,420,000 180,000 ______ $180,000 32,000 32,000 ______

$13,600,000 13,020,000 580,000 ______ $580,000

Example (Presentation of Separate Statements): Assume again that Company L and Company D are each greater than 50% owned by Mr. B. Separate financial statements will be presented for the two companies. As before, Company L sells the land with a carrying amount of $40,000 to Company D, which remits $72,000 cash. Since no eliminations will be recorded, Company L should record the $32,000 difference between the carrying amount of the land and the cash received in an equity account. This amount could be included as a component of other comprehensive income, as shown: Entry Recorded by L Cash Land Equity other comprehensive income Company D would record the following entry: Entry Recorded by D Land Equity other comprehensive income Cash The separate financial statements for Company L would appear as follows: DR 40,000 32,000 72,000 CR DR 72,000 40,000 32,000 CR

L Company: Condensed Financial Statements Balance Sheet


Liabilities & Equity Liabilities Stockholders equity Capital stock Retained earnings Accumulated other Assets Other assets comprehensive income $4,032,000 Total stockholders equity 32,000 2,532,000 1,400,000 1,100,000 $1,500,000

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Total Assets

$4,032,000 Total liabilities & equity Income Statement Revenues Expenses Net income

$4,032,000

$10,000,000 9,600,000 $400,000

Company D's separate financial statements would show the land at Company L's cost:

D Company: Condensed Financial Statements Balance Sheet


Liabilities & Equity Liabilities Stockholders equity Capital stock Retained earnings Assets Land Other assets Total Assets 40,000 Accumulated other comprehensive income (32,000) 868,000 $1,168,000 Income Statement Revenues Expenses Net income $3,600,000 3,420,000 $180,000 500,000 400,000 $300,000

$1,128,000 Total stockholders equity $1,168,000

Related party disclosures are required in the separate statements as described in Section II.A.1, above. However, the transaction does not have to be disclosed in the combined statements, since FASB ASC 850 does not require disclosure of transactions that are eliminated when entities are consolidated or combined. 208
208 FASB ASC 850-10-50-1; FAS 57, 2.

Comment: Where to include the $32,000 difference between the recorded value of the land and the cash remitted remains unsettled. Recording it in accumulated other comprehensive income appears to be an appropriate solution. Comprehensive income is comprised of all changes in equity during a period other than additional investments by owners and distributions to them. 209 Other comprehensive income includes those gains and losses that are components of comprehensive income but excluded from net income. 210 There are several compelling arguments for including the $32,000 in other comprehensive income. First, the $32,000 represents an unrealized gain that will be realized when the land is sold to an independent party. Second, other comprehensive income includes items such as unrealized gains and losses, for example, those

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associated with available-for-sale securities. The $32,000 amount is similar in concept and is therefore a candidate for inclusion in other comprehensive income. Third, with the conveyance of cash from Company D to Company L, Mr. B's investment has migrated. The investment in D has declined by $32,000 with a corresponding increase in the investment in Company L.
209 FASB ASC Term Comprehensive Income; FASB Statement No. 130, Reporting Comprehensive Income, 8. 210 FASB ASC Term Other Comprehensive Income; FAS 130, 10.

(3) Receivables From Related Parties Notes and accounts receivable due from officers, employees, or affiliated entities should be classified separately in the balance sheet. These amounts should be separately identified and not included under a general heading or commingled with trade accounts receivable. 211 Receivables from affiliates that are the equivalent of unpaid stock subscriptions should not be included in accounts receivable but instead deducted from stockholders' equity. This treatment is consistent with Rule 5-02.30 of SEC Regulation S-X, which states, Show also the dollar amount of any common shares subscribed but unissued, and show the deduction of subscriptions receivable therefrom. 212 Deferred compensation that arises when capital stock is issued or will be issued to officers or other employees should be accounted for as a deduction from stockholders' equity. 213
211 FASB ASC 850-10-50-2; ARB 43, ch. 1, A, 5. 212 SEC Regulation S-X, Rule 5-02.30, 17 C.F.R. 210.5-02.30; FASB ASC 210-10-S99-1. 213 SEC Staff Accounting Bulletin, Topic 4E.

c. Summary Accounting for Sales


Sales are recorded differently depending on whether the transacting parties are: (1) unrelated, (2) related parties not under common control, or (3) related parties under common control: Unrelated Parties Sales of short-term and long-term nonfinancial assets are recorded at fair value as measured by the monetary consideration given up. Related Parties Not Under Common Control The accounting is similar to that used for unrelated parties except when a market price or fair value is not determinable. In that eventuality, historical cost should be used to preclude skepticism about a transaction's validity. Related Parties Under Common Control Recurring sales of short-term nonfinancial assets for which valuation is not a concern should be recorded using prevailing market prices. Non-recurring sales of short-term assets, sales of short-term assets when valuation is in question, and most sales of long-term non-financial assets should be transferred at carry-over amounts without recognition of a gain or loss. This accounting is applicable when the separate statements of affiliates are presented.

4. PurchasesLong-Term Obligations a. Accounting


(1) Parties Are Unrelated FASB ASC 440, based, in part on, FASB Statement No. 47, Disclosure of Long-Term Obligations, requires disclosure of commitments under unconditional purchase obligations when an enterprise has entered into financing arrangements with a supplier. 214 According to that Topic, an unconditional

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purchase obligation is an obligation to transfer funds in the future for fixed or minimum amounts or quantities of goods or services at fixed or minimum prices. 215 An unconditional purchase contract having the following characteristics requires disclosure: 216
214 FASB ASC 440-10-50-2; FASB Statement No. 47, Disclosure of Long-Term Obligations, 6. 215 FASB ASC Term, Unconditional Purchase Obligation; FAS 47 6. 216 FASB ASC 440-10-50-2; FAS 47, 6.

Is noncancelable, or cancelable only: Upon the occurrence of some remote contingency; With the permission of the other party; If a replacement agreement is signed between the same parties; Upon payment of a penalty in an amount such that continuation of the agreement appears reasonably assured; Was negotiated as part of arranging financing for the facilities that will provide the contracted goods or services or for costs related to those goods or services, for example, carrying costs for contracted goods; 217 or Has a remaining term in excess of one year.

217 A purchaser is not required to investigate whether a supplier used an unconditional purchase obligation to help secure financing, if the purchaser would otherwise be unaware of that fact. See generally FASB ASC 440-10-50-2(b); FAS 47, 17.

(2) Related Parties Analogous to sales transactions, as discussed in Section III.A.3.a, above, related parties not under common control should record recurring purchases of nonfinancial assets consummated in the ordinary course of business at terms equivalent to those that would prevail between unrelated parties, i.e., the historical exchange price. 218 This treatment is applicable whether or not the parties are under common control, since the types of commitments contemplated are those for recurring purchases with a fixed price that presumably reflects expected market prices. If valuation is in question, the purchases should be recorded at carry-over amounts without recognizing gain or loss.
218 CON 5, 69 (not codified); EITF Issue 8521 (not codified).

b. Disclosures
(1) Parties Not Related The nature of the disclosure is dependent on whether the purchaser has recorded the obligation. If the contract has been recorded, the disclosures are to include the aggregate amount of payments for each of the five years following the date of the latest balance sheet presented. 219 If the obligation is not recorded, the disclosures are more involved and include: 220
219 FASB ASC 440-10-50-6; FAS 47, 10(a). 220 FASB ASC 440-10-50-4; FAS 47, 7.

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The nature and term of the obligation(s); The amount of the fixed and determinable portion of the obligation(s) as of the date of the latest balance sheet presented in the aggregate and, if determinable, for each of the five succeeding fiscal years; The nature of any variable components of the obligation(s); The amounts purchased under the obligation(s), for example, under a take-or-pay or throughput contract for each period for which an income statement is presented. A take-or-pay contract is an agreement between a purchaser and a seller that provides for the purchaser to pay specified amounts periodically in return for products or services. The purchaser must make specified minimum payments even if it does not take delivery of the contracted products or services. 221 A throughput contract is an agreement between a shipper (processor) and the owner of a transportation facility (such as an oil or natural gas pipeline or a ship) or a manufacturing facility that provides for the shipper (processor) to pay specified amounts periodically in return for the transportation (processing) of a product. The shipper (processor) is obligated to provide specified minimum quantities to be transported (processed) in each period and is required to make cash payments even if it does not provide the contracted quantities. 222
221 FASB ASC Term Take-or-Pay Contract; FAS 47, 23 222 FASB ASC Term Throughput Contract, FAS 47, 23.

(2) DisclosuresRelated Parties In addition to the disclosures described in the preceding section, related party disclosures should identify the related parties and describe the nature of the transactions. Applicable related party disclosures are found in FASB ASC 850 and set out in Section II.A.1, above.

c. Purchase Obligations That Are Leases


If a lease has the characteristics of an unconditional purchase contract, FASB ASC 440 indicates that the future minimum lease payments do not require disclosure under that standard if the payments are disclosed pursuant to FASB standards dealing with leases. 223 Section III.A.7, below, discusses the accounting and disclosure requirements pertaining to leases.
223 FASB ASC 440-10-50-3; FAS 47, 6.

5. Nonmonetary Transactions
Transactions are normally recorded at historical exchange prices as evidenced by the amount of cash paid, or its equivalent. 224 When an asset is exchanged in a monetary transaction, the cash consideration ostensibly represents the fair value of the asset acquired. The same basis (fair value) should be used to record nonmonetary transactions. Accordingly, nonmonetary transactions are usually recorded at fair value. FASB ASC 845 addresses the topic of nonmonetary transactions. The next several sections cover the pertinent concepts in more detail. See Worksheet 12 for a listing of the terms used.
224 CON 5, 67, 69.

a. Nonmonetary Transactions Excluded From the General Rule


Not all nonmonetary transactions are recorded using fair values. Accounting standards explicitly exclude a number of topics, including the following that deal with business combinations and certain

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stockholders' equity transactions. 225


225 FASB ASC 845-10-15-4; APB 29, 4.

Business combinations; Acquisition of nonmonetary assets or services on issuance of the capital stock of an enterprise; Stock issued or received in stock dividends and stock splits; A transfer of assets to an entity in exchange for an equity interest in that entity; A pooling of assets in a joint undertaking intended to find, develop, or produce oil or gas from a particular property or group of properties; The exchange of a part of an operating interest for a part of an operating interest owned by another party. The standards dealing with nonmonetary transactions do not address transfers of financial assets, which are covered in Section III.A.6, below. Also not explicitly addressed by these standards are transfers of nonmonetary assets solely between enterprises or persons under common control, such as between:
226 226 Id.

A parent company and its subsidiaries; Two subsidiary corporations of the same parent; A corporate joint venture and its owners. Except for recurring transfers of current assets when valuation is not in question, transfers between or among related parties under common control are accounted for using the value recorded on the books of the transferring entity: the carry-over amounts. 227 This treatment is appropriate for both reciprocal transfers (exchanges) and nonreciprocal transfers, terms that are defined in Worksheet 12 and explained in the sections that follow. There are several reasons for recording these transfers at recorded amounts: (1) the earnings process has not culminated in a transaction with an independent party outside the affiliated or controlled group, (2) valuation is typically an issue in related party nonmonetary transfers, and (3) nonmonetary transfers are usually nonrecurring. If related party transactions are eliminated in consolidation, disclosure is not required. Transactions between related parties under common control that are not eliminated are to be disclosed in accordance with FASB ASC 850, as described in Section II.A.2, above.
227 EITF Issue 8521 (not codified) (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies.

b. Types of Nonmonetary Transactions


The treatment afforded a nonmonetary transaction depends on the classification into which it falls. 228 There are three types: 229 (1) exchanges of nonmonetary assets or services, (2) nonreciprocal transfers to owners, and (3) nonreciprocal transfers to non-owners. Each is described in the following three sections.

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228 See Section III.A.5.d, below, for a description of the accounting treatment of each class of nonmonetary transaction. 229 FASB ASC 845-10-05-3; APB 29, 5.

(1) Exchanges of Nonmonetary Assets or Services The most prevalent type of nonmonetary transaction is the exchange of nonmonetary assets or services. As used in GAAP, a nonmonetary exchange is also known as a reciprocal transfer. 230 Examples include: 231
230 FASB ASC Term Exchange; APB 29, 3. 231 FASB ASC 845-10-05-6; APB 29, 7.

The exchange of product held for sale in the ordinary course of business, such as inventory, for dissimilar property as a means of selling the product to a customer; Exchange of product held for sale in the ordinary course of business, such as inventory, for similar product as an accommodation that is, at least one party to the exchange reduces transportation costs, meets immediate inventory needs, or otherwise reduces costs or facilitates the ultimate sale of the product and not as a means of selling the product to a customer; The exchange of productive assets assets employed in production rather than held for sale in the ordinary course of business for similar productive assets or for an equivalent interest in similar productive assets. This last category includes the following types of exchanges: 232
232 FASB ASC 845-10-05-6; APB 29, 7.

Trades of player contracts by professional sports organizations; Exchanges of leases on mineral properties; The exchange of one form of interest in an oil-producing property for another form of interest; Exchanges of real estate for real estate. (2) Nonreciprocal Transfers to Owners Certain nonmonetary transactions are termed nonreciprocal transfers. Nonreciprocal transfers are characterized by a one-way conveyance from transferor to transferee. There are two types: (1) nonreciprocal transfers to owners, and (2) nonreciprocal transfers to other than owners. The first type is described in this section, while the second type is discussed in the section that follows. Examples of nonreciprocal transfers to owners include distributions of nonmonetary assets, including marketable equity securities, to stockholders: 233
233 FASB ASC 845-10-05-4; APB 29, 5.

As dividends; To redeem or acquire outstanding capital stock of the enterprise;

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In corporate liquidations or plans of reorganization that involve disposing of all or a significant segment of the business (variously referred to as spin-offs, split-ups, and splitoffs); Pursuant to plans of rescission or other settlements relating to a prior business combination to redeem or acquire shares of capital stock previously issued in a business combination. (3) Nonreciprocal Transfers to Other Than Owners Examples of transfers included in this category are the contribution of nonmonetary assets by an enterprise to a charitable organization and the contribution of land by a governmental unit for construction of productive facilities by an enterprise. 234
234 FASB ASC 845-10-05-5; APB 29, 6.

c. Measurement Issues
(1) Determining Fair Value How should fair value be determined? FASB ASC 820, based, in large part, on FASB Statement No. 157, Fair Value Measurements, contains the rules for determining fair values under U.S. GAAP. Under that Topic, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 235 This price is known as the exit price because it refers to the amount an entity would receive for selling an asset, not the amount it would pay for acquiring the asset. 236 The transaction is assumed to occur in a principal market, which is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability. 237 If a principal market does not exist, then fair value is determined in the most advantageous market, defined as the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability. 238
235 FASB ASC Term Fair Value (as used in FASB ASC 820-10); FASB Statement No. 157, Fair Value Measurements, 5. 236 FASB ASC 820-10-35-3; FAS 157, 7. See also FASB ASC 820-10-35-5(a). 237 FASB ASC Term Principal Market; FAS 157, 8. 238 FASB ASC Term Most Advantageous Market; FAS 157, 8. See also FASB ASC 820-10-35-5(b).

For an exhaustive discussion on determining fair values under FASB ASC 820, see BNA Tax and Accounting Portfolio 5127-2nd, Fair Value Measurements: Valuation Principles and Audit Techniques (Accounting Policy and Practice Series). Since it may at times prove difficult to determine the fair value of nonmonetary assets, under certain conditions it may be necessary to record the exchange at the recorded (i.e., historical cost) amount of the asset relinquished. This may be the case if any of the following are applicable: 239
239 FASB ASC 845-10-30-3; APB 29, 20.

Neither the fair value of the assets relinquished, nor of those received, is determinable within reasonable limits;

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The exchange transaction is carried out to facilitate sales to customers; or The exchange transaction lacks commercial substance. An exchange transaction carried out to facilitate sales to customers is an exchange of product or property held for sale in the ordinary course of business for product or property to be sold in the same line of business to facilitate sales to customers, who are not parties to the exchange. The next section discusses the last exception exchange transactions that lack commercial substance. (2) Exchanges Lacking Commercial Substance If the exchange lacks commercial substance, it should also be recognized using recorded amounts (historical cost) rather than fair values. 240 An exchange lacks commercial substance unless the entity's future cash flows are expected to change significantly as a result of the exchange. 241 According to GAAP, cash flows are expected to undergo a significant change if either of the following criteria are met:
240 FASB ASC 845-10-30-3; APB 29, 20. 241 FASB ASC 845-10-30-4; APB 29, 21.

The configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the asset(s) transferred; 242 The entity-specific value of the asset(s) received differs from the entity-specific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged. 243

242 FASB ASC 845-10-30-4(a); APB 29, 21(a). 243 FASB ASC 845-10-30-4(b); APB 29, 21(b).

Consequently, if an entity is in a different economic position after the exchange, the transaction is assumed to have commercial substance. Making a determination as to commercial substance is a judgment call. Accounting standards indicate that the configuration of future cash flows is composed of the risk, timing, and amount of the flows. A change in any one of those components is considered to be a change in configuration. 244 Furthermore, an entity-specific value, referred to as an entity-specific measurement in FASB Concepts Statement No. 7, Using Cash Flow and Present Value Measurements, is different from a fair value measurement and is only used as a test for determining whether the exchange transaction has commercial substance. 245 An entity-specific value attempts to capture the value of an asset as it is or will be utilized by a particular entity. The entity would, for example, have to incorporate expectations about its particular use of that asset rather than any use assumed by marketplace participants in general. If the transaction is found to have commercial substance, the enterprise should measure the exchange at fair value, not the entity-specific value. 246
244 FASB ASC 845-10-30-4(a); APB 29, 21(a) n.5c. 245 FASB Concepts Statement No. 7, Using Cash Flow and Present Value Measurements, 24(b) (Feb. 2000). 246 FASB ASC 845-10-30-4(b); APB 29, 21(b) n.5d.

d. Accounting for Nonmonetary Transactions


(1) Exchanges

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(a) Commercial Substance Assumed Exchanges of nonmonetary assets or services between unrelated parties or between related parties not under common control are accounted for using fair value if the transaction has commercial substance.
247 The term commercial substance is discussed in Section III.A.5.c.(2), above. Each entity records the

value of the asset received at the fair value of the asset given up, as well as a gain or loss on the asset relinquished. If the fair value of the asset received is more clearly evident, that value should be used to record the exchange. Worksheet 13 provides an example of the accounting treatment of nonmonetary exchanges having commercial substance when a gain is involved. Worksheet 14 illustrates a loss.
247 FASB ASC 845-10-30-1; APB 29, 18.

If neither the fair value of the nonmonetary asset transferred nor the fair value of the asset received is determinable within reasonable limits, the transferring entity should record the exchange using the historical cost (i.e., carrying amount) of the asset surrendered without recognizing gain or loss. 248
248 FASB ASC 845-10-30-3(a); APB 29, 20(a).

(b) Exchanges Lacking Commercial Substance Nonmonetary exchanges that lack commercial substance are accounted for using recorded (carry-over) amounts. 249 All losses are recognized. Gains are not recognized unless monetary consideration, called boot, is involved. 250 The entity paying the cash records the asset received at the recorded amount of the asset surrendered plus the amount of cash paid without recognizing a gain. The entity receiving the monetary consideration recognizes a partial gain. The proportion of the gain that is recorded is computed by multiplying the unrealized gain by the following ratio:
249 FASB ASC 845-10-30-3c; APB 29, 20c. 250 FASB ASC 845-10-30-6; APB 29, 22.

Boot Boot + FVAR In this ratio, boot is the amount of the monetary consideration received and FVAR is the estimated fair value of the asset received. If the estimated fair value of the asset surrendered is more evident, that value should be used instead. Worksheet 15 provides an example of the applicable accounting. A loss situation is illustrated in Worksheet 16. (c) Exchanges Between Related Parties Under Common Control FASB ASC 845 does not apply to transfers of nonmonetary assets between parties under common control. 251 In transfers of nonmonetary assets between related parties under common control, each transferee records the asset received using the historical cost on the books of the transferor (i.e., the carry-over amount), and thus do not record a gain or loss. 252 Any difference between cash paid or received (or the fair value of liabilities assumed or discharged) should be recorded in an equity account if separate statements are being presented. Worksheet 17 provides an example of the accounting when related parties under common control exchange nonfinancial assets.
251 FASB ASC 845-10-15-4(b); APB 29, 4. 252 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies.

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Comment: Asset transfers among parties within a control group are recorded at carry-over amounts because, as a whole, the group is not in a different position after the transfer. An exception is made for recurring transfers of current assets when valuation is not in question and the exchange has commercial substance. 253
253 Id.

(d) SummaryAccounting for Nonmonetary Exchanges (i) Exchanges Having Commercial Substance If an exchange has commercial substance, fair value accounting is used. However, exchanges between related parties call for different treatments depending on whether or not the parties are under common control. Unrelated Parties Nonmonetary exchanges are recorded using fair values. Gains and losses are recognized. If fair value is not determinable within reasonable limits, an entity should record the exchange using the recorded amount of the asset surrendered. In the latter situation, a gain or loss is not recognized. Related Parties Not Under Common Control The accounting is usually the same as for unrelated parties. Related Parties Under Common Control Nonmonetary exchanges of short-term nonfinancial assets are recorded at prevailing market prices. Gains and losses are recognized. When market prices are unavailable, the exchange should be recorded using carry-over amounts without recording a gain or loss. Exchanges of long-term nonfinancial assets should be recorded using carry-over amounts whether or not the exchange has commercial substance. No gain or loss is recognized. (ii) Exchanges Lacking Commercial Substance If an exchange lacks commercial substance, the transaction is recorded using recorded amounts. Exchanges between related parties differ depending on whether or not the parties are under common control. Unrelated Parties Nonmonetary exchanges are recognized using the recorded amounts. All losses are recorded. A realized gain is recognized to the extent of boot involved, if any. Related Parties Not Under Common Control The accounting is usually the same as for unrelated parties. Related Parties Under Common Control Exchanges of short-term nonfinancial assets lacking commercial substance are recorded using recorded amounts without recognizing gain or loss. Exchanges of long-term nonfinancial assets are also recorded using recorded amounts without recognizing a gain or loss. (2) Nonreciprocal Transfers to Owners As indicated in Section III.A.5.b.(2), above, there are several categories of nonreciprocal transfers to owners. These transfers may include the conveyance of nonmonetary assets, including marketable equity securities, to stockholders: 254
254 FASB ASC 845-10-05-4; APB 29, 5.

As dividends; To redeem or acquire outstanding capital stock of the enterprise;

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In corporate liquidations or plans of reorganization that involve disposing of all or a significant segment of the business (variously referred to as spin-offs, split-ups, and splitoffs); and Pursuant to plans of rescission or other settlements relating to a prior business combination to redeem or acquire shares of capital stock previously issued in a business combination. Nonreciprocal transfers to owners who are unrelated parties and related parties not under common control are recorded at fair value. The transferring entity records the surrendered asset at its fair value and records a gain or loss. 255 The receiving party records the asset received using its fair value. 256 Nonmonetary transfers to owners who are related parties under common control are recorded at carry-over amounts. 257 Each category of nonreciprocal transfers to owners is discussed in the following sections.
255 FASB ASC 845-10-30-1; APB 29, 18. 256 FASB ASC 845-10-30-1; APB 29, 18. 257 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies.

(a) Distributions of Nonmonetary Assets: Dividends-In-Kind Nonmonetary assets, including marketable equity securities, conveyed to owners in a nonreciprocal transfer are recorded at the fair value of the asset transferred with a gain or loss recognized upon the disposition of the assets. 258 This type of conveyance is known as a dividend-in-kind. This treatment, however, does not apply to the entity's own capital stock. 259 If the owner is a related party under common control, the transfer is recorded using carry-over amounts. 260 Presumably, this concept pertains to all nonmonetary asset distributions to a party under common control, including those distributions for the purpose of acquiring treasury stock or retiring securities. 261
258 FASB ASC 845-10-30-1; APB 29, 18. 259 FASB ASC 845-10-30-2; APB 29, 18. 260 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies. 261 EITF Issue 85-21.

(b) Distributions to Redeem or Reacquire Outstanding Stock (i) Shareholders Not Related Parties Under Common Control At times, companies may distribute nonmonetary assets to eliminate a disproportionate part of owners' interests in order to acquire the stock for the treasury or retirement. When stockholders are unrelated or are not related parties under common control, such transfers are recorded at fair value with a gain or loss recognized on the disposition of the assets relinquished. 262 The receiving party records the assets at fair value. In these situations, the value of the reacquired stock may be more readily discernible than the value of assets transferred to the owners. If so, the transaction should reflect the stock value.
262 FASB ASC 845-10-30-1; APB 29, 18.

(ii) Related Parties Under Common Control

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The foregoing accounting is proper for stockholders who are not related parties under common control. If the recipient stockholder is also a related party under common control, the distribution should be recorded at cost. 263
263 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies.

(c) Liquidations, Reorganizations, and Settlements Related to Prior Combinations Transfers of nonmonetary assets in conjunction with liquidations or plans of reorganization are recorded using historical cost. These types of plans include: 264
264 FASB ASC 845-10-30-10; APB 29, 23.

Disposing of all or a significant segment of the business, variously referred to as spin-offs, split-ups, and split-offs. Rescission or other settlements relating to a prior business combination to redeem or acquire shares of capital stock previously issued in a business combination. The following types of plans are considered equivalent to spin-offs: 265
265 FASB ASC 845-10-30-10; APB 29, 23.

The pro-rata distribution of shares of a subsidiary or other enterprise that has been or is being consolidated; The pro-rata distribution of shares of a subsidiary or other enterprise that has been or is being accounted for under the equity method. Transfers in conjunction with all of these reorganization plans are accounted for at the recorded amounts of the nonmonetary assets given up after appropriate reduction for any indicated impairment of value. 266
266 FASB ASC 845-10-30-10; APB 29, 23.

(3) Nonreciprocal Transfers to Other Than Owners The transferring entity records a nonreciprocal transfer to other than owners at fair value, recognizing a gain or loss on disposition of the nonmonetary assets. 267 The recipient records the assets at that value. 268 If the recipient is a related party and the transactions are material, disclosure is required in accordance with FASB ASC 850.
267 FASB ASC 845-10-30-1; APB 29, 18. 268 FASB ASC 845-10-30-1; APB 29, 18.

Example: Company A donates property to a charitable organization. The charitable organization is headed by the CEO of Company A. This transfer would be recorded by both entities at the fair value of the property.

e. Involuntary Conversions

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When a nonmonetary asset is involuntarily converted to a monetary asset, a gain or loss is recorded whether or not the enterprise reinvests, or is obligated to reinvest, the monetary assets to replace the nonmonetary assets. 269
269 FASB ASC 605-40-15-2; APB 29, 4.

f. DisclosuresNonmonetary Transactions
The following financial statement disclosures are required for periods during which nonmonetary transactions occurred: 270
270 FASB ASC 845-10-50-1; APB 29, 28.

The nature of the transactions; The basis of accounting for the assets transferred; and Any gains or losses recognized on the transfers. Worksheet 18 illustrates these types of footnote disclosures found in the Coca-Cola Company's 2004 Form 10-K.

6. Transfers of Financial Instruments


This section covers the accounting and disclosure rules dealing with transfers of financial assets. Except for the rather extensive rules dealing with variable interest entities, including SPEs, transfers of financial instruments are usually not handled differently when related parties are involved unless the parties are under common control. However, if the form of a transaction between related parties differs from its substance, the records should reflect the economic substance. Financial instruments include cash, evidence of an ownership interest in an entity, or an agreement with the following two stipulations: 271
271 FASB ASC Term Financial Instrument; FASB Statement No. 107, Disclosures About Fair Value of Financial Instruments, 3.

One entity is obligated to: (1) deliver cash or another financial instrument to a second entity; or (2) exchange other financial instruments on potentially unfavorable terms with the second entity. A second entity has a contractual right to: (1) receive cash or another financial instrument from the first entity; or (2) exchange other financial instruments on potentially favorable terms with the first entity. A transfer of a financial instrument is defined as the conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. 272 A transfer includes selling receivables, putting them it into a securitization trust, or pledging them as collateral. Excluded, for example, are the origination of, settlement, or restructuring of receivables into a security in a troubled debt restructuring.
273 272 FASB ASC Term Transfer (as used in FASB ASC 860); FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, 364. 273 FASB ASC Term Transfer (as used in FASB ASC 860); FASB Statement No. 140,

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Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, 364.

The accounting standards dealing with transfers of financial instruments utilize what is termed a financial-components approach. 274 This means that after a transfer of financial instruments is effected, the enterprise should record the financial assets it controls and the liabilities it incurs. Likewise, when control has been surrendered, the applicable financial assets and liabilities are removed from the books. 275 When control is surrendered, the transfer is treated as a sale, but only to the extent of the consideration received that is not held to be beneficial interests in the transferred assets. The term beneficial interests is defined in the next section. If the transfer does not meet the criteria for a sale, it is accounted for as a secured borrowing with a pledge of collateral.
274 See, e.g., FASB ASC 405-20-10-1; FAS 140, Summary. 275 Accounting standards use the term derecognize. FASB ASC Term Derecognize. See Worksheet 19 for a listing of terms used in the standards governing transfers of financial instruments.

a. Sales
(1) Related Parties Not Under Common Control The proper accounting treatment for sales of financial instruments between related parties depends on whether the parties are under common control. Sales between related parties not under common control are typically not recorded differently from sales between unrelated parties. 276 If a transferring entity relinquishes control, the exchange is accounted for as a sale, but only to the extent that the consideration received does not amount to beneficial interests in the transferred assets. The term beneficial interests is defined as: 277
276 See generally EITF Issue 85-21. 277 FASB ASC Term Beneficial Interests; FAS 140, 364.

Rights to receive all or portions of specified cash inflows to a trust or other entity, including senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through, premiums due to guarantors, commercial paper obligations, and residual interests, whether in the form of debt or equity. In order to qualify as a sale, the transferring entity has to have surrendered control of the assets. Each of the following conditions must be met in order to satisfy this requirement: 278
278 FASB ASC 860-10-40-5; FAS 140, 9.

The transferred assets have been isolated from the transferorput presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership; Each transferee (or, if the transferee is a qualifying SPE [special purpose entity], each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor; The transferor does not maintain effective control over the transferred assets through either: (1) an agreement that both entitles and obligates the transferor to repurchase or redeem [these assets] before their maturity or (2) the ability to unilaterally cause the holder

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to return specific assets, other than through a cleanup call. 279

279 See Worksheet 19 for the definition of the term cleanup call; see also FASB ASC Term Cleanup Call Option.

Assuming each of the foregoing considerations is satisfied, the transferring entity carries out the following steps to account for the transfer as a sale: 280
280 FASB ASC 860-10-35-3; FASB ASC 860-20-25-1; FASB ASC 860-20-30-1; FAS 140, 10, 11.

Initially recognize and measure at fair value, if practicable, servicing assets and servicing liabilities that require recognition; Allocate the previous carrying amount between the assets sold, if any, and the interests that continue to be held by the transferor, if any, based on their relative fair values at the date of transfer; Continue to carry on its balance sheet any interest it continues to hold in the transferred assets, including, if applicable, beneficial interests in assets transferred to a qualifying special purpose entity in a securitization, and any undivided interests; Derecognize all assets sold, i.e., remove them from the books; Recognize all assets obtained and liabilities incurred in consideration as proceeds of the sale, including cash, put or call options held or written (for example, guarantee or recourse obligations), forward commitments (for example, commitments to deliver additional receivables during the revolving periods of some securitizations), swaps (for example, provisions that convert interest rates from fixed to variable), and servicing assets and servicing liabilities, if applicable; Initially measure at fair value assets obtained and liabilities incurred in a sale or, if it is not practicable to estimate the fair value of an asset or a liability, apply alternative measures; and Recognize in earnings any gain or loss on the sale. (2) Related Parties Under Common Control The proper accounting treatment for sales of financial instruments between related parties under common control is dependent on the prevailing circumstances. The accounting is the same as that for related parties not under common control if: (1) the sales are routine transactions, and (2) there is a ready market, such that valuation is not an issue. 281 The transferring entity records a gain or loss. Absent these two conditions, no gain or loss should be recorded. Proper treatment is important when separate financial statements of a subsidiary are being presented. Otherwise gains or losses that are eliminated in consolidation are not required to be disclosed in accordance with the related party transaction rules. 282 The profit or loss should be accounted for in accordance with the accounting standards covering consolidation or the use of the equity method, whichever is applicable. 283
281 See generally EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). 282 FASB ASC 86020251; FASB ASC 86020301; FASB ASC 86020401A and 40-1B; FAS 140, 10, 11.

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283 See generally FASB ASC 810 (ARB 51, as amended) or FASB ASC 323 (APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, as amended).

When statements of affiliates are to be combined, a gain or loss can be recorded by one affiliate and then eliminated when the statements are combined. An alternative when separate statements of affiliates are presented is to record the gain or loss in an equity account such as accumulated other comprehensive income. The following example illustrates the accounting. Example: Ardmoor Corporation is a holding company. Ardmoor Builders, Inc., a wholly owned subsidiary, manufactures modular homes sold through another wholly owned subsidiary, Ardmoor Sales. Ardmoor Savings and Loan (AS&L), a wholly owned subsidiary of Ardmoor Corporation, presents separate financial statements. AS&L typically arranges financing for customers who buy from Ardmoor Sales. AS&L often pools packages of qualifying mortgages and converts them into securities that are sold on the secondary mortgage market. Periodically, the parent, Ardmoor Corporation, purchases some of these securities, for which there is a ready market. Recently, Ardmoor Corporation paid $500,000 for securities that AS&L carried on its books for $490,000. Whether AS&L should record a gain on these sales to the parent turns on whether they are routine transfers, for which valuation is not an issue. As there is a ready market for the securities, AS&L could record the gain in income. Despite the fact that the securities are not short-term, the gain can be recorded in income because there is a ready market. If valuation is an issue, AS&L should record the gain in accumulated other comprehensive income, an equity account. In that case, Ardmoor Corporation would record the securities at AS&L's carrying amount of $490,000 and reduce equity by $10,000. In all cases, these related party transactions require disclosure if they are material and are not eliminated in consolidation. [Note that all gains or losses between affiliates are to be eliminated if the statements are combined.]

b. Transfers Accounted for as Secured Borrowings


If an entity transfers a financial instrument for cash or other consideration that excludes beneficial interests in the transferred assets and the transfer does not meet the criteria for a sale, the transfer is treated as a secured borrowing with a pledge of collateral. 284 Both the transferor and transferee record the transaction accordingly and include the appropriate disclosures in their respective financial statements.
284 FASB ASC 860-20-40-2; FAS 140, 12.

7. Leases
Leases are of two basic types: capital and operating. When virtually all of the benefits and risks of ownership rest with the lessee, the agreement is treated as a capital lease. Otherwise, it is classified as an operating lease. A capital lease is similar to an installment purchase of an asset in that the lease acts as a financing arrangement. Accounting for leases incorporates a number of technical terms that are used in the sections that follow. Worksheet 20 contains the definitions.

a. Types of Leases
(1) Classification by Lessees Lessees classify leases into the two types mentioned in the previous section: capital leases or operating leases. A lease is classified as a capital lease if it meets any one of the following criteria: 285
285 FASB ASC 840-10-25-1; FASB Statement No. 13, Accounting for Leases, 7.

The lease transfers ownership of the property to the lessee by the end of the lease term; The lease contains an option to purchase the leased property at a bargain price;

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The lease term is equal to or greater than 75% of the estimated economic life of the leased property; and The present value of rental and other minimum lease payments equals or exceeds 90% of the fair value of the leased property less any investment tax credit retained by the lessor. If the lease does not meet at least one of the foregoing criteria, it is classified as an operating lease. (2) Classification by Lessors Lessors use a more extensive classification scheme than lessees. The reason stems from the various types of activities in which lessors may engage when they are leasing assets. For example, a lessor may be a dealer such that profit on the leased asset is to be recognized. In this type of situation, the lease is termed a sales-type lease. Or, the lease may be a leveraged lease because the arrangement includes a third-party that participates in the financing. 286
286 FASB ASC 840-10-25-43(c)(2); FAS 13, 6.

(a) Direct Financing Leases A direct financing lease is simply a capital lease from the perspective of the lessor. The lease must meet one of the four criteria enumerated in Section III.A.7.a.(1), above. In addition, the collectibility of the minimum lease payments must be reasonably predictable and no important uncertainties can surround the amount of unreimbursible costs yet to be incurred by the lessor under the lease. Direct financing leases do not give rise to manufacturer's or dealer's profit (or loss) to the lessor and also do not meet the criteria established for leveraged leases discussed next. 287
287 FASB ASC 840-10-25-43(b)(2); FAS 13, 6.

(b) Leveraged Leases A leveraged lease is a financing lease with the additional feature that the lessor has borrowed funds to finance a portion of the leased asset. For a lease to be classified as a leveraged lease, it must have all of the following characteristics: 288
288 FASB ASC 840-10-25-43(c); FAS 13, 42.

It meets each of the criteria of a direct financing lease as set out in Section III.A.7.a.(1), above. It involves at least three parties: a lessee, a long-term creditor, and a lessor, who is commonly called the equity participant; The financing provided by the long-term creditor is nonrecourse as to the general credit of the lessor, although the creditor may have recourse to the specific property leased and the unremitted rentals relating to it. The amount of the financing is sufficient to provide the lessor with substantial leverage in the transaction. The lessor's net investment declines during the early years once the investment has been completed and rises during the later years of the lease before its final elimination. Such decreases and increases in the net investment balance may occur more than once. (c) Sales-Type Leases Leases that provide the lessor with a mercantile profit or loss are classified as sales-type leases. The

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characteristic that distinguishes a sales-type lease is that the cost of the leased property is different from its fair value. Accordingly, for classification as a sales-type lease, the fair value of the leased property at the inception of the lease must be different from its cost or from the carrying value if not the same as cost. In addition, the lease must meet one of the capital lease criteria specified in Section III.A.7.a.(1), above. There are two stipulations: (1) the collectibility of the minimum lease payments must be reasonably predictable, and (2) no important uncertainties surround the amount of unreimbursible costs yet to be incurred by the lessor under the lease. 289 A lease involving real estate is classified as a sales-type lease even if it does not meet these latter two stipulations. 290
289 FASB ASC 840-10-25-42 and 25-43(a)(2); FAS 13, 6. 290 FASB ASC 840-10-25-43(a)(1); FAS 13, 6.

(d) Operating Leases All other leases not meeting the criteria established for direct financing, leveraged, and sales-type leases are classified as operating leases. 291
291 FASB ASC 840-10-25-43(d); FAS 13, 8.

b. Accounting for Leases


(1) Lessees (a) Capital Leases Since a capital lease is viewed as a mechanism for financing the purchase of an asset, the lessee has both an asset, the leased property, and a liability, the lease obligation. The asset is initially recorded at the present value of the minimum lease payments over the term of the lease or the fair market value of the leased asset, whichever is less. The minimum lease payments include any obligations that the lessee is required to pay, such as penalties for failure to renew or guaranteed residual value. The lessee subsequently depreciates this asset in accordance with its normal depreciation policy. However, if the ownership does not revert to the lessee at the end of the lease or the lease contains a bargain purchase option, the asset is depreciated over the term of the lease. 292
292 FASB ASC 840-30-35-1(b); FAS 13, 11.

A bargain purchase option is a provision that allows the lessee to purchase the leased property at a stipulated exercise date. The option purchase price has to be sufficiently lower than the fair market value at that point in time such that the lessee's exercise of the option is reasonably assured. 293
293 FASB ASC Term Bargain Purchase Option; FAS 13, 5(d).

The lessee amortizes the lease obligation using the effective interest rate method to produce a constant periodic rate that allocates the periodic payments between the reduction in liability and interest expense. 294
294 FASB ASC 840-30-35-6; FAS 13, 12.

(b) Operating Leases Operating leases are recorded on a pay-as-you-go basis. The periodic rental on an operating lease is charged to expense as incurred. If lease payments are not a constant periodic amount over the term of the lease, the expense should reflect the time pattern by which use benefit is derived. 295

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295 FASB ASC 840-20-25-1; FAS 13, 15.

(2) Accounting by Lessors (a) Direct Financing Leases Lessors' accounting for direct financing leases mirrors lessees' accounting for capital leases. The lessor removes the carrying amount of the leased asset and records a lease receivable. The latter reflects the present value of the minimum lease payments plus the present value of any portion of the asset's residual value that is not paid by the lessee. The minimum lease payments include any obligations the lessee is required to pay, such as penalties for failure to renew or a guaranteed residual value. The lease receivable, often termed, net investment in capital leases, is treated as a note receivable. It is amortized using the effective interest rate method, by which the lessor records revenue at a constant periodic rate of interest. The standards require that the lessor record the gross investment in the lease as the gross amount of the lease payments plus the residual value of the property at the end of the lease term. The net investment in the lease is subtracted from the gross investment to obtain the unearned income that is amortized. 296
296 FASB ASC 840-30-30-11 and 30-13; FASB ASC 840-30-25-7; FAS 13, 18(b), as amended by FAS 98, 22(i).

(b) Sales-Type Leases Sales-type leases are accounted for in a manner analogous to that of a direct financing lease. The difference is that the lessor records the gross profit on the sale of the asset up front by recognizing sales revenue and cost of goods sold. Both are reduced by the present value of any residual value not guaranteed by the lessee. 297
297 FASB ASC 840-30-30-8 through 30-10; FAS 13, 17.

(c) Operating Leases Rental income is recorded as the payments are received. If lease payments are not a constant periodic amount over the lease term, the income should reflect the time pattern by which use benefit from the leased property is diminished. The leased asset is depreciated in accordance with the lessor's normal depreciation policy. 298
298 FASB ASC 840-20-35-3; FAS 13, 19.

c. Related Parties
(1) Form Does Not Reflect Economic Substance Lease transactions among related parties are typically not accounted for differently from agreements consummated among unrelated parties. However, if the legal form of the contract fails to reflect its economic substance, the transaction's accounting treatment should portray its substance rather than its form. 299
299 FASB ASC 840-10-25-26; FAS 13, 29.

(2) Related Parties Under Common Control: Affiliated Enterprises Lease transactions among affiliated enterprises within a control group are accounted for according to the standards governing consolidation or the equity method, whichever is applicable to the investment.
300 If an affiliated company is to be consolidated, the necessary eliminations are recorded, including

intercompany gains and losses associated with lease transactions. If the equity method is called for, the

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investor records its share of the income of the investee and records elimination entries similar to those made when preparing consolidated statements. If the principal business activity of an affiliate is leasing property or facilities to a parent or another affiliated enterprise, proper accounting calls for consolidating that entity since the equity method does not provide sufficiently transparent presentation due to the significance of the assets and liabilities of that affiliate to the overall consolidated group. 301 If affiliates' separate financial statements are presented, gains or losses should be included in an equity account, such as accumulated other comprehensive income, rather than net income. Assuming leased assets are being used within the affiliated group and the intent is not to resell those assets to parties outside the group, depreciation should be recorded on the carrying amount on the books of the transferring entity to reflect amortization of the assets. 302
300 FAS 13, 30 (not codified). 301 FASB ASC 840-10-45-1; FAS 13, 31. 302 EITF Issue 8521 (reiterating the SEC's position as stated in the SEC Observer). The EITF could not reach a consensus that such treatment is appropriate for privately held companies.

d. Disclosures
Lease transactions among related parties are to be disclosed in accordance with the related party transaction rules. 303 These requirements are set out in Section II.A.1, above. For additional accounting rules and disclosures required of all lessors and lessees, refer to 5114, Accounting for Leases: Fundamental Principles (Accounting Policy and Practice Series).
303 FASB ASC 850-10-50-1(d); FAS 57, 2.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis III. Sales, Purchases, Transfers, and Leases Between Related Parties

B. SEC Regulations for Public Companies


The previous section covers requirements for transactions involving sales, purchases, transfers, and leases consummated among related parties. This section discusses the SEC regulations that apply to those types of transactions. Transactions among related parties not under common control are generally recorded using market values, while transactions among parties under common control are usually recorded using carry-over amounts. The SEC typically requires companies filing financial statements with the Commission to prepare those statements in accordance with GAAP. SEC Regulation S-X further governs the form, content, and presentation aspects of those financial statements filed with the SEC, including the required footnote disclosures.

1. Sales
In accordance with Regulation S-X, the various categories of receivables are to be properly segregated. Those filing financial statements are to separately state amounts receivable from: 304
304 SEC Regulation S-X, Rule 5-02.3, 17 C.F.R. 210.5-02.3; FASB ASC 210-10-S99-1.

Trade customers; Related parties; Underwriters, promoters, and employees, other than related parties, not arising in the ordinary course of business; and

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All others. If receivables include amounts due under long-term contracts, the following amounts are to be stated separately in the balance sheet or in a note to the financial statements: 305
305 SEC Regulation S-X, Rule 5-02.3(c), 17 C.F.R. 210.5-02.3(c); FASB ASC 210-10-S99-1.

Balances billed but not paid by customers under retainage provisions in contracts; Amounts representing the recognized sales value of performance and such amounts that had not been billed and were not billable to customers at the date of the balance sheet, along with a general description of the prerequisites for billing; Billed or unbilled amounts representing claims or other similar items subject to uncertainty concerning their determination or ultimate realization; A description of the nature and status of the principal items comprising amounts that are subject to uncertainty as to their determination or realization. Also required are the amounts included in each of the foregoing categories that are expected to be collected after one year, as well as when any amounts of retainage are expected to be collected, by year, if practicable.

2. PurchasesLong-Term Obligations
SEC Regulation S-X also covers the reporting of accounts and notes payable arising from purchases and long-term commitments. In addition to reporting notes payable to banks, factors, holders of commercial paper, and other financial institutions for borrowings, those who file financial statements with the SEC need to separately state amounts due to: 306
306 SEC Regulation S-X, Rule 5-02.19, 17 C.F.R. 210.5-02.19; FASB ASC 210-10-S99-1.

Trade creditors; Related parties; Underwriters, promoters, and employees, other than related parties; All others.

3. TransfersNonmonetary Transactions
The SEC requires filers to record nonmonetary transactions in accordance with standards issued by the FASB, as outlined in Section III.A.5, above. 307 In general, that section indicates that nonmonetary transactions among related parties not under common control should be recorded at fair value. When parties are under common control, the transactions should usually be recorded using carry-over amounts.
307 SEC Regulation S-X, Rule 4-01(a)(1), 17 C.F.R. 210.4-01(a)(1); FASB ASC 205-10S99-1.

Accounting standards governing nonmonetary exchanges do not apply to the issuance of stock for nonmonetary assets or services in conjunction with a first-time public offering. 308 The question arises as to the proper accounting when nonmonetary assets are exchanged by promoters or shareholders for

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all or part of a company's common stock just prior to, or contemporaneously with, a first-time public offering. The SEC staff has indicated that such transfers should be recorded at the transferors' historical cost basis determined under GAAP. Deviations from this policy have been rare. Exceptions are possible when: (1) the fair value of either the stock issued or the assets acquired is objectively measurable, and (2) the shareholder's resulting ownership in the enterprise was not so significant that he or she retained a substantial indirect interest in the assets. 309
308 FASB ASC 845-10-15-4(c); APB 29, 4. 309 SAB Topic 5.G; FASB ASC 845-10-S99-1.

4. Sales and Purchases of Registered Securities a. Reporting Transactions


When certain related persons acquire the securities of registered companies or change their holdings, these individuals are required to report those transactions in accordance with the Securities Exchange Act of 1934 (the 1934 Act). Under Section 16 of the 1934 Act, directors, officers, and principal stockholders (those beneficially owning 10% or more of any class of registered securities) are required to file reports with the registered company. 310 Section IV.B.2.d, below, discusses the company's requirements under the 1934 Act.
310 Securities Exchange Act of 1934, Section 16(a), Directors, Officers, and Principal Stockholders: Disclosures Required, Securities Exchange Commission (2004).

Initial statements of beneficial ownership are filed on Form 3. Statements of changes in beneficial ownership are filed using Form 4. Form 5 is used for annual reporting but is not required if reported earlier on Form 4. 311 These reports are filed with the registered company. The term beneficial owner is defined in Rule 13d-3 of the 1934 Act as: 312
311 Securities Exchange Act of 1934, Rule16a-3, Reporting Transactions and Holdings, Securities Exchange Commission (2004). 312 Securities Exchange Act of 1934, Rule 13d-3a, Determination of Beneficial Ownership, Securities Exchange Commission (2004).

Any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: Voting power which includes the power to vote, or to direct the voting of, such security; and/or, Investment power which includes the power to dispose, or to direct the disposition of, such security. The definition adds that: 313
313 Securities Exchange Act of 1934, Rule 13d-3b, Determination of Beneficial Ownership, Securities Exchange Commission (2004).

Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of the Act shall be deemed for

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purposes of such sections to be the beneficial owner of such security.

b. Blackout Trading Restrictions


SOX Section 306(a) prohibits officers and directors from engaging in transactions involving equity securities during blackout periods. 314 This section of SOX was a direct result of the Enron scandal. At about the same time Enron was experiencing financial difficulties, the company changed pension plan administrators, which resulted in a blackout period during which plan participants were unable to sell their Enron stock. While participants were thus precluded from transacting in the market, Enron executives were selling their stock due to Enron's looming financial crisis. The resulting political fallout led to the blackout restrictions on officers and directors that were subsequently incorporated as SOX Section 306. The SEC subsequently incorporated the SOX Section 306(a) requirements into Regulation BTR, a section of the Securities Exchange Act of 1934. In this Regulation a blackout period is defined as: 315
314 SOX 306(a). 315 Securities and Exchange Commission, Securities Exchange Act of 1934, Regulation BTR, Blackout Trading Restrictions, Definitions, 245.100.

any period of more than three consecutive business days during which the ability to purchase, sell or otherwise acquire or transfer an interest in any equity security of such issuer held in an individual account plan is temporarily suspended by the issuer or by a fiduciary of the plan with respect to not fewer than 50% of the participants or beneficiaries located in the United States and its territories and possessions under all individual account plans maintained by the issuer that permit participants or beneficiaries to acquire or hold equity securities of the issuer; During such a blackout period, a director or officer of the company is not allowed to: purchase, sell or otherwise acquire or transfer any equity security of the issuerif such director or executive officer acquires or previously acquired such equity security in connection with his or her service or employment as a director or executive officer. 316 There are certain exemptions, such as acquisitions resulting from the reinvestment of dividends on securities made in accordance with a plan that provides for regular reinvestment. 317
316 Id. 245.101(a). 317 Id. 245.101(c).

SOX Section 306(b), Notice Requirements to Participants and Beneficiaries Under ERISA, amended the Employee Retirement Income Security Act (ERISA) by requiring plan administrators to give a 30-day advance written notice to plan participants and beneficiaries as to when a blackout period will occur. 318 The provisions are applicable to both public and private companies. For these purposes, a blackout period in connection with an individual account plan is: 319
318 SOX 306(b). 319 Id. 306(b)(1), Notice Requirements to Participants and Beneficiaries Under ERISA.

any period for which any ability of participants or beneficiaries under the plan, which is otherwise available under the terms of such plan, to direct or diversify assets credited to their accounts, to obtain loans from the plan, or to obtain distributions from the plan is temporarily suspended, limited, or restricted, if such suspension, limitation, or restriction is for any period of more than 3 consecutive business days.

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5. Leases
While SEC Regulation S-X covers financial statement form, content, and presentation, including footnote disclosure, the SEC also requires registrants to include certain other disclosures in the non-financial statement portions of SEC filings. 320 The latter disclosures are covered by SEC Regulation S-K. When an enterprise consummates lease transactions with related parties, Regulation S-K requires the disclosure of the aggregate amount of all periodic payments or installments due on or after the registrant's last fiscal year including any required or optional payments due during or at the conclusion of the lease. 321
320 See generally, SEC Regulation S-K, Reg. 229.404. 321 SEC Regulation S-K, Reg. 229.404(a).

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis III. Sales, Purchases, Transfers, and Leases Between Related Parties

C. New York Stock Exchange


1. Sales and Purchases of Securities by Officers and Directors
The NYSE has issued guidance to cover the sale or purchase of a listed company's securities by its officers and directors. This guidance is designed primarily to allay concerns about insider dealings and to forestall government sanctions that apply when insiders use nonpublic information for personal gain. For example, Section 16(b) of the Securities Exchange Act of 1934 allows registered companies to recover profits from related persons when those individuals deal in the securities within six months after purchase or sale. 322
322 Securities Exchange Act of 1934, Section 16(b), Directors, Officers, and Principal Stockholders, Securities Exchange Commission (2004).

Comment: In addition to this provision, Rule 10b-5 makes it illegal to employ manipulative and deceptive devices to defraud. 323 Rule10b5-1 further makes it illegal to trade on the basis of material nonpublic information. The rule states: 324
323 Securities Exchange Act of 1934, Rule10b-5, Employment of Manipulative and Deceptive Devices, Securities Exchange Commission (2004). 324 Securities Exchange Act of 1934, Rule10b5-1a, Trading on the Basis of Material Nonpublic Information in Insider Trading Cases, Securities Exchange Commission (2004).

The manipulative and deceptive devices prohibited by Section 10(b) of the Act and Rule 10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information. Trading on the basis of nonpublic information means that the individual dealing in the securities was aware of the material nonpublic information when making the purchase or sale. 325

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325 Securities Exchange Act of 1934, Rule10b5-1b, Trading on the Basis of Material Nonpublic Information in Insider Trading Cases, Securities Exchange Commission (2004).

As a consequence of the foregoing considerations, NYSE guidance deals primarily with the timing of market transactions. Shareholder approval requirements for issuances to related parties are covered in Section II.C.1.b, above.

2. Specific NYSE Guidance


NYSE guidance is designed to promote better shareholder relationships and to forestall the appearance of insider dealings.

a. Periodic Investment Programs


The NYSE suggests that registered companies establish periodic investment programs, 326 under which directors and officers can make regular purchases. The program should be administered by a broker so that the timing of purchases is outside the individual's control. A further suggestion is to establish a 30-day period when officers and directors can deal in the securities. This period could, for example, begin a week after the annual report has been mailed and the information has been widely disseminated.
326 New York Stock Exchange, Listed Company Manual, 309.00.

Timing is important to forestall the appearance of insider trading. The NYSE offers the following suggestions regarding the timing of market participation: 327
327 Id.

Following a release of quarterly results, which includes adequate comment on new developments during the period;

Following the wide dissemination of information on the status of the company and current results;

At those times when there is relative stability in the company's operations and the market for its securities;

After the release of earnings, dividends, or other important developments have appeared in the press permitting the news to be widely disseminated and negating the inference that officials had an inside advantage. Trading just before important press releases should be avoided. In addition, directors and officers should avoid trading if major developments are expected to impact the market within the next several months. To be safe, the corporate official who intends to trade should contact the chief executive officer to be sure that there are no pending developments that may create the appearance of insider trading if those eventualities were to unfold. The foregoing suggestions should also be applied to family members and close associates, since the public may perceive that these individuals have access to insider information.

b. Securities of Other Companies


Officers and directors may at times trade in the securities of companies 328 with which their company does business. Business partners are not considered to be related parties unless one party can

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significantly influence the policies and actions of the other, such that one party is prevented from pursuing its own interests. 329 Nevertheless, caution regarding the timing of trades should be applied when dealing in the securities of business partners to forestall the appearance of a conflict of interest. Accordingly, it is prudent to be aware of transactions such as important supply contracts, mergers that are pending or contemplated, and significant financing or leasing arrangements.
328 Id. 329 FASB ASC Term Related Parties; FAS 57, 24(f).

Planning Point: This consideration, along with the suggestions enumerated in the previous section, should be included in conflicts of interest statements to make the company, as well as officers and directors, aware of possible pitfalls. In addition, officers and directors should be made aware of important existing and pending transactions so that these individuals can make informed trading decisions.

c. Stock Options
Corporate officials should apply the foregoing suggestions to stock options for officers and directors. As in the case of securities, the main consideration is avoiding the appearance of insider dealings. 330
330 New York Stock Exchange, Listed Company Manual, 312.00.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis IV. Corporate Governance and the Control Environment This section discusses corporate governance and how it relates to the inappropriate use of company assets and services. Inappropriate use can result from outright misappropriation or by falsifying financial statements. In the latter case, inflated income figures can benefit insiders by providing windfalls in the form of higher bonuses, additional compensation, the ability to unload stocks at inflated prices, and the exercise of stock options that are not genuinely in the money. Corporate governance encompasses the various methods to assure that business entities are run in a manner consistent with the best interests of shareholders. These measures address the independence of directors, codes of ethics, audit committees, and other elements of the relationship among shareholders, directors, and management. Corporate governance serves a dual purpose. The first of these is to assure that directors and management carry out their fiduciary responsibilities with integrity. Second, corporate governance serves as a mechanism for monitoring the control environment, an important component of the COSO internal control framework that was incorporated into AICPA Statement on Auditing Standards No. 78, Consideration of Internal Control in a Financial Statement Audit, 331 in 1995 and sanctioned by the SEC as an acceptable standard for an audit of internal control.
332 331 See AICPA Professional Standards, Volume 1, AU 319, Consideration of Internal Control in a Financial Statement Audit. The COSO framework can be found at http://www.coso.org. 332 SEC Final Rule, Management's Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports.

The control environment includes integrity and ethical values; commitment to competence; board of directors or audit committee participation; management's philosophy and operating style; the organizational structure; assignment of authority and responsibility; and human resource policies and practices. 333 The control environment sets the tone at the top, provides an overarching mechanism that has a supervisory role in the hierarchy of controls, and impacts the effectiveness of all other controls. When operating properly, corporate governance features, working in harmony with the control

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environment, can effectively deter related parties from using corporate assets and services inappropriately.
333 AU 329.34.

This section explains numerous corporate governance measures that have emerged in the wake of SOX. These measures also are summarized in Worksheet 27. Moreover, Worksheet 28 summarizes several SEC enforcement action that illustrate the effects of corporate governance failures. The corporate governance measures enacted in SOX should increase the likelihood that the kinds of failures represented in these cases are minimized. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis IV. Corporate Governance and the Control Environment

A. The Corporate Governance Rules of Sarbanes-Oxley


Congress enacted SOX on July 30, 2002 in the aftermath of unprecedented corporate scandals and sensational bankruptcies that included Enron, WorldCom, and the fall of their auditors, Arthur Andersen. SOX contains some 50 provisions, most of which touch on corporate governance in one way or another. Some of these, such as Section 404, Management Assessment of Internal Control, are covered in other parts of this Portfolio. This section discusses the following five SOX sections having a significant impact on corporate governance: 301, Public Company Audit Committees; 302, Corporate Responsibility for Financial Reports; 402, Enhanced Conflict of Interest Provisions; 406, Code of Ethics for Senior Financial Officers; and 407, Disclosure of Audit Committee Financial Expert. Each of these five provisions is discussed in the sections that follow.

1. Section 301: Public Company Audit Committees


SOX Section 301 is one of the most important pieces of financial legislation to emerge in recent years. By requiring that the audit committee of the board of directors appoint external auditors, set their compensation, and oversee their work, the audit committee is now the de jure intermediary between management and the auditor. 334 This arrangement makes it exceedingly difficult for management to fire auditors over disagreements; thus, outside auditor independence is considerably bolstered. Moreover, SOX mandates that the audit committee members are kept in the loop, substantially facilitating their oversight responsibilities. Other provisions of Section 301 specify that each audit committee member must be a member of the board of directors; each member is to be independent; the audit committee should establish procedures for receiving, processing, and resolving, or otherwise acting on, complaints dealing with accounting, control, or auditing issues; the audit committee is authorized to engage independent counsel as it deems necessary in the course of carrying out its functions; and the committee is to be adequately funded. 335
334 SOX 301. 335 Id.

2. Section 302: Corporate Responsibility for Financial Reports

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Congress designed SOX Section 302 to remind executives of their fiduciary responsibilities and to deter fraudulent activities. Section 302 requires the principal executive officer(s) and principal financial officer(s) to certify as appropriate each quarterly and annual report filed under the Securities Exchange Act. This certification must specify that the signing officer has reviewed the report; based on the officer's knowledge the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements not misleading; and based on such officer's knowledge, the financial statements and other financial information included in the report fairly present, in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report. 336
336 Id. 302.

The signing officers are responsible for establishing and maintaining internal controls. Section 302 also specifies that these officers must have designed the controls in such a way that management is made aware of important issues impacting the company and its financial statements. Additionally, the signing officers must have evaluated the effectiveness of the company's internal controls within 90 days of each quarterly or annual report and include their conclusions about control effectiveness based on their evaluation as of that date. 337
337 Id. 302(a)(4).

In certifying the quarterly and annual reports, the signing officers also certify that they have disclosed to the company's independent auditors and the audit committee of the board of directors, or persons fulfilling the equivalent function, all significant deficiencies in the design or operation of internal controls that could adversely affect the company's ability to record, process, summarize, and report financial data, and that they have identified for the company's auditors any material weaknesses in internal controls, including any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer's internal controls. 338
338 Id. 302(a)(5).

Finally, the signing officers must indicate in the report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls after the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. 339
339 Id. 302(a)(6).

3. Section 402: Enhanced Conflict of Interest Provisions


SOX Section 402 was prompted by corporate scandals that channeled millions of dollars in personal loans to top executives of large publicly held corporations such as Enron, Tyco, and Adelphia. Section 402 prohibits personal loans to directors and executive officers: 340
340 Id. 402.

It shall be unlawful for any issuerdirectly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer. The law makes exceptions for specified types of loans granted by consumer credit companies, such as home improvement loans, loans for manufactured homes, and consumer credit or any extension of

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under an open end credit plan or charge card. 341


341 Id.

Credit extensions by registered brokers or dealers to an employee are also exempted. To be exempt, loans must be granted in the ordinary course of business of the issuer, be of the type generally made available to the public, and on market terms, or terms that are no more favorable than those offered by the issuer to the general public for such extensions of credit. For example, a brokerage may extend credit to an officer or director by means of a margin account. The balance in the account would have to comply with all Federal Reserve Board Regulation T and stock exchange requirements pertaining to margin agreements.

4. Section 406: Code of Ethics for Senior Financial Officers


SOX Section 406 requires the company to adopt a code of ethics for senior officers. The SEC requires certain disclosures regarding this code in reports filed with the SEC. These disclosure requirements are set out in Section IV.B.2.e, below. The term Code of Ethics is defined to mean a set of standards reasonably necessary to promote: 342
342 Id. 406.

honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; full, fair, accurate, timely, and understandable disclosure in the periodic reports required to be filed by the company; and compliance with applicable governmental rules and regulations. 343
343 Id.

5. Section 407: Disclosure of Audit Committee Financial Expert


SOX Section 407 contains provisions for assuring that audit committees have the necessary expertise to carry out their oversight functions. SOX amended the Securities Exchange Act of 1934 to require information about an audit committee financial expert. It did not define that term, but rather gave the SEC the power to do so. Nevertheless, the following characteristics were specified as being highly desirable: 344
344 Id. 407.

An understanding of generally accepted accounting principles and financial statements; Experience in preparing or auditing financial statements of generally comparable issuers and applying such principles in connection with the accounting for estimates, accruals, and reserves; Experience with internal accounting controls; and An understanding of audit committee functions. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis IV. Corporate Governance and the Control Environment

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B. SEC Regulations Covering Corporate Governance


Certain provisions of SOX amend existing legislation. For instance, SOX directs the SEC to issue rules for implementing various sections of the Act. This section covers those SEC rules pertaining to corporate governance, as well as other SEC regulations dealing with this topic.

1. SEC Regulation S-XRecording Compensation Expenses


Many corporate failures have involved related parties, in particular executive officers receiving large sums of undisclosed compensation. Loans were apparently forgiven and properties purchased by the entity for the personal use of executives. In many cases the transactions were either undisclosed or, if disclosed, their true nature concealed. The transactions, which represented additional compensation, often were not authorized by the board of directors. Example: In one company, the Adelphia Communications Corporation, senior officers allegedly used company funds to support a lavish lifestyle. In another case, the SEC filed a civil enforcement action against the former top executives of Tyco International, alleging that these individuals used hundreds of millions of dollars from undisclosed company loans to finance personal expenditures. Millions of dollars of these loans were allegedly forgiven without the required shareholder disclosures. 345
345 Jackson, Business Fairy Tales, above, at 207.

Proper accounting requires such expenditures to be recorded as salary or some other type of operational expense, appropriately classified and labeled. Although SEC Regulation S-X does not, strictly speaking, encompass corporate governance features, it does govern the presentation of financial statements in filings with the Commission. This Regulation requires that operating expenses be included in the income statement and material amounts be stated separately. 346 Additionally, amounts incurred in conjunction with related party transactions must be identified and those amounts properly included in the financial statements. 347
346 SEC Regulation S-X, Rule 5-03.2, 17 C.F.R. 210.5-03.2; FASB ASC 225-10-S99-2. 347 SEC Regulation S-X, Rule 4-08(k), 17 C.F.R. 210.4-08(k); FASB ASC 235-10-S99-1.

2. SEC Regulation S-KCorporate Governance Requirements


Subpart 400 of SEC Regulation S-K, entitled Management and Certain Security Holders, consists of seven sections, or Items, all of which deal with corporate governance issues. 348 Six of these are discussed in this section. Item 401 requires the company to identify directors, executive officers, promoters, and control persons. Item 402 addresses the disclosure of executive compensation. Item 403 requires companies to disclose information on individuals owning more than 5% of the company's securities, as well as ownership by management, defined for purposes of Item 403 to include directors, director nominees, and executive officers. Item 405 requires the disclosure of directors, officers, and beneficial security holders who failed to report trades of company securities on a timely bases. Item 406 contains rules for disclosure of the company's code of ethics pertaining to the principal executive officer, principal financial officer, principal accounting officer or controller, or persons who perform these functions. Finally, Item 407 is a general section covering corporate governance in the following six areas: 349
348 SEC Regulation S-K. Reg. 229.400. 349 SEC Regulation S-K, Item 407, Reg. 229.407.

Director independence;

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General meetings of the board of directors, committee meetings, and attendance data; The nominating committee; Audit committee; The compensation committee; and Shareholder communications. Each Item is discussed in sections that follow. Item 404, Transactions With Related Persons, Promoters, and Certain Control Persons, is covered extensively in Section II.B.2, above, and thus is not addressed in this section.

a. Item 401: Directors, Executive Officers, Promoters, and Control Persons


Item 401 requires companies to identify all directors and individuals who have been nominated or chosen as directors. The disclosures about directors must include names; ages; terms of office as director; periods during which the individuals have served as directors; and any arrangement or understanding with any other person, who is to be identified by name, by which any director was or is to be selected as director or nominee. 350
350 SEC Regulation S-K, Item 401(a), Reg. 229.401(a).

Similar information is to be supplied for executive officers and significant employees. 351 The latter individuals are those who may not necessarily be designated by the enterprise as executive officers but who nevertheless are key employees. These are persons who, make or are expected to make significant contributions to the business. 352 Examples include production managers, sales managers, and research scientists.
351 SEC Regulation S-K, Item 401(b), Reg. 229.401(b). 352 SEC Regulation S-K, Item 401(c), Reg. 229.401(c).

Item 401 also requires the disclosure of family relationships between directors, executive officers, or individuals who are nominated or chosen to become directors or executive officers. Family relationships for these purposes are defined as, any relationship by blood, marriage, or adoption, not more remote than first cousin. 353
353 SEC Regulation S-K, Item 401(d), Reg. 229.401(d).

This Item further requires the disclosure of each named individual's business experience and background, as well as any additional directorships held by these persons. Such directorships pertain to companies having registered securities under the Securities Exchange Act of 1934 or an investment company subject to the Investment Company Act of 1940. 354
354 SEC Regulation S-K, Items 401(e)(1) and (2), Reg. 229.401(e)(1) and (2).

Additionally, companies must disclose the named individuals' involvement in certain legal proceedings during the previous five years. 355 Such disclosures also apply to persons who were promoters or designated as control persons during the past five fiscal years. 356 Control persons are individuals who have acquired control of a registrant that is defined as a shell company or a person who is part of a group of individuals acquiring such control, where a group is defined as two or more individuals who agree to act together to acquire, hold, vote, or dispose of the equity securities of a registrant that is a

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shell company. 357 Control persons are discussed more extensively in Section II.B.2.c.(2), above.
355 SEC Regulation S-K, Item 401(f), Reg. 229.401(f). 356 SEC Regulation S-K, Item 401(g), Reg. 229.401(g). 357 SEC Regulation S-K, Item 404(c)(2), Reg. 229.404(c)(2).

b. Item 402: Executive Compensation


The SEC issued revised executive compensation rules in July, 2006. The rules are set out in Item 402 of SEC Regulation S-K. This section requires companies to comprehensively disclose all compensation awarded, earned by, or paid to executive officers and directors. The disclosure is required for the following named executive officers: 358
358 SEC Regulation S-K, Item 402(a)(3), Reg. 229.402(a)(3).

All individuals serving as the company's principal executive officer (PEO) or acting in a similar capacity during the last completed fiscal year, regardless of compensation level; All individuals serving as the company's principal financial officer (PFO) or acting in a similar capacity during the last completed fiscal year, regardless of compensation level; The company's three most highly compensated executive officers other than the PEO and PFO who were serving as executive officers at the end of the last completed fiscal year; and Up to two other individuals who would have been among the three most highly compensated executive officers had they remained in that capacity at year end. Considerable additional information must be disclosed. This additional information includes the following specific items: 359
359 SEC Regulation S-K, Items 402(b) through (k), Reg. 229.402(b) through (k).

A comprehensive discussion and analysis of the compensation programs, including objectives, what the programs are designed to reward, and each element of compensation; A Summary Compensation Table; Information concerning grants of plan-based awards made to executive officers; A table of outstanding equity awards at the end of the fiscal year; A table of options that have been exercised and stock that has vested; Executive officer pension benefits; A table of defined contribution and other deferred compensation plans that are not tax-qualified; Potential payments to be made to executive officers in connection with any termination; and Compensation of directors in tabular format. Six months after issuing the new rules in July, 2006, the SEC amended the stock option disclosure

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requirements. This action came in response to numerous comments critical of the manner in which stock options were to be reflected in the Summary Compensation Table. The Commission originally required companies to present the entire estimated value of options in the year awarded. 360 Under the revised rules, the Summary Compensation Table is to reflect the dollar amount of stock option awards recognized for financial statement purposes under the premise that including the entire fair value would artificially inflate executive compensation. 361 The estimated value of the options (the grant date fair value) is also to be disclosed, but in an additional column that was added to the Grants of Plan-Based Awards table.
360 SEC Release No. 33-8732A; 34-54302A, Executive Compensation and Related Person Disclosure, Final Rule (July 26, 2006), at 337. 361 SEC Release No. 33-8765; 34-55009, Executive Compensation Disclosure, Interim Final Rules (Dec. 22, 2006), at 49-50.

c. Item 403: Security Ownership


Item 403 of SEC Regulation S-K requires the disclosure of the beneficial ownership of all classes of voting securities. A beneficial owner of a security includes any person who directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares voting power or investment power. 362 Voting power includes the power to vote, or to direct the voting of, such security. Investment power includes the power to dispose, or direct the disposition, of such security.
362 Securities Exchange Act of 1934, Rule 13d-3a, Determination of Beneficial Ownership, Securities Exchange Commission.

The company must furnish the required information for beneficial owners of more than 5% of any voting class of security, as well as for management, defined as directors, director nominees, and the named executive officers specified in the previous section. The following information is required with regard to each of these individuals: the title of the class of securities, the person's name (as well as the addresses of those beneficially owning more then 5%), the amount and nature of the beneficial ownership, and the percentage of the class that is owned. 363
363 SEC Regulation S-K, Item 403(a)-(b), Reg. 229.403(a)-(b).

d. Item 405: Compliance With Section 16(a) of the Exchange Act


As indicated in Section III.B.4.a, above, directors, officers, and principal stockholders of a registered company must file reports with that company when these individuals acquire the company's securities or change their holdings. The reports are filed on Forms 3, 4, or 5, as applicable. While Section III.B.4.a. discusses the related persons' responsibilities under Section 16(a) of the 1934 Act, this Portfolio section describes registered companies' responsibilities under Item 405 of that Act. In addition to identifying each director, officer, and principal stockholder, 364 Item 405 requires each company to disclose for each of these individuals: the number of late reports, the number of transactions not reported on a timely basis, and any known failure to file a required form. 365
364 Defined as a beneficial owner of more than 10% of any class of equity securities. See SEC Regulation S-K, Item 405(a)(1), Reg. 229.405(a)(1). 365 SEC Regulation S-K, Item 405(a)(2), Reg. 229.405(a)(2).

e. Item 406: Code of Ethics


Item 406 of SEC Regulation S-K covers the code of ethics for senior management. Each company is

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required to: (1) disclose whether it has adopted such a code, and (2) if not, the reason(s) for not doing so. The code is to apply specifically to the company's principal executive officer, financial officer, and accounting officer or controller. 366 If the company does not use these titles, then the code applies to those individuals performing functions typical of these offices.
366 SEC Regulation S-K, Item 406(a), Reg. 229.406(a).

The code of ethics must contain written standards designed to deter wrongdoing and promote a well-described series of good corporate governance behaviors. 367 These include the following:
367 SEC Regulation S-K, Item 406(b), Reg. 229.406(b).

Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; Full, fair, accurate, timely, and understandable disclosure in reports and documents that a company files with, or submits to, the SEC and in other public communications made by the company; Compliance with applicable governmental laws, rules and regulations; The prompt internal reporting of violations of the code of ethics to an appropriate person or persons identified in the code; and Accountability for adherence to the code of ethics. In addition to disclosing the existence of a code of ethics for senior officials, the company also must file with the SEC a copy of its code of ethics that applies to the registrant's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, as an exhibit to its annual report. 368 The company must post the text of its code of ethics on its Internet Web site and disclose, in its annual report, its Internet address and the fact that it has posted the code on its Internet Web site. Alternatively, a company must offer in its annual report filed with the Commission to provide to any person without charge, upon request, a copy of its code of ethics and explain the manner in which such a request may be made. An example of a code of ethics for senior officials is found in Worksheet 21, which shows North American Scientific's code.
368 SEC Regulation S-K, Item 406(c), Reg. 229.406(c).

f. Item 407: Corporate Governance


Item 407 of SEC Regulation S-K contains rules on the following six corporate governance topics: (1) director independence; (2) information on the frequency of both general board meetings and committee meetings, as well as data on attendance at these meetings; (3) information on the nominating committee and its processes; (4) the structure, independence, and processes of the audit committee; (5) the authority, structure, and workings of the compensation committee; and (6) communication with shareholders. 369 The sections that follow briefly elaborate on each of these corporate governance features.
369 SEC Regulation S-K, Item 407, Reg. 229.407.

(1) Item 407(a): Director Independence In November 2003, the SEC approved changes to NYSE and NASDAQ standards dealing with corporate governance. 370 These changes included the requirement that a majority of the board of directors be

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independent and set out the criteria for independence. The criteria adopted by the NYSE are found in Section IV.C.1, below. The NASDAQ criteria are discussed in Section IV.D.1, below, and reproduced in Worksheet 26. Item 407(a), Director Independence, requires a company to identify each director who is independent, as well as each member of the compensation, nominating and audit committee who is not independent. 371 In making these independence determinations, the company follows the standards issued by its national exchange or inter-dealer quotation system. If the company is not listed, it uses a definition of independence set out by a national securities exchange or inter-dealer quotation system having the requirement that a majority of the board be independent. 372
370 SEC Release No. 34-48745, NASDAQ and NYSE Rulemaking: Relating to Corporate Governance (Nov. 4, 2003). 371 SEC Regulation S-K, Item 407(a), Reg. 229.407(a). 372 SEC Regulation S-K, Item 407(a)(1), Reg. 229.407(a)(1)(i)-(ii).

(2) Item 407(b): Board Meetings and Committees Item 407(b) of SEC Regulation S-K requires the company to provide the following data regarding directors' attendance at meetings of the full board and committee meetings: 373
373 SEC Regulation S-K, Item 407(b)(1)-(2), Reg. 229.407(b)(1)-(2).

The total number of meetings of the full board, both regularly scheduled and special meetings, that were held during the last full fiscal year; Names of directors attending less than 75% of the aggregate of the total meetings of the full board and all committees on which that director served; and The company's policy regarding director attendance at annual shareholders' meetings and the number of board members who attended the prior year's annual meeting. The following information about committees is also required: a statement as to whether the company has standing audit, nominating, and compensation committees; the names of members serving on each of the committees; the number of meetings held by each committee during the previous fiscal year; and a brief description of the committee functions. 374
374 SEC Regulation S-K, Item 407(b)(3), Reg. 229.407(b)(3).

(3) Item 407(c): Nominating Committee Policies Item 407(c) of SEC Regulation S-K addresses the policies and procedures of the nominating committee. If the company does not have a standing nominating committee, Item 407(c) requires the company to disclose that fact, state the board's rationale for not having such a committee, and identify each director who participates in the consideration of nominees. 375 The company is also required to furnish the following information about the process for nominating directors: 376
375 SEC Regulation S-K, Item 407(c)(1), Reg. 229.407(c)(1). 376 SEC Regulation S-K, Item 407(c)(2), Reg. 229.407(c)(2).

An assertion as to whether the committee has a charter and whether it is available on the company's Web site or in the proxy statement; The policy for considering candidates recommended by security holders and the

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procedures to be followed by security holders for making such nominations; The process for identifying and evaluating nominees; The source(s) of the recommendations for nominees; If a fee is paid to a third party for assistance in identifying and evaluating nominees, disclosure of the services provided; and The source of the recommendation for any nominees beneficially owning more than 5% of the voting common stock. (4) Item 407(d): Audit Committee Item 407(d) of SEC Regulation S-K requires companies to disclose the structure and functioning of the audit committee. As indicated in Section IV.B.2.f.(1), above, companies are to adhere to the independence standards issued by their exchange or association. The SEC issued rules governing the audit committee requirements mandated by SOX. These standards are found in Rule 10A-3, discussed next. i. Independence Standards Relating to Audit Committees SOX Section 301 amended the Securities Exchange Act of 1934 and directed the SEC to issue rules for implementing audit committee requirements. In response, the Commission issued Rule 10A-3, Listing Standards Relating to Audit Committees, requiring national securities exchanges and associations to craft regulations for listed companies. 377 The NYSE standards are described in Section IV.C.6, below, while the NASDAQ standards are described in Section IV.D.2, below.
377 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of 1934, Rule 10A-3, Listing Standards Relating to Audit Committees, (a).

The independence requirements for audit committee members set out in Rule 10A-3 are more stringent than those for independent directors who are general board members. 378 Each member of the audit committee must be a member of the board of directors of the listed company, and must otherwise be independent. To be considered independent, the committee member may not accept, directly or indirectly, any consulting, advisory, or other compensatory fee from the company or any subsidiary thereof. And the member may not be an affiliated person of the company or its subsidiaries.
378 Id. (b)(1)(i).

Rule 10A-3 defines the term affiliated person as a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified. A person will be deemed not to be in control of a specified person if the person: (1) is not the beneficial owner, directly or indirectly, of more than 10% of any class of voting equity securities of the specified person, and (2) is not an executive officer of the specified person. 379 The following are all deemed to be affiliates and therefore not independent: executive officers of affiliates; directors who are also employees of affiliates; general partners of affiliates; and managing members of affiliates. 380 Audit committee members may still receive pensions from the listed company for prior service as long as the amount is fixed, or unless the rules of the national securities exchange or association provide otherwise. 381
379 Id. (e)(1). 380 Id. (e)(1)(iii). 381 Id. (b)(1)(ii)(A).

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ii. Audit Committee Responsibilities In addition to promulgating audit committee independence standards in Rule 10A-3, Listing Standards Relating to Audit Committees, the SEC set forth four additional standards dealing with audit committee responsibilities. These relate to: (1) external auditors, (2) procedures for dealing with complaints, (3) authority to engage advisors, and (4) funding. Each of these topics is covered in sections that follow. (a) Responsibilities Relating to Registered Public Accounting Firms Section b(2) of Rule 10A-3 sets forth audit committee responsibilities for appointing, compensating, retaining, and overseeing the work of external auditors. The Rule also delineates audit committee responsibilities for resolving disagreements between management and auditors when those disagreements pertain to audit, review, and other attestation engagements. The Rule further specifies that external auditors are to report directly to the audit committee. 382
382 Id. (b)(2).

(b) Procedures for Responding to Complaints The audit committee must establish procedures for responding to complaints received by the company regarding accounting, internal control, or auditing matters. The committee should set up similar procedures to confidentially handle anonymous submissions by employees (whistleblowers) for revealing questionable accounting or auditing matters. 383
383 Id. (b)(3).

(c) Authority to Engage Advisers The company is required to provide the audit committee with the authority to engage independent counsel and other advisers, as deemed necessary by the committee to fulfill its responsibilities. 384
384 Id. (b)(4).

(d) Funding The company is also required to provide adequate funding for the audit committee, as determined by the committee, so it is in a position to compensate any registered public accounting firm that the audit committee has engaged to prepare and issue an audit report or to perform other audit, review or attest services for the company; compensate any advisers employed by the audit committee; and pay the ordinary administrative expenses necessary for the committee to be able to carry out its duties. 385
385 Id. (b)(5).

Rule 10A-3, Paragraph (c), General Exemptions, spells out certain exceptions to audit committee requirements. For example, if the company has common equity securities listed on a national exchange, listing securities of a consolidated subsidiary would not be subject to the requirements. 386
386 Id. (c).

iii. Audit Committee Disclosures Required Under Item 407(d) Item 407(d) requires companies to disclose whether the audit committee has a charter and whether that charter is available on the company's Web site or in the proxy statement. 387 Companies must also identify any committee member who fails to meet the independence standards and the nature of the relationship that makes the member not independent. In addition, the audit committee must include in

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filings with the Commission a statement certifying that it has carried out certain oversight procedures. This report must contain representations that the committee has reviewed and discussed the audited financial statements with management. 388 The report must also represent that the committee has discussed with the independent auditors the matters required to be discussed by AICPA Statement on Auditing Standards No. 61, as amended (AICPA, Professional Standards, Vol. 1. AU Section 380, Communication With Audit Committees), as adopted by the PCAOB in Rule 3200T, and reviewed and discussed the audited financial statements with management. In addition, companies in the report must represent that they have discussed with their independent auditors the matters required to be discussed by SAS 61, as amended (AICPA, Professional Standards, Vol. 1. AU Section 380, Communication With Audit Committees), as adopted by the PCAOB in Rule 3200T, and also that they have received the written disclosures and the letter from the independent accountants required by Independence Standards Board Standard No. 1, Independence Discussions With Audit Committees, as adopted by the PCAOB in Rule 3600T, and has discussed these matters with the independent accountant. Finally, Item 407(d) requires that companies must represent that they have recommended to the full board that the audited financial statements be included in the company's annual report on Form 10-K, based on the review and discussions referred to in the preceding items. The names of each audit committee member are to appear directly below this certification. 389
387 SEC Regulation S-K, Item 407(d)(1)-(2), Reg. 229.407(d)(1)-(2). 388 SEC Regulation S-K, Item 407(d)(3)(i)(A)-(D), Reg. 229.407(d)(3)(i)(A)-(D). 389 SEC Regulation S-K, Item 407(d)(3)(ii), Reg. 229.407(d)(3)(ii).

AU Section 380, Communication With Audit Committees, requires the auditor to communicate several matters to the company's audit committee. 390 In their communication to the committee, auditors must indicate the significant accounting policies the company initially selected and any changes in those policies. The auditor must describe the company's processes for formulating accounting estimates, especially those that are particularly sensitive, as well as the auditor's basis for concluding whether or not the estimates are reasonable. Another requirement is to enumerate those audit adjustments revealed by the audit and which could, in the auditor's opinion, have a significant impact on the company's financial reporting process. Moreover, the auditor is to identify those adjustments that management determines to be immaterial and were waived by the auditors. The standard also stipulates that the communication is to include the auditor's judgment concerning the quality of the company's accounting principles as they apply to its financial reporting, as well as the auditor's responsibility for assuring that the non-financial statement portions of the annual report, such as the Management's Discussion and Analysis section, do not conflict with the financial statements. Any disagreements with management are to be included, along with the manner in which these were resolved. If the auditor is aware that management has discussed auditing and accounting matters with other accountants, the auditor should include his or her views on these matters. Finally, the auditor is required to reveal any serious difficulties with management relating to the performance of the audit.
390 AU 380.06-.14.

Independence Standards Board Standard No. 1 contains specific requirements for auditors whose clients are subject to the jurisdiction of the SEC. In order to be considered independent, as that term applies to the Securities Acts, auditors are required by Independence Standards Board Standard No. 1 to disclose, in a written document to the audit committee, or the board of directors if there is no audit committee, all relationships between the auditor and the company, including related entities, that in the auditor's professional judgment may reasonably be thought to impair independence. Auditors must also confirm in that document that, in their professional judgment, they are independent of the company within the meaning of the Securities Acts. Additionally, auditors are required to discuss their independence with the audit committee. iv. Additional Disclosures: Audit Committee Financial Expert In addition to the disclosures referred to in the preceding section, the company is also required to

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disclose information regarding the audit committee financial expert. These disclosures are to include whether the company has a financial expert serving on its audit committee or an explanation as to why it does not, the name of the financial expert, and whether the named financial expert is independent as this term relates to audit committee members. (5) Item 407(e): Compensation Committee Item 407(e) of SEC Regulation S-K addresses the policies and procedures of the compensation committee. If the company does not have a standing compensation committee, paragraph 407(e) requires the company to disclose that fact, state the board's rationale for not having such a committee, and identify each director who participates in the consideration of executive officer and director compensation. 391 Regarding the process for nominating directors, the company also must assert whether the committee has a charter and whether that charter is available on the registrant's Web site or in the proxy statement, and describe in narrative form the policies for considering and determining executive officer and director compensation. 392 The company must also describe the compensation committee's scope of authority; whether that authority can be delegated and to whom; the role of executive officers in determining or recommending the amount or form of compensation; and the identity of any compensation consultants, as well as their role and the nature and scope of their assignment.
391 SEC Regulation S-K, Item 407(e)(1), Reg. 229.407(e)(1). 392 SEC Regulation S-K, Item 407(e)(2)-(5), Reg. 229.407(e)(2)-(5).

In addition to the foregoing disclosures, the company must disclose each member of the compensation committee who was an executive officer during the last completed fiscal year; each member who was formerly an officer of the company; and each member who was a related person as set out in Regulation S-K, Item 404. 393 This information is to be included under the caption Compensation Committee Interlocks and Insider Participation. 394
393 Related persons are discussed in Section II.A.2.a, above. 394 SEC Regulation S-K, Item 407(e)(4), Reg. 229.407(e)(4).

(6) Item 407(f): Shareholder Communications Item 407(f) of SEC Regulation S-K requires companies to disclose the process that enables security holders to communicate with the board. The required disclosures include the following: 395
395 SEC Regulation S-K, Item 407(f)(1)-(2), Reg. 229.407(f)(1)-(2).

Specifying whether or not the board has a process in place for security holders to send communications to the board, and if not, the basis for the board's view that such a process is inappropriate; A description of the manner by which security holders can send communications to the board, and if applicable, to individual directors; and If security holders are not provided the opportunity to communicate directly with individual board members, the process by which the board determines those communications that will be relayed to directors. At its discretion, the company may either disclose the communication process in the proxy statement or provide the Web site address where this information can be found. 396

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396 SEC Regulation S-K, Instruction 1 to Item 407(f), Reg. 229.407(f).

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis IV. Corporate Governance and the Control Environment

C. New York Stock Exchange Corporate Governance Standards


Corporate governance is covered in the NYSE Listed Company Manual. With few exceptions, the rules apply to all companies listing common equity securities. 397 Rule 10A-3, Listing Standards Relating to Audit Committees, specifies the SEC's standards related to audit committees. Accordingly, the NYSE requires listed companies to have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act. 398 In addition, the NYSE has augmented the Rule 10A-3 requirements. These additional requirements are found in the NYSE Listed Company Manual, Section 303A.07, Audit Committee Additional Requirements 399 and described in Section IV.C.6, below.
397 The exceptions are described in Section IV.C.13, below. 398 New York Stock Exchange, Listed Company Manual, 303A.06. 399 Id.

1. Independent Directors
The NYSE requires that a majority of directors be independent. The rationale is to increase the quality of board oversight and reduce conflicts of interest. Listed companies must determine which board members are independent, identify independent directors, and disclose the basis on which independence is determined. In making that determination, a company's board must establish that the director has no material relationship with the listed company (either directly, or as a partner, shareholder or officer of an organization that has a relationship with the company or any of the company's subsidiaries in the same consolidated group). 400
400 Id. 303A.02(a).

To be able to specify which members are independent, the board should establish standards within the guidelines specified by the NYSE. The board is required to disclose standards it adopts. 401 In developing these standards, a board needs to take into consideration those relationships that are explicitly proscribed by the NYSE. The NYSE does not consider a director to be independent if the director is a current employee or has been an employee in the last three years. Independence is also considered to be impaired if an immediate family member is currently an executive officer, or was employed in that capacity within the past three years. However, an individual's prior employment as an interim CEO or other executive officer would not preclude that person from being considered independent. 402
401 Id. 402 Id. 303A.02(b).

Independence is considered to be impaired if the director received more than $100,000 in direct compensation from the company during any 12-month period within the previous three years. 403 This rule also applies if the director has an immediate family member who has received such compensation. Director and committee fees, pensions, and other forms of deferred compensation for prior service are exempted provided this compensation is not contingent in any way on continued service. Compensation received for prior service as an interim CEO or other executive officer is excluded. Also excluded is

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compensation received by immediate family members who are or were employed as non-executive officer employees.
403 Id. 303A.02(b)(ii).

A director is not considered independent if that person, or the individual's immediate family member, is currently a partner of any firm that provides internal or external audit services; or the director is a current employee of such a firm. 404 If the director has an immediate family member who is a current employee of such a firm and that family member participates in the firm's audit, assurance, or tax compliance (but not tax planning) practice, independence is considered to be impaired. Even if the director or an immediate family member has left the employ of such a firm, that director is not considered to be independent if: (1) the director or an immediate family member was a partner or employee of the firm within the last three years, and (2) personally worked on the listed company's audit within that time. 405
404 Id. 303A.02(b)(iii). 405 Id. 303A.02(b)(iii).

If the director or an immediate family member is an executive officer of another company, independence may be impaired. Impairment occurs if a current executive officer of the listed company serves on the compensation committee of the company employing the director as an executive officer. The look-back period is three years. If a current executive officer served on the compensation committee during a three-year period when the director was an executive officer, independence is impaired. If the director is a current employee, or an immediate family member is a current executive officer, of a company that has made payments to, or received payments from, the listed company, the director may not be independent. Independence is impaired if the payments for property or services exceed the greater of $1 million or 2% of the other company's consolidated gross revenues. The lookback period is three years. Accordingly, if the payments exceed the limits in any of the last three fiscal years, independence is impaired. The company should only consider the director or immediate family member's current employer. That is, the three-year look-back applies to the individual's current employer and does not extend to previous employers during that period. 406
406 Id. 303A.02(b).

When applying these independence tests, an immediate family member includes a person's spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sistersin-law, and anyone (other than domestic employees) who shares such person's home. When applying the [three-year] look-back provisions, listed companies need not consider individuals who are no longer immediate family members as a result of legal separation or divorce, or those who have died or become incapacitated. 407
407 Id.

In crafting standards within the NYSE independence guidelines, the objective is to assure that material relationships between a board member and management are identified. Material relationships would be of the type whereby management's decisions hold sway over the director. Material relationships of this nature could include, among others, commercial, industrial, banking, consulting, legal, accounting, charitable, and familial relationships. While, as indicated, certain relationships have been explicitly proscribed by the NYSE, the board may wish to establish materiality thresholds for others. In making a determination about a particular director, the board should consider all the circumstances from the viewpoint of both the director and the organization or person with which the director has a relationship.

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In this regard, the board should include all affiliates of the listed company. 408
408 Id. 303A.02(a).

A straightforward approach for determining whether a relationship is material is first to establish thresholds and make a general disclosure that each director meets these standards. 409 The board is required to disclose the standards it adopts. The board can then state that board members meet these standards. This procedure avoids having to disclose immaterial relationships between the company and directors. 410 If the board has made a determination that a director is independent even if the standards are not met, the relationship must be disclosed. The NYSE notes that this approach provides investors an appropriate means for assessing board independence, as well as the propriety of the independence assessments made by the board.
409 Id. 410 Id.

Disclosures regarding director independence must be included in the company's annual proxy statement. These disclosures must set forth any standards that the company adopts; the identities of the independent directors; the basis for determining that a relationship is not material; and the basis for concluding that a director who does not meet the standards is nevertheless independent. 411 If the company does not file an annual proxy statement, then the disclosures should be included in the Form 10-K. Worksheet 22 illustrates the independence disclosures found in General Electric Company's 2007 proxy statement.
411 Id.

2. Executive Sessions
The NYSE corporate governance rules provide that non-management directors must meet at regularly scheduled executive sessions without management. The rationale is that this approach will promote open discussion and thereby enable the non-management directors to serve as a more effective check on management's decisions and actions. Non-management directors are defined as all those who are not executive officers, and includes such directors who are not independent by virtue of a material relationship, former status or family membership, or for any other reason. 412
412 Id. 303A.03.

To ensure that executive sessions accomplish the intended effect, the NYSE requires that the meetings be conducted in accordance with a prescribed protocol. The independent directors should schedule regular meetings. This feature fosters communication and forestalls any negative inference that may be associated with calling unscheduled executive sessions of the non-management directors. 413
413 Id.

In addition, a non-management director must preside at the regular meetings, although it is not required that the same person preside over all the sessions. If one individual is chosen to preside over all the meetings, that person's name is to be disclosed in the annual proxy statement, or in the Form 10-K if an annual proxy statement is not filed. If one individual does not preside over all the meetings, the company is required to disclose the procedure for selecting the presiding director, for example, the use of rotation among the directors. 414 If the group of non-management directors includes individuals who are not independent, as described in Section IV.C.1, above, the company must schedule at least one meeting per year comprising solely independent directors. 415

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414 Id. 415 Id.

Planning Point: Some companies, including Alcoa, Boeing, and Intel, have designated a Lead Director. This individual is selected from among either the non-management or independent directors to preside over the executive sessions and sometimes perform other functions, such as presiding at general board meetings in the absence of the Chair.

3. Communication With Non-Management Directors


The NYSE requires listed companies to disclose a procedure for interested parties to communicate directly with the non-management directors or with the presiding director. This disclosure should be included in the company's annual proxy statement or in the Form 10-K if the company does not file an annual proxy statement. 416 The NYSE allows companies to use the same procedure for this purpose as the system that has been established to allow the audit committee to deal with complaints under Rule 10-A3, Listing Standards Relating to Audit Committees. 417 That standard is discussed in Section IV.B.2.f.(4)(ii)(b), above.
416 Id. 417 Id.

4. Nominating/Corporate Governance Committee


One of the board's most important functions is assuring the continuation of effective and ethical policies through the selection of exceptional new board members and committee chairs. When these responsibilities are put in the hands of independent directors, there is an increased likelihood of enhancing the quality and objectivity of both. Accordingly, the NYSE requires that the nominating committee must comprise entirely independent directors. 418 The board may allocate the nominating/corporate governing process among several committees, as determined by the board. Each committee, however labeled, must comprise solely independent directors, and each committee must have a published charter. 419
418 Id. 303A.04(a). 419 Id. 303A.04.

The NYSE also expects the committee to take the lead in formulating and championing the company's corporate governance policies. At a minimum, the functions of the committee are to identify individuals qualified to become board members, consistent with the board's criteria, and select on its own, or recommend that the board select, the director nominees for the next annual shareholders' meeting. 420 The nominating/corporate governance committee must also develop and recommend to the board a set of corporate governance for the company, oversee the process for evaluating the board and management, and establish procedures for carrying out its own annual self-evaluation.
420 Id. 303A.04(b)(i)-(ii).

Planning Point: The committee may wish to establish metrics for evaluating the board and management, and for carrying out the annual self-evaluation. The evaluation of the board and management may be a quarterly or an annual process that compares actual results with pre-established goals. The committee's annual self-evaluation might include criteria pertaining to: (1) the efficacy of the nominating process, (2) the number of nominees submitted, and (3) metrics for evaluating how the committee's nominees have functioned as board members.

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The committee must have a written charter that incorporates each of the foregoing procedures. At a minimum, the charter should include the following items: 421
421 Id. 303A.04.

Function, purpose, and responsibilities; Process for carrying out the annual self-evaluation; Qualifications for sitting on the committee; Appointment and removal of members; Committee structure and operations, including authority to delegate to subcommittees; Procedure for reporting to the full board; and A statement to the effect that the committee is to have sole authority for retaining and terminating any search firm to be used in the process of identifying candidates, including the sole authority to approve the search firm's fees and retention terms. If third parties have the legal authority to nominate directors, through contract or otherwise, any directors selected and nominated through that process do not need to follow the committee's selection and nominating procedures. Such contractual or legal authority to nominate directors may arise when, for example, preferred stockholders have the right to nominate directors as a consequence of a dividend default or as a result of a shareholder or management agreement. 422
422 Id.

5. Compensation Committee
The compensation committee is charged with the important task of recommending and/or approving a compensation package for the CEO and other executive officers. The NYSE requires the committee to consist entirely of independent directors and to have a written charter. 423
423 Id. 303A.05(a)-(b).

a. CEO Compensation
At a minimum, the compensation committee's charter must describe: (1) the responsibility of the committee to review and approve corporate goals and objectives relevant to CEO compensation; (2) the assessment of the CEO's performance in relation to those goals and objectives; and (3) the setting and approval of CEO compensation based on the assessment of performance. 424 In the spirit of open communication among board members, the committee may find it desirable to discuss CEO compensation with the full board. Accordingly, the process of deciding on the type and level of compensation may be carried out by the compensation committee alone or in conjunction with the other independent board members, as indicated by the full board. 425
424 Id. 303A.05(b)(i)-(ii). 425 Id. 303A.05(b)(i)(A).

When considering an appropriate level of CEO compensation, the committee should take several factors into account. 426 One such factor is the company's overall performance compared to historical and

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market benchmarks. Another is the relative shareholder return when compared to other companies in the same industry. In addition, the committee should consider the value of similar incentive rewards at comparable companies and amounts awarded CEOs in prior periods.
426 Id. 303A.05.

Planning Point: Incentives should align with the company's strategy and link to shareholder value. Moreover, the committee should consider the appropriate mix of short- and long-term incentives. Short-term compensation might consist of annual salary and bonuses. Long-term compensation can be a mix of stock options and stock grants, in proper balance. If the stock price is out of the money, executives may take risks to boost the per-share price. Adding stock grants imparts ownership and ties executives to downside risk.

b. Other Compensation Committee Functions


Other functions, which at a minimum must also be included in the charter, include recommending to the board a compensation package for non-CEO executive officers, including incentives and equity-based plans subject to approval by the full board. 427 In addition, the committee must draft a report required by the SEC for inclusion in the annual proxy or the Form 10-K. Moreover, the committee must prepare an annual self-evaluation report.
427 Id. 303A.05(b)(i)(B)-(C),(ii).

c. Items to Be Included in the Compensation Committee Charter


The following is a list of items that, at a minimum, should be found in the committee's charter: 428
428 Id. 303A.05.

Function, purpose, and responsibilities; Process for carrying out the annual self-evaluation; Qualifications for serving on the committee; Appointment and removal of members; Committee structure and operations, including authority to delegate to subcommittees; Process for reporting to the full board; and A statement to the effect that the committee is to have sole authority to retain and terminate a consulting firm engaged to assist in evaluating or setting compensation levels for the CEO, non-CEO executive officers, or directors, including sole authority to approve the firm's fees and retention terms. The committee is not precluded from approving awards, either with or without ratification of the board, as might be required to comply with applicable tax laws. In this regard, the board may delegate its authority to the compensation committee. 429 Additionally, the board may allocate the compensation procedures among several committees, as determined by the board. Each such committee, however labeled, must be composed solely of independent directors and have its own published charter. 430

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429 Id. 430 Id.

6. Audit Committee
SOX Section 301 amended the Securities Exchange Act of 1934 and directed the SEC to issue rules for implementing audit committee requirements. In response, the SEC issued Rule 10A-3, Listing Standards Relating to Audit Committees. This Rule requires the national securities exchanges and associations to craft regulations for listed companies. 431 To be in compliance with Rule 10A-3, the NYSE now requires listed companies to have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act. 432 In addition, the Exchange augmented the Rule 10A-3 regulations by developing an expanded set of standards that are codified in the NYSE Listed Company Manual as Section 303A.07, Audit Committee Additional Requirements. 433 These requirements are discussed in the paragraphs that follow. As indicated in Section IV.C.13, below, not all entities are required to comply with the augmented standards.
431 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of 1934, Rule 10A-3, Listing Standards Relating to Audit Committees, (a). 432 New York Stock Exchange, Listed Company Manual, 303A.06. 433 Id.

a. Committee Composition
The NYSE Listed Company Manual requires that the audit committee have a minimum of three members. The NYSE requires that all members of the committee be financially literate, or become so within a reasonable period after appointment to the committee. At least one member must have accounting or related financial management expertise. The NYSE leaves it up to each company's board to determine the qualifications constituting financial literacy and the degree of expertise in accounting or financial management that is required. 434
434 Id. 303A.07(a).

Planning Point: The NYSE does not require the designation of an audit committee financial expert, as that term is defined in SEC Regulation S-K. 435 (See Section IV.A.5 and Section IV.B.2.f.(4)(iv), above.) Item 407(d) of Regulation S-K requires the following disclosure in the annual proxy or Form 10-K: Disclose that the registrant's board of directors has determined that the registrant either (1) Has at least one audit committee financial expert serving on its audit committee; or (2) Does not have an audit committee financial expert serving on its audit committee [and, if not, the company should]explain why it does not have an audit committee financial expert. 436 A disclosure indicating that the company does not have a financial expert sitting on the audit committee may send up a red flag, not only at the SEC but also among investors. A disclosure of this sort may raise the company's risk profile and result in an increased cost of capital. It appears that the most prudent course of action would be to appoint a financial expert who meets the SEC definition.
435 Id. 436 SEC Regulation S-K, Item 407(d)(5)(i), Reg. 229.407(d)(5)(i).

Due to the demands on the time of audit committee members, the NYSE recommends that listed companies restrict audit committee members from serving on more than three public company audit committees. If the listed company does not specify this limitation, the board must make a determination in each case that the member's service would not be impaired. In addition, the company

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must disclose the basis for the board's determination in the annual proxy statement, or in the Form 10-K if the company does not issue an annual proxy. 437
437 New York Stock Exchange, Listed Company Manual, 303A.07(a).

b. Committee Member Independence


Committee members must meet the independence standards for audit committee members set out in Rule 10A-3, Listing Standards Related to Audit Committees. These standards are explained in Section IV.B.2.f.(4)(i), above. Each member of the audit committee must be a member of the company's board of directors and otherwise be independent. Audit committee members must satisfy the NYSE independence tests that are set out in Section IV.C.1, above. 438 The committee member may not accept, directly or indirectly, any consulting, advisory, or other compensatory fee from the company or any of its subsidiaries. The audit committee member may not be an affiliated person of the company or any subsidiary. 439
438 Id. 303A.07(b). 439 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of 1934, Rule 10A-3, Listing Standards Relating to Audit Committees, (b)(1)(i).

c. Committee Charter
The audit committee is to have a written charter. The charter must address the committee's purpose and function, procedures for conducting an annual self-evaluation, and the committee's duties and responsibilities. 440 At a minimum, the charter must specify that the committee has the responsibility to assist with board oversight of the integrity of the listed company's financial statements and compliance with legal and regulatory requirements. In addition, the independent auditor's qualifications and independence must be covered, as well as the performance of the listed company's internal audit function and independent auditors. 441 Finally, the charter must specify that the committee must prepare an audit committee report as required by the SEC for inclusion in the annual proxy. 442 The matters to be included in this report are set out in Section IV.B.2.f.(4)(iii), above.
440 New York Stock Exchange, Listed Company Manual, 303A.07(c). 441 Id. 442 Id.

d. Internal Audit Function


The NYSE requires all listed companies to have an internal audit function. Internal audit responsibilities assigned to the audit committee by the NYSE may not be delegated to a different committee. Internal audit does not have to be staffed by company employees; the company may outsource the internal audit function. 443
443 Id. 303A.07(d).

e. Duties and Responsibilities of the Audit Committee


The duties and responsibilities of an audit committee, set out in Rule 10-A3, Listing Standards for Audit Committees, are addressed in Section IV.B.2.f.(4)(ii), above. These include those responsibilities that are related to: (1) external auditors, (2) procedures for dealing with complaints, (3) authority to engage advisors, and (4) funding. (1) Responsibilities Relating to External Auditors

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The charter must describe the committee's responsibility for appointing, compensating, retaining, and overseeing the work of any registered public accounting firm that has been engaged. 444 Also, the charter must address the committee's responsibility for resolving disagreements between management and the auditor as they pertain to the auditor's annual audit report or any other audit, review, or attest services, and include a statement that external auditors report directly to the audit committee.
444 Id. 303A.07(c)(B)(iii).

(2) Additional Responsibilities In addition to addressing the foregoing matters, the charter must incorporate additional duties and responsibilities. The committee must evaluate the qualifications, performance, and independence of the external auditors at least annually. Moreover, the charter must cover the following additional responsibilities: 445
445 Id. 303A.07(c)(iii)(A)-(H).

Meet on an annual and quarterly basis with management and the independent auditors for the purpose of discussing the annual and quarterly financial statements, including reviewing management's discussion and analysis disclosures; Provide guidance regarding the release of financial information to media, analysts and rating agencies; Discuss company policies related to risk assessment and risk management; Periodically hold separate meetings with management, internal auditors, and the independent auditors; Meet with independent auditors to review audit problems and difficulties, as well as management's response to any such items; Set clear policies related to hiring employees or former employees of the independent auditors; and Report regularly to the board of directors. Comment: Since individuals are generally more open when potentially adversarial groups are not present, quarterly and annual sessions with management and the external auditors should usually be held separately. Such meetings are typically more effective than joint sessions in assuring that problems that may have arisen are discussed in an open and candid manner. (3) Evaluation of Independent Auditors At least annually, the committee should evaluate the qualifications, performance, and independence of the external auditors by obtaining and reviewing the independent auditor's report describing the audit firm's internal quality control procedures. 446 The committee should review any issues raised by a quality control or peer review that the audit firm has undergone. In addition, the committee should examine any inquiry or investigation of one or more of the firm's audits undertaken either by a professional organization or governmental authorities within the preceding five years, as well as any steps that were taken to remedy deficiencies that may have been revealed by the inquiry or investigation. Moreover, it is the committee's responsibility to examine all relationships between the company and the auditors in order to assess the auditor's independence. 447
446 Id. 303A.07(c)(iii)(A).

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447 Id.

In evaluating the external auditors' qualifications, performance, and independence, the NYSE suggests that the committee solicit the opinions of management and the internal audit staff. The process should include an evaluation of the lead partner's performance, and assuring the regular rotation of the lead partner every five years as required by SOX Section 203. Moreover, the NYSE suggests that the committee consider a regular rotation of audit firms to enhance independence. Comment: Research into the effect of audit firm tenure is mixed. Some findings suggest a favorable effect of longer auditor tenure. 448 According to this view, the favorable findings are a result of learning and carry-over effects whereby longer tenure enables an auditor to learn more about a client's risks, industry, and internal control. Shorter tenure is believed to impair independence because auditors initially lowball fees and give concessions to attract and retain clients. Other findings indicate that longer tenure impairs independence and audit quality. These findings suggest that longer tenure is associated with greater earnings management and auditors' increased reluctance to qualify opinions. 449 Accordingly, there is no clear support for the rotation of audit firms.
448 M. Knapp, Factors That Audit Committees Use as Surrogates for Audit Quality, 10 Auditing: A Journal of Practice and Theory 35-52 (1991). 449 A. Vanstraelen, Impact of Renewable Long-Term Audit Mandates on Audit Quality, 9 European Accounting Review 419-42 (2000).

After the committee has completed its evaluation of the auditors, it should present its findings to the full board. 450
450 New York Stock Exchange, Listed Company Manual, 303A.07(c)(iii)(A).

(4) Release of Financial Information The committee should review and discuss the adequacy of the company's guidelines covering the release of financial information to the media, financial analysts, rating agencies, trade associations, government agencies, and so forth. 451
451 Id. 303A.07(c)(iii)(C).

Planning Point: Guidelines might include the types of financial information to be released, the venues, and types of acceptable presentations. For example, the committee should discuss to whom analysts' inquiries should be directed, who within the organization should be authorized to release the information, the kinds of information to be released, and agreed-upon release dates. Standards should be established to designate which information is especially sensitive and at which level in the organization the information should be reviewed. (5) Risk Assessment and Control An important part of management's responsibilities is to assess and control the organization's risks, including business and financial risks. The audit committee should review the company's guidelines concerning risk assessment and discuss the effectiveness of the policies governing the process of evaluating and managing risks. 452
452 Id. 303A.07(c)(iii)(D).

Planning Point: In the process of reviewing these guidelines, the committee should

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seek the input of management, organizational components that currently perform risk assessments, if any, and the internal audit staff. In its deliberations, the committee should evaluate the adequacy of the current process and the proper venue within the organization for performing risk assessments. The committee should also discuss the organization's major risk exposures and the steps taken by management to monitor and control these exposures. Because setting appropriate policies governing risk analysis and control can prove to be a daunting task, especially in larger organizations, the company should consider hiring outside consultants who are conversant in risk assessment and control. (6) Discussions With Independent Auditor The committee has the important responsibility to meet regularly with the independent auditors to discuss the progress of the audit. 453 A number of items should be discussed. A prime consideration is any difficulties the auditor has encountered in the course of the audit work, including any restrictions on the scope of the auditor's activities or on access to requested information. The committee would want to know of any significant disagreements between the auditors and management. High on the list are accounting adjustments that were noted or proposed by the auditor but were passed as immaterial or otherwise. The committee should be aware of any communications between the audit team and the audit firm's national office respecting auditing or accounting issues presented by the engagement. The committee should ask for any management or internal control letter issued, or proposed to be issued, by the audit firm. Finally, because external auditors often work extensively with the company's internal audit staff, the committee should solicit the external auditors' views on the effectiveness of the internal audit function. Accordingly, the committee should inquire about such matters as the internal audit department's responsibilities, the department's staffing, and the adequacy of the department's budget.
453 Id. 303A.07(c)(iii)(F).

(7) Reporting to the Board In order to be effective when reporting to the board, the committee should review major issues regarding accounting principles and financial statement presentations, including any significant changes in the company's selection or application of accounting principles. 454 The committee should address important concerns regarding the adequacy of internal controls and any specific audit steps adopted in response to material control deficiencies. It should also carefully consider analyses prepared by management and/or the independent auditor setting forth significant financial reporting issues and judgments made in connection with the preparation of the financial statements, including analyses of the effects of alternative GAAP methods on the financial statements. 455 Other issues to be reviewed include the effect of regulatory and accounting initiatives, as well as off-balance sheet structures, on the financial statements, and the type and presentation of information to be included in earnings press releases. The committee should be paying particular attention to any use of pro forma, or adjusted non-GAAP, information, as well as review any financial information and earnings guidance provided to analysts and rating agencies. 456
454 Id. 303A.07(c)(iii)(H). 455 Id. 456 Id.

After performing its review, the committee should present its findings to the full board. The presentation should cover any issues affecting the quality or integrity of the financial statements, which would include the company's compliance with legal or regulatory requirements, the independence of the external auditors, and the performance of the company's internal audit function. 457

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457 Id.

7. Corporate Governance Guidelines


Due to the importance of corporate governance, each listed company must draft a set of corporate governance guidelines to be included on its Web site, together with the charters of the most important committees. At a minimum, the committees whose charters are represented should include the audit, compensation, and nominating committees. The guidelines should include key areas including director qualifications, responsibilities, and compensation, as well as the responsibilities of the major board committees. 458
458 Id. 303A.09.

In addition, a statement is to be included in the annual proxy statement, or the Form 10-K if the company does not file an annual proxy, indicating that the information is available on the company's Web site and in print to any shareholder who requests it. 459 Making this information available helps promote investor understanding of the company's policies and procedures, as well as to enhance management and board awareness of these provisions. The corporate governance guidelines that the NYSE requires all listed companies to cover are reproduced in Worksheet 23.
459 Id.

8. Code of Business Conduct and Ethics


The NYSE Listed Company Manual requires listed companies to adopt and disclose a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers. The code of ethics should be designed to focus management and the board on areas of ethical risk, provide guidance for personnel in dealing with ethical issues, offer a mechanism for reporting unethical conduct, and help promote an atmosphere of integrity and ethical conduct. 460
460 Id. 303A.10.

The code of ethics must be accompanied by compliance standards to ensure that a company takes fair, consistent, and prompt action when violations arise. Any waivers from the code that are granted to executive officers or directors can be authorized only by the board or a board committee and have to be disclosed to shareholders. 461 This provision should prevent waivers except for unusual or pressing circumstances and should assure that any waivers are accompanied by controls that deter abuse.
461 Id.

The code of ethics must be included on the company's Web site. A statement is to be included in the annual proxy statement, or the Form 10-K if the company does not file an annual proxy, indicating that the foregoing information is available on the company's Web site and that the code of ethics is available in print to any shareholder who requests it. 462 The NYSE allows a listed company to create its own codes of ethics. However, the NYSE does specify certain topics that should be addressed by all companies. These topics are reproduced in Worksheet 24.
462 Id.

9. Foreign Private Issuer Disclosure


Because corporate governance procedures vary from country to country, listed foreign private issuers

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need to make their U.S. investors aware of how their home country corporate governance practices differ from those prevalent in the United States. 463 The NYSE requires only a brief, general summary rather than extensive analysis.
463 Id. 303A.11.

Disclosure on the company's Web site is required. The site must be available in the English language and accessible in the United States. The fact that the disclosures are found on the Web site should be made known in the annual report, along with the Web site address. 464 Worksheet 25 illustrates the disclosures provided by Elan Corporation.
464 Id.

10. Certification Requirements


The CEO of each company must certify annually that he or she is not aware of any violations of NYSE corporate governance standards and is to qualify the report as required. 465 This certification, along with those required to be filed with the Form 10-K under SOX Section 302, are to be included in the company's annual report to shareholders. If the company does not issue an annual report, the certification is to be included in the Form 10-K. Section IV.A.2, above, describes the SOX certifications that are to be included in the Form 10-K. Each issuer also must submit to the NYSE annually an executed Written Affirmation. A company is to promptly notify the NYSE upon learning that it is not materially in compliance with NYSE corporate governance standards. Additionally, the company is to submit an interim Written Affirmation whenever there is a change in the composition of the board or any of the committees required by NYSE corporate governance standards. 466 The Written Affirmation form and instructions are available on the NYSE Web site. 467
465 Id. 303A.12. 466 Id. 467 The NYSE Web site can be found at http://www.nyse.com. Click on Listed Companies, and then Corporate Governance Forms to locate the Written Affirmations form.

11. Public Reprimand Letter


The NYSE sanctions companies for violations of the listing standards, including those pertaining to corporate governance. The sanctions range from a public reprimand letter to suspension of trading and delisting. 468 Since the more severe sanctions have a deleterious impact on shareholders, these measures are used sparingly. For initial violations, the NYSE will typically use the less severe sanction of issuing a public letter of reprimand. The more severe sanctions are still available for repeat offenders or more flagrant violations. 469 Letters of reprimand are not used when companies fall below the continued listing standards thresholds or fail to comply with the audit committee listing standards. The more severe sanctionssuspension and delistingare used in such situations. The continued listing standards are found in the NYSE Listed Company Manual, Section 802.01, Continued Listing Criteria. The NYSE's audit committee listing standards are found in Section IV.C.6, above.
468 New York Stock Exchange, Listed Company Manual, 303A.13. 469 Id.

12. Web Site Requirement


The NYSE requires all listed companies to create and maintain a public Web site. If a company is required to have committees (nominating/corporate governance, compensation, or audit committees) a printable version of the charters must be on the Web site. Those companies required to establish

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corporate governance guidelines and adopt a code of ethics must make printable versions of these documents available. 470 Foreign private issuer disclosures must appear on the Web sites of those companies. See Section IV.C.9, above, for more detail. The next section describes the types of companies that are exempted from certain of the NYSE corporate governance rules.
470 Id. 303A.14.

13. Exceptions to NYSE Corporate Governance Standards


Some companies are required to follow the SEC Rule 10A-3 requirements but are exempt from certain requirements of the additional NYSE audit committee found in the Listed Company Manual, Section 303A.07, Audit Committee Additional Requirements, which are discussed in Section IV.C.6, above. The types of companies exempt from certain additional NYSE audit committee requirements are controlled companies, limited partnerships and companies in bankruptcy, closed- and open-end funds, certain other entities, foreign private issuers, and companies that list only preferred or debt securities.

a. Controlled Companies
A controlled company is a listed company of which more than 50% of the voting power is held by an individual, a group or another company. 471 A controlled company is exempt from the corporate governance standards pertaining to director independence and the requirements to establish nominating and compensation committees. It must, however, comply with the rest of the rules. The company must disclose its choice to exercise these exemptions, stating that it is a controlled company, as well as the basis for using this designation. These disclosures should appear in the annual proxy statement or in the Form 10-K if the company does not issue an annual proxy statement. 472
471 Id. 303A.00. 472 Id.

b. Limited Partnerships and Companies in Bankruptcy


Limited partnerships and all companies in bankruptcy proceedings are not required to comply with the standards dealing with director independence and the requirements to establish nominating and compensation committees. 473 Companies in bankruptcy proceedings and limited partnerships at the general partner level must comply with the rest of the standards.
473 Id.

c. Closed-End and Open-End Funds


(1) Closed-End Funds Since closed-end funds are subject to the Investment Company Act of 1940, they are exempt from most of the NYSE corporate governance standards. 474 Closed-end funds must have an audit committee that satisfies the requirements of Rule 10A-3, Listing Standards Relating to Audit Committees. (See Section IV.C.6, above, for more details.) In addition, these funds must have an audit committee consisting of at least three members with one member having accounting or related financial management expertise as defined by the board. However, since the same board members typically serve all the funds in the complex, closed-end funds are exempt from the requirement to disclose simultaneous service of a member on more than three public company audit committees. 475 (See Section IV.C.6.a, above, for more details.) In addition, Rule 10A-3 requires companies to establish procedures allowing employees to submit confidential, anonymous information regarding questionable accounting or auditing matters.
476 The NYSE requires closed-end funds to establish those procedures for employees of the

management company plus implement similar procedures for employees of the investment adviser, administrator, principal underwriter, and any other provider of accounting services. This responsibility is

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to be included in the audit committee charter. 477


474 Id. 475 Id. 476 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of 1934, Rule 10A-3, Listing Standards Relating to Audit Committees, (b)(3)(iii), Complaints. 477 New York Stock Exchange, Listed Company Manual, 303A.00.

(2) Open-End Funds These funds must have an audit committee consisting of at least three members with one member having accounting or related financial management expertise as defined by the board. They are subject to the same requirement as closed-end funds regarding the extension of the complaint procedures (see previous section). 478
478 Id.

(3) Business Development Companies These entities are a type of closed-end management investment company. They are defined in the Investment Company Act of 1940, but not registered under that Act. Business development companies are required to adhere to all the corporate governance listing standards, except that standard pertaining to director independence. 479 A director of a business development company is considered to be independent if he or she is not an interested person as that term is defined in Section 2(a)(19) of the Investment Company Act. 480
479 Id. 480 Id.

d. Other Entities
The NYSE's corporate governance standards do not apply to passive business organizations. 481 The latter are organizations such as trusts, derivatives and special purpose securities as described in Sections 703.16, .19, .20, and .21 of the NYSE Listed Company Manual. To the extent that Rule 10A-3, Listing Standards Related to Audit Committees, applies to these entities, they must establish an audit committee in compliance with that Rule. Passive business organizations are also required to comply with the NYSE standard requiring entities to notify the NYSE of any material noncompliance. In the instance at hand, the notification pertains to any material noncompliance with the applicable audit committee provisions. (See Section IV.C.6, above). 482
481 Id. 482 Id.

e. Foreign Private Issuers


Companies that are foreign private issuers may follow home company corporate governance practices.
483 However, they must meet the Rule 10A-3 audit committee requirements. Foreign private issuers

are also required to comply with the NYSE standard requiring disclosure of differences between home company and U.S. corporate governance practices (see Section IV.C.9, above) and the standard requiring notification of material non-compliance (see Section IV.C.10, above). 484
483 Id.

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484 Id.

f. Preferred and Debt Listings


The corporate governance standards generally do not apply to companies that list only preferred or debt securities. 485 However, to the extent required by Rule 10A-3, Listing Standards Relating to Audit Committees, those companies listing only preferred or debt securities must comply with the NYSE listing standard, Section 303A.06, Audit Committee, which states, Listed companies must have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act. 486 The Rule 10A-3 guidance is set out in Section IV.B.2.f.(4), above. Additionally, the company must notify the NYSE whenever it is not materially in compliance with the audit committee requirements and also execute a Written Affirmation. 487 The non-compliance standard is covered in Section IV.C.10, above.
485 Id. 486 Id. 303A.06. 487 Id. 303A.00.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis IV. Corporate Governance and the Control Environment

D. NASDAQ Corporate Governance Standards


NASDAQ terms its corporate governance standards qualitative listing requirements. These apply to all listed companies except limited partnerships. Additionally, certain exemptions apply. These exemptions are found in Section IV.D.5, below.

1. Independent Directors
NASDAQ requires that a majority of the board of directors be independent as that term is defined in Rule 4200 of the NASDAQ Manual. Rule 4200 is reproduced in Worksheet 26. The listed company is required to disclose the names of the directors that the board has determined to be independent. The disclosure is to appear in the company's annual proxy or, if the company does not file a proxy, in its Form 10-K (or Form 20-F if a foreign private issuer). 488
488 NASDAQ Manual, 4350(c)(1).

If a company is unable to comply due to a vacancy or because one director ceases to be independent and the circumstances are beyond the control of the issuer, the company is required to comply by the earlier of its next annual shareholders meeting or one year from the event causing the noncompliance.
489 If the annual shareholders' meeting occurs 180 days or less after that event, the company is given

180 days from that date to regain compliance. As soon as the company learns of the event or circumstance causing the non-compliance, it is to notify NASDAQ of the circumstances. 490
489 Id. 490 Id.

a. Executive Sessions
Independent directors are to hold regular meetings composed only of independent directors. 491
491 Id. 4350(c)(2).

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b. Executive Officer Compensation


Chief executive officer compensation, as well as compensation for all other executive officers, must be determined, or recommended to the board for determination, either by a majority of the independent directors, or a compensation committee comprised solely of independent directors. 492 The CEO is not allowed to be present during the voting or deliberations on his or her compensation.
492 Id. 4350(c)(3).

c. Compensation Committee
NASDAQ does not require the listed company to form a compensation committee if executive officer compensation is determined by a majority of the independent directors. If a compensation committee is established, however, it must comprise solely independent directors. If the committee comprises at least three members, one non-independent director may serve on the committee (see Worksheet 26 for NASDAQ's definition of an independent director). 493 This individual may not be a current officer or employee of the company or a family member of an officer or employee. This appointment should be an exception, made only under limited circumstances, when, as determined by the board, the exception is in the best interests of the company and its shareholders. Moreover, the listed company must disclose this exception in the proxy statement for the next annual meeting following a determination that the exception is necessary. If the company does not file a proxy, the disclosure appears in the issuer's Form 10-K (or Form 20-F if a foreign private issuer), along with the nature of the relationship and the reasons for the exception. A member appointed under these circumstances cannot serve for more than two years. 494
493 Id. 494 Id.

d. Nomination of Directors
Nominees for director must be selected, or recommended for the board's selection, either by a majority of the independent directors, or a nominations committee comprising solely independent directors. 495 The company must certify that it has adopted a formal written charter or board resolution, as applicable, that describes the process for nominating directors and any related matters that may be required under the federal securities laws. 496
495 Id. 4350(c)(4)(A). 496 Id. 4350(c)(4)(B).

Independent director oversight of the nomination process does not apply in cases where the right to nominate a director rests with a third party. This exception is allowable only if the company is subject to a binding obligation that requires a director nomination process inconsistent with the NASDAQ procedures and the obligation pre-dates the approval date of the NASDAQ rules. The company is nevertheless required to comply with the committee composition requirements applicable to nominations and audit committees. 497
497 Id. 4350(c)(4)(D).

As indicated above, NASDAQ does not require the listed company to have a nominations committee if a majority of independent members carries out the nomination process. If a nominations committee is formed, however, it must comprise solely independent directors. If the committee comprises at least three members, one director who is not independent (see Worksheet 26 for NASDAQ's definition of an independent director) may be appointed. This individual cannot be a current officer or employee of the

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company or a family member of an officer or employee. The appointment is to come about only under limited circumstances, when the board determines that the exception is in the best interests of the company and shareholders. The issuer is to disclose the exception in the proxy statement for the next annual meeting subsequent to the board's decision that an exception is warranted. 498 If the company does not file a proxy, the disclosure is to appear in the issuer's Form 10-K (or Form 20-F if a foreign private issuer), along with the nature of the relationship and the reasons for the exception. A member who is appointed under these circumstances cannot serve for more than two years. 499
498 Id. 4350(c)(4)(C). 499 Id.

To obtain NASDAQ's booklet entitled Corporate Governance Guidelines for the Board of Directors, go to the NASDAQ website at http://www.nasdaq.com. 500
500 Once on the website, click on Investor Relations and Corporate Governance.

2. Audit Committee
SEC Rule 10A-3, Listing Standards Relating to Audit Committees, sets out the required standards for audit committees under the Securities Exchange Act of 1934. The SEC has required national securities exchanges and associations to craft regulations for listed companies. 501 The standards issued by NASDAQ in response to this SEC requirement are found in the sections that follow.
501 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of 1934, Rule 10A-3, Listing Standards Relating to Audit Committees, (a).

a. Committee Composition
NASDAQ requires each listed company to certify that it has and will continue to have an audit committee comprising at least three members. These members must possess certain characteristics. They must meet the independence criteria defined in Rule 4200(a)(15) of the NASDAQ Manual (which are set out in Worksheet 26, NASDAQ Definition of Independent Director). They must also meet the audit committee independence criteria set forth in Rule 10A-3(b)(1), subject to the exemptions provided in Rule 10A-3(c). 502 A discussion of these independence standards is found in Section IV.B.2.f.(4)(i), above. Rule 10A-3, paragraph (c) lists various exemptions to the audit committee requirements set out in the Rule.
502 NASDAQ Manual, 4350(d)(2)(A).

NASDAQ rules further require that audit committee members must not have participated in preparing the financial statements of the company or any current subsidiary of the company at any time during the past three years. They must be able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and statement of cash flows. Moreover, each listed company must certify that it has, and will continue to have, at least one member of the audit committee who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual's financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities. 503
503 Id.

A company may appoint one audit committee member who does not meet the NASDAQ independence criteria found in Worksheet 26. This individual is, however, required to meet the standards set forth in

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Section 10A(m)(3) of the Securities Exchange Act of 1934. 504 Those standards stipulate that each audit committee member must be a member of the board of directors. There are also compensation criteria that are more stringent than for general board members. The audit committee member cannot accept any consulting, advisory, or other compensatory fee from the company or be an affiliated person of the company or any of the company's subsidiaries. 505
504 Id. 4350(d)(2)(B). 505 Securities Exchange Act of 1934 (17 C.F.R. 240.12b-2), 10A, (m)(3).

For the independence exception to be valid under the NASDAQ rules, the individual may not be a current officer or employee, or a family member of an officer or employee. The appointment is to occur only as an exception under limited circumstances, and the board must determine that the exception is in the best interests of the company and shareholders. The company is required to disclose the exception in the proxy statement for the next annual meeting subsequent to the board's making its determination that the exception is advantageous to the company. If the company does not file a proxy, the disclosure is to appear in the issuer's Form 10-K (or 20-F if a foreign private issuer), along with the nature of the exception, as well as the rationale. A member who is appointed under these circumstances cannot serve for more than two years. 506
506 NASDAQ Manual, 4350(d)(2)(B).

Example: The NASDAQ independence requirements reproduced in Worksheet 26 contain a three-year lookback period for employees. Accordingly, to be considered independent, a director cannot have been an officer employed by the company within the previous three-year period. However, a former CFO who had just retired from the company's employ could become a member of the company's audit committee under the foregoing exception.

b. Committee Charter
NASDAQ requires each company to certify that it has adopted a formal written charter for its audit committee. Additionally, the committee is required to annually reassess the adequacy of its charter, which is to encompass the following matters: 507
507 Id. 4350(d)(1)(A)-(D).

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The committee's responsibilities and how it carries them out; Structure, procedures, and membership requirements; Its responsibility to ensure the receipt of a formal written statement from the external auditors delineating all relationships between the auditor and the company, consistent with Independence Standards Board's Standard No. 1, Independence Discussions With Audit Committees; Its responsibility to discuss with the outside auditors any relationships or services that may impact their independence; Its responsibility for taking appropriate action to oversee the independence of the outside auditor or for recommending that the full board take such action; The committee's oversight function as it pertains to the company's accounting and financial reporting processes and the financial statement audits; and The responsibilities and authority that are required to assure the committee is in compliance with SEC Rule 10A-3, Listing Standards Relating to Audit Committees. The specific responsibilities of audit committees are covered in the next section.

c. Specific Responsibilities of Audit Committees


As indicated in the previous section, each audit committee is to have the authority necessary to meet its responsibilities under SEC Rule 10A-3. The specific responsibilities enumerated in that standard cover: (1) those functions pertaining to registered public accounting firms; (2) procedures for handling complaints and the confidential, anonymous submission of concerns regarding questionable accounting or auditing matters; (3) the authority to engage advisors as the committee deems necessary; and (4) the authority for adequate funding to enable the committee to effectively carry out its functions. 508 These four items are enumerated in Section IV.B.2.f.(4)(ii), above.
508 Id. 4350(d)(3).

Investment company audit committees have the additional responsibility to extend the procedures for handling confidential anonymous submissions beyond their own employees. These procedures are to be made available to employees of the investment adviser, administrator, principal underwriter, or any other provider of accounting related services for the investment company. 509
509 Id.

d. Exemption From NASDAQ Audit Committee Standards


If a company lists certain securities of: (1) a direct or indirect consolidated subsidiary, or (2) a subsidiary that is at least 50% beneficially owned by the issuer, those securities are not subject to the NASDAQ audit committee requirements. Equity securities are not exempt, except for non-convertible, non-participating preferred stock. Additionally, the issuer must have listed on another national securities exchange or association a class of equity or similar securities that are subject to the requirements of SEC Rule 10A-3. 510
510 Id. 4350(d)(5).

3. Notification of Material Noncompliance


If a company finds that it is not materially in compliance with the NASDAQ qualitative listing

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requirements covering corporate governance as set out in the NASDAQ Manual, Section 4350, the company is required to promptly notify NASDAQ that it is non-compliant. 511
511 Id. 4350(m).

4. Code of Conduct
NASDAQ qualitative listing requirements require each company to adopt a code of conduct that pertains to directors, officers, and employees. This code is to be publicly available, typically on the issuer's Web site. The code must comply with the rules pertaining to a code of ethics as set out in SOX Section 406(c), as well as the rules issued by the SEC to assure compliance with SOX. 512 The company must also set up enforcement procedures. Waivers for directors or executive officers require board approval and are required to be disclosed on a Form 8-K and filed within four business days of the waiver authorization. (Foreign private issuers should disclose waivers either on Form 6-K or the next regularly filed Form 20-F or 40-F.) 513
512 Id. 4350(n). 513 Id.

5. Exemptions From the NASDAQ Qualitative Listing Standards


With few exceptions, NASDAQ qualitative listing requirements apply to all listed companies except limited partnerships. The exemptions are set out in the paragraphs that follow.

a. Foreign Private Issuers


A foreign private issuer may follow its home country corporate governance practices rather than those promulgated by NASDAQ. If the company does so, it must disclose in its annual SEC filings each NASDAQ requirement that is not followed and describe the alternative home country practice. 514
514 Id. 4350(a).

A foreign private issuer making its initial public offering or first U.S. listing on NASDAQ is required to make these same disclosures in its registration statement. Additionally, the issuer must have an audit committee that satisfies the audit committee responsibilities and independence requirements that are found in SEC Rule 10A-3, Listing Standards Relating to Audit Committees. 515
515 SEC, General Rules and Regulations Promulgated Under the Securities Exchange Act of 1934, Rule 10A-3, Listing Standards Relating to Audit Committee.

b. Management Investment Companies


Management investment and business development companies are subject to all the NASDAQ qualitative listing requirements, except that management investment companies subject to the Investment Company Act of 1940 are exempt from: (1) the independent director requirements, and (2) the provision to adopt a code of conduct. 516
516 NASDAQ Manual, 4350(a).

c. Asset-Backed Issuers and Other Passive Issuers


The following types of entities are exempt from those provisions pertaining to director independence, as well as the requirements to form an audit committee and adopt a code of conduct: 517

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517 Id.

Asset-backed issuers; Other passive entities; Unit investment trusts that are organized as trusts; Other unincorporated associations that Do not have a board of directors or persons acting in a similar capacity, and Engage in activities that are limited to passively owning or holding, as well as administering and distributing, amounts associated with securities, rights, collateral or other assets on behalf of, or for the benefit of, the holders of the listed securities.

d. Cooperatives
Cooperative entities, such as agricultural cooperatives, are often structured solely to comply with relevant state law and with federal tax law. Typically, they do not have a publicly traded class of common stock. These entities are exempt from the requirements that deal with the independence of directors. Nevertheless, they must comply with all federal securities laws, including Section 10A(m) of the Exchange Act, Standards Relating to Audit Committees, and Rule 10A-3, Listing Standards Relating to Audit Committees. 518
518 Id.

e. Controlled Companies
A controlled company is a company in which more than 50% of the voting power is held by an individual, a group, or another company. These companies are exempt from the requirement that the board is to consist of a majority of independent directors. 519 Nevertheless, those independent directors on the board must hold regularly scheduled executive sessions. A controlled company that relies on this exemption is required to disclose that it is a controlled company and the rationale for its designation as such. These disclosures are to appear in the annual proxy or, if a proxy statement is not filed, in the Form 10-K (or Form 20-F, if a foreign private issuer). 520
519 Id. 4350(c)(5). 520 Id.

E. Corporate Governance Summary and Illustrative Cases The previous sections provide an extensive discussion of the numerous corporate governance features that have emerged in the wake of Sarbanes-Oxley. These measures are summarized in Worksheet 27. When appropriately implemented, corporate governance measures provide an effective mechanism for preventing and detecting deceptive practices. Worksheet 28 contains a number of SEC enforcement actions that illustrate how corporate governance failures can lead to the inappropriate use of company assets and services. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis V. Financial Statement Audit Issues

A. AICPA Audit Rules

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The controlling audit pronouncement dealing with related parties is AICPA Statement on Auditing Standards 45, Omnibus Statement on Auditing Standards1983, which supersedes AICPA Statement on Auditing Standards 6, Related Party Transactions. SAS 45 is codified as AU Section 334, Related Parties, in AICPA, Professional Standards, Vol. 1. Planning Point: Management should become familiar with auditing requirements dealing with related party transactions because such an awareness can aid in management's development of effective controls for assuring the proper accounting and disclosure of related party transactions. Such controls can facilitate a SOX 404 audit of internal control. Moreover, management can better prepare not only for both the audit of internal controls, but also for the audit of financial statements. Supplying external auditors with the necessary documentation and accounting records will help assure a smooth-functioning audit and can reduce audit fees.

1. Accounting Considerations
As indicated in Section II.A, above, FASB ASC 850 sets out the accounting and disclosure requirements for related party transactions. Although the accounting treatment of related party transactions is usually not different from those transactions between or among unrelated parties, the nature of related party transactions requires special considerations. Accordingly, the adequacy of disclosure is of primary importance. This caution is warranted since related party transactions are not always what they purport to be. As noted in SAS 45, the auditor should be aware that the substance of a particular transaction could be significantly different from its form and that financial statements should recognize the substance of particular transactions rather than merely their legal form. 521
521 AU 334.02.

Comment: The issuance of SAS 6 in 1975 was unusual in that this standard effectually promulgated accounting rules for the disclosure of related party transactions. No accounting pronouncements on related parties were in force at the time, except for rules concerning the classification of receivables found in ARB 43. In fact, an accounting pronouncement dealing specifically with related party transactions was not published until 1982, when FASB issued FAS 57, which does not differ substantially from SAS 6. FASB remarked at the time it issued FAS 57, The Board has not undertaken a comprehensive reconsideration of the accounting and reporting issues discussed in SAS 6 and related interpretations thereof. The related party disclosure requirements contained in those documents have been extracted without significant change, except that this Statement does not address the issues pertaining to economic dependency.
522 SAS 6 had required consideration of one entity's economic dependence on another,

for example, a large retailer being the sole customer of a small supplier. SAS 6 indicated that disclosure of the relationship may be necessary if one entity exercises significant management or ownership influence over the other. 523 FASB indicated it may take up this issue at a later time. One other notable difference is the succinctness of FAS 57 compared to SAS 6. This aspect can be a blessing in today's world of overly prescriptive accounting pronouncements. The downside is that the codified rules under FASB ASC 850, which are based primarily on FAS 57, provide less guidance.
522 FAS 57, 10 (background material not codified). 523 AICPA Statement on Auditing Standards No. 6, Related Party Transactions (1975).

Auditing standards caution auditors to be alert to certain types of transactions whose nature suggests that they may be of the kind consummated with related parties, including: 524
524 AU 334.03.

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Borrowing or lending on an interest-free basis or at a rate significantly above or below market rates prevailing at the time of the transaction; Selling real estate at a price that differs significantly from its appraised value; Exchanging property for similar property in a nonmonetary transaction; and Making loans with no scheduled terms for when or how the funds will be repaid. Comment: Even if transactions between related parties are not recorded, they are considered to be related party transactions. 525
525 FASB ASC 850-10-05-5; FAS 57, 1. See also AU 334.03 n.3.

2. Audit Procedures
An audit designed to reveal the proper treatment of related party transactions should generally have the following seven steps: Carrying out procedures to become aware of the possible existence of related party transactions; Becoming familiar with the dynamics, business model and processes by obtaining a thorough understanding of the enterprise; Conducting procedures to become aware of existing conditions that may provide motivation for related party transactions; Determining the existence of related parties; Identifying transactions with related parties; Examining identified related party transactions; and Performing more extensive procedures when confronted with unusual or complex circumstances.

a. Gaining an Awareness of Related Party Transactions


Paragraph 4 of AU Section 334 indicates that an audit performed in accordance with GAAP cannot be expected to provide assurance that all related party transactions will be discovered. 526 Nevertheless, in addition to being familiar with the disclosure requirements set out in FASB ASC 850, auditors are cautioned to be aware of the possible existence of related party transactions. As part of this process, auditors are directed to obtain: 527
526 AU 334.04. 527 Id.

The names of those individuals who are defined as related parties in FASB ASC 850; and A listing of common ownership or control relationships. Throughout an engagement, auditors conduct many procedures that may reveal related party transactions. Other procedures specifically targeting related party transactions are set out in SAS 45

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(AU 334). Comment: While Paragraph 4 of AU Section 334 indicates that an audit cannot be relied on to reveal all related party transactions, an audit conducted in accordance with Generally Accepted Auditing Standards is supposed to be designed to provide reasonable assurance that material related party transactions are detected and disclosed. In this regard, AU Section 110, Responsibilities and Functions of the Independent Auditor, states: 528
528 AU 110.02.

The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute assurance that material misstatements are detected. Planning Point: In order to be more effective in uncovering material related party transactions, auditors are directed to comply with all applicable auditing standards, especially AICPA Statement on Auditing Standards 99 (AU 316), Consideration of Fraud in a Financial Statement Audit. 529 The successful prosecution of auditors has often come about because defendants were not able to satisfy the court that their audit procedures were effective and complete. With the passage of SOX, auditors have an additional defense. SOX Section 303 makes it unlawful for management to knowingly mislead an auditor. 530 Consequently, it is in management's best interest to fully cooperate with auditors by revealing all known related party transactions.
529 AU 316. 530 SOX 303(a).

b. Becoming Familiar With the Enterprise


Normally, the structure of the entity and the manner by which its operations are conducted are a function of: (1) management's abilities and talents, (2) tax and legal considerations, (3) product diversification, and (4) geographic dispersion. Nevertheless, corporate structure and/or operating style may have been designed to conceal related party transactions. 531 For this reason, when determining the procedures for revealing, accounting for, and disclosing material related party transactions, auditors are instructed to become aware of the many aspects of enterprise dynamics, including: 532
531 AU 334.05. 532 Id.

An understanding of management responsibilities and operating style; The relationship of each component to the total entity; The business purpose served by each component; and Controls over management activities.

c. Indicators of Related Party Transactions


AU Section 334.06 indicates that an auditor should not assume that related party transactions are

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outside the ordinary course of business unless evidence indicates otherwise. 533 However, AU Section 334.06 points out that certain conditions may have been the impetus for related party transactions, including: 534
533 AU 334.06. 534 Id.

A lack of sufficient working capital or credit to continue in business; An urgent desire for a continued favorable earnings record in the hope of supporting the price of the company's stock; An overly optimistic earnings forecast; Dependence on a single or relatively few products; A declining industry characterized by a large number of business failures; Excess capacity; Significant litigation, especially litigation between stockholders and management; and Significant obsolescence dangers because the company is in a high-technology industry. Each of the foregoing conditions may provide incentive for recording fraudulent related party transactions or related party transactions that management is reluctant to disclose.

d. Determining the Existence of Related Parties


Early in the process, auditors should determine the parties that are related to the entity in order to compile a listing of related parties and the possible existence of related party transactions. An initial step consists of reviewing the corporate structure to ascertain the company's subsidiaries and investees. In addition, AU Section 334.07 suggests following these procedures: 535
535 AU 334.07.

Evaluating the company's internal procedures aimed at identifying and properly accounting for related party transactions; Asking management to supply the names of all related parties; Inquiring whether there were any transactions with the related parties that management has identified; Reviewing filings with the SEC and other regulatory agencies to ascertain the names of related parties and other businesses in which officers and directors may hold management or directorship positions; Obtaining the names of all pensions and other trusts established for the benefit of employees, as well as the names of the officers and trustees of these entities; Reviewing stockholder listings of closely held companies to identify principal stockholders; Reviewing prior years' working papers for the names of known related parties; Inquiring of predecessor, principal, or other auditors of related entities concerning their

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knowledge of existing relationships and the extent of management involvement in material transactions; and Reviewing material investment transactions during the period under audit to determine whether the nature and extent of investments during the period create related parties. If part of the audit examination is being conducted by other auditors, the principal auditor and the other auditors are to exchange information on known related parties. This discussion should take place early in the planning stages of the engagement. 536
536 AU 9334.12 and .13

In addition to the procedures outlined above, an auditor should consider obtaining representations from senior management and the board of directors as to whether they have engaged in transactions with the entity during the period covered by the audit engagement. 537 Auditing standards point out that there are risks associated with management's representations in that management is not an independent source of evidence. Accordingly, auditing standards caution auditors to assess any financial statement assertions regarding related party transactions with more scrutiny than those associated with other types of evidential matter. The reason is that management may be using related party transactions to conceal fraud, defalcations, or undisclosed compensation. 538
537 AU 9334.20 and .21. 538 AU 9334.18.

e. Identifying Transactions With Related Parties


Once auditors identify parties that are related to the entity under examination, subsequent steps include: 539
539 AU 334.08.

Determining whether there were transactions between the identified parties and the entity; and Identifying transactions that may indicate the existence of related parties that the auditors were previously unaware of. AU Section 334.08 enumerates the following procedures that are aimed at achieving these two objectives: 540
540 Id.

Provide audit personnel performing segments of the audit or auditing and reporting separately on the accounts of related components of the reporting entity with the names of known related parties so that they may become aware of transactions with such parties during their audits; Review the minutes of meetings of the board of directors and executive or operating committees for information about material transactions authorized or discussed at their meetings; Review proxy and other material filed with the SEC and comparable data filed with other

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regulatory agencies for information about material transactions with related parties; and Review conflict-of-interest statements. Planning Point: Conflict-of-interest statements can benefit both management and auditors since they are a good tool for revealing previously unidentified related party transactions. Many organizations direct the internal audit department to canvass all employees to determine the existence of conflicts of interest and, ultimately, related party transactions. Here are additional procedures often used by auditors to identify transactions with related parties: 541
541 Id.

Review the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of previously undisclosed relationships; Consider whether transactions are occurring, but are not being given accounting recognition, such as receiving or providing accounting, management or other services at no charge, or a major stockholder absorbing corporate expenses; Review accounting records for large, unusual, or nonrecurring transactions or balances, paying particular attention to transactions recognized at or near the end of the reporting period; Review confirmations of compensating balance arrangements for indications that balances are or were maintained for or by related parties; Review invoices from law firms that have performed regular or special services for the company for indications of the existence of related parties or related party transactions; and Review confirmations of loans receivable and payable for indications of guarantees and determine their nature and the relationships, if any, of the guarantors to the reporting entity.

f. Examining Related Party Transactions


Having identified related party transactions, the next step is to apply auditing procedures to obtain sufficient, competent evidential matter. Auditors' procedures should be extensive enough to determine the purpose and extent of related party transactions and their impact, if any, on the financial statements. 542
542 AU 334.09.

Inquiry of management is a starting point for these purposes. However, taken alone, management representations do not constitute sufficient competent evidence. Accordingly, management representations need to be corroborated with supporting evidence. 543
543 Id.

AU Section 334.09 states that an auditor should consider utilizing the following procedures to examine the related party transactions that were identified: 544

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544 Id.

Obtain an understanding of the business purpose of the transaction; Examine invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents; Determine whether the transaction has been approved by the board of directors or other appropriate officials; Test for reasonableness the compilation of amounts to be disclosed, or considered for disclosure, in the financial statements; Arrange for the audits of intercompany account balances to be performed at concurrent dates, even if the fiscal years differ, and for the examination of specified, important, and representative related party transactions for each of the related parties, with appropriate exchanges of relevant information; and Inspect or confirm and obtain satisfaction concerning the transferability and value of collateral. Auditors' procedures should be extensive enough to provide reasonable assurance that the financial statements are free of material misstatement. Since the true nature of related party transactions may be purposefully obscured, such transactions represent a greater audit risk than similar transactions carried out at arm's-length. Accordingly, auditors are cautioned to scrutinize related party transactions more closely. In assessing audit risk, auditors are to obtain an understanding of the business purpose of the transaction. Unless auditors understand the business purpose, an audit cannot be completed without having a scope limitation that would preclude an unqualified opinion. 545 Understanding the purpose of related party transactions may require consulting with experts having the requisite knowledge of the transactions. In addition, auditors may have to obtain the audited or unaudited financial statements of the related party and apply audit procedures at the related party's premises, and/or audit the financial statements of the related party. 546
545 For a more detailed treatment of auditors' opinions, see 5400, Auditors' Reports (Accounting Policy and Practice Series). 546 AU 9334.17 and .19.

The so-called Continental Vending case illustrates the importance of auditing a related party's financial statements when questions remain unanswered. 547 In that case, Harold Roth, president of Continental Vending, directed funds to be diverted to Valley Commercial Corporation, a company in which Roth had a controlling interest. Roth diverted funds to Valley, thereby creating a large receivable on Continental's balance sheet. When Roth was unable to repay, Continental Vending went into receivership. The auditors declined to examine Valley's financial statements. Had they done so, they probably would have discovered that the receivable from Valley was worthless. The auditors were found guilty of filing false statements in violation of the Securities Exchange Act of 1934.
547 U.S. v. Simon, 425 F.2d 796 (2d Cir.1969).

Planning Point: This case illustrates the joint responsibility of management and auditors for the sufficiency of evidence. Auditors need to attain sufficient competent evidence even if that means auditing an affiliate. Management is responsible for providing access to the financial statements and records of all affiliated entities. When there is a principal auditor-other auditor relationship, the principal auditor may perform the audit

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of the affiliate's books, or may request the other auditor to do so. If the other auditor has already conducted the audit, the principal auditor should request relevant portions of those working papers that may be required to understand complex or unusual transactions. The other auditor ordinarily should allow the principal auditor access to those working papers. 548
548 AU 9334.15.

g. Performing More Extensive Procedures


In ordinary situations, the procedures enumerated in the preceding section may be sufficient. At times, auditors may need to conduct more extensive procedures in order to fully understand a related party transaction or series of transactions. When unusual or complex situations are encountered, auditors are supposed to consider modifying the nature, extent, and/or timing of audit procedures. In such circumstances, AU Section 334.10 suggests that auditors carry out the following procedures: 549
549 AU 334.10.

Confirm transaction amounts and terms, including guarantees and other significant data, with the other party or parties to the transaction; Inspect evidence in possession of the other party or parties to the transaction; Confirm or discuss significant information with intermediaries, such as banks, guarantors, agents, or attorneys, to obtain a better understanding of the transaction; Refer to financial publications, trade journals, credit agencies, and other information sources when there is reason to believe that unfamiliar customers, suppliers, or other business enterprises with which material amounts of business have been transacted may lack substance; and With respect to material uncollected balances, guarantees, and other obligations, obtain information about the financial capability of the other party or parties to the transaction. The foregoing information may be obtained from: Audited financial statements; Unaudited financial statements; Income tax returns; and Reports issued by regulatory agencies, taxing authorities, financial publications, or credit agencies. With regard to determining the financial viability of a counterparty, auditors should assure that he or she has obtained an adequate degree of assurance. When the available information does not provide sufficient assurance regarding the other party's financial viability, there is a limitation on the scope of the audit, which necessitates a modified audit opinion. 550
550 See generally AU 334.10.e, 508.22.

h. Adequacy of Financial Statement Disclosures


The disclosures required by FASB ASC 850 are outlined in Section II.A.2, above. To adequately address these disclosure requirements, AU Section 334.11 instructs an auditor to gain an understanding of: (1)

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the relationship of the parties involved, and (2) the effect of related party transactions on the financial statements for each: 551
551 AU 334.11.

Material related party transaction (or aggregation of similar transactions); Common ownership; and/or Control relationship. An auditor is cautioned to obtain sufficient, competent evidence to assure that he or she has an understanding of each of the foregoing. When an auditor is convinced that he or she has obtained enough evidence to gain the required understanding, the auditor will evaluate all the available evidence and decide whether: (1) the disclosures are adequate, (2) the transactions have been properly accounted for, and (3) all requirements set out in FASB ASC 850 have been addressed. If management omits related party disclosures required to make the financial statements not misleading, auditing standards stipulate a qualified or adverse opinion. AU Section 431, Adequacy of Disclosure in Financial Statements, indicates that an auditor should provide the omitted information in his or her report if that is practicable. In this context, the term practicable means that the information is reasonably obtainable from management's accounts and records and that providing the information in the report does not require the auditor to assume the position of a preparer of financial information.
552 552 AU 431.03.

i. Representations That Infer Comparability With Arm's-Length Transactions


At times, preparers of financial statements and reports may include statements to the extent that related party transactions were entered into under terms equivalent to those prevailing in arm's-length transactions. If these representations are included, the preparer must be able to substantiate them in accordance with FASB ASC 850, which states that such representations cannot be included in financial statement disclosures unless the representations can be substantiated. 553 (See Section II.A.4, above.) Since it is usually not possible to ascertain comparability to arm's-length transactions, such representations are difficult to substantiate. If these representations are included and an auditor believes they are unsubstantiated, a modified opinion is called for. Depending on the materiality of the transactions, auditing standards call for a qualified or adverse opinion due to a departure from GAAP.
554 553 FASB ASC 850-10-50-5; FAS 57, 3. 554 AU 334.12. Opinion modifications due to a departure from GAAP because of inadequate disclosure are found in AU 508.41.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Detailed Analysis V. Financial Statement Audit Issues

B. PCAOB Audit Rules


SOX requires public accounting firms that audit public companies to register with the Public Company Accounting Oversight Board (PCAOB) and adhere to professional standards established by that Board for audits of public companies. On June 5, 2003, the SEC issued Release No. 33-8238 to implement Section 404(a) of SOX, which requires management to include in the annual report to shareholders their

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assessment of the effectiveness of the company's internal control. Under Section 404(b) of SOX, the company's external auditors must attest to and report on this assessment. 555 In that same year, the PCAOB issued PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements, to provide guidance to external auditors. 556 Three years later, this standard was superseded by PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated With An Audit of Financial Statements. 557
555 This requirement pertains to accelerated filers for their fiscal years beginning on or after November 15, 2004. Accelerated filers are defined in SEC Release Nos. 33-8128 and 33-8128A. See Management's Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Securities Act Release No. 8392, Exchange Act Release No. 49,313, Investment Company Act Release No. 26,357, 69 Fed. Reg. 9722 (Mar. 1, 2004). After several SEC extensions to delay this requirement for non-accelerated filers, Congress granted non-accelerated filers a permanent exemption from Section 404(b) of SOX. Dodd-Frank Wall Street Reform and Consumer Protection Act, 111-203, 989G (July 21, 2010) (amending Section 404 of SOX). See 5402, Internal Controls: Sarbanes-Oxley Act 404 and Beyond (Accounting Policy and Practice Series), at Section III.A. 556 PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements (Mar. 9, 2004). 557 PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated With An Audit of Financial Statements (May 24, 2007).

1. Approach to the Audit


PCAOB Auditing Standard No. 5 differs from PCAOB Auditing Standard No. 2 in that PCAOB Auditing Standard No. 5 takes a top-down approach, beginning with an assessment of overall control risks. 558 Accordingly, the auditor is to identify risks that controls will not prevent, detect, and/or correct financial statement errors. The focus begins with controls at the entity level and works down to significant accounts, classes of transactions, and financial statement disclosures. Entity-level controls include, for example, audit committee oversight, the internal audit function, and codes of ethics. Next is identification of the financial statement assertions that are related to accounts, classes of transactions, and disclosures. After confirming his or her understanding of the company's processes and control procedures, the auditor assesses the control risks associated with all assertions pertaining to the aforementioned accounts, classifications, and disclosures.
558 Id. 21.

With these assessments, the auditor is in a position to select controls for testing. Those that are selected should address control risks that have been identified for each of the relevant financial statement assertions associated with the significant accounts, classes of transactions, and disclosures.
559 Having tested those controls, the auditor evaluates any deficiencies and communicates them, as well as any control weaknesses, to appropriate company officials. 560 The auditor also obtains written

representations from management concerning the effectiveness of internal control. 561


559 Id. 39. 560 Id. 62-70, 78-84. 561 Id. 75-77.

The auditor's opinion on the effectiveness of internal control over financial reporting relates to a point in time and taken as a whole. 562 The time dimension implies that the auditor must be assured that

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controls have operated effectively for a sufficient length of time. The idea behind internal control taken as a whole is that there is evidence of little control risk for all financial statement assertions that are associated with the identified significant accounts, classes of transactions, and financial statement disclosures. An unqualified opinion is precluded if any material weaknesses in internal control are identified. In that instance, the auditor is required to render an adverse opinion on the effectiveness of internal control over financial reporting. 563
562 Id. B1-B2. 563 Id. 90.

Comment: Unlike the earlier standard, PCAOB Auditing Standard No. 5 does not require a report on management's assessment of internal control unless that assessment is deficient in some respect. 564 The auditor is required to modify the audit report if management's internal control certifications required by SOX Section 302 and the Securities Exchange Act are misstated. 565
564 Id. C2. 565 Id. C1, C15; Securities Exchange Act of 1934, Rules 13a-14(a) and 15d-14(a).

2. Related Party Aspects of an Internal Control Audit


Embedded within the internal control audit are a number of considerations dealing specifically with related parties and related party transactions. The issues include: Fraud considerations; Identifying significant accounts; Evaluating deficiencies in internal control over financial reporting; and The effect of substantive procedures on the auditor's conclusions about the operating effectiveness of controls. Each of these topics is discussed in the following sections.

a. Fraud Considerations
Management is responsible for establishing controls designed to prevent, deter, and detect fraud. Such controls, in conjunction with a culture of honesty and integrity, can contribute significantly toward reducing the incentives and opportunity to commit fraud. Controls designed specifically to address the risk of fraud are typically of a broad and overarching nature and therefore are pervasive throughout the organization. PCAOB Auditing Standard No. 5 specifically states that controls over related party transactions are important in addressing the risk of fraud. 566 Examples of these types of controls include audit committee oversight, internal audit, self-assessment, internal risk assessment, and conflict of interest statements. PCAOB Auditing Standard No. 5 requires auditors to identify risks that material misstatements may occur due to fraud and evaluate whether controls adequately address those risks.
567 566 PCAOB Auditing Standard No. 5, 14. 567 Id.

b. Identifying Significant Accounts

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The top-down approach of PCAOB Auditing Standard No. 5 begins with an assessment of overall control risks, a procedure that, of necessity, requires the auditor to obtain an understanding of the company's business processes, operations, and accounting and control procedures. Having obtained this organizational knowledge, the auditor is in a position to identify those accounts, classes of transactions, and financial statement disclosures that are significant. The term significant, as used in the standard, means those accounts and disclosures that have a reasonable possibility of being materially misstated.
568 Accordingly, identifying significant accounts is an important aspect of determining the scope of the

internal control audit.


568 Id. A10.

PCAOB Auditing Standard No. 5 indicates that an auditor needs to evaluate the qualitative and quantitative risk factors that are associated with the various financial statement line items and disclosures. The auditor should consider the following risk factors when deciding which accounts pose significant exposure. The existence of related party transactions is among these considerations: 569
569 Id. 29.

Size and composition of the account; Susceptibility to misstatement due to errors or fraud; Volume of activity, complexity, and homogeneity of the individual transactions processed through the account or reflected in the disclosure; Nature of the account or disclosure (for example, suspense accounts generally warrant greater attention); Accounting and reporting complexities associated with the account or disclosure; Exposure to losses in the account (for example, loss accruals related to a consolidated construction contracting subsidiary); Likelihood (or possibility) of significant contingent liabilities arising from the activities reflected in the account or disclosure; Existence of related party transactions in the account [emphasis added]; and Changes from the prior period in the characteristics of the account or disclosure (for example, new complexities, altered circumstances, increased subjectivity or new types of transactions). Comment: Although the dollar amounts of related party transactions in an account may be important, a more significant aspect of these transactions is the possibility of fraudulent activities.

c. Evaluating Control Deficiencies


Auditors may find that a company's controls are insufficient to assure the timely disclosure of related party transactions. Whether this finding would preclude the issuance of an unqualified opinion depends on the severity of the control deficiency and the likely impact on the financial statements. According to PCAOB Auditing Standard No. 5, an internal control deficiency exists when the design or operation of a control does not allow for the timely prevention or detection of misstatements. 570 Paragraph A11 of the Standard defines a significant internal control deficiency as one that is less severe than a material weakness but sufficiently important to warrant attention from those who are responsible for overseeing

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the financial reporting process (e.g., the audit committee of the board of directors). 571
570 Id. A2. 571 Id. A11.

Example: A company does not reconcile its intercompany transactions. If the auditor expects the impact of a misstatement to be significant but not material, the deficiency would be considered a significant deficiency but not a material weakness because the impact on the financial statements is not material. To formulate an opinion on internal control, an auditor has to evaluate all the evidence obtained in the audit. If the auditor finds that controls are unreliable and that a material weakness exists, PCAOB Auditing Standard No. 5 calls for an adverse opinion on the effectiveness of internal control. Paragraph A7 defines a material weakness as, a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. 572 The term reasonable possibility used in PCAOB Auditing Standard No. 5 is not analogous to the term reasonably possible as used in FASB ASC 450, Contingencies. 573 In PCAOB Auditing Standard No. 5, the term reasonable possibility contemplates a broader probability range encompassing the two FASB ASC 450 intervals: reasonably possible and probable. 574
572 Id. A7. 573 FASB ASC Term Reasonably Possible; FASB Statement No. 5, Accounting for Contingencies, 3. ([T]he chance of the future event or events occurring is more than remote but less than likely.). 574 PCAOB Auditing Standard No. 5, A7.

Identifying material weaknesses requires auditors to: (1) examine identified deficiencies to determine whether any should be classified as significant deficiencies, and (2) consider whether to classify any of the significant deficiencies as material weaknesses. Considerable professional judgment is required when assessing the significance of a deficiency. Auditors should consider: The potential for a misstatement, not whether a misstatement has actually occurred; The impact of a deficiency, including the amounts or totals of transactions exposed and the volume of transactions in the affected accounts; and How the interaction of controls with other controls, including their interdependence and redundancies, affects their proper functioning. Differentiating a significant deficiency from a material weakness is highly subjective. The distinguishing characteristic of a material weakness is the existence of a reasonable possibility that a material misstatement will not be prevented or detected on a timely basis. Determining just what constitutes a material weakness is a tough call. The difficulty lies in operationalizing the phrase reasonable possibility. A practical way for an auditor to proceed is as follows: Estimate the monetary impact of each weakness uncovered; Assign a material misstatement likelihood factor to each weakness, for example, remote, reasonably possible, probable, similar to the labels found in FAS 5; Rank all weaknesses on this material misstatement likelihood factor; Denote all weaknesses with more than a remote likelihood as material weaknesses;

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Determine the significance of the remaining deficiencies by reviewing the estimated monetary impact of each; and Examine those deficiencies designated significant to decide whether a combination thereof constitutes a material weakness.

d. Effect of Substantive Procedures


A significant component of a financial statement audit consists of testing dollar amounts. These testing procedures are termed substantive tests. The results of these tests may directly impact an auditor's assessment of the adequacy of internal control. For example, substantive testing may reveal a material misstatement in the financial statements. If this misstatement was not identified by the company, the usual conclusion is that a material control weakness exists. Accordingly, the stronger the company's controls, the lower the likelihood of a material misstatement that may result in an adverse opinion on the controls. According to PCAOB Statement No. 5, auditors are required to evaluate the possible impact of substantive audit testing and assess the implications of the results as they pertain to the effectiveness of internal control. This evaluation normally will include, but not necessarily be limited to, the following:
575 575 Id. B8.

The auditor's risk assessments in connection with the selection and application of substantive procedures, especially those related to fraud; Findings with respect to illegal acts and related party transactions [emphasis added]; Indications of management bias in making accounting estimates and in selecting accounting principles; and Misstatements detected by substantive procedures. The magnitude of any misstatements that are uncovered by substantive testing might alter an auditor's judgment about the effectiveness of the company's internal control. Related party transactions occupy a prominent position in considering the impact of the financial statement audit on the adequacy of internal control over financial reporting.

e. Impact of Related Party Transactions on an Audit of Internal Control


This Portfolio illustrates the pervasiveness of related party transactions in financial reporting. In the context of evaluating the adequacy of internal control, related party transactions can impact the following aspects of an external auditor's internal control audit: (1) the evaluation of controls developed by management to assess the risk of fraud, (2) the identification of accounts for testing, (3) the evaluation of deficiencies in internal control, and (4) the impact of substantive testing on the evaluation of control effectiveness. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

TABLE OF WORKSHEETS
B-101 B-201 Worksheet 1 Worksheet 2 Principal Acronyms and Abbreviations Used in Portfolio FASB ASC 850 Definitions: Excerpts From FASB ASC 850 Glossary

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B-301

Worksheet 3

Disclosures Required by FASB ASC 850: Excerpts From Annual Report of McKesson Corporation, Inc. on Form 10-K (Mar. 31, 2007) Disclosures Required by FASB ASC 850 in Consolidated Statements: Excerpts From Annual Report of Hurco Companies, Inc. on Form 10-K (Oct. 31, 2006) Regulation S-K, Section 404(a) Disclosures Transactions With Related Persons: Excerpts From Atmel Corporation Proxy Statement on Schedule 14A (Jul. 9, 2007) Regulation S-K, Section 404(a) Lease Disclosures Transactions With Related Persons: Excerpts From Frozen Food Express Industries, Inc. Proxy Statement Regulation S-K, Section 404(a) Indebtedness Disclosures: Excerpts From Amgen, Inc. Proxy Statement on Schedule 14A (Mar. 22, 2006) Regulation S-K, Section 404(b) Disclosure of Process for Reviewing Transactions With Related Parties: Excerpts From General Electric Company's Proxy Statement on Schedule 14A (Feb. 27, 2007) Regulation S-K, Section 404(c) Disclosure of Transactions With Promoters: Excerpts From 21st Century Telesis, Inc. Form 10 (Aug. 19, 1998) EITF Issue No. 02-5: Definition of Common Control in Relation to FASB Statement No. 141 EITF 85-21: Changes of Ownership Resulting in a New Basis of Accounting Nonmonetary Transactions: Definitions: Excerpts From FASB Current Standards, Nonmonetary Transactions Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common Control: Exchange Having Commercial SubstanceGain Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common Control: Exchange Having Commercial SubstanceLoss Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common Control: Exchange Without Commercial SubstanceGain Nonmonetary ExchangesUnrelated Parties and Related Parties Not Under Common Control: Exchange Without Commercial SubstanceLoss Nonmonetary ExchangesExchange Between Related Parties Under Common Control

B-401

Worksheet 4

B-501

Worksheet 5

B-601

Worksheet 6

B-701

Worksheet 7

B-801

Worksheet 8

B-901

Worksheet 9

B-1001 B-1101

Worksheet 10 Worksheet 11

B-1201 B-1301

Worksheet 12 Worksheet 13

B-1401

Worksheet 14

B-1501

Worksheet 15

B-1601

Worksheet 16

B-1701

Worksheet 17

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B-1801

Worksheet 18

Disclosure of Nonmonetary Exchange Among Related Parties: Excerpts From The Coca-Cola Company, Form 10-K, Item 9 (Dec. 31, 2004) Transfers of Financial Instruments: Definitions Excerpts From FASB Current Standards Financial Instruments: Transfers Leases: DefinitionsExcerpts From FASB Current Standards, Leases Regulation S-K, Item 406 Code of Ethics: Excerpts From North American Scientific, Inc.'s Proxy Statement on Schedule 14A (Apr. 25, 2007) New York Stock Exchange Listed Company Manual, Section 303A.02(a), Disclosures Pertaining to Director Independence: Excerpts From General Electric Company's Proxy Statement on Schedule 14A (Feb. 27, 2007) New York Stock Exchange Listed Company Manual, Corporate Governance Guidelines (June 1, 2006) New York Stock Exchange Listed Company ManualCode of Ethics Guidelines Sample Disclosure of Corporate Governance DifferencesNYSE Listed Company Manual Section 303A.11: Excerpts From Elan Corporation's Web site: www.elan.com NASDAQ Definition of an Independent Director Excerpts From NASDAQ Manual Section 4200 Definitions: Independent Director Summary of Corporate Governance Features SEC Enforcement Actions

B-1901

Worksheet 19

B-2001 B-2101

Worksheet 20 Worksheet 21

B-2201

Worksheet 22

B-2301

Worksheet 23

B-2401 B-2501

Worksheet 24 Worksheet 25

B-2601

Worksheet 26

B-2701 B-2801

Worksheet 27 Worksheet 28

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 1 Principal Acronyms and Abbreviations Used in Portfolio


AICPA American Institute of Certified Public Accountants National member organization for CPAs Plays a significant role in developing the profession and GAAP Has primary role in the development of standards for tax services and auditing Predecessor of the FASB Formed by the AICPA Existed from 1959-1973 Issued 31 APB Opinions

APB

Accounting Principles Board

ARB

Accounting Research Bulletin

Piece of authoritative accounting literature Issued by the Committee on

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Accounting Procedures Earliest predecessor of the FASB Existed from 1939-1959 ASB Auditing Standards Board An AICPA technical committee Produces auditing guides, Statements on Auditing Standards, and Statements on Standards for Attestation Engagements Successor to Auditing Standards Executive Committee Issues only auditing standards for private companies as standards for public companies now issued by the PCAOB Auditing pronouncement issued by the PCAOB AICPA Professional Standards are the current text version of Statements on Auditing Standards (SASs) SEC regulation governing sales of securities Purpose is to prevent directors and officers from trading in a company's securities during periods when pension plan participants are unable to do so Issued by the Financial Accounting Standards Board Sets forth fundamentals on which financial accounting and reporting standards are based Formed by FASB in 1984 Issues consensus opinions helping to set standards for complicated issues where there is often no other authoritative guidance Sets standards for most voluntarily established pension plans in private industry FASB Statement of Accounting Standards Formed in 1973 Plays most significant role in developing U.S. GAAP Issues Statements of Financial Accounting Standards (FASs) and Interpretations Issues Technical Bulletins Issues Qs and As Issues Statements of Financial Accounting Concepts Standard-setting body for international accounting standards Successor to International Accounting Standards Committee

AS AU

Auditing Standard Auditing Standards Section of AICPA Professional Standards Blackout Trading Restrictions

BTR

CON

Statement of Financial Accounting Concepts

EITF

Emerging Issues Task Force

ERISA

Employee Retirement Income Security Act Financial Accounting Standard Financial Accounting Standards Board

FAS FASB

IASB

International Accounting Standards Board

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Issues International Financial Reporting Standards (IFRSs) IASC International Accounting Standards Committee Predecessor standard-setting body to International Accounting Standards Board (IASB) Issued International Accounting Standards (IASs) IASs have authority equal to standards issued by the International Accounting Standards Board An AICPA technical committee Issues standards dealing with auditors' independence issues Produces Independence Board Standards (ISBs)

ISB

Independence Standard Board

NASDAQ National Association of Securities Dealers A national stock exchange Automated Quotations Sets forth rules and regulations for issuers of listed securities NYSE New York Stock Exchange A national stock exchange Issues rules and regulations for listed companies Created by Sarbanes-Oxley Act of 2002 Oversees the auditors of public companies Sets standards for the audits of public companies Issues Auditing Standards Successor to the ASB for standards pertaining to audits of public companies (as of April 16, 2003) Staff Accounting Bulletins issued by the SEC Enforces the Securities Act of 1933 and the Securities Exchange Act of 1934 Issues Regulations Issues Accounting and Auditing Enforcement Releases (AAERs) Statements issued by the AICPA's Auditing Standards Board All SASs pertaining to public companies were adopted by the PCAOB SEC Regulation governing non-financial disclosures in filings with the Commission SEC Regulation governing the disclosures in financial statements included with SEC filings Statements issued by the AICPA Most often issued by various committees

PCAOB

Public Company Accounting Oversight Board

SAB SEC

Staff Accounting Bulletin Securities and Exchange Commission

SAS

Statement on Auditing Standards

S-K

Regulation S-K

S-X

Regulation S-X

SOP

Statement of Position

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SOX

Sarbanes-Oxley Act of 2002

A United States federal law designed to reform the oversight of public company audits and protect investors Created the PCAOB Contains wide-ranging corporate governance provisions

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 2 FAS 57 Definitions

Excerpts From FASB ASC 850 Glossary 11


11 FASB ASC 850-20.

Affiliate. A party that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with an entity. Control. The possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an entity through ownership, by contract, or otherwise. Immediate family. Family members who might control or influence a principal owner or a member of management, or who might be controlled or influenced by a principal owner or a member of management, because of the family relationship. Management. Persons who are responsible for achieving the objectives of the entity and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management normally includes members of the board of directors, the chief executive officer, chief operating officer, vice presidents in charge of principal business functions (such as sales, administration, or finance), and other persons who perform similar policymaking functions. Persons without formal titles also may be members of management. Principal owners. Owners of record or known beneficial owners of more than 10 percent of the voting interests of the enterprise. Related parties. Affiliates of the entity; entities for which investments in their equity securities would be required, absent the election of the fair value option, are accounted for by the equity method by the investing entity; trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management; principal owners of the entity and members of their immediate families; management of the entity and members of their immediate families; other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests; and other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 3 Disclosures Required by FASB ASC 850

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Excerpts From Annual Report of McKesson Corporation, Inc. on Form 10-K (Mar. 31, 2007)

McKESSON CORPORATION FINANCIAL NOTES (Continued)

20. Related Party Balances and Transactions Notes receivable outstanding from certain of our current and former officers and senior managers totaled $25 million and $45 million at March 31, 2007 and 2006. These notes related to purchases of common stock under our various employee stock purchase plans. The notes bear interest at rates ranging from 4.7 % to 7.1 % and were due at various dates through February 2004. Interest income on these notes is recognized only to the extent that cash is received. These notes, which are included in other capital in the consolidated balance sheets, were issued for amounts equal to the market value of the stock on the date of the purchase and are full recourse to the borrower. At March 31, 2007, the value of the underlying stock collateral was $20 million. The collectability of these notes is evaluated on an ongoing basis. As a result, we recorded net credits of $2 million, $9 million and $6 million in 2007, 2006 and 2005 based on changes in price of the underlying stock collateral. At March 31, 2007 and 2006, we provided a reserve of approximately $6 million and $12 million for the outstanding notes. Other receivable balances held with related parties, consisting of loans made to certain officers and senior managers and an equity-held investment, at March 31, 2007 and 2006 amounted to $1 million. In 2007, 2006 and 2005 we incurred approximately $7 million to $8 million annually of rental expense paid to an equity-held investment. In addition, in 2007, 2006 and 2005 we purchased $3 million of services per year from an equity-held investment. At March 31, 2007, we had a $6 million loan receivable from an equity held investment. The loan bears interest at 7.9%. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 4 Disclosures Required by FASB ASC 850 in Consolidated Statements


Excerpts From Annual Report of Hurco Companies, Inc. on Form 10-K (Oct. 31, 2006) HURCO COMPANIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued

9. RELATED PARTY TRANSACTIONS We own approximately 24% of one of our Taiwanese-based contract manufacturers. This investment of $1.3 million is accounted for using the equity method and is included in Investments and Other Assets on the Consolidated Balance Sheets. Purchases of product from this contract manufacturer totaled $2.0 million, $2.7 million and $4.4 million for the years ended October 31, 2006, 2005 and 2004, respectively. Sales of product to this contract manufacturer were $70,000, $117,000 and $199,000 in fiscal 2006, 2005 and 2004 respectively. Trade payables to this contract manufacturer were $256,000 at October 31, 2006, and $509,000 at October 31, 2005. Trade receivables were $32,000 at October 31, 2006, and $136,000 at October 31, 2005. As of October 31, 2006, we owned 35% of Hurco Automation, Ltd. (HAL), a Taiwan based company.

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HAL's scope of activities includes the design, manufacture, sales and distribution of industrial automation products, software systems and related components, including control systems and components produced under contract for sale exclusively to us. We are accounting for this investment using the equity method. The investment of $2.0 million at October 31, 2006 is included in Investments and Other Assets on the Consolidated Balance Sheets. Purchases of product from this supplier amounted to $10.5 million, $7.7 million and $6.6 million in 2006, 2005 and 2004, respectively. Sales of product to this supplier were $2.0 million, $1.8 million and $1.9 million for the years ended October 31, 2006, 2005 and 2004, respectively. Trade payables to HAL were $1.9 million and $1.6 million at October 31, 2006 and 2005, respectively. Trade receivables from HAL were $235,000 and $242,000 at October 31, 2006 and 2005, respectively. Summary financial information for the two affiliates accounted for using the equity method of accounting is as follows:

(in thousands) Net Sales Gross Profit Operating Income Net Income Current Assets Non-current Assets Current Liabilities

2006 $ 58,286 10,932 4,209 3,727 $ 27,903 7,684 20,156

2005 $ 50,896 8,947 2,676 2,313 $ 21,553 1,824 14,857

2004 $ 23,469 7,780 2,210 1,479 $ 16,194 2,031 17,215

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 5 Regulation S-K, Section 404(a) Disclosures Transactions With Related Persons

Excerpts From Atmel Corporation Proxy Statement on Schedule 14A (Jul. 9, 2007)

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In accordance with the charter for the Audit Committee, our Audit Committee reviews and approves in advance in writing any proposed related person transactions. The most significant related person transactions, as determined by the Audit Committee, must be reviewed and approved in writing in advance by our Board. Any related person transaction will be disclosed in the applicable SEC filing as required by the rules of the SEC. For purposes of these procedures, related person and transaction have the meanings contained in Item 404 of Regulation S-K. During 2006, we paid approximately $250,000 to MartSoft Corporation pursuant to a development agreement. The Chief Executive Officer of MartSoft is the wife of Tsung-Ching Wu, Ph.D., an executive officer and director of Atmel. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 6 Regulation SK, Section 404(a) Lease Disclosures Transactions With Related Persons

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Excerpts From Frozen Food Express Industries, Inc. Proxy Statement on Schedule 14A (Aug. 29, 2006)

Regulation S-K, Section 404(a) Lease Disclosures Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 7 Regulation S-K, Section 404(a) Indebtedness Disclosures Excerpts From Amgen, Inc. Proxy Statement on Schedule 14A (Mar. 22, 2006)
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Loans to Executive Officers As a result of the Sarbanes-Oxley Act, the Company no longer makes personal loans to executive officers that are prohibited by such act. Prior to the Sarbanes-Oxley Act, the Company had made personal loans to the executive officers of the Company listed below, generally in connection with their relocation closer to the Company. The annual interest rate on the loans to each officer, except the loan to Mr. Nanula, was 3% during the year ended December 31, 2005 and will be 3% for the year ending December 31, 2006. These interest rates are established and adjusted annually based on the average introductory rates on adjustable loans offered by California banks and savings and loans. The loan to Mr. Nanula is fixed at 5% for the term of the loan.

Name
Hassan Dayem George J. Morrow Richard D. Nanula Roger M. Perlmutter

Largest Aggregate Aggregate Outstanding Indebtedness Indebtedness Original Since at Date of Amount of January 1, March 13, Loan Loan($) 2005($) 2006($)
July 2002 March 2001 June 2001 June 2001 500,000 1,000,000 3,000,000 1,000,000 500,000 500,000 3,162,500 1,000,000 0 0 3,105,000 1,000,000

Maturity Date (1)

June 2010 June 2006

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 8 Regulation S-K, Section 404(b) Disclosure of Process For Reviewing Transactions With Related Parties

Excerpts From General Electric Company's Proxy Statement on Schedule 14A (Feb. 27, 2007)

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Certain Relationships and Related Person Transactions

Review and Approval of Related Person Transactions. We review all relationships and transactions in which the company and our directors and executive officers or their immediate family members are participants to determine whether such persons have a direct or indirect material interest. The company's legal staff is primarily responsible for the development and implementation of processes and controls to obtain information from the directors and executive officers with respect to related person transactions and for then determining, based on the facts and circumstances, whether the company or a related person has a direct or indirect material interest in the transaction. As required under SEC rules, transactions that are determined to be directly or indirectly material to the company or a related person are disclosed in the company's proxy statement. In addition, the Audit Committee reviews and approves or ratifies any related person transaction that is required to be disclosed. As set forth in the Audit Committee's key practices, in the course of its review and approval or ratification of a disclosable related party transaction, the committee considers: the nature of the related person's interest in the transaction; the material terms of the transaction, including, without limitation, the amount and type of transaction; the importance of the transaction to the related person; the importance of the transaction to the company; whether the transaction would impair the judgment of a director or executive officer to act in the best interest of the company; and any other matters the committee deems appropriate. Any member of the Audit Committee who is a related person with respect to a transaction under review may not participate in the deliberations or vote respecting approval or ratification of the transaction, provided, however, that such director may be counted in determining the presence of a quorum at a meeting of the committee that considers the transaction. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 9 Regulation S-K, Section 404(c) Disclosure of Transactions With Promoters Excerpts From 21st Century Telesis, Inc. Form 10 (Aug. 19, 1998)
Item 7 Certain Relationships and Related Transactions (a) Transactions with management and others Philip J. Chasmar and Jeffery V. Barbieri, both of whom are promoters and directors of registrant, control Aventine, Inc., a Texas corporation which in turn owns all the outstanding capital stock of Atlantic-Pacific Financial, Inc., an NASD broker-dealer which has participated in private placements of the securities of registrant. For the twelve months ended September 30, 1996 registrant paid brokerage commissions of $453,512 to Atlantic-Pacific Financial for sale of registrant's securities, and $618,648 for the comparable period ended September 30, 1997. Registrant also paid finders fees and fees for marketing consulting to Aventine totaling $1,010,444 for the twelve months ended September 30, 1996 and $436,959 for the like period ended September 30, 1997. Aventine, Inc. paid salaries of $45,000 during calendar year 1996 to each of Messrs. Chasmar and Barbieri, and to Mr. Lawrence Kaufman, a promoter and a director of registrant, and $62,000 each to Messrs. Chasmar, Barbieri and Kaufman for calendar year 1997.

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During December, 1996 and January, 1997 registrant paid a total of $174,104 to Hart Engineers, a telecommunications engineering firm owned by Mr. Robert Andrew Hart IV, the Chairman and Chief Executive Officer of registrant, and one of registrant's promoters. The payments were reimbursements for advances made by Hart Engineers for the benefit of registrant, principally during the period prior to the commencement of and during the FCC's PCS auctions. Registrant utilizes the services of Hart Engineers to provide engineering oversight services for the deployment of registrant's PCS systems. The arrangement, as authorized by registrant's board, calls for Hart Engineers to be compensated for such services on a time and materials basis, at rates not to exceed those customary in the industry for services of like character. Registrant paid $227,170 to Hart Engineers for services for the twelve month period ended September 30, 1997, and had an unpaid balance of an additional approximately $254,752 as of such date . . .. (d) Transactions with Promoters Registrant was formed through the promotional efforts of Messrs. Robert Andrew Hart IV, Philip J. Chasmar, Jeffery V. Barbieri, Lawrence Kaufman and Dion Whitman. All five individuals continue to serve in executive capacities, and all save Mr. Whitman are members of registrant's board of directors. Compensation received by the promoters is as shown in Item 7 (a) above and Item 6. The ownership of registrant's stock by each promoter is shown in Item 4. All shares shown in Item 4 were issued for services rendered by the promoters. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 10 EITF Issue No. 02-5: Definition of Common Control in Relation to FASB Statement No. 141

FASB Emerging Issues Task force EITF 02-5 Dates Discussed


March 2021, 2002; June 19-20, 2002

EITF 02-5 References


FASB Statement No. 141, Business Combinations FASB Technical Bulletin No. 85-5, Issues Relating to Accounting for Business Combinations AICPA Accounting Research Bulletin No. 51, Consolidated Financial Statements APB Opinion No. 16, Business Combinations AICPA Accounting Interpretation 27, Entities Under Common Control in a Business Combination, of APB Opinion No. 16 AICPA Accounting Interpretation 39, Transfers and Exchanges Between Companies Under Common Control, of APB Opinion No. 16

EITF 02-5 ISSUE


1. Consistent with the guidance previously provided in Opinion 16, paragraph 11 of Statement 141 provides that the term business combination excludes transfers of net assets or exchanges of equity interests between entities under common control. Paragraph D12 of Statement 141 further provides that, in those situations, related assets and liabilities are to be recorded at their carrying amounts at the date of transfer. However, neither Opinion 16 nor Statement 141 defines the term common control. 2. Questions exist with respect to whether separate entities are under common control when common majority ownership exists by an individual, a family, or a group affiliated in some other manner. For example, some suggest that the accounting should presume that immediate family members will vote their shares in concert absent evidence to the contrary. If that presumption is appropriate, an additional

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issue is how to define immediate family member. Further, some question whether companies owned by individuals that are not members of an immediate family could ever be under common control. 3. The FASB staff understands that the SEC staff has indicated that common control exists between (or among) separate entities only in the following situations: a. An individual or enterprise holds more than 50 percent of the voting ownership interest of each entity. b. Immediate family members hold more than 50 percent of the voting ownership interest of each entity (with no evidence that those family members will vote their shares in any way other than in concert). (1) Immediate family members include a married couple and their children, but not the married couple's grandchildren. (2) Entities might be owned in varying combinations among living siblings and their children. Those situations would require careful consideration regarding the substance of the ownership and voting relationships. c. A group of shareholders holds more than 50 percent of the voting ownership interest of each entity, and contemporaneous written evidence of an agreement to vote a majority of the entities' shares in concert exists. 4. The issue is how to determine whether separate entities are under common control in the context of Statement 141 when common majority ownership exists by an individual, a family, or a group affiliated in some other manner.

EITF 02-5 DISCUSSION


5. The Task Force did not reach a consensus on the issue of how to determine whether common control of separate entities exists. The Task Force discussed the practice being followed by SEC registrants. Some Task Force members expressed uncertainty as to whether common control might exist in situations other than those described above. 6. Additionally, the Task Force noted that the FASB expects to address this Issue in its business combinations project. 7. The SEC Observer stated that SEC registrants should continue to follow the guidance in paragraph 3, above, when determining whether common control of separate entities exists.

EITF 02-5 STATUS


No further EITF discussion is planned. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 11 EITF 85-21: Changes of Ownership Resulting in a New Basis of Accounting

FASB Emerging Issues Task Force EITF 85-21 Dates Discussed


June 27, 1985; September 4, 1986; October 16, 1986

EITF 85-21 References


FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries AICPA Issues Paper, Push Down Accounting , dated October 30, 1979 SEC Staff Accounting Bulletin No. 54, Application of Push Down Basis of Accounting in Financial

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Statements of Subsidiaries Acquired by Purchase

EITF 85-21 ISSUE


What level of ownership change in a company should result in a new basis of accounting for that company? How would the new basis of accounting be computed? At what amount would minority interests be reported?

EITF 85-21 DISCUSSION


The Task Force was unable to reach a consensus on this issue. One Task Force member indicated, and others agreed, that current practice with respect to application of a new basis is diverse. Several members stated that this diversity results from lack of authoritative guidance and inconsistent positions taken about the applicability of new basis accounting as expressed in SAB 54 when the situation involves less than 100 percent acquisition of a company or when step acquisitions are involved. The SEC Observer stated that new basis accounting is being required (with one exception) only in those situations in which there is both virtually a 100 percent acquisition (for example, 97 percent) and no outstanding publicly held debt or preferred stock. Any inconsistencies in application are unintended and may have resulted because not all registrant filings are examined. The SEC Observer stated that the SEC staff's views on carrying over historical cost to record, in the separate financial statements of each entity, transfers between companies under common control or between a parent and its subsidiary run primarily to transfers of net assets (as in a business combination) or long-lived assets. Those views would not normally apply to recurring transactions for which valuation is not in question (such as routine transfers of inventory) in the separate financial statements of each entity that is a party to the transaction. The Task Force members were not in agreement as to whether new basis accounting is acceptable for privately held companies. One Task Force member indicated that the authoritative literature could be read to support the practice. One Task Force member indicated that a concept of the reporting entity would be helpful. Some Task Force members indicated a need for FASB guidance. The Task Force Chairman encouraged Task Force members as well as the SEC to provide the FASB staff with examples of new basis accounting.

EITF 85-21 STATUS


In October 1987, the FASB issued Statement 94, which addresses the consolidation of all majority-owned subsidiaries. However, Statement 94 does not address the above issue. Issues affecting reporting by an entity that is or has been a subsidiary (which include so-called push-down or new basis accounting questions) will be addressed in later stages of the FASB's project on the reporting entity, including consolidations and the equity method. No further EITF discussion is planned. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 12 Nonmonetary Transactions: Definitions


Excerpts From FASB Current Standards, Nonmonetary Transactions 1
1 APB 29, 1-3.

Exchange (or exchange transaction). A reciprocal transfer between an enterprise and another entity that results in the enterprise's acquiring assets or services or satisfying liabilities by surrendering other assets or services or incurring other obligations. A reciprocal

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transfer of a nonmonetary asset shall be deemed an exchange only if the transferor has no substantial continuing involvement in the transferred asset such that the usual risks and rewards of ownership of the asset are transferred. Monetary assets (and liabilities). Assets and liabilities whose amounts are fixed in terms of units of currency by contract or otherwise. Examples are cash, short- or long-term accounts and notes receivable in cash, and short- or long-term accounts and notes payable in cash. Nonmonetary assets and (liabilities). Assets and liabilities other than monetary ones. Examples are inventories; investments in common stocks; property, plant, and equipment; and liabilities for rent collected in advance. Nonmonetary transactions. Exchanges and nonreciprocal transfers that involve little or no monetary assets or liabilities. Nonreciprocal transfer. A transfer of assets or services in one direction, either from an enterprise to its owners (whether or not in exchange for their ownership interests) or another entity or from owners or another entity to the enterprise. An enterprise's reacquisition of its outstanding stock is an example of a nonreciprocal transfer. Productive assets. Assets held for or used in the production of goods or services by the enterprise. Productive assets include an investment in another entity if the investment is accounted for by the equity method but exclude an investment not accounted for by that method. Similar productive assets. Productive assets that are of the same general type, that perform the same function or that are employed in the same line of business. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 13 Nonmonetary Exchanges Unrelated Parties and Related Parties Not Under Common Control Exchange Having Commercial Substance Gain
Assumptions Prior to Exchange
Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $ 1,100 for Asset B having a fair value of $1,400. Company A pays $300 cash in addition to transferring Asset A.

Company A
Recorded amount of Asset A Fair value of Asset A Cash paid Total value surrendered $ 600 $ 1,100 300 $ 1,400

Company B
Recorded amount of Asset B Fair value of Asset B Cash paid Total value surrendered $1,200 $1,400 -0$1,400

Accounting Entries
Each company records the asset received at the fair value of the assets surrendered and recognizes a gain:

Company A Dr
Asset B Asset A Cash 1,400 600 300

Company B Cr
Asset A Cash Asset B

Dr
1,100 300

Cr

1,200

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Gain Computation of Gain Fair value of Asset A Book value Gain

500 $1,100 600 $500

Gain Computation of Gain Fair value of Asset B Book value Gain

200 $1,400 1,200 $200

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 14 Nonmonetary Exchanges Unrelated Parties and Related Parties Not Under Common Control Exchange Having Commercial Substance Loss
Assumptions Prior to Exchange
Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $400 for Asset B having a fair value of $900. Company A pays $500 cash in addition to the Asset A exchanged.

Company A
Recorded amount of Asset A Fair value of Asset A Cash paid Total value surrendered $600 $400 500 $900

Company B
Recorded amount of Asset B Fair value of Asset B Cash paid Total value surrendered $1,200 $900 -0$900

Accounting Entries
Each company records the asset received at the fair value of the assets surrendered and recognizes a loss:

Company A Dr
Asset B Loss Asset A Cash Computation of Loss Fair value of Asset A Book value Loss $400 600 ($200) 900 200 600 500

Company B Cr
Asset A Cash Loss Asset B Computation of Loss Fair value of Asset B Book value Loss $900 1,200 ($300)

Dr
400 500 300

Cr

1,200

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 15 Nonmonetary Exchanges Unrelated Parties and Related Parties Not Under Common Control Exchange Without Commercial Substance Gain
Assumptions Prior to Exchange
Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $1,100 for Asset B having a fair value of $1,400. Company A pays $300 cash in addition to transferring Asset A.

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Company A
Recorded amount of Asset A Fair value of Asset A Cash paid Total value surrendered $ 600 $ 1,100 300 $ 1,400

Company B
Recorded amount of Asset B Fair value of Asset B Cash paid Total value surrendered $1,200 $1,400 -0$1,400

Accounting Entries Company A


Company A records the exchange at the recorded amount of the asset surrendered plus the cash paid without recognizing a gain:

Dr
Asset B Asset A Cash 900

Cr
600 300

Company B
Company B records the exchange by realizing a gain on a proportionate amount of the asset surrendered (Asset B). The proportion is based on the cash received. The contention is that the amount of cash received represents the proportion of Asset B that was sold. The proportion assumed to be sold is the ratio of the cash received to the total value received. *Asset A is recognized at its recorded amount less the proportion sold ($1,200 - $257=$943).

Dr
Asset A Cash Asset B Gain 943 300

Cr

1,200 43

Computation of Gain
Cash received Total value received Proportion sold
* Proportion sold: 300

300 1,400 21.4%

Fair value of Asset B Book value Gain

$1,400 1,200 $200 =

Realized Gain $43

____ 1400

$1,200 = $257

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 16 Nonmonetary Exchanges Unrelated Parties and Related Parties Not Under Common Control Exchange Without Commercial Substance Loss

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Assumptions Prior to Exchange


Companies A and B exchange assets. Company A exchanges Asset A having a fair value of $400 for Asset B having a fair value of $900. Company A pays $500 cash in addition to the Asset A exchanged.

Company A
Recorded amount of Asset A Fair value of Asset A Cash paid Total value surrendered $600 $400 500 $900

Company B
Recorded amount of Asset B Fair value of Asset B Cash paid Total value surrendered $1,200 $900 -0900

Accounting Entries
Each company records the asset received at recorded amounts recognizing any loss indicated by the exchange:

Company A Dr
Asset B Loss Asset A Cash Computation of Loss Fair value of Asset A Book value Loss $400 600 ($200) 900 200 600 500

Company B Cr
Asset A Cash Loss Asset B Computation of Loss Fair value of Asset B Book value Loss $900 1,200 ($300)

Dr
400 500 300

Cr

1,200

Company A records Asset B at the amount of the assets surrendered. Company B records the transaction using the recorded amount of Asset B given up, recognizing the loss on Asset B. Asset A cannot be recorded at an amount greater than its fair value. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 17 Nonmonetary Exchanges Exchange Between Related Parties Under Common Control
Assumptions Prior to Transfer Companies A and B are affiliates under common control. A and B exchange assets. Company A exchanges Asset A having a fair value of $1,100 for Asset B having a fair value of $1,400. Company A pays $300 cash in addition to the Asset A exchanged.

Company A
Recorded amount of Asset A Fair value of Asset A Cash paid Total value surrendered $ 600 $ 1,100 300 $ 1,400

Company B
Recorded amount of Asset B Fair value of Asset B Cash paid Total value surrendered $1,200 $1,400 -0$1,400

Accounting Entries Company A


Company A records the exchange at carry-over amounts without recognizing a gain. Any difference

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between cash paid (or the fair value of liabilities assumed) and the carrying value of the asset received is recorded in an equity account.*

Dr
Asset B Asset A Cash Equity* 1,200

Cr
600 300 300

Company B
Company B records the exchange using carry-over amounts. No loss is recognized. Any difference between cash received (or the fair value of liabilities discharged) and the carrying value of the asset received is recorded in equity.

Dr
Asset A Cash Equity* Asset B 600 300 300

Cr

1,200

*For example, Accumulated Other Comprehensive Income Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 18 Disclosure of Nonmonetary Exchange Among Related Parties Excerpts From The Coca-Cola Company, Form 10-K, Item 9 (Dec. 31, 2004)
NOTE 2: BOTTLING INVESTMENTS (Continued) Effective May 6, 2003, one of our Company's equity method investees, Coca-Cola FEMSA consummated a merger with another of the Company's equity method investees, Panamerican Beverages, Inc. (Panamco). Our Company received new Coca-Cola FEMSA shares in exchange for all Panamco shares previously held by the Company. Our Company's ownership interest in Coca-Cola FEMSA increased from 30 percent to approximately 40 percent as a result of this merger. This exchange of shares was treated as a nonmonetary exchange of similar productive assets, and no gain was recorded by our Company as a result of this merger. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 19 Transfers of Financial Instruments: Definitions


Excerpts From FASB Current Standards Financial Instruments: Transfers 1
1 FAS 140, 364.

Beneficial interests. Rights to receive all or portions of specified cash inflows to a trust or other entity, including senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through, premiums due to guarantors, commercial

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paper obligations, and residual interests, whether in the form of debt or equity. Benefits of servicing. Revenues from contractually specified servicing fees, late charges, and other ancillary sources, including float. Cleanup call. An option held by the servicer or its affiliate, which may be the transferor, to purchase the remaining transferred financial assets, or the remaining beneficial interests not held by the transferor, its affiliates, or its agents in a qualifying SPE (or in a series of beneficial interests in transferred assets within a qualifying SPE), if the amount of outstanding assets or beneficial interests falls to a level at which the cost of servicing those assets or beneficial interests becomes burdensome in relation to the benefits of servicing. Collateral. Personal or real property in which a security interest has been given. Derecognize. Remove previously recognized assets or liabilities from the statement of financial position. Financial asset. Cash, evidence of an ownership interest in an entity, or a contract that conveys to a second entity a contractual right (a) to receive cash or another financial instrument from a first entity or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Financial liability. A contract that imposes on one entity a contractual obligation (a) to deliver cash or another financial instrument to a second entity or (b) to exchange other financial instruments on potentially unfavorable terms with the second entity. Proceeds. Cash, derivatives, or other assets that are obtained in a transfer of financial assets, less any liabilities incurred. Recourse. The right of a transferee of receivables to receive payment from the transferor of those receivables for (a) failure of debtors to pay when due, (b) the effects of prepayments, or (c) adjustments resulting from defects in the eligibility of the transferred receivables. Seller. A transferor that relinquishes control over financial assets by transferring them to a transferee in exchange for consideration. Servicing asset . A contract to service financial assets under which the estimated future revenues from contractually specified servicing fees, late charges, and other ancillary revenues are expected to more than adequately compensate the servicer for performing the servicing. A servicing contract is either (a) undertaken in conjunction with selling or securitizing the financial assets being serviced or (b) purchased or assumed separately. Servicing liability. A contract to service financial assets under which the estimated future revenues from contractually specified servicing fees, late charges, and other ancillary revenues are not expected to adequately compensate the servicer for performing the servicing. Transfer . The conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. Thus, a transfer includes selling a receivable, putting it into a securitization trust, or posting it as collateral but excludes the origination of that receivable, the settlement of that receivable, or the restructuring of that receivable into a security in a troubled debt restructuring. Transferee. An entity that receives a financial asset, a portion of a financial asset, or a group of financial assets from a transferor. Transferor. An entity that transfers a financial asset, a portion of a financial asset, or a group of financial assets that it controls to another entity. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 20 Leases: Definitions


Excerpts From FASB Current Standards, Leases

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Bargain purchase option. A provision allowing the lessee, at the lessee's option, to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at the inception of the lease, to be reasonably assured. FAS 13, 5(d). Estimated economic life of leased property. The estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease, without limitation by the lease term. FAS 13, 5(g). Estimated residual value of leased property. The estimated fair value of the leased property at the end of the lease term. FAS 13, 5(h). Executory costs. Those costs such as insurance, maintenance, and taxes incurred for leased property, whether paid by the lessor or lessee. Amounts paid by a lessee in consideration for a guarantee from an unrelated third party of the residual value are also executory costs. If executory costs are paid by a lessor, any lessor's profit on those costs is considered the same as executory costs. FAS 13, 7, 10. Fair value of the leased property. The price that would be received to sell the property in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers that are independent of the reporting entity, that is, they are not related parties at the measurement date. FAS 13, 5(c). Minimum Lease Payments. From the standpoint of the lessee: The payments that the lessee is obligated to make or can be required to make in connection with the leased property. Contingent rentals shall be excluded from minimum lease payments. However, a guarantee by the lessee of the lessor's debt and the lessee's obligation to pay (apart from the rental payments) executory costs in connection with the leased property shall be excluded. If the lease contains a bargain purchase option, only the minimum rental payments over the lease term and the payment called for by the bargain purchase option shall be included in the minimum lease payments. Otherwise, minimum lease payments include the following: (1) The minimum rental payments called for by the lease over the lease term. (2) Any guarantee by the lessee or any party related to the lessee of the residual value at the expiration of the lease term, whether or not payment of the guarantee constitutes a purchase of the leased property. When the lessor has the right to require the lessee to purchase the property at termination of the lease for a certain or determinable amount, that amount shall be considered a lessee guarantee. When the lessee agrees to make up any deficiency below a stated amount in the lessor's realization of the residual value, the guarantee to be included in the minimum lease payments shall be the stated amount, rather than an estimate of the deficiency to be made up. (3) Any payment that the lessee must make or can be required to make upon failure to renew or extend the lease at the expiration of the lease term, whether or not the payment would constitute a purchase of the lease property. In this connection, it should be noted that the definition of lease term includes all periods, if any, for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at the inception of the lease, to be reasonably assured. If the lease term has been extended because of that provision, the related penalty shall not be included in minimum lease payments. From the standpoint of the lessor: The payments described above plus any guarantee of the residual value or of rental payments beyond the lease term by a third party unrelated to either the lessee or the lessor, provided the third party is financially capable of discharging the obligations that may arise from the guarantee. FAS 13, 5(j). Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

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Worksheet 21 Regulation S-K, Item 406 Code of Ethics Excerpts From North American Scientific, Inc.s Proxy Statement on Schedule 14A (Apr. 25, 2007)

CODE OF ETHICS The Company has a written Code of Ethics that applies to all employees, including our Chief Executive Officer, Chief Financial Officer, and Corporate Controller. The full text of the Company's Code of Ethics is published on our website at www.nasmedical.com under the Investor Center-Corporate Governance caption. The Company will disclose any future amendments to, or waivers from, certain provisions of the Code of Ethics applicable to our Chief Executive Officer, Chief Financial Officer and Corporate Controller on our website within four business days following the date of such amendment or waiver.

Excerpts From North American Scientific, Inc.s Website www.nasmedical.com

North American Scientific Business Ethics Program

INTRODUCTION North American Scientific (sometimes referred to as the Company) and its operating business units are dedicated to achieving our business objectives. At the same time, we are equally dedicated to achieving those objectives in accordance with the high ethical standards we have set in our Code of Ethics. Often, good common sense is all we need to act in an ethical manner. However, in some situations, more guidance may be needed. That is the purpose of our Guidelines of Business Conduct.

Our Code of Ethics is a reflection of our core values. Our core values are:

* Professionalism and ethical behavior in all our actions * Pursue innovation, creativity and discovery * Quality in everything we do * Commitment to unparalleled customer service, both internally and externally * Success through teamwork * Corporate growth that benefit our employees and shareholders

The nature and scope of North American Scientific's operations place a significant trust in individual employees. North American Scientific rewards the contribution of its employees by providing challenging employment as well as competitive compensation, benefits and retirement plans.

Employees over the years have understood and met the high ethical standards demanded by North American Scientific. With continued growth and the addition of new operating units, however, it is

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appropriate to be more specific concerning how the Company's ethical standards apply to certain business situations. For this reason North American Scientific has prepared the following Business Conduct Guidelines and Code of Ethics, which apply to all units of the Company.

This booklet sets forth our Code of Ethics and our Guidelines for Business Conduct. It specifies the legally correct and ethical conduct expected of employees in a variety of identified business situations.

However, this booklet does not and cannot cover every situation in which you will be faced with ethical questions. Questions will arise concerning interpretation, intent, and application. All such questions should be discussed with your supervisor, who will consult with an appropriate member of management.

All employees must comply with all applicable laws and regulations and must avoid situations that could result in the appearance of wrongdoing or impropriety under these guidelines. Any violation of these guidelines that you become aware of must be reported immediately to any of the following:

The Chief Executive Officer of North American Scientific The President of Theseus Imaging Corp. The Director of Human Resources/Legal Affairs of North American Scientific

If you prefer to make an anonymous report, you may submit a report, in writing, to any of the three people listed above, whereupon your request will be held in confidence.

As an employee of North American Scientific, you are expected to study the Guidelines and Code of Ethics, and to pledge personal commitment and compliance. A response card is provided for you to certify your compliance with the program. All supervisory employees have a special obligation to maintain exemplary business conduct as a model for their subordinates.

We are confident that North American Scientific people will appreciate this expression of the ethical standards that are vital to the continued success of the Company and its employees. All of us are on a team. We must be able to depend on our teammates to support these standards for the mutual benefit of all of us.

L. Michael Cutrer President & Chief Executive Officer

North American Scientific Code of Ethics

North American Scientific is committed to the highest standards of ethical business conduct. These standards reflect our core values. We believe that adherence to these standards ensures our long-term success, even though they may cause us to forgo some perceived near-term business opportunities.

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We expect the business behavior of the Company and each of its employees, directors and agents to conform to the following principles:

* We are committed to: Quality products and services, delivered on time and at competitive prices Mutually fair, responsible and beneficial arrangements with our suppliers Fairness, respect, and opportunity for all employees Competitive compensation and benefits Operating for prudent long-term growth while sustaining historic or improved operating ratios, sound and conservative financial policies and an attractive rate of return for our shareholders Ensuring that all company operations and products are safe and environmentally sound Communicating with competitors only under appropriate circumstances and in strict accordance with the law Existing as a good corporate citizen in the communities in which we operate

* We will only employ persons who: Are qualified to fulfill their assigned responsibilities Make a commitment to quality in their work Have initiative and creativity Demonstrate high standards and integrity Have respect and concern for others Understand the value of teamwork in achieving the Company's business objectives Handle company assets prudently Are honest, accurate, complete, and timely in all Company communications and records

Our Code of Ethics can also be expressed as commitments to the following stakeholders in North American Scientific:

Our Customers Unless we consistently fulfill our customers' needs, we cannot serve any of our other stakeholders. Thus, we are committed to providing high quality products at competitive prices. We constantly strive for technical excellence through innovation, creativity and discovery. We are forthright and honest in our communications and transactions with customers.

Our Shareholders We are committed to providing a superior long-term return to our shareholders. We are also committed to protecting and improving the value of their investment through the prudent utilization of corporate resources and by observing the highest standards of legal and ethical conduct in all of our business dealings. Our Employees Our employees are North American Scientific's most important resource. As such, we are committed to treating one another with respect and fairness. We respect each other's privacy and treat each other

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with dignity and respect regardless of age, race, color, gender, religion, disability, sexual orientation, or nationality. We will provide safe and healthy working conditions for every employee. We strive to maintain an atmosphere of open communication.

Our Suppliers We deal honestly and openly with our suppliers. We encourage competition and, at the same time, value our long-term relationships with suppliers.

Our Communities North American Scientific is a good corporate citizen and we encourage and support all of our employees to be good citizens. We respect the environment and natural resources.

By their very nature, the Code of Ethics is a brief list of principles and values we believe are very important. Additional topics and more detail are included in the Guidelines of Business Conduct. If more clarification or guidance is needed, we urge employees to consult with management or the other listed Company sources of assistance.

North American Scientific Guidelines of Business Conduct

Business Conduct Guideline #1 BE HONEST IN ALL BUSINESS DEALINGS

The Company expects its employees to be honest in dealings with all of its stakeholders, including: * Fellow employees * The Company * Suppliers * Customers * All members of the business community

At some time or another, you may have the opportunity to profit, at the expense of the Company and fellow employees, by dishonesty. Such behavior could take the form of: * Filing a false expense statement * Accepting a bribe or kickback from a supplier * Copying computer software * Lying to a supervisor or customer concerning business facts, such as mischarging time on a company time sheet * Taking company products, supplies, or money, etc.

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The Company has taken precautions to reduce temptation and to encourage honesty. We would like to see each of you enjoy a long-term, productive relationship with North American Scientific. We will not hesitate, however, to discharge and prosecute anyone who knowingly violates the rule of basic honesty, whether or not covered specifically by the Guidelines of Business Conduct.

Expense reports must be completed accurately and on time. Expenses must be properly documented and only those that are reasonable and necessary to our business will be reimbursed. Personal expenses must not be submitted to the Company for reimbursement. In addition, North American Scientific has published a Travel Policy which can be obtained through the Company's Finance Department. It is expected that all employees will adhere to the guidelines set forth in the Travel Policy.

Business Conduct Guideline #2 AVOID CONFLICTS OF INTEREST IN ANY FORM A conflict of interest is a divided loyalty between the interests of North American Scientific and the personal interest of the employee. Employees must not allow personal considerations or relationships, whether actual or potential, to influence them in any way when representing the Company in dealings with other persons or organizations. All of us have the obligation to avoid not only situations that give rise to a conflict of interest, but also those situations that create the appearance of a conflict of interest. You may encounter potential conflicts of interest in a variety of situations. Some of the most likely areas are:

* Relationships with customers or suppliers, especially relating to entertainment situations or gifts * Financial or other dealings with outside organizations that do business with our Company * Outside employment with any competitor, customer, or supplier of the Company, or any other outside employment arrangements that could jeopardize our interests or interfere with our productivity

You should not give or receive gifts or similar business courtesies without the approval of a director or above at North American Scientific. There should never be a benefit given to a customer with an explicit or implicit requirement to use or purchase a North American Scientific product without the approval of the Legal Department or an Officer of the Company. If any questions arise about gifts, tickets, or business-related gifts, please contact the Legal Department.

You should reexamine your investments, relationships and activities periodically to avoid becoming involved in a conflict of interest. If you are in doubt concerning the propriety of any activity, you are obliged to review the situation with your supervisor. The Company reserves the right to determine whether certain activities constitute a conflict of interest. If, after such determination and appropriate discussion, you persist in engaging in such activities, discharge may result.

Business Conduct Guideline #3 MAKE SURE THAT ALL ENTRIES IN THE BOOKS AND RECORDS OF NORTH AMERICAN SCIENTIFIC ARE COMPLETE AND ACCURATE

All entries made in North American Scientific's books, records and accounts must properly and fairly reflect the actual transactions being recorded, to the best knowledge, information, and belief of the employee(s) making the entries. Any person who reports Company information (which likely comprises

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every employee of the Company in one fashion or another) is required to report such information completely, correctly, and honestly.

Our policy expressly forbids the improper handling of our funds and assets. All funds and assets of the Company must be disclosed and recorded properly; no undisclosed or unrecorded fund or asset of the Company is to be established for any purpose.

Business Conduct Guideline #4 DO NOT USE COMPANY FUNDS OR RESOURCES, DIRECTLY OR INDIRECTLY, FOR UNAUTHORIZED POLITICAL OR CHARITABLE PURPOSES

In support of the democratic process, we encourage our employees to actively participate personally in political activities which are kept separate from their work. If you are engaged in a political activity of any kind, you must be careful not to use North American Scientific's name or resources, and ensure that such activities do not adversely affect any business relationships. In addition, you should exercise discretion in discussing political subjects with business contacts. If you have any questions about your participation in political activities, you are obliged to discuss the situation with your supervisor.

Company funds or assets should not be used for making political contributions or personal contributions to charity of any kind, whether in the United States or in a foreign country. This prohibition covers not only direct contributions, but indirect support of candidates or political parties, for example, the purchase of tickets for special dinners or other fund-raising events, the loan of employees to political parties or committees, the furnishing of transportation or duplicating services, etc. Company political or charitable activity is limited to those matters which are:

1. Clearly lawful 2. Closely related to the interests of the Company, its employees, or its shareholders 3. Performed with the prior written approval of the President of North American Scientific Business Conduct Guideline #5 DO NOT USE THE COMPANY NAME, ASSETS OR INFORMATION FOR PERSONAL GAIN

North American Scientific's name, assets, and information belong to the Company, and not to individual employees, regardless of their position in the Company.

Employees may not use the Company name in connection with personal activities, except as part of biographical summaries of work experience. If you intend to participate in meetings or publish materials where the Company name is coupled with the participant's or author's name, you must have advance written approval by the President of North American Scientific. In addition, any approved speech, presentation material, paper, or article to be published must be reviewed prior to publication by any of the following: President of North American Scientific, President of Theseus Imaging Corp., Director of Legal Affairs of North American Scientific.

Employees should regard the protection of Company assets (both physical and intangible) and services as a vital responsibility. Company assets include Company manuals, samples, forms, plans, customer

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lists and files, software, and all other documents, writings, and copies used or relied upon in your employment. These materials are proprietary and confidential to North American Scientific. They must not be used for personal benefit or any other improper purpose. They must not be sold, lent, given away, or otherwise disposed of, regardless of condition or value, except with proper authorization. They must be returned upon request or upon termination of employment. Personal use of Company telephones and computers must be reasonable and may not interfere with the accomplishment of one's assigned duties.

Company information is valuable both to the Company and to outsiders. Employees should follow the only safe rule: Give to outsiders only information that is:

* Clearly immaterial * Already available to the public (via press releases, annual reports, quarterly reports, filings with the SEC, etc.), * Required to properly perform the job * Not in response to a media inquiry. All media inquiries must be directed to an Officer of the Company

North American Scientific's Information Technology Department has established a prudent set of controls to prevent unauthorized distribution of Company information. Access to classified or confidential information stored on the mainframe computer system is controlled by a combination of passwords, physical access controls, and other security procedures. Similar security and control measures have been established for individual computers within and outside the Company. For further information about these procedures, you should consult with North American Scientific's Chief Information Officer.

A specific area of concern relates to non-public information about the Company, positive or negative, that could have a material effect on the market price of the Company's securities. Please ensure that you have read and understood the Company's most recent policy on insider trading, entitled Insider Trading Policies and Related Conduct. If you have any questions, or if you have not received the document and returned the acknowledgment, please contact North American Scientific's Director of Legal Affairs. Business Conduct Guideline #6 REFRAIN FROM THE PROMOTION, USE, OR SELLING OF ILLEGAL DRUGS

Improper use of narcotics and other controlled substances has become a significant problem to businesses, employees and society in general. Their sale, use and abuse, when connected to the conduct of business and the work environment, can threaten the safety, morale and public image of both the Company and its employees. Because of our strong concern in this area, we have established the following policy regarding illegal drugs:

1. No person will be hired who is known to be a promoter, user or seller of illegal drugs 2. Possession or use of illegal drugs on Company premises or during working hours, including break or meal periods, or working under the influence of illegal drugs, is strictly prohibited. Violation of this policy may result in immediate disciplinary action, up to and including discharge 3. Employees who are found to be sellers or involved in the sale, solicitation, or dealing of illegal drugs

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will be subject to immediate discharge from the Company

Business Conduct Guideline #7 EXERCISE GOOD JUDGMENT IN THE USE OF ALCOHOL

It is the Company's policy to discourage the use of alcoholic beverages during business hours, including lunch. The possession or use of alcoholic beverages on Company premises, except for authorized functions, is prohibited. Reporting to work or performing one's job assignments under the influence of alcohol is a safety risk and will result in immediate disciplinary action, up to and including discharge.

Business Conduct Guideline #8 STRICTLY ADHERE TO ALL SAFETY PROCEDURES, RULES AND REGULATIONS

North American Scientific considers employee safety and health as one of its highest priorities. The products made by North American Scientific and handled by many of our employees require strict adherence to safety procedures, rules and regulations. Your safety and the safety of each of your colleagues depend upon constant safety consciousness.

Employees must report any unsafe situation to one of the following persons: President of North American Scientific, President of Theseus Imaging Corp., Radiation Safety Officer, Alternate Radiation Safety Officer, Health Physicist, Director of Human Resources. In addition to complying with federal and state safety and health laws and regulations, employees will receive training on and should be familiar with the Company's safety and health policies.

Business Conduct Guideline #9 UPHOLD LAWS WITH RESPECT TO COMPETITIVE PRACTICES

North American Scientific operates in highly competitive markets. As a result, antitrust laws are an important fact of everyday business life. The antitrust laws are complex and must be strictly followed. Routine business decisions involving prices, terms and conditions of sale, dealings with suppliers and customers, and many other matters present sensitive situations under antitrust laws. The penalties for violating antitrust laws can be severe. It is therefore essential that every Company employee be aware of the antitrust laws and guard against their violation. North American Scientific employees should not:

* Discuss pricing or pricing practices with competitors * Divide customers, markets, or territories with competitors * Agree with anyone not to deal with another company * Force a customer to buy one product in order to get another product * Attempt to control a customer's resale price

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The purpose of these laws is to promote vigorous, free, and open competition in the marketplace. Competition helps ensure that the customer will get the best product at the lowest price. If in doubt about whether a certain practice violates antitrust laws, employees should consult the Legal Department.

North American Scientific Business Ethics Program

IMPLEMENTATION Employees are encouraged to seek advice about any issues raised by this booklet or encountered in their work. Advice may be obtained from your supervisor or any other member of management. Your Human Resources, Legal, Health Physics, Finance, and Information Technology Departments also can provide specific advice.

Any employee who becomes aware of conduct inconsistent with this booklet should report it immediately to appropriate management, as identified herein. Simply put, it is your duty to contact an appropriate member of management if you become aware of a violation of our Code of Ethics. Appropriate remedial action will be taken by the Company, up to and including termination of employment for offending parties. In addition, intentional violations may give rise to civil sanctions and criminal prosecution.

Attempts to use the Business Ethics Program to libel, slander, or otherwise harm another individual through false accusations, malicious rumors, or other irresponsible actions are prohibited.

Also prohibited is reprisal or the threat of reprisal against an employee who, in good faith, raises a concern about the implementation or enforcement of Company policy, including specifically the Guidelines of Business Conduct.

Such reprisal not only violates explicit Company policy, but also various federal and state laws and regulations.

COOPERATION WITH GOVERNMENT INVESTIGATIONS

If North American Scientific becomes involved in a government investigation regarding its operations, employees, customers, or suppliers, we will fully cooperate. North American Scientific will not alter or destroy any Company documents in anticipation of government investigation. Furthermore, North American Scientific will not lie or make any misleading statements to any government investigator or attempt to cause any other person to provide any false or misleading information. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 22 New York Stock Exchange Listed Company Manual Section 303A.02(a) Disclosures Pertaining to Director Independence

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Excerpts From General Electric Company's Proxy Statement on Schedule 14A (Feb. 27, 2007)
Director Independence. With 12 independent directors out of 16, the Board has satisfied its objective that at least two-thirds of the Board should consist of independent directors. For a director to be considered independent, the Board must determine that the director does not have any direct or indirect material relationship with GE. The Board has established guidelines to assist it in determining director independence, which conform to, or are more exacting than, the independence requirements in the New York Stock Exchange listing standards. In addition to applying these guidelines, which are set forth in Section 4 of our Governance Principles and attached as Appendix B to this proxy statement, the Board will consider all relevant facts and circumstances in making an independence determination. The independent directors are named above under Election of Directors. In the course of the Board's determination regarding the independence of each nonmanagement director, it considered any transactions, relationships and arrangements as required by the company's independence guidelines. In particular, with respect to each of the most recent three completed fiscal years, the Board evaluated for: each of directors Gonzalez, Lafley and Lane, the annual amount of sales to GE by the company where he serves as an executive officer, and purchases by that company from GE, and determined that the amount of sales and the amount of purchases in each fiscal year was below one percent of the annual revenues of each of those companies; director Jung, (1) the annual amount of purchases from GE by the company where she serves as an executive officer, and determined that the amount of purchases in each fiscal year was below one percent of the annual revenues of that company, and (2) the total amount of that company's indebtedness to GE, and determined that the amount of indebtedness was below one percent of that company's total consolidated assets; director Hockfield, the annual amount of sales to GE by a company where one of her immediate family members serves as an executive officer, and determined that the amount of sales in each fiscal year was below one percent of the annual revenues of that company; and director Lazarus, the annual amount of sales to GE by the company where she serves as an executive officer, and determined that the amount of sales in each fiscal year was below one percent of the annual revenues of that company. In addition, with respect to directors Cash, Fudge, Gonzalez, Hockfield, Jung, Lafley, Lane, Larsen, Lazarus, Nunn, Swieringa and Warner, the Board considered the amount of GE's discretionary charitable contributions to charitable organizations where he or she serves as an executive officer, director or trustee, and determined that GE's contributions constituted less than the greater of $200,000 or one percent of the charitable organization's annual consolidated gross revenues during the organization's last completed fiscal year. All members of the Audit, Management Development and Compensation, and Nominating and Corporate Governance Committees must be independent directors as defined by the Board's Governance Principles. Members of the Audit Committee must also satisfy a separate Securities and Exchange Commission (SEC) independence requirement, which provides that they may not accept directly or indirectly any consulting, advisory or other compensatory fee from GE or any of its subsidiaries other than their directors' compensation. As a policy matter, the Board has determined to apply a separate, heightened independence standard to members of both the Management Development and Compensation Committee and the Nominating and Corporate Governance Committee. No member of either committee may be a partner, member or principal of a law firm, accounting firm or investment banking firm that accepts consulting or advisory fees from GE or any of its subsidiaries below one percent of the annual revenues of that company. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

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Worksheet 23 New York Stock Exchange Listed Company Manual Corporate Governance Guidelines (June 1, 2006)578

New York Stock Exchange Listed Company Manual Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 24 New York Stock Exchange Listed Company Manual Code of Ethics Guidelines579

Worksheet 24 Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 25 Sample Disclosure of Corporate Governance Differences NYSE Listed Company Manual Section 303A.11 Excerpts From Elan Corporation's Web site: www.elan.com

Sample Disclosure of Corporate Governance Differences Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 26 NASDAQ Definition of an Independent Director Excerpts From NASDAQ Manual Section 4200 Definitions: Independent Director
1

1 NASDAQ Manual, Section 4200(a)(15), Independent Director.

Independent director means a person other than an executive officer or employee of the company or any other individual having a relationship which, in the opinion of the issuer's board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following persons shall not be considered independent: (A) a director who is, or at any time during the past three years was, employed by the company; (B) a director who accepted or who has a Family Member who accepted any compensation from the company in excess of $100,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than the following: (i) compensation for board or board committee service; (ii) compensation paid to a Family Member who is an employee (other than an executive officer) of the company; or (iii) benefits under a tax-qualified retirement plan, or non-discretionary compensation.

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Provided, however, that in addition to the requirements contained in this paragraph (B), audit committee members are also subject to additional, more stringent requirements under Rule 4350(d), [Audit Committee] (C) a director who is a Family Member of an individual who is, or at any time during the past three years was, employed by the company as an executive officer; (D) a director who is, or has a Family Member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient's consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: (i) payments arising solely from investments in the company's securities; or (ii) payments under non-discretionary charitable contribution matching programs. (E) a director of the issuer who is, or has a Family Member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the issuer serve on the compensation committee of such other entity; or (F) a director who is, or has a Family Member who is, a current partner of the company's outside auditor, or was a partner or employee of the company's outside auditor who worked on the company's audit at any time during any of the past three years. (G) in the case of an investment company, in lieu of paragraphs (A)(F), a director who is an interested person of the company as defined in Section 2(a)(19) of the Investment Company Act of 1940, other than in his or her capacity as a member of the board of directors or any board committee. Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

Worksheet 27 Summary of Corporate Governance Features


Sarbanes-Oxley Act of 2002 1 Section 301 302 402 406 407 Title Public Company Audit Committees Corporate Responsibilities for Financial Reports Enhanced Conflict of Interest Provisions Code of Ethics for Senior Financial Officers Disclosure of Audit Committee Financial Expert Corporate Governance Feature Establishes audit committee responsibilities Requires executive officer certification of SEC filings Prohibits personal loans to executive officers Requires adoption of a code of ethics Requires one member of the audit committee to be a financial expert.

1 Sarbanes-Oxley Act of 2002.

Securities and Exchange Commission Regulation S-K 1 Section Title Corporate Governance Feature 2 Requires the identification of directors, executive officers, promoters, and control persons.

229.401 Directors, Executive Officers, (Item Promoters and Control Persons 401)

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229.402 Executive Compensation (Item 402) 229.403 Security Ownership of Certain (Item Beneficial Owners and Management 403)

Calls for disclosure of executive compensation. Requires disclosure of information regarding individuals owning more than 5% of the registrant's voting securities, as well as ownership by management. Requires a code of ethics pertaining to the principal executive officer, principal financial officer, principal accounting officer or controller, or persons who perform these functions Covers corporate governance in six areas. Establishes standards covering director independence. Calls for disclosure of data regarding director attendance at meetings. Establishes requirements pertaining to nominating committee policies and procedures. Establishes requirements for audit committee policies and procedures. Establishes requirements for compensation committee policies and procedures. Calls for procedures that enable security holders to communicate with the board of directors.

229.406 Code of Ethics (Item 406)

229.407 Corporate Governance (Item 407) Item 407(a) Item 407(b) Item 407(c) Item 407(d) Item 407(e) Item 407(f) Director Independence Board Meetings and Committees; Annual Meetings Attendance Nominating Committee

Audit Committee Compensation Committee

Shareholder Communications

1 SEC Regulation S-K. Reg. 229.400. 2 Regulation S-K, Section 229.404 (Item 404), Transactions With Related Persons, Promoters, and Certain Control Persons, is discussed extensively in Section II.B.2, Non-Financial Statement Disclosures: Regulation S-K Requirements. Section 229.405 (Item 405), Compliance of Section 16(a) of the Exchange Act, is covered in Section III.B.4.a, Reporting Transactions.

NYSE Corporate Governance Standards Listed Company Manual 1 Section 303A.00 Title Introduction-General Application Corporate Governance Feature Specifies the entities to which the NYSE corporate governance standards apply. Calls for a majority of directors to be independent. Covers standards for determining director independence. Calls for non-management directors to meet regularly at separately scheduled executive

303A.01 303A.02 303A.03

Independent Directors Independence Tests Executive Sessions

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303A.04

Nominating/Corporate Governance Committee

sessions without management; at least one annual meeting of only independent directors. Covers principles governing the operations of the nominating/corporate governance committee composed entirely of independent directors. Deals with principles governing the operations of the compensation committee composed entirely of independent directors. Calls for establishing an audit committee that satisfies SEC Rule 10A-3, Listing Standards Relating to Audit Committees, requiring, among other items, members who are independent directors. Sets out audit committee standards for NYSE listed companies. Establishes requirement that stockholders vote on all equity compensation plans and plan revisions.

303A.05

Compensation Committee

303A.06

Audit Committee

303A.07

Audit Committee Additional Requirements Shareholder Approval of Equity Compensation Plans 2

303A.08

303A.09

Corporate Governance Guidelines Requires that listed companies adopt and disclose corporate governance guidelines. Code of Business Conduct and Ethics Requires listed companies to adopt a code of ethics applicable to directors, officers, and employees. Requires foreign private issuers to disclose differences between home country and US corporate governance standards. Requires the CEO of a listed company to certify annually that he or she is not aware of any violation of the NYSE corporate governance listing standards. Indicates the Exchange has the option of issuing a public reprimand letter to any company that violates a NYSE listing standard. Requires companies to maintain a public website with printable versions of committee charters, company code of ethics, and corporate governance guidelines.

303A.10

303A.11

Foreign Private Issuer Disclosure

303A.12

Certification Requirements

303A.13

Public Reprimand Letter

303A.14

Website Requirement

1 New York Stock Exchange, Listed Company Manual.

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2 Not covered in this Portfolio.

NASDAQ Qualitative Listing Requirements for Issuers NASDAQ Manual 1 Section 4350(a) Applicability Title Corporate Governance Feature Specifies the entities to which NASDAQ qualitative listing requirements apply. Calls for a majority of directors to be independent. Requires independent directors to meet at regularly scheduled executive sessions without non-independent directors or management. Establishes requirements that executive officer compensation be determined by or recommended to the board by either a majority of independent directors or a compensation committee comprised only of independent directors. Specifies that directors are to be selected by or recommended for the board's selection by either a majority of independent directors or by a nominations committee comprised solely of independent directors. Requires certification that issuer has, and will continue to have, an audit committee of at least three independent members who satisfy the independence requirements of SEC Rule 10A-3, Listing Standards Relating to Audit Committees. Requires company to notify NASDAQ after any executive officer becomes aware that the issuer is not in compliance with the NASDAQ qualitative listing requirements. Stipulates that each issuer adopt a code of conduct applicable to directors, officers, and employees. To be made publicly available.

4350(c)(1) Independent Directors 4350(c)(2) Independent Directors Must Have Regularly Scheduled Meetings (Executive Sessions)

4350(c)(3) Compensation of Officers

4350(c)(4) Nomination of Directors

4350(d)(2) Audit Committee Composition

4350(m)

Notification of Material Noncompliance

4350(n)

Code of Conduct

1 NASDAQ Manual.

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Working Papers

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Worksheet 28 SEC Enforcement Actions

This Worksheet illustrates how corporate governance failures can lead to the inappropriate use of company assets and services. The schemes appear in many forms. This Worksheet discusses a few of the deceptive practices, including: Undisclosed compensation; Using company funds to pay personal expenses; Inappropriate use of company services; The commingling of funds and expenses; Sales to related parties; Personal loans; and Profiteering in overvalued stock. 1. Undisclosed CompensationCollins and Aikman Corporation The SEC filed civil fraud charges against Collins & Aikman Corporation, an auto parts manufacturer, David A. Stockman, Collins's former CEO and chairman of the board, and eight other Collins directors and officers, including the chief financial officer, corporate controller, the treasurer, and a former member of Collins's board of directors. 1 The SEC alleges that by improperly accounting for supplier payments, Stockman and other officers inflated net income between 2001 and 2005. The complaint alleges that the defendants carried out the scheme by obtaining false documents from suppliers. According to the complaint, during this same time period, Stockman collected millions of dollars in management fees that were paid by Collins to a private equity fund owned by Stockman. The allegations stated that after certain elements of these activities were revealed, Stockman and other officers engaged in a public disinformation campaign to mislead investors by minimizing the extent of the fraudulent activities and hiding Collins's true financial condition. Collins and Aikman Corporation simultaneously settled the charges, without admitting or denying the allegations, by consenting to the entry of a final judgment enjoining the company from violating provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. Further, the complaint seeks permanent injunctions against the individual defendants against future violations of these provisions.
1 U.S. Securities And Exchange Commission Litigation Release No. 20055 / March 26, 2007 Accounting and Auditing Enforcement Release No. 2581 /March 26, 2007 Securities and Exchange Commission v. Collins & Aikman Corporation, David A. Stockman, J. Michael Stepp, Gerald E. Jones, David R. Cosgrove, John G. Galante, Elkin B. McCallum, Paul C. Barnaba, Christopher M. Williams and Thomas V. Gougherty, United States District Court for the Southern District of New York, SEC v. Collins & Aikman Corporation, et al., Civil Action No. 1:07-CV-2419(LAP) (S.D.N.Y. March 26, 2007).

2. Using Company Funds to Pay Personal ExpensesBuca, Inc. The SEC filed a complaint against Joseph P. Micatrotto, Sr., former chief executive officer, president, and chairman of the board of Buca, Inc., the corporate parent of the restaurant chains Buca di Beppo and Vinny T's of Boston. 2 In the complaint, the Commission alleges that Micatrotto received compensation that was not disclosed in SEC filings and that he also participated in undisclosed related party transactions. From 2000 to 2003, Micatrotto is alleged to have improperly billed Buca for numerous personal and non-business expenditures amounting to $849,100, for which he received reimbursement. These expenditures included $131,000 in ATM withdrawals; $127,000 in airline tickets that were submitted for reimbursement multiple times; a bill for the groom's dinner at his son's wedding; dog kenneling; and remodeling houses he owned in California, Las Vegas, and Minneapolis.

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2 U.S. Securities and Exchange Commission Litigation Release No. 19719 / June 7, 2006; Accounting and Auditing Enforcement Release No. 2438 / June 7, 2006; SEC v. Joseph P. Micatrotto, Sr. (U.S.D.C. Minnesota, Civil Action Number 06-CV-2319, filed June 7, 2006).

According to the complaint, since these expenses constituted additional compensation, they should have been disclosed in Buca's proxy statements. Allegedly, Buca's financial statements during this period understated Micatrotto's annual compensation by amounts ranging from 27% to 74%. Moreover, Buca's filings, which were reviewed and approved by Micatrotto, did not reveal two related party transactions. First, Micatrotto sought reimbursement for the purchase and renovation of a villa he owned in Italy. Second, instead of turning over to Buca a $65,000 payment made by a vendor for one of the company's corporate conferences, Micatrotto deposited the payment in his personal bank account. Without admitting or denying the allegations in the complaint, Micatrotto consented to the entry of a final judgment enjoining him permanently from violating specified sections of the Securities Act of 1933 and the Securities Exchange Act of 1934. In addition, he agreed to be barred from acting as a director or officer of a publicly traded company, paid disgorgement of $65,000 plus interest and was assessed a penalty of $500,000. 3. Inappropriate Use of Company ServicesITB The SEC brought public administrative proceedings against William H. Warner, chief financial officer and treasurer of ITB from 1983, and Robert J. Quigley, a director of ITB from 1980 and former president. 3 Nunzio DeSantis was a member of the board and chief executive officer from January 1997 until he resigned in January 1999. The Commission's findings are as follows. In February 1997, DeSantis instructed Warner to start making payments for the operating expenses and salaries of Southwest Jet, a corporate airline charter service. Southwest was operated by Louis DeSantis, DeSantis's 23-year-old son. The company, which had no assets of its own, operated an airplane that was partially owned by Nunzio DeSantis. Around this same time, DeSantis instructed Warner to place DeSantis's personal cook on the ITB payroll. As of March 31, 1997 ITB's payments to Southwest Jet and DeSantis's cook amounted to approximately $160,000. As these dealings constituted related party transactions, they required disclosure in ITB's financial statements and in SEC filings. Warner instead concealed these payments by classifying them as general and administrative expenses. The payments constituted approximately 10% of ITB's net loss for the first quarter of 1997 and contributed to a burgeoning cash-flow crisis.
3 United States Of America Before The Securities And Exchange Commission Securities Exchange Act Of 1934 Release No. 45441 / February 13, 2002 Accounting And Auditing Enforcement Release No. 1505 / February 13, 2002 Administrative Proceeding File No. 3-10699.

These findings were binding only on Warner and Quigley, who were ordered to cease and desist from causing violations or any future violations of specified sections of the Securities Exchange Act. The SEC filed a related civil injunctive action against Nunzio DeSantis and ITB. 4. Commingling Funds and ExpensesSentinel On August 20, 2007, the SEC filed an emergency civil action in U.S. District Court for the Northern District of Illinois against Sentinel Management Group, Inc. 4 Sentinel is an investment adviser located in Northbrook, Illinois. The Commission alleged that Sentinel had improperly commingled, misappropriated, and leveraged client securities in violation of the Investment Advisor Act of 1940. The SEC stated that Sentinel's advisory clients suffered undisclosed losses and risks of losses as a result of several unauthorized practices engaged in by Sentinel. 5 These practices allegedly included the following: 6
4 SEC v. Sentinel Management Group, Inc., Civil Action No. 07 C 4684 (N.D. IL), SEC News Digest, Issue 2007-161, August 21, 2007. 5 SEC v. Sentinel Management Group, Inc., Civil Action No. 07 C 4684 (N.D. IL), SEC News

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Digest ,Issue 2007-161, August 21, 2007. 6 SEC v. Sentinel Management Group, Inc., Civil Action No. 07 C 4684 (N.D. IL), SEC News Digest ,Issue 2007-161, August 21, 2007.

Pledging securities owned by clients as collateral in order to obtain a line of credit as high as $500 million for Sentinel; Placing at least $460 million of client securities properly belonging in segregated customer accounts in Sentinel's house proprietary account; Commingling client assets without the ability to verify ownership of particular securities by particular clients; and Providing false client account statements that did not accurately reflect client portfolio holdings or the fact that securities had been encumbered by Sentinel. Accordingly, Sentinel was ordered to provide, within five days of the court's order, a full accounting of its assets and liabilities, as well as those of its clients. Sentinel was also ordered to produce brokerage and bank documents so that a determination could be made regarding its clients' holdings and security ownership. 5. Sales to Related PartiesHollinger International, Inc. On March 16, 2007, the SEC settled an enforcement action that was pending in U.S. District Court, Northern District of Illinois, against F. David Radler, former deputy chairman and chief operating officer of Hollinger International, Inc. 7 Radler was ordered to pay approximately $23.7 million in disgorgement and prejudgment interest and a $5 million civil penalty. Furthermore, he was barred from serving as an officer or director of a public company. Radler consented to the judgment without admitting or denying the allegations in the Commission's complaint.
7 U.S. Securities And Exchange Commission Litigation Release No. 20043 / March 16, 2007 Accounting and Auditing Enforcement Release No. 2582 / March 16, 2007 U.S. Securities and Exchange Commission v. Conrad M. Black, F. David Radler and Hollinger Inc., Civil Action No. 04C7377 (N.D. Ill. 2004).

The enforcement action had been filed on November 15, 2004 against Radler; Hollinger, Inc., Hollinger International's controlling shareholder; and Conrad M. Black, Hollinger International's former chairman and CEO. In their complaint, the Commission alleged that from approximately 1999 through 2003, the defendants engaged in a fraudulent and deceptive scheme to divert cash and assets from Hollinger International, Inc., through a series of related party transactions. 8 The Commission alleged that through these transactions, Black and Radler diverted approximately $85 million to themselves, to other corporate insiders, and to Hollinger, Inc. According to the compliant, these funds were portrayed as non-competition payments by the defendants but arose from proceeds of Hollinger International's sales of newspaper publications. Black and Radler also allegedly directed Hollinger International to sell newspaper publications at below-market prices to a privately-held company that was owned and controlled by the defendants, including one sale that was consummated for $1.00. In addition, it was alleged that the defendants misled both Hollinger International's audit committee and board of directors with regard to the true nature of these related party transactions.
8 U.S. Securities And Exchange Commission Litigation Release No. 20043 / March 16, 2007 Accounting and Auditing Enforcement Release No. 2582 / March 16, 2007 U.S. Securities and Exchange Commission v. Conrad M. Black, F. David Radler and Hollinger Inc., Civil Action No. 04C7377 (N.D. Ill. 2004).

Given that these transactions slipped past Hollinger International's audit committee and board, it is worthwhile to examine whether these two bodies adequately carried out their fiduciary responsibilities. One of the related party sales involved the conveyance of assets for $1.00. This highly unusual

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transaction should have raised red flags with the committee and the board. This episode illustrates that it is in the best interests of audit committees to prepare a list of possible related parties, including all subsidiaries and affiliates, and closely scrutinize all transactions involving the listed company and these parties. In addition, the committee should investigate any unusual transactions that are consummated among related parties. Of course, the board has the ultimate responsibility for the financial statements and reports and should assure that the audit committee has carried out a reasonable investigation. 6. Personal LoansTyco The SEC filed a civil enforcement action against three former top executives of Tyco International Ltd., including L. Dennis Kozlowski, former chief executive officer and chairman of the board, Mark H. Swartz, former chief financial officer and a director, and Mark A. Belnick, former chief legal officer. 9 These defendants allegedly directed the company to grant to them hundreds of millions of dollars in undisclosed loans that carried a low or zero rate of interest. The defendants allegedly used the proceeds from these loans for personal expenses. According to the complaint, they later directed the company to forgive tens of millions of dollars of the outstanding loans. The complaint indicated that neither the nature of the loans nor their forgiveness was disclosed as required by law. According to the complaint, the defendants also engaged in other related party transactions that were likewise not disclosed to investors. These transactions allegedly bilked shareholders out of hundreds of thousands or even millions of dollars. According to the complaint, Belnick failed to disclose that he had received more than $14 million of interest-free loans from the company and used more than $10 million of the proceeds to acquire two residences that included an apartment in New York City and a house in Park City, Utah. Moreover, at about the same time they were granted the undisclosed loans, the complaint alleges that Kozlowski, Swartz, and Belnick were profiting by selling Tyco stock valued in the millions of dollars.
9 United States Securities and Exchange Commission Litigation Release No. 17722 / September 12, 2002 Accounting and Auditing Enforcement Release No. 1627 / September 12, 2002.

7. Profiteering on Overvalued StockCEC Industries The SEC filed a complaint on September 28, 1999 in U.S. District Court for the District of Columbia alleging that Gerald and Marie Levine overstated the assets of CEC in reports filed with the Commission for fiscal years 1996 and 1997. 10 Gerald Levine was CEC's chief executive officer. His wife Marie was secretary-treasurer and principal financial officer. The complaint further alleged that the Levines, cognizant that CEC's assets were overstated and the stock therefore overvalued, profited by selling CEC stock through an affiliate, Wire to Wire Inc. The Levines claimed that two overstated assets were corporate-owned: (1) a tract of land in Tennessee described as holding 52 million tons of coal and substantial timber assets, and (2) a large number of paintings, which, according to the Levines, had a value of $1.7 million. At trial, the SEC proved that CEC and its corporate affiliates did not have title to the land and that the paintings were worth only slightly more than $10,000. The Court found that the Levines had violated specific sections of both the Securities Act of 1933 and the Securities Exchange Act of 1934. They were enjoined for a period of 10 years from violating these provisions. The Levines were also barred for a period of 10 years from serving as an officer or director of a company that has securities registered under Section 12 of the Exchange Act or that is required to file reports under Section 15(d) of that Act.
10 U.S. Securities and Exchange Commission Litigation Release No. 20124 / May 22, 2007 Accounting and Auditing Enforcement Release No. 2610 / May 22, 2007 SEC v. Gerald H. Levine and Marie A. Levine, Civil Action No. 99 CIV 02568 (D.D.C.) (May 8, 2007).

Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Bibliography

OFFICIAL

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Public Laws:
Pub. L. No. 107-204, 116 Stat. 745, Sarbanes-Oxley Act of 2002.

Securities and Exchange Commission (SEC): Accounting and Auditing Enforcement Releases
United States Securities and Exchange Commission Litigation Release No. 17722 / September 12, 2002 and Accounting and Auditing Enforcement Release No. 1627 / September 12, 2002. U.S. Securities and Exchange Commission Litigation Release No. 19719 / June 7, 2006; Accounting and Auditing Enforcement Release No. 2438 / June 7, 2006; SEC v. Joseph P. Micatrotto, Sr., (U.S.D.C. Minnesota, Civil Action Number 06-CV-2319, filed June 7, 2006). U.S. Securities and Exchange Commission Litigation Release No. 20043 / March 16, 2007 Accounting and Auditing Enforcement Release No. 2582 / March 16, 2007 U.S. Securities and Exchange Commission v. Conrad M. Black, F. David Radler and Hollinger Inc., Civil Action No. 04C7377 (N.D. Ill. 2004). U.S. Securities and Exchange Commission Litigation Release No. 20055 / March 26, 2007 Accounting and Auditing Enforcement Release No. 2581 / March 26, 2007 Securities and Exchange Commission v. Collins & Aikman Corporation, David A. Stockman, J. Michael Stepp, Gerald E. Jones, David R. Cosgrove, John G. Galante, Elkin B. McCallum, Paul C. Barnaba, Christopher M. Williams and Thomas V. Gougherty, United States District Court for the Southern District of New York, SEC v. Collins & Aikman Corporation, et al. Civil Action No. 1:07-CV-2419(LAP) (S.D.N.Y. March 26, 2007). U.S. Securities and Exchange Commission Litigation Release No. 20124 / May 22, 2007 Accounting and Auditing Enforcement Release No. 2610 / May 22, 2007 SEC v. Gerald H. Levine and Marie A. Levine, Civil Action No. 99 CIV 02568 (D.D.C.) (May 8, 2007). United States of America Before the Securities and Exchange Commission Securities Exchange Act of 1934 Release No. 45441 / February 13, 2002 Accounting and Auditing Enforcement Release No. 1505 / February 13, 2002 Administrative Proceeding File No. 3-10699.

Acts
Securities Act of 1933, 17 C.F.R. 220 (1933). Securities Exchange Act of 1934, 17 C.F.R. 240 (1934).

News Digest
SEC v. Sentinel Management Group, Civil Action No. 07 C 4684 (N.D. IL), SEC News Digest, Issue 2007-161, August 21, 2007.

Regulations
17 C.F.R. 229, Regulation S-K (1934). 17 C.F.R. 210, Regulation S-X (1934). 17 C.F.R. 245, Regulation BTRBlackout Trading Restriction (2003).

Reports
Securities and Exchange Commission, Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002 (2003).

Securities Act Industry Guides


Industry Guide 3, Statistical Disclosure by Bank Holding Companies, 17 C.F.R. 229.802(c).

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Staff Accounting Bulletins


SEC Staff Accounting Bulletin 4, Equity Accounts. SEC Staff Accounting Bulletin 5, Miscellaneous Accounting.

Federal Reserve System


Title 12, Banks and Banking, Chapter II, Federal Reserve System, Part 220, Credit by Brokers and Dealers (Regulation T): 12 C.F.R. part 220.

Court Cases:
TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969). In re Enron Corp. Securities, 235 F. Supp. 2d 549 (2002).

Financial Accounting Standards Board (FASB): FASB Accounting Standards Codification


FASB ASC 205-10, Presentation of Financial Statements Overall FASB ASC 210-10, Balance Sheet Overall FASB ASC 235-10, Notes to Financial Statements Overall FASB ASC 250-10, Accounting Changes and Error Corrections Overall FASB ASC 323, Investments Equity Method and Joint Ventures FASB ASC 405-20, Liabilities Extinguishments of Liabilities FASB ASC 440-10, Commitments Overall FASB ASC 450, Contingencies FASB ASC 605-40, Revenue Recognition Gains and Losses FASB ASC 810-10, Consolidation Overall FASB ASC 820-10, Fair Value Measurements and Disclosures Overall FASB ASC 840-10, Leases Overall FASB ASC 840-20, Leases Operating Leases FASB ASC 840-30, Leases Capital Leases FASB ASC 845-10, Nonmonetary Transactions Overall FASB ASC 850-10, Related Party Disclosures Overall FASB ASC 860-10, Transfers and Servicing Overall FASB ASC 860-20, Transfers and Servicing Sales of Financial Assets FASB ASC Term Bargain Purchase Option FASB ASC Term Beneficial Interest

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FASB ASC Term Comprehensive Income FASB ASC Term Control FASB ASC Term Derecognize FASB ASC Term Exchange FASB ASC Term Fair Value (as used in FASB ASC 820) FASB ASC Term Financial Instrument FASB ASC Term Most Advantageous Market FASB ASC Term Other Comprehensive Income FASB ASC Term Principal Market FASB ASC Term Reasonably Possible FASB ASC Term Related Parties FASB ASC Term Take-or-Pay Contract FASB ASC Term Throughput Contract FASB ASC Term Transfer (as used in FASB ASC 860) FASB ASC Term Unconditional Purchase Obligation Accounting Rules and Disclosures Portfolio 5148-2nd: Related Party Transactions Bibliography

UNOFFICIAL American Institute of Certified Public Accountants (AICPA): AICPA Accounting Interpretations
AICPA Accounting Interpretations 18-1, 18-2, 18-3, The Equity Method of Accounting for Investments in Common Stock: Accounting Interpretations of APB Opinion No. 18.

AICPA Accounting Principles Board Opinions


APB Opinion No. 18, The Equity Method for Investments in Common Stock (Mar. 1971). APB Opinion No. 29, Accounting for Nonmonetary Transactions (May 1973).

AICPA Accounting Research Bulletins


ARB No. 43, Restatement and Revision of Accounting Research Bulletins (June 1953). ARB No. 51, Consolidation (Aug. 1959).

AICPA Statements on Auditing Standards


Statement on Auditing Standards No. 1, Codification of Auditing Standards and Procedures, AU 110. Statement on Auditing Standards No. 6, Related Party Transactions (July 1975). Superseded by SAS 45. Statement on Auditing Standards No. 45, Omnibus Standard on Auditing Standards, AU 334. Statement on Auditing Standards No. 78, Consideration of Internal Control in a Financial Statement Audit: An Amendment to Statement on Auditing Standards No. 55, AU 319.

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Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit, AU 316.

AICPA Technical Practice Aids


AICPA Technical Practice Aids/Technical Questions and Answers, TIS Section 1400.27, Consolidated Financial Statements.

Financial Accounting Standards Board (FASB): FASB Concepts Statements


FASB Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information (May 1980). FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (Dec. 1984). FASB Statement of Financial Accounting Concepts No. 7, Using Cash Flow and Present Value in Accounting Measurements (Feb. 2000).

FASB Emerging Issues Task Force


EITF Issue No. 02-5, Definition of Common Control in Relation to FASB Statement No. 141 (June 19-20, 2002). EITF Issue No. 85-21, Changes in Ownership Resulting in a New Basis of Accounting (Oct. 16, 1986).

FASB Statements of Standards


FASB Statement No. 5, Accounting for Contingencies. FASB Statement No. 13, Accounting for Leases. FASB Statement No. 47, Disclosure of Long-Term Obligations. FASB Statement No. 57, Related Party Disclosures. FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries An Amendment of ARB No. 51, With Related Amendments of APB Opinion No. 18 and ARB No. 43, Chapter 12. FASB Statement No. 98, Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate, Sales-Type Leases of Real Estate, Definition of the Lease Term, and Initial Direct Costs of Direct Financing Leases An Amendment of FASB Statements No. 13, 66, and 91 and a Rescission of FASB Statement No. 26 and Technical Bulletin No. 79-11. FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments. FASB Statement No. 130, Reporting Comprehensive Income. FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. FASB Statement No. 141, Business Combinations. FASB Statement No. 154, Accounting Changes and Error Corrections. FASB Statement No. 157, Fair Value Measurements.

FASB Technical Bulletins


FASB Technical Bulletin 85-5, Issues Relating to Accounting for Business Combinations.

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International Accounting Standards Committee: Statements of International Accounting Standards


Statement of International Accounting Standard No. 24, Related Party Disclosures (Dec. 2003).

Public Company Accounting Oversight Board:


Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements (Mar. 9, 2004). Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated With An Audit of Financial Statements (May 24, 2007).

Stock Exchange Regulations:


National Association of Securities Dealers Automated Quotations, NASDAQ Manual (NASDAQ, 2007). New York Stock Exchange, New York Stock Exchange Listed Company Manual (NYSE, 2007).

Books, Handbooks, and Treatises:


Cecil W. Jackson, Business Fairy Tales (Thomson 2006). Alister, K. Mason, Related Party Transactions (The Canadian Institute of Chartered Accountants 1979). William C. Powers, Jr., Chair, Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corporation (2002). S. Shapiro, Wayward Capitalists: Targets of the Securities and Exchange Commission (Yale University Press 1984).

Articles:
Timothy Bell and J. Carcello, A Decision Aid for Assessing the Likelihood of Fraudulent Financial Reporting, 19(1) Auditing: A Journal of Practice and Theory, 169-184 (2000). M. Beasley, J. Carcello and D. Hermanson, Top Ten Audit Deficiencies-SEC Sanctions, 191(4) Accounting, 63-67 (2001). Geriesh, Lotfi, Organizational Culture and Fraudulent Financial Reporting, 73 CPA J., 28-32 (Mar. 2003). Lev, Baruch, Corporate Earnings: Fact and Fiction, 17(2) J. Econ. Perspectives, 27-50 (2003). Wall Street Journal, Many Companies Report Transactions With Top Officers, (Dec. 29, 2003), at A1. Henry, Elaine, Elizabeth A. Gordon and D. Palia, Related Party Transactions and Corporate Governance, 9 Advances in Financial Economics, 1-28 (2004). G. D. Moyes, P. Lin and R.M. Landry, Raise the Red Flag, 62 Internal Auditor, 47-51 (2005). Henry, Elaine, Elizabeth A. Gordon, Brad Reed and Tim Louwers, The Role of Related Party Transactions in Fraudulent Financial Reporting, Working Paper, University of Miami (2006).

BNA Portfolios:
5114, Sebik and Starczewski, Accounting for Leases: Fundamental Principles (Accounting Policy and Practice Series). 5127, Ketz and Zyla, Fair Value Measurements: Valuation Principles and Audit Techniques (Accounting

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Policy and Practice Series). 5400, Guy and Blanco-Best, Auditors' Reports (Accounting Policy and Practice Series). 5402, Lorne, Smalley and Schultz, Internal Controls: Sarbanes-Oxley Act 404 and Beyond (Accounting Policy and Practice Series).

Contact us at http://www.bna.com.tjsl.idm.oclc.org/contact/index.html or call 1-800-372-1033 ISSN 1947-3923 Copyright 2011, The Bureau of National Affairs, Inc. Reproduction or redistribution, in whole or in part, and in any form, without express written permission, is prohibited except as permitted by the BNA Copyright Policy. http://www.bna.com.tjsl.idm.oclc.org/corp/index.html#V

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