Auditing Derivative Instruments, Hedging Activities, and Investments in Securities – AICPA Audit Guide

Preface

Applicability of Requirements of the Sarbanes-Oxley Act of 2002

Publicly held companies and other issuers (see definition, which follows) are subject to the provisions of the Sarbanes-Oxley Act of 2002 (the act) and related Securities and Exchange Commission (SEC) regulations implementing the act. Their outside auditors are also subject to the provisions of the act and to the rules and standards issued by the Public Company Accounting Oversight Board (PCAOB).

The following sections summarize certain key areas addressed by the act, the SEC, and the PCAOB that are particularly relevant to the preparation and issuance of an issuer's financial statements and the preparation and issuance of an audit report on those financial statements. However, the provisions of the act, the regulations of the SEC, and the rules and standards of the PCAOB are numerous and are not all addressed in this section or in this guide.

Definition of an Issuer

The act states that the term issuer means an issuer (as defined in Section 3 of the Securities Exchange Act of 1934 [15 U.S.C. 78c]), the securities of which are registered under Section 12 of that act (15 U.S.C. 78l), or that is required to file reports under Section 15(d) (15 U.S.C. 78o[d]), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 U.S.C. 77a et seq.), and that it has not withdrawn.

Issuers, as defined by the act, and other entities when prescribed by the rules of the SEC (collectively referred to in this guide as issuers or issuer) and their public accounting firms (who must be registered with the PCAOB) are subject to the provisions of the act, implementing SEC regulations, and the rules and standards of the PCAOB, as appropriate.

Nonissuers are those entities not subject to the act or the rules of the SEC.

Guidance for Issuers

Management Assessment of Internal Control

As directed by Section 404 of the act, the SEC adopted final rules requiring companies subject to the reporting requirements of the Securities Exchange Act of 1934 (the exchange act), other than registered investment companies and certain other entities, to include in their annual reports a report of management on the company's internal control over financial reporting. The SEC rules clarify that management's assessment and report is limited to internal control over financial reporting. The SEC's definition of internal control encompasses the Committee of Sponsoring Organizations of the Treadway Commission (COSO) definition but the SEC does not mandate that the entity use COSO as its criteria for judging effectiveness.

The auditor's attestation on the effectiveness of the internal control over financial reporting is currently required for large accelerated filers and accelerated filers. As established by Rule 12b-2 of the exchange act, the auditor's attestation for large accelerated and accelerated filers is currently effective; however, for nonaccelerated filers, the auditor's attestation is required for annual reports for fiscal years ending on or after December 15, 2009.

In its Interpretive Release No. 33-8810, Commission Guidance Regarding Management's Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, dated June 20, 2007, the SEC provides guidance for management regarding its evaluation and assessment of internal control over financial reporting. This guidance is organized around two broad principles. The first principle is that management should evaluate whether it has implemented controls that adequately address the risk that a material misstatement of the financial statements would not be prevented or detected in a timely manner. This guidance describes a top-down, risk-based approach to this principle. The second principle is that management's evaluation of evidence about the operation of its controls should be based on its assessment of risk. This guidance provides an approach for making risk based judgments about the evidence needed for the evaluation.

In its Final Rule Release No. 33-8809, Amendments to Rules Regarding Management's Report on Internal Control Over Financial Reporting, dated June 20, 2007, the SEC establishes, among other significant provisions, that a company performing an evaluation in accordance with the aforementioned interpretive guidance also satisfies the annual evaluation required by Exchange Act Rules 13a-15 and 15d-15. Also, the SEC defined the term material weakness and revised the requirements regarding the auditor's attestation report on the effectiveness of internal control over financial reporting to require the auditor to express an opinion directly on the effectiveness of internal control over financial reporting and not on management's evaluation process.

In its Final Rule Release No. 33-8829, Definition of the Term Significant Deficiency, dated August 3, 2007, the SEC defined the term significant deficiency for the purpose of implementing Section 302 and Section 404 of the act. By including a definition of significant deficiency in SEC rules, in addition to the definition of material weakness, the SEC has enabled management to refer to its rules and guidance for information on the meaning of these terms rather than referring to the auditing standards. Readers should refer to the SEC Web site at www.sec.gov for more information.

Guidance for Auditors

The act mandates a number of requirements concerning auditors of issuers, including mandatory registration with the PCAOB, the setting of auditing standards, inspections, investigations, disciplinary proceedings, prohibited activities, partner rotation, and reports to audit committees, among others. The PCAOB continues to establish rules and standards implementing provisions of the act concerning the auditors of issuers.

Applicability of Generally Accepted Auditing Standards and PCAOB Standards

Subject to SEC oversight, Section 103 of the act authorizes the PCAOB to establish auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms in the preparation and issuance of audit reports for entities subject to the act or the rules of the SEC. Accordingly, public accounting firms registered with the PCAOB are required to adhere to all PCAOB standards in the audits of issuers and other entities when prescribed by the rules of the SEC.

For those entities not subject to the act or the rules of the SEC, the preparation and issuance of audit reports remain governed by generally accepted auditing standards (GAAS) as issued by the Auditing Standards Board.

Major Existing Differences Between GAAS and PCAOB Standards

Major differences between GAAS and PCAOB standards are described in both part I of volume I of the AICPA Professional Standards and in part I of the AICPA publication PCAOB Standards and Related Rules. Please refer to appendix A, "Major Existing Differences Between AICPA Standards and PCAOB Standards," of this guide for a summary of the major existing differences between AICPA standards and PCAOB standards.

Select SEC Developments

International Financial Reporting Standards

International Financial Reporting Standards (IFRSs) is a set of accounting standards developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of public company financial statements. The IASB is an independent accounting standards body, based in London, that consists of 14 members from nine countries, including the United States. The IASB began operations in 2001, when it succeeded the International Accounting Standards Committee (IASC). The IASC was formed in 1973, soon after the formation of the Financial Accounting Standards Board (FASB). In 2001, the IASC was disbanded and a new oversight body, the IASC Foundation, was created to oversee the IASB. This oversight role is very similar to that of the Financial Accounting Foundation in its capacity as the oversight body of FASB, the Governmental Accounting Standards Board, and other advisory councils.

The term IFRS has both a narrow and a broad meaning. Narrowly, the IFRSs refer to the new numbered series of pronouncements that the IASB is issuing, as differentiated from the International Accounting Standards (IAS) issued by its predecessor. More broadly, the IFRSs refer to the entire body of the IASB pronouncements, including standards and interpretations approved by the IASB as well as the IASs and the related interpretations issued by the Standing Interpretations Committee as approved by the IASC.

Timeline of SEC Activities Towards Adoption of the IFRSs

A significant step forward towards acceptance of the IFRSs in the United States occurred when, in 2005, the then-chief accountant of the SEC, published a "roadmap" for the possible elimination of the requirement for foreign private issuers (FPI) to reconcile financial statements prepared under the IFRSs to U.S. generally accepted accounting principles (GAAP). The roadmap sets forth a series of steps and standards to be met before the IFRSs will be accepted by the SEC as equivalent to U.S. GAAP for FPI.

In December 2007, the SEC made further progress towards convergence with the issuance of Final Rule Release No. 33-8879, Acceptance From Foreign Private Issuers of Financial Statements Prepared in Accordance With International Financial Reporting Standards Without Reconciliation to U.S. GAAP, in December 2007, that permits an FPI in its filings with the SEC to use financial statements prepared in accordance with the IFRSs as issued by the IASB without reconciliation to U.S. GAAP. The rule amendments are effective for annual financial statements for financial years ending after November 15, 2007.

In August 2007, the SEC issued Concept Release 33-8831, Concept Release On Allowing U.S. Issuers To Prepare Financial Statements In Accordance With International Financial Reporting Standards, to gather input regarding the role of the IFRSs as a basis of financial reporting in the U.S. public capital market by U.S. issuers. This action reflected the growing interest in equitable treatment of U.S. issuers to adopt the IFRSs as the basis of accounting in financial statements filed with the SEC just as their foreign counterparts have the option to do.

In November 2008, the SEC issued Proposed Rule Release No. 33-8982, Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, that sets forth seven milestones which, if achieved, could lead to the mandatory adoption of IFRS by U.S. issuers. These seven milestones relate to

The implementation of the proposed rule provides for a staged transition rather than having all U.S. issuers transition at once. Provisionally, under the proposed transition period, IFRS filings would begin for SEC registrants as follows:

This proposed rule indicates that in 2011 the SEC, after reviewing the status of the milestones and considering whether the adoption of the IFRSs is in the public interest and promotes investor protection, would determine whether to proceed with rules requiring U.S. public companies to file financial statements prepared in accordance with the IFRSs. Given the recent changes in the political administration as well as the SEC leadership, readers are encouraged to monitor developments related to the adoption of the IFRSs on the SEC's Web site at www.sec.gov/spotlight.shtml.

FASB and IASB Memorandum of Understanding

In September 2008, FASB and the IASB updated their Memorandum of Understanding (MoU), originally published in 2006 to reaffirm their respective commitments to the development of high quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. In developing the original MoU, FASB and the IASB agreed on priorities and established milestones as part of a joint work program to develop new common standards that improve the financial information reported to investors.

The boards of FASB and the IASB agreed that the goal of joint projects is to produce common, principles-based standards, subject to the required due process. In the MoU, the boards identified the following 11 convergence topics on which to focus:

Both FASB and the IASB note that their individual and joint efforts are not limited to the preceding items, but they remain committed to the MoU.

Readers are also encouraged to monitor developments on the AICPA's Web site, www.ifrs.com, in addition to FASB, IASB, and SEC Web sites. The growing acceptance of the IFRSs as a basis for U.S. financial reporting could represent a fundamental change for the U.S. accounting profession. Acceptance of a single set of high-quality accounting standards for worldwide use by public companies has been gaining momentum around the globe for the past few years.

Interactive Data to Improve Financial Reporting

SEC Final Rule Release No. 33-9002, Interactive Data to Improve Financial Reporting, issued in January 2009, requires domestic and foreign public companies that prepare their financial statements in accordance with U.S. GAAP, and foreign private issuers that prepare their financial statements in accordance with the IFRSs as issued by the IASB, to use interactive data for financial information. Companies will provide their financial statements to the SEC and on their corporate Web sites in interactive data format using the eXtensible Business Reporting Language. This will allow investors to use interactive data to receive important information in a fast, more reliable manner, at a reduced cost. In the past, companies voluntarily filed SEC financial information in interactive data format.

This approval requires that for public companies, interactive data financial reporting will occur on a phased-in schedule beginning in 2009. The largest companies who file using U.S. GAAP with a public float exceeding $5 billion (approximately 500 companies) will be required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2009. The remaining companies who file using U.S. GAAP will be required to file with interactive data on a phased-in schedule over the next two years. Companies reporting in the IFRSs issued by the IASB will be required to provide their interactive data reports starting with fiscal years ending on or after June 15, 2011. Companies can adopt interactive data earlier than their required start date. All U.S. public companies will have filed interactive data financial information by December 2011 for use by investors. The full text of the final rule is available on the SEC's Web site at www.sec.gov/rules/final/2009/33- 9002.pdf.

Select PCAOB Developments

PCAOB Auditing Standard No. 6, Evaluating Consistency of Financial Statements

In January 2008, the PCAOB adopted PCAOB Auditing Standard No. 6, Evaluating Consistency of Financial Statements (AICPA, PCAOB Standards and Related Rules, Auditing Standards), and related conforming amendments, which became effective November 15, 2008. This standard and its related amendments, among other significant provisions, update the auditor's responsibilities to evaluate and report on the consistency of a company's financial statements and align the auditor's responsibilities with FASB Statement No. 154, Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3. FASB Statement No. 154 has been codified primarily in FASB Accounting Standards Codification 250-10. PCAOB Auditing Standard No. 6 requires the auditor to recognize, in the auditor's report, a company's correction of a material misstatement, regardless of whether it involves the application of an accounting principle. This standard also clarifies that the auditor's report should indicate whether an adjustment to previously issued financial statements results from a change in accounting principle or the correction of a misstatement.

In the conforming amendments, the PCAOB removed the GAAP hierarchy from its standards because it believes the hierarchy is more appropriately located in the accounting standards. These amendments do not change the principles in AU section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles (AICPA, PCAOB Standards and Related Rules, Interim Standards), for evaluating fair presentation of the financial statements in conformity with GAAP. This action was prompted by and issued concurrently with FASB's issuance of FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles, which also became effective November 15, 2008. Refer to the related discussion in the notice to readers for more information on FASB Statement No. 168, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles— a replacement of FASB Statement No. 162, which replaced FASB Statement No. 162.

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