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Aicpa Sec Independence Rules Comparison Essay

17 CFR PARTS 230 and 240

[RELEASE NOS. 33-7801, 34-42430; INTERNATIONAL SERIES NO. 1215]

FILE NO. S7-04-00

[RIN: 3235-AH65]

INTERNATIONAL ACCOUNTING STANDARDS

AGENCY: Securities and Exchange Commission.

ACTION:

Concept release; request for comment.

SUMMARY:

With the activities and interests of investors, lenders and companies becoming increasingly global, the Commission is increasing its involvement in a number of forums to develop a globally accepted, high quality financial reporting framework. Our efforts, at both a domestic and international level, consistently have been based on the view that the only way to achieve fair, liquid and efficient capital markets worldwide is by providing investors with information that is comparable, transparent and reliable. That is why we have pursued a dual objective of upholding the quality of financial reporting domestically, while encouraging convergence towards a high quality global financial reporting framework internationally. In this release, we are seeking comment on the necessary elements of such a framework, as well as on ways to achieve this objective. One aspect of this is seeking input to determine under what conditions we should accept financial statements of foreign private issuers that are prepared using the standards promulgated by the International Accounting Standards Committee.

DATES:

Comments should be received on or before May 23, 2000.

ADDRESSES:

Please send three copies of your comments to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. You also may submit your comments electronically at the following e-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-04-00; you should include this file number in the subject line if e-mail is used. Comment letters can be inspected and copied in our public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549-0102. We will post electronically submitted comments on our Internet Web site at <www.sec.gov>.

FOR FURTHER INFORMATION CONTACT:

Sandra Folsom Kinsey, Senior International Counsel, Division of Corporation Finance at (202) 942-2990, or D.J. Gannon, Professional Accounting Fellow, Office of the Chief Accountant at (202) 942 4400.

SUPPLEMENTARY INFORMATION

I. INTRODUCTION AND PURPOSE OF THIS RELEASE

Over the last two decades, the global financial landscape has undergone a significant transformation. These developments have been attributable, in part, to dramatic changes in the business and political climates, increasing global competition, the development of more market-based economies, and rapid technological improvements. At the same time, the world's financial centers have grown increasingly interconnected.

Corporations and borrowers look beyond their home country's borders for capital. An increasing number of foreign companies routinely raise or borrow capital in U.S. financial markets, and U.S. investors have shown great interest in investing in foreign enterprises. This globalization of the securities markets has challenged securities regulators around the world to adapt to meet the needs of market participants while maintaining the current high levels of investor protection and market integrity.

Our efforts to develop a global financial reporting framework have been guided by the cornerstone principle underlying our system of regulation -- pursuing our mandate of investor protection by promoting informed investment decisions through full and fair disclosure. Financial markets and investors, regardless of geographic location, depend on high quality information in order to function effectively. Markets allocate capital best and maintain the confidence of the providers of capital when the participants can make judgments about the merits of investments and comparable investments and have confidence in the reliability of the information provided.

Because of increasing cross-border capital flows, we and other securities regulators around the world have an interest in ensuring that high quality, comprehensive information is available to investors in all markets. We stated this view in 1988, when we issued a policy statement that noted that "all securities regulators should work together diligently to create sound international regulatory frameworks that will enhance the vitality of capital markets."1 We have applied this approach in a number of instances, including our recent adoption of the International Disclosure Standards developed by the International Organization of Securities Commissions (IOSCO) for non-financial statement information.2 Our decision to adopt the International Disclosure Standards was based on our conclusion that the standards were of high quality and that their adoption would provide information comparable to the amount and quality of information that U.S. investors receive today.

Currently, issuers wishing to access capital markets in different jurisdictions must comply with the requirements of each jurisdiction, which differ in many respects. We recognize that different listing and reporting requirements may increase the costs of accessing multiple capital markets and create inefficiencies in cross-border capital flows. Therefore, we are working with other securities regulators around the world to reduce these differences. To encourage the development of accounting standards to be considered for use in cross-border filings, we have been working primarily through IOSCO, and focusing on the work of the International Accounting Standards Committee (IASC). Throughout this effort, we have been steadfast in advocating that capital markets operate most efficiently when investors have access to high quality financial information.

However, ensuring that high quality financial information is provided to capital markets does not depend solely on the body of accounting standards used. An effective financial reporting structure begins with a reporting company's management, which is responsible for implementing and properly applying generally accepted accounting standards. Auditors then have the responsibility to test and opine on whether the financial statements are fairly presented in accordance with those accounting standards. If these responsibilities are not met, accounting standards, regardless of their quality, may not be properly applied, resulting in a lack of transparent, comparable, consistent financial information.

Accordingly, while the accounting standards used must be high quality, they also must be supported by an infrastructure that ensures that the standards are rigorously interpreted and applied, and that issues and problematic practices are identified and resolved in a timely fashion. Elements of this infrastructure include:

  • effective, independent and high quality accounting and auditing standard setters;
  • high quality auditing standards;
  • audit firms with effective quality controls worldwide;
  • profession-wide quality assurance; and
  • active regulatory oversight.

In this release, we discuss a number of issues related to the infrastructure for high quality financial reporting. We solicit views on the elements necessary for developing a high quality, global financial reporting framework for use in cross-border filings. We believe these issues should be considered in the development of any proposals to modify current requirements for enterprises that report using IASC standards because our decisions should be based on the way the standards actually are interpreted and applied in practice.

We recognize that each of the elements of the infrastructure may be at different stages of development and that decisions and progress on some of these infrastructure issues may be independent of the body of accounting standards used.

II. ELEMENTS OF A HIGH QUALITY GLOBAL FINANCIAL REPORTING STRUCTURE

A. High Quality Accounting Standards

High quality accounting standards are critical to the development of a high quality global financial reporting structure. Different accounting traditions have developed around the world in response to varying needs of users for whom the financial information is prepared. In some countries, for example, accounting standards have been shaped primarily by the needs of private creditors, while in other countries the needs of tax authorities or central planners have been the predominant influence. In the United States, accounting standards have been developed to meet the needs of participants in the capital markets.

U.S. accounting standards provide a framework for reporting that seeks to deliver transparent, consistent, comparable, relevant and reliable financial information. Establishing and maintaining high quality accounting standards are critical to the U.S. approach to regulation of capital markets, which depends on providing high quality information to facilitate informed investment decisions.

High quality accounting standards consist of a comprehensive set of neutral principles that require consistent, comparable, relevant and reliable information that is useful for investors, lenders and creditors, and others who make capital allocation decisions. High quality accounting standards are essential to the efficient functioning of a market economy because decisions about the allocation of capital rely heavily on credible and understandable financial information.

When issuers prepare financial statements using more than one set of accounting standards, they may find it difficult to explain to investors the accuracy of both sets of financial statements if significantly different operating results, financial positions or cash flow classifications are reported under different standards for the same period. Questions about the credibility of an entity's financial reporting are likely where the differences highlight how one approach masks poor financial performance, lack of profitability, or deteriorating asset quality.

The efficiency of cross-border listings would be increased for issuers if preparation of multiple sets of financial information was not required. However, the efficiency of capital allocation by investors would be reduced without consistent, comparable, relevant and reliable information regarding the financial condition and operating performance of potential investments. Therefore, consistent with our investor protection mandate, we are trying to increase the efficiency of cross-border capital flows by seeking to have high quality, reliable information provided to capital market participants.

B. High Quality Auditing Standards

The audit is an important element of the financial reporting structure because it subjects information in the financial statements to independent and objective scrutiny, increasing the reliability of those financial statements. Trustworthy and effective audits are essential to the efficient allocation of resources in a capital market environment, where investors are dependent on reliable information.

Quality audits begin with high quality auditing standards. Recent events in the United States have highlighted the importance of high quality auditing standards and, at the same time, have raised questions about the effectiveness of today's audits and the audit process.3 We are concerned about whether the training, expertise and resources employed in today's audits are adequate.

Audit requirements may not be sufficiently developed in some countries to provide the level of enhanced reliability that investors in U.S. capital markets expect. Nonetheless, audit firms should have a responsibility to adhere to the highest quality auditing practices -- on a world-wide basis -- to ensure that they are performing effective audits of global companies participating in the international capital markets. To that end, we believe all member or affiliated firms performing audit work on a global audit client should follow the same body of high quality auditing practices even if adherence to these higher practices is not required by local laws.4 Others have expressed similar concerns.5

C. Audit Firms with Effective Quality Controls

Accounting and auditing standards, while necessary, cannot by themselves ensure high quality financial reporting. Audit firms with effective quality controls are a critical piece of the financial reporting infrastructure. Independent auditors must earn and maintain the confidence of the investing public by strict adherence to high quality standards of professional conduct that assure the public that auditors are truly independent and perform their responsibilities with integrity and objectivity. As the U.S. Supreme Court has stated: "It is not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's financial statements depends upon the public perception of the outside auditor as an independent professional...."6 In addition, audit firms must ensure that their personnel comply with all relevant professional standards.

The quality control policies and procedures applicable to a firm's accounting and auditing practice should include elements such as:7

  • independence, integrity and objectivity;
  • personnel management, including proper training and supervision;
  • acceptance and continuance of clients and engagements;
  • engagement performance; and
  • monitoring.

A firm's system of quality control should provide the firm and investors with reasonable assurance that the firm's partners and staff are complying with the applicable professional standards and the firm's standards of quality.

Historically, audit firms have developed internal quality control systems based on their domestic operations. However, as clients of audit firms have shifted their focus to global operations, audit firms have followed suit and now operate on a world-wide basis. Therefore, quality controls within audit firms that rely on separate national systems may not be effective in a global operating environment. We are concerned that audit firms may not have developed and maintained adequate internal quality control systems at a global level.8

D. Profession-Wide Quality Assurance

The accounting profession should have a system to ensure quality in the performance of auditing engagements by its members. Necessary elements of the system include:

  • providing continuing education and training on recent developments;
  • providing an effective monitoring system to ensure that:
    • firms comply with applicable professional standards;
    • firms have reasonable systems of quality control;
    • there is an in-depth, substantive and timely study of firms' quality controls, including reviews of selected engagements;
    • deficiencies and/or opportunities for improvements in quality controls are identified; and
    • results of monitoring are communicated adequately to the appropriate parties.
  • providing an effective and timely disciplinary process when individuals or firms have not complied with applicable firm or professional standards.

In some jurisdictions the local accounting profession may have a system of quality assurance. However, structures focused on national organizations and geographic borders do not seem to be effective in an environment where firms are using a number of affiliates to audit enterprises in an increasingly integrated global environment.

E. Active Regulatory Oversight

The U.S. financial reporting structure has a number of separate but interdependent elements, including active regulatory oversight of many of these elements, such as registrants' financial reporting, private sector standard-setting processes and self-regulatory activities undertaken by the accounting profession. Each of these elements is essential to the success of a high quality financial reporting framework. This oversight reinforces the development of high quality accounting and auditing standards and focuses them on the needs of investors. It provides unbiased third party scrutiny of self-regulatory activities. Regulatory oversight also reinforces the application of accounting standards by registrants and their auditors in a rigorous and consistent manner and assists in ensuring a high quality audit function.

III. BACKGROUND ON EFFORTS TO REDUCE BARRIERS TO CROSS- BORDER CAPITAL FLOWS

A. Foreign Private Issuers -- The Current Requirements

The Securities Act of 19339 and the Securities Exchange Act of 193410 establish the disclosure requirements for public companies in the United States. The form and content requirements for financial statements filed with the Commission are set forth in Regulation S-X.11 This framework establishes the initial and continuing disclosures that companies must make if they wish to offer securities in the United States or have their securities traded publicly on an exchange or quoted on the Nasdaq stock market.12

Our current financial statement requirements for foreign private issuers parallel those for U.S. domestic issuers, except that foreign private issuers may prepare financial statements in accordance with either U.S. generally accepted accounting principles (U.S. GAAP) or with another comprehensive body of accounting standards (including IASC standards). A foreign private issuer using accounting standards other than U.S. GAAP must provide an audited reconciliation to U.S. GAAP.13

There are some exceptions to this reconciliation requirement. For example, we have amended our requirements for financial statements of foreign private issuers to permit use of certain IASC standards without reconciliation to U.S. GAAP.14 These are:

  • use of International Accounting Standard (IAS) 7, Cash Flow Statements (as amended in 1992) for the preparation of a statement of cash flows;
  • acceptance of portions of IAS 22, Business Combinations (as amended in 1993), regarding the method of accounting for a business combination and the determination of the amortization period for goodwill and negative goodwill; and
  • acceptance of portions of IAS 21, The Effects of Changes in Foreign Exchange Rates (as amended in 1993), regarding translation of amounts stated in a currency of an entity in a hyperinflationary economy.

By requiring a U.S. GAAP reconciliation, with the exceptions noted above,we do not seek to establish a higher or lower disclosure standard for foreign companies than for domestic companies. Rather, the objective of this approach is to protect the interests of U.S. investors by requiring that all companies accessing U.S. public markets provide high quality financial reporting that satisfies the informational needs of investors, without requiring use of U.S. standards in the presentation of that information.15

The U.S. GAAP reconciliation requirement requires foreign issuers to supplement their home country financial statements. The total number of foreign reporting companies increased from 434 in 1990 to approximately 1,200 currently.

B. Towards Convergence of Accounting Standards in a Global Environment

In the past, different views of the role of financial reporting made it difficult to encourage convergence of accounting standards. Now, however, there appears to be a growing international consensus that financial reporting should provide high quality financial information that is comparable, consistent and transparent, in order to serve the needs of investors. Over the last few years, we have witnessed an increasing convergence of accounting practices around the world. A number of factors have contributed to this convergence. First, large multinational corporations have begun to apply their home country standards, which may permit more than one approach to an accounting issue, in a manner consistent with other bodies of standards such as IASC standards or U.S. GAAP. Second, the IASC has been encouraged to develop standards that provide transparent reporting and can be applied in a consistent and comparable fashion worldwide. Finally, securities regulators and national accounting standard-setters are increasingly seeking approaches in their standard-setting processes that are consistent with those of other standard-setters.16 Some national standard-setters are participating in multinational projects, such as those on accounting for business combinations, in order to draw on a broader range of comment about an issue.

If convergence of disclosure and accounting standards contributes to an increase in the number of foreign companies that publicly offer or list securities in the U.S. capital markets, investors in the United States would benefit from increased investment opportunities and U.S. exchanges would benefit from attracting a greater number of foreign listings. Although the U.S. markets have benefited greatly from the high quality financial reporting that U.S. GAAP requires, current disparities in accounting practices may be a reason foreign companies do not list their securities on U.S. exchanges. As Congress has recognized,

[E]stablishment of a high quality comprehensive set of generally accepted international accounting standards would greatly facilitate international financing activities and, most importantly, would enhance the ability of foreign corporations to access and list in the United States markets.17

These concerns are offset by significant benefits realized by companies reporting under U.S. GAAP, as a result of improvements in the quality of information available to both management and shareholders as a result of reporting under U.S. GAAP.18 It is important that convergence does not sacrifice key elements of high quality financial reporting that U.S. investors enjoy currently. Investors benefit when they have the ability to compare the performance of similar companies regardless of where those companies are domiciled or the country or region in which they operate.

Over the years, we have realized that foreign companies make their decisions about whether to offer or list securities in the United States for a variety of economic, financial, political, cultural and other reasons. Many of these reasons are unrelated to U.S. regulatory requirements.19 However, some foreign companies cite, among other reasons, a reluctance to adopt U.S. accounting practicesas a reason for not listing in the United States. These companies have indicated that they have forgone listing in the United States rather than follow accounting standards that they have not helped formulate. Therefore, accepting financial statements prepared using IASC standards without requiring a reconciliation to U.S. GAAP could be an inducement to cross-border offerings and listings in the United States.

On the other hand, other factors could continue to deter foreign access to the U.S. markets. For example, some foreign companies have expressed concern with the litigation exposure and certain public disclosure requirements that may accompany entrance into the U.S. markets.20 Foreign companies also may be subject to domestic pressure to maintain primary listings on home country stock exchanges.

C. Development of the Core Standards Project

After studying issues relating to international equity flows, IOSCO noted that development of a single disclosure document for use in cross-border offerings and listings would be facilitated by the development of internationally accepted accounting standards. Rather than attempt to develop those standards itself, IOSCO focused on the efforts of the IASC. In 1993, IOSCO identified for the IASC what IOSCO believed to be the necessary components of a core set of standards that would comprise a comprehensive body of accounting principles for enterprises making cross-border securities offerings. IOSCO later identified a number of issues relating to the then-current IASC standards. The IASC then prepared a work plan designed to address the most significant issues identified by IOSCO -- the "core standards" work program. In 1995, IOSCO and the IASC announced agreement on this work program, and IOSCO stated that if the resulting core standards were acceptable to IOSCO's Technical Committee, that group would recommend endorsement of the IASC standards. The focus of IOSCO's involvement in the core standards project is on use of IASC standards by large, multinational companies for cross-border capital-raising and listing.21

IV. MAJOR ISSUES TO BE ADDRESSED IN OUR ASSESSMENT OF THE IASC STANDARDS

A. Criteria for Assessment of the IASC Standards

In an April 1996 statement regarding the IASC core standards project, we indicated that, once the IASC completed its project, we would consider allowing use of the resulting standards in cross-border filings by foreign issuers offering securities in the United States.22 The three criteria set forth in that statement remain the criteria that will guide our assessment of the IASC standards. We request your views on whether the IASC standards:

    1. constitute a comprehensive, generally accepted basis of accounting;

    2. are of high quality; and

    3. can be rigorously interpreted and applied.

In responding to the requests for comment set forth below, please be specific in your response, explaining in detail your experience, if any, in applying IASC standards, and the factors you considered in forming your opinion. Please consider both our mandate for investor protection and the expected effect on market liquidity, competition, efficiency and capital formation.

IASC standards are published and copyrighted by the IASC, and we can not reproduce those standards as part of this release. However, copies of the standards have been placed in our public reference rooms. The IASC also has summaries of each standard available on its website at <www.iasc.org.uk>. A listing of the IASC standards and their effective dates is included as Appendix B. For your convenience, a listing of questions 1-26 is included as Appendix A.

1. Are the Core Standards Sufficiently Comprehensive?

The goal of the core standards project was to address the necessary components of a reasonably complete set of accounting standards that would comprise a comprehensive body of principles for enterprises undertaking cross-border offerings and listings. In developing the work program for the core standards project, IOSCO specified the minimum components of a set of "core standards" and identified issues to be addressed by the IASC.23 For topics outside the core standards, such as industry-specific accounting standards, it was agreed that IOSCO members either would accept "home country" treatment or require specific "host country" treatment or equivalent disclosure.

Q.1 Do the core standards provide a sufficiently comprehensive accounting framework to provide a basis to address the fundamental accounting issues that are encountered in a broad range of industries and a variety of transactions without the need to look to other accounting regimes? Why or why not?

Q.2 Should we require use of U.S. GAAP for specialized industry issues in the primary financial statements or permit use of home country standards with reconciliation to U.S. GAAP? Which approach would produce the most meaningful primary financial statements? Is the approach of having the host country specify treatment for topics not addressed by the core standards a workable approach? Is there a better approach?

Q.3 Are there any additional topics that need to be addressed in order to provide a comprehensive set of standards?

2. Are the IASC Standards of Sufficiently High Quality? Why or Why Not?

When we refer to the need for high quality accounting standards, we mean that the standards must result in relevant, reliable information that is useful for investors, lenders, creditors and others who make capital allocation decisions. To that end, the standards must (i) result in a consistent application that will allow investors to make a meaningful comparison of performance across time periods and among companies; (ii) provide for transparency, so that the nature and the accounting treatment of the underlying transactions are apparent to the user; and (iii) provide full disclosure, which includes information that supplements the basic financial statements, puts the presented information in context and facilitates an understanding of the accounting practices applied. Such standards should:

  • be consistent with an underlying accounting conceptual framework;
  • result in comparable accounting by registrants for similar transactions, by avoiding or minimizing alternative accounting treatments;
  • require consistent accounting policies from one period to the next; and
  • be clear and unambiguous.

In assessing the quality of the IASC standards, we are applying these criteria on a standard-by-standard basis, as well as to the IASC standards as a whole. In comment letters submitted to the IASC, the SEC staff has raised concerns including, but not limited to:

  • the ability to override an IAS where application of the IAS would not result in a "true and fair view" (see IAS 1);
  • the option to revalue property, plant and equipment to fair value (see IAS 16);
  • transition provisions that permit unrecognized minimum pension and employee benefit obligations (see IAS 19);
  • the amortization of negative goodwill to offset restructuring costs (see IAS 22);
  • unlimited useful lives for goodwill and other intangibles (see IAS 22 and IAS 38);
  • the capitalization of costs related to the development of internally generated intangible assets (see IAS 38);
  • the remeasurement of impaired assets at an amount other than fair value (see IAS 36); and
  • principles for derecognition of financial assets, and a modified form of basis adjustment for cash flow hedges, including hedges of anticipated transactions and firm commitments (see IAS 39).

You may wish to review the SEC staff and IOSCO comment letters for a further discussion of these and other issues.24 We, of course, welcome comments on other issues posed by specific approaches taken in the IASC standards, regardless of whether they were raised in IOSCO or SEC staff comment letters.

Indeed, we are seeking advice on any technical issues arising with respect to the IASC standards. In general, we are seeking to determine whether preparers, auditors and users of financial statements have identified particular issues based on their experience with the IASC standards and whether they have developed strategies for addressing those issues. We also would benefit from the public's views regarding whether any of the standards represent a significant improvement over U.S. accounting practices.25

A critical issue in assessing the quality of the IASC standards will be whether they would produce the same level of transparency and comparability that generally is provided to U.S. investors under U.S. GAAP. The focus of the staff's comments to the IASC has not been on the differences between the proposed standards and U.S. GAAP; rather, the staff focused on the quality of the proposed standards. An analysis of the differences, however, could serve as a useful tool for highlighting what differing information might be provided in financial statements prepared using IASC standards compared with U.S. GAAP financial statements.26 If the differences between the IASC standards and U.S. GAAP are significant, the financial position and operating results reported under the IASC standards may be difficult to compare with results reported under U.S. GAAP. The ability to make such a comparison is important for an investor making capital allocation decisions between U.S. and non-U.S. enterprises, especially within the same industry.

Q.4 Are the IASC standards of sufficiently high quality to be used without reconciliation to U.S. GAAP in cross-border filings in the United States? Why or why not? Please provide us with your experience in using, auditing or analyzing the application of such standards. In addressing this issue, please analyze the quality of the standard(s) in terms of the criteria we established in the 1996 press release. If you considered additional criteria, please identify them.27

Q.5 What are the important differences between U.S. GAAP and the IASC standards? We are particularly interested in investors' and analysts' experience with the IASC standards. Will any of these differences affect the usefulness of a foreign issuer's financial information reporting package? If so, which ones?

Q.6 Would acceptance of some or all of the IASC standards without a requirement to reconcile to U.S. GAAP put U.S. companies required to apply U.S. GAAP at a competitive disadvantage to foreign companies with respect to recognition, measurement or disclosure requirements?

Q.7 Based on your experience, are there specific aspects of any IASC standards that you believe result in better or poorer financial reporting (recognition, measurement or disclosure) than financial reporting prepared using U.S. GAAP? If so, what are the specific aspects and reason(s) for your conclusion?

3. Can the IASC Standards be Rigorously Interpreted and Applied?

(a) The Experience to Date

High quality financial reporting cannot be guaranteed solely by developing accounting standards with the strongest theoretical bases; financial reporting may be weak if conceptually sound standards are not rigorously interpreted and applied. If accounting standards are to satisfy the objective of having similar transactions and events accounted for in similar ways, preparers must recognize their responsibility to apply these standards in a way that is faithful to both the requirements and intent of the standards, and auditors and regulators around the world must insist on rigorous interpretation and application of those standards. Otherwise, the comparability and transparency that are the objectives of common standards will be eroded.

In this respect, it is difficult to evaluate the effectiveness of certain of the IASC standards at this stage. First, there is little direct use of IASC standards in developed capital markets. Second, even where IASC standards are used directly in those markets, a number of the new or revised standards may not have been implemented yet.28 For that reason, financial statements currently prepared using IASC standards may not reflect the improvements achieved by the IASC in the core standards project. Therefore, preparers, users and regulators may not have significant implementation experience with respect to those standards to assist us in our evaluation of the quality of the standards as they are applied.

In order for any body of standards to be able to be rigorously interpreted and applied, there must be a sufficient level of implementation guidance. The IASC standards frequently provide less implementation guidance than U.S. GAAP. Instead, they concentrate on statements of principles, an approach that is similar to some national standards outside the United States. Also, the IASC has formatted its standards by using bold (`black') lettering to emphasize basic requirements of the standards while placing explanatory text in normal (`gray') lettering. We believe that the requirements of an IASC standard are not limited to the black lettered sections and that compliance with both black and gray letter sections of IASC standards should be regarded as necessary. Additionally, the IASC has published a basis for conclusions for only two of its standards. The basis for conclusion in U.S. standards often is useful in promoting consistent understanding of the standard setter's reasoning and conclusions.

Comparability may be achieved with respect to less detailed standards through common interpretation and practice by companies and auditors who are familiar with the standards. Earlier standard-setting organizations in the United States, such as the Accounting Principles Board, followed this approach and developed less detailed standards. Our experience with that approach was not favorable, however, and led to the current organization and approach to standard-setting under the FASB.29

Q.8 Is the level of guidance provided in IASC standards sufficient to result in a rigorous and consistent application? Do the IASC standards provide sufficient guidance to ensure consistent, comparable and transparent reporting of similar transactions by different enterprises? Why or why not?

Q.9 Are there mechanisms or structures in place that will promote consistent interpretations of the IASC standards where those standards do not provide explicit implementation guidance? Please provide specific examples.

Q.10 In your experience with current IASC standards, what application and interpretation practice issues have you identified? Are these issues that have been addressed by new or revised standards issued in the core standards project?

Q.11 Is there significant variation in the way enterprises apply the current IASC standards? If so, in what areas does this occur?

(b) The Need for a Financial Reporting Infrastructure

Effective financial reporting begins with management, which is responsible for implementing and applying properly a comprehensive body of accounting principles. Rigorous and consistent application of accounting standards also depends on implementation efforts of the standard-setter, auditors and regulators. There are concerns that current IASC standards may not be rigorously and consistently applied. For example, a recent study authored by the former IASC secretary-general identifies non-compliance with IASC standards by a number of the 125 companies surveyed. It also cites examples of auditors who failed to identify properly a lack of compliance with IASC requirements in their reports on an issuer's financial statements.30

In addition, the SEC staff has noted inconsistent applications of IAS 22, Business Combinations. The staff has received a number of requests to accept characterizations of business combinations as "unitings of interests" despite IAS 22's clear intention that uniting of interest accounting be used only in rare and limited circumstances. In addition, the SEC staff, based on its review of filings involving foreign private issuers using IASC standards, has identified a number of situations involving not only inconsistent application of the standards but also misapplication of the standards.31 In these circumstances, the SEC staff has required adjustments to the financial statements in order to comply with IASC standards.

Q.12 After considering the issues discussed in (i) through (iv) below, what do you believe are the essential elements of an effective financial reporting infrastructure? Do you believe that an effective infrastructure exists to ensure consistent application of the IASC standards? If so, why? If not, what key elements of that infrastructure are missing? Who should be responsible for development of those elements? What is your estimate of how long it may take to develop each element?

(i) The Interpretive Role of the Standard-Setter

In order for a set of accounting standards to be fully operational, the standard-setter must support reasonably consistent application of its standards. A standard-setter's responsibility for ensuring consistent application of its standards includes providing an effective mechanism for identifying and addressing interpretive questions in an expeditious fashion.

The IASC began addressing interpretive issues in 1997 with the creation of its Standing Interpretations Committee (SIC) to provide resolution of interpretive issues arising in the application of the IASC standards that are likely to receive divergent or unacceptable treatment in the absence of authoritative guidance.

Q.13 What has your experience been with the effectiveness of the SIC in reducing inconsistent interpretations and applications of IASC standards? Has the SIC been effective at identifying areas where interpretive guidance is necessary? Has the SIC provided useful interpretations in a timely fashion? Are there any additional steps the IASC should take in this respect? If so, what are they?

(ii) The Restructuring of the IASC

The IASC has published a restructuring plan which is expected to result in an independent Board whose members are selected based on technical expertise, with oversight provided by an independent set of Trustees. The restructuring also is expected to integrate the roles of the IASC and those of national standard-setters.32

At this time, we do not anticipate adopting a process-oriented approach (like our approach to the FASB33) to IASC standards. Instead, we expect to continue a product-oriented approach, assessing each IASC standard after its completion. Nonetheless, the quality of the standard-setter has relevance to our consideration of the IASC standards, particularly with respect to implementation and interpretation questions. Since many of the IASC standards are new or relatively new, application issues may arise that require the response of an effective and high quality standard setter. Additionally, the quality of the standard-setter has critical implications for the development and acceptance of future standards.34

An effective high quality standard-setter is characterized by:

  • an independent decision-making body;
  • an active advisory function;
  • a sound due process;
  • an effective interpretive function;
  • independent oversight representing the public interest; and
  • adequate funding and staffing.

Q.14 Do you believe that we should condition acceptance of the IASC standards on the ability of the IASC to restructure itself successfully based on the above characteristics? Why or why not?

(iii) The Role of the Auditor in the Application of the Standards

High quality accounting standards and an effective interpretive process are not the only requirements for effective financial reporting. Without competent, independent audit firms and high quality auditing procedures to support the application of accounting standards, there is no assurance that the accounting standards will be applied appropriately and consistently. As discussed in the introduction to this release, increasing globalization of business and integration of capital markets raise challenging questions of how to provide oversight of audit professionals on a world-wide basis to ensure consistent high quality and ethical audit and accounting practices.

In the United States, implementation and application of U.S. GAAP are supported through professional quality control practices and professional and governmental (state and federal) oversight and enforcement activities. National technical offices of U.S. accounting firms serve an important role in ensuring an appropriate and consistent interpretation and application of U.S. GAAP and U.S. auditing standards.

Q.15 What are the specific practice guidelines and quality control standards accounting firms use to ensure full compliance with non-U.S. accounting standards? Will those practice guidelines and quality control standards ensure application of the IASC standards in a consistent fashion worldwide? Do they include (a) internal working paper inspection programs and (b) external peer reviews for audit work? If not, are there other ways we can ensure the rigorous implementation of IASC standards for cross-border filings in the United States? If so, what are they?

Q.16 Should acceptance of financial statements prepared using the IASC standards be conditioned on certification by the auditors that they are subject to quality control requirements comparable to those imposed on U.S. auditors by the AICPA SEC Practice Section, such as peer review and mandatory rotation of audit partners?35Why or why not? If not, should there be disclosure that the audit firm is not subject to such standards?

In many jurisdictions, including the United States, accountants and auditors are trained and tested in their domestic accounting standards, but do not receive training in IASC standards. For that reason, accountants and auditors around the world will need to develop expertise with IASC standards to support rigorous interpretation and application of these standards.

Q.17 Is there, at this time, enough expertise globally with IASC standards to support rigorous interpretation and application of those standards? What training have audit firms conducted with respect to the IASC standards on a worldwide basis? What training with respect to the IASC standards is required of, or available to, preparers of financial statements or auditors certifying financial statements using those standards?

(iv) The Role of the Regulator in the Interpretation and Enforcement ofAccounting Standards

While the Commission has the authority to establish accounting standards,36 historically we have looked to the private sector for leadership in establishing and improving accounting standards to be used by public companies.37 As a result, the Commission has recognized the FASBas the private sector body whose standards it considers to have substantial authoritative support. This partnership with the private sector facilitates input into the accounting standard-setting process from all stakeholders in U.S. capital markets, including financial statement preparers, auditors and users, as well as regulators. Our willingness to look to the private sector, however, has been with the understanding that we will, as necessary, supplement, override or otherwise amend private sector accounting standards.

The SEC staff is involved with the application of accounting standards on a daily basis through its review and comment process. This review process, administered by the Division of Corporation Finance, allows the staff to review and comment on a company's application of GAAP and related SEC disclosure requirements. The SEC staff would have the same significant interpretive and enforcement role in the application of the IASC standards when those standards are used to prepare financial statements included in SEC filings.38 To perform that role, our staff would need to develop expertise regarding the IASC standards.39

However, other jurisdictions accepting IASC standards may develop conflicting interpretations or may accept applications of IASC standards that would not be acceptable in the United States and other jurisdictions, in part, because of lack of expertise, resources, or even the authority to question a company's application of accounting standards. We are seeking to identify ways to reduce the development of diverging interpretations of IASC standards.

Q.18 Is there significant variation in the interpretation and application of IASC standards permitted or required by different regulators? How can the risk of any conflicting practices and interpretations in the application of the IASC standards and the resulting need for preparers and users to adjust for those differences be mitigated without affecting the rigorous implementation of the standards?

In considering changes in our current financial reporting requirements, we will consider the effects of possible changes on the ability of our enforcement program to provide an effective deterrent against financial reporting violations by foreign issuers, their corporate officials and their auditors.

Q.19 Would further recognition of the IASC standards impair or enhance our ability to take effective enforcement action against financial reporting violations and fraud involving foreign companies and their auditors? If so, how?

To facilitate its investigations of possible securities law violations, the SEC staff may need to obtain access to a non-U.S. auditor's working papers, as well as testimony, in connection with audit work done outside the United States.40 In some prior investigations, we have obtained access to information through the voluntary cooperation of the company or its foreign auditors. We also have the potential of using domestic compulsory mechanisms or enforcement tools such as memoranda of understanding and other arrangements with non-U.S. regulators. However, these approaches for obtaining information about an auditor's work can cause delays in investigations, and may still not permit obtaining access to working papers and testimony that are needed to assess information the issuer has provided to its auditors and to investigate the adequacy of the work supporting the auditor's report. The circumstances in which we need this information have grown, due to the expanded multinational activities of U.S. companies and the increasing number of foreign issuers that are listed on U.S. exchanges. Greater acceptance of the IASC standards may increase further the instances in which an issuer's auditor is not based in the United States.

Q.20 We request comment with respect to ways to assure access to foreign working papers and testimony of auditors who are located outside the United States. For example, should we amend Regulation S-X to require a representation by the auditor that, to the extent it relied on auditors, working papers, or information from outside the United States, the auditor will make the working papers and testimony available through an agent appointed for service of process? If not, should we require that the lack of access to auditors' workpapers be disclosed to investors? Is there another mechanism for enhancing our access to audit working papers and witnesses outside the United States?

B. Possible Approaches to Recognition of the IASC Standards for Cross-Border Offerings and Listings

As discussed, IOSCO and Commission recognition of the IASC standards will depend on the outcome of the current assessment work. The assessment work has two aspects: (1) considering the quality of each of the IASC standards individually and (2) evaluating whether the body of standards operates effectively as a whole.

The goal of the core standards project has been to develop a high quality set of generally accepted international accounting standards that ultimately would reduce or eliminate the need for reconciliation to national standards. Any Commission action could take several forms, including, for example:

  • Maintaining the current reconciliation requirements in all respects.
  • Removing some of the current reconciliation requirements for selected IASC standards and extending that recognition to additional IASC standards as warranted based on future review of each standard. Under this approach, when alternative treatments are specified (such as benchmarks and allowed alternatives), we may specify one treatment as acceptable, while retaining the reconciliation requirement to those financial statements that employ the unacceptable treatment. For example, we might require reconciliation if a company applies the allowed alternative treatment of periodically writing-up long-lived assets to estimated fair value.41 Other items for which reconciliation might be required include unrecorded pension liabilities and costs capitalized for internally generated intangible assets.
  • Relying on the IASC standards for recognition and measurement principles, but requiring U.S. GAAP and SEC supplemental disclosure requirements for footnote disclosures and the level of detail for the line items in financial statements.
  • Accepting financial statements prepared in accordance with the IASC standards without any requirement to reconcile to U.S. GAAP.

There may be other approaches, or combinations of approaches, that would be appropriate. In determining what approach to take we will consider outstanding substantive issues noted by IOSCO in its report, the underlying work assessing the IASC standards performed by the SEC staff and other members of IOSCO, as well as responses we receive to this release. In addition, the approach we adopt initially may change in light of future modifications of the IASC standards or further development of the related infrastructure elements.

Q.21 What has been your experience with the quality and usefulness of the information included in U.S. GAAP reconciliations? Please explain, from your viewpoint as a preparer, user, or auditor of non-U.S. GAAP financial statements, whether the reconciliation process has enhanced the usefulness or reliability of the financial information and how you have used the information provided by the reconciliation. Please identify any consequences, including quantification of any decrease or increase in costs or benefits, that could result from reducing or eliminating the reconciliation requirement.

Q.22 Should any requirements for reconciliation differ based on the type of transaction (e.g., listing, debt or equity financing, rights offering, or acquisition) or the type of security (e.g., ordinary shares, convertible securities, investment grade or high yield debt)? Are there any other appropriate bases for distinction?

Q.23 If the current reconciliation requirements are reduced further, do you believe that reconciliation of a "bottom line" figure would still be relevant (e.g., presenting net income and total equity in accordance with U.S. GAAP)?

Q.24 Should any continuing need for reconciliation be assessed periodically, based on an assessment of the quality of the IASC standards?

Q.25 The IASC standards finalized as part of the core standards project include prospective adoption dates. Most standards are not required to be applied until fiscal years beginning on or after January 1, 1998, at the earliest. Should we retain existing reconciliation requirements with respect to the reporting of any fiscal year results that were not prepared in accordance with the revised standards or simply require retroactive application of all revised standards regardless of their effective dates? If not, why not?

The current reconciliation requirements are designed to make financial statements prepared under non-U.S. GAAP more comparable to those prepared under U.S. GAAP. Additionally, there may be indirect benefits realized from those requirements. For example, some multinational accounting firms have stated that the reconciliation process has served as a quality control mechanism with respect to audit work performed by their local offices with respect to foreign companies. On the other hand, the SEC staff, based on its review of filings involving foreign private issuers using non-U.S. GAAP, has noted a number of situations involving the inclusion of reconciling items that appear to be the result of non-compliance with home country GAAP rather than a difference between the home country (or IASC) basis of accounting and U.S. GAAP. As such, there should not be a reconciling item. This may be indicative of not enough focus on the accuracy of the primary financial statements.

Q.26 Does the existence of a reconciliation requirement change the way in which auditors approach financial statements of foreign private issuers? Also, will other procedures develop to ensure that auditors fully versed in U.S. auditing requirements, as well as the IASC standards, are provided an opportunity to review the financial reporting practices for consistency with those standards? If so, please describe these procedures. Alternatively, will the quality of the audit and the consistency of the application of the IASC standards depend on the skill and expertise of the local office of the affiliate of the accounting firm that conducts the audit?

V. CONCLUSION

Following receipt and review of comments, we will determine whether rulemaking or other further action is appropriate. In addition to responding to the specific questions we have presented in this release, we encourage commenters to provide any information to supplement the information and assumptions contained in this release regarding the role of accounting standards in the capital-raising process, the information needs of investors and capital markets, and the other matters discussed. We also invite commenters to provide views and data as to the costs and benefits associated with the possible changes discussed in this release in comparison to the costs and benefits of the existing regulatory framework. In order for us to assess the impact of changes that could affect capital formation, market efficiency and the protection of investors, we solicit comment from the point of view of a variety of groups, including, without limitation, foreign and domestic issuers, underwriters, broker-dealers, analysts, investors, accountants and attorneys involved in the registration process and other interested parties.

By the Commission.

Jonathan G. Katz
Secretary

February 16, 2000

APPENDIX A

LISTING OF QUESTIONS IN THE CONCEPT RELEASE

Criteria for Assessment of the IASC Standards

Are the Core Standards Sufficiently Comprehensive?

Q.1 Do the core standards provide a sufficiently comprehensive accounting framework to provide a basis to address the fundamental accounting issues that are encountered in a broad range of industries and a variety of transactions without the need to look to other accounting regimes? Why or why not?

Q.2 Should we require use of U.S. GAAP for specialized industry issues in the primary financial statements or permit use of home country standards with reconciliation to U.S. GAAP? Which approach would produce the most meaningful primary financial statements? Is the approach of having the host country specify treatment for topics not addressed by the core standards a workable approach? Is there a better approach?

Q.3 Are there any additional topics that need to be addressed in order to provide a comprehensive set of standards?

Are the IASC Standards of Sufficiently High Quality? Why or Why Not?

Q.4 Are the IASC standards of sufficiently high quality to be used without reconciliation to U.S. GAAP in cross-border filings in the United States? Why or why not? Please provide us with your experience in using, auditing or analyzing the application of such standards. In addressing this issue, please analyze the quality of the standard(s) in terms of the criteria we established in the 1996 press release. If you considered additional criteria, please identify them.

Q.5 What are the important differences between U.S. GAAP and the IASC standards? We are particularly interested in investors' and analysts' experience with the IASC standards. Will any of these differences affect the usefulness of a foreign issuer's financial information reporting package? If so, which ones?

Q.6 Would acceptance of some or all of the IASC standards without a requirement to reconcile to U.S. GAAP put U.S. companies required to apply U.S. GAAP at a competitive disadvantage to foreign companies with respect to recognition, measurement or disclosure requirements?

Q.7 Based on your experience, are there specific aspects of any IASC standards that you believe result in better or poorer financial reporting (recognition, measurement or disclosure) than financial reporting prepared using U.S. GAAP? If so, what are the specific aspects and reason(s) for your conclusion?

Can the IASC Standards be Rigorously Interpreted and Applied?

The Experience to Date

Q.8 Is the level of guidance provided in IASC standards sufficient to result in a rigorous and consistent application? Do the IASC standards provide sufficient guidance to ensure consistent, comparable and transparent reporting of similar transactions by different enterprises? Why or why not?

Q.9 Are there mechanisms or structures in place that will promote consistent interpretations of the IASC standards where those standards do not provide explicit implementation guidance? Please provide specific examples.

Q.10 In your experience with current IASC standards, what application and interpretation practice issues have you identified? Are these issues that have been addressed by new or revised standards issued in the core standards project?

Q.11 Is there significant variation in the way enterprises apply the current IASC standards? If so, in what areas does this occur?

The Need for a Financial Reporting Infrastructure

Q.12 After considering the issues discussed in (i) through (iv) below, what do you believe are the essential elements of an effective financial reporting infrastructure? Do you believe that an effective infrastructure exists to ensure consistent application of the IASC standards? If so, why? If not, what key elements of that infrastructure are missing? Who should be responsible for development of those elements? What is your estimate of how long it may take to develop each element?

The Interpretive Role of the Standard-Setter

Q.13 What has your experience been with the effectiveness of the SIC in reducing inconsistent interpretations and applications of IASC standards? Has the SIC been effective at identifying areas where interpretive guidance is necessary? Has the SIC provided useful interpretations in a timely fashion? Are there any additional steps the IASC should take in this respect? If so, what are they?

Q.14 Do you believe that we should condition acceptance of the IASC standards on the ability of the IASC to restructure itself successfully based on the above characteristics? Why or why not?

The Role of the Auditor in the Application of the Standards

Q.15 What are the specific practice guidelines and quality control standards accounting firms use to ensure full compliance with non-U.S. accounting standards? Will those practice guidelines and quality control standards ensure application of the IASC standards in a consistent fashion worldwide? Do they include (a) internal working paper inspection programs and (b) external peer reviews for audit work? If not, are there other ways we can ensure the rigorous implementation of IASC standards for cross-border filings in the United States? If so, what are they?

Q.16 Should acceptance of financial statements prepared using the IASC standards be conditioned on certification by the auditors that they are subject to quality control requirements comparable to those imposed on U.S. auditors by the AICPA SEC Practice Section, such as peer review and mandatory rotation of audit partners? Why or why not? Why or why not? If not, should there be disclosure that the audit firm is not subject to such standards?

Q.17 Is there, at this time, enough expertise globally with IASC standards to support rigorous interpretation and application of those standards? What training have audit firms conducted with respect to the IASC standards on a worldwide basis? What training with respect to the IASC standards is required of, or available to, preparers of financial statements or auditors certifying financial statements using those standards?

The Role of the Regulator in the Interpretation and Enforcement of Accounting Standards

Q.18 Is there significant variation in the interpretation and application of IASC standards permitted or required by different regulators? How can the risk of any conflicting practices and interpretations in the application of the IASC standards and the resulting need for preparers and users to adjust for those differences be mitigated without affecting the rigorous implementation of the standards?

Q.19 Would further recognition of the IASC standards impair or enhance our ability to take effective enforcement action against financial reporting violations and fraud involving foreign companies and their auditors? If so, how?

Q.20 We request comment with respect to ways to assure access to foreign working papers and testimony of auditors who are located outside the United States. For example, should we amend Regulation S-X to require a representation by the auditor that, to the extent it relied on auditors, working papers, or information from outside the United States, the auditor will make the working papers and testimony available through an agent appointed for service of process? If not, should we require that the lack of access to auditors' workpapers be disclosed to investors? Is there another mechanism for enhancing our access to audit working papers?

Possible Approaches to Recognition of the IASC Standards for Cross-Border Offerings and Listings

Q.21 What has been your experience with the quality and usefulness of the information included in U.S. GAAP reconciliations? Please explain, from your viewpoint as a preparer, user, or auditor of non-U.S. GAAP financial statements, whether the reconciliation process has enhanced the usefulness or reliability of the financial information and how you have used the information provided by the reconciliation. Please identify any consequences, including quantification of any decrease or increase in costs or benefits, that could result from reducing or eliminating the reconciliation requirement.

Q.22 Should any requirements for reconciliation differ based on the type of transaction (e.g., listing, debt or equity financing, rights offering, or acquisition) or the type of security (e.g., ordinary shares, convertible securities, investment grade or high yield debt)? Are there any other appropriate bases for distinction?

Q.23 If the current reconciliation requirements are reduced further, do you believe that reconciliation of a "bottom line" figure would still be relevant (e.g., presenting net income and total equity in accordance with U.S. GAAP)?

Q.24 Should any continuing need for reconciliation be assessed periodically, based on an assessment of the quality of the IASC standards?

Q.25 The IASC standards finalized as part of the core standards project include prospective adoption dates. Most standards are not required to be applied until fiscal years beginning on or after January 1, 1998, at the earliest. Should we retain existing reconciliation requirements with respect to the reporting of any fiscal year results that were not prepared in accordance with the revised standards or simply require retroactive application of all revised standards regardless of their effective dates? If not, why not?

Q.26 Does the existence of a reconciliation requirement change the way in which auditors approach financial statements of foreign private issuers? Also, will other procedures develop to ensure that auditors fully versed in U.S. auditing requirements, as well as the IASC standards, are provided an opportunity to review the financial reporting practices for consistency with those standards? If so, please describe these procedures. Alternatively, will the quality of the audit and the consistency of the application of the IASC standards depend on the skill and expertise of the local office of the affiliate of the accounting firm that conducts the audit?

APPENDIX B

LIST OF CORE STANDARDS AND EACH

STANDARD'S EFFECTIVE DATE

IAS

Title

Effective Date

1

Presentation of Financial Statements (revised)

1 Jan 99

2

Inventories

1 Jan 95

4

Depreciation Accounting

1 Jan 77***

7

Cash Flow Statements

1 Jan 94

8

Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies

1 Jan 95

10

Events After the Balance Sheet Date (revised)

1 Jan 00

11

Construction Contracts

1 Jan 95

12

Income Taxes (revised)

1 Jan 98

14

Segment Reporting (revised)

1 Jul 98

16

Property, Plant and Equipment (revised)

1 Jul 99

17

Leases (revised)

1 Jan 99

18

Revenue

1 Jan 95

19

Employee Benefits (revised)

1 Jan 99

20

Accounting For Government Grants and Disclosure of Government Assistance

1 Jan 84

21

The Effects of Changes in Foreign Exchange Rates

1 Jan 95

22

Business Combinations (revised)

1 Jul 99

23

Borrowing Costs

1 Jan 95

24

Related Party Disclosures

1 Jan 86

25

Investment Properties ###

1 Jan 87

27

Consolidated Financial Statements and Accounting for Investments in Subsidiaries

1 Jan 90

28

Accounting for Investments in Associates

1 Jan 90

29

Financial Reporting in Hyperinflationary Economies

1 Jan 90

31

Financial Reporting of Interests in Joint Ventures

1 Jan 92

32

Financial Instruments: Disclosure and Presentation

1 Jan 96

33

Earnings Per Share

1 Jan 99

34

Interim Financial Reporting

1 Jan 99

35

Discontinuing Operations

1 Jan 99

36

Impairment of Assets

1 Jul 99

37

Provisions, Contingent Liabilities and Contingent Assets

1 Jul 99

38

Intangible Assets

1 Jul 99

39

Financial Instruments: Recognition and Measurement

1 Jan 01

*** Will be withdrawn once IAS 38 becomes effective.

### Revisions to this standard are being debated currently. E64, Investment Properties, has been issued for comment. The IASC expects to finalize this standard in March 2000.



APPENDIX C

THE CORE STANDARDS PROJECT

A. The IASC and IOSCO

The International Accounting Standards Committee (IASC) is a private sector body whose membership includes all the professional accountancy bodies that are members of the International Federation of Accountants (IFAC). IFAC has more than 140 members from over 100 countries. The IASC has the dual objectives of (i) formulating international accounting standards and promoting their acceptance and observance; and (ii) working generally for improvement and harmonization of accounting standards.

Currently,42 the business of the IASC is conducted by a Board with 16 voting delegations43 and five non-voting observer delegations with the privilege of the floor.44 Each delegation includes up to three members who share a single vote. Delegation members normally are drawn from the accountancy profession and preparer community; representatives of national standard-setters may be included in a delegation, often as the technical advisor. The Board currently meets approximately four times a year for about a week to receive reports from its staff and steering committees and to discuss and approve exposure drafts and final standards for publication.

Board delegates serve on a part-time, volunteer basis. The IASC has a small full-time staff based in London. This staff provides a manager for most IASC projects; project staffing, in the form of Steering Committees, is provided by volunteers who represent a mix of Board member and non-Board member IFAC organizations. IOSCO (the International Organization of Securities Commissions) and the European Commission are non-voting observers for most Steering Committees.45

IOSCO is an association of securities regulatory organizations. It has approximately 135 ordinary, associate and affiliate members, including twelve based in the United States. Two key IOSCO committees following this project are the Technical Committee and its Working Party No. 1 on Multinational Disclosure and Accounting. The Technical Committee is composed of 16 regulatory agencies46 that regulate some of the world's largest, more developed and internationalized markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Both the Commission and the Commodity Futures Trading Commission are members of this committee. We are represented by a member of the Commission.

Working Party No. 1 is one of several working groups that report to the Technical Committee. It has members from sixteen jurisdictions and is chaired by a Commission staff member. Commission staff members from the Division of Corporation Finance and the Office of the Chief Accountant are members of the Working Party.47

As a member of IOSCO, the Commission has been a significant participant in efforts to harmonize regulatory requirements for cross-border offerings and listings. Most recently, IOSCO approved and recommended that its members adopt a set of non-financial statement disclosure standards for the purposes of cross-border offerings and listings.48 We have amended our foreign private issuer disclosure requirements to implement these IOSCO disclosure standards.49

B. Development of the Core Standards Project50

In 1989, IOSCO prepared a report entitled, "International Equity Offers."51 That report noted that cross-border offerings would be greatly facilitated by the development of internationally accepted accounting standards. Rather than attempt to develop those standards itself, IOSCO focused on the efforts of the IASC.

In 1993, IOSCO wrote to the IASC detailing the necessary components of a reasonably complete set of standards to create a comprehensive body of principles for enterprises undertaking cross-border securities offerings. In 1993, the IASC completed a project to improve the comparability and usefulness of financial statements prepared in accordance with its standards. Prior to this project, a number of IASC standards codified existing practice in multiple jurisdictions, permitting several alternative (and at times inconsistent) treatments for a single type of transaction. As a result of this improvement project, many alternatives were eliminated, although, in a few areas, the IASC standard retained multiple approaches, with one designated as a "benchmark" treatment and the other as an "allowed alternative."

In 1994, IOSCO completed a review of the revised IASC standards and identified a number of issues that would have to be addressed, as well as standards that the IASC would have to improve, before IOSCO could consider recommending IASC standards for use in cross-border listings and offerings. IOSCO divided the issues into three categories:

    1. Issues that required a solution prior to consideration by IOSCO of an endorsement of the IASC standards;

    2. Issues that would not require resolution before IOSCO could consider endorsement, although individual jurisdictions might specify treatments that they would require if those issues were not addressed satisfactorily; and

    3. Areas where improvements could be made, but that the IASC did not need to address prior to consideration of the IASC standards by IOSCO.

In July 1995, IOSCO and the IASC agreed that the proposed "core standards work program" would, if completed successfully, address all the issues that required a resolution before IOSCO would consider endorsement.52 IOSCO stated that, if the resulting IASC standards are acceptable to its Technical Committee, that group would recommend endorsement of those standards for cross-border capital raising and listing purposes.

C. Overview of the Work Program

The IASC's work program identified 12 areas that required new or substantially revised standards. As of January 2000, the IASC had published seven new standards and ten revised standards addressing those areas. One standard remains under consideration.53 Since the IASC standards are copyrighted, we have not reproduced them as part of this release. However, summaries of the IASC standards, as well as information about obtaining the full text of these standards, are available from the IASC website at <www.iasc.org.uk>. Additionally, copies of the IASC standards have been placed in our public reference room in the public file for this release.

IOSCO, through Working Party No. 1, is a non-voting observer at meetings of the IASC Board, its Steering Committees, and its Standing Interpretations Committee. The Working Party has attempted to reply to each document the IASC published for comment. The Working Party comment letters alerted the IASC to concerns of the Working Party or its members while the issues were under discussion.

Some members of the Working Party also commented individually on proposed standards. In addition to contributing to Working Party comment letters, the Commission staff issued comment letters that provided detailed technical comments on substantially all of the IASC's published documents.54In developing comment letters, the staff focused on the type of information that would be provided to investors. The letters sought to identify areas where comparability and transparency might be compromised, and where other significant investor protection issues existed. The staff did not focus its analysis on eliminating differences from U.S. GAAP. In fact, in several instances the staff encouraged the IASC to benefit from U.S. experience with a particular component of U.S. GAAP and adopt a different and improved approach.

D. The Assessment Process

The pace of the IASC work program has required that, immediately following the adoption of a final standard, the Working Party and Commission staff shift their attention to other pending standards. As a result, the Working Party and Commission staff did not stop to evaluate each completed standard and assess the extent to which it addressed the concerns raised in the comment letters. This approach also was consistent with the understanding between the IASC and IOSCO that the Working Party would assess the completed standards, individually and as a group, once the IASC completed all of the core standards. That assessment of the core standards is now underway, and is focusing not only on the extent to which the completed standards address the IOSCO concerns, but also on whether the IASC's standards work together to form an operational basis of accounting.

Following its review and assessment of the core standards, the Working Party will make a report to IOSCO's Technical Committee that will describe outstanding substantive issues with the IASC standards and suggest ways to address these issues. The Technical Committee then is expected to develop and circulate to IOSCO's membership a resolution regarding the IASC standards.

Resolutions of both the Technical Committee and IOSCO as a whole are non-binding on its member organizations. Accordingly, were the Technical Committee to recommend to IOSCO's members that they accept financial statements prepared using IASC standards, each member would have to determine whether and how to implement that recommendation at a domestic level.

If, as a result of its assessment of the completed core standards, we conclude that changes to our current requirements for foreign private issuers are appropriate, we will issue a rule proposal for public comment. This may include modifications of the financial statement requirements for registration and reporting forms utilized by foreign private issuers, such as Forms F-1 and 20-F.



APPENDIX D

SUMMARY OF THE FASB'S IASC/ US GAAP

COMPARISON PROJECT

This document is an excerpt from the FASB's "The IASC-U.S. Comparison Project: A Report on the Similarities and Differences between IASC Standards and U.S. GAAP," copyrighted by the Financial Accounting Standards Board, Norwalk, Connecticut, USA, 1999.

Please note that the attached document was produced by the Financial Accounting Standards Board and is not a Commission or SEC staff document. The reproduction of this document here is for the convenience of readers of this Concept Release only. Our inclusion of this document does not indicate that it reflects our views or the views of the SEC staff.

CHAPTER 2-SUMMARY OF OBSERVATIONS

Introduction

In keeping with the objectives of the project, the comparative analyses presented in Chapters 3-30 of this report provide an information base to facilitate decision making about IASC standards by investors, analysts, standard setters, regulators, and others. Each comparative analysis was undertaken independently. However, based on the types of differences identified by the individual authors, there are some general observations that can be made about the potential comparability of information reported in financial statements between an enterprise using IASC standards and one using U.S. GAAP. Those observations are the subject of this chapter.

The discussion of observations that follows generally centers on the extent to which the similarities and differences identified by the authors of the comparative analyses could affect the comparability of actual reported financial information. That is, the discussion focuses on those similarities and differences deemed most likely to be significant to financial statement users comparing the financial statements of enterprises following IASC standards and those following U.S. GAAP. There are some limitations to that approach. Primarily, the basis for the project was limited to the comparison of accounting standards; it did not seek to observe the actual application and enforcement of those standards. How standards are interpreted and applied and the extent to which they are enforced can have a significant impact on reported financial information. Evaluating the effects of actual application and enforcement of accounting standards was beyond the scope of the project. It is not yet possible to observe those effects because many of the IASC standards and some U.S. standards that are the subject of the chapters that follow have yet to be used in preparing financial statements.

This chapter is presented in three sections. The first provides some background for understanding how differences in accounting standards can be important for assessing financial statement comparability. The second section provides some general observations about the most significant types of differences observed by the authors of the comparative analysis chapters and provides examples to illustrate those types of differences. The last section summarizes the key points of this chapter.

A Word about Differences

The IASC-U.S. comparison project set out to identify similarities and differences between IASC standards and U.S. GAAP (primarily FASB standards) predisposed to the view that the shortest route to understanding comparability would be to zero in on differences. Therefore, this report, by its very nature, focuses on differences as a basis for comparison. Similarities tend to be identified and described in a general manner, while differences are discussed in more detail.

IASC standards are different from FASB standards. That conclusion is not new, nor is it unique to this report. It is neither the objective nor the intent of the IASC to develop standards identical to FASB standards. IASC standards and FASB standards seek to serve different environments (international versus national), respond to different mandates, have different technical support levels, and result from different standard-setting structures and processes.55 Differences between those two sets of standards, therefore, are inevitable and not necessarily inappropriate. However, if financial statements based on IASC standards are to be considered appropriate for cross-border access to the world's capital markets (including those in the United States), it is essential that IASC standards meet the demands of those capital markets for high-quality financial information.

In undertaking the project, the FASB staff sought to obtain greater understanding of the specific nature of IASC standards. At the time that the project began (in 1995), detailed information about the level of comparability of reported financial results between financial statements prepared based on IASC standards and those prepared based on U.S. GAAP was available to relatively few individuals. In large part due to increased awareness resulting from publicity surrounding the IASC's core standards project, research on the issues related to international comparability has increased. However, conclusions about the acceptability of IASC standards for cross-border securities listings and other purposes are mixed and often are supported by fragmentary evidence.

Some studies that compare IASC standards with U.S. GAAP have asserted that the two sets of standards are broadly similar or that use of IASC standards can lead to results similar to those that would have been obtained had U.S. GAAP been used. As some of the comparative analyses in this report show, some of the IASC standards and their U.S. GAAP counterparts do have a similar underlying approach to accounting in certain areas and it may be possible to arrive at similar results under both standards. However, the existence of alternatives, even within standards that are very similar, can create the potential for very different reported results. The comparative analysis of IAS 23, Borrowing Costs, provides an example. The allowed alternative treatment in IAS 23 requires capitalization of borrowing costs incurred in the acquisition, construction, or production of certain assets. That is very similar to the U.S. GAAP requirement. However, IAS 23's benchmark treatment requires that borrowing costs be expensed. That is very different from the allowed alternative treatment (and, consequently, from U.S. GAAP). The existence of both a benchmark and allowed alternative treatment has the potential to result in noncomparability both between IASC-based and U.S. GAAP-based financial statements and among financial statements prepared under IASC standards.

Other studies have concluded that IASC standards are too broad and general to ensure that similar accounting methods are applied in similar circumstances or that similar results are consistently achieved. While the guidance provided by IASC standards often is more general than that found in U.S. GAAP, IASC standards may be more rigorous than the national standards of some countries and, in some circumstances, may be equally or more effective than U.S. GAAP. For example, both IAS 2, Inventories, and U.S. GAAP provide broad, general guidance on cost-flow assumptions in estimating inventory cost. However, IAS 2 provides more-extensive guidance than does U.S. GAAP on the topic of accounting for inventories of service providers.

On the other hand, an absence of implementation guidance can lead to differences in applying standards that are broadly similar. For example, IAS 33, Earnings per Share, and its U.S. GAAP counterpart, FASB Statement No. 128, Earnings per Share, resulted from a cooperative standard-setting effort between the IASC and the FASB.The two standards are very similar. However, Statement 128 provides more-specific implementation guidance for some of the calculations required for determining earnings per share, for example, for determining the impact of different types of contingencies related to contingently issuable shares. There may be differences in earnings-per-share calculations between enterprises following IAS 33 and those following Statement 128 because, in the absence of implementation guidance, enterprises following IAS 33 are not required to determine the impact of contingently issued shares on the same basis as that described in Statement 128 and would not be prohibited from using alternative bases for making that determination.

Finally, not all questions about comparability relate to the comparability of financial statements prepared using different sets of accounting standards. Few studies have focused on comparability among the financial statements of enterprises following IASC standards. For example, there is little (if any) research that provides evidence of whether the IASC-based financial statements provided by an enterprise from France are comparable to the financial statements provided by a similar enterprise from Japan that also is following IASC standards. That type of comparison was beyond the scope of this report. Notwithstanding similarities with or differences from U.S. GAAP, because IASC standards will be applied in different national environments-each with its own set of national accounting standards or conceptual framework-IASC standards must be capable of being consistently interpreted and applied in order to meet the objective of international comparability among those enterprises that use IASC standards.

Thus, it would be misleading to make sweeping generalizations or blanket assertions about the relative quality of IASC standards based solely on the similarities and differences between two sets of accounting standards. The mere existence of differences between accounting standards is not a sufficient measure of the quality or merit of any particular accounting standard relative to the other. The true test of an accounting standard is whether it satisfies the demand for information in the environment in which it is intended to be used. What is required, therefore, is a fuller understanding of the nature of similarities and differences in the information provided in the financial statements as a result of applying the two sets of accounting principles. The FASB staff believes that the comparative analyses in this report will provide useful information to help interested parties evaluate the current state of IASC-U.S. GAAP comparability and draw their own conclusions.

Types of Differences

The staff of the Division of Investment Management has prepared the following responses to questions about the rule 206(4)-2, the "custody rule" under the Investment Advisers Act of 1940 and expects to update from time to time our responses to additional questions. These responses represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Securities and Exchange Commission, and the Commission has neither approved nor disapproved this information. The adopting release for the most recent amendments to the rule (dated December 30, 2009, the "Adopting Release") can be found at: http://www.sec.gov/rules/final/2009/ia-2968.pdf. These responses supersede the previously posted responses to questions regarding the 2003 amendments to the rule. The adopting release for those 2003 amendments ("2003 Release") can be found at http://www.sec.gov/rules/final/
ia-2176.htm. (Answers that are indicated as modified from the prior version related to the 2003 amendments may have been either changed or clarified without substantive change.)

I. Compliance Dates (This section I is new and posted March 5, 2010.)

Question I.1

Q: An investment adviser that currently sends account statements to its clients in lieu of those from a qualified custodian now must arrange for the account statements to be delivered directly by a qualified custodian. When must the qualified custodian send the first account statements directly to the adviser's clients?

A: The compliance date is March 12, 2010. Accordingly, qualified custodians must deliver account statements for all periods ending on or after March 12, 2010. Thus, quarterly statements ending on March 31, 2010, must be sent by qualified custodians directly to clients. The account statement need only cover the period between the compliance date and March 31, 2010 (but may of course also cover periods before March 12).

Question I.2

Q: Some investment advisers have omnibus account arrangements with qualified custodians who have no client information and thus do not deliver client statements. Advisers are converting these relationships to meet the requirements of amended rule 206(4)-2, but such conversions require obtaining new account documentation from clients and system reprogramming, which may not be feasible in time for the qualified custodian to send account statements for the period ending March 31, 2010. May these advisers have more time to complete these conversions?

A: The Division would not recommend enforcement action to the Commission if an adviser modifying an omnibus arrangement as described above complies with rule 206(4)-2(a)(3) for those accounts no later than the delivery of the account statement for the third quarter of 2010, provided that (i) the adviser sends notice to each client no later than the time of sending the account statement for the period ending March 31, 2010, clearly describing the way in which the adviser intends to change the account arrangements to comply with the amended rule and the expected timing of those changes, and (ii) the adviser undergoes a surprise examination for 2010.

Question I.3

Q: Must the surprise examination required under rule 206(4)-2(a)(4) be completed before December 31, 2010?

A: No. The surprise examination must commence on or before December 31, 2010 but does not need to be completed until 120 days after the time chosen by the accountant performing the surprise examination. If the adviser itself maintains client assets as qualified custodian, the first surprise examination must commence no later than six months after obtaining the internal control report. For an adviser that becomes subject to the rule after the effective date, the surprise examination must commence within six months after it becomes subject to the rule. However, as a transitional matter, the Division would not recommend enforcement action to the Commission if an adviser that becomes subject to the rule after the effective date has its first surprise examination commence by the later of six months after the adviser becomes subject to the rule or December 31, 2010. (Modified March 15, 2010)

Question I.4

Q: Does the requirement that the accountant performing an annual audit on a pooled investment vehicle for purposes of compliance with the rule must be registered with and subject to regular inspection by the Public Company Accounting Oversight Board ("PCAOB") pursuant to rule 206(4)-2(b)(4)(ii) apply to the 2009 fiscal year?

A: This requirement applies to audits for fiscal years beginning on or after January 1, 2010.

Question I.5

Q: Section III.B.3. of the adopting release (transition section) indicates that for pooled investment vehicles, "[a]n investment adviser to a pooled investment vehicle may rely on the annual audit provision if the adviser (or a related person) becomes contractually obligated to obtain an audit of the financial statements of the pooled investment vehicle for fiscal years beginning on or after January 1, 2010 by an independent public accountant registered with, and subject to regular inspection by, the PCAOB." Does this mean an adviser must be a party to a written engagement letter with the auditor?

A: No. The obligation to obtain an audit may be evidenced in a partnership agreement, disclosure statement, or engagement letter with the auditor. See 2003 Release, Footnote 47.

Question I.6

Q: Under rule 206(4)-2(b)(4), an independent public accountant performing an annual audit on a pooled investment vehicle in lieu of the required annual surprise examination must be registered with, and subject to, regular inspection by the PCAOB. The effective date of the rule is March 12, 2010. If an accountant is not currently subject to regular inspection by the PCAOB, may the adviser satisfy the requirement for exemption from the surprise examination if the accountant becomes subject to regular inspection by the PCAOB before the issuance of the audited financial statements for the pooled investment vehicle's 2010 fiscal year?

A: Yes.

Question I.7

Q: Rule 206(4)-2(a)(6) requires that an adviser or its related person that maintains client assets as a qualified custodian must obtain (or receive from the related person) a written internal control report (e.g., Type II SAS 70 report) regarding the adviser's or its related person's custodial practices. What is the compliance date for the internal control report?

A: The compliance date for obtaining an internal control report is September 12, 2010 for advisers subject to the requirement on March 12, 2010. Advisers that are newly subject to Rule 206(4)-2(a)(6) (e.g., newly maintaining, or having a related person maintaining, client assets as a qualified custodian after March 12, 2010) must obtain the internal control report within six months of becoming subject to the requirement.

Question I.8

Q: Rule 206(4)-2(a)(6) requires that an adviser or its related person that maintains client assets as a qualified custodian must obtain (or receive from the related person) a written internal control report (e.g., Type II SAS 70 report) regarding the custodial services of the qualified custodian. Does the internal control report need to address the effectiveness of controls over custodial services prior to March 12, 2010, the effective date of the amended rule?

A: No, the internal control report does not need to address the effectiveness of controls over custodial services prior to March 12, 2010, the effective date of the amended rule, even if it results in a shortened examination period for the 2010 internal control report.

Question I.9

Q: Currently, qualified custodians often obtain custody-related SAS 70 reports prepared on a regular reporting cycle. If a qualified custodian obtained a SAS 70 report in 2009 and plans to obtain a SAS 70 report in 2010, is the qualified custodian expected to alter its reporting cycle to meet (or allow its related person investment adviser to meet) the initial September 12, 2010 compliance date?

A: No, a qualified custodian that obtained a custody-related SAS 70 report in 2009 is not expected to alter its reporting cycle in 2010.

Question I.10

Q: When must advisers registered with the SEC begin using the amended Form ADV?

A: Advisers must provide responses to the additional questions in amended Form ADV in their first annual updating amendment after January 1, 2011. Advisers who file an initial Form ADV before the updated Form ADV is available in IARD may use their first annual updating amendment to provide answers to these additional questions.

II. Definition of Custody; Scope of the Rule

Question II.1

Q: If an adviser inadvertently receives securities from a client, under the amended rule may the adviser forward the securities to the qualified custodian instead of returning the securities to the client?

A: No. If the adviser does not return the securities to the sender within three business days, the adviser not only has custody but has also violated the amended rule's requirement that client securities be maintained in an account with a qualified custodian.1 However, the Division would not recommend enforcement action to the Commission under certain circumstances if an adviser inadvertently receives tax refunds from tax authorities, or client settlement proceeds from administrators in connection with class action lawsuits and other legal actions, or stock certificates, dividends, or evidence of new debt from issuers in connection with class action lawsuits involving bankruptcy or business reorganization, and forwards these client assets within five business days of its receipt and maintains appropriate records. See Investment Adviser Association, SEC Staff Letter, (Sept. 20, 2007), available at http://www.sec.gov/divisions/investment/noaction/
2007/iaa092007.pdf. (Modified March 5, 2010.)

Question II.2

Q: If an employee of an advisory firm serves as a trustee to a firm client, does the firm have custody?

A: Generally, yes. The role of the supervised person as trustee is imputed to the advisory firm, thus causing the firm to have custody.

Footnote 139 of the Adopting Release explains, however, that the role of the supervised person as trustee will not be imputed to the advisory firm if the supervised person has been appointed as trustee as a result of a family or personal relationship with the grantor or beneficiary and not as a result of employment with the adviser. A similar analysis would apply where the supervised person serves as the executor to an estate as a result of a family or personal relationship with the deceased. A personal relationship developed as a result of providing advisory services to a client over many years is not the type of "personal relationship" contemplated by footnote 139. (Modified March 5, 2010.)

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients' funds and securities. (Posted 2003.)

Question II.4

Q: Does an adviser have custody if it has authority to transfer client funds or securities between two or more of a client's accounts maintained with the same qualified custodian or different qualified custodians?

A: Under rule 206(4)-2(d)(2)(ii), an adviser has custody if it has the authority to withdraw client assets maintained with a qualified custodian upon the adviser's instruction to the custodian. We do not interpret the authority to withdraw assets to include the limited authority to transfer a client's assets between the client's accounts maintained at one or more qualified custodians if the client has authorized the adviser in writing to make such transfers and a copy of that authorization is provided to the qualified custodians, specifying the client accounts maintained with qualified custodians. In the staff’s view, “specifying” would mean that the written authorization signed by the client and provided to the sending custodian states with particularity the name and account numbers on sending and receiving accounts (including the ABA routing number(s) or name(s) of the receiving custodian) such that the sending custodian has a record that the client has identified the accounts for which the transfer is being effected as belonging to the client. That authorization does not need to be provided to the receiving custodian. Moreover, in the staff’s view, an adviser’s authority to transfer client assets between the client’s accounts at the same qualified custodian or between affiliated qualified custodians that both have access to the sending and receiving account numbers and client account name (e.g., to make first-party journal entries) does not constitute custody and does not require further specification of client accounts in the authorization. (Modified February 21, 2017.)

Question II.5.A

Q: Does an adviser have custody if it has authority to instruct the qualified custodian that maintains a client's account to remit the funds or securities from the account to the same client at his or her address of record?

A: We do not interpret the authority to instruct the qualified custodian maintaining a client's account to remit the funds or securities from the account from time to time to the same client at his or her address of record as having custody if (1) the client has granted such authority to the adviser in writing and a copy of that authorization is provided to the qualified custodian, (2) the adviser has no authority to open an account on behalf of the client; and (3) the adviser has no authority to designate or change the client's address of record with the qualified custodian. (Modified September 9, 2010)

Question II.5.B

Q: Many qualified custodians are subject to regulatory requirements designed to protect against improper or unauthorized changes of address. For example, broker-dealers must send a customer who is a natural person a notification of a change of address to the customer's old address on or before the 30th day after receiving a notice of the requested change pursuant to Rule 17a-3(a)(17)(i)(B)(2) under the Securities Exchange Act of 1934. Similarly, banking regulators have issued guidance, such as Federal Reserve System Supervisory Letter SR 0-11 (April 26, 2001), Office of Comptroller of the Currency Advisory Letter 2001-4 (April 30, 2001), Federal Deposit Insurance Corporation Financial Institution Letter 39-2001 (May 9, 2001), Office of Thrift Supervision CEO Letter No. 139 (May 4, 2001), and National Credit Union Administration Letter No. 01-CU-09 (September 2001), providing that banks should send confirmation of a customer request for a change of address to both the old and new address on record. If an adviser has a reasonable belief that the qualified custodian, upon receiving the request for change of address, sends a notice of such change to the client at the client's old address of record, may the adviser change a client's address of record with the qualified custodian and still rely on the answer to Question II. 5. A?

A: Yes. (Posted September 9, 2010)

Question II.6

Q: If an adviser has the ID number and password to a client's pension fund account to rebalance and adjust investments in the account, does the adviser have custody?

A: The adviser has custody if password access provides the adviser with the ability to withdraw funds or securities or transfer them to an account not in the client's name at a qualified custodian. (Posted May 20, 2010)

Question II.7

Q: An adviser has a related natural person who is the owner of an account to which the adviser provides advisory services. The adviser otherwise does not have custody under the rule. Does the adviser have custody simply because the related natural person has the ability to withdraw his or her own assets by virtue of being the account holder?

A: If the related person is a natural person and is both the legal and beneficial owner (e.g., he or she is not the trustee of another person) of the account and the beneficial owner for purposes of the securities laws, this related person's access to his or her own account will not impute custody to the adviser. (Posted May 20, 2010)

Question II.8

Q: Under what circumstances does an independent public accountant engaged by an adviser for purposes of complying with the rule need to be registered with, and subject to regular inspection by, the PCAOB?

A: An accountant must be registered with, and subject to regular inspection by, the PCAOB if it is engaged to (1) perform an annual audit of a pooled investment vehicle in accordance with rule 206(4)-2(b)(4); (2) perform an annual surprise examination of an adviser that maintains client assets with a qualified custodian that is the adviser or a related person of the adviser in accordance with rule 206(4)-2(a)(4); or (3) prepare an internal control report in accordance with rule 206(4)-2(a)(6). (Posted March 15, 2010)

Question II.9

Q: Must a registered investment adviser comply with rule 206(4)-2 with respect to the funds and securities of a person to whom the adviser provides investment advisory services but from which the adviser receives no compensation?

A: Yes. Under rule 203(b)(3)-1(b)(4), an adviser relying on the exemption from registration provided by section 203(b)(3) of the Investment Advisers Act of 1940 need not count as a client any person for whom the adviser provides investment advisory services without compensation. However, rule 203(b)(3)-1 does not control the determination of when a person is considered the client of a registered investment adviser for purposes of rule 206(4)-2. (Posted March 15, 2010)

Question II.10

Q: If an adviser has custody of a client's assets that include a swap agreement with a counterparty and posts funds or securities as collateral in connection with the swap on behalf of the client, must the collateral be maintained with a qualified custodian?

A: Yes. Such collateral must be maintained with a qualified custodian. If the qualified custodian is a related person, the adviser must receive an internal control report from the custodian. In addition, the adviser must undergo a surprise examination unless the custodian is operationally independent. Both the surprise examination, if required, and internal control report must be performed by an accountant that is registered with, and subject to regular inspection by, the PCAOB. (Posted May 20, 2010)

III. Fee Deductions

Question III.1

Q: A client has instructed its custodian to debit the client's account for advisory fees each quarter. The custodian makes all fee calculations, based on the advisory contract. The adviser does not calculate the fee, nor does it send a bill. Does the adviser have custody?

A: If the qualified custodian is not a related person of the adviser, the adviser does not have custody. Under these circumstances, the custodian is acting only as agent for the client, and the adviser does not have access to the client's funds. (Modified May 20, 2010.)

IV. Account Statements; Surprise Examinations

Question IV.1

Q: May account statements be delivered electronically?

A: Yes. Electronic delivery is permissible, if (1) the client has given informed consent to receiving the information electronically; (2) the client can effectively access the electronically delivered information; and (3) evidence of the delivery is received, such as an email return-receipt or other confirmation that the information was accessed. See Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Release No. 33-7288 (May 9, 1996) [61 FR 24644 (May 15, 1996)]. These guidelines are available at www.sec.gov/rules/concept/33-7288.txt.

Advisers whose clients receive electronic statements from qualified custodians must still form a reasonable belief after due inquiry that the clients are receiving those statements. The adviser may satisfy this requirement by, for example, being copied on the email notifications of account statement postings sent to clients in addition to having access to client statements on the custodian's website, although this is not the exclusive means of forming that reasonable belief (footnote 21 of the Adopting Release). (Modified March 5, 2010.)

Question IV.2

Q: Can an adviser voluntarily continue to send its own quarterly account statements to clients in addition to the statements that the clients receive directly from qualified custodians?

A: Yes. If an adviser voluntarily sends account statements, it must insert a legend required under paragraph (a)(2) of the rule urging the client to compare information provided in its statements with those from the qualified custodian in account opening notices and subsequent statements sent to the client for whom the adviser opens custodial accounts with the qualified custodian. (Modified March 5, 2010.)

Question IV.3

Redesignated as Question XVI.4.

Question IV.4

Q: Is there an example of a report that may be issued by the independent public accountant performing a surprise examination of the adviser?

A: Yes. As stated within the Commission's Guidance for Accountants (see Release No. IA 2969), the surprise examination is a compliance examination to be conducted in accordance with AICPA attestation standards. The AICPA has issued an illustrative surprise examination report to reflect the reporting specified in the Guidance for Accountants. The illustrative report is available on the AICPAs website at https://www.aicpa.org/content/dam/aicpa/interestareas/frc/industryinsights/downloadabledocuments/custody-report-september-1final.

Additionally, the AICPA published this illustrative surprise examination report in the May 2010 edition of the Audit and Accounting Guide — Investment Companies. (Posted September 9, 2010)

Question IV.5

Q: The Guidance for Accountants (http://www.sec.gov/rules/interp/2009/ia-2969.pdf) states that the accountant's surprise examination report must include an opinion as to whether the investment adviser had been complying with rule 204-2(b) since the prior examination date. When an investment adviser becomes subject to the surprise examination requirement for the first time, what period should such opinion cover?

A: The accountant should report on the investment adviser's compliance with rule 204-2(b) for a period beginning no later than the date the adviser became subject to the surprise examination requirement through the examination date. (Posted December 2, 2010)

Question IV.6.A

Q: Who must file Form ADV-E and the certificate of accounting (surprise examination report)?

A: Form ADV-E and the surprise examination report must be filed electronically through IARD by the independent public accountant performing the surprise examination. Paper filings are no longer accepted. (Posted December 2, 2010)

Question IV.6.B

Q: How does the independent public accountant file Form ADV-E and the surprise examination report?

A: This is a two-step process: (1) the adviser must submit a Form ADV-E in IARD that identifies the independent public accountant who will be performing the surprise examination (see the IARD Users Manual on http://www.iard.com/pdf/formADVE_guide.pdf ), and (2) the independent public accountant receives an email from IARD providing a unique, secure link which allows the accountant to upload a surprise examination report to IARD (see http://www.iard.com/pdf/formADV-E.pdf for instructions). (Posted December 2, 2010)

V. Notice to Clients

Question V.1

Q: An adviser uses three different custodians for one of its clients, and the assets are moved among them depending on the trading in the account. At any given moment, one or two of those custodians might not be holding that client's funds or securities. Must the adviser provide the client with a new notice each time the assets are moved, or can the adviser provide the client with notice at one time advising the client of all three custodians?

A: The adviser can give the client a one-time notice of all three custodians, and is not required to provide a new notice each time the assets move among the three. The purpose of the notice is to tell the client whom to contact to get his assets, if necessary, and this purpose is satisfied even if the client has to contact three custodians. (Posted 2003.)

VI. Pooled Investment Vehicles

Question VI.1

Q: How does an investment adviser to a pooled investment vehicle comply with the custody rule if it does not use the "audit provision"?

A: If the financial statements of the pooled investment vehicle are not audited and distributed to investors in accordance with paragraph (b)(4) of the rule, the exceptions provided in that paragraph will not be available to the adviser. As a consequence, the adviser, among other things, must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements to each investor in the pool and must obtain an annual surprise examination with respect to the pool's assets. We note that, because the privately offered securities exception provided in paragraph (b)(2) is not available with respect to assets of an unaudited pool, the adviser must maintain privately offered securities owned by the pool with a qualified custodian. (Posted May 20, 2010)

Question VI.2

Q: When a qualified custodian is required to send account statements directly to investors in a pooled investment vehicle, should each account statement be a statement of funds and securities held by the pool and transactions entered into by the pool, or a statement of the investor's ownership interest in the pool (e.g., the investor's ending capital balance in a limited partnership)?

A: Each account statement sent should be a statement of funds and securities held by the pool and transactions entered into by the pool. (Modified May 20, 2010.)

Question VI.3

Q: Should the accountant's confirmation procedures for a surprise examination of a pooled investment vehicle include confirmation with investors of the pooled investment vehicle?

A: Yes. The accountant should obtain confirmation from investors of (i) funds and securities held by the pooled investment vehicle as of the date of the examination and (ii) contributions and withdrawals of funds and securities to and from the pooled investment vehicle by the investor since the date of the last examination. The quarterly account statements required to be sent by the qualified custodian[s] (see also Question VI.2) should provide investors with the information necessary to respond to the confirmation. (Posted May 20, 2010)

Question VI.4

Q: Does each limited partner need to have a separate independent representative or can one independent representative serve for all limited partners?

A: The representative can serve for all limited partners, so long as the representative is, in fact, independent and satisfies the definition in rule 206(4)-2(d)(4). (Modified March 5, 2010.)

Question VI.5

Q: To use the "audit approach" relying on rule 206(4)-2(b)(4), must the financial statements be prepared in accordance with U.S. GAAP?

A: Yes, the financial statements for pooled vehicles must be prepared in accordance with U.S. GAAP in order to meet the requirements of the rule, with some exceptions for non-U.S. funds and non-U.S. advisers.

Pooled vehicles organized outside of the United States, or having a general partner or other manager with a principal place of business outside the United States, may have their financial statements prepared in accordance with accounting standards other than U.S. GAAP so long as they contain information substantially similar to statements prepared in accordance with U.S. GAAP. Any material differences with U.S. GAAP must be reconciled. The Division would not recommend enforcement action if that reconciliation is included only in the financial statements delivered to U.S. persons. See generally Goodwin, Proctor & Hoar, SEC Staff Letter, Feb. 28, 1997. The required audit of those financial statements must be by an independent public accountant and meet with requirements of U.S. generally accepted auditing standards ("U.S. GAAS").

In addition, offshore advisers registered with the SEC are not subject to the custody rule, with respect to offshore funds. See ABA Subcommittee on Private Investment Entities, SEC Staff Letter, Aug. 10, 2006 ("ABA Letter"), available at http://www.sec.gov/divisions/investment/
noaction/aba081006.pdf. The terms "offshore adviser" and "offshore fund" are defined in the ABA Letter. (Modified March 10, 2010.)

Question VI.6

Q: To use the "audit provision" allowed under rule 206(4)-2(b)(4), must the audit meet the requirements of U.S. GAAS?

A: Yes. If the audit does not meet U.S. GAAS requirements, the adviser cannot rely upon the "audit provision." (Modified March 10, 2010.)

Question VI.7

Q: Does a fund of funds have to meet the 120-day deadline for sending out its audited financial statements?

A: The Division has issued a letter indicating that it would not recommend enforcement action to the Commission if an adviser relying on the "audit provision" for a fund of funds distributes the audited financials to investors within180 days from the end of the fund of funds' fiscal year. A fund of funds is a pooled investment vehicle that invests 10 percent or more of its total assets in other pooled investment vehicles that are not, and are not advised by, a related person of the pool, its general partner, or its adviser. A "related person" of an adviser includes officers, partners, directors, most employees, and anyone controlled by, controlling or under common control with the adviser. See Adopting Release at footnote 45 and the ABA Letter. (Modified March 5, 2010.)

Question VI.8A

Q: An adviser's client is a pooled investment vehicle that invests in a fund of funds, but the "top tier" pool is not a fund of funds as defined in the ABA Letter because it is affiliated with the fund of funds in which it invests — for example, the top tier pool is a feeder fund in a master-feeder structure where the master fund is a fund of funds. If the top tier pool wishes to rely on the "audit provision," must it distribute its audited financial statements within 120 days of its fiscal year end, or may it use the extended 180-day deadline available to the fund of funds?

A: In these circumstances, the auditors of the top tier pool, like the auditors to the fund of funds, might not be able to complete their work until the audit reports of the funds underlying the fund of funds are available. The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser to a top tier pool that invests 10 percent or more of its total assets in a fund of funds if the adviser distributes the top tier pool's audited financial statements within 180 days of the end of the fiscal year of the fund of funds. (Modified March 5, 2010.)

Question VI.8B

Q: An adviser's client is a "top tier" pooled investment vehicle that invests in one or more funds of funds. Such top tier pool invests 10 percent or more of its total assets in one or more funds of funds, as defined in the ABA Letter, that are not, and are not advised by, a related person of the top tier pool, its general partner, or its adviser. An audit of the top tier pool cannot be completed prior to the completion of the audits of the funds of funds in which it invests, whose advisers have up to 180 days after the end of their fiscal year to distribute audited financial statements. If the adviser to the top tier pool wishes to rely on the "audit provision," when must it distribute its audited financial statements?

A: The Division would not recommend enforcement action to the Commission under rule 206(4)-2 if the audited financial statements of the top tier pool are distributed to pool investors within 260 days of the end of the top tier pool's fiscal year. (Posted April 1, 2011)

Question VI.9

Q: If a pooled investment vehicle is subject to an annual audit and its adviser is relying on the "audit provision" under rule 206(4)-2(b)(4), would the adviser be in violation of the rule if the pooled vehicle fails to distribute its audited financial statements within 120 days after the end of its fiscal year?

A: The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(4) and that reasonably believed that the pool's audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances. (Modified March 5, 2010.)

Question VI.10

Q: Some registered fund families have organized unregistered money market funds for investment exclusively by their registered investment companies, in compliance with rule 12d1-1 under the Investment Company Act of 1940.2 The financial statements of the unregistered money market funds are audited, but are delivered to the registered investment companies, which may be related persons of the adviser. Under rule 206(4)-2(c), sending audited financial statements solely to pooled investment vehicle investors that are themselves pooled investment vehicles and related persons of the adviser does not satisfy the financial statement delivery requirement under rule 206(4)-2(b)(4). Must the financial statements of the unregistered money market funds be delivered to each shareholder in the registered investment companies investing in the unregistered fund?

A: The Division would not recommend enforcement action to the Commission under rule 206(4)-2 if the audited financial statements of the unregistered money market funds are not delivered to the shareholders of the registered investment companies, provided that the financial statements are delivered to each registered investment company's chief compliance officer, audit committee members and the members of the board of directors who are not interested persons of the adviser. (Posted March 5, 2010.)

Question VI.11

Q: Section 206(4)-2(b)(4) provides that an adviser may comply with the rule's requirements with respect to an account of a "limited partnership (or limited liability company, or another type of pooled investment vehicle)" by delivering audited financial statements of the limited partnership to investors. In some cases such pooled investment vehicles are formed where the general partner has only a nominal capital account and there is a single limited partner. Similarly, a limited liability company may have a single member. Is there a minimum number of investors that a limited liability company or other entity must have in order to come within the meaning of section 206(4)-2(b)(4)?

A: No. (Posted March 5, 2010.)

VII. Privately Offered Securities

Question VII.1

Q: If the client is a pooled investment vehicle that does not rely on the "audit provision" under the amended custody rule, may the adviser use the exception for privately offered securities for that client?

A: No. The exception provided under paragraph (b)(2) of the rule is only available for an adviser to a pool that is audited pursuant to rule 206(4)-2(b)(4). (Modified March 5, 2010.)

Question VII.2

Q: The limited partnership an adviser manages does not undergo an annual audit, and the amended custody rule therefore requires that privately offered securities owned by the limited partnership be maintained with qualified custodians. Some of these securities, however, are recorded only on the books of their issuers that are not qualified custodians. May the adviser satisfy this requirement of rule 206(4)-2(a)(1) by keeping the subscription agreement for the security with a qualified custodian or having the custodian act as nominee for the limited partnership?

A: Yes. Under this circumstance, an adviser may satisfy the requirements of rule 206(4)-2(a)(1) by keeping the originally signed subscription agreement (instead of the security itself) with a qualified custodian or having the custodian act as nominee for the limited partnership. (Modified March 5, 2010.)

Question VII.3

Q: When does an adviser have custody when it advises a client with respect to the purchase of privately offered uncertificated securities, i.e., the securities described in paragraph (b)(2)(i) of the rule?

A: Whether an adviser has custody of client funds and securities depends upon whether the adviser directly or indirectly holds the securities or has any authority to possess them. Custody does not turn on whether the securities are maintained with a qualified custodian. Thus, an adviser that is a general partner of a limited partnership or a trustee of a trust would always have custody of such securities held by the partnership or the trust. An adviser that does not have such legal authority to obtain possession of such securities would generally not have custody, for example if the client must sign a subscription agreement to purchase a privately offered security, and the adviser has no authority to transfer or redeem those securities without client consent to the issuer. (Posted March 5, 2010.)

VIII. Independent Representatives

Question VIII.1

Q: If an adviser appoints an independent representative for a client, must the adviser obtain the client's consent?

A: The rule does not address this point. However, an adviser's fiduciary duties, client contract or limited partnership contract may require it to obtain client consent for the appointment. Appointment of a representative without consent of the client suggests that the representative may be controlled by the adviser and is not truly independent. (Posted 2003.)

Question VIII.2

Q: If an accounting firm acts as the independent auditor (or independent surprise examiner) of an adviser, may the accounting firm also act as the independent representative for the limited partners of a pooled investment vehicle run by the adviser?

A: Likely not. The accounting firm would have to meet the definition of "independent representative" set out in the rule. We note that the concept of independence for purposes of the definition of "independent representative" under the rule is distinct from the concept of independence for purposes of the Commission's auditor independence rules. (Posted 2003.)

Question VIII.3

Q: If an accounting firm acts as the independent auditor of a pooled investment vehicle, may the accounting firm also act as the independent representative for the investors in the pool?

A: Likely not. The accounting firm would have to meet the definition of "independent representative" set out in the amended custody rule. As noted in the previous question, the concept of independence for purposes of the definition of "independent representative" under the amended custody rule is distinct from the concept of independence for purposes of the Commission's auditor independence rules.

In addition, if the audited financial statements are intended to be delivered to the independent representative rather than to the investors in the pooled vehicle, then the accounting firm would be receiving its own audit results; in those circumstances, we believe that the accountant may not be able to act solely in the limited partners' interests. (Posted 2003.)

Question VIII.4

Q: If an adviser is a trustee for a client's trust, can a co trustee be the "independent representative" to receive statements for the trust?

A: The co-trustee can be the independent representative provided it meets the tests for independence set out in the rule. (Posted 2003.)

Question VIII.5

Q: Can someone who is an advisory client of an adviser act as an independent representative for other clients of that adviser?

A: Yes, if it meets the tests for independence set out in the rule. If the client relationship is a "material business relationship" (or the person has another material business relationship) with the advisory firm, the person will not meet the tests for independence. (Posted 2003.)

IX. Sub-Custodians

Question IX.1

Q: If an adviser that is a qualified custodian uses a sub-custodian (that is also a qualified custodian) to hold some book-entry securities, may the adviser send its advisory clients consolidated account statements that incorporate the sub custodian's account statements, or must the sub-custodian send separate account statements?

A: If the adviser/custodian's account includes the assets maintained with the sub custodian, the adviser/custodian can send a consolidated statement. (Posted 2003.)

X. Auditing Non-Pool Accounts

Question X.1

Q: Can an adviser use the audit approach under the rule with respect to the account of a client that is not a pooled investment vehicle (e.g., an endowment, an individual, or a pension fund)? What if the client co-invests alongside an audited private pool?

A: No. The audit approach is not available if the client is not a pooled investment vehicle; account statements must be sent to the client by a qualified custodian. The answer does not change if the client co-invests alongside an audited pool. (Modified March 5, 2010.)

XI. Balance Sheet

Question XI.1

Q: Under what circumstances must an adviser still provide an audited balance sheet to its advisory clients?

A: Although having custody no longer causes SEC-registered advisers to be subject to the balance sheet requirement, Item 18 of Form ADV Part 2A requires an SEC-registered adviser that receives the prepayment of fees exceeding $1,200 per client and six or more months in advance to include an audited balance sheet in its brochure to clients from whom the adviser has received such prepayments. (Modified December 2, 2010.)

XII. Trustees

Question XII.1

Q: A related person of an investment adviser (e.g., an officer or director of the adviser) may act as the trustee of the participant-directed defined contribution plan established for the benefit of the adviser's employees. As trustee of the plan, the related person selects the service providers for the plan, such as an administrator and may select the investment options available under the plan, e.g., mutual funds. Must the adviser treat the assets of the plan as client assets of which it has custody?

A: The Division will not recommend enforcement action to the Commission against an investment adviser that does not treat the assets of a participant-directed defined contribution plan established for the benefit of adviser's employees as those of a client of which it has custody in these circumstances solely because a related person of the adviser is trustee which may select service providers and investment options for the plan, provided that (i) neither the investment adviser nor a related person otherwise acts as an investment adviser to the plan or any investment option available under the plan and (ii) the investment adviser and the related person trustee are, to the extent applicable, in compliance with the Employee Retirement Income Security Act of 1974 (ERISA) and rules and regulations issued thereunder with respect to the plan. (Posted March 5, 2010.)

Question XII.2

Q: In some trusts, co-trustees are required either by law or the trust instrument in order to protect the trust beneficiaries from the actions of a single trustee acting alone. In these situations, no co-trustee is able to withdraw assets without the prior written consent of the other co-trustee(s). Would an adviser acting as trustee in this type of arrangement have custody of the trust's assets for purposes of the rule?

A: The Division would not consider an adviser to have custody in such circumstances, provided that (i) the trust has a co-trustee that is a bank or a trust company that meets the definition of a qualified custodian under rule 206(4)-2(d)(6) and is not a related person of the adviser, (ii) the qualified custodian delivers account statements directly to each co-trustee that is not itself the custodian, and (iii) under the trust instrument or by law the withdrawal of any assets of the trust by the adviser requires the prior written consent of all of its co-trustee(s). (Posted March 10, 2010.)

Question XII.3

Q: For estate planning and other purposes, some people form revocable grantor trusts. With these trusts, the person who establishes and funds the trusts (the grantor) may revoke or modify the trust at will, including changing beneficiaries. If an adviser is co-trustee along with the grantor, would the adviser have custody of the trust's assets for purposes of the rule?

A: The Division would not consider an adviser to have custody under rule 206(4)-2 in such circumstances if (i) the adviser is prohibited by the trust instrument or by law from withdrawing any assets from the trust without the prior written consent of all of its co-trustees, (ii) each grantor who has contributed assets to the trust acts as co-trustee, and (iii) the qualified custodian delivers account statements directly to each co-trustee. (Posted March 10, 2010.)

XIII. Internal Control Report

Question XIII.1

Q: Is an adviser required to undergo a surprise examination and receive an internal control report from a related person that has custody of client assets, but does not serve as a "qualified custodian" for purposes of the rule of those assets?

A: An adviser must obtain an internal control report only if the adviser or its related person is acting as a qualified custodian of client assets. See Rule 206(4)-2(a)(6). For example, an adviser to a private fund the general partner of which is a related person of the adviser would not need to receive an internal control report from (i) the general partner if the general partner is not serving as a qualified custodian and (ii) the prime broker that is serving as qualified custodian but is not a related person of the adviser. However, the adviser would be required to obtain a surprise examination unless the fund qualified for the audit provision. See Rule 206(4)-2(b)(4). (Posted March 10, 2010)

Question XIII.2

Q: Rule 206(4)-2(b)(6) provides an exception to the surprise examination requirement to an adviser when a related person is acting as qualified custodian for the adviser's clients if the related person is "operationally independent" (as defined in paragraph (d)(5)) from the adviser. In such case, must the adviser receive an internal control report from the related person?

A: Yes. An adviser must receive an internal control report from the related person that acts as a qualified custodian for the adviser's clients, even if that person is operationally independent. (Posted March 10, 2010)

Question XIII.3

Q: Within the Guidance for Accountants contained in Release IA-2969, the Commission indicated that two types of reports issued under the AICPA professional standards (Type II SAS 70 or AT 601 compliance attestation) would be sufficient to satisfy the requirements of the internal control report. Are there other report formats that can be used to satisfy the custody rule?

A: Yes. The AICPA recently developed a report that under AT 101, Attest Engagements, of the AICPA's professional standards that would be acceptable under the custody rule. An illustrative report is currently available on the AICPA's website at https://www.aicpa.org/content/dam/aicpa/interestareas/frc/industryinsights/downloadabledocuments/custody-report-september-1final. (Posted October 10, 2017)

XIV. Introducing Broker

Question XIV.1

Q: An investment adviser may also act as an introducing broker or have a related person acting as an introducing broker for its clients. Introducing brokers may have a variety of different relationships with a carrying broker with respect to matters such as the handling of customer funds and securities and sending customer account statements. In some cases, an introducing broker may maintain some client funds or securities, on a temporary and/or on-going basis (e.g., introducing brokers subject to paragraph (a)(2)(iv) of Rule 15c3-1 under the Securities Exchange Act of 1934). Is the introducing broker subject to the internal control report requirement in these circumstances?

A: Yes. An internal control report is required whenever an adviser or its related person is acting as a qualified custodian for client assets. (Posted March 10, 2010)

Question XIV.2

Q: If an introducing broker that is also an adviser or an adviser's related person is not acting as a qualified custodian under the rule for funds or securities of the adviser's clients, is the introducing broker subject to the internal control report requirement?

A: No. We would not consider an introducing broker to be acting as a qualified custodian under the rule if all client funds and securities are maintained with a carrying broker (which is not a related person of the adviser). Such an introducing broker must not receive client funds or securities other than checks drawn by clients and made payable to third parties such as the carrying broker. (Posted March 10, 2010)

Question XIV.3

Q: Does an adviser that meets the conditions above in Question XIV. 2 have custody of client funds or securities?

A: It depends. An adviser or its related person may have custody of client funds and securities without maintaining those funds or securities as qualified custodian for purposes of paragraph (a)(6) of the rule. For example, if the adviser or its related person has authority to withdraw client funds or securities maintained by the carrying broker, the adviser has custody of those assets. In that case, the adviser would be subject to all the applicable requirements of the rule, including the surprise examination requirement under paragraph (a)(4) of the rule. (Posted March 10, 2010)

XV. Transfer Agents

Question XV.1

Q: A transfer agent to a mutual fund is permitted to be used in lieu of a qualified custodian with respect to that mutual fund's shares under rule 206(4)-2(b)(1). If the mutual fund transfer agent is a related person of the adviser, must the adviser undergo a surprise examination and receive an internal control report from the transfer agent?

A: Yes. (Posted March 15, 2010)

XVI. Auditor Independence

Question XVI.1

Q. Pursuant to the custody rule, an accountant performing a surprise examination must meet the standards of independence described in rules 2-01(b) and (c) of Regulation S-X. Rule 2-01(b) provides the general standard of independence. Rule 2-01(c) provides a non-exclusive list of circumstances, including specific relationships and services, which would be inconsistent with the general standard. How should an accountant who performs a surprise examination under the custody rule consider the propriety of non-audit services specified in rule 2-01(c)(4)(i)-(v) if such services are not subject to the accountant’s procedures during the surprise examination?

A. When engaged to issue an audit or attest report to satisfy a requirement in the custody rule, the accountant should consider the application of the general standard of independence to such engagements. The Commission’s 2003 adopting release (Release No. 33-8183 (January 28, 2003), Strengthening the Commission’s Requirements Regarding Auditor Independence), states that there is a rebuttable presumption that certain prohibited non-audit services (e.g., bookkeeping, financial information systems design and implementation) will be subject to audit procedures during an audit of the audit client’s financial statements. Rule 2-01(c)(4) provides that these non-audit services are prohibited unless “it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements.” Therefore, it is the staff’s position that, subject to Rule 2-01(b) of Regulation S-X, an accountant performing a surprise examination under the custody rule would be able to perform certain non-audit services as long as it is reasonable to conclude that: (1) the results of the non-audit service will not be subject to attest procedures which might be performed during the surprise examination; and (2) the results of the non-audit service would not be subject to audit procedures if the accountant had been engaged to perform a financial statement audit. For example, if a pooled investment vehicle is included in the scope of an adviser’s surprise examination under the custody rule, the accountant performing the surprise examination would be prohibited from compiling the pooled investment vehicle’s financial statements. (Posted December 13, 2011.)

Question XVI.2

Q. The custody rule requires that an accountant performing a surprise examination of an adviser, preparing an internal control report of an adviser’s related person qualified custodian or performing an audit of a pooled investment vehicle’s financial statements for purposes of the adviser’s compliance with the custody rule must be an “independent public accountant” and thus comply with the applicable provisions of rule 2-01 of Regulation S-X, including the term “audit and professional engagement period” as defined in rule 2-01(f)(5). How should the term “audit and professional engagement period” be applied for accountants performing surprise examinations, preparing internal control reports, and auditing pooled investment vehicles’ financial statements pursuant to the custody rule?

A. Under the provisions of rule 2-01 of Regulation S-X, for a surprise examination, the audit and professional engagement period begins the earliest of: (1) the date the accountant signs an initial written agreement to perform the surprise examination as required by rule 206(4)-2(a)(4); (2) the date the accountant begins attest procedures; or (3) the beginning of the period subject to the surprise examination.

For the preparation of an internal control report or an audit of a pooled investment vehicle’s financial statements, the audit and professional engagement period begins the earliest of: (1) the date the accountant signs an engagement letter or other agreement to prepare the qualified custodian’s internal control report or audit the pooled investment vehicle’s financial statements; (2) the date the accountant begins attest or audit procedures; or (3) the beginning of the period covered by the internal control report or pooled investment vehicle’s financial statements.

In general, the audit and professional engagement period for the surprise examination ends when the accountant notifies the Commission of its termination pursuant to rule 206(4)-2(a)(4)(iii). While neither the accountant nor the audit client is required to notify the Commission of the termination of an engagement to prepare an internal control report or to audit a pooled investment vehicle’s financial statements under the custody rule, consistent with the provisions of rule 2-01 of Regulation S-X, the audit and professional engagement period for these engagements ends when the audit client or the accountant, as applicable, notifies the other that the client is no longer the accountant’s client for such engagement. See also Question XVI.3. (Posted December 13, 2011.)

Question XVI.3

Q. The definition of “audit and professional engagement period” in rule 2-01(f)(5) of Regulation S-X provides that the professional engagement period ends when the audit client or the accountant notifies the Commission that the client is no longer that accountant’s audit client. How is the end date affected if the notification of termination of the engagement period is not effective until some future date or event? For example, where the client notifies the accountant that the relationship terminates with the conclusion of the engagement for the current fiscal year, when does the “audit and professional engagement period” end?

A. In this situation (absent any subsequent notice of termination), the professional engagement period ends with the issuance of the accountant’s report for that particular engagement. It is important to note, however, that even where the termination of the professional engagement period is not effective until a future date or event, the obligation to make a filing under Commission regulations (e.g., on Form 8-K, Form ADV-E, or pursuant to rule 17a-5 of the Securities Exchange Act of 1934, as applicable) upon notification is not affected. (Posted December 13, 2011.)

Question XVI.4

Q. If an accounting firm regularly audits an advisory firm’s books or the books of a limited partnership run by the advisory firm, can that accounting firm also be an “independent” public accountant for purposes of performing the surprise examination under the custody rule?

A. Yes, provided that the accounting firm meets the definition of “independent public accountant” in section (d)(3) of the rule. (Modified March 5, 2010.)


Endnotes


1See also Section II.A. of the 2003 Release. An adviser that is also a qualified custodian would not necessarily have violated the rule if it places the securities in an appropriate account and identifies them in quarterly statements to the client.

2 Pursuant to rule 12d1-1 under the Investment Company Act, a registered investment company may invest in an affiliated unregistered money market fund.