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with the governmental rules and regulations. Although there are many regulatory
agencies, of particular importance are the Securities and Exchange Commission
and the Federal Trade Commission.

The principal purpose of the SEC
Securities and Exchange Commission
laws is to provide public disclosure of the relevant facts with respect to new secu-
rities and securities listed on the stock exchanges.45 In particular, the SEC requires
a registration statement that contains background information, such as the size and
competitive position of the corporation. Moreover, a prospective investor must be
furnished a prospectus, which is a summary of the registration statement. For ex-
ample, the prospectus will contain such matters as the offering price of the secu-
rities, the use of the proceeds by the registrant, and the financial statements.46
Furthermore, the SEC requires periodic reports from the corporations in order to
update its files on each corporation. Such periodic reports include the annual re-
port (10-K) and interim reports (10-Q and 8-K).47
The SEC annual Form 10-K report is used to update the information that is in-
cluded in the registration statement. This report must be filed within 90 days of the
end of a registrant™s fiscal year. The report contains this information:

Part I”Item
1. Business
2. Properties
3. Legal proceedings
4. Submission of matters to a note of security holders

Part II”Item
5. Market for the registrant™s common stock and related stockholder matters
6. Selected financial data
7. Management™s discussion and analysis of financial condition and results of
7a. Quantitative and qualitative disclosure about market risk
8. Financial statements and supplementary data
9. Changes in and disagreements with accountants on accounting and financial

Such rules of law are contained in the Accounting Series Releases, Staff Accounting Bulletins, and
Financial Reporting Releases of the SEC.
For a complete description of all the items in the prospectus, see Part I of Form S-1, which is the reg-
istration statement.
See Appendix C on this book™s website for further information. For further details and description of
all forms, see Regulation S-X and Regulation S-K. Copies may be obtained from the U.S. Govern-
ment Printing Office.
122 The External Users of Accounting Information

Part III”Item
10. Directors and executive officers of the registrant
11. Executive compensation
12. Security ownership of certain beneficial owners and management
13. Certain relationships and related transactions
14. Controls and procedures

Part IV”Item
15. Exhibits, financial statement schedules, and reports on Form 8-K

Certification (Sarbanes-Oxley Act, Section 302)
Certification (Sarbanes-Oxley Act, Section 906)

The SEC quarterly Form 10-Q report is used to report interim changes in the
financial position and the results of operating the corporation. This particular re-
port must be filed within 45 days after the close of each of the first three quarters
for nonaccelerated filers (market capitalization of $75 million or less).
Accelerated filers are required to file their annual report on Form 10-K within
60 days of their fiscal year-end and their quarterly report on Form 10-Q within 35
days of their quarter-end. The new SEC requirement allows for a three-year phase-
in of the new rules.48
With respect to the financial information, the report contains information on
the preparation of financial information, reviews by the independent public ac-
countants, and other financial information. Concerning other information, the re-
port discloses information on such matters as legal proceedings, changes in
securities, and other materially important events.
The SEC Form 8-K report is an interim or current report that contains infor-
mation with respect to certain significant special events. For example, a change in
the independent accounting firm must be reported within two business days sub-
sequent to the change. Other events include such items as a change in control of
the registrant or significant legal proceedings. This report is particularly important
since it provides timely information regarding the disclosure of material events.
Consequently, the SEC needs accounting information not only to monitor man-
agement™s compliance with its rules but also to protect the investing public.

SEC Topical Developments
The SEC has focused on a number of financial reporting areas that relate to the
audit committee™s oversight responsibility. The more significant developments in
these reporting areas are discussed in the next paragraphs.

For further information on additional reportable events, see Securities and Exchange Commission,
Acceleration of Periodic Report Filing Dates and Disclosure Concerning Website Access to Reports,
August 27, 2002, www.sec.gov.
Regulatory Agencies 123

The quality of information re-
Management™s Discussion and Analysis
ported to the SEC concerning Management™s Discussion and Analysis (MD&A)
of Financial Condition and Results of Operations in the registrant™s filings has
been of major concern to the investing public and to the SEC. In response, the SEC
issued Financial Reporting Release No. 36, which is an interpretive release re-
garding disclosures required by Item 303 of Regulation S-K with respect to the
registrants™ filings containing Management™s Discussion and Analysis of Financial
Condition and Results of Operations.49 Based on a review project of such filings,
the Commission found that several key disclosure matters, namely, prospective in-
formation, liquidity and capital resources analysis, material changes in financial
statement line items, and business segment analysis, should be considered by reg-
istrants in preparing MD&A disclosures. Apparently the SEC determined that in-
terpretive guidance is needed for disclosures concerning the aforementioned
The SEC requires management to discuss favorable or unfavorable trends, sig-
nificant events, and uncertainties that impact the various reporting areas. Given
that MD&A reporting is highly subjective and that management must comply
with Item 303 of Regulation S-K, the question is frequently asked: Is the objective
of the MD&A disclosure requirement being accomplished? Clearly, the MD&A
narrative discussion is the appropriate vehicle to provide early warning signals or
red flags to the investing public. As a case in point, Management Accounting re-
cently observed that the SEC issued an order complaining about a registrant™s
MD&A reporting that did not tell investors that nearly 23 percent of its 1989 earn-
ings came from a foreign subsidiary unit”a situation that would not recur. James
Adelman of the SEC™s Enforcement Division stated, “It will no longer be accept-
able for companies to use ˜boilerplate™ language in MD&As when they know un-
folding developments will have an effect on corporate earnings in the future.”50
In addition to management™s involvement with the preparation of MD&A, in-
dependent auditors must review this information to ensure that the narrative dis-
cussion is not inconsistent with their findings and conclusions regarding their
audit report. For example, if management knows of events, trends, or uncertainties
that are reasonably likely to occur, then such information should be reported under
prospective information. Conversely, if management concludes that events, trends,
or uncertainties are not reasonably likely to occur, then no disclosure is required.

Securities and Exchange Commission, “Management™s Discussion and Analysis of Financial Condi-
tion and Results of Operations; Interpretive Release,” Title 17, Code of Federal Regulations, Secs.
211, 231, 241, and 271 (June 1989), pp. 1“44. See Chapter 10 for additional discussion about the ap-
plication of critical accounting policies.
Stephen Barlas, “SEC Cracks Down on MD&A Sections,” Management Accounting 73, No. 12
(June 1992), p. 8. See Accounting and Auditing Enforcement Release No. 363 (March 31, 1992), 51
SEC Docket 300. Also see Statement on Standards for Attestation Engagements No. 8, “Manage-
ment™s Discussion and Analysis” (New York: AICPA, 1998), which provides guidance to independent
accountants engaged to examine or review MD&A as well as the use of agreed-on procedures; Reva
B. Steinberg and Judith Fellner Weiss, “New Rules on Disclosure of Certain Significant Risks and Un-
certainties,” CPA Journal 65, No. 3 (March 1995), pp. 16“20; SEC™s interpretation on year 2000 enti-
tled, Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers,
Investment Companies, and Municipal Securities Issues (Washington, DC: SEC, 1998).
124 The External Users of Accounting Information

Thus the reasonably likely standard, and whether management knows of the
trends, events, or uncertainties, determines whether such information is disclosed.
If management anticipates such trends, events, or uncertainties, then disclosure is
optional under prospective information. Professional auditing standards, in partic-
ular SAS No. 59, “The Auditor™s Consideration of an Entity™s Ability to Continue
as a Going Concern,” dictate that the independent auditors do have the power to
issue an unqualified audit report with an explanatory paragraph describing the ma-
terial uncertainty.51 This type of audit report gives a warning signal or a red flag to
the investing public with respect to the financial condition of the company. An-
thony B. Billings and Larry D. Crumbley assert that auditors have a role in sig-
naling a going concern problem. Their role is governed by SAS No. 59, which
advances categories of conditions that may arise, including adverse financial ra-
tios, negative trends, and loan defaults.52 Moreover, John E. Ellingsen, Kurt Pany,
and Peg Fagan point out that “an auditor may have designed and performed audit
procedures”such as analyzing liquidity ratios”to ascertain whether the entity is
complying with certain loan covenants. Evaluation of the liquidity ratios not only
assists the auditor vis-à-vis the loan covenants but also helps the auditor evaluate
whether the ratios raise doubt about the company™s ability to continue as a going
concern.”53 Of course, the auditor must consider the conditions and events in the
aggregate, so that unfavorable liquidity ratios coupled with declining profitability
ratios and increased debt-solvency ratios may cause substantial doubt about the
entity™s going concern ability. Accordingly, SAS No. 59 requires that the inde-
pendent auditors evaluate, in every audit engagement, whether there is substantial
doubt about the entity™s ability to continue as a going concern.
Given the continuing debate over business failure versus audit failure and the
continued number of lawsuits against well-known publicly held companies and
public accounting firms, it is imperative that the audit committee focus its atten-
tion on MD&A disclosures in the financial reporting process. The committee
should (1) review and discuss the SEC™s mandate concerning MD&A reporting
and (2) evaluate management™s compliance with the SEC™s mandated disclosures
and its interpretive release. Clearly, one would expect the audit committee to help
improve the quality of MD&A disclosures in light of the SEC™s interpretive re-
lease. This subject is further discussed in Chapter 10.
An example of disclosure of critical accounting policies of Wal-Mart Stores,
Inc. is as follows:
Summary of Critical Accounting Policies
Management strives to report the financial results of the Company in a clear and un-
derstandable manner, even though in some cases accounting and disclosure rules are
complex and require us to use technical terminology. We follow generally accepted
accounting principles in the U.S. in preparing our consolidated financial statements.

Statement of Auditing Standards, No. 59, “The Auditor™s Consideration of an Entity™s Ability to Con-
tinue as a Going Concern” (New York: AICPA, 1988).
Anthony B. Billings and Larry D. Crumbley, “Financial Difficulties of Governmental Units,” CPA
Journal 58, No. 7 (October 1988), p. 52.
John E. Ellingsen, Kurt Pany, and Peg Fagan, “SAS No. 59: How to Evaluate Going Concern,” Jour-
nal of Accountancy 168, No. 1 (January 1989), p. 27.
Regulatory Agencies 125

These principles require us to make certain estimates and apply judgments that affect
our financial position and results of operations. Management continually reviews its
accounting policies, how they are applied and how they are reported and disclosed in
our financial statements. Following is a summary of our more significant accounting
policies and how they are applied in preparation of the financial statements.

We use the retail last-in, first -out (LIFO) inventory accounting method for the Wal-
Mart Stores segment, cost LIFO for the SAM™S CLUB segment and other cost mea-
sures, including the retail first-in, first-out (FIFO) and average cost methods, for the
international segment. Inventories are not recorded in excess of market value. Histor-
ically, we have rarely experienced significant occurrences of obsolescence or slow-
moving inventory. However, future changes in circumstances, such as changes in
customer merchandise preference or unseasonable weather patterns, could cause the
company™s inventory to be exposed to obsolescence or be slow-moving.
Financial Instruments
We use derivative financial instruments for purposes other than trading to reduce our
exposure to fluctuations in foreign currencies and to minimize the risk and cost as-
sociated with financial and global operating activities. Generally, the contract terms
of hedge instruments closely mirror those of the item being hedged, providing a high
degree of risk reduction and correlation. Contracts that are highly effective at meet-
ing the risk reduction and correlation criteria are recorded using hedge accounting.
On February 1, 2001, we adopted financial Accounting Standards Board (FASB) State-
ments No. 133, 137, and 138 (collectively “FAS 133”) pertaining to the accounting
or derivatives and hedging activities. FAS 133 requires all derivatives, which are fi-
nancial instruments used by the Company to protect (hedge) itself from certain risks,
to be recorded on the balance sheet at fair value and establishes accounting treatment
for hedges. If a derivative instrument is a hedge, depending on the nature of the
hedge, changes in the fair value of the instrument will either be offset against the
change in fair value of the hedged assets, liabilities, or firm commitment through
earnings or recognized in other comprehensive income until the hedged item is rec-
ognized in earnings. The ineffective portion of an instrument™s change in fair value
will be immediately recognized in earnings. Most of the company™s interest rate
hedges qualify for the use of the “short-cut” method of accounting to assess hedge ef-
fectiveness. The Company uses the hypothetical derivative method to assess the ef-
fectiveness of certain of its net investments and cash flow hedges. Instruments that do
not meet the criteria for hedge accounting or contracts for which we have not elected
hedge accounting are marked to fair value with unrealized gains or losses reported
currently in earnings. Fair values are based upon management™s expectation of future
interest rate curves and may change based upon changes in those expectations.
Impairment of Assets
We periodically evaluate long-lived assets other than goodwill for indicators of im-
pairment and test goodwill for impairment annually. Management™s judgments re-
garding the existence of impairment indicators are based on market conditions and
operational performance. Future events could cause management to conclude that im-
pairment indicators exist and that the value of long-lived assets and goodwill associated
with acquired businesses is impaired. Goodwill is evaluated for impairment annually
under the provisions of FAS 142 which requires us to make judgments relating to fu-
ture cash flows and growth rates as well as economic and market conditions.
126 The External Users of Accounting Information

Revenue Recognition
We recognize sales revenue at the time a sale is made to the customer, except for the
following types of transactions. Layaway transactions are recognized when the cus-
tomer satisfies all payment obligations and takes possession of the merchandise. We
recognize SAM™S CLUB membership fee revenue over the 12-month term of the
membership. Customer purchases of Wal-Mart/SAM™S CLUB shopping cards are
not recognized until the card is redeemed and the customer purchases merchandise
using the shopping card. Defective merchandise returned by customers is either re-
turned to the supplier or is destroyed and reimbursement is sought from the supplier.


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