Small Business Investment Companies; Accounting and Financial Reporting Standards

SUMMARY: The Small Business Administration (SBA) currently provides

accounting guidance for Small Business Investment Companies (SBICs) in

two appendices to SBA regulations. These appendices have not been

significantly revised since 1986. Subsequent changes in generally

accepted accounting principles and in the SBIC program have caused the

accounting standards to become outdated and incomplete. This rule

updates the standards for accounting and financial reporting by SBICs,

as well as the guidelines for Independent Public Accountants (IPAs)

performing audits of SBIC financial statements.

The current appendix I includes SBA Form 468, on which SBICs

prepare the required Annual Financial Report to SBA. The current

appendix II includes the standard chart of accounts for SBICs. This

rule deletes both the Form 468 and the chart of accounts from the

regulations and consolidates the remaining material in appendices I and

II into one appendix.

DATES: This interim final rule is effective February 7, 1995. Written

comments on this rule must be received no later than March 9, 1995.

ADDRESSES: Written comments should be sent to Robert D. Stillman,

Associate Administrator for Investment, Small Business Administration,

Suite 6300, 409 3rd Street SW., Washington, DC 20416.

FOR FURTHER INFORMATION CONTACT:

Carol Fendler, Office of Program Support; telephone no. (202) 205-7559.

SUPPLEMENTARY INFORMATION: The accounting standards published by SBA on

August 28, 1986 (51 FR 30752) have since undergone only minor

revisions. As a result, these standards do not reflect subsequent

changes in the SBIC program mandated by the Small Business Investment

Act of 1958, as amended (Act), as well as changes in generally accepted

accounting principles (GAAP).

This rule updates the accounting standards for the SBIC program,

while also reorganizing the material to make information on specific

topics easier to find. The accounting, financial reporting and auditing

requirements included in the current appendices I and II to Part 107 of

SBA regulations are consolidated into a revised appendix I.

Two items currently included in the appendices are deleted: (1) The

schedules which constitute SBA Form 468, on which SBICs prepare their

Annual Financial Report to SBA, and (2) the standard SBIC chart of

accounts. SBA is deleting Form 468 in the interest of consistency,

since none of the other standard forms used in the SBIC program is

included in Part 107 of the regulations or its appendices. The SBIC

chart of accounts represents the type of explanatory material that SBA

considers more appropriate for inclusion in a Policy and Procedural

Release rather than in Agency regulations. SBA plans to provide updated

versions of both the Form 468 and the SBIC chart of accounts after this

rule is published. Until then, Licensees should continue to use the

existing versions.

While many of the topics covered in this rule should be familiar to

users of the current appendices, some are either new or significantly

revised, including the following:

1. Independent Auditors' Report--Includes a sample report which

satisfies current requirements of the American Institute of Certified

Public Accountants.

2. Access to Accountants' Working Papers--States explicitly that

SBA, in its discretion, may assign its examiners or other personnel to

review accountants' working papers prepared in connection with audits

of SBICs. Although this statement does not appear in the existing

appendices, it is consistent with SBA's current position that working

papers are subject to the requirements concerning records and reports

set forth in Sec. 107.1002 of the regulations.

3. Accounting for Income Taxes--Revised in accordance with FASB

Statement No. 109, issued in February 1992, which sets forth current

GAAP in this area.

4. Interest Income--Provides more specific guidance than before

concerning the accounting treatment of delinquent interest. This

section sets forth conditions which are deemed to create a presumption

that the collection of interest is doubtful; SBICs would have the

opportunity to rebut such a presumption. This approach is consistent

with the valuation guidelines for interest-bearing securities published

in the Federal Register on June 2, 1994 (59 FR 28471) and is intended

to achieve greater consistency in financial reporting by SBICs.

5. Undistributed Realized Earnings--Provides more detailed

definitions of Undistributed Net Realized Earnings and Noncash Gains/

Income, the two components of Undistributed Realized Earnings. These

definitions are consistent with the interpretations currently used by

SBA in practice.

6. Retained Earnings Available for Distribution--Corrects

contradictory statements in the current appendices and provides

additional detail concerning the computation of this amount, consistent

with the definition of Retained Earnings Available for Distribution

which was published in the Federal Register on April 8, 1994 (59 FR

16898).

7. Preferred Securities Leverage for Section 301(d) Licensees--

Provides guidance on accounting for 4% redeemable preferred securities,

a topic which is not addressed in the current appendices.

8. Participating Securities--Provides general guidance on financial

statement presentation of these new equity-type securities, which may

be issued by Licensees pursuant to the final rule published in the

Federal Register on April 8, 1994. Additional guidance and computer

software to perform the various profit and distribution computations

associated with Participating Securities will be provided to issuers of

such securities.

Compliance With Executive Orders 12866, 12612 and 12778, and the

Regulatory Flexibility and Paperwork Reduction Acts

Executive Order 12866 and Regulatory Flexibility Act

This rule will not constitute a significant regulatory action for

purposes of Executive Order 12866 because it is not likely to have an

annual impact on the national economy of $100 million or more, and, for

purposes of the Regulatory Flexibility Act, 5 U.S.C. 601 et seq., it

will not have a substantial impact on a significant number of small

entities.

1. The legal basis for this regulation is section 308(c) of the

Small Business Investment Act, 15 U.S.C. 687(c).

2. The potential benefits of this regulation have been set forth in

the discussion above, under Supplementary Information.

3. The potential cost of this regulation cannot be quantified or

estimated.

4. There are no Federal rules which duplicate, overlap, or conflict

with this rule.

5. SBA is not aware of regulatory alternatives that could achieve

the same objectives at lower cost.

This rule was not reviewed under Executive Order 12866.

[[Page 7393]]

Executive Order 12612

SBA certifies that this regulation has no federalism implications

warranting the preparation of a Federal Assessment in accordance with

Executive Order 12612.

Paperwork Reduction Act

For purposes of the Paperwork Reduction Act, 44 U.S.C., ch. 35, SBA

hereby certifies that this rule, in and of itself, will impose no new

reporting or recordkeeping requirements. This rule prescribes the

accounting treatment for certain types of financial transactions which

are new to the SBIC program; such treatment, however, is dictated by

the substance of these transactions, which has already been established

by statute (primarily section 403 of Pub. L. 102-366).

Executive Order 12778

SBA certifies that this rule is drafted, to the extent practicable,

in accordance with the standards set forth in Section 2 of Executive

Order 12778.

SBA certifies pursuant to 5 U.S.C. 553(b)(B) that notice and

comment in the promulgation of this regulation is impracticable. In

this regard, the rule provides necessary accounting guidance to

Licensees on recently implemented aspects of the SBIC program (such as

Participating Securities and commitments from Institutional Investors).

It also revises the guidelines to reflect recent regulatory changes in

such areas as valuations, Retained Earnings Available for Distribution,

and electronic reporting requirements. Licensees need to have access to

this information in order to prepare their year end financial

statements in a manner acceptable to SBA.

Other changes to the accounting guidelines are intended to bring

them into compliance with generally accepted accounting principles.

Some areas of the present guidelines (such as accounting for income

taxes and preparation of the Independent Accountant's Report) are so

out of date that they have become sources of significant confusion to

Licensees.

Finally, this rule provides for the deletion of the present SBA

Form 468 from the appendix to Part 107. This will allow SBA to

implement a revised 468 (subject to OMB approval) for companies with

fiscal years ending on or after December 31, 1994. The revised Form 468

is needed to accommodate reporting related to statutorily mandated

programs, and also to provide Licensees with a format in which to show

information such as economic impact data, investments in Smaller

Concerns, and computations of Regulatory and Leverageable Capital.

Without the new Form 468, Licensees will find it difficult to report

required financial information to SBA, and SBA will find it difficult

to monitor key aspects of their financial condition and regulatory

compliance.

Therefore, this rule is being promulgated as an interim final rule,

and the public is offered an opportunity to comment on it subsequent to

its publication. Comments will be taken into consideration in the

ultimate finalization of the rule.

List of Subjects in 13 CFR Part 107

Investment companies, Loan programs--business, Small businesses.

For the reasons set forth above, Title 13, Part 107 of the Code of

Federal Regulations is amended as follows:

PART 107--SMALL BUSINESS INVESTMENT COMPANIES

1. The authority citation for Part 107 continues to read as

follows:

Authority: Title III of the Small Business Investment Act, 15

U.S.C. 681 et seq.; 15 U.S.C. 687c; 15 U.S.C. 683; 15 U.S.C. 687d;

15 U.S.C. 687g; 15 U.S.C. 687b; 15 U.S.C. 687m, as amended by Pub.

L. 102-366.

2. Appendix I is revised to read as follows:

Appendix I to Part 107--Accounting Standards and Financial Reporting

Requirements for Small Business Investment Companies

Table of Contents

I. Introduction

II. Recordkeeping and Financial Reporting

A. Records and Reports

B. Account Classification

C. Annual Financial Report (SBA Form 468)

D. Filing of Annual Financial Report

E. Portfolio Financial Report (SBA Form 1031)

F. Interim Reports

III. Selection and Qualification of the Auditor

A. Selection of the Auditor

B. Qualification of the Auditor

C. Independence

IV. Annual Report

A. Generally Accepted Auditing Standards

B. Independent Auditors' Report

C. Access to Accountants' Working Papers

D. Accountants' Reponsibility for Valuations

E. Audit Adjustments

F. Reporting Irregularities

G. Detecting Noncompliance With Laws and Regulations

V. Accounting Policies and Procedures

A. Generally Accepted Accounting Principles

B. Accrual Basis of Accounting

C. Reporting Entity

D. Fair Value of Loans and Investments

E. Interest Income

F. Dividend Income

G. Profit Participation in Small Concerns

H. Fees Charged to Small Concerns

I. Accounting for Investments in Flow-Through Entities

J. Equity Method of Accounting

K. Accounting for Income Taxes

L. Realized Gain (Loss) on Investments

M. Nonmonetary Transactions

N. Interest, Notes and Accounts Receivable

O. Compensating Balances

P. Organization Costs

Q. Contingent Liabilities

R. Transactions with Related Parties

S. Leverage--Debentures Guaranteed or Purchased by SBA

T. Leverage--Participating Securities Guaranteed by SBA

U. Preferred Securities Leverage for Section 301(d) Licensees

V. Contributed Capital and Committed Capital

W. Unrealized Gain (Loss) on Securities Held

X. Undistributed Realized Earnings

Y. Retained Earnings Available for Distribution

Z. Partnership Capital Accounts

VI. Availability of Publications and Forms

I. Introduction

i. This appendix provides guidance to Small Business Investment

Companies (SBICs) on accounting policies and procedures, financial

reporting to SBA, and selection of an auditor. In addition, this

appendix contains guidelines for Independent Public Accountants

(IPAs) engaged to conduct annual audits of SBICs. This appendix is

not intended to be a comprehensive treatment of all accounting and

auditing issues which may arise in an SBIC; instead, its purpose is

to cover those topics that are particularly relevant to the SBIC

program and which may involve the application of specialized

industry practices. Therefore, Licensees and their IPAs should

consult other appropriate sources of information as needed.

Furthermore, as in any audit, the independent auditor of an SBIC

must exercise professional judgment as to the work required to

satisfy generally accepted auditing standards.

ii. This appendix contains references to Securities and Exchange

Commission (SEC) Rules and Regulations, pronouncements of the

Financial Accounting Standards Board (FASB) and its predecessors,

publications of the American Institute of Certified Public

Accountants (AICPA), and the Internal Revenue Code. Such references

are subject to change. It is the responsibility of the Licensee and

its advisors to be aware of any regulatory, accounting, or tax code

changes that could have an effect on the Licensee.

II. Recordkeeping and Financial Reporting

A. Records and Reports

All books, records, ledgers, and other supporting documents

shall be maintained in the English language. See Sec. 107.1002 for

specific requirements relating to the retention of records and the

filing of reports with SBA.

B. Account Classification

i. Licensees shall maintain their books of account in accordance

with the system of [[Page 7394]] account classification prescribed

by SBA. The system has been prescribed to insure that standard books

of account are maintained by Licensees and that uniform accounting

policies are followed.

ii. Books of account for a management consulting or other

subsidiary shall be maintained using accounts compatible with those

used by the Licensee.

C. Annual Financial Report (SBA Form 468)

i. The Small Business Administration, under authority granted by

the Small Business Investment Act of 1958, as amended (the Act),

requires each Licensee to submit an Annual Financial Report as of

the close of its fiscal year (see Sec. 107.1002(e)). The Annual

Financial Report consists of audited financial statements and

supplementary schedules prepared on SBA Form 468, the Independent

Public Accountant's report, the notes accompanying the financial

statements, and the required certifications.

ii. Preparation of the Annual Financial Report is the

responsibility of the Licensee. The Independent Public Accountant's

responsibility is to perform an audit and to express an opinion on

the financial statements and supplementary schedules based on the

audit.

D. Filing of Annual Financial Report

i. The Annual Financial Report on SBA Form 468 shall be

submitted to SBA by the Licensee no later than the last day of the

third month following the end of the Licensee's fiscal year.

The Licensee shall include in its filing a copy of any

transmittal letter, special report, or other communication furnished

by its auditor.

ii. For all fiscal years ending on or after June 30, 1994, SBA

Form 468 shall be submitted electronically, in accordance with

Sec. 107.101(h). All Licensees must use the electronic reporting

software provided by SBA for this purpose. A complete filing of Form

468 consists of the following:

(1) The electronic reporting data diskette;

(2) Two printed copies of the financial statements and

supplementary schedules;

(3) The signed management certifications which appear on the

last page of Form 468 (two copies, one with original signatures);

(4) The IPA's report (two copies, one with original signature);

and

(5) The notes to the financial statements (two copies).

E. Portfolio Financing Report (SBA Form 1031)

For each financing of a small concern, Licensees shall submit a

Portfolio Financing Report on SBA Form 1031 within 30 days of the

closing date of the financing. Such reports shall be prepared using

software provided by SBA. Licensees may submit a printout of the

form to SBA or transmit it electronically. The report, which is used

for program evaluation purposes, provides summary information

concerning the amount and terms of the financing, the financial

condition of the small concern and the intended use of proceeds, as

well as information which will be used to assess the economic impact

of the financing.

F. Interim Reports

SBA may require Licensees to submit interim reports containing

unaudited financial and/or management information, pursuant to

Sec. 107.1002(g). The form and content of such reports may be

standardized or determined by SBA on a case-by-case basis. Interim

reports shall be submitted in such manner and at such time as SBA

shall direct.

III. Selection and Qualification of the Auditor

A. Selection of the Auditor

i. The Licensee's Board of Directors or General Partner is

responsible for selecting the Independent Public Accountant (IPA).

Within 30 days of its engagement by the Licensee, the Independent

Public Accountant shall file with the SBA a completed IPA

Certification (CO Form 112) certifying as to its qualifications and

independence. The IPA shall be deemed approved unless the Licensee

is notified to the contrary by SBA within 90 days after receipt of

the IPA Certification.

ii. Submittal of the IPA Certification is required only upon the

initial engagement of the IPA. An IPA engaged to audit an SBIC on a

recurring basis does not need to submit a new Certification each

year.

iii. The Licensee shall notify the SBA in writing of a change in

accountants and shall explain the reason for the change.

B. Qualification of the Auditor

Any Certified Public Accountant or Public Accountant, licensed

by a regulatory authority of a State or other political subdivision

of the United States, may be considered qualified to render an

opinion on behalf of a Licensee, provided the following conditions

are met: (1) The accountant is independent with respect to the

Licensee, and (2) the accountant is duly authorized to practice and

is in good standing under the laws of the State or other comparable

authority in which so authorized.

C. Independence

i. Independent Public Accountants approved by SBA are to follow

the Code of Professional Conduct adopted by the AICPA. In

considering questions which may arise concerning the independence of

an accountant with respect to a Licensee, the SBA will give

appropriate consideration to all relevant circumstances, including

evidence bearing on relationships between the accountant and such

Licensee or any of its affiliates.

ii. Independence will be considered to be impaired by

circumstances including, but not limited to, the following:

1. During the professional engagement, or at the time of

expressing an opinion, the accountant or his/her firm:

a. Had or was committed to acquire any direct or indirect

financial interest in the Licensee; or

b. Had any joint closely held business investment with the

Licensee or any of its officers, directors or principal

stockholders, or any general or limited partner, which was material

in relation to the net worth of the accountant or his/her firm; or

c. Had any loan to or from the Licensee or any of its officers,

directors or principal stockholders, or any general or limited

partner.

2. During the period covered by the financial statements during

the professional engagement, or at the time of expressing an

opinion, the accountant or his/her firm:

a. Was connected with the Licensee as a promoter, underwriter,

or voting trustee, a director of officer or in any capacity

equivalent to that of a member of management or of an employee; or

b. Was a trustee of any trust or executor or administrator of

any estate is such trust or estate had a direct or material indirect

financial interest in the Licensee; or was a trustee for any pension

or profit-sharing trust of the Licensee; or

c. Rendered bookkeeping services to the Licensee; Provided

however, that SBA may approve the rendering of bookkeeping services

by independent accountants on a case by case basis.

iii. Independent public accountants who audit Licensees which

elect to qualify as Regulated Investment Companies should become

familiar with Section 600 (``Matters Relating to Independent

Accountants'') of the SEC's ``Codification of Financial Reporting

Policies.''

IV. Annual Audit

A. Generally Accepted Auditing Standards

The IPA shall perform an audit of the Licensee's financial

statements in accordance with generally accepted auditing standards

(GAAS) of the AICPA. It is the responsibility of accountants to be

informed of any changes in GAAS as they occur. AICPA recommendations

for the application of GAAS to audits of the financial statements of

investment companies are presented in the publication, ``Audits of

Investment Companies'', which is updated periodically. Although this

publication deals primarily with companies investing in marketable

securities, many of its recommended audit procedures are applicable

to SBICs.

B. Independent Auditor.s Report

i. The Independent Auditor's Report shall conform to current

AICPA recommendations regarding the application of generally

accepted auditing standards to reports on audited financial

statements of investment companies. As of the publication date of

these regulations, such recommendations are presented in chapter 9

of the AICPA publication, ``Audits of Investment Companies.'' It is

the responsibility of accountants to be aware of any changes in

generally accepted auditing standards which may affect reporting

requirements.

ii. The opinion expressed in the Independent Auditors' Report

must refer specifically to the financial statements as they appear

in SBA Form 468. An opinion expressed on financial statements

prepared for general purposes, or for any specific purpose other

than inclusion in SBA Form 468, is not acceptable. The financial

statements may be listed by name in the auditor's report, or listed

separately and referred to in the report (for example, the report

could refer to the financial statements [[Page 7395]] ``as listed on

the following page'' or ``as listed in the accompanying index'').

iii. In addition to expressing an opinion on the basic financial

statements (the statement of financial position, statement of

operations realized and statement of cash flows), the accountant

must express an opinion on the supplementary financial information.

The supplementary information should be addressed in a separate

paragraph of the Independent Auditors' Report. As with the basic

financial statements, the supplementary statements and schedules may

be listed in the report itself or listed separately and referred to

in the report.

iv. Almost all SBICs have Loans and Investments, the value of

which must be estimated by the Board of Directors or General

Partner(s) in the absence of readily ascertainable market values.

The auditor's reports for such SBICs must include an explanatory

paragraph addressing portfolio valuations, in which the auditor

states whether the valuation procedures are reasonable and the

underlying documentation is appropriate. It is no longer acceptable

to state that valuations involve subjective judgment which is not

susceptible to substantiation by auditing procedures. The paragraph

should follow the AICPA's reporting recommendations presented in

chapter 9 of ``Audits of Investment Companies''.

V. Sample Report. Following is a sample Independent Auditors'

Report which is acceptable to SBA, based on generally accepted

auditing standards in effect as of the publication date of these

regulations. Any subsequent changes in generally accepted auditing

standards which affect reporting requirements must be reflected in

the Independent Auditors' Report included in a Licensee's filing of

SBA Form 468, regardless of whether or not SBA has published an

updated sample report.

Independent Auditors' Report

The Board of Directors of [Licensee]

or

The General Partner(s) and Limited Partners of [Licensee]

We have audited the statement of financial position of

[Licensee] as of [closing date of fiscal year] and the related

statements of operations realized and cash flows for the year then

ended included in SBA Form 468. These financial statements are the

responsibility of the Company's management. Our responsibility is to

express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with generally accepted

auditing standards. Those standards require that we plan and perform

the audit to obtain reasonable assurance about whether the financial

statements are free of material misstatement. An audit includes

examining, on a test basis, evidence supporting the amounts and

disclosures in the financial statements. An audit also includes

assessing the accounting principles used and significant estimates

made by management, as well as evaluating the overall financial

statement presentation. We believe that our audit provides a

reasonable basis for our opinion.

In our opinion, the financial statements referred to above

present fairly, in all material respects, the financial position of

[Licensee] as of [closing date of fiscal year], and the results of

its operations and cash flows for the year then ended in conformity

with generally accepted accounting principles.

As explained in Note ____, the financial statements include

investments valued at $________ as of [closing date of fiscal year],

whose values have been estimated by the [Board of Directors]

[General Partner(s)], in the absence of readily ascertainable market

values. We have reviewed the procedures used by the [Board of

Directors] [General Partner(s)] in arriving at its estimates of

value of such investments and have inspected underlying

documentation, and, in the circumstances, we believe the procedures

are reasonable and the documentation appropriate. However, because

of the inherent uncertainty of valuation, those estimated values may

differ significantly from the values that would have been used had a

ready market for the investments existed, and the differences could

be material.

Our audit was made for the purpose of forming an opinion on the

basic financial statements taken as a whole. The supplementary

information contained in the [analysis of stockholders' equity]

[analysis of partners' capital], computations of retained earnings

available for distribution and of regulatory and leverageable

capital, schedules of commitments and guarantees, and schedules 1

through 7 is presented for purposes of additional analysis and is

not a required part of the basic financial statements. Such

information has been subjected to the auditing procedures applied in

the audit of the basic financial statements and, in our opinion, is

fairly stated in all material respects in relation to the basic

financial statements taken as a whole.

C. Access to Accountants' Working Papers

At its discretion, SBA may assign its examiners or other

personnel to review the accountant's working papers. The audit

engagement agreement between the Licensee and the IPA shall provide

that the accountant's working papers will be made available for

review upon request of the SBA.

D. Accountants' Responsibility for Valuations

i. The investment portfolios of virtually all SBICs contain

nonmarketable securities, the values of which must be estimated in

the absence of readily ascertainable market values. It is the

responsibility of the Board of Directors or the General Partner(s)

to estimate the value of such securities in good faith.

ii. The IPA does not act as an appraiser for security values

estimated by the Board of Directors or General Partner(s), and is

not expected to perform an audit of the portfolio concerns. The

IPA's review of a Licensee's portfolio valuations shall address the

following questions:

(1) Does the Licensee have a written valuation policy which has

been approved by SBA?

(2) Do the Licensee's valuations of its portfolio concerns

reflect consistent adherence to its valuation policy?

(3) Has the Licensee documented the basis for its valuations,

and does such documentation indicate that a reasonable analysis of

available information has been performed?

iii. Based upon the auditing procedures performed, the IPA shall

express an opinion as to whether the Licensee's valuation procedures

are reasonable and the documentation is appropriate.

iv. SBA requirements concerning portfolio valuations are set

forth in Appendix II to Part 107. Appendix II contains recommended

valuation techniques for securities of various types, as well as

requirements concerning written valuation policy, frequency of

valuation, and documentation. A Licensee has the option of adopting

the model valuation policy included in Appendix II or obtaining SBA

approval of an alternative valuation policy.

v. In addition to the SBA valuation requirements, IPAs may also

wish to review SEC Accounting Series Release No. 118 (section

404.03, ``Codification of Financial Reporting Policies'').

vi. The IPA shall test a sufficient number of valuations to

support an opinion. Testing of valuations representing less than 50

percent of the value of the entire portfolio shall be presumed to be

insufficient to support an opinion.

vii. If the audit discloses that the valuation procedures are

inadequate, unreasonable or inconsistent with the Licensee's

valuation policy, or that the underlying documentation does not

adequately support the valuations, the IPA's opinion shall be

modified to indicate a lack of conformity with generally accepted

accounting principles. The opinion may be qualified (using the

phrase ``except for'') or, depending upon the possibility of a

material misstatement, the accountant may determine that an adverse

opinion is appropriate.

E. Audit Adjustments

All audit adjustments shall be entered in the Licensee's records

before issuance of the Independent Auditors' Report. As a result,

the financial statements accompanying the report will agree with the

books as adjusted as of the statement date, giving consideration to

reclassification of account balances for report purposes. If the

adjustments are not so recorded on the Licensee's books, a statement

shall be made by the IPA to this effect.

F. Reporting Irregularities

i. Reporting Irregularities and Illegal Acts to SBA. An

independent public accountant that detects irregularities or illegal

acts individually or collectively material to the financial

statements, or irregularities or illegal acts relative to SBA

programs whether or not material, shall advise management in

writing. Management, in turn, shall immediately advise, in writing,

the Associate Administrator for Investment, Investment Division, 409

Third Street, SW, Washington, DC 20416. Management, in advising SBA,

shall, to the extent practicable, describe the irregularities or

illegal acts and their effects on the financial statements and SBA

programs. Auditors shall determine whether management reported the

irregularities or [[Page 7396]] illegal acts and, if management

fails to report, the auditor shall report to SBA at the address

listed above.

ii. Reporting Internal Control Structure Reportable Conditions.

Reportable conditions in an SBIC's internal control structure shall

be reported to SBIC management in writing and SBIC management shall

immediately transmit this auditor's report to SBA. Reportable

conditions and the manner of reporting such conditions are addressed

in AU Section 325, Codification of Statements on Auditing Standards,

issued by the American Institute of Certified Public Accountants.

G. Detecting Noncompliance With Laws and Regulations

i. Audits of SBICs are performed in accordance with generally

accepted auditing standards. These standards require IPAs to design

audit procedures which will provide reasonable assurance of

detecting instances of noncompliance with applicable laws and

regulations that could have a material effect on Licensees'

financial statements.

ii. A GAAS audit is neither a substitute for nor a duplication

of the examination of an SBIC performed by SBA's examiners. The

purpose of such examinations is to provide a comprehensive

evaluation of the Licensee's compliance with laws and regulations

governing the SBIC program. In contrast, IPAs perform audits in

which compliance issues are viewed in the context of the possible

effects of noncompliance on the financial statements.

iii. As part of the audit planning process, all IPAs shall be

responsible for reviewing and becoming familiar with the laws and

regulations applicable to SBICs. Auditors must have sufficient

knowledge of such laws and regulations to be able to design

appropriate audit procedures for an SBIC, and to recognize instances

of noncompliance which may become evident in the course of

performing such procedures. The laws and regulations governing the

SBIC program include the following:

1. Small Business Investment Act of 1958, as amended (Act). The

Act (15 U.S.C. 681 et seq.) provides a statement of the public

purpose of the SBIC program and establishes the legislative

framework upon which the regulations are based. Licensees are

permitted to engage in activities contemplated by the Act, and in no

other activities. Provisions of the Act governing SBICs are found

primarily in Title III.

2. Code of Federal Regulations, title 13, parts 107 and 121 (13

CFR 107 and 121). Part 107 contains the regulations governing the

SBIC program, and auditors should become familiar with this part in

its entirety. Part 121 contains small business size regulations

which apply to various SBA programs; particular attention should be

given to the definition of ``Affiliation'' (Sec. 121.401) and the

SBIC size standard (Sec. 121.802).

iv. In addition to the Act and regulations themselves, SBA has

various materials available which may assist auditors in developing

an overall understanding of the SBIC program. These include basic

informational brochures about the program; the preambles to final

rules published in the Federal Register, which provide rationales

for and interpretations of new regulations; and a regulatory

compliance checklist for small business financings.

v. Preparation for an SBIC audit should include a review of

AICPA Statement on Auditing Standards No. 54 (SAS 54). This

statement discusses the consideration an auditor should give to the

possibility of illegal acts by a client in a financial statement

audit performed in accordance with GAAS. As defined in the

statement, ``illegal acts'' include violations of laws or government

regulations.

vi. In addition to any specific audit procedures deemed

necessary which may relate to compliance issues, the IPA shall

obtain representation from the Licensee regarding its lawful

operation as contemplated by the Act.

V. Accounting Policies and Procedures

A. Generally Accepted Accounting Principles

i. As a general rule, Licensees shall follow generally accepted

accounting principles (GAAP) as promulgated by the Financial

Accounting Standards Board, its predecessors (such as the Accounting

Principles Board), and the AICPA. Sources of information concerning

specialized accounting and reporting principles for investment

companies include the AICPA publication, ``Audits of Investment

Companies'', as well as this accounting guide. In the event of any

conflict between this appendix and other sources, this appendix

shall govern for purposes of financial reporting to SBA.

ii. Licensees and their IPAs should be aware that some of the

specialized GAAP promulgated for investment companies is oriented

towards companies which do not share many of the characteristics of

SBICs. Appendix A of ``Audits of Investment Companies'' discusses

some of the distinctive characteristics of venture capital companies

in general, and of SBICs in particular, relative to other types of

investment companies. These characteristics may include active

rather than passive investment, illiquid portfolios with no public

market, relatively long holding periods for investments, and the

existence of significant debt in the case of SBICs.

iii. Appendix A includes the following statement: ``Though all

venture capital investment companies should prepare their financial

statements in conformity with generally accepted accounting

principles and are subject to audit as are other investment

companies, the statement presentation of some companies may need to

be tailored to present the information in a manner most meaningful

to their particular group of investors.'' SBA, as the regulator and

major creditor of the SBIC industry, has tailored Form 468 to

provide financial information in a format which will satisfy SBA's

analytical and regulatory requirements. An IPA should exercise

professional judgment in determining whether reporting on Form 468

requires a material departure from GAAP for a particular SBIC. If

such a departure exists, the Independent Auditors' Report should be

modified accordingly.

B. Accrual Basis of Accounting

Books of account shall be maintained on an accrual basis. All

accruals are to be entered in the records and posted at the end of

the fiscal year, and as of the closing dates of any other fiscal

periods to be covered by interim or special financial report to SBA.

C. Reporting Entity

i. For most SBICs, the reporting entity is the Licensee only.

Application of this general rule and certain exceptions to it are

discussed in this paragraph C.

ii. Investment in Management Services Company. The provisions of

Sec. 107.501(c) permit a Licensee to organize a wholly-owned

corporation solely to provide management services. The regulation

states that reports submitted to SBA shall reflect the consolidated

results of the Licensee and its subsidiary.

iii. Investment in Section 301(d) Licensee. Under Sec. 107.712,

a Section 301(d) Licensee may be licensed to operate as the

subsidiary of one or more Licensee companies (``Participant

Licensees''), with or without non-Licensee participation. Each

Participant Licensee shall own at least twenty percent of the voting

securities of the Section 301(d) Licensee. Such an investment should

be reported on the equity method, under the caption ``Investment in

301(d) Licensee'' on the Statement of Financial Position. SBA

recognizes that this accounting treatment may constitute a departure

from GAAP if the Participant Licensee is the majority owner of the

Section 301(d) Licensee. The independent public accountant may wish

to express a qualified opinion if the departure is considered

material.

iv. Temporary Control. Under certain circumstances, as described

in Sec. 107.801, a Licensee may temporarily own more than a 50

percent interest in a small business concern. These investments

shall be classified in the appropriate category of Loans and

Investments on the Statement of Financial Position (generally, this

will be ``Operating Concerns Acquired''), and shall be reported at

their fair value. This treatment is consistent with FASB Statement

No. 94, which provides an exception to the general rule of

consolidating majority-owned subsidiaries when control is likely to

be temporary.

D. Fair Value of Loans and Investments

i. In accordance with generally accepted accounting principles

for investment companies, SBICs shall report Loans and Investments

(presented on lines 1 through 10 of the Statement of Financial

Position, page 2 of SBA Form 468) at fair value. To the extent

possible, fair value shall be represented by quoted market prices

(appropriately discounted for such factors as restrictions on

marketability or large holdings relative to daily trading volume).

In the absence of quoted market prices, fair value shall be an

estimate determined in good faith by the Board of Directors or

General Partner(s), based on the application of valuation policies

which are consistent with SBA guidelines.

ii. In response to new statutory requirements concerning

valuations, SBA [[Page 7397]] published regulations which included

new Sec. 107.101(g) as well as a new Appendix II to Part 107,

``Valuation Guidelines for SBICs''. These new valuation regulations

supersede the guidelines previously published in SBA Policy and

Procedural Release #2006. Licensees may adopt the model valuation

policy included in Appendix II or submit an alternate policy to SBA

for approval. In addition to valuation policy, Sec. 107.101(g) and

Appendix II also set forth requirements concerning frequency of

valuation, documentation, and responsibility for valuations.

iii. The following statement is included in Sec. 107.101(g):

``The boards of directors of corporations and the general partners

of partnerships shall have sole responsibility for adopting the

Licensee's valuation policy and, pursuant thereto, for valuing Loans

and Investments of such Licensee.'' This statement establishes

responsibility for all valuations assigned to portfolio securities

by the Licensee. SBA, in its capacity as a regulator, retains the

same oversight responsibilities over valuations as it does over all

other issues affecting regulatory compliance.

iv. Accounting considerations. Licensees shall maintain separate

general ledger accounts for the original cost of Loans and

Investments and any valuation adjustments thereto. Valuation

adjustments shall be in the form of unrealized appreciation or

depreciation, respectively representing valuations above or below

cost. The sum of cost and unrealized appreciation or depreciation

represents fair value.

v. Unrealized appreciation may be recognized on equity

investments and debt investments which contain equity features, such

as options or warrants. Recognition of unrealized appreciation on

loans is not permitted under SBA's valuation guidelines.

vi. A general allowance for losses on Loans and Investments is

not utilized in fair value accounting. Rather, the Licensee's Board

of Directors or General Partner(s) shall value Loans and Investments

individually as of the financial statement date. This requirement

applies equally to Licensees engaged in equity investing and in

lending. A Licensee which is primarily engaged in lending, however,

may also identify additional anticipated losses on the basis of its

portfolio history, industry experience, or other relevant factors;

such amounts may be reported in the Statement of Financial Position

of SBA Form 468 as additional unrealized depreciation not associated

with specific portfolio assets.

vii. An appropriate tax provision shall be established for net

unrealized appreciation on securities held by taxable corporate

Licensees. There may also be circumstances in which a tax benefit

for net unrealized depreciation should be recognized, depending on

the likelihood of realization. Such a provision or benefit shall be

determined in accordance with FASB Statement No. 109, ``Accounting

for Income Taxes''.

E. Interest Income

i. Interest income shall be accrued according to the terms of

interest bearing loans and investments. Premiums or discounts

associated with debt instruments represent adjustments to interest

income which shall be amortized over the stated life of the debt

instrument.

ii. Collection in Doubt. Interest income shall not be recognized

if collection is doubtful. Licensees may choose to handle doubtful

interest receivable in either of two ways: (1) Make no entry to

accrue interest in the regular general ledger accounts and track

interest due in a memorandum account; or (2) accrue the interest and

provide a 100% reserve (debit provision for loss on receivables,

credit allowance for uncollectible interest receivable). The method

used by the Licensee must be disclosed in the footnote to the

financial statements summarizing significant accounting policies.

iii. Collection of interest is presumed to be in doubt when

either or both of the following conditions occur: (1) The small

concern is in bankruptcy, insolvent, or there is substantial doubt

about its ability to continue as a going concern; or (2) the small

concern is in default more than 120 days to the Licensee. Licensees

may rebut this presumption by providing evidence of collectibility

satisfactory to SBA. Such evidence may include the existence of

collateral, the value of which has been verified through an

appraisal by an independent professional appraiser acceptable to

SBA. Such an appraisal shall be at liquidation value (net of

liquidation costs) and shall have been performed within the 12

months immediately preceding the valuation date. In considering

whether collateral provides an appropriate basis for valuations, SBA

will consider the nature of a Licensee's claim on the collateral

(for example, whether other parties have security interests senior

to the Licensee's, or whether the Licensee's security interest in an

asset is perfected). SBA will also review the Licensee's operating

history for evidence concerning its willingness and ability to

pursue available remedies (including foreclosure) in default

situations.

iv. The two conditions cited in the preceding paragraph are not

the only possible indicators of a collection problem. Even if

neither condition is present, other circumstances may cause the

Board of Directors or General Partner(s) to conclude that collection

is in doubt.

v. When interest income is not being recorded on a loan or debt

security, the Licensee shall so note in its Annual Financial Report

on Form 468. The note should include the date at which interest

accrual was discontinued. In addition, the total amount of interest

not accrued because collection is in doubt shall be disclosed in a

footnote to the financial statements.

vi. When the accrual of interest is discontinued, the full

amount of any interest receivable recorded in prior periods must be

either reversed or fully reserved.

F. Dividend Income

i. Dividend income from investments in common or preferred stock

is normally recognized as of the date of record (the date at which

official ownership of shares is determined for the purpose of paying

the dividend). Dividend income shall not be accrued in the absence

of a dividend declaration by the small concern's board of directors.

This treatment shall apply to all dividends, including dividends on

redeemable preferred stock or similar securities with some debt-like

characteristics.

ii. Any cash distribution which is identified as a return of

capital shall not be recognized as income. Such distributions are a

reduction in the cost basis of an investment.

iii. Stock splits and stock dividends (in stock of the same

class as that owned) are not income because the Licensee's

proportional interest in the small business concern does not change

as a result of such events. The cost of the shares previously held

should be allocated, on a rational basis, to the number of shares

held after the split or dividend. Similarly, when stock rights are

received, a portion of the cost basis of the related investment may

be allocated to the rights.

iv. Dividends in kind are recorded as income at the fair value

of the property received. Such income should be classified as Non-

Cash Gains/Income in the Statement of Financial Position of SBA Form

468. If the Licensee has a choice between a dividend in cash or in

kind, and chooses to receive an in-kind dividend, the fair value is

deemed to be the amount of cash that could have been received.

G. Profit Participation in Small Concerns

Participation in the profits of a loan- or debt-financed small

business concern represents additional interest income to the

Licensee. For regulatory purposes, any profits received must be

included in the calculation of the Cost of Money.

H. Fees Charged to Small Concerns

i. Income from nonrefundable fees charged by SBICs in connection

with the origination of loans shall be deferred and amortized over

the term of the financing, regardless of whether or not such fees

are included in the Cost of Money. Licensees should be aware of the

provisions set forth in Sec. 107.402 (d) through (g) concerning

permissible fees, prepayment penalties, obligations of SBICs to

provide certain fee-related information in writing to small

concerns, and circumstances in which SBICs may be required to refund

fees paid by small concerns.

ii. If a Licensee has made a commitment for a financing which

does not take place, any processing fees which the Licensee is

permitted to retain pursuant to Sec. 107.402(d) shall be recognized

as income upon expiration of the commitment.

I. Accounting for Investments in Flow-Through Entities

i. On SBA Form 468, in the Statement of Operations Realized,

Licensees are asked to report income (loss) from investments in

partnerships or other types of flow-through entities. This category

of investments is intended to include any entity which allocates its

income and losses to its equity holders and is not taxed at the

entity level. Any such investments made by SBICs would most commonly

be in limited partnerships.

ii. For investments of this type, original cost is adjusted at

the end of each accounting [[Page 7398]] period to recognize the

investor's share of earnings or losses of the investee. The amount

of the adjustment is included in the net income of the investor.

Distributions received from an investee reduce the carrying amount

of the investment.

iii. It should be noted that the steps in the preceding

paragraph determine only the cost basis of investments. Any

investment included in an SBIC's portfolio of Loans and Investments

still must be valued by the Board of Directors or General Partner(s)

and presented at fair value in the Licensee's financial statements.

iv. Any income from investment in flow-through entities must be

included initially in Non-cash Gains/Income, as discussed in

paragraph X of this section V. When a Licensee actually receives a

distribution from the investee, the amount received should be

reclassified from Non-cash Gains/Income to Undistributed Net

Realized Earnings.

J. Equity Method of Accounting

i. The only type of investment which shall be accounted for

under the equity method is an investment in the common stock of a

Section 301(d) Licensee, as permitted under Sec. 107.712. Since a

Licensee investing in a Section 301(d) Licensee is required to have

an ownership interest of at least 20 percent, use of the equity

method will normally be appropriate. Under the equity method,

original cost is adjusted at the end of each accounting period to

recognize the investor's share of earnings or losses of the

investee. The amount of the adjustment is included in the net income

of the investor. Dividends or distributions received from an

investee reduce the carrying amount of the investment.

ii. Licensee should not use the equity method to account for

investments in the common stock of small business concerns, even if

a Licensee's ownership interest exceeds 20 percent. SBICs, whether

or not registered under the Investment Company Act of 1940, are

exempt from the usual requirements concerning use of the equity

method because they account for investments at fair value (see APB

Opinion No. 18, ``The Equity Method of Accounting for Investments in

Common Stock'', paragraph 2).

K. Accounting for Income Taxes

i. In February 1992, the FASB issued Statement No. 109,

``Accounting for Income Taxes''. The Statement is effective for

fiscal years beginning after December 15, 1992. Statement No. 109

supersedes FASB Statement No. 96, as well as APB Opinion No. 11,

which many companies continued to follow during the period when

adoption of Statement No. 96 was optional.

ii. Statement No. 109 establishes the following basic principles

to be applied in accounting for income taxes at the date of

financial statements:

(1) A current tax liability or asset is recognized for the

estimated taxes payable or refundable on tax returns for the current

period.

(2) A deferred tax liability is recognized for the estimated

future tax effects of ``taxable temporary differences'' (events

which will result in future taxes payable).

(3) A deferred tax asset is recognized for the estimated future

tax effects of ``deductible temporary differences'' (events which

will result in future tax savings), operating loss carryforwards,

and tax credit carryforwards.

(4) A valuation allowance is recognized to reduce the deferred

tax asset to the extent that the tax benefits are not expected to be

realized.

(5) Both current and deferred tax liabilities and assets are

based on provisions of the enacted tax law; the effects of future

changes in tax laws or rates are not anticipated.

iii. The ability to recognize deferred tax assets under certain

circumstances represents a significant change from earlier

pronouncements. Licensees which recognize deferred tax assets should

take careful note of the requirements of Statement No. 109 in

determining whether it is ``more likely than not'' that such assets

will be realized. Generally, application of the ``more likely than

not'' standard means that when ``negative evidence'' exists which

suggests that benefits will not be realized, there must be

sufficient ``positive evidence'' to outweigh it; otherwise, a

valuation allowance is required.

iv. Because SBICs must report their Loans and Investments at

value, many Licensees will find it necessary to apply the criteria

of Statement No. 109 in determining whether to recognize deferred

tax liabilities or assets reflecting the estimated future tax

effects of unrealized gains or losses. Both unrealized gains and

unrealized losses are temporary differences as defined in the

statement. Previously, SBA required Licensees with net unrealized

appreciation to record a provision for estimated future taxes, but

did not permit Licensees with net unrealized depreciation to record

a corresponding benefit. In accordance with current GAAP, such a

benefit may now be recorded.

v. The reporting of unrealized gains and losses and the related

tax effects must be consistent. Since SBIC program accounting

guidelines require that changes in unrealized appreciation or

depreciation be excluded from net income (that is, they do not

appear in the statement of operations realized), it follows that the

related tax effects must be similarly excluded. Both elements,

however, are included in ``comprehensive income'' (that is, they

affect the equity of Licensees). This is reflected in the

presentation of net unrealized appreciation or depreciation, net of

estimated future tax effects, as Unrealized Gain (Loss) on

Securities Held in the Capital section of the Statement of Financial

Position.

L. Realized Gain (Loss) on Investments

i. Realized gain or loss on investment shall be recorded by

Licensees in accordance with generally accepted accounting

principles.

ii. Capital gains realized on the sale of securities shall be

recognized provided that collection of proceeds is reasonably

assured and the earnings process is complete. For the earnings

process to be considered complete, the Licensee must have no further

obligation related to the transaction. Any transaction with recourse

upon the Licensee or involving any understanding, agreement, option,

privilege, or other rights to repurchase by and/or resell to the

Licensee shall not be considered as a final transaction.

Transactions which do not meet the criteria in this paragraph L for

current recognition of gains shall be accounted for using an

appropriate alternate method, such as the installment method or the

cost recovery method. Under the installment method, a portion of the

gain is recognized with each installment payment received; under the

cost recovery method, no gain is recognized until the full amount of

the seller's cost has been collected.

iii. Capital losses may arise not only from sales, but also from

write-offs or charge-offs of securities held (the two terms are

generally used synonymously in this appendix; in contrast, the term

``write-down'' refers to the recording of unrealized depreciation).

Write-offs may be either full or partial. Writing off an investment,

in comparison with recording unrealized depreciation, represents a

stronger judgment concerning loss of value. However, it is not

necessary to have a definitive event (such as bankruptcy of the

small business concern) in order to write off an investment.

Generally accepted accounting principles call for the recognition of

loss when it becomes evident that previously recognized future

economic benefits of an asset have been reduced or eliminated.

iv. A Licensee may also realize capital gains or losses in

connection with the exchange or non-reciprocal transfer of

securities. The treatment of such transactions is governed by APB

Opinion No. 29, ``Accounting for Nonmonetary Transactions'', and is

discussed in paragraph M of this section V.

v. If a Licensee acquires shares of an investee's stock (of the

same class) at different times and prices, SBA requires that the

average cost method be used to determine the cost of such securities

when sold.

vi. When a gain or loss is realized, whether as a result of the

sale, other disposal or write-off of an asset, any previously

recorded unrealized appreciation or depreciation associated with the

asset shall be reversed.

vii. Non-cash Gains. When a Licensee realizes capital gains, but

does not receive cash at the time of the transaction, SBA requires

Licensees to segregate such ``Non-cash Gains'' from other components

of Undistributed Realized Earnings, until such time as any non-cash

assets received are converted to cash. Non-cash Gains are realized

earnings which have been recognized in the Licensee's Statement of

Operations. They are segregated in the Statement of Financial

Position only because they are subject to certain restrictions under

SBA regulations, primarily concerning distributions. In effect, Non-

cash Gains can be considered a type of restricted retained earnings.

For further information on Non-cash Gains, see ``Undistributed

Realized Earnings'' in paragraph X of this section V.

M. Nonmonetary Transactions

i. Licensees should follow APB Opinion No. 29 to the extent

applicable when accounting for nonmonetary transactions. Such

transactions include both reciprocal and non-reciprocal transfers of

nonmonetary assets or liabilities between the Licensee and

[[Page 7399]] another entity or person, or between the Licensee and

its stockholders or partners. The cost of an asset acquired in a

nonmonetary transaction is the fair value of the asset relinquished

to obtain it, and a gain or loss should be recognized on the

exchange. Any gain recognized shall be reported on SBA Form 468 as a

Non-cash Gain.

ii. Nonmonetary transactions in which the Licensee exchanges

certain securities or assets for other securities or assets will

result in the realization of gain or loss for financial reporting

purposes, regardless of whether such transactions are taxable or

non-taxable exchanges.

iii. Fair value of a nonmonetary asset transferred to or from a

Licensee should be determined by referring to estimated realizable

values in cash transactions of the same or similar quoted market

prices, independent appraisals, estimated fair values of assets, or

other available evidence.

iv. In cases where the values are not clearly determinable,

assets received will have the same accounting basis as the assets

transferred.

v. Dividends In Kind and Spin-offs. Dividends or other

distributions in kind, consisting of shares of a small business

concern or other securities, are nonreciprocal transfers of non-

monetary assets from a Licensee to its owners. Such transfers shall

be reported at the fair value of the assets distributed.

N. Interest, Notes and Accounts Receivable

i. Interest Receivable. In reporting interest receivable,

Licensees should make certain that amounts are properly classified

between current and noncurrent assets. Current assets are those

providing benefits which are expected to be realized within the next

fiscal year.

ii. Interest receivable is reported net of an allowance for

uncollectible amounts, which represents a conservative estimate of

probable losses. The allowance shall be adjusted, at a minimum, as

of the end of the fiscal year. Interim adjustment to reflect changes

in the status of receivables is strongly encouraged. See paragraph E

(``Interest Income'') of this section V for guidelines to be used by

SBICs in evaluating the collectibility of interest income.

iii. Expense is recognized whenever the allowance for

uncollectible amounts is adjusted to reflect a change in the

valuation of interest receivable. An actual write-off of interest

receivable is normally recorded as a reduction of the receivable and

a corresponding reduction of the allowance, and does not result in

the recognition of expense.

iv. The total expense recognized during a fiscal year with

respect to uncollectible interest receivable appears on Form 468 in

the Statement of Operations Realized, under the caption, ``Provision

for Losses on Accounts Receivable.''

v. Requirements concerning the recording of interest receivable

and the related interest income appear in this appendix under the

heading, ``Interest Income.''

vi. Notes and Accounts Receivable. The accounting treatment of

notes receivable and accounts receivable shall be governed by the

same rules which apply to interest receivable, as previously

described in this paragraph N.

vii. Notes Receivable represents the unpaid balance of

miscellaneous notes which do not fit into any category of Loans and

Investments. It does not include notes representing amounts due from

purchasers of assets acquired in liquidation of portfolio

securities, which are presented separately in the Loans and

Investments section of the Statement of Financial Position on Form

468.

viii. Accounts Receivable represents amounts due on account,

such as for management consulting, appraisal, or other services

rendered. Accounts Receivable also includes accrued fees for

services rendered in connection with participations or joint

financings and accrued fees receivable from small concerns.

O. Compensating Balances

i. In those instances where idle funds are encumbered or are

required to be maintained at a financial institution as compensating

balances in connection with debt of the SBIC, the nature of the

encumbrance and the terms of any applicable agreements shall be

disclosed in a footnote to the financial statements.

ii. Depending upon the specific terms, it may be necessary to

classify idle funds subject to a compensating balance agreement as

non-current assets.

P. Organization Costs

i. Organization costs are incurred in the formation of an SBIC

and may include such items as legal fees, incorporation and various

other fees imposed by states, and promotional expenditures. SBICs

should amortize organization costs over a term of not more than five

years.

ii. If an SBIC incurs organization costs which are deemed by SBA

to be unreasonable or excessive, such costs must be excluded from

Regulatory Capital as long as they are carried as an asset by the

SBIC. Once such costs have been amortized to expense, the regulatory

deduction is no longer required. No deduction is ever required for

organization costs accepted by SBA as reasonable.

iii. Operating losses incurred by a company prior to licensing

as an SBIC are not considered organization costs and shall not be

capitalized.

Q. Contingent Liabilities

i. Licensees shall accrue or disclose contingent liabilities, as

appropriate, in accordance with the requirements of FASB Statement

No. 5. Such requirements vary depending upon whether the likelihood

of realizing a loss is evaluated as ``probable'', ``reasonably

possible'', or ``remote''. Contingent liabilities may arise from

such transactions or events as the issuance of guarantees, pending

litigation, and the sale of portfolio interests with recourse.

ii. In addition to the reporting requirements of FASB Statement

No. 5, Licensees and their IPAs should be familiar with SBA's

requirements for reporting of certain contingencies. These

additional requirements include the completion of the Schedule of

Guarantees (include in SBA Form 468) by Licensees which have

guaranteed the obligations of small concerns and the filing of a

litigation report by Licensees which become a party to litigation

(see Sec. 107.1002(f)).

iii. A Licensee which has sold portfolio securities (or any

interest therein) on a recourse basis should be aware that any

amounts for which it may be contingently liable must be treated as

investments in small concerns for overline purposes (see

Secs. 107.707(b) and 107.303).

R. Transactions with Related Parties

i. Licensees shall disclose material transactions with related

parties in accordance with FASB Statement No. 57. In applying the

requirements of this pronouncement to SBIC financial statements, a

Licensee shall consider the term ``related party'' to encompass any

person or entity which is an Associate as defined in Sec. 107.3.

Footnote disclosures of related party transactions shall include the

name of the related party as well as the nature of the relationship.

ii. Licensees and their IPAs should be aware that certain

transactions involving Associates are either prohibited by SBA

regulations or permitted only with SBA's prior written approval. See

Sec. 107.903 (``Conflicts of Interest'').

S. Leverage--Debentures Guaranteed or Purchased by SBA

i. SBICs which qualify on the basis of financial soundness and

regulatory compliance are eligible to receive long-term leverage in

the form of five-year or ten-year debentures guaranteed (or, in some

cases, purchased directly) by SBA. Debentures with an interest rate

subsidy of three percentage points for the first five years of their

term are available to Section 301(d) Licensees only.

ii. Debentures, net of current maturities, shall be classified

in the financial statements as long-term debt, and shall be shown at

face value in the Statement of Financial Position of Form 468.

iii. Licensees issuing debentures pay a user fee (currently 2

percent of the amount borrowed) and an underwriter's fee (currently

.625 percent). These fees shall be capitalized and amortized over

the life of the debenture. Generally accepted accounting principles

normally require that debt be reported net of the unamortized

portion of related fees; Licensees, however, should report the

unamortized fees as an asset and the debentures at their gross

amount. SBA does not believe that this treatment will constitute a

material departure from GAAP for most Licensees.

iv. Debentures are subject to the terms and conditions set forth

in SBA regulations. In most respects, debentures incorporate by

reference the regulations as amended from time to time. With respect

to events of default, however, debentures incorporate those events

and associated remedies in existence at the date of issue. Thus,

debentures issued at different times may be subject to different

default provisions. Events of default include both financial and

regulatory conditions, which may result in [[Page 7400]] the entire

indebtedness of the Licensee being declared due and payable.

v. If SBA decides to demand payment in accordance with the

acceleration provisions of the debentures, such demand ordinarily

will be presented in a letter specifying the violations that have

occurred.

T. Leverage--Participating Securities Guaranteed by SBA

i. Participating Securities are redeemable preferred equity-type

securities. Issuers are required to make equity investments in an

amount at least equal to the amount of Participating Securities

issued (see the defined term ``Equity Capital Investments'' in

Sec. 107.3 for the specific categories of investments permitted).

The structure, terms and conditions of the Participating Security

are set forth in detail in Secs. 107.240 through 107.247.

ii. The Act authorizes SBA to guarantee Participating Securities

issued in the form of limited partnership interests, preferred

stock, or debentures with interest payable only to the extent of

earnings. Currently, the only form of Participating Security for

which documentation has been created is a limited partnership

interest to be held by SBA. Other forms will be made available in

the future as required to meet the needs of Licensees.

iii. The Participating Security has the following significant

features:

(1) Licensees issue Participating Securities to SBA, which in

turn assigns certain of its interests in such securities to a pool.

Investors (known as ``certificate holders'') then purchase interests

in the pool through a public offering. Each Licensee issuing

Participating Securities pays a cumulative preferred return

(``Prioritized Payments'') which is passed through to the

certificate holders, but such payments are contingent upon the

profitability of the issuer. Any Prioritized Payments which exceed

the cumulative earnings of a Licensee will be paid to the

certificate holders by SBA as guarantor. The Licensee, however, will

be ineligible to make any other profit distributions until it has

paid all of its Prioritized Payments (including reimbursement of

amounts previously advanced on its behalf by SBA).

(2) In consideration for SBA's guarantee, profitable Licensees

must pay a percentage of earnings to SBA as ``Profit

Participation''. SBA's profit percentage (the ``Profit Participation

Rate'') depends upon the Licensee's ratio of Participating

Securities issued to Leverageable Capital, as well as the interest

rate on 10-year Treasury securities at the time each Participating

Security was issued.

(3) Except for Prioritized Payments, SBA (the ``Preferred

Limited Partner'') and the Licensee's private limited partners

receive distributions at the same time, allocated in accordance with

legislative formulas.

(4) The securities have a 10-year term, at the end of which

redemption is mandatory. It is expected, however, that most

Participating Securities will be redeemed, at least in part, before

the mandatory redemption date.

iv. Participating Securities will be reported in a ``Redeemable

Securities'' section of the Statement of Financial Position on SBA

Form 468. The amount of Participating Securities issued represents

the capital contribution of SBA, the Preferred Limited Partner.

SBA's capital account will increase by the amount of any Prioritized

Payments or Profit Participation which the License becomes obligated

to pay on the basis of profits earned, and will decrease as

distributions are actually received. Distributions to SBA will be

applied as Prioritized Payments, Profit Participation, or

redemptions of outstanding leverage in accordance with Secs. 107.243

through 107.245.

v. In a footnote to the financial statements, the Licensee shall

provide a description of the terms of the Participating Securities

issued, including disclosure of the mandatory redemption date. If

there are any ``accumulated'' Prioritized Payments (representing a

contingency for amounts paid to certificate holders by SBA on the

Licensee's behalf, which the Licensee must repay as profits are

realized), a footnote shall provide the dollar amount of the

accumulation for the current fiscal year period and the aggregate

amount accumulated.

vi. For companies licensed after March 31, 1993, the obligation

to pay Prioritized Payments and Profit Participation is conditioned

upon the profitability of the Licensee as a whole. Those licensed

earlier, however, may be permitted to exclude profits attributable

to portfolio assets in existence as of March 31, 1993.

vii. Because of the complexity of the required profit and

distribution computations, all Licensees issuing Participating

Securities shall use SBA-provided software to perform such

computations.

U. Preferred Securities Leverage for Section 301(d) Licensees

i. Four Percent Preferred Securities. Section 301(d) Licensees

which qualify on the basis of financial soundness and regulatory

compliance are eligible to receive long-term leverage by selling 4%

redeemable preferred securities (either preferred stock or a

preferred limited partnership interest) directly to SBA. Such

securities must be redeemed not later than 15 years from the date of

issuance, at which time any unpaid portion of the preferred and

cumulative 4% return due to SBA must also be paid. No distributions

may be made to any investor other than SBA unless the Licensee is

current on all amounts due SBA.

ii. Like Participating Securities, 4% preferred securities will

be reported in the ``Redeemable Securities'' section of the

Statement of Financial Position on SBA Form 468. Unlike

Participating Securities, however, which specifically provide for

the extinguishment of any obligation to pay Prioritized Payments in

excess of the issuer's profits, the legislation which authorized 4%

preferred securities does not set forth any circumstances in which

the 4% return would be extinguished.

iii. The initial carrying amount of 4% preferred securities

shall be the purchase price paid by SBA at the date of issue (for 4%

preferred stock issued by corporate Licensees, this amount must be

equal to the par value). At the end of each accounting period, the

carrying amount shall be increased by the amount of any 4% returns

not currently paid or declared. A breakdown of the total carrying

amount, showing separately the purchase price of 4% preferred

securities and the accrued 4% returns in arrears, is reported on the

Statement of Financial Position.

iv. Cumulative 4% returns in arrears must be recorded as a

charge against Undistributed Net Realized Earnings. For some Section

301(d) Licensees, these amounts may exceed Undistributed Net

Realized Earnings. Ordinarily, a company in these circumstances

would reduce paid-in capital or partners' contributed capital by the

amount of the excess. Because such treatment would reduce Regulatory

Capital, however, it could result in certain unintended regulatory

compliance problems for Licensees (such as overline violations).

Therefore, on SBA Form 468, Licensees shall report all 4% returns in

arrears as a reduction of Undistributed Net Realized Earnings, even

though this treatment may result in a deficit, and shall not reduce

paid-in capital or partners' contributed capital.

v. Because Section 301(d) Licensees must charge the 4% return to

Undistributed Net Realized Earnings whether it is paid or not, any

unpaid amounts must be added back in order to determine a Licensee's

Retained Earnings Available for Distribution. Unpaid 4% returns must

be paid in full from Retained Earnings Available for Distribution

before any other distributions can be made.

vi. In a footnote to the financial statements, the Licensee must

provide a description of the terms of the preferred securities

issue, including disclosure of the mandatory redemption date. If

there are 4% returns in arrears, a footnote shall provide the dollar

amount of the arrearage for the current fiscal period, the aggregate

amount in arrears, and the number of periods in arrears.

vii. Three Percent Preferred Stock. Before November 21, 1989,

corporate Section 301(d) Licensees were eligible to receive long-

term leverage by issuing 3% cumulative preferred stock to SBA at par

value. Three percent preferred stock has no mandatory redemption

date and is classified as equity for financial reporting purposes.

However, it shall not be treated as Regulatory or Leverageable

Capital for any purpose.

viii. No dividends may be paid to any investor other than SBA

unless the Licensee is current on all 3% preferred dividends due

SBA.

ix. Three Percent Preferred Stock Repurchase Program. SBA

published in the Federal Register a notice announcing the

implementation of a program under which Section 301(d) Licensees may

apply to repurchase their outstanding 3% preferred stock from SBA at

a set price of 35 percent of par value. Specific guidelines

governing repurchase transactions are set forth in SBA Policy and

Procedural Release #2021, issued June 14, 1994. Licensees will have

three years from the date of the Policy and Procedural Release

during which to apply for and complete the Repurchase Program.

x. Participants in the Repurchase Program will receive detailed

accounting guidance [[Page 7401]] from SBA at the time their

repurchases are completed. In general, when a company repurchases

its own stock at a discount (that is, for less than the original

issue price), it records an increase in paid-in surplus equal to the

discount. Section 301(d) Licensees will follow this general rule,

but the increase in surplus attributable to the repurchase must be

separately identified (as ``Restricted Contributed Capital

Surplus'') on SBA Form 468 because it is subject to certain

restrictions for regulatory purposes.

V. Contributed Capital and Committed Capital

i. In general, ``contributed capital'' refers to funds

contributed to a Licensee by private investors (although such funds

may also include ``qualified nonprivate funds'' from State and local

government sources, in accordance with the definition of Private

Capital in Sec. 107.3). Although some Licensees may obtain financial

assistance through the issuance of equity-type securities purchased

or guaranteed by SBA, such securities are reported on Form 468 as

SBA leverage rather than as contributed capital. The contributed

capital of a corporate Licensee consists of the par value of its

capital stock (which may consist of one or more classes or stock)

and its aggregate paid-in surplus, excluding Restricted Contributed

Capital Surplus obtained through the repurchase of 3 percent

preferred stock from SBA. For a partnership Licensee, contributed

capital consists of proceeds from the sale of partnership interests

to the general partners and the limited partners (other than SBA).

For all Licensees, contributed capital shall be recorded net of

expenses incurred to obtain the capital.

ii. Capital contributed to a Licensee in the form of non-cash

assets requires the prior approval of SBA, unless such assets are

physical assets to be currently employed by the Licensee in its

operations (see Sec. 107.705). Equity securities issued in exchange

for approved non-cash assets will be excluded from a Licensee's

Regulatory Capital until the assets received are converted to cash.

iii. Commitments from Investors. In addition to its contributed

capital, a Licensee may have outstanding commitments from

individuals or entities to invest additional funds in the Licensee

at a future date. Binding commitments from Institutional Investors

(as defined in Sec. 107.3) may be included in the Licensee's

Regulatory Capital; the principal effects of such inclusion are to

increase the Licensee's overline limitation (See Sec. 107.303) and

to increase the capital base used in the computation of Capital

Impairment (see Sec. 107.210(h)).

iv. Unfunded commitments from investors shall not be reported as

part of the contributed capital of the Licensee on SBA Form 468. The

amount of such commitments shall be disclosed in a footnote to the

financial statements, which shall separately identify commitments

included in Regulatory Capital and any other commitments

outstanding. Any significant terms and conditions associated with

investor commitments, including the timing of anticipated drawdowns

if known, shall also be disclosed.

W. Unrealized Gain (Loss) on Securities Held

i. Unrealized Gain (Loss) on Securities Held results from the

valuation of Loans and Investments by the Board of Directors or

General Partner(s). Unrealized appreciation is recognized for

valuations above cost and unrealized depreciation is recognized for

valuations below cost. Unrealized gain or loss is the aggregate

amount obtained by summing the unrealized appreciation or

depreciation of all Loans and Investments, net of any estimated

future income tax effects.

ii. Unlike some other types of investment companies, such as

mutual funds, SBICs do not report changes in net unrealized

appreciation or depreciation in the Statement of Operations.

Instead, such changes are recorded directly in the capital account,

Unrealized Gain (Loss) on Securities Held. SBA requires this

treatment for two reasons: (1) because most securities held by SBICs

have no readily ascertainable market values and valuation of such

securities is highly subjective, SBA prefers that reported net

income not be influenced by changes in valuation; and (2)

segregation of unrealized gains and losses on the Statement of

Financial Position makes it easier to perform certain computations

required by SBA regulations.

X. Undistributed Realized Earnings

i. Undistributed Realized Earnings is the defined term used in

SBA regulations to represent the earned capital of a Licensee. In

general, Undistributed Realized Earnings are the cumulative balance

of periodic net investment income (loss) and realized gain (loss) on

investments, less dividends or distributions (at times, an SBIC may

need to make an adjustment which is not reflected in this general

formula). To accommodate regulatory requirements, two components of

Undistributed Realized Earnings are presented separately in the

financial statements:

ii. Non-cash Gains/Income consists of (1) gains on the

disposition of securities realized in the form of notes, securities

or any other non-cash assets; (2) income from investments in pass-

through entities (such as limited partnerships) which has not been

distributed to the Licensee; (3) dividends received in kind; (4)

interest income accrued on deferred interest notes, zero coupon

bonds or similar instruments; and (5) delinquent accrued interest

converted into a new note or added to the principal of an existing

note (the amount of such interest which is included in Undistributed

Net Realized Earnings must be reclassified to Non-cash Gains/

Income).

iii. Non-cash Gains/Income represents realized earnings of an

SBIC which have been recognized in the Statement of Operations. Such

earnings are segregated in the Statement of Financial Position only

because they are subject to certain restrictions under SBA

regulations, primarily concerning distributions. In effect, Non-cash

Gains/Income can be considered a type of restricted retained

earnings.

iv. Classification of capital gains or other income as non-cash

items is intended to be temporary. As a Licensee receives payments

on a note, receives distributions from a partnership in which it has

invested, sells shares of stock received as a dividend or otherwise

converts non-cash assets to cash, amounts initially reported as Non-

cash Gains/Income shall be transferred to Undistributed Net Realized

Earnings.

v. Undistributed Net Realized Earnings is a residual, computed

by subtracting the balance in Non-cash Gains/Income from

Undistributed Realized Earnings. If an SBIC holds treasury stock,

Undistributed Net Realized Earnings are restricted (i.e., not

available for distribution) to the extent of the cost of such

treasury stock.

Y. Retained Earnings Available for Distribution

i. Retained Earnings Available for Distribution represents, in

most cases, the maximum amount that an SBIC may distribute to

investors. For SBICs which have received financial assistance from

SBA in a form other than debentures, the term ``investors''

encompasses SBA as well as private investors.

ii. In some instances, SBA is entitled to receive payments from

Retained Earnings Available for Distribution on a priority basis,

and must receive these payments before any amounts may be

distributed to investors or transferred to private capital.

Dividends (or equivalent distributions) on 4% preferred securities

issued by Section 301(d) Licensees are examples of such payments. In

other cases, SBA may be entitled to receive payments from Retained

Earnings Available for Distribution in proportion to any

distributions received by private investors. Profit participations

on Participating Securities are an example of this type of payment.

iii. For most Licensees, Retained Earnings Available for

Distribution is computed by subtracting unrealized depreciation on

Loans and Investments from Undistributed Net Realized Earnings

(excluding any restricted amounts). Unrealized depreciation and

unrealized appreciation are not netted in this computation.

iv. For Section 301(d) Licensees which have issued 4% preferred

securities, there is one additional element in the computation.

Because 4% distributions in arrears are accrued and charged against

Undistributed Net Realized Earnings, they must be added back to

determine Retained Earnings Available for Distribution.

v. Although partnerships do not ordinarily report retained

earnings as such, partnership SBICs must compute Retained Earnings

Available for Distribution in the same manner as corporate SBICs.

Further discussion of the equity classifications used by partnership

SBICs in financial reporting to SBA appears in paragraph Z

(``Partnership Capital Accounts'') of this section V.

vi. If a Licensee has negative Retained Earnings Available for

Distribution as of the end of a fiscal period, and has made or

declared a distribution during such period, the distribution may

have violated SBA regulations. It is the Licensee's responsibility

to show, to the satisfaction of SBA, that it had sufficient Retained

Earnings Available for Distribution at the time the distribution was

made. In particular, a Licensee should [[Page 7402]] consider the

adequacy of its unrealized depreciation before making a

distribution.

vii. Capitalization of Retained Earnings Available for

Distribution. Ordinarily, contributed capital and earned capital are

maintained and reported separately. In the SBIC program, however, a

Licensee which has attained positive Retained Earnings Available for

Distribution has the option of ``capitalizing'' such earnings by

permanently reclassifying them as contributed capital. As a result

of the reclassification, Undistributed Net Realized Earnings are

reduced, while paid-in capital is increased; the net effect is the

same as if the Licensee had made a distribution to its owners, who

then reinvested the same amount in the Licensee. From a regulatory

perspective, this action results in an increase in the Licensee's

Leverageable Capital, thus increasing its eligibility for SBA

leverage. Capitalization of Retained Earnings Available for

Distribution reflects the intent of a Licensee to pursue long-term

growth by reinvesting its earnings in small businesses.

viii. 1940 Act Companies. A Licensee which has registered under

the Investment Company Act of 1940 may elect to be taxed as a

regulated investment company under the Internal Revenue Code

(Secs. 851 through 855). In general, such a company can avoid

taxation at the corporate level if it distributes at least 90

percent of its investment company taxable income for a given year.

ix. Licensees which are (or contemplate becoming) 1940 Act

companies should be aware that the distribution requirements imposed

on such companies by the Internal Revenue Code may, under certain

circumstances, conflict with SBA regulations concerning

distributions to shareholders. SBA regulations allow profit

distributions to be made only from Retained Earnings Available for

Distribution. Any distribution which would exceed Retained Earnings

Available for Distribution requires the prior written approval of

SBA.

Z. Partnership Capital Accounts

i. To provide the information necessary to determine compliance

with various SBA regulations, Licensees which organize as limited

partnerships must divide partners' capital into specified

categories. The categories are (1) Partners' Contributed Capital,

(2) Unrealized Gain (Loss) on Securities Held, (3) Non-Cash Gains/

Income, and (4) Undistributed Net Realized Earnings (Partners'

Earned Capital). The sum of these four accounts is the equivalent of

the total partners' capital of a non-SBIC partnership. The Licensee

must also record the general and limited partners' shares of each

capital account, which results in eight separate control accounts

for partners' capital.

ii. Partners' Permanent Capital Contribution. This balance

represents proceeds from the sale of partnership units and any other

partners' contributions of cash or other consideration to the

partnership, less any returns of capital or other deductions.

iii. Undistributed Net Realized Earnings and Non-Cash Gains/

Income. The sum of these two accounts represents the total

undistributed earned capital of the Licensee. Separate totals must

be maintained because SBA rules and regulations do not permit Non-

cash Gains/Income to be distributed until they have been converted

to cash. Both of these terms are explained in detail in paragraph X

of this section V.

iv. Unrealized Gain (Loss) on Securities Held. This component of

partnership capital results from the valuation of Loans and

Investments by the Board of Directors or General Partner(s).

Unrealized appreciation is recognized for valuations above cost and

unrealized depreciation is recognized for valuations below cost.

Unrealized gain or loss is the sum of the unrealized appreciation or

depreciation of all Loans and Investments. Estimated future tax

effects associated with unrealized appreciation or depreciation are

not taken into account because partnerships are not taxed at the

entity level. For further information, see paragraph W of this

section V.

VI. Availability of Publications and Forms

i. This section contains information about where to obtain

various publications and forms cited in this appendix I.

ii. The following forms may be obtained from the Investment

Division of SBA, 409 Third Street, SW., suite 6300, Washington, DC

20416: Form 468 (Annual Financial Report), Form 1031 (Portfolio

Financing Report), and CO Form 112 (IPA Certification). Forms 468

and 1031 are provided to all Licensees in the form of electronic

reporting software. SBA Policy and Procedural Releases #2001 through

2021 may also be obtained from the Investment Division.

iii. Pronouncements of the Financial Accounting Standards Board

(FASB) and its predecessor, the Accounting Principles Board (APB)

may be purchased from the Order Department, FASB, 401 Merritt 7,

P.O. Box 5116, Norwalk, CT 06856-5116.

iv. Publications of the American Institute of Certified Public

Accountants (AICPA) may be purchased from the Order Department,

AICPA, Harborside Financial Center, 201 Plaza III, Jersey City, NJ

07311-3881.

3. Appendix II, Chart of accounts for SBICs, is removed and

Appendix III, Valuation Guidelines for SBICs, is redesignated as

Appendix II.

Dated: December 7, 1994.

Philip Lader,

Administrator.

[FR Doc. 95-2937 Filed 2-6-95; 8:45 am]

BILLING CODE 8025-01-M