Security Regulation and the Regulation Test of the CPA Exam - dummies

Security Regulation and the Regulation Test of the CPA Exam

By Kenneth W. Boyd

The Regulation (REG) test of the CPA exam covers securities regulation, specifically the requirements of the Securities and Exchange Commission (SEC). Generally, the SEC regulates companies that sell securities (stocks and bonds) to the public. This is an important area for CPAs, because many businesses sell stock and bonds to investors. The Securities Acts of 1933 and 1934 cover most of the securities regulation that’s covered on the REG test.

A security is defined as a passive investment. Passive means that the investor isn’t actively involved in the operation of the business. Instead, the investor relies on the firm’s management to make business decisions. The two most common types of investments are stocks and bonds. The definition of a security also includes stock options, convertible securities, and certain partnership interests.

To succeed on the securities regulation section of the REG test, you need to know the differences between the Securities Acts of 1933 and 1934. The Act of ’33 covers the regulation of securities when they’re sold to the public for the first time. On the other hand, the Act of ’34 regulates securities when they’re trading between investors. The big emphasis on the REG test is the disclosure requirements for each of the acts.

An initial public offering (IPO) refers to a company’s issuing of securities (usually common stock) to the public for the first time. A firm may have issued securities to investors in a private offering before the IPO.

The Securities Act of ’33

The SEC was created in response to the stock market crash of 1929. After the crash, legislators and securities industry officials determined that many investors had bought securities based on little or no accurate financial information. As a result, many investors were unaware of the financial risk they were taking.

To address this concern, Congress passed the Securities Act of 1933, which requires that companies selling securities to the public register their securities with the SEC.

The term registration means that the issuer (the company issuing securities) discloses specific information and that the information is made available to the public. The SEC, however, doesn’t ensure that the information is accurate. Here are some details on the registration process:

  • Groups involved in securities registration: The issuer is the firm selling the securities to the public. The underwriter puts together the legal documents for the securities. A dealer sells the securities to the public for the issuer. Each of these parties must register with the SEC. Registration requires these parties to disclose information about their businesses.

  • Documents:

    • Prospectus: A prospectus is a lengthy document that explains why the company is raising money, notes how it will use the funds, and includes a disclosure of the firm’s audited financial statements.

    • Registration statement: The other required document is a registration statement. Typically, a registration statement is provided to investors before the prospectus is complete. The registration statement allows investors to educate themselves and consider placing an order to buy the securities before the prospectus is finalized.

Some types of securities are exempt from the Securities Act of ’33, so these securities don’t have to register with the SEC. These securities aren’t sold using an SEC-required prospectus or registration statement. Although investors may be provided with information on these investments, the documents don’t have to be submitted to the SEC. Here are some types of exempt securities that you may see on the REG test:

  • Intrastate sales

  • Commercial paper

  • Insurance policies

  • Securities issued by not-for-profit and religious organizations

The Securities Act of ’34

Like the Act of ’33, the 1934 Act was passed by Congress to protect investors and ensure that companies provide sufficient disclosure about securities. The Securities Act of 1934 regulates securities that trade between investors.

After a company issues a security to an investor, that investor may sell that security to someone else. If Harold sells a security to Maude, that’s simply an exchange between two investors. The company issuing the securities doesn’t receive any proceeds after the securities are issued for the first time.

The Act of ’34 oversees exchanges, which are entities set up to allow buyers and sellers of securities to trade with each other. The New York Stock Exchange is one example. The ’34 Act also contains additional registration requirements and reporting requirements.

The ’34 Act requires these types of entities to register with the SEC:

  • Publicly traded companies

  • Private companies with minimum assets and shareholders

  • Affiliates: The term affiliates include exchanges as well as brokers and dealers. Brokers and dealers sell securities to the public.

Keep in mind that the REG test refers to brokers and dealers separately. The securities industry, however, uses the term “broker-dealer” as one phrase. If you work in the securities industry, realize that the REG test handles these terms differently from how your industry does.

One goal of the ’34 Act was to expand on disclosure that had already been provided using ’33 Act filings. Investors rely on that updated information to make decisions about buying or selling the stock. That’s the purpose of the ’34 Act.

The ’34 Act requires that specific financial reporting be submitted. The act also requires reporting of some key events and transactions. Here are some of those requirements:

  • Filing reports: Companies file an annual 10-K report to the SEC. Each quarter, the firms file a 10-Q.

  • Tender offers: The SEC website defines a tender offer as a broad solicitation to purchase a substantial percentage of a company equity. Any shareholder who will own 5 percent or more of the outstanding stock shares after a tender offer must file a report with the SEC.

  • Proxy solicitation: A proxy solicitation occurs when anyone tries to obtain shareholder agreement for a proposal (or a set of proposals). The company or any individual can create a proxy solicitation.

  • A trade by an insider: An insider is a person who owns 10 percent or more of the voting stock of a company. Company board members and senior officers (like the CEO or CFO) are also considered insiders. Insiders must report their trading activity to the SEC.

Keep in mind that companies can issue common stock that doesn’t allow the shareholder to vote on company issues (or that limits voting). This is one of the few places on the CPA exam where voting versus non-voting stock is an issue. Unless you’re told otherwise, assume that all common stock shares allow the shareholder to vote on important company issues.