Tag Archives: 10-Q

MD&A: A New Known-Trend Enforcement Case

By: George M. Wilson & Carol A. Stacey

 

One of the “golden rules” of MD&A we discuss in our workshops is “no surprise stock drops”. (Thanks to Brink Dickerson of Troutman Sanders for the rules!) Actually, it is OK if management is surprised with a stock drop. However, it can be problematic if management previously knew of some issue that, when disclosed, causes a surprise stock drop for investors.

 

The classic start to a known trend enforcement case is a company announcement that results in a stock price drop. On February 26, 2014, UTi, a logistics company, filed an 8-K with news of a severe liquidity problem. UTi’s shares fell to $10.74, a decline of nearly 30% from the prior day’s close of $15.26.

 

The reason this is an SEC reporting issue is this paragraph from the MD&A guidance in Regulation S-K Item 303 paragraph (a)(3)(ii):

 

Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed. (emphasis added)

 

If management knows of some sort of uncertainty that could result in a material impact if it comes to fruition, they must evaluate whether they “reasonably expect” this to happen. If they do “reasonably expect” this to happen then it should be disclosed in MD&A.

 

When there is a surprise stock drop like the one experienced by UTi, the questions the SEC Enforcement Division will ask, to borrow from another context, are “what did management know about the problem” and “when did they know it?”

 

Enforcement Release, AAER 3877 revealed that the genesis of UTi’s liquidity problem was an issue in the implementation of a new IT system that created billing problems. And, it was clear from the facts, including an internal PowerPoint presentation, that management knew they had a problem well before they filed the 8-K.

 

However, in their 10-Q for their third quarter ended October 31, 2013, which was filed in December of 2013, UTi did not disclose the liquidity problem. In fact, they said:

 

Our primary sources of liquidity include cash generated from operating activities, which is subject to seasonal fluctuations, particularly in our Freight Forwarding segment, and available funds under our various credit facilities. We typically experience increased activity associated with our peak season, generally during the second and third fiscal quarters, requiring significant disbursements on behalf of clients. During the second quarter and the first half of the third quarter, this seasonal growth in client receivables tends to consume available cash. Historically, the latter portion of the third quarter and the fourth quarter tend to generate cash recovery as cash collections usually exceed client cash disbursements.

 

They also made no mention of the implementation problems with their new IT system. They actually said:

 

Freight Forward Operating System. On September 1, 2013, we deployed our global freight forwarding operating system in the United States. As of that date, based on a variety of factors, including but not limited to operational acceptance testing and other operational milestones having been achieved, we considered it ready for its intended use. Amortization expense with respect to the system began effective September 2013, and accordingly, we recorded amortization expense related to the new application of approximately $3.3 million during the third quarter ended October 31, 2013.

 

Hence the surprise when the 8-K disclosed the problems. Both the CEO and CFO are also named in the Enforcement Release and paid penalties.

 

As mentioned above, the probability standard for disclosure is “reasonably expects”. More about this complex probability assessment in our next post!

 

As always, your thoughts and comments are welcome!

Going Concern Reporting – The Gap in GAAP Versus GAAS- Part Three

By: George M. Wilson & Carol A. Stacey

 

Our first two posts in this series have presented an example of a company (Sears Holdings) and auditor reporting requirements for going concern issues as well as reviewed reporting requirements for companies. In this last post we review reporting requirements for auditors and explore the gaps in more detail.

 

Auditor Requirements

 

For auditors of public companies the PCAOB did not change existing GAAS when the FASB Issued ASU 2014-15. Auditors follow this guidance in section AS 2415 of the PCAOB’s auditing standards:

 

02        The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited (hereinafter referred to as a reasonable period of time). The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Information about such conditions or events is obtained from the application of auditing procedures planned and performed to achieve audit objectives that are related to management’s assertions embodied in the financial statements being audited, as described in AS 1105, Audit Evidence.

 

02        The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited (hereinafter referred to as a reasonable period of time). The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Information about such conditions or events is obtained from the application of auditing procedures planned and performed to achieve audit objectives that are related to management’s assertions embodied in the financial statements being audited, as described in AS 1105, Audit Evidence.

 

The Gaps

 

There are gaps between what companies disclose and how auditors report. Two of the gaps are:

 

  1. The time period for going concern considerations, and

 

  1. The probability level for the company compared to the auditor for these disclosures

 

Time Period Gap

 

The auditor’s GAAS reporting requirement clearly states that the period over which going concern issues are evaluated is a “reasonable period of time, not to exceed one year beyond the date of the financial statements being audited”. The requirement under GAAP for companies is “within one year after the date that the financial statements are issued”. In practice, many auditors have actually used the period of one year after the financial statements are issued as their going concern disclosure threshold, but they are not strictly required to do this.

 

Probability GAP

 

The disclosure requirement for management in GAAP is that if it “is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued” then they must make disclosures. This threshold of “probable” has its roots in one of the earliest FASB standards (SFAS 5, now ASC 450) dealing with contingencies. This standard set out the definition of “probable” as:

 

“The future event or events are likely to occur”.

 

The auditor’s GAAS standard uses the probability threshold “substantial doubt”:

 

The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time

 

So, what is the difference between “probable that an entity will not be able to meet its obligations as they become due” and “substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time”? This is of course a matter of judgment. Many practitioners would believe that probable is a higher threshold than substantial doubt. What is clear is that this is a subjective evaluation.

 

The PCAOB addressed this difference in their guidance about the new disclosure requirements. This language is from Staff Audit Practice Alert No. 13:

In evaluating whether the financial statements are presented fairly, in all material respects, in conformity with the applicable financial reporting framework, including whether they contain the required disclosures, auditors should assess management’s going concern evaluation. In making this assessment the auditor should look to the requirements of the applicable financial reporting framework

In addition, auditors should continue to look to the existing requirements in AU sec. 341 when evaluating whether substantial doubt regarding the company’s ability to continue as a going concern exists for purposes of determining whether the auditor’s report should be modified to include an explanatory paragraph regarding going concern. The AU sec. 341 requirements for the auditor’s evaluation, and the auditor’s reporting when substantial doubt exists, have not changed and continue to be in effect. Under AU sec. 341, the auditor’s evaluation of whether substantial doubt exists is qualitative based 341.Accordingly, a determination that no disclosure is required under the ASC amendments or IAS 1, as applicable, is not conclusive as to whether an explanatory paragraph is required under AU sec. 341. Auditors should make a separate evaluation of the need for disclosure in the auditor’s report in accordance with the requirements of AU sec. 341.

 

This is of course another gap between GAAP and GAAS. Time will tell how the market reacts to this kind of presentation. And this explains why Sears Holdings disclosed their going concern uncertainty and their auditors did not modify their report.

 

There is one more interesting aspect to all this disclosure and auditor reporting discussion. What happens in a Form 10-Q where generally there is no auditor’s report?

 

The requirements in ASC 205-40-50 for interim periods are:

 

If conditions or events continue to raise substantial doubt about an entity’s ability to continue as a going concern in subsequent annual or interim reporting periods, the entity shall continue to provide the required disclosures in paragraphs 205-40-50-12 through 50-13 in those subsequent periods. Disclosures should become more extensive as additional information becomes available about the relevant conditions or events and about management’s plans. An entity shall provide appropriate context and continuity in explaining how conditions or events have changed between reporting periods. For the period in which substantial doubt no longer exists (before or after consideration of management’s plans), an entity shall disclose how the relevant conditions or events that raised substantial doubt were resolved.

 

Sears Holdings’ Form 10-Q for the first quarter of F/y 18 includes this disclosure:

 

We acknowledge that we continue to face a challenging competitive environment and while we continue to focus on our overall profitability, including managing expenses, we reported a loss in the first quarter of 2017, when excluding significant items noted in our Adjusted Earnings Per Share tables, and were required to fund cash used in operating activities with cash from investing and financing activities. We expect that the actions outlined above will further enhance our liquidity and financial flexibility. In addition, as previously discussed, we expect to generate additional liquidity through the monetization of our real estate, additional debt financing actions, and potential asset securitizations. We expect that these actions will be executed in alignment with the anticipated timing of our liquidity needs.

 

We also continue to explore ways to unlock value across a range of assets, including exploring ways to maximize the value of our Home Services and Sears Auto Centers businesses, as well as our Kenmore and DieHard brands through partnerships or other

means of externalization that could expand distribution of our brands and service offerings to realize significant growth. We expect to continue to right-size, redeploy and highlight the value of our assets, including monetizing our real estate portfolio and exploring potential asset securitizations, in our transition from an asset intensive, historically “store-only” based retailer to a more asset light, integrated membership-focused company.

 

We believe that the actions discussed above are probable of occurring and mitigate the liquidity risk raised by our historical operating results and satisfy our estimated liquidity needs during the next 12 months from the issuance of the financial statements. The PPPFA contains certain limitations on our ability to sell assets, which could impact our ability to complete asset sale transactions or our ability to use proceeds from those transactions to fund our operations. Therefore, the planned actions take into account the applicable restrictions under the PPPFA.

 

If we continue to experience operating losses, and we are not able to generate additional liquidity through the actions described above or through some combination of other actions, while not expected, then our liquidity needs may exceed availability under our amended Domestic Credit Agreement and we might need to secure additional sources of funds, which may or may not be available to us. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Moreover, if the borrowing base (as calculated pursuant to our outstanding second lien debt) falls below the principal amount of such second lien debt plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for such debt on the last day of any two consecutive quarters, it could trigger an obligation to repurchase or repay second lien debt in an amount equal to such deficiency.

 

No more use of the term “substantial doubt”. It might be helpful if the change from year-end to quarter-end was explained in more detail.

 

As always, your thoughts and comments are welcome!

Rev Rec Trail Blazers? We Can Learn Together!

By: George M. Wilson & Carol A. Stacey

What do United Health Group, Alphabet, and Ford have in common? What if we also included Raytheon? That’s right, all these companies have early adopted the FASB’s new revenue recognition standard! Microsoft and Workday have also indicated that they plan to early adopt. Microsoft has indicated they will adopt as of July 1, 2017 and file their first 10-Q under the new method for the quarter-ended September 30, 2017. Workday has said that they will early adopt as of February 1, 2017 and hence their first 10-Q under the new method will be for the quarter-ended April 30, 2017, which should be filed soon. Here is a summary of some of the early adopters:

 

Early adopters who have filed with ASU 2014-09:

Alphabet                                        January 1, 2017           Modified Retrospective

Ford                                                 January 1, 2017           Modified Retrospective

United Health Group               January 1, 2017            Modified Retrospective

First Solar                                     January 1, 2017            Full Retrospective

General Dynamics                     January 1, 2017            Full Retrospective

Raytheon                                     January 1, 2017            Full Retrospective

 

Planned adoptions – no filing yet:

Workday                                  February 1, 2017         Full Retrospective

Microsoft                                July 1, 2017                 Full Retrospective

 

(If you know of any other companies that have early adopted it would be great if you could mention them in a comment on this post or email Carol or George – Thanks!)

 

As is always the case with a major new standard, it is helpful to learn from the experience of folks who have gone past the frontier to the leading, and hopefully not the bleeding, edge! Here are a few highlights and links to Form 10-Q’s with the new standard adopted.

 

From Alphabet’s Form 10-Q for the first quarter of 2017:

 

In May 2014, the FASB issued Accounting Standards Update No. 2014-09 (Topic 606) “Revenue from Contracts with Customers.” Topic 606 supersedes the revenue recognition requirements in Topic 605 “Revenue Recognition” (Topic 605), and requires entities to recognize revenue when control of the promised goods or services is transferred to customers at an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. We adopted Topic 606 as of January 1, 2017 using the modified retrospective transition method. See Note 2 for further details.

 

Alphabet’s disclosures, including how they decided to disaggregate revenues, make for interesting reading!

 

From Fords Form 10-Q for the quarter ended March 31, 2017:

 

On January 1, 2017, we adopted the new accounting standard ASC 606, Revenue from Contracts with Customers and all the related amendments (“new revenue standard”) to all contracts using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. We expect the impact of the adoption of the new standard to be immaterial to our net income on an ongoing basis.

 

You can read about the impact of the change on revenues and review Fords Note 3 – Revenue to see how they decided to present the new disclosure for disaggregated revenues.

 

Raytheon, who had previously announced they would early adopt, did so in their Form 10-Q for the First Quarter of 2017, which you can find here.

 

Note 2: Accounting Standards

In May 2014, the Financial Accounting Standards Board (FASB) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which replaces numerous requirements in U.S. GAAP, including industry-specific requirements, and provides companies with a single revenue recognition model for recognizing revenue from contracts with customers. The core principle of the new standard is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The two permitted transition methods under the new standard are the full retrospective method, in which case the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of initial application. In July 2015, the FASB approved the deferral of the new standard’s effective date by one year. The new standard is effective for annual reporting periods beginning after December 15, 2017. The FASB permits companies to adopt the new standard early, but not before the original effective date of annual reporting periods beginning after December 15, 2016. Effective January 1, 2017, we elected to early adopt the requirements of Topic 606 using the full retrospective method.

 

Raytheon’s disclosures for the full retrospective adoption, and the volume of their disclosures overall because of their government contracting business, are great reading for anyone facing similar issues.

 

From United Health Groups Form 10-Q for the quarter ended March 31, 2017:

 

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” as modified by subsequently issued ASUs 2015-14, 2016-08, 2016-10, 2016-12 and 2016-20 (collectively
ASU 2014-09). ASU 2014-09 superseded existing revenue recognition standards with a single model unless those contracts are within the scope of other standards (e.g., an insurance entity’s insurance contracts). The revenue recognition principle in ASU 2014-09 is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

 

The Company early adopted the new standard effective January 1, 2017, as allowed, using the modified retrospective approach. A significant majority of the Company’s revenues are not subject to the new guidance. The adoption of ASU 2014-09 did not have a material impact on the Company’s consolidated financial position, results of operations, equity or cash flows as of the adoption date or for the three months ended March 31, 2017. The Company has included the disclosures required by ASU 2014-09 above.

 

General Dynamics early adopted with the full retrospective method. From their Form 10-Q for quarter one 2017:

 

The majority of our revenue is derived from long-term contracts and programs that can span several years. We account for revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers, which we adopted on January 1, 2017, using the retrospective method. See Note Q for further discussion of the adoption, including the impact on our 2016 financial statements.

 

 

First Solar also early adopted and used the full retrospective transition method. Here is an excerpt from their Form 10-Q for quarter one of 2017:

 

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), to clarify the principles of recognizing revenue and create common revenue recognition guidance between U.S. GAAP and International Financial Reporting Standards. Under ASU 2014-09, revenue is recognized when a customer obtains control of promised goods or services and is recognized at an amount that reflects the consideration expected to be received in exchange for such goods or services. In addition, ASU 2014-09 requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

 

We adopted ASU 2014-09 in the first quarter of 2017 using the full retrospective method. This adoption primarily affected our systems business sales arrangements previously accounted for under ASC 360-20, which had required us to evaluate whether such arrangements had any forms of continuing involvement that may have affected the revenue or profit recognition of the transactions, including arrangements with prohibited forms of continuing involvement. When such forms of continuing involvement were present, we reduced the potential profit on the applicable project sale by our maximum exposure to loss.

 

Microsoft and Workday will also be filing with the new standard this year, so watch for their first 10-Q’s this year. Here is Microsoft’s SAB 74 disclosure (not included here is the section in which they say it is their intent to also early adopt the new lease standard as of July 1, 2017), followed by Workday’s SAB 74 disclosure for revenue recognition.

 

Microsoft:

Revenue from Contracts with Customers

In May 2014, the FASB issued a new standard related to revenue recognition. Under the standard, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

 

The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (modified retrospective method). We plan to adopt the standard using the full retrospective method to restate each prior reporting period presented.

 

The standard will be effective for us beginning July 1, 2018, with early adoption permitted as of the original effective date of July 1, 2017. We plan to adopt the standard effective July 1, 2017. While our ability to early adopt using the full retrospective method depends on system readiness, including software procured from third-party providers, and completing our analysis of information necessary to restate prior period consolidated financial statements, we remain on schedule and have implemented key system functionality to enable the preparation of restated financial information.

 

We have reached conclusions on key accounting assessments related to the standard. However, we are finalizing our assessment and quantifying the impacts related to accounting for costs incurred to obtain a contract based on guidance issued by the FASB Transition Resource Group as part of their November 2016 meeting. We will continue to monitor and assess the impact of any changes to the standard and interpretations as they become available.

 

The most significant impact of the standard relates to our accounting for software license revenue. Specifically, under the standard we expect to recognize Windows 10 revenue predominantly at the time of billing rather than ratably over the life of the related device. We expect to recognize license revenue at the time of contract execution rather than over the subscription period from certain multi-year commercial software subscriptions that include both software licenses and Software Assurance. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard will depend on contract-specific terms and in some instances may vary from recognition at the time of billing.

 

We expect revenue recognition related to our hardware, cloud offerings including Office 365, LinkedIn, and professional services to remain substantially unchanged.

We are nearing completion of retrospectively adjusting financial information for fiscal year 2016 and are progressing as planned for fiscal year 2017. We estimate our revenue would have been approximately $6 billion higher in fiscal year 2016 under the standard primarily due to the net change in Windows 10 revenue recognition.

 

 

Workday:

 

We have closely assessed the new standard and monitored FASB activity, including the interpretations by the FASB Transition Resource Group for Revenue Recognition, throughout fiscal 2017. In the fourth quarter of fiscal 2017, we finalized our assessment of the new standard, including completing our contract reviews and our evaluation of the incremental costs of obtaining a contract. Based on our assessment, we decided to early adopt the requirements of the new standard in the first quarter of fiscal 2018, utilizing the full retrospective method of transition.

 

The impact of adopting the new standard on our fiscal 2017 and fiscal 2016 revenues is not material. The primary impact of adopting the new standard relates to the deferral of incremental commission costs of obtaining subscription contracts. Under Topic 605, we deferred only direct and incremental commission costs to obtain a contract and amortized those costs over the term of the related subscription contract, which was generally three years. Under the new standard, we defer all incremental commission costs to obtain the contract. We amortize these costs over a period of benefit that we have determined to be five years.

 

As always, your thoughts and comments are welcome! And if you hear of or know of any other early adopters please put that in a comment to this post, or email George or Carol

ICFR Changes and the New Revenue Recognition, Leases, and Financial Instrument Impairment Transitions

By: George M. Wilson & Carol A. Stacey

 

In his recent, much publicized speech, Chief Accountant Wesley Bricker discussed the transition to the new revenue recognition standard. A bit later in the speech he addressed a not so frequently discussed issue, the requirement to disclose material changes in ICFR as it relates to implementation of the new revenue recognition, leases, credit losses and other standards. Here is an excerpt:

 

Over the next several years, updating and maintaining internal controls will be particularly important as companies work through the implementation of the significant new accounting standards. Companies’ implementation activities will require careful planning and execution, as well as sound judgment from management, as I have mentioned earlier in illustrating areas of judgment in the new GAAP standards.

 

In his remarks, well worth the read, he also comments on two crucial ICFR concerns in these new standards:

Having the requisite skills in the accounting and financial reporting area to make the many new, complex judgements required by these standards, and

Setting an appropriate tone at the top to assure these judgments are made in a reasonable, consistent and appropriate manner.

 

We did a post about reporting changes in ICFR in November 2016. To refresh your memory, or if you are not familiar with this area, here is a summary of the disclosures required for material changes in ICFR. This applies to material changes made to implement new accounting standards as well as any other material changes.

 

These requirements begin with Item 9A in Form 10-K and Part I Item 4 in Form 10-Q. They both refer to S-K Item 308(c):

 

(c) Changes in internal control over financial reporting. Disclose any change in the registrant’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of §240.13a-15 or 240.15d-15 of this chapter that occurred during the registrant’s last fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.

 

With changes to ICFR for revenue recognition for information about contracts and estimates, like stand-alone selling price and when control transfers, and changes to ICFR for capitalization of all leases, these new standards could require material changes to ICFR. Are these the types of changes included in the S-K 308(c) disclosure requirement?

 

This is an excerpt from the ICFR C&DI’s, number 7, about SOX reporting which you can find here:

 

After the registrant’s first management report on internal control over financial reporting, pursuant to Item 308 of Regulations S-K or S-B, the registrant is required to identify and disclose any material changes in the registrant’s internal control over financial reporting in each quarterly and annual report. This would encompass disclosing a change (including an improvement) to internal control over financial reporting that was not necessarily in response to an identified material weakness (i.e. the implementation of a new information system) if it materially affected the registrant’s internal control over financial reporting. Materiality, as with all materiality judgments in this area, would be determined upon the basis of the impact on internal control over financial reporting and the materiality standard articulated in TSC Industries, Inc. v. Northway, Inc. 426 U.S. 438 (1976) and Basic Inc. v. Levinson, 485 U.S. 224 (1988). This would also include disclosing a change to internal control over financial reporting related to a business combination for which the acquired entity that has been or will be excluded from an annual management report on internal control over financial reporting as contemplated in Question 3 above. As an alternative to ongoing disclosure for such changes in internal control over financial reporting, a registrant may choose to disclose all such changes to internal control over financial reporting in the annual report in which its assessment that encompasses the acquired business is included.

 

 

The SEC Regulations Committee of the CAQ has also discussed a particularly intricate issue in this transition. What if you change your ICFR this year, but the change is for future reporting when you begin to report under the new standard next year? This issue is still in play, as this excerpt from the minutes discusses:

 

Changes in ICFR in preparation for the adoption of a new accounting standard

Item 308(c) of Regulation S-K requires disclosure of changes in internal control over financial reporting (“ICFR”) during the most recent quarter that have materially affected or are reasonably likely to materially affect the registrant’s ICFR. The Committee and the staff discussed how this requirement applies to changes in ICFR that are made in preparation for the adoption of a new accounting standard when those changes are in periods that precede the date of adoption and do not impact the preparation of the financial statements until the new standard is adopted.

 

The staff indicated that they are evaluating whether additional guidance is necessary for applying the requirements of Item 308(c) in connection with the transition to the new revenue standard.

 

So, as you begin implementing systems and processes for these new standards, don’t forget this part of the reporting!

 

As always, your thoughts and comments are welcome!

The SEC Comment Process – What if?

In all our workshops and seminars, when we discuss the SEC review process we always emphasize that when you get a comment from the staff you do NOT immediately change disclosure in response to the comment. As the staff says in their on-line “Filing Review Process” document, they view the process of issuing comments as a “dialogue with a company about its disclosure”.

You can find the filing review process document, which is updated on a regular basis at:

www.sec.gov/corpfin/Article/filing-review-process—corp-fin.html

 

To illustrate, here is a real life comment example.

 

STEP ONE – COMMENT RECEIVED

What would you do if you received this comment?

 

Reportable Segments, page 39

  1. Your segment discussion and analysis only refers to non-GAAP amounts. Pursuant to Item 10(e) of Regulation S-K, we remind you that more prominence should not be given to non-GAAP financial measures compared to GAAP financial measures. In this regard, please revise your discussion and analysis to first provide a discussion of the corresponding GAAP amounts for each segment ensuring equal prominence to that of your non-GAAP amounts.

The comment uses the language “please revise”, which is a bit scary, and in the back of our minds we hope we can push the comment to an “in future filings” comment if we decide the staff is on-point. The comment is focused on the use of non-GAAP measures in MD&A as discussed in operating segment disclosures. Of course, the use of non-GAAP measures in segment disclosures is appropriate if in fact your chief operating decision maker uses non-GAAP information. So, your first step in the research process for this comment might be to go review that part of ASC 280.

 

 

STEP TWO – REVIEW GAAP LITERATURE

Here is the relevant section:

Measurement

50-27     The amount of each segment item reported shall be the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing a public entity’s general-purpose financial statements and allocations of revenues, expenses, and gains or losses shall be included in determining reported segment profit or loss only if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets that are included in the measure of the segment’s assets that is used by the chief operating decision maker shall be reported for that segment. If amounts are allocated to reported segment profit or loss or assets, those amounts shall be allocated on a reasonable basis.

ASC 280 then goes on to require disclosure about the measurement basis used for segment disclosures:

50-29     A public entity shall provide an explanation of the measurements of segment profit or loss and segment assets for each reportable segment. At a minimum, a public entity shall disclose all of the following (see Example 3, Cases A through C [paragraphs 280-10-55-47 through 55-49]):

  1. The basis of accounting for any transactions between reportable segments.
  2. The nature of any differences between the measurements of the reportable segments’ profits or losses and the public entity’s consolidated income before income taxes, extraordinary items, and discontinued operations (if not apparent from the reconciliations described in paragraphs 280-10-50-30 through 50-31). Those differences could include accounting policies and policies for allocation of centrally incurred costs that are necessary for an understanding of the reported segment information.
  3. The nature of any differences between the measurements of the reportable segments’ assets and the public entity’s consolidated assets (if not apparent from the reconciliations described in paragraphs 280-10-50-30 through 50-31). Those differences could include accounting policies and policies for allocation of jointly used assets that are necessary for an understanding of the reported segment information.
  4. The nature of any changes from prior periods in the measurement methods used to determine reported segment profit or loss and the effect, if any, of those changes on the measure of segment profit or loss.
  5. The nature and effect of any asymmetrical allocations to segments. For example, a public entity might allocate depreciation expense to a segment without allocating the related depreciable assets to that segment.

 

ASC 280 also includes this reconciliation requirement:

 

50-30     A public entity shall provide reconciliations of all of the following (see Example 3, Case C [paragraphs 280-10-55-49 through 55-50]):

  1. The total of the reportable segments’ revenues to the public entity’s consolidated revenues.
  2. The total of the reportable segments’ measures of profit or loss to the public entity’s consolidated income before income taxes, extraordinary items, and discontinued operations. However, if a public entity allocates items such as income taxes and extraordinary items to segments, the public entity may choose to reconcile the total of the segments’ measures of profit or loss to consolidated income after those items.
  3. The total of the reportable segments’ assets to the public entity’s consolidated assets.
  4. The total of the reportable segments’ amounts for every other significant item of information disclosed to the corresponding consolidated amount. For example, a public entity may choose to disclose liabilities for its reportable segments, in which case the public entity would reconcile the total of reportable segments’ liabilities for each segment to the public entity’s consolidated liabilities if the segment liabilities are significant.

 

With this, our review of the relevant GAAP literature is well underway, and substantially complete.

 

STEP THREE – REVIEW THE RELEVANT SEC NON-GAAP GUIDANCE

As you research the SEC’s requirements surrounding the use of non-GAAP measures, most of us are familiar with Reg G, which applies to non-GAAP measures in documents that are not filed, such as earnings releases. But this comment is about S-K Item 10(e) which applies to non-GAAP measures included in MD&A. As you read Item 10(e) you would find:

(5) For purposes of this paragraph (e), non-GAAP financial measures exclude financial measures required to be disclosed by GAAP, Commission rules, or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the registrant. However, the financial measure should be presented outside of the financial statements unless the financial measure is required or expressly permitted by the standard-setter that is responsible for establishing the GAAP used in such financial statements.

Where to go from here? Lets get into the specific facts in the company’s Form 10-K.

 

 

STEP FOUR – APPLY THE RESEARCH TO THE COMPANY’S DISCLOSURES

Here is an excerpt from the company’s segment note:

 

“We prepared the financial results for our reportable segments on a basis that is consistent with the manner in which we internally disaggregate financial information to assist in making internal operating decisions. We included the earnings of equity affiliates that are closely associated with our reportable segments in the respective segment’s net income. We have allocated certain common expenses among reportable segments differently than we would for stand-alone financial information. Segment net income may not be consistent with measures used by other companies. The accounting policies of our reportable segments are the same as those applied in the consolidated financial statements.”

Here is an excerpt from the MD&A disclosure that the SEC comment is focused on:

When compared to the same period last year, core earnings increased in the twelve months ended December 31, 2013 by $202 million, or 13%, driven by the following items:

 

· Higher core earnings in the Optical Communications, Life Sciences,

Environmental Technologies and Display Technologies segments in the

amounts of $59 million, $44 million, $11 million and $7 million, respectively; and

·  

Lower operating expenses in the amount of $49 million, driven by a decrease in

variable compensation and cost control measures implemented by our segments.

 

You can find the company’s Form 10-K at:

files.shareholder.com/downloads/glw/1822865217x0xS24741%2D15%2D15/24741/filing.pdf

 

You can read the issues the SEC is commenting about in MD&A on page 39, and the segment note starts on page 137.

At this point we are ready to make an informed judgment about the comment. And this one follows a really twisty path! First, the MD&A clearly includes non-GAAP measures for “core” operations. And, interestingly, these are not the measures that are disclosed in the segment note in the financial statements. Since the measures used in the MD&A are not in the segment note the provision in S-K Item 10(e) excluding disclosures required under GAAP does not apply, and so the company must comply with the provisions. The next step is to, as we said above, make a case with the staff that it will be appropriate to fix this comment in future filings and not amend the current Form 10-K.

 

STEP FIVE – RESPOND TO THE COMMENT

Here is the company’s response to the comment, and the staff did allow this to become a future filings comment:

We acknowledge the Staff’s comments and, beginning with our Form 10-Q filed for the second quarter of 2014, will revise our future disclosure to ensure that more prominence is not given to non-GAAP financial measures when compared to GAAP financial measures.  With respect to the request to revise our discussion and analysis to first provide a discussion of the corresponding GAAP amounts for each segment, we provide the following updated disclosure, which we propose to use in future filings.

You can read the response letter and the complete version of the response to comment 8 including the proposed disclosure at:

 

www.sec.gov/Archives/edgar/data/24741/000002474114000025/filename1.htm

 

 

As always, your thoughts and comments are welcome!