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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!

SEC Reporting and FASB Updates Specific to Small and Mid-Sized Companies Take Center Stage

The Financial Reporting Regulatory landscape is chock full of recent updates and new regulations, chief among them is the new FASB Revenue Recognition Standard and revised Lease Accounting. Most surveys agree that filers are well behind schedule in implementing the changes needed to comply. Practitioners at small and mid-sized companies will receive the essential information and advice needed to get up to speed by attending SEC Reporting & FASB Forum live program September 14-15 in Las Vegas.

http://www.pli.edu/Content/13th_Annual_SEC_Reporting_FASB_Forum_for/_/N-1z10lptZ4k?ID=298604

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

By: George M. Wilson & Carol A. Stacey

 

In our last post, we looked at Sears Holdings’ disclosures about its going concern issues and saw that the company used the language “substantial doubt exists related to the Company’s ability to continue as a going concern” in the footnotes to their financial statements. We also saw that Sears Holdings’ auditors did not mention this issue in their report.

 

While this might seem like a bit of a disconnect, it turns out that there is a gap between the disclosure requirements for companies and the reporting requirements for auditors. (Actually, there are multiple gaps!)

 

This post reviews the GAAP requirements of ASU 2015-15, which became effective for companies for years ending after December 15, 2016.

 

In the third and last post of this series we will explore the auditor’s reporting requirements and the “gaps” between company requirements and auditor’s requirements.

 

Company Requirements

 

Here is a brief summary with some excerpts from the requirements for companies in ASC 205-40-50:

In connection with preparing financial statements for each annual and interim reporting period, an entity’s management shall evaluate whether there are conditions and events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable).

 

……………………………..

 

Management shall evaluate whether relevant conditions and events, considered in the aggregate, indicate that 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. The evaluation initially shall not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued (for example, plans to raise capital, borrow money, restructure debt, or dispose of an asset that have been approved but that have not been fully implemented as of the date that the financial statements are issued).

 

……………………………..

 

When relevant conditions or events, considered in the aggregate, initially indicate that 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 (and therefore they raise substantial doubt about the entity’s ability to continue as a going concern), management shall evaluate whether its plans that are intended to mitigate those conditions and events, when implemented, will alleviate substantial doubt about the entity’s ability to continue as a going concern.

 

……………………………..

 

With this as the general requirement for an evaluation, the disclosure requirement comes with a binary determination about the impact of management’s plans:

 

Disclosures When Substantial Doubt Is Raised but Is Alleviated by Management’s Plans (Substantial Doubt Does Not Exist)

 

ASC 240-40-50-12

 

If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is alleviated as a result of consideration of management’s plans, an entity shall disclose in the notes to financial statements information that enables users of the financial statements to understand all of the following (or refer to similar information disclosed elsewhere in the notes):

 

  1. Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.

 

 

 

Disclosures When Substantial Doubt Is Raised and Is Not Alleviated (Substantial Doubt Exists)

 

ASC 240-40-50-13

 

If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is not alleviated, the entity shall include a statement in the notes to financial statements indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Additionally, the entity shall disclose information that enables users of the financial statements to understand all of the following:

 

  1. Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern.

 

An interesting difference between these two levels of disclosure is that there is no requirement to use the terminology “substantial doubt” when management’s plans alleviate the uncertainty.

 

The language Sears Holdings used was:

 

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements.

 

 

The company used the term “substantial doubt” even though they believed their plans mitigated this “substantial doubt”. Their disclosure went beyond the requirements of the standard.

 

In our next post, we will explore how this interacts with GAAS for auditors.

 

As always, your thoughts and comments are welcome!

Going Concern Reporting – The Gap in GAAP Versus GAAS – Part One

By: George M. Wilson & Carol A. Stacey

 

This is the first of three posts about an interesting conundrum in reporting that arose last year. The FASB, with ASU 2014-15, now requires disclosures by companies about going concern issues. However, there can be gaps between what companies are required to disclose and impact of going concern issues on the auditor’s report.

ASU 2014-15 added subtopic 205-40 “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” to the Accounting Standards Codification. This update became effective for periods ending after December 15, 2016. Previously there was no specific requirement for management to make these disclosures. (This is of course Generally Accepted Accounting Principles, or GAAP).

Auditors have had guidance in this area for many years courtesy of the PCAOB’s standard in AU section 341, which is now section AS 2415 in the PCAOB’s reorganized auditing standards. (This is Generally Accepted Auditing Standards, or GAAS).

 

To explore the gap between GAAP for companies and GAAS for auditors when reporting going concern issues we are going to present a series of three posts:

 

This first post will present an example of a going concern disclosure by a company and whether or not the auditor’s report was modified. (Spoiler – there was no mention in the auditor’s report!)

 

The second post will explore company disclosure requirements.

 

The third and last post will review auditor’s reporting requirements and detail the gaps between company and auditor reporting.

 

Sears Holdings, the retailer that owns Kmart and Sears, provided an example of this gap in their Form 10-K for the year ended January 28, 2017. In their financial statements Sears Holdings included this language:

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 2016 and were required to fund cash used in operating activities with cash from investing and financing activities. We expect that the actions taken in 2016 and early 2017 will enhance our liquidity and financial flexibility. In addition, as previously discussed, we expect to generate additional liquidity through the monetization of our real estate and additional debt financing actions. 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 our real estate portfolio, in our transition from an asset intensive, historically “store-only” based retailer to a more asset light, integrated membership-focused company.

 

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements. However, we cannot predict, with certainty, the outcome of our actions to generate liquidity, including the availability of additional debt financing, or whether such actions would generate the expected liquidity as currently planned. In addition, 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 mechanisms described above or through some combination of other actions, while not expected, we may not be able to access additional funds 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 the indenture) falls below the principal amount of the notes plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for the notes on the last day of any two consecutive quarters, it could trigger an obligation to repurchase notes in an amount equal to such deficiency.

 

Sears Holdings used the term “substantial doubt”, but indicated that they believed their plans mitigated this “substantial doubt”.

 

This was the report of Sear’s Auditors:

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sears Holdings Corporation and subsidiaries as of January 28, 2017 and January 30, 2016, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 28, 2017, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 28, 2017, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

No mention of a going concern issue at all in the auditor’s report! What is an investor to think? Historically, when the only concrete guidance was in GAAS, it was very rare to see this issue not discussed in both the financial statements and the auditor’s report.

 

This is, of course, part of the gap between GAAP and GAAS. In our next post we will begin to explore the space in this gap!

 

 

As always, your thoughts and comments are welcome!

Frequent Comment Update: Part Two – Cash Flows

By: George M. Wilson & Carol A. Stacey

 

In our blog post “Time Again for a Frequent Comment Update”, we listed the frequent comment areas that CorpFin Staff members have been discussing at our Midyear Forums. In that post, we also highlighted a number of recent comments about non-GAAP measures. In this post, we turn our attention to comments about the statement of cash flows.

 

In the last several years there have been a number of restatements related to the statement of cash flows, some undoubtedly related to comment letters. Additionally, the FASB and EITF have issued two ASU’s to address various issues in the statement of cash flows.

 

ASU 2016-15 in August 2016

Provides guidance on 8 specific cash flow issues

 

ASU 2016-18 in November 2016

Provides guidance on classification and presentation of restricted cash

 

 

There is much discussion about root causes for cash flow statement problems. Theories range from the idea that the statement is prepared late in the reporting process and perhaps tends to be a more mechanical, “do it the way we did it last year” process, to the fact that there are some areas that are ambiguous in the cash flow statement guidance. Whatever the causes, there is clearly a need for care and review in preparing the statement of cash flows.

 

This first comment is about being sure you are familiar with the statement of cash flow requirements and also addresses a frequent problem area of ASC 230, discontinued operations:

 

We note your presentation of the decrease in cash and cash equivalents from discontinued operations in one line item. Please note that ASC 230-10-45-10 requires that a statement of cash flows shall classify cash receipts and cash payments as resulting from investing, financing, or operating activities. Please revise your current presentation to classify the cash flows from discontinued operations within each of the operating, investing and financing categories.

 

Whether to show cash flows from financing activities on a gross or net basis is not a mechanical decision. It requires judgment about the substance of the financing as this comment demonstrates:

 

We note from your financing activities section in your statement of cash flows that you present net proceeds (repayments) of short-term borrowings rather than on a gross basis. Please explain to us your basis for this presentation. Refer to ASC 230-10-45-7 through 9.

 

Another interesting aspect of cash flow statement preparation is how to treat hybrid items that have an element of two different types of cash flows. This comment demonstrates this is not always a mechanical process:

 

We note your presentation of payments for the costs of solar energy systems, leased and to be leased. Given that approximately 61% of your revenues for the year ended December 31, 2015 and 64% of your revenues for the period ended June 30, 2016 represented solar energy systems and product sales, please tell us how you reflect the costs of solar energy systems sold on your statements of cash flows pursuant to ASC 230.

 

These last two comments are not strictly speaking financial statement comments. They are common MD&A comments, and definitely needs to be part of the statement of cash flows conversation. Frequently MD&A tries to explain operating cash flows with confusing or mechanical language relating to items in the indirect method reconciliation from net income to operating cash flows.

 

Note the mention of drivers in this comment:

 

We note that your discussion of cash flows from operating activities is essentially a recitation of the reconciling items identified on the face of the statement of cash flows. This does not appear to contribute substantively to an understanding of your cash flows. Rather, it repeats items that are readily determinable from the financial statements. When preparing the discussion and analysis of operating cash flows, you should address material changes in the underlying drivers that affect these cash flows. These disclosures should also include a discussion of the underlying reasons for changes in working capital items that affect operating cash flows. Please tell us how you considered the guidance in Section IV.B.1 of SEC Release 33-8350.

 

Lastly, note the focus on underlying reasons for change in this comment:

 

You say that in the statement of cash flows, you provide reconciliation from net loss to cash flows used in operating activities where you have provided quantitatively the sources of your operating cash flows. However, as you use the indirect method to prepare your cash flows from operating activities, merely reciting changes in line items reported in the statement of cash flows is not a sufficient basis for an investor to analyze the impact on cash. Therefore, please expand your disclosure of cash flows from operating activities to quantify factors to which material changes in cash flows are attributed and explain the underlying reasons for such changes. Refer to Section IV.B.1 of “Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations” available on our website at http://www.sec.gov/rules/interp/33-8350.htm for guidance. Provide us a copy of your intended revised disclosure.

 

 

As always, your thoughts and comments are welcome!

Fake SEC Filings and Enforcement in the Electronic Age

By: George M. Wilson & Carol A. Stacey

 

Over the many decades that equity securities have traded in the U.S., and over the centuries that equities have traded around the world, unscrupulous people have always tried to find ways to cheat others. From pump and dump schemes to fake analyst reports new ways are constantly evolving as less than ethical people look for a quick buck. One of the more recently developed sneaky tricks is to create a fictitious user ID in the SEC’s EDGAR system and try to manipulate a company’s stock with fake SEC filings such as tender offer documents. In a way this is kind of a “pump and dump” strategy, and it is all about fake news.

 

In February of this year an artist in Chicago used this trick to try and manipulate Alphabet’s stock. In May 2015, Avon stock was used in a similar scheme. In September 2015, a person used an SEC filing in the name of “LMZ & Berkshire Hathaway Co.” to try and manipulate Phillips 66 and Kraft Heinz. The report was signed with a false name.

 

That same false name was used on a filing to announce a fake tender offer for Fitbit in November 2017.

 

When there are new kinds of crimes, the SEC sets out to develop the right tools and techniques to find the perpetrators and protect investors and the markets from bad actors. They are making progress with this new kind of electronic and internet based crime. On May 19, 2017, fairly soon after the Fitbit false filing, the SEC announced an enforcement action against Robert W. Murray, the alleged perpetrator of this fraud, with a parallel criminal action by the U.S. Attorney’s Office for the Southern District of New York. Mr. Murry is a mechanical engineer based in Virginia.

 

According to the SEC Murray wove a tangled technical trail:

 

The SEC alleges that Murray created an email account under the name of someone he found on the internet, and the email account was used to gain access to the EDGAR system.  Murray then allegedly listed that person as the CFO of ABM Capital and used a business address associated with that person in the fake filing.  The SEC also alleges that Murray attempted to conceal his identity and actual location at the time of the filing after conducting research into prior SEC cases that highlighted the IP addresses the false filers used to submit forms on EDGAR.  According to the SEC’s complaint, it appeared as though the system was being accessed from a different state by using an IP address registered to a company located in Napa, California.

 

In the words of enforcement, this attempt to hide his actions did not work:

 

“As alleged in our complaint, Murray used deceptive techniques in a concerted effort to evade detection, but we were able to connect the dots quickly and hold him accountable,” said Stephanie Avakian, Acting Director of the SEC Enforcement Division.

 

For all his effort, and for the potential consequences, Murray’s ill-gotten gains in this scheme were only about $3,100!

 

Always fun to see how new ways to try and cheat don’t evade the consequences!

 

As always, your thoughts and comments are welcome!

 

Demystifying Alternative Financing Solutions for Emerging and Growing Companies

Auditors and Financial Officers of companies who raise capital with complex financial instruments often find themselves drowning in convoluted accounting issues and restatements. Avoid the confusion by attending the live workshop, Debt vs. Equity Accounting for Complex Financial Instruments being held June 23rd in San Francisco. Through a detailed review of the accounting literature and numerous examples and case studies this Workshop will help you build the knowledge and experience to appropriately recognize, initially record and subsequently account for these complex financing tools

http://www.pli.edu/Content/Debt_vs_Equity_Accounting_for_Complex_Financial/_/N-1z10odmZ4k?ID=290521&t=WLH7_PDAD

Time Again for a Frequent Comment Update

By: George M. Wilson & Carol A. Stacey

Every six months, when we do our Midyear Forums in May and June and again when we do our Annual Forums in November and December, we discuss the SEC Division of Corporation Finance’s presentation of frequent comment areas. At our recent Midyear in Dallas the staff discussed the topics below, which are not in any particular order:

 

  • Non-GAAP Measures
  • Statement of Cash Flows
  • Segments
  • Income Taxes
  • Business Combinations
  • Fair Value
  • Goodwill
  • Revenue Recognition
  • Disclosure of Recently Issued Standards
  • Compensation
  • Internal Control over Financial Reporting

 

As usual the list contains many familiar topics and themes. In the next several weeks we will post about each of these topics.

 

For this first post, we’ve chosen non-GAAP measures which shouldn’t be a surprise. We are all likely familiar with the SEC’s focus on this area and the C&DI’s they issued in May 2016. For our review here we thought we would explore three of the more problematic C&DI’s and recent staff comments for each of them:

 

Question 100.01, which is about whether or not presentation of certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading,

 

Question 100.04, which is about attempts to build tailored accounting principles that are not in accordance with GAAP, and

 

Question 102.10, which discusses “equal or great prominence”.

 

 

When is an Adjustment Misleading, Even if it is Not Specifically Prohibited?

 

The full text of this C&DI is:

 

Question 100.01

 

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

 

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading. [May 17, 2016]

 

 

The idea of “normal, recurring, cash operating expenses” can be subjective. Here is an example where that C&DI is translated into a comment:

 

We note that you exclude pre-opening expenses as part of your calculation of Adjusted EBITDA. Please explain to us why these are not normal, recurring, cash operating expenses necessary to operate your business. In this regard, we note pre-opening expenses for all periods presented, along with your discussion throughout the Form S-1 that your growth strategy is to expand the number of your stores from 71 to 400 within the next 15 years. Please refer to Question 100.01 of the updated Non-GAAP Compliance and Disclosure Interpretations issued on May 17, 2016.

 

Here is another similar example:

 

Management’s Discussion and Analysis Earnings Before Interest, Taxes, Depreciation and Amortization (Non-GAAP measure)

 

Please tell us how you concluded that the amounts in the acquisition-related adjustments reconciling item were appropriately excluded from your non-GAAP measures (e.g., adjusted EBITDA, adjusted gross margin and adjusted SG&A) presented here and in your Item 2.02 Forms 8-K filed October 25, 2016 and December 8, 2016. It appears that in each period presented you may be reversing a portion of your GAAP rental expense and removing recurring cash operating expenses, like sponsor fees and other costs. Refer to Non-GAAP Financial Measures Compliance and Disclosure Interpretation, Questions 100.01 and 100.04, which can be found at:

 

http://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.

 

What is a Tailored Accounting Principle?

 

The full text of the C&DI is:

 

Question 100.04

 

Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?

 

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.   [May 17, 2016]

 

Here are two comments to illustrate that a company should not try to tinker with GAAP to create their own accounting principles. This first comment is an attempt to adjust revenue recognition so that a non-GAAP measure would include revenue that is deferred under GAAP:

 

  1. We note your response to prior comment 4. The adjustment “change in deferred amusement revenue and ticket liability” in arriving at your non-GAAP measure “adjusted EBITDA” appears to accelerate the recognition of revenue associated with the deferred amusement and ticket liability that otherwise would not be recognized in any of the periods for which adjusted EBITDA is presented. Accordingly, adjusted EBITDA substitutes a tailored revenue recognition method for that prescribed by GAAP and does not comply with Question 100.04 of the staff’s Compliance & Discussion Interpretations on Non-GAAP Financial Measures. Please remove this adjustment from your computation.

 

This second comment shows an attempt to undo business combination accounting:

 

Refer to the line items, ‘purchase accounting adjustments,’ and ‘purchase accounting amortization’ within the reconciliation of net income to adjusted income before income taxes. Please explain to us the basis behind these adjustments as they appear to portray tailored accounting principle under GAAP for business combination. Refer to the guidance under Questions 100.01 and 100.04 of C&DI on Non-GAAP Financial Measures.

 

What Does Equal or Greater Prominence Mean?

 

The text of this much-discussed C&DI is:

 

Question 102.10

 

Question: Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K.  Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?

 

Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:

 

Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;

 

Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;

 

Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;

 

A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);

 

Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;

 

Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;

 

Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and

 

Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence. [May 17, 2016]

 

This C&DI created perhaps the most confusion, or maybe consternation, raising issues of what is bolded and which measure is presented first. This first example comment is about a recent earnings release:

 

Your headline references “Record Q1 Non-GAAP Revenues and EPS, Growing 29% and 44% Respectively Year-over-Year” but does not provide an equally prominent descriptive characterization of the comparable GAAP measure. We also note several instances where you present a non-GAAP measure without presenting the comparable GAAP measure. This is inconsistent with Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016 (“the updated C&DI’s”). Please review this guidance when preparing your next earnings release.

 

This second example is from a recent MD&A:

 

Management’s Discussion and Analysis Non-GAAP Measures

 

Return on Invested Capital, page 47

 

Please present the comparable GAAP measure with equal or greater prominence and label the non-GAAP calculation as “adjusted” or similar. Refer to Item10(e)(1)(i)(A) and Question 102.10 of staff’s Compliance and Discussion Interpretation on Non-GAAP Financial Measures for guidance.

 

And this last comment is from a 2016 earnings release:

 

  1. We have the following observations regarding the non-GAAP disclosures in your fourth quarter 2016 earnings release:

 

  • Your statement of “net sales growth across all segments” in the earnings release headline is inconsistent with the segment results table on page 3 and appears to be based on pro forma adjusted results excluding foreign currency translation impact. In this regard, we note that both the Consumer and Other segments had a decrease in the reported net sales in 2016.

 

  •  It appears that you provide earnings results discussion and analysis of only non- GAAP measures in the body of the release without providing a similar discussion and analysis of the comparable GAAP measures.

 

  •  The measure you refer to as “free cash flow” is adjusted for items in addition to what is commonly referred to as free cash flow.

 

Please revise future filings to use titles or descriptions for non-GAAP financial measures that accurately reflect the amounts presented or calculated, and are not the same as, or confusingly similar to, GAAP measures. Also, to the extent you continue to discuss your results based on non-GAAP measures, you should also provide the comparative measures determined according to GAAP with equal or greater prominence. Refer to Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016.

 

Stay tuned for our next topic, the statement of cash flows next week, and as always, your thoughts and comments are welcome!

New FASB Lease Guidance – Any Early Adopters?

FASB lease guidance is effective in 2019 but early adoption is permitted. Are there any companies considering early adoption?

Here at SECI, the only early adopter that we know about so far is Microsoft.  They plan to early adopt on July 1, 2017 as their fiscal year ends June 30, 2017.

This is from their March 31, 2017 quarterly report on Form 10-Q:

Leases

In February 2016, the FASB issued a new standard related to leases to increase transparency and comparability among organizations by requiring the recognition of right-of-use (“ROU”) assets and lease liabilities on the balance sheet. Most prominent among the changes in the standard is the recognition of ROU assets and lease liabilities by lessees for those leases classified as operating leases under current U.S. GAAP. Under the standard, disclosures are required to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. We will be required to recognize and measure leases existing at, or entered into after, the beginning of the earliest comparative period presented using a modified retrospective approach, with certain practical expedients available.

The standard will be effective for us beginning July 1, 2019, with early adoption permitted. We plan to adopt the standard effective July 1, 2017 concurrent with our adoption of the new standard related to revenue recognition. We intend to elect the available practical expedients on adoption. While our ability to early adopt 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 anticipate this standard will have a material impact on our consolidated balance sheets. However, we do not expect adoption will have a material impact on our consolidated income statements. While we are continuing to assess potential impacts of the standard, we currently expect the most significant impact will be the recognition of ROU assets and lease liabilities for operating leases. We expect our accounting for capital leases 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 expect adoption of the standard will result in the recognition of additional ROU assets and lease liabilities for operating leases of approximately $5 billion as of June 30, 2016. ROU assets and lease liabilities for operating leases are expected to increase in fiscal year 2017 primarily due to the acquisition of LinkedIn Corporation (“LinkedIn”) and additional datacenter leases.

SECI is holding a live interactive workshop on Lease Accounting in New York and San Francisco.  Join us to hear more about how to implement the new standard!

Implementing the FASB’s New Lease Accounting Standard Workshop being held September 8th & November 3rd in New York City and October 16th in San Francisco. Attendees will learn the conceptual underpinnings, overall structure and details of this new standard as it applies to both lessees and lessors. Implementation considerations, system issues and related topics will be discussed in detail and concepts will be reinforced by use of examples and case studies.

http://www.pli.edu/Content/Implementing_the_FASB_s_New_Lease_Accounting/_/N-1z10dmcZ4k?ID=309314&t=WLH7_DPAD

Projects, Pronouncements and Developments Affecting Your SEC Reporting

How do the latest SEC, EITF, PCAOB and FASB updates affect your reporting? Attend FASB, SEC and PCAOB Update for SEC Reporting Professionals Workshop being held August 23rd in Grapevine, Tx. Get up to date in-depth information on all the latest developments and practical tips on applying existing financial reporting requirements, including pushdown accounting, debt issuance costs and commitment fees, discontinued operations and dispositions, segment reporting and goodwill impairment.

http://www.pli.edu/Content/FASB_SEC_and_PCAOB_Update_for_SEC_Reporting/_/N-1z10odqZ4k?ID=290526