Category Archives: Comment of the Week

Contingent Consideration and an SEC Comment

One of the more challenging estimates accounting for business combinations requires us to make is the fair value of contingent consideration.  This seems like a particularly challenging process because one of the reasons contingent consideration may be part of a deal is that the buyer and seller of the business could not agree on a price!  Nevertheless, in a transaction that involves contingent consideration ASC 805 states:

Contingent Consideration

805-30-25-5

The consideration the acquirer transfers in exchange for the acquiree includes any asset or liability resulting from a contingent consideration arrangement. The acquirer shall recognize the acquisition-date fair value of contingent consideration as part of the consideration transferred in exchange for the acquiree.

So, despite the fact that the buyer and seller of the business did not agree on a price, we accountants estimate the fair value of the contingent consideration.

As time passes and circumstances evolve or become clearer this estimate is bound to change.  Hence this subsequent measurement guidance:

Contingent Consideration

805-30-35-1

Some changes in the fair value of contingent consideration that the acquirer recognizes after the acquisition date may be the result of additional information about facts and circumstances that existed at the acquisition date that the acquirer obtained after that date. Such changes are measurement period adjustments in accordance with paragraphs 805-10-25-13 through 25-18 and Section 805-10-30. However, changes resulting from events after the acquisition date, such as meeting an earnings target, reaching a specified share price, or reaching a milestone on a research and development project, are not measurement period adjustments. The acquirer shall account for changes in the fair value of contingent consideration that are not measurement period adjustments as follows:

a.  Contingent consideration classified as equity shall not be remeasured and its subsequent settlement shall be accounted for within equity.

b.  Contingent consideration classified as an asset or a liability shall be remeasured to fair value at each reporting date until the contingency is resolved. The changes in fair value shall be recognized in earnings unless the arrangement is a hedging instrument for which Topic 815requires the changes to be initially recognized in other comprehensive income.

Changes to estimates of contingent consideration, except in extremely simple cases, are inevitable.  And, the opportunity to use such estimates for earnings management or other manipulative purposes is clear.  As you would expect, the SEC CorpFin staff asks questions when they see unusual fluctuations.  Here is one example comment:

  1. We note a significant gain of $31 million recorded during 2017 relating to a reduction in the contingent consideration of an acquisition in 2015. Please tell us, and revise to disclose, the nature of the events that lead to the reduction in the contingent consideration and how the reduced amount was calculated or determined.

The issue in the company’s financial statements underlying this comment was a decrease in SG&A from $151,353,000 in 2016 to $133,314,000 in 2017.  Net income for 2017 increased over net income for 2016 by $2,500,000.  The company’s disclosures surrounding this challenging contingent consideration estimate included the following: (note that the amounts in this footnote are in 000’s)

Note 1 –    GENERAL (Cont.)

ACQUISITIONS AND INVESTMENTS

In July 2015, the Company acquired a division from an Israeli-based company (the “Seller”), for a total consideration of approximately $154,000, of which approximately $40,000 is contingent consideration, which may become payable on the occurrence of certain future events.

In December 2016, following certain claims and allegations demanding indemnification pursuant to the asset purchase agreement, the Company signed a settlement agreement with the Seller, in which the parties agreed on certain cash payments and a reduction of up to $4,000 from any contingent consideration payment to Seller. During 2017, the Company recognized a reduction of approximately $31,200 in its contingent consideration related to the acquisition of the division from the Seller (the reductions in the contingent consideration offset general and administrative expenses).

With all that as prelude, here is the company’s response to the SEC’s comment:

 Response:

The asset purchase agreement (“APA”) applicable to the 2015 acquisition provided for contingent consideration to be paid to the seller if the acquired division met certain post-acquisition performance targets.  Such performance targets were based on accumulated revenues during, and surplus backlog (based on actual orders received) at the end of, an earn-out period starting January 1, 2015 and ending December 31, 2017 (the “earn-out period”).

It should be noted that due to orders that could have been booked up to the last day of the earn-out period, the surplus backlog could be finally determined only at the end of 2017, based on order bookings and revenues up to that date.

The APA provided that any contingent consideration was to be determined following the end of 2017, with the Company delivering its calculation thereof to the seller by March 31, 2018, whereupon the seller would have a period of 45 days to review and notify the Company of any dispute with Company’s computation of the earn-out.

Following the end of the earn-out period, on December 31, 2017, the Company considered the facts and circumstances at that date and performed a detailed analysis involving the sales & marketing, finance and corporate management departments, to conclude whether the acquired division’s performance achieved the targets set forth in the APA. The Company’s analysis included a review of the acquired division’s actual revenues during the earn-out period as well as a review of the actual backlog as of December 31, 2017, the earn-out period expiration date.

Additionally, because of a possible commercial dispute with the seller due to the possible subjective judgment involved in determining the surplus backlog, and since the seller’s review and dispute period had not commenced, the Company assessed the likelihood of whether the seller might object to such a determination and retained contingent consideration of $4.5 million, which represented the Company’s best estimate for a potential settlement after the seller’s review of the calculations. Accordingly, the Company recognized a net gain of approximately $31 million resulting from the adjustment of the carrying amount of the earn-out contingent liability at December 31, 2017, which was recognized in general and administrative expenses on the consolidated statements of income.

During the first quarter of 2018, the Company delivered to the seller a schedule setting forth a computation of the earn-out amount, informing the seller that the performance targets under the APA were not met and no earn-out payment was required. During the second quarter of 2018, the seller’s review period expired without any claims made by the seller. Therefore, the Company decreased the earn-out contingent liability to $0.

In view of the circumstances described above regarding the contingent earn-out obligation and its resolution and finalization during 2018, we propose the following additional disclosure in our future filings, commencing with our 2018 Form 20-F, which will be filed in March 2019 (revisions are marked in underlined italics for the convenience of the Staff):

“During 2018 and 2017, the Company recognized reductions of approximately $4,500 and $31,200, respectively, in its earn-out contingent liability related to the acquisition of a division, since the Company concluded that the acquired division had not achieved the performance requirements necessary for making contingent earn-out paymentsFurther, in May 2018, the period in which the Seller could have filed a dispute over the earn-out computation expired without any claim or demand from the Seller. The income resulting from the reductions in the contingent consideration liability was recognized in general and administrative expenses.”

The next letter from the SEC?  The one we like to see:

We have completed our review of your filing. We remind you that the company and its management are responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff.

 Yes, it is an estimate.  And yes, it is challenging.  And yes, a reasonable, well documented approach to such estimates is crucial!  This will become even more important when the PCAOB’s new standard about auditing accounting estimates becomes effective.  More about this in a future post.

As always, your thoughts and comments are welcome!

 

An SEC Comment Challenge: Find the Non-GAAP Measure Issue – Post Three

In this series of posts we are focusing on non-GAAP measure problems and related SEC comments.  As the first and second posts in this series did, this post gives you an opportunity to see if you can spot the issue, and then provides the background and SEC guidance behind the issue.

As a brief reminder, the SEC’s guidance about the use of non-GAAP measures is primarily in three places:

Regulation G for non-GAAP measures used anywhere,

S-K Item 10(e), for non-GAAP measures in filed documents, and

The related Compliance and Disclosure Interpretations.

 Just like the first and second posts in this series, you can read the excerpt of the release behind the comment and try to spot the issue.  If you prefer, you can read straight through to the comment and explanation that follow.

These excerpts are from Papa John’s International, Inc’s Form 10-K for the fiscal year ended December 29, 2019.  Can you spot the non-GAAP issue?  As you review this information, focus your thoughts on the “special charges” and in particular the “Marketing fund investments.”

To begin, here is one of the non-GAAP measures presented by Papa John’s:

PapaJohn One

Papa John’s also provided this detail about the special charges:

PapaJohn Two

As you review the list of non-GAAP adjustments, letter (b) regarding marketing support to franchisees seems like it is a cash expense.

This is the comment the SEC issued about this non-GAAP adjustment:

Form 10-K for the Fiscal Year Ended December 29, 2019

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Items Impacting Comparability; Non-GAAP Measures, page 40

  1. Please tell us the consideration you gave to Question 100.01 of the Non-GAAP Financial Measures Compliance and Disclosure Interpretations in adjusting your non-GAAP measures to remove marketing fund investments made by you.

The C&DI referenced, Question 100.01 makes a very important point:

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]

This is Papa John’s first of two responses to this comment:

We did consider the guidance in Question 100.01 of the Non-GAAP Financial Measures Compliance and Disclosure Interpretations in our presentation of our adjusted (non-GAAP) financial results excluding marketing fund investments identified as “Special charges.” The marketing fund investments included in “Special charges” of $27.5 million and $10.0 million for the years ended December 29, 2019 and December 30, 2018, respectively, represent discretionary, non-contractual marketing fund investments to support national media initiatives. Domestic Company-owned and franchised Papa John’s restaurants are required to contribute a certain minimum percentage of their sales (currently 5.0% of sales) to the Papa John’s Marketing Fund, our national marketing fund, which are not included as part of the “Special charges.” The national marketing fund is responsible for developing and conducting marketing and advertising for the domestic Papa John’s system. Beginning in the fourth quarter of 2018, the Company began making significant discretionary, non-contractual marketing fund investments to supplement the contractual Company-owned and franchised restaurant-level system contributions.  These discretionary, non-contractual marketing fund investments were part of the Company’s previously announced program of increased support and financial assistance to the North America franchise system in response to the severe decline in North America sales. The decline in North America sales followed extensive negative publicity and consumer sentiment as a result of statements by the Company’s founder and former spokesman in late 2017 and July 2018. The discretionary, non-contractual marketing fund investments were made as a response to these extraordinary adverse events to defend and repair the brand’s reputation and were not made in the ordinary course of business.

Question 100.01 notes that a non-GAAP financial measure may be misleading if it excludes “normal, recurring, cash operating expenses necessary to operate a registrant’s business.” The Company does not consider the incremental marketing fund investments to be normal, recurring, cash operating expenses necessary to operate the Company’s business. Furthermore, as stated in the Company’s Form 10-K for the fiscal year ended December 29, 2019, such investments are of a limited duration and are only “expected to continue through the third quarter of 2020”, which further supports the conclusion that the charges are not of a recurring nature. As a result, we do not consider these investments to be representative of our underlying operating performance and thus believe the exclusion in our non-GAAP financial results provides investors with important additional information regarding our underlying operating results and is important for purposes of comparisons to prior year results.  In addition, management uses the non-GAAP financial results to evaluate the Company’s underlying operating performance and to analyze trends. Accordingly, we respectfully advise the staff that we considered the guidance in Question 100.01 and believe that the exclusion of the discretionary marketing fund investments from our non-GAAP financial results and the related presentation and disclosure does not cause those results to be misleading.

To help further clarify the nature of these charges, beginning in our Form 10-Q for the quarter ended March 29, 2020, we will revise the footnoted description of these marketing fund investments in our “Special charges” table as follows: “Represents incremental discretionary marketing fund investments in excess of contractual Company-owned restaurant-level contributions, which were made as part of our previously announced temporary support package to our franchisees.”

After this first response the SEC and Papa John’s had further phone discussions about this issue.  Interestingly, the SEC did not issue a second comment letter.  While we cannot know the content of these discussions, they were clearly substantive.  They resulted in this final answer by Papa John’s:

Response: As discussed during the phone conversation between the Staff and the Company on April 24, 2020, beginning with the Company’s earnings release for the first quarter of fiscal 2020, the Company will no longer present adjusted (non-GAAP) financial results excluding the marketing fund investments made by the Company.

As always, your thoughts and comments are welcome!

An SEC Comment Challenge: Find the Non-GAAP Measure Issue – Post Two

In this series of posts we are focusing on non-GAAP measure problems and related SEC comments in earnings releases.  As the first post in this series did, this post gives you an opportunity to see if you can spot the issue, and then provides the background and SEC guidance about the issue.

As a brief reminder, the SEC’s guidance about the use of non-GAAP measures is primarily in three places:

Regulation G for non-GAAP measures used anywhere,

S-K Item 10(e), for non-GAAP measures in filed documents, and

The related Compliance and Disclosure Interpretations.

 Just like the first post in this series, you can read the excerpt of the release behind the comment and try to spot the issue.  If you prefer, you can read straight through to the comment and explanation that follow.

This excerpt is from an 8-K filed by The Interpublic Group of Companies on April 22, 2020.  Can you spot the non-GAAP issue?

Interpublic One

The issue here goes back to the concept that companies should not try to create the impression that non-GAAP measures provide a better view of the company than GAAP.  Here is the related SEC comment:

Form 8-K filed April 22, 2020

Exhibit 99.1
Reconciliation of Adjusted Results, page 7

  1. Please tell us your consideration of the guidance in Question 102.10 of the Non-GAAP Compliance and Disclosure Interpretations related to your presentation of full non-GAAP income statements when reconciling non-GAAP measures in your earnings releases.

The C&DI mentioned states:

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]

The issue behind this comment is that the company presented a full non-GAAP income statement.  The SEC does not permit this kind of presentation.

This is the Company’s response to the comment:

The Company acknowledges the Staff’s comment and advises that it had not previously viewed the non-GAAP reconciliation on page 7 to be a full non-GAAP income statement but will revise its disclosures going forward to ensure that future non-GAAP reconciliations in the Company’s earnings releases and other investor materials do not resemble full non-GAAP income statements. Below please find an example of how the Company intends to present future non-GAAP reconciliations, using the quarter ended March 31, 2020 results for illustrative purposes. We note that this presentation is also included in our Investor Presentation which was included as Exhibit 99.2 to Form 8-K filed on April 22, 2020.

Interpublic Fixed

As always, your thoughts and comments are welcome!

But Wait … there’s More!

By: George M. Wilson & Carol A. Stacey

If the words above seem to be “borrowed”, they are. Their source is the iconic Ron Popeil, founder of Ronco. From the Veg-o-Matic to the Beef Jerky Machine, and all the creative products in between, it is hard to find a person who does not know of Ronco products.

 

In this “deal”, the “more” that Ron Popeil always promises is that Ronco is in the process of selling stock. Hoping to raise as much as $30,000,000, the Company is using Tier 2 of Regulation A and has a Form 1-A available to view on its website.

 

This is an interesting example of the Reg A process.

 

But wait ….. for there’s more – You can also order a Deluxe Veg-o-Matic on the same web page!

 

As always, your thoughts and comments are welcome!

Year-End Topic 6 – Should You Consider Any Issues for OCA Consultation?

As we approach year-end another issue to plan well in advance is whether or not you should ask OCA to pre-clear any extremely complex or subjective accounting decisions. This is a well-established process and when you are faced with a complex transaction, extremely subjective accounting determinations or an area where GAAP is not clearly established it makes sense to pre-clear the issue and avoid the possibility of restatement, amendment, or getting hung up in the CorpFin comment process. This is especially true when we know we will all be reviewed at least once every three years.

 

OCA’s process for consultation is outlined here. The process does need a significant amount of preparation and usually requires a few weeks to complete, sometimes more, so advance planning is important.   The document link above has a very detailed list of what needs to be included in your correspondence with OCA and what to expect from the process.

 

Since this is a consultation with the Office of the Chief Accountant, the answer you get will be definitive and cannot be over-ridden in the review process.

 

There is also a telephone consultation service you can use to consult with the CorpFin Chief Accountants office, a different process of course, but sometimes a good starting point. You can find out about this less formal process here.

 

Lastly, here is a recent list of frequent OCA consultation areas you can use to access whether your issues would benefit from this process:

 

Revenue Recognition, gross vs net etc.

Business combinations, who is the acquirer, business vs assets, contingent consideration

Financial assets, impairments valuation

Segments and aggregation

Consolidation VIE

Long lived assets, e.g. goodwill impairment

Taxes,

Leases

Pension

Debt vs equity

 

As always, your thoughts and comments are welcome!

SEC Review News – No More “Tandy” Language

Have you ever wondered why the SEC puts this language at the end of every comment letter?

We urge all persons who are responsible for the accuracy and adequacy of the disclosure in the filing to be certain that the filing includes the information the Securities Exchange Act of 1934 and all applicable Exchange Act rules require. Since the company and its management are in possession of all facts relating to a company’s disclosure, they are responsible for the accuracy and adequacy of the disclosures they have made.

In responding to our comments, please provide a written statement from the company acknowledging that:

  • the company is responsible for the adequacy and accuracy of the disclosure in the filing;
  • staff comments or changes to disclosure in response to staff comments do not foreclose the Commission from taking any action with respect to the filing; and
  • the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.

The history of this language goes all the way back to the 70’s. Tandy was the first company to receive this language in a comment letter. The comment process had been asserted as a possible defense and the staff wanted to make it clear that this was not appropriate. It was in 2004, after a flood of FOIA requests to obtain comment letters, that the staff decided to make all comment letters and responses public. With that decision they decided to require “Tandy” language in all comment letter responses. You can read more in this 2004 release.

The Staff has now changed their position. Since this language has been around for so long they will no longer require it in each response. Instead, the staff will simply put this language in comment letters:

We remind you that the company and its management are responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff.

You can read the details here.

The change is effective immediately, so all comment letter responses after October 5, 2016 do not need the “Tandy” language.

As always, your thoughts and comments are welcome!

 

Disclosures About Risks and Uncertainties

All the news about Apple’s international tax situation, a significant uncertainty that they and many other companies face, presents a great opportunity to review how uncertainties and the big questions they pose should be disclosed.

Developing disclosures about uncertainties is never simple. One reason for this complexity is how many areas they can affect in a 10-K or 10-Q. The key places to focus are:

Risk Factors

Financial statements – GAAP contingency disclosures

MD&A – possible known trend disclosures

The key disclosures will be in the three above items, and that is where we will focus for now. It is important to remember though that other areas could be involved. Disclosure might be included for example in legal proceedings in Item 3 (which would generally be similar to the financial statement disclosures but would likely include more details) and perhaps even the business description in Item 1 if the uncertainty was a significant general development.

Risk Factor Disclosure

S-K Item 503(c) contains this requirement:

(c) Risk factors. Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make the offering speculative or risky. This discussion must be concise and organized logically.

Clearly a material uncertainty could fall into this disclosure requirement. Apple talked about tax issues in their most recent Form 10-Q Part II Item 1A disclosure (emphasis added):

The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities.

The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. For example, in June 2014, the European Commission opened a formal investigation of Ireland to examine whether decisions by the tax authorities with regard to the corporate income tax to be paid by two of the Company’s Irish subsidiaries comply with European Union rules on state aid. If the European Commission were to conclude against Ireland, it could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid, and such amount could be material.

The Company is also subject to the examination of its tax returns and other tax matters by the Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition, operating results and cash flows could be adversely affected.

 

Financial Statement Disclosures

After the risk factor, where perhaps we use an “everything including the kitchen sink” approach, Apple goes further. In the notes to the financial statements they included this disclosure. Note here that ASC 450 dealing with contingencies and the three levels of probability — probable, reasonably possible and remote — would apply, along with guidance about uncertain tax positions. Here, along with disclosure about other tax issues, Apple discloses the issue again (check out the last paragraph in particular).

Note 5 – Income Taxes

As of June 25, 2016, the Company recorded gross unrecognized tax benefits of $7.6 billion, of which $2.8 billion, if recognized, would affect the Company’s effective tax rate. As of September 26, 2015, the total amount of gross unrecognized tax benefits was $6.9 billion, of which $2.5 billion, if recognized, would have affected the Company’s effective tax rate. The Company’s total gross unrecognized tax benefits are classified as other non-current liabilities in the Condensed Consolidated Balance Sheets. The Company had $1.5 billion and $1.3 billion of gross interest and penalties accrued as of June 25, 2016 and September 26, 2015, respectively, which are classified as other non-current liabilities in the Condensed Consolidated Balance Sheets.

Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease (whether by payment, release or a combination of both) in the next 12 months by as much as $800 million.

On June 11, 2014, the European Commission issued an opening decision initiating a formal investigation against Ireland for alleged state aid to the Company. The opening decision concerns the allocation of profits for taxation purposes of the Irish branches of two subsidiaries of the Company. The Company believes the European Commission’s assertions are without merit. If the European Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount could be material, as of June 25, 2016 the Company is unable to estimate the impact.

One of the areas the SEC focuses on in reviewing contingency disclosures is the “reasonably possible” probability level. In this situation disclosure is required and an amount must be disclosed if it can be estimated. If it can’t be estimated disclosure is still required.

 

MD&A

 

And, lastly MD&A requires disclosure of known trends and uncertainties. The language in S-K Item 303 includes this requirement:

 

 

(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.

 

Here is an excerpt from Apple’s MD&A.

 

 

On June 11, 2014, the European Commission issued an opening decision initiating a formal investigation against Ireland for alleged state aid to the Company. The opening decision concerns the allocation of profits for taxation purposes of the Irish branches of two subsidiaries of the Company. The Company believes the European Commission’s assertions are without merit. If the European Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount could be material, as of June 25, 2016 the Company is unable to estimate the impact.

 

 

Uncertainty disclosures are never easy, and with all the areas that can potentially be involved, a place to be very careful!

 

As always, your thoughts and comments are welcome!

Year-End Planning – Number Four – Recently Issued Accounting Standards and a Few Example Comments

In recent weeks we have been posting about areas to deal with in advance of year-end. So far we have addressed:

Issues in the Statement of Cash Flows

Evaluating and Auditing ICFR

The New Item 16 Form 10-K Summary

 

The spirit and rationale behind these posts is that it is always a good idea to proactively anticipate problems that may arise and act to keep issues from becoming problems.

As we continue this series our next post is about SAB 74 (Topic 11-M in the SAB Codification), the requirement for disclosures about recently issued accounting standards.

 

With the major changes coming from the new revenue recognition standard, the new lease standard, and for financial companies the new financial instrument impairment standard, these disclosures become increasingly important. Users need to be forewarned about the expected impact of these new standards. This is essentially a known trend disclosure in your MD&A.

 

Here is an excerpt from Topic 11-M. You can read the entire SAB here.

 

Interpretive Response: The staff believes that the registrant should evaluate each new accounting standard to determine the appropriate disclosure and recognizes that the level of information available to the registrant will differ with respect to various standards and from one registrant to another. The objectives of the disclosure should be to (1) notify the reader of the disclosure documents that a standard has been issued which the registrant will be required to adopt in the future and (2) assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the registrant when adopted. The staff understands that the registrant will only be able to disclose information that is known.

 

The following disclosures should generally be considered by the registrant:

 

A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier.

 

A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.

 

A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made.

 

Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.

 

 

As a company gets closer to the adoption date for a new standard these disclosures should evolve. And although “[t]he staff understands that the registrant will only be able to disclose information that is known”, the other side of this disclosure is that when you know something, you should disclose it!

 

One last heads up – when you file your 10-K for the year before adoption, in other words you will adopt the day after that year-end, the staff will likely expect robust disclosure, including quantification of the impact of adoption.

 

When a company has decided which method it will use to adopt, it should disclose that information!

 

As a company researches and builds an understanding of how much a new standard will affect the financial statements, this impact should be disclosed.

 

Frequently we are concerned that there is uncertainty in this process, and that is never comfortable to discuss in an SEC report. Here are two excerpts that are examples of this disclosure from a June 30, 2016 Form 10-K. They deal with this uncertainty (emphasis added):

 

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 lease assets and lease liabilities on the balance sheet. Most prominent among the amendments is the recognition of assets and liabilities by lessees for those leases classified as operating leases under previous U.S. GAAP. Under the new 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 at the beginning of the earliest period presented using a modified retrospective approach.

 

The new standard will be effective for us beginning July 1, 2019, with early adoption permitted. We currently anticipate early adoption of the new standard effective July 1, 2017 in conjunction with our adoption of the new revenue standard. Our ability to early adopt is dependent on system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements.

 

We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for office, retail, and datacenter operating leases.

 

Revenue from Contracts with Customers

 

In May 2014, the FASB issued a new standard related to revenue recognition. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which 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 FASB has recently issued several amendments to the standard, including clarification on accounting for licenses of intellectual property and identifying performance obligations.

 

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 (the cumulative catch-up transition method). We currently anticipate adopting the standard using the full retrospective method to restate each prior reporting period presented.

 

The new standard will be effective for us beginning July 1, 2018, and adoption as of the original effective date of July 1, 2017 is permitted. We currently anticipate early adoption of the new standard effective July 1, 2017. Our ability to early adopt using the full retrospective method is dependent on system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements.

 

We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for software license revenue. We expect revenue related to hardware, cloud offerings, and professional services to remain substantially unchanged. Specifically, under the new standard we expect to recognize (Product A) revenue predominantly at the time of billing rather than ratably over the life of the related device. We also expect to recognize license revenue at the time of billing 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 be dependent on contract-specific terms, and may vary in some instances from recognition at the time of billing.

 

We currently believe that the net change in (Product A) revenue from period to period is indicative of the net change in revenue we expect from the adoption of the new standard.

 

Lastly, as we always like to do, here are two example comments to reinforce the issues in this disclosure:

 

Please revise your disclosures to fully comply with Question 2 of SAB Topic 11:M for each standard listed. Specifically, if early adoption is permitted, you should state the date that you plan to adopt the standard. You should also discuss the impact that adoption of each standard is expected to have on your financial statements or, if applicable, make a statement to the effect that you are still assessing the impact that adoption of each standard will have on your financial statements and the impact is not known or reasonably estimable at this time.

 

Please revise to include a discussion of the potential effects that recently issued accounting standards will have on your financial statements when adopted in a future period. Refer to SAB Topic 11.M. For example, please revise to disclose the potential effect of ASU No. 2014-09, Revenue from Contracts with Customers.

$100 Million in Whistleblower Awards!

Way back in April of 2015 we did a post about whistleblowers and the upside financial risk in blowing the whistleblowing to the SEC. The Sarbanes-Oxley whistleblower process requires an anonymous path to the audit committee, but the Dodd-Frank process, which is direct to the SEC, is the whistleblower path that can result in financial rewards.

 

This week the SEC announced that awards under this program have now exceeded $100 million. This happened after the recent payment of the program’s second largest award, $22 million.

 

To add a bit of focus, in the related press release, Enforcement Division Director Andrew Ceresney said:

 

“The SEC whistleblower program has had a transformative impact on the agency, enabling us to bring high quality enforcement cases quicker using fewer resources,” said Andrew Ceresney, Director of the SEC Division of Enforcement. “The ultimate goal of our whistleblower program is to deter securities violations and paying more than $100 million in whistleblower awards demonstrates the value that whistleblowers have added to our enforcement program.”

 

As always, your thoughts and comments are welcome!

Year End Planning Topic 3 – The New Item 16 Form 10-K Summary (and Disclosure Philosophy!)

Everyone who works with SEC periodic reports knows that making changes to disclosure is not a simple process. Reporting involves so many stakeholders and so many approval points that without an early start it is almost impossible to make improvements (or even simple changes such as formatting!).

This post is about one possible change that will need some time for consideration, adding the new Item 16 summary. With this reminder hopefully you will have enough time to consider whether this optional item makes sense for you.

This kind of summary has always been permitted, or at least never prohibited. However, in the process of making periodic reports more about communication than compliance, the FAST Act required the SEC to formally put a summary into Form 10-K, hence new Item 16. You can read the text of Item 16 in this post.

Your Communication Philosophy

If you read a lot of Form 10-K’s (and what is more fun than that?) you will see a variety of communication styles. We discuss different communication styles or “philosophies” in our workshops. We encourage companies to articulate their “philosophy” of disclosure.

To simplify a bit, some companies adopt a very “compliance” based philosophy for disclosure. In this model companies disclose what the SEC requires to be disclosed and essentially nothing more. This can be done in a fairly mechanical fashion and is usually very simple and direct, if not almost terse.

At the other end of a disclosure spectrum some companies adopt a more “communications” based philosophy where they disclose more than the bare bones requirements in an effort to tell a more complete “story” of how their company operates.

A simple example of this difference can be found in Form 10-K Item 1. This is the description of the business and the required disclosures are in Regulation S-K Item 101. Nowhere in Item 101 is there any requirement to disclose a company’s business strategy. And many companies do not say anything about the strategic orientation of their business. And yet, many companies discuss their strategy at length. Check out the differences in these two companies:

Here is a very well done example for an SRC (Golden Enterprises) of the compliance approach. Golden makes snack foods and does a simple, direct presentation. (Also, best potato chips ever!)

Here is another well-done example of a company (Square) that uses a more communications oriented approach. Square is a payment processor and supports businesses in many ways.

To be clear, there is no right or wrong way in this discussion; we are talking about a judgment you need to make. So, why do some companies disclose more than the S-K requirement?   These companies are considering disclosure as more than a compliance process. They are using the reporting process as a communications tool.

If you are going to focus more on communication the SEC’s Interim Final Rule about a Form 10-K summary could be a new element in your communication strategy. Almost every business writer will suggest that an executive level overview for a long document is a good communication strategy.

FR 72 suggested this for MD&A way back in 2003:

Many companies’ MD&A could benefit from adding an introductory section or overview that would facilitate a reader’s understanding. As with all disclosure, what companies would appropriately include in an introduction or overview will depend on the circumstances of the particular company. As a general matter, an introduction or overview should include the most important matters on which a company’s executives focus in evaluating financial condition and operating performance and provide the context for the discussion and analysis of the financial statements. Therefore, an introduction or overview should not be a duplicative layer of disclosure that merely repeats the more detailed discussion and analysis that follows.

In recent remarks the SEC staff has said they are seeing more companies using their filings as communication documents and this trend certainly fits into the SEC’s disclosure effectiveness program.

So, as you get into your annual reporting process, be sure you articulate this overall strategy for disclosure, and if you think it appropriate, put consideration of the new Item 16 summary into your thought process.

As always, your thoughts and comments are welcome!