Preparing for Year-End 2018: Number Five – Are Market Risk Disclosures Getting More Scrutiny?

One area where companies have not received many SEC comments – and, in all honesty, we don’t like to think about much – is market risk disclosures in Item 7A of Form 10-K and Part 1 – Item 3 in Form 10-Q.  In this time of more volatile markets this forward-looking disclosure about the extent of risk is becoming more important.

We have recently seen three comment letters with questions about market risk disclosures.  In a June 27, 2018 letter the only comment the company received was this market risk question:

Item 7A. Quantitative and Qualitative Disclosures about Market Risk, page 60

  1. Please tell us how you determined it was unnecessary to provide quantitative disclosures about foreign currency exchange risk. Please refer to Item 305 of Regulation S-K.

Another June 27, 2018 letter contained this comment:

Form 10-K for the Fiscal Year Ended December 31, 2017

Market Risks, page K-29

We note that you are exposed to market risk related to the fluctuations of interest rates on your fixed and floating-rate debt instruments, i.e. interest rate risk. Please revise your future filings to disclose the interest rate risk with respect to your fixed rate debt instruments using one of the three disclosure alternatives as prescribed under Item 305(a) of Regulation S-K.

In an August 29, 2018 letter a company received this market risk comment:

  1. We note that you are exposed to the following market risks: interest rate risk related to your debt instruments, foreign currency exchange rate risk related to your construction contracts denominated in euros, and fuel price risk related to your operations. Please revise your future filings to disclose for all market risks the quantitative information for the preceding fiscal year along with the reasons for material changes in amounts from the preceding year. Refer to 305(a)(3) and Instruction 3(F) to Item 305(a) of Regulation S-K.

Market risk disclosures as required by Regulation S-K Item 305 are one of the more complex and least understood disclosures required in periodic reports.  Part of the issue with these disclosures is that they are entirely forward looking and are designed to help investors understand how much a future price or rate change could affect the business.  This post from 2015walks though the objectives of the disclosure and breaks down the S-K Item 305 requirements.

While there is not a lot of public discussion about market risk, in this time of more volatile markets it is not unexpected that it should get more emphasis.  We would suggest taking a fresh look at your disclosures to be sure they are on-point.

As always, your thoughts and comments are welcome!

Non-GAAP Fines? Yes! Don’t Forget “Equal or Greater Prominence”!

On December 26, 2018, the SEC levied a fine on a company that failed to follow the Regulation S-K Item 10 (e) guidance concerning the use of non-GAAP measures.  Specifically, the company did not present the most directly comparable GAAP measure with equal or greater prominence in the headline and highlights in two of its earnings releases.

As you can read about here, the issue was aggravated because while the company touted increases in non-GAAP measures such as adjusted EBITDA, which showed “profitability” in the headline and highlights of its earnings releases, the comparable GAAP measure, net loss, had actually worsened.  It clearly raises concerns when a non-GAAP measure shows profitability and the comparable GAAP measure shows a loss and where the measures are moving in different directions.

The company agreed to pay a fine of $100,000.

As always, your thoughts and comments are welcome!

Preparing for Year-End 2018: Number Four – Begin Considering Integrated Reporting for Long-Term Development

In this fourth post of our series discussing issues for year-end planning consideration, we are suggesting an area where you can start now to begin creating momentum for change. In his speech at the annual SEC/FASB/PCAOB conference, AICPA Chair Barry Melancon highlighted integrated reporting. Sustainability and integrated reporting were also the focus of a disclosure panel at the conference.

You can find some background about integrated reporting on the AICPA’s webpage and on the International Integrated Reporting Council’s webpage.  In addition, this blog post by Bob Laux at the IIRC, who is also a Director here at SEC Institute, provides a valuable perspective.

The SEC raised the issue of disclosures about ESG matters in its 2016 Regulation S-K Concept Releaseand many companies have begun to make disclosures in the move towards the goal of communicating information to present a more complete and transparent picture of performance, utilization of resources, and ability to create value over the long term. This 2017 posthas some real company example disclosures.

Research shows that almost all of the Fortune 500 companies are making some level of sustainability disclosures.  A report from the Governance and Accountability Institute states that 85% of the Fortune 500 companies make a sustainability report.

With all this activity surrounding integrated Reporting our suggestion is to put this topic on your disclosure agenda, and as you work through year-end begin to think of areas where it would be appropriate for your company and your financial statement users to begin providing incremental information.

As always, your thoughts and comments are welcome!

Preparing for Year-End 2018: Number Three – Building in Critical Audit Matter Disclosure Preparation

In this third post of our year-end preparation series we are highlighting a planning area to incorporate in year-end now to hopefully avoid last-minute challenges next year.  Critical Audit Matters, or CAMs, will be discussed by your auditors in their reports for years ended on or after June 30, 2019 for Large Accelerated Filers and for years ended after December 15, 2020 for others.

There has been significant discussion about the advantages of doing a “dry-run” of CAMs well in advance of the date the disclosure is required in audit reports.  There are a number of good reasons to do this, including helping to understand if any original information could potentially be disclosed in the auditor’s report and to help assure that there are no glaring inconsistencies between Critical Accounting Estimate disclosure in MD&A and CAM disclosure in the auditor’s report.

To help companies in this process the Center for Audit Quality has issued a very helpful report titled “Critical Audit Matters: Lessons Learned, Questions to Consider, and an Illustrative Example.”  Along with an interesting example of CAM disclosure, the report also includes a helpful list of questions for audit committees to consider as auditors prepare to report CAMs.

As always, your thoughts and comments are welcome!

Another Direct Method Statement of Cash Flows Company!

Thanks to Pat Finnegan, who works with Fitch and has helped us as a workshop leader, for letting us know that CVS is another company that uses the direct method for their statement of cash flows in their Form 10-K.

It is pretty neat and more understandable when we see line items such as “Cash receipts from customers” and “Cash paid for inventory and prescriptions dispensed by retail pharmacies” on the statement of cash flow.

Perhaps more interesting and useful, in CVS’s 10-Kcheck out their MD&A liquidity and capital resources discussion.  The presentation is much more understandable when based on direct method information such as changes in cash receipts from customers rather than items like changes in accounts receivable.  Small wonder that FR 72suggests that even companies using the indirect method would benefit if they developed direct method information for MD&A.  From Section IV.B.1:

  1. Operations

The discussion and analysis of operating cash flows should not be limited by the manner of presentation in the statement of cash flows.  Alternate accounting methods of deriving and presenting cash flows exist, and while they generally yield the same numeric result in the major captions, they involve the disclosure of different types of information. When preparing the discussion and analysis of operating cash flows, companies should address material changes in the underlying drivers (e.g. cash receipts from the sale of goods and services and cash payments to acquire materials for manufacture or goods for resale), rather than merely describe items identified on the face of the statement of cash flows, such as the reconciling items used in the indirect method of presenting cash flows

Thanks again to Pat, and as always, your thoughts and comments are welcome!

Preparing for Year-End 2018: Number Two – PCAOB Inspection Readiness

In this second post of our series discussing areas to consider as we navigate our way through the year-end reporting process, we are focusing on the latest news from the PCAOB concerning the inspection process.

As the new PCAOB Board continues to implement their strategic plan (you can read more about the plan here), how they will guide the inspection process has been addressed in an “Inspections Outlook” document issued on December 6, 2018.

The Inspection Outlook begins with a discussion of “transformation” of the inspection process.  In this section the Board says:

“We are considering topics such as the procedures we perform on the review of specific engagements and systems of quality control, our approach to selecting engagements for inspection and areas of focus, and how and what we communicate about our inspections. We are also considering how to make our process forward-looking and how to more effectively consider evolving risks, environmental factors, and the changing needs of our stakeholders.”

Areas addressed in the Inspection Outlook include:

System of quality control

Independence

Recurring inspection deficiencies

External considerations

Cybersecurity risks

Software audit tools

Digital assets

Audit quality indicators

Changes in the auditor’s report

Implementation of new accounting standards

You can read the details of each area in the Inspection Outlook document.

As always, your thoughts and comments are welcome!

Preparing for Year-End 2018: Number One – A Disclosure Update and Simplification Reminder

As we move through the calendar towards year-end or quarter-end, we are presenting a series of posts focusing on issues to consider as we navigate through the reporting process. This first post is a reminder to make sure to update your Form 10-K or Form 10-Q for the SEC’s Disclosure Update and Simplification Rule. The major areas to update include:

Form 10-K changes:

  1. Item 1 – Changes to S-K Item 101
  2. Item 5 – Changes to S-K Item 201
  3. The impact of the Rule on the Annual Report to Shareholders
  4. The elimination of the earnings to fixed charges ratio

Form 10-Q changes:

  1. Item 1 – Changes to S-X Article 10 – Addition of changes in shareholders’ equity information
  2. Item 1 – Changes to S-X Article 10 – Removal of contingency disclosure language

As overviewed in this previous post, our “cookbook” to help you through the mechanics of each of the above changes can be found here.

Post Number Two in this series will have the news of the latest Inspection Outlook from the PCAOB.

As always, your thoughts and comments are welcome!

Have You Ever Seen the Direct Method Statement of Cash Flows?

The ASC 230 guidance for the statement of cash flows includes the following language in paragraph 230-10-45-25:

In reporting cash flows from operating activities, entities are encouraged to report major classes of gross cash receipts and gross cash payments and their arithmetic sum—the net cash flow from operating activities (the direct method). (Paragraphs 230-10-55-1 through 55-4 and paragraph 230-10-55-21, respectively, discuss and illustrate a method by which those major classes of gross operating cash receipts and payments generally may be determined indirectly.)

Although the direct method is the “preferred” method, very few companies present the direct method. The reasons behind use of the indirect method, where net income is reconciled to cash from operating activities, generally go back to system issues and information availability.  (And, if a company uses the direct method they are still required to present indirect method information.)

Erie Indemnity, a very unique company that provides service to an “insurance exchange” has a robust approach to reporting and a 10-K filled with good examples.  One of the most interesting examples is that they use the direct method when presenting their statement of cash flows, one of very few companies that use this method.

You can find their annual report here, and the statement of cash flows is on page 45.

As always, your thoughts and comments are welcome!

Another MD&A Known Trend Disclosure and Materiality Lesson

In our workshop discussions dealing with MD&A the disclosure of “known trends” is always a complex topic.  The idea of disclosing something that isn’t hurting your business currently but might hurt it in future periods is rarely easy to deal with.  Regulation S-K Item 303 makes this a requirement though if it meets a “reasonably likely” probability threshold:

(3) Results of operations.

****

(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.

This clearly forward-looking disclosure means that if a company knows of something that is “reasonably likely” to have an impact on the company in the future it should be disclosed to shareholders.  Problems with this requirement almost always come to light when a company makes an announcement that surprises shareholders and it results in a drop in stock price. This was exactly the case in August 2014, when SeaWorld filed their earnings release Form 8-Kfor the second quarter of 2014.  Tucked away in the discussion was this sentence:

“In addition, the Company believes attendance in the quarter was impacted by demand pressures related to recent media attention surrounding proposed legislation in the state of California.”

When this announcement was made, SeaWorld’s stock price fell from $28.15 to $18.90.  This 33% fall in stock price decreased SeaWorld’s market capitalization by approximately $830 million.  The issue beneath this disclosure was the movie “Blackfish” and how the film had affected SeaWorld’s business.

Two major questions arise from such an announcement:

When did SeaWorld’s management know they had a problem?

Should SeaWorld’s management have known the problem was material?

On September 18, 2018, the SEC announced in a press releasethat the company and two of its officers had settled fraud charges for misleading investors about the impact of the documentary on the company’s business.

Interestingly, as is true for almost all of these kinds of known trend cases, there was no involvement of the actual financial statements.  The basis for the case was that forward-looking information that should have been included in the MD&A was withheld from investors.

As you can read in the complaint concerning the company and its former CEO,the SEC enumerates the issues that underlie the enforcement. Over a fairly lengthy period of time the company dealt with the impact of the film on its business by surveying customers and using other resources.  It is clear that the company knew the film was having an impact.  The company’s data showed that customers were affected by the film.  Management, however, asserted in public forums that the film had not affected attendance.

In the complaint (paragraph 37) the SEC makes this important point:

  1. Securities Act Regulation S-K, Item 303(a)(3)(ii) (“SK-303”) requires issuers, such as SeaWorld, to disclose “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 from continuing operations.”Despite the above events indicating that Blackfish either was affecting or would affect SeaWorld’s financial performance, SeaWorld never conducted an evaluation of Blackfish’s potential impact on SeaWorld’s operational results, or made any disclosure regarding the known trends or uncertainties associated with Blackfish under SK-303 in connection with the filing of its FY 2013 Form 10-K on March 21, 2014, or its Q1 2014 Form 10-Q on May 15, 2014.

The complaint, starting at paragraph 11, also includes discussion of why management should have known the information was material, including this interesting observation related to the impact of a news article early in the series of events:

  1. On August 28, 2013, an article in the financial press suggested that, despite SeaWorld’s denial, there might have been a link between Blackfish and SeaWorld’s declining attendance. Immediately following the article, SeaWorld’s share price dropped by five percent (5%). The Defendants should have known that the Blackfish effect, if and when such occurred, would be material to investors.

At the time of this article management was still asserting there was no impact from the movie.

The company and the CEO paid fines totaling more than $5 million.  Another important aspect of the case is that the CEO actually sold stock during the period when the company knew there was a “Blackfish effect.”

As always, your thoughts and comments are welcome!

A Late Change – More About the S-K 201(d) Table!

Thanks to a reader of the blog and a member of our SEC reporting community, here is a late change and an interesting difference between the originally published Final Rule for Disclosure Update and Simplification and the version that was published later which is conformed to the Federal Register version.

In the originally published version of the final rule (which is no longer on the SEC’s webpage) the S-K Item 201(d) table was removed as a disclosure requirement in Form 10-K Item 12 and was also removed from the proxy rule disclosures in Schedule 14A.

In the conformed version now on the SEC’s webpage both these changes have been removed!  So, interestingly, this change has been undone!

This language is from page 55 of the conformed version of the final rule:

After further consideration, we are retaining the equity compensation plans disclosure requirements and are referring them to the FASB for potential incorporation into U.S. GAAP. We recognize the concerns expressed by commenters that U.S. GAAP does not explicitly require certain information, such as the formula for calculating the number of securities available for issuance under the plan. This information may be material to investors in making informed decisions about the scope of an issuer’s equity compensation program and the potential dilutive effect, both economically and in voting power, of awards authorized for issuance under all equity compensation plans.

So, even when a rule is final, corrections can still be made!  In fact, this language appears on page 1 of the conformed version:

Corrected to Conform to Federal Register Version

We have updated our PDF document that you can download here, and also taken down the post that originally discussed this change.

Thanks to all of you who read the blog and contribute!

And, as always, your thoughts and comments are welcome!