On October 26, 2021, SEC Acting Chief Accountant Paul Munter released a Statement titled “The Importance of High Quality Independent Audits and Effective Audit Committee Oversight to High Quality Financial Reporting to Investors.”  In the Statement, Mr. Munter focuses on the responsibilities of audit committees, management, and of course auditors, in assuring auditors are independent of clients.

He discusses the importance of auditor independence to our capital markets, the shared responsibility for auditor independence, and the importance of gatekeepers in this process, saying:

“The independence of the auditor, in both fact and appearance, is foundational to the credibility of the financial statements.   While sourcing a high quality independent auditor is a key responsibility of the audit committee,  compliance with auditor independence rules is a shared responsibility of the issuer, its audit committee, and the auditor.

As we near the twentieth anniversary of SOX, it is critical for all gatekeepers to continue to vigilantly maintain the independence of auditors, in both fact and appearance. In this regard, auditors and audit clients must carefully consider the scope of their audit and any permissible non-audit engagements that have been pre-approved by the audit committee to guard against impairments of independence. As part of this responsibility, all gatekeepers in the financial reporting ecosystem should be especially mindful of the nature and the scope of any other services provided by the independent auditor.”

The Statement highlights the four guiding principles in Regulation S-X behind the SEC’s auditor independence rules.  Regulation S-X Article 2.01 states:

“In considering this standard, the Commission looks in the first instance to whether a relationship or the provision of a service:

• Creates a mutual or conflicting interest between the accountant and the audit client;
• places the accountant in the position of auditing his or her own work
• results in the accountant acting as management or an employee of the audit client; or
• places the accountant in a position of being an advocate for the audit client.

These factors are general guidance only, and their application may depend on particular facts and circumstances.”

This auditor independence enforcement case involving an audit firm, three of the firm’s partners, and a public company’s former chief accounting officer, illustrates Mr. Munter’s key point that auditor independence is a shared responsibility of companies, audit committees and auditors.  In this case, the audit firm paid a penalty of $10 million, three partners in the firm paid penalties and were barred from SEC practice, and the former chief accounting officer of the company involved paid a fine and was barred from SEC practice.

As always, your thoughts and comments are welcome!

Many MD&A liquidity and capital resources discussions try to explain changes in operating cash flows with opaque explanations, such as “our cash from operating activities decreased because of an increase in accounts receivable.”  Trying to unpack the logic behind this kind of statement to a non-accountant is almost impossible.  It is far more understandable to say, “our cash collections from customers decreased resulting in a decrease in cash flows from operating activities.”  The problem with this more understandable statement, which is essentially based on the direct method of preparing the statement of cash flows, is that reporting systems frequently do not provide the necessary information.

Finding the balance between convoluted statements about how changes in balance sheet accounts affect cash flows and the lack of information necessary to apply the direct method to the statement of cash flows is complex and frequently frustrating.

The SEC challenges companies on this issue when disclosure is unclear.  Here is an example where a company was called upon to clarify these kinds of disclosures in MD&A.

To begin, here is the company’s operating cash flows discussion:

Cash Flows

Operating Activities. Net cash provided by operating activities for the years ended December 31, 2019 and 2018 was $306.3 million and $199.1 million, respectively. Cash provided by operations in 2019 and 2018 resulted from our net income adjusted for non-cash charges for share-based compensation, depreciation and amortization, timing of income tax and employee related payments and changes in other working capital. The significant increase in net cash from operating activities between 2018 and 2019 is primarily due to the higher net income and changes in working capital balances.

This disclosure triggered the following comment from the SEC:

Liquidity, Capital Resources, and Financial Position

Cash Flows

Operating Activities, page 51

Staff Comment:

It appears from the statement of cash flows changes in assets and liabilities, which include working capital items, between 2019 and 2018 of $101.6 million is the substantial cause of the $107.3 million, or 54%, increase in 2019 operating cash flows compared to 2018.  Please revise your disclosure to discuss the material items and the associated underlying factors contributing to the variance.  Refer to IV.B.1 of SEC Release No. 33-8350 for guidance.  Quantify any factors cited, pursuant to section 501.04 of the staff’s Codification of Financial Reporting.  Additionally, define what you consider to be your working capital.

And here is the company’s response, including example new disclosures:

The Company acknowledges the Staff’s comment and will include in its future Annual Reports on Form 10-K enhanced disclosure regarding the matters identified above substantially similar to the following:

Operating Activities.  Net cash provided by operating activities for the years ended December 31, 2019 and 2018 was $306.3 million and $199.1 million, respectively.  Cash provided by operations increased $101.6 million from 2018 to 2019 as a result of changes in the Company’s working capital balances in 2018, resulting from the transaction with GCU.  The Company defines working capital as the assets and liabilities, other than cash, generated through the Company’s primary operating activities.  Changes in these balances are included in the changes in assets and liabilities presented in the consolidated statement of cash flows.  Additionally, for the year ended December 31, 2019 an increase in net income of $30.2 million was partially offset by decreases in non-cash reconciling items of $24.5 million over the prior year period.

Our working capital balances changed primarily due to the transaction with GCU on July 1, 2018, which resulted in operational changes that impacted cash flows of the Company in the second half of 2018.  Commencing July 1, 2018, the Company transitioned to an education services company and no longer has student receivables but records a receivable each month for education services provided to university partners. These changes, along with accrual of interest on the Secured Note receivable from GCU, resulted in a combined $59.3 million reduction in cash inflows from receivables in 2018.    Additionally, in 2018, accounts payable and accrued liabilities associated with our operations prior to the Transaction were settled, resulting in net cash outflows of $30.0 million.

The Company will provide similar disclosures for material fluctuations in operating cash flows in future filings.

As always, your thoughts and comments are welcome!

Electronic Filing Requirements

On November 4, 2021, in a unanimous vote, the SEC proposed two rules to:

• Require electronic filing of certain documents that are currently filed in paper, and

• Change selected filing to improve their readability.

You can read more about the proposals in this Fact Sheet.  According to the related Press Release:

“The amendments are intended to promote efficiency, transparency, and operational resiliency by modernizing the manner in which information is submitted to the Commission and disclosed. Furthermore, publicly filed electronic submissions would be more readily accessible to the public and would be available on our website in easily searchable formats, which benefits both investors and the broader public.”

Among the changes proposed are:

• A company’s “glossy” annual report would have to be filed in pdf form. Current requirements are that the “glossy” annual report be available on a company’s webpage or furnished in paper form to the SEC.

• The financial statements and notes in Form 11-K would have to be tagged with Inline XBRL.

You can find the proposed rules here.  Both will have a comment period of 30 days after publication in the Federal Register.

Filing Fee Disclosure and Payment Methods

On October 13, 2021, in a unanimous vote, the SEC adopted a Final Rule that modernizes filing fee disclosure and payment methods.  According to the SEC’s Press Release:

“The amendments revise most fee-bearing forms, schedules, and related rules to require companies and funds to include all required information for filing fee calculation in a structured format. The amendments also add new options for Automated Clearing House (ACH) and debit and credit card payment of filing fees and eliminate infrequently used options for filing fee payment via paper checks and money orders.”

You can read more about the changes in this Fact Sheet.  The new rules will generally be effective on January 31, 2022.  Certain provisions have extended transition provisions.

As always, your thoughts and comments are welcome!

As we blogged about in this post, the SEC’s November 2020 MD&A Final Rule provides companies an option to present sequential quarterly analysis in interim MD&As.

If you would like to see an example of a company that has implemented sequential quarterly analysis, check out this Form 10-Q from Umpqua Holdings Corporation, a bank holding company in Portland, Oregon.  At the beginning of their MD&A you will find the required disclosures to make the transition to sequential quarterly analysis.

As always, your thoughts and comments are welcome.

In recent months SEC enforcement cases related to public company reporting have focused on a number of key themes, including financial reporting fraud, cybersecurity and perks disclosures.  It is clear the Enforcement Division is sending messages with these cases, and it is important for us as reporting professionals to understand these messages.  To help in that process, here are recent cases focused on each of these themes.

Cases focused on financial reporting fraud include:

The Kraft Heinz Company and two former officers

Healthcare Services Group, Inc.

HeadSpin Inc.’s former CEO

Tandy Leather Factory Inc. and former CEO

FTE Networks’ former CEO and CFO

Under Armour Inc.

Cases focused on cybersecurity and related disclosures include:

Pearson plc

First American Financial Corporation

Cases focused on perks disclosures include:

The Dow Chemical Company

Argo Group International Holdings, Ltd.

Hilton Worldwide Holdings Inc.

MusclePharm Corporation

Provectus

The Enforcement Division’s 2020 Annual Report reinforces these themes.  The very first section of the main body of the report is titled “Focus on Financial Fraud and Issuer Disclosure”:

Integrity and accuracy in financial statements and issuer disclosures are critical to the functioning of our capital markets. During the last fiscal year, the Division maintained its ongoing focus on identifying and investigating securities laws violations involving different components of the financial reporting process.

In addition to traditional case sources, the Division took a proactive, risk-based analytic approach to identifying potential violations, which resulted in several important actions. For example, the Division’s EPS (Earnings Per Share) Initiative uses risk-based data analytics to uncover potential accounting and disclosure violations caused by, among other things, earnings management practices to mask unexpectedly weak performances. Investigations under the EPS Initiative resulted in settled actions against Interface Inc. and two of its former executives, and against Fulton Financial Corporation, for improper accounting practices that resulted in the reporting of quarterly EPS that met or exceeded analyst consensus estimates.  The Division also used risk-based data analytics to uncover potential violations related to corporate perquisites, which led to a settled enforcement action against Hilton Worldwide Holdings Inc. for failing to fully disclose perquisites and personal benefits provided to executive officers.

Many of the cases above name individuals.  The Enforcement Division’s Annual Report includes a section titled “Individual Accountability”:

Holding individuals accountable is among the Commission’s most effective methods of achieving deterrence. Experience teaches that individual accountability drives behavior and can also broadly impact corporate culture. In Fiscal Year 2020, 72% of the Commission’s standalone actions involved charges against one or more individuals. This percentage is in line with the results of the last several fiscal years. The individuals charged in our actions include those at the top of the corporate hierarchy—including chief executive officers, chief financial officers, and chief operating officers—as well as gatekeepers like accountants, auditors, and attorneys.

The message in the volume of these cases is clear and all of us involved in the preparation and auditing of public company reports should listen carefully.

As always, your thoughts and comments are welcome!