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!

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!

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:

5. Item 1 – Changes to S-X Article 10 – Addition of changes in shareholders’ equity information
6. 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!

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!

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.

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(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:

37. 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:

13. 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!

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!

Thanks to Gary Brown, Partner at  Nelson Mullins Riley & Scarborough LLP, who is also a workshop leader and speaker here at PLI, for finding the comment below and planting the seed for this post!

Way back when, in the days before Sarbanes-Oxley (and yes, that really is way back when!), the SEC was concerned about the use of what was then called “pro-forma” information.  The term “pro-forma” was used to describe information that started with GAAP measures which were then “adjusted” to present what companies maintained (or perhaps hoped), was more relevant information to investors.

In those pre-SOX days the SEC was concerned that such “pro-forma” presentations could be misleading. For example, some companies would maintain that presenting operating results with the impact of restructuring charges removed was a better way to evaluate the future earnings potential of a business.  This may be the case, but some companies that had restructuring charges every year, and sometimes in multiple quarters within a year, would present such measures in this fashion.  Clearly such a presentation could be misleading.

In response to this situation Congress, in the Sarbanes-Oxley Act, gave the SEC the power and responsibility to regulate the use of such measures.  Here is where the terminology had to be clarified.  Companies, in their earnings releases, would use the term “pro-forma” when presenting such adjusted measures.  However, the SEC’s guidance already used this term, particularly in Regulation S-X Article 11.  As a result, the SEC had to create new terminology.

This Final Rule for the use of Non-GAAP measures was effective on March 28, 2003.  It is where the pendulum of non-GAAP guidance started swinging back and forth, and is still a great summary of both Regulation G(applicable to any presentation anywhere of a non-GAAP measure) andS-K Item 10(e)(for presentations in filed documents).  If you read footnote 12in the Final Rule you will see this language:

Section 401(b) of the Sarbanes-Oxley Act directs the Commission to adopt rules concerning the public disclosure or release of “pro forma financial information” by a company filing reports under Section 13(a) [15 U.S.C. § 78m(a)] or 15(d) [15 U.S.C. § 780(d)]. Because the Commission’s rules and regulations address the use of “pro forma financial information” in other contexts, particularly in Regulation S-X, and use that term differently from its use in the Sarbanes-Oxley Act, we are adopting the term “non-GAAP financial measures” to identify the types of information targeted by Section 401(b) of the Sarbanes-Oxley Act.

Why all this historical trivia?  Check out this comment from an August 22, 2018 comment letter:

Selected Historical Consolidated Financial and Other Data 

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures, page 17

1.  We note that you have titled several of your non-GAAP measures as “pro forma.” Based on the information in the filing, it does not appear that this information is pro forma financial information based on the guidance in Article 11 of Regulation S-X. If true, please revise your presentation to more clearly present your non-GAAP measures eliminating the use of the words pro forma.

As always, your thoughts and comments are welcome!

Contingency disclosures have historically been specifically addressed in the SEC’s interim financial statement requirements.  Regulation S-X Article 10’s interim financial statement disclosure requirements included this language:

(a)

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(5) The interim financial information shall include disclosures either on the face of the financial statements or in accompanying footnotes sufficient so as to make the interim information presented not misleading. Registrants may presume that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year and that the adequacy of additional disclosure needed for a fair presentation, except in regard to material contingencies, may be determined in that context. Accordingly, footnote disclosure which would substantially duplicate the disclosure contained in the most recent annual report to security holders or latest audited financial statements, such as a statement of significant accounting policies and practices, details of accounts which have not changed significantly in amount or composition since the end of the most recently completed fiscal year, and detailed disclosures prescribed by Rule 4-08 of this Regulation, may be omitted. However, disclosure shall be provided where events subsequent to the end of the most recent fiscal year have occurred which have a material impact on the registrant. Disclosures should encompass for example, significant changes since the end of the most recently completed fiscal year in such items as: accounting principles and practices; estimates inherent in the preparation of financial statements; status of long-term contracts; capitalization including significant new borrowings or modification of existing financing arrangements; and the reporting entity resulting from business combinations or dispositions. Notwithstanding the above, where material contingencies exist, disclosure of such matters shall be provided even though a significant change since year end may not have occurred.

 Interestingly, essentially duplicating this disclosure requirement for continencies from the SEC, US GAAP (ASC 270-10-50-6) requires disclosure in interim financial statements of material information about contingencies:

50-6     

Contingencies and other uncertainties that could be expected to affect the fairness of presentation of financial data at an interim date shall be disclosed in interim reports in the same manner required for annual reports. Such disclosures shall be repeated in interim and annual reports until the contingencies have been removed, resolved, or have become immaterial. The significance of a contingency or uncertainty should be judged in relation to annual financial statements. Disclosures of such items shall include, but not be limited to, those matters that form the basis of a qualification of an independent auditor’s report.

Because this requirement is part of US GAAP, the SEC decided to remove this requirement from S-X Article 10 in their Disclosure Update and Simplification Rule.  The marked version of paragraph 5 from the demonstration version(page A-59) shows this deletion:

(5) The interim financial information shall include disclosures either on the face of the financial statements or in accompanying footnotes sufficient so as to make the interim information presented not misleading. Registrants may presume that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year and that the adequacy of additional disclosure needed for a fair presentation, except in regard to material contingencies, may be determined in that context. Accordingly, footnote disclosure which would substantially duplicate the disclosure contained in the most recent annual report to security holders or latest audited financial statements, such as a statement of significant accounting policies and practices, details of accounts which have not changed significantly in amount or composition since the end of the most recently completed fiscal year, and detailed disclosures prescribed by Rule§4-08of this Regulation, may be omitted. However, disclosure shall be provided where events subsequent to the end of the most recent fiscal year have occurred which have a material impact on the registrant. Disclosures should encompass for example, significant changes since the end of the most recently completed fiscal year in such items as: accounting principles and practices; estimates inherent in the preparation of financial statements;  status of long-term contracts; capitalization including significant new borrowings or modification of existing financing arrangements; and the reporting entity resulting from business combinations or dispositions. Notwithstanding the above, where material contingencies exist, disclosure of such matters shall be provided even though a significant change since year end may not have occurred.

This is a great example of a simplification that is more perhaps a “clean-up” in the SEC’s rules where an issue is already addressed by GAAP.

And, the key issue here is that even though the SEC’s rules have changed for disclosures about contingencies in interim financial statements, the disclosure requirements have not changed!

As always, your thoughts and comments are welcome!