Category Archives: Hot Topic

SASB and IIRC Complete Merger to Become The Value Reporting Foundation

Hot Topic, Reporting

As investors, companies and regulators focus on developing frameworks and standards for ESG and related disclosures, two important organizations in this space have combined.

The SASB, a non-profit organization founded in 2011, has been actively working to develop sustainability standards.  The SASB Standards are currently available for 77 industries and primarily address ESG issues related to financial performance.

The IIRC, starting with its 2013 International Integrated Reporting Framework, has built a set of concepts and related approaches to build reports that focus on “value creation over time and related communications regarding aspects of value creation.”

Hopefully this combination will provide clarity in this rapidly evolving reporting area.  As you can read here, with the combination of the two organizations, they now provide resources including Integrated Thinking Principles, the Integrated Reporting Framework, and SASB Standards.  Companies can tailor their approach to ESG reporting using these tools.

As always, your thoughts and comments are welcome.

The New MD&A Rule: Part Two – Objective

Hot Topic, Reporting

In this post, we overviewed the SEC’s Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information Final Rule. This rule was published in the Federal Register on January 11, 2021, and is effective for filings on or after February 10, 2021.

The rule’s transition provisions provide a mandatory transition date but also allow voluntary early compliance.  The mandatory transition date is each company’s first fiscal year that ends after August 9, 2021, which is 210 days after the effective date.  Companies may voluntarily apply the new rule, on an S-K item-by-item basis, in any filing made on or after the effective date of February 10, 2021.

This means a company that files a Form 10-K on or after February 10, 2021, has the option to early implement this new MD&A (S-K Item 303) guidance.  If a company has not implemented the rule early, as we suggested in the earlier post, this is a good project to put on our to-do list for the summer.  Additionally, implementation of the new rule provides an opportunity to look for other opportunities to improve our MD&A disclosure.

This post explores the first of the changes to the MD&A requirements, the addition of an objective to S-K Item 303.

A clear writing objective is crucial to effective business writing such as MD&A.  Before this new rule, the most recent statement of the MD&A objective was in FR 72, the 2003 MD&A release which states:

The purpose of MD&A is not complicated. It is to provide readers information “necessary to an understanding of [a company’s] financial condition, changes in financial condition and results of operations.”  The MD&A requirements are intended to satisfy three principal objectives:

  • to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management;
  • to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
  • to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.

This articulation of MD&A’s objective is over 17 years old, but it has never been part of the core guidance for MD&A in S-K Item 303.  In the new rule, the SEC included a writing objective as part of S-K Item 303 and modernized the language:

229.303 (Item 303) Management’s discussion and analysis of financial condition and results of operations.

(a) Objective. The objective of the discussion and analysis is to provide material information relevant to an assessment of the financial condition and results of operations of the registrant including an evaluation of the amounts and certainty of cash flows from operations and from outside sources. The discussion and analysis must focus specifically on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations, as well as matters that are reasonably likely based on management’s assessment to have a material impact on future operations. The discussion and analysis must be of the financial statements and other statistical data that the registrant believes will enhance a reader’s understanding of the registrant’s financial condition, cash flows and other changes in financial condition and results of operations. A discussion and analysis that meets these requirements is expected to better allow investors to view the registrant from management’s perspective.

In the Final Rule the SEC included these statements about the new objective:

By emphasizing the purpose of MD&A at the outset of Item 303, the proposal was intended to provide clarity and focus to registrants as they consider what information to discuss and analyze. The proposal was also intended to facilitate a thoughtful discussion and analysis, and encourage management to disclose factors specific to the registrant’s business, which management is in the best position to know, and underscore materiality as the overarching principle of MD&A.

Registrants should regularly revisit these objectives in Item 303(a) as they prepare their MD&A and consider ways to enhance the quality of the analysis provided. These objectives provide the overarching requirements of MD&A and apply throughout amended Item 303. As such, they emphasize a registrant’s future prospects and highlight the importance of materiality and trend disclosures to a thoughtful MD&A.

The Final Rule also focused on the principles-based requirements for MD&A:

Rather, we continue to believe that MD&A’s materiality-focused and principles-based approach facilitates disclosure of complex and often rapidly evolving areas, without the need to continuously amend the text of the rule to update or impose additional prescriptive requirements. These amendments are intended to further emphasize these goals.

This objective will help companies improve MD&A.  Based on this new objective, here are three key issues to remember in drafting and reviewing MD&A:

  1. Don’t write from a theoretical or academic perspective. Write about what management regards as important and regularly reviews in the financial statements.
  1. Focus on the future as much as the past. Any known issues that indicate historical financial performance is not predictive of future financial performance must be considered for disclosure. (As a reminder of this disclosure requirement check out this enforcement action which involved a $5,000,000 fine when a company failed to disclose an issue that meant that revenues were likely to decline in future periods.)
  1. MD&A must focus on the financial statements but cannot stop there.It should include “other statistical data that the registrant believes will enhance a reader’s understanding of the registrant’s financial condition, cash flows and other changes in financial condition and results of operations.” (This is very consistent with the SEC’s new metrics release which you can read about in this post and hear more about in our March 6, 2020 One-Hour Briefing.)

The updated objective of MD&A and these three framing concepts help us understand what we must communicate to investors and are the foundation for effective MD&A disclosure.

In our next post we will begin applying this foundation.

As always, your thoughts and comments are welcome!

New Item 9C in Form 10-K – Holding Foreign Companies Accountable Act Disclosures

10-K Tips, Hot Topic, Reporting

On March 18, 2021, the SEC Adopted Interim Final Rules implementing disclosure requirements in the “The Holding Foreign Companies Accountable Act” (HFCA Act).  The Act became law on December 18, 2020.  The SEC’s Interim Final Rules became effective on May 5, 2021.  These rules added new Item 9C to Form 10-K and made similar changes to Forms 20-F and 40-F.

The HFCA Act requires disclosures by companies that have retained a PCAOB registered public accounting firm to issue an audit report where “that registered public accounting firm has a branch or office that:

  • Is located in a foreign jurisdiction; and
  • The PCAOB has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.”

These companies are referred to as “Commission-Identified Issuers.”  New Item 9C(a) in Form 10-K requires that these companies “must electronically submit to the Commission on a supplemental basis documentation that establishes that the registrant is not owned or controlled by a governmental entity in the foreign jurisdiction.”  They must submit this documentation before the due date of the form.  This requirement does not apply if the company is owned or controlled by a foreign governmental entity.

If the SEC determines that a company is a Commission-Identified Issuer for three consecutive years, Section 2 of the HFCA Act requires that the Commission prohibit trading of the company’s securities.

A Commission-Identified Issuer that is a foreign issuer must make additional disclosures.  The term foreign issuer is defined in Exchange Act Rule 3b-4:

 “The term foreign issuer means any issuer which is a foreign government, a national of any foreign country or a corporation or other organization incorporated or organized under the laws of any foreign country.”

The required disclosures are specified in Section 3 of the HFCA Act and are included in Item 9C(b) below.

The updated instructions to Form 10-K now include new Item 9C:

Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections.

(a) A registrant identified by the Commission pursuant to Section 104(i)(2)(A) of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7214(i)(2)(A)) as having retained, for the preparation of the audit report on its financial statements included in the Form 10-K, a registered public accounting firm that has a branch or office that is located in a foreign jurisdiction and that the Public Company Accounting Oversight Board has determined it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction must electronically submit to the Commission on a supplemental basis documentation that establishes that the registrant is not owned or controlled by a governmental entity in the foreign jurisdiction. The registrant must submit this documentation on or before the due date for this form. A registrant that is owned or controlled by a foreign governmental entity is not required to submit such documentation.

(b) A registrant that is a foreign issuer, as defined in 17 CFR 240.3b-4, identified by the Commission pursuant to Section 104(i) (2)(A) of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7214(i)(2)(A)) as having retained, for the preparation of the audit report on its financial statements included in the Form 10-K, a registered public accounting firm that has a branch or office that is located in a foreign jurisdiction and that the Public Company Accounting Oversight Board has determined it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction, for each year in which the registrant is so identified, must disclose:

(1) That, for the immediately preceding annual financial statement period, a registered public accounting firm that the PCAOB was unable to inspect or investigate completely, because of a position taken by an authority in the foreign jurisdiction, issued an audit report for the registrant;

(2) The percentage of shares of the registrant owned by governmental entities in the foreign jurisdiction in which the registrant is incorporated or otherwise organized;

(3) Whether governmental entities in the applicable foreign jurisdiction with respect to that registered public accounting firm have a controlling financial interest with respect to the registrant;

(4) The name of each official of the Chinese Communist Party who is a member of the board of directors of the registrant or the operating entity with respect to the registrant; and

(5) Whether the articles of incorporation of the registrant (or equivalent organizing document) contains any charter of the Chinese Communist Party, including the text of any such charter.

Rule 12b-13 requires that all item numbers be included in Form 10-K.  That said, for most companies the response to this new item will likely be “Not applicable.”

As always, your thoughts and comments are welcome.

It Is “Déjà vu All Over Again” – Another SEC Channel Stuffing Enforcement

Hot Topic

In this October 2020 post, we reviewed an SEC enforcement case involving HP Inc.  That case focused on HP “pushing” inventory into its distribution channels and eventually surprising investors with an unexpected revenue shortfall when channels could not accept any more inventory.  The déjà vu in that post was remembering back to a very similar “gallon pushing” enforcement involving Coca-Cola.

The “déjà vu all over again” (and thanks Yogi Berra!) in this post is about a May 3, 2021 case involving Under Armour.  This Accounting and Auditing Enforcement Release (AAER) tells an eerily similar story to the HP Inc. and Coca-Cola cases.

In mid-2015, Under Armour’s FP&A group determined that the company’s forecasted revenue growth rate would not meet internal targets or analysts’ expectations.  This forecasted revenue shortfall was a major concern for Under Armour management.  Under Armour had reported year-over-year revenue growth of over 20% for 26 consecutive quarters.  Management consistently emphasized this growth rate in its communications with investors and analysts.

Under this pressure to maintain the 20% revenue growth rate, according to the AAER, “Under Armour’s senior management directed the FP&A group and senior sales personnel, among other things, to identify existing orders that customers had requested be shipped in the next quarter that could instead be shipped in the current quarter.”  This began a six-quarter process of “pulling forward” customer orders to increase revenues to meet analysts’ expectations.

As you would expect, and just as happened in the HP Inc. and Coca-Cola cases, this robbing Peter to pay Paul process could not continue forever.  According to the AAER, “[o]n January 31, 2017, Under Armour announced revenue of $1.308 billion for the fourth quarter of 2016, which reflected year-over-year revenue growth of 12%.  Under Armour did not meet analysts’ revenue estimates for the fourth quarter of 2016, and it did not report year-over-year revenue growth of over 20%. That day, the company’s stock price dropped by approximately 23%.”

A 23% stock price drop provides clear evidence that the failure to meet revenue forecasts was material information. And while this is evidence viewed with 20-20 hindsight, it seems likely management was aware that this was material information.

When management knows there is a potential problem on the horizon (failing to meet sales growth expectations in this case), the S-K Item 303 known-trend requirements in MD&A require that companies 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 or income from continuing operations.”

In addition, Instruction 3 to S-K Item 303(a) requires that within MD&A:

“discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”

The AAER states:

“Under Armour’s use of pull forwards created an uncertainty or event that was known to Under Armour’s senior management and was reasonably expected to have a material effect on the registrant’s future revenues. Under Armour’s failure to attribute growth in revenue to the use of pull forwards did not provide investors with material information about its revenue necessary for an understanding of its results of operations. As a consequence, Under Armour violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13, and 12b-20 thereunder.”

There are other important legal issues in this case.  In the AAER, the SEC states that Under Armour violated the provisions of both the 1933 and 1934 Acts:

“As a result of the conduct described above, Under Armour violated Section 17(a)(2) and (3) of the Securities Act, which prohibit any person from directly or indirectly obtaining money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or engaging in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser, in the offer or sale of securities. A violation of these provisions does not require scienter and may rest on a finding of negligence. See Aaron v. SEC, 446 U.S. 680, 685, 701-02 (1980).”

“Also as a result of the conduct described above, Under Armour violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11, and 13a-13 thereunder, which require reporting companies to file with the Commission complete and accurate annual, current, and quarterly reports. Under Armour also violated Rule 12b-20 of the Exchange Act, which requires an issuer to include in a statement or report filed with the Commission any information necessary to make the required statements in the filing not materially misleading.”

One important aspect of this case surrounds revenue recognition accounting.  There was no issue with how and when Under Armour recognized revenue.  No accounting issues were raised in the AAER.  The enforcement is all about disclosure.

Under Armour entered into a Cease and Desist Order and paid a $9,000,000 fine.

As always, your thoughts and comments are welcome!

PCAOB Provides Insights Into the 2021 Inspection Process

Hot Topic, Reporting

On April 6, 2021, the PCAOB published two documents addressing 2021 inspections:

Audit Committee Resource – 2021 Inspections Outlook, and

Spotlight – Staff Outlook for 2021 Inspections.

While these documents are directed primarily to auditors, they provide insights to help company management avoid audit surprises and problems.

The Audit Committee Resource reinforces the PCAOB’s commitment to “seeking views and feedback from audit committees” through its outreach process.  In 2019 and 2020 the PCAOB visited with over 700 audit committee chairs.  It also provides audit committee perspectives for areas including:

  • Auditor’s Risk Assessments
  • Firms’ Quality Control Systems
  • How Firms Comply with Auditor Independence Requirements
  • Fraud Procedures
  • Critical Audit Matters
  • How Firms Implement New Auditing Standards
  • Supervision of Audits Involving Other Auditors

The Spotlight report outlines several inspection process changes and focus areas for 2021.  Changes to the inspection process will include reviewing financial reporting and audit risks posed by COVID-19 and reducing the predictability of the inspection process.  The PCAOB will select more engagements randomly and inspect more “non-traditional” audit areas.

The report outlines areas where inspections continue to find deficiencies, such as revenue and accounting estimates.  The list of other areas where the staff plans to concentrate inspection resources includes firm quality control systems, how firms comply with independence requirements, fraud procedures, critical audit matters, implementation of new auditing standards, responding to cyber threats, auditing digital assets and supervision of audits involving other auditors.  These areas are consistent with those in the Audit Committee Resource.

As always, your thoughts and comments are welcome

A Risk Factor Rewrite Example

10-K Tips, Hot Topic, Reporting

The SEC’s May 2020 risk factor disclosure modernization created a great opportunity to rethink risk factor disclosures and focus on communicating material risks.

The prior S-K disclosure requirements for risk factors included this language:

229.105 (Item 105) Risk factors.

Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make an investment in the registrant or offering speculative or risky. This discussion must be concise and organized logically. Do not present risks that could apply generically to any registrant or any offering. Explain how the risk affects the registrant or the securities being offered. Set forth each risk factor under a subcaption that adequately describes the risk.

The May 2020 Final Rule revised the requirements with this language:

229.105   (Item 105) Risk factors.

(a) Where appropriate, provide under the caption “Risk Factors” a discussion of the material factors that make an investment in the registrant or offering speculative or risky. This discussion must be organized logically with relevant headings and each risk factor should be set forth under a subcaption that adequately describes the risk. The presentation of risks that could apply generically to any registrant or any offering is discouraged, but to the extent generic risk factors are presented, disclose them at the end of the risk factor section under the caption “General Risk Factors.”

(b) Concisely explain how each risk affects the registrant or the securities being offered. If the discussion is longer than 15 pages, include in the forepart of the prospectus or annual report, as applicable, a series of concise, bulleted or numbered statements that is no more than two pagessummarizing the principal factors that make an investment in the registrant or offering speculative or risky.

(Note: the entire new text of S-K Item 105 can be found here.)

Three aspects of this rule change create opportunities to rethink this disclosure:

The change in language from “significant factors” to “material factors,”

The requirement to put “generic” risk factors at the end of the discussion and use the heading “General Risk Factors,” and

The requirement to include a summary if risk factors are longer than 15 pages.

Lumen Technologies took advantage of this opportunity in a meaningful way.   In Lumen Technologies’ Form 10-K for the year-ended December 31, 2019, risk factors are on pages 20 to 48, 28 pages long.  Risks described range from “Risks Affecting Our Business” to “Other Risks.”  It would be fair to say that some of the risk factors, such as “We may not be able to compete successfully against current and future competitors” might be “risks that could apply generically to any registrant or any offering.”

After implementing the new disclosure requirements, and a major amount of work, in Lumen Technologies’ Form 10-K for the year ended December 31, 2020, risk factors are on pages 21 to 32.  This is a reduction from 28 to 11 pages!  The revised disclosures start with “Business Risks,” a simpler and more direct heading, and finish with “General Risks” as required by the new rule.  Interestingly, the General Risks are less than one page.  Competitive issues are addressed in a more tailored risk factor titled “We operate in an intensely competitive industry and existing and future competitive pressures could harm our performance.”

“We took the SEC’s changes to S-K Item 105 as an opportunity to take a fresh look at our risk factors,” said David Hamm, Associate General Counsel at Lumen Technologies. “After a robust cross-functional effort, we believe we enhanced and streamlined our risk factors while maintaining existing protections.”

Lumen Technologies’ revised presentation is more direct and clearly more investor friendly.

As always, your thoughts and comments are welcome!

Disruption for SPACs – Debt versus Equity and Possible Restatements

Hot Topic, Reporting

Debt versus equity classification for complex financial instruments has caused more public company restatements over the last 15 years than almost any other issue.  SPACs almost always issue warrants in their original formation and subsequent IPO.  These warrants, as it turns out, frequently have complex features that raise debt versus equity questions.

On April 12, 2021, the Acting Director of the Division of Corporation Finance and the Acting Chief Accountant issued a statement – “Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”).”

The Statement notes that the staff has recently evaluated fact patterns surrounding SPAC warrants.  It would appear that this review has found situations where SPACs may not have properly accounted for warrants and may need to restate financial statements.  It is important to remember that this complex issue depends on the specific features of each warrant.  Warrants with very similar features can have very different accounting treatments.

The Statement addresses two areas where, if SPACs did not properly apply GAAP, and the amounts involved are material, restatement would be required.  The issues focus on

  1. whether the instruments are “indexed” to the issuer’s equity, and
  2. whether certain redemption provisions could trigger a cash settlement where all equity holders do not participate equally.

The US GAAP “indexation guidance” requires a close link between the fair values of a SPAC’s warrants and equity securities.  If the warrants have features that break this relationship, they are not “indexed to the company’s stock” and must be classified as liabilities.  This technical and complex determination generally depends on the inputs to the warrant’s fair value computation.

The redemption issue focuses on whether a warrant could require a net cash settlement which is outside the control of the issuer.  This generally would require liability classification.  There is an exception to this requirement that if the holders of the warrants and all the underlying securities would receive a cash settlement, equity classification could still be appropriate.  This can be a very complex and technical determination based on the specific provisions of a warrant.

If a SPAC has issued warrants that involve these issues and did not appropriately classify the warrants as liabilities, restatement would be required if the amounts are material.

The Statement provides reminders about the restatement process, related Internal Control Over Financial reporting issues, potential requirements to file an Item 4.02 Form 8-K and communication issues related to Reg FD.

The number of SPAC restatements and the ultimate market impact will unfold in coming weeks.

As always, your thoughts and comments are welcome!

De-SPAC Transaction Liability – A Public Statement from the CorpFin Acting Director

Hot Topic, Reporting

On April 8, 2021, Acting CorpFin Director John Coates issued a Public Statement – “SPACs, IPOs and Liability Risk under the Securities Laws.”

Mr. Coates briefly reviews how SPACs, as shell companies, raise capital in an IPO and use this capital to acquire a private company in a “de-SPACing transaction.”  The de-SPACing transaction is structured so that the SPAC’s public company status and exchange listing survive to the combined entity.  Given the volume and complexity of these transactions, Mr. Coates affirms that the CorpFin staff is “continuing to look carefully at filings and disclosures by SPACs and their private targets.”

He then provides a thoughtful discussion about legal liabilities in disclosures surrounding de-SPACing transactions.  He addresses various “claims” that de-SPACing transactions present reduced liability compared to a traditional IPO transaction.  As an example, part of the discussion addresses how the 1995 Private Securities Litigation Reform Act applies to disclosures, particularly projections, in de-SPACing transactions.  Mr. Coates explores the definition of initial public offering and whether a de-SPACing transaction, where a private company is seen by the public for the first time, could be an initial public offering as contemplated in the 1995 Act.  If this were the case, the 1995 Act safe harbors might not apply to de-SPACing transactions.

There is much relevant discussion along with suggestions for next steps in Mr. Coates statement.

As always, your thoughts and comments are welcome.

ESG and Lending Tied Together in Real Life

Hot Topic, Reporting

On April 6, 2021, BlackRock filed an Item 2.03 Form 8-K disclosing a new credit agreement.  Generally, this is not a particularly newsworthy event.  This agreement though, while increasing the company’s revolving credit line by $400,000,000 to $4,400,000,000, also includes provisions linking the interest rate and commitment fee to various ESG factors.

BlackRock’s lending costs can increase or decrease depending on how well it meets or fails to meet targets related to:

  • Black, African American, Hispanic and Latino Employment Rate,
  • Female Leadership Rate, and
  • Sustainable Investing AUM (Assets Under Management) Amount.

You can find the details of the ESG adjustments in the amendment to the credit agreement filed as an exhibit to the Form 8-K.

You can read more about BlackRock’s ESG perspectives in this Letter to CEOs from BlackRock Chairman and CEO, Larry Fink.

This new lending arrangement puts ESG even more squarely in the spotlight for BlackRock.

As always, your thoughts and comments are welcome.