By: George M. Wilson & Carol A. Stacey

One of the “golden rules” of MD&A we discuss in our workshops is “no surprise stock drops”. (Thanks to Brink Dickerson of Troutman Sanders for the rules!) Actually, it is OK if management is surprised with a stock drop. However, it can be problematic if management previously knew of some issue that, when disclosed, causes a surprise stock drop for investors.

The classic start to a known trend enforcement case is a company announcement that results in a stock price drop. On February 26, 2014, UTi, a logistics company, filed an 8-K with news of a severe liquidity problem. UTi’s shares fell to $10.74, a decline of nearly 30% from the prior day’s close of $15.26.

The reason this is an SEC reporting issue is this paragraph from the MD&A guidance in Regulation S-K Item 303 paragraph (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. (emphasis added)

If management knows of some sort of uncertainty that could result in a material impact if it comes to fruition, they must evaluate whether they “reasonably expect” this to happen. If they do “reasonably expect” this to happen then it should be disclosed in MD&A.

When there is a surprise stock drop like the one experienced by UTi, the questions the SEC Enforcement Division will ask, to borrow from another context, are “what did management know about the problem” and “when did they know it?”

Enforcement Release, AAER 3877 revealed that the genesis of UTi’s liquidity problem was an issue in the implementation of a new IT system that created billing problems. And, it was clear from the facts, including an internal PowerPoint presentation, that management knew they had a problem well before they filed the 8-K.

However, in their 10-Q for their third quarter ended October 31, 2013, which was filed in December of 2013, UTi did not disclose the liquidity problem. In fact, they said:

Our primary sources of liquidity include cash generated from operating activities, which is subject to seasonal fluctuations, particularly in our Freight Forwarding segment, and available funds under our various credit facilities. We typically experience increased activity associated with our peak season, generally during the second and third fiscal quarters, requiring significant disbursements on behalf of clients. During the second quarter and the first half of the third quarter, this seasonal growth in client receivables tends to consume available cash. Historically, the latter portion of the third quarter and the fourth quarter tend to generate cash recovery as cash collections usually exceed client cash disbursements.

They also made no mention of the implementation problems with their new IT system. They actually said:

Freight Forward Operating System. On September 1, 2013, we deployed our global freight forwarding operating system in the United States. As of that date, based on a variety of factors, including but not limited to operational acceptance testing and other operational milestones having been achieved, we considered it ready for its intended use. Amortization expense with respect to the system began effective September 2013, and accordingly, we recorded amortization expense related to the new application of approximately $3.3 million during the third quarter ended October 31, 2013.

Hence the surprise when the 8-K disclosed the problems. Both the CEO and CFO are also named in the Enforcement Release and paid penalties.

As mentioned above, the probability standard for disclosure is “reasonably expects”. More about this complex probability assessment in our next post!

As always, your thoughts and comments are welcome!

Gain an in-depth understanding of how to apply the FASB standard (codified in ASC 805) on business combinations, including recent related ASUs, how to make journal entries in specific situations, the areas where estimation and judgment is required, the SEC requirements for financial statements and pro forma information for significant business combinations, and the appropriate financial statement disclosure. Attend SECI’s live interactive workshop, Accounting for Business Combinations being held August 16^th in New York City. http://www.pli.edu/Content/Accounting_for_Business_Combinations_Workshop/_/N-1z10od5Z4k?ID=290625&t=WLH7_ADDP

By: George M. Wilson & Carol A. Stacey

One of the most popular parts of the IPO on-ramp created by the JOBS Act allows Emerging Growth Companies (EGCs) to request confidential review of their initial 1933 Act registration statements. Confidential review allows EGCs to keep sensitive financial and other information out of the public spotlight until 15 days before they begin marketing their stock.

On June 29, the SEC announced that they will provide this kind of confidential review to all companies in the IPO process. The new benefit will begin July 10. Additionally, the SEC will also permit confidential review for most offerings made within one year of a company’s IPO. The Staff also posted FAQs related to the announcement.

New Chair Jay Clayton said this about the policy change:

“By expanding a popular JOBS Act benefit to all companies, we hope that the next American success story will look to our public markets when they need access to affordable capital. We are striving for efficiency in our processes to encourage more companies to consider going public, which can result in more choices for investors, job creation, and a stronger U.S. economy.”

Capital formation is an important part of the SEC’s mission, and this change clearly supports that process.

As always, your thoughts and comments are welcome!

By: George M. Wilson & Carol A. Stacey

In our last post, we looked at Sears Holdings’ disclosures about its going concern issues and saw that the company used the language “substantial doubt exists related to the Company’s ability to continue as a going concern” in the footnotes to their financial statements. We also saw that Sears Holdings’ auditors did not mention this issue in their report.

While this might seem like a bit of a disconnect, it turns out that there is a gap between the disclosure requirements for companies and the reporting requirements for auditors. (Actually, there are multiple gaps!)

This post reviews the GAAP requirements of ASU 2015-15, which became effective for companies for years ending after December 15, 2016.

In the third and last post of this series we will explore the auditor’s reporting requirements and the “gaps” between company requirements and auditor’s requirements.

Company Requirements

Here is a brief summary with some excerpts from the requirements for companies in ASC 205-40-50:

In connection with preparing financial statements for each annual and interim reporting period, an entity’s management shall evaluate whether there are conditions and events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable).

……………………………..

Management shall evaluate whether relevant conditions and events, considered in the aggregate, indicate that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. The evaluation initially shall not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued (for example, plans to raise capital, borrow money, restructure debt, or dispose of an asset that have been approved but that have not been fully implemented as of the date that the financial statements are issued).

……………………………..

When relevant conditions or events, considered in the aggregate, initially indicate that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (and therefore they raise substantial doubt about the entity’s ability to continue as a going concern), management shall evaluate whether its plans that are intended to mitigate those conditions and events, when implemented, will alleviate substantial doubt about the entity’s ability to continue as a going concern.

……………………………..

With this as the general requirement for an evaluation, the disclosure requirement comes with a binary determination about the impact of management’s plans:

Disclosures When Substantial Doubt Is Raised but Is Alleviated by Management’s Plans (Substantial Doubt Does Not Exist)

ASC 240-40-50-12

If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is alleviated as a result of consideration of management’s plans, an entity shall disclose in the notes to financial statements information that enables users of the financial statements to understand all of the following (or refer to similar information disclosed elsewhere in the notes):

1. Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)
2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
3. Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.

Disclosures When Substantial Doubt Is Raised and Is Not Alleviated (Substantial Doubt Exists)

ASC 240-40-50-13

If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is not alleviated, the entity shall include a statement in the notes to financial statements indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Additionally, the entity shall disclose information that enables users of the financial statements to understand all of the following:

1. Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
3. Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern.

An interesting difference between these two levels of disclosure is that there is no requirement to use the terminology “substantial doubt” when management’s plans alleviate the uncertainty.

The language Sears Holdings used was:

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements.

The company used the term “substantial doubt” even though they believed their plans mitigated this “substantial doubt”. Their disclosure went beyond the requirements of the standard.

In our next post, we will explore how this interacts with GAAS for auditors.

As always, your thoughts and comments are welcome!

By: George M. Wilson & Carol A. Stacey

This is the first of three posts about an interesting conundrum in reporting that arose last year. The FASB, with ASU 2014-15, now requires disclosures by companies about going concern issues. However, there can be gaps between what companies are required to disclose and impact of going concern issues on the auditor’s report.

ASU 2014-15 added subtopic 205-40 “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” to the Accounting Standards Codification. This update became effective for periods ending after December 15, 2016. Previously there was no specific requirement for management to make these disclosures. (This is of course Generally Accepted Accounting Principles, or GAAP).

Auditors have had guidance in this area for many years courtesy of the PCAOB’s standard in AU section 341, which is now section AS 2415 in the PCAOB’s reorganized auditing standards. (This is Generally Accepted Auditing Standards, or GAAS).

To explore the gap between GAAP for companies and GAAS for auditors when reporting going concern issues we are going to present a series of three posts:

This first post will present an example of a going concern disclosure by a company and whether or not the auditor’s report was modified. (Spoiler – there was no mention in the auditor’s report!)

The second post will explore company disclosure requirements.

The third and last post will review auditor’s reporting requirements and detail the gaps between company and auditor reporting.

Sears Holdings, the retailer that owns Kmart and Sears, provided an example of this gap in their Form 10-K for the year ended January 28, 2017. In their financial statements Sears Holdings included this language:

We acknowledge that we continue to face a challenging competitive environment and while we continue to focus on our overall profitability, including managing expenses, we reported a loss in 2016 and were required to fund cash used in operating activities with cash from investing and financing activities. We expect that the actions taken in 2016 and early 2017 will enhance our liquidity and financial flexibility. In addition, as previously discussed, we expect to generate additional liquidity through the monetization of our real estate and additional debt financing actions. We expect that these actions will be executed in alignment with the anticipated timing of our liquidity needs. We also continue to explore ways to unlock value across a range of assets, including exploring ways to maximize the value of our Home Services and Sears Auto Centers businesses, as well as our Kenmore and DieHard brands through partnerships or other means of externalization that could expand distribution of our brands and service offerings to realize significant growth. We expect to continue to right-size, redeploy and highlight the value of our assets, including our real estate portfolio, in our transition from an asset intensive, historically “store-only” based retailer to a more asset light, integrated membership-focused company.

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements. However, we cannot predict, with certainty, the outcome of our actions to generate liquidity, including the availability of additional debt financing, or whether such actions would generate the expected liquidity as currently planned. In addition, the PPPFA contains certain limitations on our ability to sell assets, which could impact our ability to complete asset sale transactions or our ability to use proceeds from those transactions to fund our operations. Therefore, the planned actions take into account the applicable restrictions under the PPPFA.

If we continue to experience operating losses, and we are not able to generate additional liquidity through the mechanisms described above or through some combination of other actions, while not expected, we may not be able to access additional funds under our amended Domestic Credit Agreement and we might need to secure additional sources of funds, which may or may not be available to us. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Moreover, if the borrowing base (as calculated pursuant to the indenture) falls below the principal amount of the notes plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for the notes on the last day of any two consecutive quarters, it could trigger an obligation to repurchase notes in an amount equal to such deficiency.

Sears Holdings used the term “substantial doubt”, but indicated that they believed their plans mitigated this “substantial doubt”.

This was the report of Sear’s Auditors:

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sears Holdings Corporation and subsidiaries as of January 28, 2017 and January 30, 2016, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 28, 2017, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 28, 2017, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

No mention of a going concern issue at all in the auditor’s report! What is an investor to think? Historically, when the only concrete guidance was in GAAS, it was very rare to see this issue not discussed in both the financial statements and the auditor’s report.

This is, of course, part of the gap between GAAP and GAAS. In our next post we will begin to explore the space in this gap!

As always, your thoughts and comments are welcome!

By: George M. Wilson & Carol A. Stacey

In our blog post “Time Again for a Frequent Comment Update”, we listed the frequent comment areas that CorpFin Staff members have been discussing at our Midyear Forums. In that post, we also highlighted a number of recent comments about non-GAAP measures. In this post, we turn our attention to comments about the statement of cash flows.

In the last several years there have been a number of restatements related to the statement of cash flows, some undoubtedly related to comment letters. Additionally, the FASB and EITF have issued two ASU’s to address various issues in the statement of cash flows.

ASU 2016-15 in August 2016

Provides guidance on 8 specific cash flow issues

ASU 2016-18 in November 2016

Provides guidance on classification and presentation of restricted cash

There is much discussion about root causes for cash flow statement problems. Theories range from the idea that the statement is prepared late in the reporting process and perhaps tends to be a more mechanical, “do it the way we did it last year” process, to the fact that there are some areas that are ambiguous in the cash flow statement guidance. Whatever the causes, there is clearly a need for care and review in preparing the statement of cash flows.

This first comment is about being sure you are familiar with the statement of cash flow requirements and also addresses a frequent problem area of ASC 230, discontinued operations:

We note your presentation of the decrease in cash and cash equivalents from discontinued operations in one line item. Please note that ASC 230-10-45-10 requires that a statement of cash flows shall classify cash receipts and cash payments as resulting from investing, financing, or operating activities. Please revise your current presentation to classify the cash flows from discontinued operations within each of the operating, investing and financing categories.

Whether to show cash flows from financing activities on a gross or net basis is not a mechanical decision. It requires judgment about the substance of the financing as this comment demonstrates:

We note from your financing activities section in your statement of cash flows that you present net proceeds (repayments) of short-term borrowings rather than on a gross basis. Please explain to us your basis for this presentation. Refer to ASC 230-10-45-7 through 9.

Another interesting aspect of cash flow statement preparation is how to treat hybrid items that have an element of two different types of cash flows. This comment demonstrates this is not always a mechanical process:

We note your presentation of payments for the costs of solar energy systems, leased and to be leased. Given that approximately 61% of your revenues for the year ended December 31, 2015 and 64% of your revenues for the period ended June 30, 2016 represented solar energy systems and product sales, please tell us how you reflect the costs of solar energy systems sold on your statements of cash flows pursuant to ASC 230.

These last two comments are not strictly speaking financial statement comments. They are common MD&A comments, and definitely needs to be part of the statement of cash flows conversation. Frequently MD&A tries to explain operating cash flows with confusing or mechanical language relating to items in the indirect method reconciliation from net income to operating cash flows.

Note the mention of drivers in this comment:

We note that your discussion of cash flows from operating activities is essentially a recitation of the reconciling items identified on the face of the statement of cash flows. This does not appear to contribute substantively to an understanding of your cash flows. Rather, it repeats items that are readily determinable from the financial statements. When preparing the discussion and analysis of operating cash flows, you should address material changes in the underlying drivers that affect these cash flows. These disclosures should also include a discussion of the underlying reasons for changes in working capital items that affect operating cash flows. Please tell us how you considered the guidance in Section IV.B.1 of SEC Release 33-8350.

Lastly, note the focus on underlying reasons for change in this comment:

You say that in the statement of cash flows, you provide reconciliation from net loss to cash flows used in operating activities where you have provided quantitatively the sources of your operating cash flows. However, as you use the indirect method to prepare your cash flows from operating activities, merely reciting changes in line items reported in the statement of cash flows is not a sufficient basis for an investor to analyze the impact on cash. Therefore, please expand your disclosure of cash flows from operating activities to quantify factors to which material changes in cash flows are attributed and explain the underlying reasons for such changes. Refer to Section IV.B.1 of “Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations” available on our website at http://www.sec.gov/rules/interp/33-8350.htm for guidance. Provide us a copy of your intended revised disclosure.

As always, your thoughts and comments are welcome!

By: George M. Wilson & Carol A. Stacey

Over the many decades that equity securities have traded in the U.S., and over the centuries that equities have traded around the world, unscrupulous people have always tried to find ways to cheat others. From pump and dump schemes to fake analyst reports new ways are constantly evolving as less than ethical people look for a quick buck. One of the more recently developed sneaky tricks is to create a fictitious user ID in the SEC’s EDGAR system and try to manipulate a company’s stock with fake SEC filings such as tender offer documents. In a way this is kind of a “pump and dump” strategy, and it is all about fake news.

In February of this year an artist in Chicago used this trick to try and manipulate Alphabet’s stock. In May 2015, Avon stock was used in a similar scheme. In September 2015, a person used an SEC filing in the name of “LMZ & Berkshire Hathaway Co.” to try and manipulate Phillips 66 and Kraft Heinz. The report was signed with a false name.

That same false name was used on a filing to announce a fake tender offer for Fitbit in November 2017.

When there are new kinds of crimes, the SEC sets out to develop the right tools and techniques to find the perpetrators and protect investors and the markets from bad actors. They are making progress with this new kind of electronic and internet based crime. On May 19, 2017, fairly soon after the Fitbit false filing, the SEC announced an enforcement action against Robert W. Murray, the alleged perpetrator of this fraud, with a parallel criminal action by the U.S. Attorney’s Office for the Southern District of New York. Mr. Murry is a mechanical engineer based in Virginia.

According to the SEC Murray wove a tangled technical trail:

The SEC alleges that Murray created an email account under the name of someone he found on the internet, and the email account was used to gain access to the EDGAR system.  Murray then allegedly listed that person as the CFO of ABM Capital and used a business address associated with that person in the fake filing.  The SEC also alleges that Murray attempted to conceal his identity and actual location at the time of the filing after conducting research into prior SEC cases that highlighted the IP addresses the false filers used to submit forms on EDGAR.  According to the SEC’s complaint, it appeared as though the system was being accessed from a different state by using an IP address registered to a company located in Napa, California.

In the words of enforcement, this attempt to hide his actions did not work:

“As alleged in our complaint, Murray used deceptive techniques in a concerted effort to evade detection, but we were able to connect the dots quickly and hold him accountable,” said Stephanie Avakian, Acting Director of the SEC Enforcement Division.

For all his effort, and for the potential consequences, Murray’s ill-gotten gains in this scheme were only about $3,100!

Always fun to see how new ways to try and cheat don’t evade the consequences!

As always, your thoughts and comments are welcome!