On February 10, 2023, CorpFin issued 15 Compliance and Disclosure Interpretations (C&DIs) to address issues arising in preparing the Pay Versus Performance disclosures adopted in August 2022.  Given that the new disclosures are required in proxy and information statements that include Regulation S-K Item 402 disclosures for fiscal years ending on or after December 16, 2022, the C&DIs are very timely!

In addition to other topics, the new C&DIs

• • Answer questions about the computation of tabular information required in pay versus performance disclosures;
  • Clarify that pay versus performance information is not required in Form 10-K;
  • Provide guidance for disclosing details of the adjustments to arrive at compensation actually paid; and
  • Discuss considerations in selecting financial performance measures.

As a reminder, in this post, you can find a template for preparation of pay versus performance disclosures from Gary Brown of Nelson Mullins.

As always, your thoughts and comments are welcome!

It its 2020 MD&A Modernization Rule, the SEC eliminated this separate paragraph addressing the impact of inflation:

(iv)  For the three most recent fiscal years of the registrant or for those fiscal years in which the registrant has been engaged in business, whichever period is shortest, discuss the impact of inflation and changing prices on the registrant’s net sales and revenues and on income from continuing operations.

This disclosure dated back to earlier periods when inflation had been a material issue for many companies.  In 2020, when the rule was adopted, inflation had not been a significant issue for most companies since the 1980s.  The rationale for this change in the Final Rule is based on the assumption that inflation may not be material to “most registrants”:

The purpose of the elimination is to streamline Item 303 by eliminating the specific reference to these topics, which may not be material to most registrants. This change is consistent with the principles-based disclosure framework of Item 303

That said, the principles-based nature of MD&A means that if inflation is a material issue for a company in any period, it should be addressed in MD&A.  This principle is clearly articulated in the Final Rule:

We do not believe that these changes will result in a loss of material information for market participants.   Registrants will still be required to discuss in their MD&A the impact of inflation and changing prices, if material, as is currently required.

In the current environment, the staff has been reminding companies of this requirement in the comment letter process.  Here are two examples.

Results of Operations, page 42

1. 2. Please expand your disclosure to address any known trends, events or uncertainties that have had, or that are reasonably likely to have, a material impact on your cash flows, liquidity, capital resources, cash requirements, financial position, or results of operations, as may be attributable to the inflation risk that you discuss on page 19.

Please clarify the extent to which your revenues and cost of product sales have been or are expected to be impacted by inflation, and discuss any plans that you have to respond to or counter any adverse circumstances.

Guess?, Inc., August 8, 2022

Management’s Discussion and Analysis of Financial Condition and Results of Operations, page 44

1. 1. We note you disclosed that your operating results for 2022 were negatively affected by inflationary cost pressures. Please revise to address the following:

• • • • Disclose any known trends or uncertainties that have had or are reasonably likely to have a material impact on your cash flows, liquidity, capital resources, cash requirements, financial position, or results of operations arising from, related to, or caused by the inflation;
      • Expand to identify the principal factors contributing to the inflationary pressures you have experienced and clarify the resulting impact to the company; and
      • Expand your disclosure to identify specific actions planned or taken, if any, to mitigate inflationary pressures.

FedEx Corporation, September 1, 2022

As always, your thoughts and comments are welcome!

As we discussed in a prior post, three parts of the SEC’s 2020 MD&A modernization have become focus areas in the comment process:

• • Critical accounting estimate disclosures
  • Quantitative and qualitative disclosures about material changes
  • Meaningfully addressing liquidity and capital resources

We also explored how one of the reasons behind this increase in MD&A comments could be that companies are reluctant to change MD&A, even when the change is to comply with a new rule or to improve MD&A!

In an earlier post we explored a comment letter exchange focused on critical accounting estimate disclosures.

Today’s post presents an example comment and company response for the second of these three areas, providing quantitative and qualitative disclosures about material financial statement changes.

The Regulation S-K Item 303 guidance for this disclosure is very direct:

Where the financial statements reflect material changes from period-to-period in one or more line items, including where material changes within a line item offset one another, describe the underlying reasons for these material changes in quantitative and qualitative terms.

Companies frequently describe qualitative factors behind changes without quantitative information to explain their relative magnitude.  While this has been a frequent comment area before the 2020 change, it has become the source of even more comments now that there is an objective requirement in S-K Item 303.  This is clearly an easily avoided comment.

Here is an example disclosure from a company’s Form 10-K that generated a comment to provide both quantitative and qualitative information.

Voyage expenses

To the extent that we employ our vessels on voyage charters, we incur expenses that include but are not limited to bunkers, port charges and canal tolls, as these expenses are borne by the vessel owner on voyage charters. Bunkers, port charges, and canal toll expenses primarily increase in periods during which more vessels are employed on voyage charters.

Voyage expenses for the year ended December 31, 2021 were $104.6 million, compared with $89.5 million for the year ended December 31, 2020. Voyage expenses have primarily increased due to an increase in bunker consumption expense, an increase in broker commission expense and an increase in port expenses.

The SEC’s comment is simple and direct:

Results of Operations for Years Ended December 31, 2021 and 2020, page 78

1. 1. We note that you list multiple factors that contribute to changes in your results. For example, you disclose several factors contributing to the increase in voyage expense. Revise your disclosure to quantify each material factor that contributes to a change in your revenues or expenses. Refer to Item 303(b) of Regulation S-K.

The company’s response is also simple and direct, as well as detailed:

The Company acknowledges the Staff’s comment and undertakes in future filings to include additional information to quantify material factors that contribute to a change in our revenues or expenses. To illustrate the Company’s intention with respect to such disclosure, we have provided below the relevant portions of the 2021 Form 10-K, revised to include such additional information (with underlined and strikethrough text indicating additions and deletions, respectively):

Voyage expenses

To the extent that we employ our vessels on voyage charters, we incur expenses that include but are not limited to bunkers, port charges and canal tolls, as these expenses are borne by the vessel owner on voyage charters. Bunkers, port charges, and canal toll expenses primarily increase in periods during which more vessels are employed on voyage charters.

Voyage expenses for the year ended December 31, 2021 were $104.6 million, compared with $89.5 million for the year ended December 31, 2020. Voyage expenses have primarily increased primarily due to an increase in bunker consumption expense of $8.0 million, which was driven by an increase in bunker fuel prices, an increase in broker commission expense of $4.6 million, which was driven by an increase in related revenues, and an increase in port expenses of $2.0 million, which was driven by an increase in the number of voyage days.

Our next post will explore the third of these frequent comment areas, liquidity and capital resources discussions.

As always, your thoughts and comments are welcome!

In November 2020 the SEC made several changes to the MD&A requirements in Regulation S-K Item 303. While many of the changes dealt with “modernization” clarifications and related details, others were more substantive in nature.  Unfortunately, many companies did not implement the required changes to MD&A the year the rule became effective.  As a result, the SEC has been issuing more and more comments focused on the rule’s substantive requirements.  What has become clear, now is the time to be sure your MD&A appropriately deals with these requirements.

From recent SEC comments, we can observe that the SEC staff is currently focused on the following three areas of MD&A:

Critical accounting estimate disclosures

Quantitative and qualitative disclosures about material changes

Meaningfully addressing liquidity and capital resources

Here are example comments that demonstrate the staff’s concerns in each of these areas:

Critical accounting estimate disclosures

1. In accordance with Item 303(b)(3), please provide a discussion and analysis
   of critical accounting estimates and assumptions that:

• • • identifies your critical accounting estimates or assumptions;
      • supplements, but does not duplicate, the description of accounting policies in the notes to the financial statements; and
    • provides greater insight into the quality and variability of information regarding financial condition and operating performance.

Quantitative and qualitative disclosures about material changes

2. We note that you list multiple factors that contribute to changes in your results. For example, you disclose several factors contributing to the increase in voyage expense. Revise your disclosure to quantify each material factor that contributes to a change in your revenues or expenses. Refer to Item 303(b) of Regulation S-K.

Meaningfully addressing liquidity and capital resources

1. Please discuss your material cash requirements from known contractual and other obligations as of December 31, 2021, the anticipated source of funds needed to satisfy such cash requirements and the relevant time period for the related cash requirements in accordance with Item 303(b)(1) of Regulation S-K. In this regard, we note you have purchase obligations relating to take-or pay contracts of approximately $283 million as of December 31, 2021. For further guidance refer to Instruction 4 to Item 303(b) of Regulation S-K.

All too often companies are reluctant or slow to change MD&A.  The fear of SEC comments or other questions frequently impedes improving MD&A disclosure. However, in the current environment, exactly the opposite is true.  Not making appropriate updates to MD&A may well result in SEC comments.  These comments could easily be avoided by making appropriate updates.

In the next few posts, we will explore each area in detail, reviewing example disclosures and the comments they generated.

As always, your thoughts and comments are welcome.

With the current disruption and distress in crypto asset markets, on December 8, 2022, the SEC Division of Corporation Finance issued a Sample Letter to Companies highlighting frequent crypto asset market comments.  The first example comment in the letter focuses on the overall impact of crypto asset market disruption on a business:

Provide disclosure of any significant crypto asset market developments material to understanding or assessing your business, financial condition and results of operations, or share price since your last reporting period, including any material impact from the price volatility of crypto assets.

The letter also provides example crypto asset market comments for the description of the business, MD&A and risk factors.

As always, your thoughts and comments are welcome!

Financial reporting frauds have historically occurred in waves and sometimes in tidal waves as in the period of Enron, Worldcom, Tyco, Adelphia, Quest, etc.  When economic times turn challenging or become uncertain, fraud frequently increases.

Given the time since a major wave of financial reporting frauds and the current economic environment, it may not be a coincidence that Paul Munter, the SEC’s Chief Accountant, released a Statement titled “The Auditor’s Responsibility for Fraud Detection” on October 11, 2022.  (At that time Mr. Munter was Acting Chief Accountant.)

In the Statement, Mr. Munter focuses on the auditor’s gatekeeper responsibilities as they relate to financial statement fraud.  The Statement discusses detailed considerations in a number of areas, including the auditor’s role and responsibilities; the importance of a strong system of quality controls, risk assessment and responses; and good practices.

Mr. Munter’s Statement begins with an important reminder about the nature of the auditor’s role:

“Auditors must plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

In addition, the Statement highlights that:

“The PCAOB auditing standards further require auditors to exercise due professional care, which requires the auditor to exercise appropriate levels of professional skepticism [emphasis added] throughout the audit.”

With respect to the auditor’s responsibility, after noting several auditing standards that include fraud considerations, Mr. Munter goes on to say:

“We emphasize that the auditor’s risk assessment and use of the fraud lens is a continual and iterative process that continues until the issuance of the audit report.”

The Statement includes an important point concerning an auditor’s quality control system, which is that budget, time, and other kinds of pressure could distract an auditor from appropriately identifying fraud risk.

In his discussion of risk assessment and responses, Mr. Munter emphasizes the importance of professional skepticism, noting:

“For instance, the mindset of ‘trust but verify’ may represent potential bias if it is anchored in the belief that management is honest and has integrity. Such a mindset may interfere with an auditor’s ability to effectively evaluate signs of fraud when evaluating misstatements or to objectively challenge evidence provided by management.”

With respect to appropriate “good practices,” the Statement notes that examples of fraud risk factors in the auditing literature should not be considered a checklist.  Rather, they should inform the process of building a tailored list of fraud risk factors for each engagement.

This “early warning” Statement, which addresses many other important fraud related issues, is likely based on a desire to get out in front of any incentives that could result in increases in fraud in coming periods.  It may also inform parts of the PCAOB inspection process.  Auditors and companies should begin incorporating its points in their year-end planning now.

As always, your thoughts and comments are welcome!

On January 4, 2023, the U.S. Office of Information and Regulatory Affairs released the SEC’s Fall Reg Flex Agenda.  The agenda addresses many issues, including Human Capital Management Disclosures (Proposed Rule Stage), Cybersecurity Risk Governance (Final Rule Stage), and Climate Change Disclosure (Final Rule Stage).

In a Statement on the agenda, Chair Gary Gensler said:

“I support this agenda as it reflects the need to modernize our ruleset, moving deliberately to update our rules in light of ever-changing technologies and business models in the securities markets. Our ability to meet our mission depends on having an up-to-date rulebook—consistent with our mandate from Congress, guided by economic analysis, and shaped by public input.”

As always, your thoughts and comments are welcome!