The SEC reinforced its focus on accounting for contingencies in an August 24, 2021 enforcement case against Health Care Services Group, Inc.  Accounting Standards Codification Topic 450 requires that loss contingencies be recorded when it is probable that a loss will be incurred, and the amount can be reasonably estimated.  Contingencies frequently involve high stakes and appropriate accounting requires complex and subjective judgments.  Contingencies are lightning rods for SEC review and enforcement.

In the Health Care Services Group case the SEC found that the company failed to record loss contingencies surrounding private litigation against the company in the proper periods.  The Enforcement Division found that the company, by failing to record loss contingencies in the appropriate period, managed its earnings to meet analyst’s estimates for several quarters.

A fascinating aspect of this case is that, according to Enforcement Division Director Gurbir Grewal, the company “reported EPS that met analyst estimates for multiple quarters as a result of accounting violations that were uncovered by the Division of Enforcement’s ongoing EPS Initiative,” Mr. Grewal also said:

“As today’s actions demonstrate, we will continue to leverage our in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations.”

Accounting for contingencies is not a new theme in SEC enforcement.  In 2007 the SEC fined Cardinal Health $35 million for engaging in a four-year long accounting fraud that, among other misstatements, involved manipulation of a number of reserve and contingency accounts creating misstatements of over $65 million.  The company also accrued $22 million of expected proceeds from a litigation settlement before recognition under GAAP was appropriate.  As you would suspect, these steps helped Cardinal meet earnings estimates.

BorgWarner provided another example of the SEC’s ongoing focus on accounting for contingencies.  This case is more complex.  It is based on ASC 450’s guidance about when to record a contingent liability.  It started with this comment the company received on its December 31, 2016 Form 10-K in a May 11, 2017 comment letter:

Note 14: Contingencies

Asbestos-related Liability, page 95

1. We note your disclosure that you have made enhancements to the management and analysis of asbestos-related claims, including the engagement of new national coordinating council and new local counsel panels, outsourcing administration and claims handling, implementing improvements in processing, and increasing audits and compliance reviews of counsel handling asbestos-related claims. You state that this has resulted in improvements in both the quantity and quality of information available and an increased ability to reasonable forecast the number of potential future claims that may be asserted.

You also state that you hired a third party consultant in the third quarter of 2016 to further assist you in the analysis of potential future asbestos-related claims. It appears that with the assistance of this external consultant and the updated data and analysis resulting from your claims review process, you determined that your best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, is $879.3 million as of December 31, 2016, which is $770.8 million higher than the prior year.

Please tell us your consideration of accounting for this as a correction of an error in previously issued financial statements rather than as a change in estimate. Refer to ASC 250- 10-20.

The key issue in this comment is the timing of recording the contingent liability related to potential asbestos claims.  Given the material increase in the accrual in 2016, it is logical to ask if the amount was “probable” and capable of reasonable estimation in an earlier period.  In its lengthy response, the company included this language:

In connection with the preparation of its annual financial statements for 2016, the Company was able to determine for the first time that its potential liability for asbestos-related claims not yet asserted was capable of reasonable estimation. That determination became possible at such time for several reasons:

• during 2016, the Company was able to identify and verify trends in the Company’s claims data which indicated that the Company’s claims experience was stabilizing, becoming less volatile, and becoming consistently related to industry trends in the tort system generally, which led to the Company’s belief that extrapolation from its past claims experience could, for the first time, form the basis for a reasonable estimate of potential future claims,

• the Company’s handling and processing of asbestos-related claims (as noted by the Staff in the May 11 letter) collectively improved the quantity and quality of information available to the Company respecting those claims, which in turn increased the real-time visibility to the Company and its senior professionals regarding the handling and resolution of individual asbestos-related claims. This information has been used by the Company in its litigation and settlement efforts to determine better how to resolve individual claims, resulting in more consistent litigation and settlement efforts respecting asbestos claims as a whole and more stable settlement and defense costs,

• changes implemented by courts in certain jurisdictions in which the Company is most often named as a defendant in asbestos-related litigation, which were incorporated into the Company’s litigation and settlement efforts, allowing for greater litigation and settlement consistency and predictability in the Company’s claims projections,

• co-defendant bankruptcies and the magnitude and timing of bankruptcy trust payments to claimants became more consistent, and information as to both was increasingly required to be made available by claimants, which affected the value of claims asserted against the Company, and

• the number of asbestos-related claims faced by the Company was significantly reduced as a result of the Company’s ongoing efforts to eliminate many claims that had become dormant as a result of the passage of time or otherwise capable of being dismissed, which allowed the Company greater ability to forecast outcomes respecting potential claims not yet asserted.

The culmination of all of the foregoing factors in 2016 led the Company to consider, as part of its ongoing review process, that it had become possible to make a reasonable estimate of its potential liability for asbestos-related claims not yet asserted. The Company engaged a third-party consultant in the third quarter of 2016, as the Staff notes in the May 11 letter, to assist the Company with its evaluation of such potential liability. The consultant prepared its analysis during the third and fourth quarters of 2016, and presented its final analysis to the Company in the first quarter of 2017. The Company reviewed the analysis and made its own assessment in connection with the Company’s preparation of its annual financial statements for 2016 that the best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, was $879.3 million, and adjusted its liability on its consolidated balance sheet in accordance with ASC 450-20-25-2.

The Company does not consider this additional reserve to be a correction of an error in prior financial statements because no error was made. There were no mistakes in the application of GAAP, mathematical errors or oversight or misuse of facts in previously issued financial statements. The Company was diligent in its efforts to monitor and track available information to measure the potential liability for future asbestos-related claims, and appropriately recorded a reserve when information sufficient to support a reasonable estimate became available. The Company followed generally accepted accounting principles – specifically, ASC 450-20-25-2 – in only accruing a liability once such amount was capable of being reasonably estimated.

After this response by BorgWarner, the SEC issued this follow-up comment:

1. We note your response that you concluded your revised estimate for asbestos-related claims is a change in accounting estimate rather than a correction of an error in previously issued financial statements because the quarter ending December 31, 2016 is the first time that the liability attributable to potential asbestos-related claims not yet asserted could be reasonably estimated. You state that prior to the quarter ending December 31, 2016, you concluded claims data was too volatile, and the circumstances in which future asbestos-related claims would be resolved too uncertain, to support a reasonable estimate of the liability for potential claims not yet asserted.

Based on your response, it appears you believed a liability for potential claims not asserted was probable prior to the quarter ending December 31, 2016, but that such liability was not recognized because it could not be reasonably estimated. Please confirm whether our understanding is correct.

Regarding periods prior to the quarter ending December 31, 2016, please tell us whether you (1) attempted to estimate a liability for potential claims but concluded the resulting estimate of loss (or range) was not reasonable or (2) did not attempt to estimate a liability because you believed you could not develop a reasonable estimate. If the former, please tell us the results of your estimation including your estimated liability (or range thereof) as of December 31, 2015 and why you did not believe the estimate(s) to be reasonable.

The back and forth continued and ultimately resulted in a restatement by BorgWarner to record the contingent liability for the asbestos-related claims in earlier years, as you can see in this
Form 10-K/A.

As each of these three cases demonstrates, the SEC carefully scrutinizes the accounting, disclosures and judgments surrounding contingencies.  This is a reminder that we should carefully make and document judgments surrounding contingent liabilities.

As always, your thoughts and comments are welcome!

On September 22, 2021, CorpFin staff posted this “Sample Letter to Companies” to provide example climate change disclosure comments.  These Sample Letters, which are a successor to older “Dear CFO” letters, provide illustrative comments about emerging and “hot-button” issues companies should consider in their disclosure processes. (For example, one of the previous letters dealt with securities offerings during times of extreme price volatility.)

This Sample Letter is a next step in CorpFin’s focus on climate change, which was directed by then Acting Chair Allison Herren Lee in this February 24, 2021 Public Statement.

The Sample letter references the SEC’s current climate change disclosure guidance in FR-82 (Release 33-9106, 34-61469) Commission Guidance Regarding Disclosure Related to Climate Change.

Many of the example comments have their roots in FR-82.  For example, FR-82 includes this paragraph dealing with separate ESG reports that many companies issue:

“Although much of this reporting is provided voluntarily, registrants should be aware that some of the information they may be reporting pursuant to these mechanisms also may be required to be disclosed in filings made with the Commission pursuant to existing disclosure requirements.”

The Sample Letter includes this related example comment:

General

1. We note that you provided more expansive disclosure in your corporate social responsibility report (CSR report) than you provided in your SEC filings.  Please advise us what consideration you gave to providing the same type of climate-related disclosure in your SEC filings as you provided in your CSR report.

The Sample Letter focuses on risk factor and MD&A disclosure and, consistent with topics addressed in FR-82, provides example comments focused on indirect and physical effects of climate change.

As we move towards our next quarter and year-end reporting cycles, and as disclosure committees consider current disclosure issues, this letter is a reminder to review FR-82 and any other climate change related reports our companies and clients prepare and to carefully consider how to address these matters in our reporting.

You can learn more and review the SEC’s Request for Comment on Climate Disclosure on this ESG section of SEC.gov.

As always, your thoughts and comments are welcome!

The SEC’s very successful whistleblower program has, as of September 15, 2021, paid out over $1 Billion in awards.  As you can read in this Press Release, the first award was paid in 2012 and the pace of awards has increased regularly.

You can learn more about the SEC’s Office of the Whistleblower here.

As always, your thoughts and comments are welcome!

In this post from June 28, 2021, we reviewed an SEC enforcement action focused on the relationship between cybersecurity risks and disclosure controls and procedures.  This relationship was emphasized in the SEC’s February 26, 2018 Release, Commission Statement and Guidance on Public Company Cybersecurity Disclosures:

“Crucial to a public company’s ability to make any required disclosure of cybersecurity risks and incidents in the appropriate timeframe are disclosure controls and procedures that provide an appropriate method of discerning the impact that such matters may have on the company and its business, financial condition, and results of operations, as well as a protocol to determine the potential materiality of such risks and incidents.”

On August 16, 2021, less than two months after the June case, the SEC announced another cybersecurity-related enforcement involving failure to make appropriate disclosures about a breach and the related lack of necessary disclosure controls and procedures.

You can read the details in this Press Release and the related SEC Order.  According to the SEC the company, an educational publisher, learned in March 2019 that:

 “…millions of rows of data stored on the AIMSweb 1.0 server had been accessed and downloaded by a sophisticated threat actor using an unpatched vulnerability on this server.”

Further, according to the SEC Order, even though an actual breach had occurred, the company referred to the risk as hypothetical in its mid-year report:

“In its July 26, 2019 report furnished to the Commission, (the company’s) risk factor disclosure implied that (the company) faced the hypothetical risk that a “data privacy incident” “could result in a major data privacy or confidentiality breach” but did not disclose that (the company) had in fact already experienced such a data breach.”

According to the Press Release, in a July 2019 statement, released after the company had been contacted by the media about the breach, it indicated that “the breach may include dates of births and email addresses.”  When the company released this statement, it knew that this information had been breached. In addition, the statement said the company had “strict protections” in place.  In reality, it had failed to patch the critical vulnerability behind the breach for six months after a vendor notified it about the problem.

The company’s share price fell by 3.3% after this announcement.  The SEC Order discusses various considerations in determining the materiality of the breach, including this statement in paragraph 11:

“The breach at issue was material because (the company’s) business, including but not limited to AIMSweb 1.0, involved collection and storage of large quantities of private data on school-age children around the world.”

Disclosure controls and procedures were directly addressed in this part of the SEC Order:

“(The company’s) processes and procedures around the drafting of its July 26, 2019 Form 6-K Risk Factor disclosures and its July 31, 2019 media statement failed to inform relevant personnel of certain information about the circumstances surrounding the breach. Although protecting student and user data is critical to (the company’s) business, and (the company) had identified the potential for improper access to such data as a significant risk, it failed in this way to maintain disclosure controls and procedures designed to analyze or assess such incidents for potential disclosure in the company’s filings.”

The message in this case is clear.  Companies must assure that cybersecurity breaches are communicated in the disclosure process and carefully evaluated for materiality and disclosure to investors.

As always, your thoughts and comments are welcome!

This is the eighth and last in a series of blog posts in which we are diving into the details of 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.  It is effective for filings on or after February 10, 2021.

The rule’s transition provisions include 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, 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.  Even if a company does not implement the rule early, it is not too soon to start planning for any required changes.  And, hopefully, this exploration can be a possible stepping-off point for a process to review and possibly improve MD&A as a communication document.

In this first post, we overviewed the MD&A changes.  The second, third,  fourth, fifth,  sixth, and seventhposts reviewed and discussed:

The addition of an objective to S-K Item 303,

New critical accounting estimate disclosures,

Changes to results of operations and known trend discussions,

The elimination of a separate paragraph with disclosure requirements for off-balance sheet arrangements,

Replacing the Contractual Obligations Table with a Principles-Based Requirement, and

Sequential Quarterly Analysis In Interim MD&As.

This eighth and last post addresses perhaps the most significant change in the final rule, expansion and clarification of the requirements for the discussion of liquidity and capital resources.  The old guidance for this part of MD&A was very brief and “high level”:

Old S-K Item 303 (A):

(1) Liquidity. Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action that the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquid assets.

(2)  Capital resources. (i) Describe the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period, and indicate the general purpose of such commitments and the anticipated source of funds needed to fulfill such commitments.

(ii) Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off-balance sheet financing arrangements.

This old MD&A guidance did not provide a clearly articulated goal for the discussion of liquidity and capital resources.  As a result, in many MD&As, it is challenging to understand how a business has funded itself in its most recent year and how it plans to fund itself in future years.

The new liquidity and capital resources disclosure requirements clarify the purpose and objective of this disclosure and add helpful detail.  Included are requirements to:

Provide an overall analysis of cash requirements by type of obligation and discuss how the company will generate or obtain liquidity to meet these requirements,

Analyze liquidity and capital resources in both the short-term and long term, and

Include cash requirements related to contractual obligations in the discussion.

These requirements are spelled out in this new language in S-K Item 303:

(1) Liquidity and capital resources. Analyze the registrant’s ability to generate and obtain adequate amounts of cash to meet its requirements and its plans for cash in the short-term (i.e., the next 12 months from the most recent fiscal period end required to be presented) and separately in the long-term (i.e., beyond the next 12 months). The discussion should analyze material cash requirements from known contractual and other obligations. Such disclosures must specify the type of obligation and the relevant time period for the related cash requirements. As part of this analysis, provide the information in paragraphs (b)(1)(i) and (ii) of this section.

(i) Liquidity. Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way. If a material deficiency is identified, indicate the course of action that the registrant has taken or proposes to take to remedy the deficiency. Also identify and separately describe internal and external sources of liquidity, and briefly discuss any material unused sources of liquid assets.

(ii) Capital resources. (A) Describe the registrant’s material cash requirements, including commitments for capital expenditures, as of the end of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements and the general purpose of such requirements.

(B) Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any reasonably likely material changes in the mix and relative cost of such resources.

The primary focus of these new requirements is a clear discussion of cash requirements, including requirements from contractual obligations, and an analysis of how those cash requirements will be met.  This discussion must include both short- and long-term analyses.  While we could discuss how old FR 72 included similar guidance, it is now included in the core S-K Item 303 requirements.

As we discussed in this post, the requirement for the contractual obligations table was removed in the Final Rule and replaced with this more principles-based instruction:

4. For the liquidity and capital resources disclosure, discussion of material cash requirements from known contractual obligations may include, for example, lease obligations, purchase obligations, or other liabilities reflected on the registrant’s balance sheet. Except where it is otherwise clear from the discussion, the registrant must discuss those balance sheet conditions or income or cash flow items which the registrant believes may be indicators of its liquidity condition.

The SEC made this overall comment about improving this disclosure in the Final Rule:

The amendments to Item 303(b) are intended to clarify the requirements while continuing to emphasize a principles-based approach focused on material short- and long-term liquidity and capital resources needs, while also specifying that material cash requirements from known contractual and other obligations should be considered as part of these disclosures. Specifically, these amendments:

• Create a new Item 303(b)(1) to provide the overarching requirements for liquidity and capital resources disclosures in order to clarify these requirements;
• Incorporate in Item 303(b)(1) portions of current Instruction 5 to Item 303(a), which defines “liquidity” as the ability to generate adequate amounts of cash to meet the needs for cash, clarifying its applicability to the liquidity and capital resources requirements more generally;
• Codify prior Commission guidance that specifies that short-term liquidity and capital resources covers cash needs up to 12 months into the future while long- term liquidity and capital resources covers items beyond 12 months;
• Require the discussion on both a short-term and long-term basis; and
• Require the discussion to analyze material cash requirements from known contractual and other obligations and such disclosures to specify the type of obligation and the relevant time period for the related cash requirements.

The Final Rule’s principles-based expansion and clarification of the liquidity and capital resources discussion provides an important opportunity to improve MD&A.  This discussion is, unfortunately, frequently hard to understand.  While there are many causes for this lack of clarity, the  brevity of the old requirements is likely one of them.  With the new requirements in S-K Item 303, many companies have a chance to improve the liquidity and capital resources section of their MD&A.

As always, your thoughts and comments are welcome!

In this Form 10-Q for the quarter-ended May 31, 2021, Pure Cycle reflected a “little-r” prior-period adjustment related to public improvement reimbursables and related interest.  The Form 10-Q includes this footnote

The Company discovered certain errors in the amounts previously reported for the three and six months ended February 28, 2021, which if these errors though immaterial in the given periods, were corrected in the three months ended May 31, 2021, management believes these corrections would have a material impact on the current reported three month consolidated statement of operations, specifically the recognition of Public improvement reimbursables including interest income – related party. The Company’s President and the Chief Financial Officer evaluated the effects of the errors on the consolidated financial statements for the three and six months ended February 28, 2021, which each concluded that the errors were not material to those presented results. Based on this evaluation, the errors did not rise to the level of requiring a restatement of the financial information for the three and six months ended February 28, 2021, contained in the Form 10-Q as previously filed. Accordingly, management has corrected these errors by adjusting opening accumulated deficit for the three month period ended May 31, 2021 and has retrospectively adjusted the cumulative periods for the impact of such errors in the financial statements presented for the three and nine months ended May 31, 2021. The errors were a result of ineffective controls related to management’s preparation and review of spreadsheets which compromised the integrity of the spreadsheets used to support and record the transactions related to the recording and tracking of the public improvement reimbursable amounts. Please see Item 4 in this Quarterly Report on Form 10-Q for our remediation plans.

As required by SAB 108 (Topic 1-N), even though no individual period was misstated by a material amount, the company still adjusted all periods because the cumulative amount was considered material to the current period.  This is the “roll-over” versus “iron-curtain” analysis required by SAB 108 (Topic 1-N).

Perhaps the most interesting aspect of this adjustment is controls over the use of spreadsheets, an on-going and complex issue.  It provides a timely reminder to be sure we establish appropriate controls over the creation, maintenance and use of spreadsheets in the accounting process.

As you would expect, there is an ICFR impact from this financial statement adjustment.  While a full report on ICFR is not required in a Form 10-Q, the company included this disclosure of a material weakness in Part I – Item 4: 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures as defined in Rule 13a-15(e) of the Exchange Act that are designed to ensure that information required to be disclosed in our reports filed or submitted to the SEC under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that information is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures. The President and the Chief Financial Officer evaluated the effectiveness of disclosure controls and procedures as of May 31, 2021, pursuant to Rule 13a-15(b) under the Exchange Act. Based on that evaluation, the President and the Chief Financial Officer each concluded that, during the period covered by this report, our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective due to a material weakness in internal controls over financial reporting resulting from ineffective controls related to the management preparation and review of spreadsheets which compromised the integrity of the spreadsheets used to support and record transactions related to the public improvement reimbursable amounts and related interest income.

To address this material weakness, management has devoted, and plans to continue to devote, significant effort and resources to the remediation and improvement of its internal control over financial reporting by implementing additional steps in the review process of various complex schedules that support accounting entries on a monthly and quarterly basis or moving these manual tracking and reconciliation processes to a purchase software system.

This disclosure is a great reminder that Disclosure Controls and Procedures include ICFR and a material weakness in ICFR likely means that Disclosure Controls and Procedures are not effective.

As always, your thoughts and comments are welcome!

This is the seventh in a series of blog posts in which we are diving into the details of the SEC’s Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial InformationFinal Rule. This rule was published in the Federal Register on January 11, 2021.  It is effective for filings on or after February 10, 2021.

The rule’s transition provisions include 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, 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.  Even if a company does not implement the rule early, it is not too soon to start planning for any required changes.  And, hopefully, this exploration can be a possible stepping-off point for a process to review and possibly improve MD&A as a communication document.

In this post, we overviewed the MD&A changes.  The second, third,  fourth, fifth, and sixth posts reviewed and discussed:

The addition of an objective to S-K Item 303,

New critical accounting estimate disclosures,

Changes to results of operations and known trend discussions,

The elimination of a separate paragraph with disclosure requirements for off-balance sheet arrangements, and

Replacing the Contractual Obligations Table with a Principles-Based Requirement.

This seventh post addresses another change many preparers welcome, the addition of a provision to the interim MD&A requirements that allows companies to use sequential quarterly analysis.  With this option, companies can compare the most recent quarter to the immediately preceding quarter rather than to the same quarter in the previous fiscal year.  This new option for sequential quarterly analysis may be a more meaningful presentation for companies that do not have significant seasonality in their operations.  Under the old rules, if a company thought sequential quarter analysis better fit their business, it still had to present the quarter this year compared to the quarter last year along with sequential quarter analysis.

The SEC made this comment in the Final Rule:

“We continue to believe that the flexibility provided by these amendments will help registrants provide a more tailored and meaningful analysis that is relevant to their specific business cycles while also providing investors with material information to assess quarterly performance. Because not all businesses are seasonal, a comparison to the corresponding quarter of the preceding year may not be as meaningful as a comparison to the preceding quarter. Additionally, by requiring registrants not only to explain the reasons for a change in comparison from prior periods but also to provide both comparisons when there is such a change, we believe investors will benefit from greater insight into a registrant’s decision making and have sufficient disclosure to understand any period-over-period change.”

The change was made by adding language to the old MD&A requirement, which was also moved to new paragraph S-K Item 303(c):

(ii) Discuss any material changes in the registrant’s results of operations with respect to either the most recent quarter for which a statement of comprehensive income is provided and the corresponding quarter for the preceding fiscal year or, in the alternative, the most recent quarter for which a statement of comprehensive income is provided and the immediately preceding sequential quarter. If the latter immediately preceding sequential quarter is discussed, then provide in summary form the financial information for that immediately preceding sequential quarter that is subject of the discussion or identify the registrant’s prior filings on EDGAR that present such information. If there is a change in the form of presentation from period to period that forms the basis of comparison from previous periods provided pursuant to this paragraph, the registrant must discuss the reasons for changing the basis of comparison and provide both comparisons in the first filing in which the change is made.

If a company uses sequential quarterly analysis, it most include summary financial information for the preceding quarter or identify the prior filing that contains the earlier quarter.  And, if a change in approach is made, the company must discuss the reasons for the change and present both comparisons in the filing where the change is made.

At the most recent meeting of the Center For Audit Quality SEC Regulations Committee, the staff addressed a question for companies that want to change to the sequential quarter  approach when they adopt this new guidance.  The minutes of the meeting include this guidance from the SEC Staff:

“…the staff confirmed, that a registrant which elects to revise the quarterly periods being compared upon initial compliance with the New Rules would be required to present the MD&A comparison in both its historic presentation and the new revised presentation. For example and assuming the change in MD&A comparison occurs in the first quarter Form 10-Q, the registrant would disclose both the comparison of the first quarter of the current year with that of the prior year and the comparison of the first quarter of the current year with the fourth quarter of the prior year. It would also disclose the reason for the change.”

If you would like to see an example of a company using this presentation, check out this Form 10-Q for ChampionX Corporation.  If your company or a company you follow has used sequential quarterly analysis in their MD&A, would you please add a comment to this blog and identify the company?  Examples are always helpful!

As always, your thoughts and comments are welcome!

Robinhood Markets’ recent IPO attracted extensive press and investor attention.  One interesting disclosure in the company’s Registration Statement on Form S-1 is the Risk Factors section, which starts on page 35 and ends on page 110.  Since this is clearly more than 15 pages, as required by Regulation S-K Item 105, the company provided a two-page summary of their risk factors which you can find on pages 10-12 of the Registration Statement.

As always, your thoughts and comments are welcome!

This is the sixth in a series of blog posts in which we are diving into the details of 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.  It is effective for filings on or after February 10, 2021.

The rule’s transition provisions include 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, 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.  Even if a company does not implement the rule early, it is not too soon to start planning for any required changes.  And, hopefully, this exploration can be a possible stepping-off point for a process to review and possibly improve MD&A as a communication document.

In this post, we overviewed the MD&A changes.  The second, third,  fourth and fifth posts reviewed and discussed:

The addition of an objective to S-K Item 303,

New critical accounting estimate disclosures,

Changes to results of operations and known trend discussions, and

The elimination of a separate paragraph with disclosure requirements for off-balance sheet arrangements.

This sixth post addresses a change many preparers welcome, eliminating the Contractual Obligations Table.  As is frequently the case though, when a disclosure requirement is removed, a new requirement is put in place.  The Final Rule expands disclosures about liquidity requirements and capital resources in a new, principles-based requirement. (More about this in the last post in this series.) Thus, the rules-based table is replaced with a broad, principles-based requirement for disclosure about capital resources and related information.

Over the years since the Sarbanes-Oxley Act, when the table was introduced, a multitude of questions has arisen about how to handle situations that did not easily fit the table’s brief instructions.  Perhaps the best suggestion about the table was in the SEC’s 2010 Liquidity Release – FR 83:

The purpose of the contractual obligations table is to provide aggregated information about contractual obligations and contingent liabilities and commitments in a single location so as to improve transparency of a registrant’s short-term and long-term liquidity and capital resources needs and to provide context for investors to assess the relative role of off-balance sheet arrangements; registrants should prepare the disclosure consistent with that objective. …… Registrants should determine how best to present the information that is relevant to their own business in a manner that is clear, consistent with the purpose of the disclosure and not misleading, and should provide additional disclosure where necessary to explain what the tabular data includes and does not include.

This is a very rules-based disclosure and even this statement of an overall objective for the table did not eliminate questions.  In the MD&A Final Rule Release, the SEC made these comments about eliminating the table:

Our amendments are also intended to address commenters’ concerns about the challenges imposed by the current contractual obligations table. We recognize that, because the current contractual obligations table does not have a materiality threshold, the burdens imposed by the table on registrants can include identifying, evaluating, and aggregating contracts that are not material.

By eliminating the prescriptive requirement to prepare a contractual obligations table and refocusing instead on a principles-based approach that requires a robust discussion of liquidity and capital resources, including a discussion of contractual obligations, our intent is to relieve registrants of these burdens while continuing to provide investors with material information.

 In addition, the Final Rule Release makes these important points about the principles-based approach to the discussion of contractual obligations:

We are eliminating Item 303(a)(5) as proposed and, in consideration of comments received, we are also amending Item 303(b) to specifically require disclosure of material cash requirements from known contractual and other obligations as part of a liquidity and capital resources discussion. As discussed in the Proposing Release, the Commission believed that eliminating current Item 303(a)(5) should not result in the loss of material information.

This approach is now built into S-K Item 303 with this new instruction:

4. For the liquidity and capital resources disclosure, discussion of material cash requirements from known contractual obligations may include, for example, lease obligations, purchase obligations, or other liabilities reflected on the registrant’s balance sheet. Except where it is otherwise clear from the discussion, the registrant must discuss those balance sheet conditions or income or cash flow items which the registrant believes may be indicators of its liquidity condition.

So, along with the elimination of the table we need to delve into the Final Rule’s principles-based expansion of the liquidity and capital resources discussion.  And with these changes, there is a real opportunity to improve MD&A.  The liquidity and capital resources discussion is, unfortunately, frequently poorly written.  Part of this goes back to the lack of clarity and the brevity of the old requirements, and part of it goes back to challenges in discussing what is presented in the statement of cash flows.  All in all, most companies have a chance to improve this section of their MD&A.  And that will be the focus of the last post in this series where we explore the changes for liquidity and capital resources.

As always, your thoughts and comments are welcome!

In this post, we overviewed the changes to MD&A in 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.  It is effective for filings on or after February 10, 2021.

The rule’s transition provisions include 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, 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.  Even if a company does not implement the rule early, it is not too soon to start planning for any required changes.

In the second, third and fourth posts in this series, we reviewed and discussed the addition of an objective to S-K Item 303, the new critical accounting estimate disclosures, and changes to results of operations and known trend discussions.

This fifth post addresses the SEC’s proposed changes to disclosures about off-balance sheet arrangements or OBAs.

The history of OBA disclosures is deeply entwined with the history of one company, Enron.  When MD&A was created in 1980, well before Enron made news, it required discussion of OBAs via this requirement in S-K Item 303(a) for capital resources:

(2) Capital resources. (i) Describe the registrant’s material commitments for capital expenditures as of the end of the latest fiscal period, and indicate the general purpose of such commitments and the anticipated source of funds needed to fulfill such commitments.

(ii) Describe any known material trends, favorable or unfavorable, in the registrant’s capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off-balance sheet financing arrangements.

Even with this requirement, Enron demonstrated that companies did not always robustly disclose these risks.  In the wake of Enron’s use of OBAs, Congress wrote new requirements into the Sarbanes-Oxley Act to expand OBA disclosures.  The SEC implemented this requirement via a new paragraph 4 in S-K Item 303, which starts with this language:

(4) Off-balance sheet arrangements. (i) In a separately-captioned section, discuss the registrant’s off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

While the term off-balance sheet arrangements can be interpreted in several ways, S-K Item 303(a) limits this disclosure to four very technical areas:

(ii) As used in this paragraph (a)(4), the term off-balance sheet arrangement means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant has:

(A) Any obligation under a guarantee contract that has any of the characteristics identified in FASB ASC paragraph 460-10-15-4 (Guarantees Topic), as may be modified or supplemented, and that is not excluded from the initial recognition and measurement provisions of FASB ASC paragraphs 460-10-15-7, 460-10-25-1, and 460-10-30-1.

(B) A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to such entity for such assets;

(C) Any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument, except that it is both indexed to the registrant’s own stock and classified in stockholders’ equity in the registrant’s statement of financial position, and therefore excluded from the scope of FASB ASC Topic 815, Derivatives and Hedging, pursuant to FASB ASC subparagraph 815-10-15-74(a), as may be modified or supplemented; or

(D) Any obligation, including a contingent obligation, arising out of a variable interest (as defined in the FASB ASC Master Glossary), as may be modified or supplemented) in an unconsolidated entity that is held by, and material to, the registrant, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the registrant.

Over time the FASB began to require financial statement disclosures about many of these areas.  In the Final Rule the SEC notes:

Since the adoption of Item 303(a)(4), as described further in the Proposing Release, the FASB has issued additional requirements that have caused U.S. GAAP to further overlap with the item. In the Commission staff’s experience, this overlap often leads to registrants providing cross-references to the relevant notes to their financial statements or providing disclosure that is duplicative of information in the notes in response to Item 303(a)(4).

The SEC also includes this rationale for the change:

For the reasons discussed in the Proposing Release, we continue to believe that the updates to U.S. GAAP since the adoption of Item 303(a)(4), as well as the current amendments designed to emphasize the principles-based nature of MD&A, justify the replacement of the current, more prescriptive requirement with a principles-based instruction.

The new MD&A guidance removes the old disclosure in paragraph (a)(4) and adds this instruction to S-K Item 303:

8. Discussion of commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have or are reasonably likely to have a material current or future effect on a registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements or capital resources must be provided even when the arrangement results in no obligations being reported in the registrant’s consolidated balance sheets. Such off-balance sheet arrangements may include: guarantees; retained or contingent interests in assets transferred; contractual arrangements that support the credit, liquidity or market risk for transferred assets; obligations that arise or could arise from variable interests held in an unconsolidated entity; or obligations related to derivative instruments that are both indexed to and classified in a registrant’s own equity under U.S. GAAP.

In theory, this change would eliminate disclosure that essentially duplicates information in the financial statement footnotes and would focus on the potential “future effect” such arrangements might have.  The opportunity to improve MD&A here focuses on eliminating information that is already in the financial statements and making MD&A disclosure more focused on risk and how OBAs might affect future financial position and performance.

As always, your thoughts and comments are welcome!