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!

The SEC’s Dodd-Frank “pay versus performance” final rule raised a number of overall and detailed implementation questions.  To help companies as they build these disclosures, Gary M. Brown of Nelson Mullins Riley & Scarborough LLP, and a frequent SEC Institute workshop leader, has built a very helpful implementation template.  You can find the template here.

In addition, on January 5, 2023, Mr. Brown and SEC Institute Director George M. Wilson will present a One-Hour Briefing,  Finished Business – The SEC’s New Pay Versus Performance and Clawback Rules, to provide insights and guidance for companies as they implement these complex new requirements.

As always, your thoughts and comments are welcome!

On December 8, 2022, the PCAOB issued a report titled “Staff Update and Preview of 2021 Inspection Observations”.  The report shows an increase in the number of audits with deficiencies at audit firms inspected in 2021.  The report indicates that many of the areas that have historically been the source of audit deficiencies continue to be problematic.  These include ICFR audit areas such as testing controls with a review element and identifying controls to test, and financial statement audit areas such as revenue recognition and inventory.  In addition, deficiencies related to the reporting of critical audit matters increased in 2021 inspections.

You can read more in this News Release and the staff report.

As always, your thoughts and comments are welcome!

On December 13, 2022, just in time for the holidays, CorpFin updated several non-GAAP measure Compliance and Disclosure Interpretations.  You can find the CorpFin announcement here and the updated C&DIs here.  C&DI Questions 100.01, 100.04 – 100.06, and 102.10(a)(b)(c) were updated.  All companies that use non-GAAP measures should review these updates.

As an example, the old language of C&DI 100.01 read:

Question 100.01

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading. [May 17, 2016]

The update expands the discussion of what might make an adjustment misleading.  The changed language is in bold below:

Question 100.01

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. Whether or not an adjustment results in a misleading non-GAAP measure depends on a company’s individual facts and circumstances.

Presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business is one example of a measure that could be misleading.

When evaluating what is a normal, operating expense, the staff considers the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment.

The staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring. [December 13, 2022]

As always, your thoughts and comments are welcome!

On November 15, 2022, the SEC Enforcement Division issued a press release announcing its fiscal year 2022 results.  As it did last year, the Commission again used this simpler release rather than a glossy annual report.  Highlights for the year include:

• • Money ordered in SEC actions in f/y 2022 actions totaled $6.439 billion, a significant increase over $3.852 billion for f/y 2021,
  • The Division filed 760 enforcement actions in 2022, an increase of 9 percent over the prior year, and
  • Actions included 169 “follow-on” cases to bar or suspend individuals.

You can read more details, including the SEC’s focus on individual accountability, along with commentary by SEC Chair Gary Gensler in this Press Release and accompanying addendum.

If you would like to hear a deeper discussion of the Enforcement Division’s report, you can check out this episode of our inSecurities Podcast where co-hosts Chris Ekimoff and Kurt Wolfe delve into the report with a number of experts and former inSecurities guests.  And, if you would like a deeper dive into accounting-related enforcement issues and the role of the Enforcement Division’s Chief Accountant, check out this episode of inSecurities where Chris and Kurt discuss these issues along with the auditor’s responsibility for identifying fraud with Matt Jacques, a former Chief Accountant for the SEC’s Enforcement Division.

As always, your thoughts and comments are welcome!