Category Archives: Reporting

Getting Ahead of the MD&A Update Curve – Critical Accounting Estimates

Reporting, SEC Hot Topic, Uncategorized

As we discussed in this 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!

This post presents an example comment and company response for the first of these three areas, critical accounting estimate disclosures.  While the example, particularly the revised disclosure, is lengthy, the lesson is simple.  Critical accounting estimates are not the same thing as accounting policies.  This is a very simple comment to avoid.

The Regulation S-K Item 303 guidance for critical accounting estimate disclosures, which was in FR 72 prior to the 2020 rule modernization, requires companies to go beyond accounting policy disclosure in the financial statements:

Critical accounting estimates. Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant. Provide qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the critical accounting estimate has had or is reasonably likely to have on financial condition or results of operations to the extent the information is material and reasonably available. This information should include why each critical accounting estimate is subject to uncertainty and, to the extent the information is material and reasonably available, how much each estimate and/or assumption has changed over a relevant period, and the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation.

Here is an example disclosure from a company’s Form 10-K that became the source of a critical accounting estimate comment. (Note that the title in this example is out of date.  It should, as stated in S-K Item 303, be Critical Accounting Estimates.)

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities at the date of the financial statements. We believe our estimates and assumptions are reasonable; however, actual results could differ from those estimates.

Our most significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult, subjective, or complex judgments, or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria:

(1) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and

(2) different estimates reasonably could have been used, or changes in the estimate that are reasonably

We have identified the following critical accounting policies:

      • Revenue Recognition
      • Loyalty Program Accounting
      • Asset Impairment Analysis
      • Valuation of the TRA Liability

(Note: For the sake of illustration only the Loyalty Program Accounting disclosure is included here.  You can find the entire disclosure by the company here.)

Loyalty Program Accounting – The Company records a liability for loyalty points earned by passengers under its Sun Country Rewards program using two methods: (1) a liability for points that are earned by passengers on purchases of the Company’s services is established by deferring revenue based on the redemption value net of breakage; and (2) a liability for points attributed to loyalty points issued to the Company’s Visa card holders is established by deferring a portion of payments received from the Company’s co-branded agreement. The Company’s Sun Country Rewards program allows for the redemption of points to include payment towards air travel, land travel, taxes, and other ancillary purchases. The Company estimates breakage for loyalty points that are not likely to be redeemed. These estimates are based on historical experience of loyalty point redemption activity and other factors, such as program changes and modifications that could affect the ultimate usage pattern of loyalty points.

While this seems like a fairly robust accounting policy disclosure, as a critical accounting estimate disclosure it generated this comment:

Management’s Discussion and of Financial Condition and Results of Operations Critical Accounting Policies and Estimates, page 4

    1. The disclosures of your critical accounting policies and estimates appear to be a
      repetition of certain of your significant accounting policies. Please revise your disclosures to address the material implications of the uncertainties that are associated with the methods, assumptions and estimates underlying your critical accounting estimates. Your expanded disclosure should address the risk related to using different assumptions and analyze their sensitivity to change based on outcomes that are deemed reasonably likely to occur. For additional guidance, refer to Item 303(b)(3) of Regulation S-K and the related Instruction 3 to paragraph (b) of Item 303.

The essence of this comment is a frequent theme, that simply repeating an accounting policy is not a critical accounting estimate disclosure.  Here is the company’s response, which, as you can read, significantly expands the disclosure (note, it’s ok to skim this lengthy disclosure!):

The Company respectfully acknowledges the Staff’s comment and will revise future filings in response to the Staff’s comment. Utilizing the disclosure from the most recent annual report on Form 10-K, the following reflects our proposed updated disclosures to be included in future filings. The Company notes there have been no changes to the selection and application of its critical accounting policies and estimates. The Company will continue to evaluate any reasonably likely changes that could impact its critical accounting estimates and provide updated disclosure in future filings as necessary. All numbers below are presented in thousands consistent with the disclosure approach used in the Company’s most recent annual report on Form 10-K.

Critical Accounting Policies and Estimates

……..

Loyalty Program Accounting

The Sun Country Rewards program provides loyalty awards to program members based on accumulated loyalty points. The Company records a liability for loyalty points earned by passengers under the Sun Country Rewards program using two methods: (1) a liability for points that are earned by passengers on purchases of the Company’s services is established by deferring revenue based on the redemption value, net of breakage; and (2) a liability for points attributed to loyalty points issued to the Company’s Visa card holders is established by deferring a portion of payments received from the Company’s co-branded agreement. The Company’s Sun Country Rewards program allows for the redemption of points to include payment towards air travel, land travel, taxes, and other ancillary purchases. The balance of the Loyalty Program Liabilities fluctuates based on seasonal patterns, which impact the volume of loyalty points awarded through travel or issued to co-branded credit card and other partners (deferral of revenue) and loyalty points redeemed (recognition of revenue). The Company records an estimate for loyalty points breakage in Passenger Revenue upon issuance of the loyalty points. Loyalty points held by co-branded credit card members do not expire. All other loyalty points expire if unused after three years.

Points Earned Through Travel Purchases. Passenger sales that earn Sun Country Rewards provide customers with travel services and loyalty points, which are each considered distinct performance obligations. The Company values each performance obligation on a standalone basis. The Company determines the standalone selling price of loyalty points issued using a redemption value approach which considers the value a passenger will receive upon redemption of the loyalty points. Consideration allocated to loyalty points is deferred, net of estimated breakage, and recognized as Passenger Revenue when both the loyalty points have been redeemed and the passenger travel occurs.

Points Earned through the Co-Branded Credit Card Program. Under the Company’s co-branded credit card program, funds received for the marketing of a co-branded credit card and delivery of loyalty points are accounted for as a multiple-deliverable arrangement. The Company determined the arrangement has two distinct performance obligations: loyalty points to be awarded; and use of our brand and access to our customer lists, and certain other advertising and marketing elements (collectively, the marketing performance obligation). Funds received from the co-branded credit card program are allocated to the two performance obligations based on relative standalone selling price. The assumptions used to allocate the funds received are not considered critical to the application of the accounting model for the Company’s loyalty program. Consideration allocated to loyalty points is deferred, net of estimated breakage, and recognized as Passenger Revenue when both the loyalty points have been redeemed and the passenger travel occurs. Consideration allocated to the marketing performance obligation is recognized as revenue as the spend occurs and is recorded in Other Revenue.

The Company estimates breakage for loyalty points that are not likely to be redeemed. Loyalty points are combined in one homogenous pool, that includes both air and non-air travel awards, and are not separately identifiable. The estimated breakage rate is primarily based on historical experience of loyalty point redemption activity and other factors that may not be indicative of future trends, such as the COVID-19 pandemic, program changes or modifications that could affect the ultimate usage pattern of loyalty points. The Company continuously monitors its breakage rate assumptions and may adjust its estimated breakage rate for loyalty points in the future. Changes in the Company’s estimated breakage rate assumptions impact revenue recognition prospectively.

During the year ended 2021, the Company recognized $852 of loyalty points breakage within Passenger Revenue. A 10% change in the Company’s loyalty point estimated breakage rate would have resulted in a change to Passenger Revenue of approximately $170.

Our next post will explore another frequent comment area, providing both quantitative and qualitative explanations for material changes.

As always, your thoughts and comments are welcome!

Are You Behind the MD&A Update Curve?

Hot Topic, Reporting

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

  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.

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.

CorpFin Issues Sample Letter to Companies Addressing Crypto Asset Markets

Hot Topic, Reporting

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!

CorpFin Addresses Universal Proxy Questions

Reporting

The SEC’s November 2021 adoption of universal proxy rules was expected to create detailed questions related to their use.  As a reminder, universal proxy cards allow shareholders to vote in the same way they could if they voted in person at a meeting.  To make this possible, a universal proxy includes all duly nominated persons from all parties on the same card.  This allows shareholders to select candidates from different slates as they vote on the universal proxy card.

On December 6, 2022, CorpFin issued three Compliance and Disclosure Interpretations (C&DIs) addressing questions concerning dissident shareholder nominations and universal proxy cards.  You can find the three new C&DIs here.

As always, your thoughts and comments are welcome!

Fraud – A Forewarning Message from the Chief Accountant?

Hot Topic, Reporting

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!

Check Out the SEC’s Fall 2022 Reg Flex Agenda

Hot Topic, Reporting

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!

A Pay Versus Performance Template from Gary M. Brown of Nelson Mullins

Hot Topic, Reporting

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!

PCAOB Previews 2021 Inspection Observations

Hot Topic, Reporting

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!

CorpFin Updates Non-GAAP Compliance and Disclosure Interpretations

Hot Topic, Reporting

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!

SEC Enforcement Division Announces Fiscal Year 2022 Results

Hot Topic, Reporting

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!