Tag Archives: financial accounting

Message From Enforcement: Metrics Matter!

Hot Topic, , , , , , , , , , , , ,

Metrics, measures of performance drivers outside the financial statements, have become a larger part of how companies communicate with investors in recent years. As with all communication tools, a carefully planned, balanced presentation is important. Well-designed metrics can provide greater insight into the fundamentals of a company’s operations.

As with other elements of financial reporting, metrics can be misused. A metric could be poorly designed and not really correlate with financial performance. A metric could also be misstated or manipulated.

Poorly Designed Metrics

Many tech companies have complex and hard to understand revenue models. Measures such as “daily active users” and “monthly active users” can help users understand a company’s performance. That said, the link between the metric and performance needs to be clear. The CorpFin Staff has written many comments about this issue. Here are a couple of examples:

  1. In your various quarterly earnings calls, we note your discussion of the performance of your business in terms of the “add/quit metric” and “uniform wearer losses” (based upon changes in the number of uniform wearers within particular sectors of your customer base). We further note this is your fourth consecutive quarter of negative uniform wearer losses. Please expand your MD&A to include this information as well as a discussion of any trends or uncertainties. Additionally, the add/stop metric appears to have a meaningful impact on operating margins and growth rate. Please expand your disclosure to provide a complete picture of the relationship between the add/quit metric, operating margins, and growth rate for each material sector of your customer base. Please refer to Item 303(a)(3) of Regulation S-K and Section III.B.1. of SEC Release 33-8350.

 

  1. We note your statement that your results are highly dependent on comparable store sales. We further note that your comparable store sales have declined over the last three years and within each year have generally declined each quarter. We also note your statements that your comparable store sales are difficult to predict in the current competitive landscape and may get marginally worse before they get better. Given the importance of this metric to your results and its significant decline over the last three fiscal years, please tell us and disclose in more detail the factors that contributed to this decline, such as any significant declines in prices, including significant increases in your promotional activity, any significant declines in the volume of items sold, any change in the mix of products being sold or any other material factors that had a significant impact on the decline in your comparable store sales. While this decline in comparable store sales may ultimately be driven by your competitive environment, we believe a more detailed discussion of changes in intermediate factors such as price and volume will provide more transparency to your investors as to how you are affected by this competition, any steps management has taken to mitigate the impact of this competition and the success of management’s strategies. Refer to Item 303(a)(3)(iii) of Regulation S-K and SEC Release No. 33-8350.

 

Misstated Metrics and Enforcement

When companies present metrics, they should be very careful to use a balanced approach to the information and use the metric consistently to avoid presenting potentially misleading information. We discussed many of these issues in our One-Hour Briefing about Non-GAAP Measures and Metrics. You can find the briefing at:

 

www.pli.edu/Content/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-1z10vnyZ4n?ID=282910

 

One really “old school” example metric would be the financial ratio gross margin. It is not a non-GAAP measure so long as it is computed using the revenues, cost of sales and gross margin lines on a company’s income statement. For retailers, it is a crucial measure of performance. Gross margin trend over time can have a significant impact on how investors view a retailer.

In a recent enforcement case the SEC fined a large outdoor products retailer and its CFO for manipulating their gross margin and then misstating why gross margin changed. The source of the issue was a fee the company charged to its wholly owned banking subsidiary. In the retailer’s financial statements the fee was used to reduce cost of sales and thus increase gross margin. Such a fee would normally be eliminated in consolidation. Here though, the company failed to eliminate this intercompany transaction. As a result, in the consolidated financial statements the net income of the financing part of the business was understated and the gross margin of the retailing part of the business was overstated. Additionally, the company did not disclose that this intercompany fee had increased their gross margin and actually attributed the increase to other causes.

 

Here is a quote from the enforcement order:

This in turn increased ——– merchandise gross margin percentage, a key company-specific financial metric that signaled the profitability of the company and was referenced by the company in earnings releases and analysts calls.

 

The end result: Enforcement!

And, a clear message, manipulating metrics can get a company into just as much trouble as manipulating the financial statements!

You can read the enforcement release at:

www.sec.gov/litigation/admin/2016/34-77717.pdf

 

As always, your thoughts and comments are welcome!

A non-GAAP Measure Subtle Trap

Hot Topic, , , , , , , , , , , , , , , , , , ,

One of the more complex traps when presenting non-GAAP measures is this question:

Which source of SEC non-GAAP measure guidance applies to your earnings release:

Reg G, or

S-K Item 10(e)?

In case you are not familiar with Reg G and S-K Item 10(e) and when each of them applies:

Reg G applies when you use a non-GAAP measure in a non-filed source, and

S-K Item 10(e) applies when you use a non-GAAP measure in a filed document.

You can learn more about these two non-GAAP rules in some of the earlier posts on our blog. Here is a post with the basics:

 

seciblog.pli.edu/?p=401

 

You can also check out our one-hour briefing about non-GAAP measures from March 2016 at:

www.pli.edu/Content/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-1z10vnyZ4n?ID=282910

 

The trap here is this: You might believe that since an earnings release is not a filed document Reg G is the applicable guidance, and all you have to do is present the most directly comparable GAAP measure and provide a reconciliation.

That is NOT the case. The reason that S-K Item 10(e) applies to your earnings release is actually very subtle. It is in the instructions to Form 8-K. Tucked away in the earnings release 8-K, Item 2.02, is this instruction:

 

  1. The requirements of paragraph (e)(1)(i) of Item 10 of Regulation S-K (17 CFR 229.10(e)(1)(i)) shall apply to disclosures under this Item 2.02.

 

Thus, the first part of S-K Item 10(e) DOES apply to your earnings release, even though it is not “filed” and even though the Item 2.02 8-K is not a filed document!

 

So, to be very detailed, this part of S-K Item 10(e) applies to year earnings release (there are other requirements in S-K Item 10(e) that do not apply, we won’t list them here):

 

(e) Use of non-GAAP financial measures in Commission filings. (1) Whenever one or more non-GAAP financial measures are included in a filing with the Commission:

 

(i) The registrant must include the following in the filing:

(A) A presentation, with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with Generally Accepted Accounting Principles (GAAP);

 

(B) A reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historical non-GAAP measures presented, and quantitative, to the extent available without unreasonable efforts, for forward-looking information, of the differences between the non-GAAP financial measure disclosed or released with the most directly comparable financial measure or measures calculated and presented in accordance with GAAP identified in paragraph (e)(1)(i)(A) of this section;

 

(C) A statement disclosing the reasons why the registrant’s management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant’s financial condition and results of operations; and

 

(D) To the extent material, a statement disclosing the additional purposes, if any, for which the registrant’s management uses the non-GAAP financial measure that are not disclosed pursuant to paragraph (e)(1)(i)(C) of this section; and

 

One area the staff will comment on is the “equal or greater prominence” requirement in paragraph (A) above. Here is an example comment:

 

  1. We note that in the Financial Highlights section of your press release furnished on Form 8-K, you disclose Total Segment EBITDA, a non-GAAP financial measure, without the disclosure of the most comparable GAAP measure. Please note that under Item 10(e)(1)(i)(A) when a non-GAAP financial measure is presented, the most directly comparable financial measure calculated in accordance with GAAP must be disclosed with equal or greater prominence. Please revise accordingly. See also Instruction 2 to Item 2.02 of Form 8-K.

 

As always, your thoughts and comments are welcome!

 

 

The SEC Comment Process – What if?

SEC Hot Topic, , , , , , , , , , , , , , , , , , ,

In all our workshops and seminars, when we discuss the SEC review process we always emphasize that when you get a comment from the staff you do NOT immediately change disclosure in response to the comment. As the staff says in their on-line “Filing Review Process” document, they view the process of issuing comments as a “dialogue with a company about its disclosure”.

You can find the filing review process document, which is updated on a regular basis at:

www.sec.gov/corpfin/Article/filing-review-process—corp-fin.html

 

To illustrate, here is a real life comment example.

 

STEP ONE – COMMENT RECEIVED

What would you do if you received this comment?

 

Reportable Segments, page 39

  1. Your segment discussion and analysis only refers to non-GAAP amounts. Pursuant to Item 10(e) of Regulation S-K, we remind you that more prominence should not be given to non-GAAP financial measures compared to GAAP financial measures. In this regard, please revise your discussion and analysis to first provide a discussion of the corresponding GAAP amounts for each segment ensuring equal prominence to that of your non-GAAP amounts.

The comment uses the language “please revise”, which is a bit scary, and in the back of our minds we hope we can push the comment to an “in future filings” comment if we decide the staff is on-point. The comment is focused on the use of non-GAAP measures in MD&A as discussed in operating segment disclosures. Of course, the use of non-GAAP measures in segment disclosures is appropriate if in fact your chief operating decision maker uses non-GAAP information. So, your first step in the research process for this comment might be to go review that part of ASC 280.

 

 

STEP TWO – REVIEW GAAP LITERATURE

Here is the relevant section:

Measurement

50-27     The amount of each segment item reported shall be the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing a public entity’s general-purpose financial statements and allocations of revenues, expenses, and gains or losses shall be included in determining reported segment profit or loss only if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets that are included in the measure of the segment’s assets that is used by the chief operating decision maker shall be reported for that segment. If amounts are allocated to reported segment profit or loss or assets, those amounts shall be allocated on a reasonable basis.

ASC 280 then goes on to require disclosure about the measurement basis used for segment disclosures:

50-29     A public entity shall provide an explanation of the measurements of segment profit or loss and segment assets for each reportable segment. At a minimum, a public entity shall disclose all of the following (see Example 3, Cases A through C [paragraphs 280-10-55-47 through 55-49]):

  1. The basis of accounting for any transactions between reportable segments.
  2. The nature of any differences between the measurements of the reportable segments’ profits or losses and the public entity’s consolidated income before income taxes, extraordinary items, and discontinued operations (if not apparent from the reconciliations described in paragraphs 280-10-50-30 through 50-31). Those differences could include accounting policies and policies for allocation of centrally incurred costs that are necessary for an understanding of the reported segment information.
  3. The nature of any differences between the measurements of the reportable segments’ assets and the public entity’s consolidated assets (if not apparent from the reconciliations described in paragraphs 280-10-50-30 through 50-31). Those differences could include accounting policies and policies for allocation of jointly used assets that are necessary for an understanding of the reported segment information.
  4. The nature of any changes from prior periods in the measurement methods used to determine reported segment profit or loss and the effect, if any, of those changes on the measure of segment profit or loss.
  5. The nature and effect of any asymmetrical allocations to segments. For example, a public entity might allocate depreciation expense to a segment without allocating the related depreciable assets to that segment.

 

ASC 280 also includes this reconciliation requirement:

 

50-30     A public entity shall provide reconciliations of all of the following (see Example 3, Case C [paragraphs 280-10-55-49 through 55-50]):

  1. The total of the reportable segments’ revenues to the public entity’s consolidated revenues.
  2. The total of the reportable segments’ measures of profit or loss to the public entity’s consolidated income before income taxes, extraordinary items, and discontinued operations. However, if a public entity allocates items such as income taxes and extraordinary items to segments, the public entity may choose to reconcile the total of the segments’ measures of profit or loss to consolidated income after those items.
  3. The total of the reportable segments’ assets to the public entity’s consolidated assets.
  4. The total of the reportable segments’ amounts for every other significant item of information disclosed to the corresponding consolidated amount. For example, a public entity may choose to disclose liabilities for its reportable segments, in which case the public entity would reconcile the total of reportable segments’ liabilities for each segment to the public entity’s consolidated liabilities if the segment liabilities are significant.

 

With this, our review of the relevant GAAP literature is well underway, and substantially complete.

 

STEP THREE – REVIEW THE RELEVANT SEC NON-GAAP GUIDANCE

As you research the SEC’s requirements surrounding the use of non-GAAP measures, most of us are familiar with Reg G, which applies to non-GAAP measures in documents that are not filed, such as earnings releases. But this comment is about S-K Item 10(e) which applies to non-GAAP measures included in MD&A. As you read Item 10(e) you would find:

(5) For purposes of this paragraph (e), non-GAAP financial measures exclude financial measures required to be disclosed by GAAP, Commission rules, or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the registrant. However, the financial measure should be presented outside of the financial statements unless the financial measure is required or expressly permitted by the standard-setter that is responsible for establishing the GAAP used in such financial statements.

Where to go from here? Lets get into the specific facts in the company’s Form 10-K.

 

 

STEP FOUR – APPLY THE RESEARCH TO THE COMPANY’S DISCLOSURES

Here is an excerpt from the company’s segment note:

 

“We prepared the financial results for our reportable segments on a basis that is consistent with the manner in which we internally disaggregate financial information to assist in making internal operating decisions. We included the earnings of equity affiliates that are closely associated with our reportable segments in the respective segment’s net income. We have allocated certain common expenses among reportable segments differently than we would for stand-alone financial information. Segment net income may not be consistent with measures used by other companies. The accounting policies of our reportable segments are the same as those applied in the consolidated financial statements.”

Here is an excerpt from the MD&A disclosure that the SEC comment is focused on:

When compared to the same period last year, core earnings increased in the twelve months ended December 31, 2013 by $202 million, or 13%, driven by the following items:

 

· Higher core earnings in the Optical Communications, Life Sciences,

Environmental Technologies and Display Technologies segments in the

amounts of $59 million, $44 million, $11 million and $7 million, respectively; and
·  

Lower operating expenses in the amount of $49 million, driven by a decrease in

variable compensation and cost control measures implemented by our segments.

 

You can find the company’s Form 10-K at:

files.shareholder.com/downloads/glw/1822865217x0xS24741%2D15%2D15/24741/filing.pdf

 

You can read the issues the SEC is commenting about in MD&A on page 39, and the segment note starts on page 137.

At this point we are ready to make an informed judgment about the comment. And this one follows a really twisty path! First, the MD&A clearly includes non-GAAP measures for “core” operations. And, interestingly, these are not the measures that are disclosed in the segment note in the financial statements. Since the measures used in the MD&A are not in the segment note the provision in S-K Item 10(e) excluding disclosures required under GAAP does not apply, and so the company must comply with the provisions. The next step is to, as we said above, make a case with the staff that it will be appropriate to fix this comment in future filings and not amend the current Form 10-K.

 

STEP FIVE – RESPOND TO THE COMMENT

Here is the company’s response to the comment, and the staff did allow this to become a future filings comment:

We acknowledge the Staff’s comments and, beginning with our Form 10-Q filed for the second quarter of 2014, will revise our future disclosure to ensure that more prominence is not given to non-GAAP financial measures when compared to GAAP financial measures.  With respect to the request to revise our discussion and analysis to first provide a discussion of the corresponding GAAP amounts for each segment, we provide the following updated disclosure, which we propose to use in future filings.

You can read the response letter and the complete version of the response to comment 8 including the proposed disclosure at:

 

www.sec.gov/Archives/edgar/data/24741/000002474114000025/filename1.htm

 

 

As always, your thoughts and comments are welcome!

Some XBRL News and A Few Tidbits

XBRL News, , , , , , , , , , , , , , , , , ,

XBRL has not really been in the news much lately, but on March 29, 2016 the SEC released a second DERA study about tagging processes. The study, titled “Staff Observations of Custom Axis Tags” is at:

www.sec.gov/structureddata/reportspubs/osd_assessment_custom-axis-tags.html

Here is an excerpt from the introduction of the report:

As part of our ongoing process to monitor registrant compliance with the requirements to report their financial information in their eXtensible Business Reporting Language (XBRL) exhibits, staff in the SEC Division of Economic and Risk Analysis recently assessed certain aspects of the XBRL exhibits that affect the data quality of the disclosures provided. Specifically, the staff examined the use of custom axis tags in XBRL exhibits that reporting companies submitted with their annual reports on Form 10-K. An axis tag in XBRL allows a filer to divide reported elements into different dimensions (e.g., revenue by geographical area, fair value measurement levels, components of total equity (e.g., common, preferred)) while also showing the relationships between separately reported elements.

……………

The staff’s analysis resulted in a few key observations. First, unlike our previous staff observations that revealed a lower average rate of custom line item tags among large filers, staff observed a higher average use of custom axis tags as filer size increased, with the rate of custom axis tags highest for large accelerated filers. Second, for a random sample of filings that staff reviewed, staff observed instances of filers creating custom axis tags unnecessarily when an appropriate standard axis tag existed in the U.S. GAAP taxonomy.

 

This is an interesting development, and clearly demonstrates the SEC’s work to help make XBRL information more reliable and useful.

The earlier information the SEC has issued about XBRL include:

A “Dear CFO” letter about calculation structures that is at:

www.sec.gov/divisions/corpfin/guidance/xbrl-calculation-0714.htm

This earlier DERA study of extension use at:

www.sec.gov/dera/reportspubs/assessment-custom-tag-rates-xbrl.html

 

Getting XBRL Right

Next, here is a good reminder to make sure that your XBRL submissions are prepared properly and tagging is done appropriately. While XBRL is not subject to ICFR and there is no requirement for any sort of auditor review, XBRL submissions are subject to your disclosure controls and procedures. As a result you should have appropriate controls to assure that your XBRL submission:

“is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.”

The above quote is from the definition of Disclosure Controls and Procedures in Exchange Act Rule 13a-15 which is at:

www.ecfr.gov/cgi-bin/text-idx?SID=8e0ed509ccc65e983f9eca72ceb26753&node=17:4.0.1.1.1&rgn=div5#se17.4.240_113a_615

This requirement is highlighted in a recent Form 10-K/A filed by Goldman Sachs to make some corrections in their XBRL submission. Goldman filed their original 10-K on February 19, 2016 and on March 1, 2016 filed a Form 10-K/A. As is required by the Exchange Act Rules for amendments, Goldman included this explanatory note:

EXPLANATORY NOTE

Due to an error by our external financial printer, our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 (Original Form 10-K) was filed with an incorrect version of Exhibit 101, which provides items from our Original Form 10-K formatted in eXtensible Business Reporting Language.

This Amendment No. 1 on Form 10-K/A (Amendment) to our Original Form 10-K, filed on February 19, 2016, is being filed in accordance with Rule 12b-15 under the Securities Exchange Act of 1934 for the sole purpose of including the correct version of Exhibit 101.

This Amendment does not amend or otherwise update any other information in the Original Form 10-K and does not reflect events occurring after the date of the Original Form 10-K.

Goldman was perhaps doing something that is appropriate, which we discuss in our workshops. After the filing someone likely double checked the XBRL submission and found the problem, and they fixed it as soon as possible. This is an example of disclosure controls in action on a detective basis, and again, while the SEC has not really indicated that they will do a lot of review of XBRL submissions, we need to make sure they are done appropriately. And, who knows, it is possible the SEC pointed this out to Goldman.

 

Taxonomy Update

On March 7, 2016 the SEC updated the EDGAR system to accept the 2016 XBRL taxonomies previously released by the FASB. The announcement is at:

www.sec.gov/structureddata/announcement/osd-announcement-030716—xbrl-taxonomy-update.html

 

Using XBRL Information

While we still don’t hear a lot about users taking advantage of all the information in the XBRL database, user tools are continuing to evolve. One tool that provides a nice way to access and use XBRL data comes from a company called Calcbench. If you do peer group analysis or are searching for comparable disclosures, this is a very useful tool. You can learn more at:

www.calcbench.com

 

As usual your thoughts and comments, including any insights you have about people using XBRL or XBRL user tools, is welcome!

Ever Been to an SEC Event? Mark out April 13 for a webcast!

Uncategorized, , , , , , , , , , , , , , , , , , , , , ,

In our workshops we sometimes joke (a bit) about how fun it is to listen to a webcast of an SEC meeting. And yes, we do say the same thing about FASB meetings. (Total Geek-Out For Sure!)

These meetings are interesting in that you can observe the process the SEC Commissioners and the FASB follow. The depth of the discussions and their careful consideration of the issues is always fascinating to observe.

These meetings generally do not tell you what might happen in the short-term, but do provide a longer-term glimpse into the directions of policy-making and standard setting.

Disclosure effectiveness is a major longer-term initiative at the SEC right now. On April 13, 2016 the SEC is going to discuss “whether to issue a concept release seeking comment on modernizing certain business and financial disclosure requirements in Regulation S-K.”

As you know, this kind of change is something the SEC staff has wanted to do for years. In addition, provisions of both the JOBS Act and the FAST Act focused on disclosure effectiveness. And here is the logical next step – this meeting will likely help illuminate the future direction of disclosure effectiveness.

 

In addition, this meeting may offer ideas that you can implement now to help make your disclosure more direct and useful to investors.

 

So, perhaps this is the time to listen to one of the meetings? You could play it on your computer, have the sound coming out of your speakers, and think how many of your colleagues would join you and listen! SEC Party time perhaps? If you can’t make the live webcast, you can find all of the archived meetings at http://www.sec.gov/news/openmeetings.shtml

 

You can learn more at:

sec.gov/news/openmeetings/2016/ssamtg033016.htm

 

where the original meeting was announced and at:

www.sec.gov/news/openmeetings/2016/ssamtg041316.htm

where the date was changed from March 30 to April 13, 2016.

 

As always, your thoughts and comments are welcome!

Known Trends and Self-Fulfilling Prophecies

SEC Hot Topic, , , , , , , , , , , , , , , , , , , ,

Forewarning disclosures, the “known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations” are one of the topics we discuss occasionally in our blog posts. This MD&A disclosure can be very problematic because the information disclosed may alarm investors or make management nervous about creating a “self-fulfilling prophecy”.

We are always watching how companies deal with these issues, and here are two examples from both ends of the potential disclosure spectrum.

The first example, dealing with goodwill impairment, is from a company that has been in the news a lot lately, Yahoo. Along with all the issues they have dealt with involving their investment in Alibaba, Yahoo continues to work on building their core business. As part of this process in June of 2013 they acquired Tumblr, the blog-hosting website. The purchase price was $990 million and in connection with the acquisition Yahoo recorded $749 million in goodwill. (See note 4 about acquisitions in the consolidated F/S in the 2015 10-K)

Fast forward the acquisition to December 31, 2015 and in note 5 to the consolidated F/S dealing with impairments Yahoo says:

As identified above, in step one, in 2015, the carrying value of the U.S. & Canada, Europe, Tumblr and Latin America reporting units exceeded the estimated fair value. The Company completed an assessment of the implied fair value of these reporting units, which resulted in an impairment of all goodwill for the U.S. & Canada, Europe, and Latin America reporting units and a partial impairment for the Tumblr reporting unit. The Company recorded goodwill impairment charges of $3,692 million, $531 million, $230 million and $8 million, associated with the U.S. & Canada, Europe, Tumblr, and Latin America reporting units, respectively, for the year ended December 31, 2015. The impairments were a result of a combination of factors, including a sustained decrease in our market capitalization in fourth quarter of 2015 and lower estimated projected revenue and profitability in the near term.

 

So, from June 2013 to December 31, 2015 the $749 million in Tumblr related goodwill was reduced by $230 million. In the tech world, these things happen.

But what about the future? In an interesting spot, Critical Accounting Estimates in their 2015 10-K MD&A Yahoo included this statement:

Given the partial impairment recorded in our Tumblr reporting unit in 2015, it is reasonably possible that changes in judgments, assumptions and estimates we made in assessing the fair value of goodwill could cause us to consider some portion or all of the remaining goodwill of the Tumblr reporting unit to become impaired, which comprised $519 million of our remaining $808 million goodwill balance as of December 31, 2015. In addition, a future decline in market conditions and/or changes in our market share could negatively impact the estimated future cash flows and discount rates used in the income approach to determine the fair value of the reporting unit and could result in an impairment charge in the foreseeable future.

 

This is a direct warning, using the S-K words “reasonably possible”.

 

Here is the second example. These comments are from a letter to a retailing company, and you can see the SEC is asking whether the company effectively dealt with an uncertainty in their future:

  1. Please expand this section to discuss any known material trends, events or uncertainties that have had or are reasonably expected to have a material impact on your liquidity or revenues or income from continuing operations. In this regard, we note (i) persistent comparable store sales decreases in fiscal year 2014 and through the first three quarterly periods of 2015 and (ii) that the company has scaled back its previously planned strategic retail expansion for fiscal year 2016 and beyond.

We also note management’s concern, as expressed in recent earnings calls, regarding the cannibalization effect from new retail stores, coupled with softer than expected new store performances. Please discuss whether you expect comparable store sales to continue to decrease, due to continued cannibalization or otherwise, and the short and long-term actions that you are taking to address any perceived trends. In this regard, your discussion should address your past and future financial condition and results of operation, with particular emphasis on the prospects for the future. See Item 303(a) of Regulation S-K and SEC Release No. 33- 8350.

 

One really interesting part of this comment is how the staff went well beyond the company’s filings to information disclosed in earnings calls.

 

 

As always, your thoughts and comments are appreciated!

Comment of the Week – Market Risk Reminder

Comment of the Week, , , , , , , , , , , , , , , , , , , , , , , , ,

 

We have been discussing the topic of Market Risk Disclosures a lot in this environment of volatile exchange rates, bumpy commodity prices and uncertain interest rates. This disclosure is one of the most confusing parts of Regulation S-K. Without going into a whole lot of details about S-K Item 305 (which we covered in an earlier blog at seciblog.pli.edu/?p=489), as we move towards the end of the first quarter it will continue to be important to focus on getting this disclosure right.

 

So, with this post as a reminder, here is a quick example in a recent comment:

Item7A. Quantitative and Qualitative Disclosures About Market Risk, page 63

  1. Please provide an analysis on whether your “cash flow hedges,” discussed in the second- to-last paragraph of page 63, are material, such that you would need to provide the disclosure in Item 305(a) of Regulation S-K. Please see General Instruction 5.B to Item 305(a) and (b).

 

As usual, your thoughts and comments are welcome!

Another SEC Accounting Enforcement

SEC Hot Topic, , , , , , , , , , , ,

 

The most recent fruit of the SEC Enforcement Division’s on-going efforts to find and bring financial reporting cases is against Monsanto Company and several individuals. It was announced on February 9, 2016. You can read the release here:

www.sec.gov/news/pressrelease/2016-25.html

 

The case involves some of the classic financial reporting problem areas including revenue recognition, manipulation of expenses and ICFR.

 

The settlement includes fines for both the company and individuals as well as two officers being barred from SEC practice. Interestingly, the settlement also requires the company to hire a compliance consultant to deal with the enforcement related issues.

 

The CEO and CFO, while not named in the case, voluntarily repaid bonuses and share based payment awards that would not have been paid if financial results had not been manipulated. This was essentially a voluntary clawback. As a result, the SEC did not have to bring a case based on the clawback provisions of SOX.

 

As always, your thoughts and comments are welcome!

The New Revenue Recognition Standard – When to Start Implementation?

SEC Hot Topic, , , , , , , , , , , , , , , ,

Implementing the new revenue recognition standard is a major challenge that many of us face between now and January 1, 2018 (or whatever fiscal year you have that begins after that date of course.) Many professionals are happy to be close to retirement at this point in time!

With the magnitude of the change in this new standard, including the significantly expanded disclosures which apply to everyone, when is the appropriate time to begin implementation efforts? This is a very complex question. There are still some moving parts as the FASB and IASB continue to make changes to the final standard. The new standard can have varying impacts across companies depending on such issues as complexity of contracts, how product is delivered, do you have software licenses, and principal versus agent issues, to name a few. While the TRG has addressed many issues, there are only a few left to be resolved. While this may seem to be a good sign, the SEC staff has stated concerns that there are not more issues being raised, attributing the low number as a sign that perhaps implementation initiatives are not far enough along or are not being elevated to the TRG (see the September 17th speech by Wesley Bricker, Deputy Chief Accountant in the SEC’s Office of Chief Accountant at: http://www.sec.gov/news/speech/wesley-bricker-remarks-bloomberg-bna-conf-revenue-recognition.html)

There is much discussion about when to begin implementation discussions. To date there has not been much hard data about what companies are actually doing. The Financial Executives Research Foundation (FERF), which is an affiliate of FEI, and PwC have teamed up to survey companies about this issue.

As nearly as we can tell, this is the first really good data about where companies are in the implementation process. You can find the study at:

www.pwc.com/us/revrecsurvey

The survey deals with a number of issues surrounding the impact and implementation of the new standard. It is a good read, and worth spending some time digesting. Here are a couple of things to ponder while you read.

  1. Do you have a reasonable understanding of how the new standard will affect your accounting and disclosure?
  2. What resources will you need in this effort?
  3. What level of organizational involvement across functional areas will be necessary (e.g., sales, legal, etc.)?

As always, your comments and thoughts are welcome!

Comment of the Week – The Mystery of Market Risk Disclosures

Comment of the Week, , , , , , , , , , , , , , , , ,

Market Risk Disclosures are one area that many participants in our workshops seem to shy away from. This Item is one of the less well understood disclosures in Forms 10-K and 10-Q. The mechanics of writing the disclosure are, well, at best, mysterious.

With all the volatility in exchange rates, oil prices and other markets in the current environment these disclosures will likely become more important for many companies this year end. Because of this, we thought “going to go back to the basics” of this disclosure would be helpful in many companies’ year end process. So, this post includes a review of the objective of the disclosure and some tips to navigate the requirements in S-K Item 305 as you prepare the disclosure.

Since this is a comment of the week post, there are also some comments at the end of the post. If you are already comfortable with what market risk disclosures are about and how they work, you can skip to the end!

Objective of the Disclosure

To prepare these disclosures well it is crucial to understand their objective, what they are supposed to tell a reader. To understand this objective the first step is to understand what kind of risk the term “Market Risk” means. Market risk is a term that can be interpreted in a number of different ways ranging from the market for a particular product to market driven rates such as interest rates or commodity prices.

Deep in the body of Regulation S-K – Item 305, likely one of the most challenging reads in all of Regulation S-K, you find these instructions:

Instructions to paragraph 305(b): 1. For purposes of disclosure under paragraph 305(b), primary market risk exposures means:

  1. The following categories of market risk: interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market rate or price risks (e.g., equity price risk); and
  2. Within each of these categories, the particular markets that present the primary risk of loss to the registrant. For example, if a registrant has a material exposure to foreign currency exchange rate risk and, within this category of market risk, is most vulnerable to changes in dollar/yen, dollar/pound, and dollar/peso exchange rates, the registrant should disclose those exposures. Similarly, if a registrant has a material exposure to interest rate risk and, within this category of market risk, is most vulnerable to changes in short-term U.S. prime interest rates, it should disclose the existence of that exposure.

To paraphrase, these disclosures are not about the “market” for a product like computers or smartphones. They are about the risks a company faces from market driven prices like interest rates or commodity prices. So, while the market for smart phones could affect a company, the Market Risk Disclosures are about issues like how a change in interest rates could affect a company if the company has significant investments or borrowings.

And that brings us to the next step in understanding the objective of these disclosures. Once we know what sort of market risk we need to describe, what should we say about it?

In S-K Item 305(a)(1)(ii)(A) you will find this language:

“sensitivity analysis disclosure that expresses the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates”

In other words, this disclosure is designed to help a reader assess how much a change in a market driven price, such as an interest rate or a commodity price, would affect the business.

Conceptually what this disclosure is about is fairly easy to understand. However, the application of S-K Item 305 is complex. It requires both qualitative and quantitative information   Our review here is fairly brief. S-K Item 305 has a maze of detailed rules. If you will be drafting or reviewing the disclosure you should refer to the actual S-K language. Also, the comments below illustrate several of the complexities in this rule.

Qualitative Disclosures

The logical place to start drafting is with qualitative disclosures. Knowing what a company’s market risks are is necessary before quantitative information will make sense to a reader. Unfortunately, in Item 305, the qualitative disclosures are sort of hard to find, as they are not the first thing listed. You can find them in paragraph (b), which says:

(b) Qualitative information about market risk.

(1) To the extent material, describe:

(i) The registrant’s primary market risk exposures;

(ii) How those exposures are managed. Such descriptions shall include, but not be limited to, a discussion of the objectives, general strategies, and instruments, if any, used to manage those exposures; and

(iii) Changes in either the registrant’s primary market risk exposures or how those exposures are managed, when compared to what was in effect during the most recently completed fiscal year and what is known or expected to be in effect in future reporting periods.

This qualitative information is really pretty simple; say what market driven prices such as interest rates, exchange rates, commodity prices or other types of prices affect the company; talk about how you manage them; and tell if they have changed. Note that the rules do not require that a company manage these risks, so if you don’t manage them, you should disclose that, along with the other information in (b) (10) above.  (Here is one place to review Item 305 in detail, as this disclosure needs to be broken down in pretty specific ways by type and source of risk.)

Quantitative Disclosures

The second part of this disclosure is quantitative, and is designed to help a reader understand how much a hypothetical change in market prices or rates could affect the business. Again, this is a very detailed requirement, but in essence starts with a choice among three alternatives:

Tabular Disclosure

S-K Item 305(a)(1)(i)(A)(1) describes a tabular presentation of information related to market risk sensitive instruments. This information includes fair values of the market risk sensitive instruments and contract terms sufficient to determine future cash flows from those instruments, categorized by expected maturity dates. In essence you are providing a reader with the input they could use to build a spreadsheet, make a price change assumption, and see how much the price change would affect the company’s income, cash flows or fair values.

Sensitivity Analysis

S-K Item 305(a)(1)(ii)(A) describes a sensitivity analysis disclosure that expresses the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices over a selected period of time. In essence, in this disclosure you build your own spreadsheet and assume a hypothetical change in rates or prices and compute the impact.

Value at Risk Analysis

S-K Item 305(a)(1) (iii)(A) describes value at risk disclosures that express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments over a selected period of time, with a selected likelihood of occurrence, from changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices. This is actually a complex econometric modeling process, and we won’t discuss it any further in this post. If your treasury or risk management group already uses this technique to assess risk it may well be a good disclosure option.

Again, this is very complex disclosure. You can choose one of the three alternatives for different risks, however you must disclose the most significant impact based on future earnings, fair values, and cash flows. Therefore, you must calculate the impact of a price change on income, cash flows and fair value to determine which has the greatest change, and thus is disclosed. Of course, If future earnings had the greatest impact last year, and this year the greatest impact is in fair value, then you would need to recast the prior year. These are only some of the judgments necessary to prepare this disclosure.
One last note, as you can see this disclosure is very forward looking, and is another reason the 1995 Private Securities Litigation Reform Act safe harbors are so important!
Example Comments

Last but not least, as this is a comment of the week post, here are some comments. Notice the focus on simple compliance with the S-K Item 305 disclosure requirements!

Foreign Currency Fluctuations, page 37

  1. We note from your disclosure on page 28 and in Note 26 that a substantial portion of your cash is held by foreign subsidiaries and 46% of your net sales to unaffiliated customers for fiscal 2014 were attributed to your foreign subsidiaries, respectively. We believe your market risk disclosures should be enhanced to provide a more robust discussion of the effects of foreign currency risk on your results of operations and financial condition. Additionally, your discussion of this market risk does not appear to comply with the guidance outlined in Item 305 of Regulation S-K. Please revise to expand your discussion of foreign currency risk to comply with one of the disclosure alternatives in Item 305(a) of Regulation S-K.

Quantitative and qualitative disclosure about market risk, page 70

  1. Please tell us how you considered the disclosures required by Item 305(a) of Regulation S-K with respect to your term loan.

Item 7A. Quantitative and Qualitative Disclosure About Market Risk

Foreign Currency Risk, page 125

  1. Please tell us what consideration you gave to providing a sensitivity analysis for each currency (e.g., British Pounds and Euro) that may have an individually significant impact on future earnings.

Item 7A – Quantitative and Qualitative Disclosures About Market Risk, page 30

  1. We note your quantitative disclosure of interest rate risk associated with your investments in cash and cash equivalents and investment securities. We also note that your disclosure does not address market risk for other financial instruments such as the senior unsecured notes. Please revise to include qualitative and quantitative information about market risk in accordance with one of the three disclosure alternatives within Item 305 of Regulation S-K and that addresses the interest rate risk for the senior unsecured notes.