Tag Archives: GAAP

Jeepers, You Say There is More Non-GAAP News?

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In the latest step in the SEC’s continuing efforts to, in the words of Corp Fin Chief Accountant Mark Kronforst, “crack down” on the inappropriate use of non-GAAP measures, on May 17, 2016 the SEC updated their Compliance and Disclosure Interpretations about the use of non-GAAP measures.

(At this point we almost want to apologize for how many recent posts we have done about non-GAAP measures, but this new guidance is important.)

You will find them at:

www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm

If you use non-GAAP measures anywhere, earnings releases, MD&A, wherever, read them!

To help you get started, here are a couple of highlights.

This first question is a broad theme in current SEC public remarks, as we have discussed them in recent posts:

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]

This C&DI clarifies issues about per-share presentations:

 

Question 102.05

Question: While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of Commission guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?

 

Answer: No. Item 10(e) recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission, consistent with Accounting Series Release No. 142. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure.  When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure. [May 17, 2016]

 

As always, your thoughts and comments are welcome.

Lots Happening at the PCAOB!

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Since its inception with the Sarbanes-Oxley Act the PCAOB has faced many challenges in fulfilling its responsibilities to establish GAAS for public company audits, inspect audit firms and enforce when auditors do not fulfill their responsibilities. As the PCAOB has evolved one important lesson we have all learned is that their activities and agenda do not affect just auditors. All public company reporting participants have a stake in what they do. For example, the recent audit standard about related party issues was important not just for auditors, but companies needed to assure they would have the information the new standard required auditors to obtain. Some companies even modified their D and O questionnaires in this process.

To help us be aware of where the PCAOB’s activities could impact us all, here are a few items of note going on at the PCAOB right now.

  1. Auditor’s Involvement in non-GAAP Measures

If you use non-GAAP measures in an earnings release, MD&A or other communication vehicles you will want to follow the events of the May 18-19, 2016 meeting of the PCAOB’s Standing Advisory Group. A significant part of the first day’s agenda is a discussion of “Company Performance Measures and the Role of the Auditor”. The meeting will include breakout discussion sessions and a report of the breakout discussions on day two of the meeting. You can find the agenda and how to access a webcast at:

pcaobus.org/News/Releases/Pages/SAG-meeting-agenda-May-18-19.aspx\

  1. Anticipating and Avoiding Accounting and Auditing Problems

The PCAOB inspections staff has published a “Staff Inspections Brief” which provides a preview of their observations from 2015 inspections. Interestingly the number of audit deficiencies identified for annually inspected firms, those with over 100 public clients, has decreased. For firms with less than 100 public clients, who are inspected every three years, the inspection staff found “an overall high number of audit deficiencies”. Areas with frequent deficiencies were:

Auditing internal control over financial reporting

Assessing and responding to the risk of material misstatement

Auditing accounting estimates, including fair value

Audit areas affected by economic risks, including factors such as oil prices

 

The report also discussed several financial reporting issues including business combination accounting, the statement of cash flows, revenue recognition and income taxes.

 

Auditor independence continued to be a problem area, particularly for triennially inspected firms.

You can read the whole Staff Inspection Brief at:

pcaobus.org/News/Releases/Pages/staff-inspection-brief-2015-issuer-inspections.aspx

 

  1. A Board Member’s Perspective on Inspections, Enforcement and Standard Setting

This speech, delivered by Board Member Jeanette Franzel, is a wide ranging summary of “progress in audit oversite” and has some interesting perspectives on changes that could be in store for the inspection process. She comments that inspections of large firms are showing fewer audit deficiencies but that at smaller firms there are still some that “just don’t get it”. She also provides summaries of the enforcement program and standard setting at the PCAOB.

You can read the speech at:

pcaobus.org/News/Speech/Pages/Franzel-progress-in-audit-oversight-Baruch-5-5-16.aspx

 

  1. A “Darker” Staff Practice Alert

The PCAOB inspectors continue to see enough instances of auditors making changes after audit workpapers are supposed to be “locked down” that they have issued a Staff Practice Alert to remind, or perhaps warn, auditors not to make changes inappropriately in advance of an inspection. You can read the Alert at:

pcaobus.org/News/Releases/Pages/staff-audit-practice-alert-improper-alteration-of-documents-4-21-16.aspx

Interestingly, the last section of the new release has a link to the PCAOB’s tip line……

 

  1. Re-proposed Changes to the Auditor’s Report?

The Board met on May 11, 2016 to consider re-proposing changes to the standard auditor’s report. The current pass/fail model would be retained, but the original proposal and the potentially revised proposal hope to provide additional information to make the report more relevant and informative. Stay tuned for updates on the results of the meeting; in the meantime you can read about the meeting, the revised proposal and related original proposal at:

pcaobus.org/News/Releases/Pages/PCAOB-5-11-16-open-meeting-announcement.aspx

 

  1. Naming the Audit Partner is a Done Deal and the PCAOB’s Standard Setting Agenda

 

Last, as you may have heard, the SEC has approved the PCAOB’s new Auditing Standard requiring disclosure of the names of audit partners and information about other firms involved in an audit beyond the principal auditor. To learn about that change and to see what else is on the horizon, here is a link to the PCAOB’s current rulemaking agenda:

pcaobus.org/Standards/Pages/Current_Activities_Related_to_Standards.aspx

Clearly, the PCAOB is busy!

As always, your thoughts and comments are welcome!

SEC Non-GAAP Concerns Ratchet Up

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We discuss non-GAAP measures frequently in our blog. We also did a One-Hour Briefing “Non-GAAP Measures and Metrics: Getting it Right” on April 1 which you can find at:

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

 

While we try to avoid being “preachy” we do see some real problems in how companies are using non-GAAP measures. Our most recent blog post about these non-GAAP measure problems is at:

seciblog.pli.edu/?p=615

 

To reinforce these issues from the SEC’s perspective Deputy Chief Accountant Wesley Bricker and OCA Chief Accountant Mark Kronforst both addressed the use of non-GAAP measures at a recent conference.

 

You can read Mr. Bricker’s speech at:

www.sec.gov/news/speech/speech-bricker-05-05-16.html

 

In his speech he outlines four major areas where the SEC believes that companies may not be using non-GAAP measures appropriately. He even makes the comment that if a company uses a non-GAAP revenue measure they can expect a comment from the staff.

While Mr. Kronforst’s speech is not on the SEC web page, he reportedly used the words “crack down” when talking about how the SEC will be reviewing the use of non-GAAP measures.

The message is clear, be thoughtful and careful with non-GAAP measures!

 

As always, your thoughts and comments are welcome!

Due Care and Good Faith with Accounting Judgments – More Enforcement News!

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On April 19th the SEC Enforcement Division announced two financial fraud enforcement cases in which companies, officers and in one of the cases the company’s auditors were named and barred or paid fines. Financial fraud enforcement cases are on the rise, but the interesting issue in these cases is that both centered on the challenging, grey area judgements that we make in the accounting process.

In the release Enforcement Division Director Andrew Ceresney said:

“We are intensely focused on whether companies and their officers evaluate judgmental accounting issues in good faith and based on GAAP.”

The most unsettling implication of these two cases is that while we make these judgements with uncertain and sometimes incomplete information, the people who pass judgment on them after the fact always operate with 20-20 hindsight.

The areas involved in these two cases are classic accounting estimate areas. One of the named companies/executives used a warranty accrual, failure to appropriately amortize intangibles and failure to appropriately write down inventory to lower of cost or market to be able to meet earnings targets.

In the other case, company executives failed to appropriately value accounts receivable from and impair investments in an electric car manufacturer that was a major customer. In addition, the audit engagement partner was suspended from appearing before the SEC.

You can read the release at:

www.sec.gov/news/pressrelease/2016-74.html

This message is more than unsettling, it’s downright scary. It almost starts to feel that someone is watching over our shoulder as we make difficult judgment calls. And we know that when we make these kinds of accounting judgments and estimates there is usually no “right answer”. In fact, different professionals may arrive at different conclusions when making these kinds of judgements, but there is usually a range of reasonable estimates.

 

That said, the message is clear, be sure to exercise due care and follow GAAP when making subjective accounting judgments, because if things go wrong, enforcement may be asking questions! And, as we said above, when they ask questions, they will have the benefit of 20-20 hindsight.

 

How do we assure that when someone with hindsight evaluates our decisions we have as strong a position as possible? Here are a few reminders about your process for making and documenting these judgments:

  1. Always create your documentation contemporaneously. If you wait to document a decision until you are asked about it by someone like the SEC, you will never remember all the issues and considerations in your decision. And, it will be easy to see that you created the documentation after the fact.

 

  1. In your documentation be sure to thoroughly evaluate all the different alternatives in the decision process. Lay out in clear language each alternative and the pros and cons of each alternative. Include all relevant factors on all sides of the decision. If someone wants to second guess your decisions and you have not addressed all the issues, it will be more likely that you will be second guessed.

 

  1. Support your discussion with appropriate references to the Accounting Standards Codification. Explain what GAAP you think is relevant and how the guidance applies in your situation. Most importantly, document and be faithful to the principles underneath the GAAP you are using.

 

  1. As part of ICFR, have a documented review process. All appropriate levels of involvement in the decision should be documented, and if your company has a policy about reviewing accounting decisions it should be documented that that policy was followed. If you know there is a material intentional error, such as occurred in these cases, use the appropriate channels within your company to rectify it.

 

If you would like some background about writing these kinds of white papers you could check our One-Hour Briefing about drafting accounting white papers at:

www.pli.edu/Content/How_to_Write_an_Accounting_White_Paper/_/N-1z11dsbZ4n?ID=264615

And lastly, if you are thinking about how the issues in this enforcement relate to issues that could be critical accounting estimates, you could also review the requirements for these disclosures in FR 72. You can find them at the end of the FR at:

www.sec.gov/rules/interp/33-8350.htm

 

As always, your thoughts and comments are welcome!

Message From Enforcement: Metrics Matter!

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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

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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!

 

 

Non-GAAP Measures in the News

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How companies use non-GAAP measures is one of the “hot topics” that we post about frequently. This is not just because we think it is interesting. (Although we do!). More to the point, it is a subject of frequent SEC comment, and in the last several weeks both SEC Chair Mary Jo White and Chief Accountant James Schnurr have expressed their concern about more aggressive use of non-GAAP measures. And a recent report from FACTSET (mentioned in more detail below) bears out this concern.

Carol and George, your blog authors, recently did a One-Hour Briefing about Non-GAAP measures.

You can find the archived One-Hour Briefing at:

www.pli.edu/Content/OnDemand/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-4nZ1z10vny?fromsearch=false&ID=283312

 

In the Briefing we included this quote from Mr. Schnurr’s March 22, 2016 speech to the 12’th Annual Life Sciences Accounting and Reporting Congress in Philadelphia, PA:

 

Non-GAAP measures

Before I conclude today’s remarks, I’d like to provide my perspectives on non-GAAP measures, which is a topic that continues to receive attention from investors, those at the SEC, as well as the general news media.

The Commission adopted rules in 2003 addressing the disclosure of non-GAAP financial measures, both generally and with respect to inclusion in SEC filings. While the Commission’s rules allow companies to provide non-GAAP measures to investors as alternative measures that supplement information in the financial statements, the rules are clear that the non-GAAP measures must not be misleading. The SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover.

 

Non-GAAP measures are intended to supplement the information in the financial statements and not supplant the information in the financial statements. However, when the financial news networks report quarterly earnings, they very frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings, often not even identifying it as having been adjusted. In addition, I am particularly troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation. In my view, preparers should carefully consider whether significant adjustments to profitability outside of customary measures such as EBITDA or non-recurring items or other charges to the business, such as the sale of portions of the business in order to provide the user with an understanding of how these events impact trends and future performance, are appropriate. As it relates to cash measures, I believe those measures should be reconciled to cash flow from operations.

 

Staff in the Division of Corporation Finance continues to monitor non-GAAP disclosures as part of its selective review process and regularly issues comments on this issue. The staff also provides guidance on the application of Commission rules through speeches and other mechanisms — and of course, staff comment letters are publicly available. You can expect that the staff will continue to be vigilant in their review of the use of these measures for compliance with the rules.

 

The proliferation of non-GAAP reporting measures among registrants, and reliance and reporting by analysts, should warrant increased focus by management and the audit committee. I believe the focus should go beyond determinations that the measures comply with the Commission’s rules and include probing questions on why, in contrast to the GAAP measure, the non-GAAP measure is an appropriate way to measure the company’s performance and is useful to investors. In addition, companies should ensure that the measure is prepared in a manner that includes appropriate controls and oversight procedures.

 

You can find the whole speech at:

www.sec.gov/news/speech/schnurr-remarks-12th-life-sciences-accounting-congress.html

 

Chair White’s Speech at an AICPA conference in December included these remarks:

  • Another financial reporting topic of shared interest and current conversation is the use of non-GAAP measures.  This area deserves close attention, both to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices.  Non-GAAP measures are allowed in order to convey information to investors that the issuer believes is relevant and useful in understanding its performance.  By some indications, such as analyst coverage and press commentary, non-GAAP measures are used extensively and, in some instances, may be a source of confusion.
  • Like every other issue of financial reporting, good practices in the use of non-GAAP measures begin with preparers.  While your chief financial officer and investor relations team may be quite enamored of non-GAAP measures as useful market communication devices, your finance and legal teams, along with your audit committees, should carefully attend to the use of these measures and consider questions such as:
    • Why are you using the non-GAAP measure, and how does it provide investors with useful information?
    • Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules?
    • Are your explanations of how you are using the non-GAAP measures – and why they are useful for your investors – accurate and complete, drafted without boilerplate?
    • Are there appropriate controls over the calculation of non-GAAP measures?

 

So, the message has clearly been sent, be thoughtful about the use of non-GAAP measures and be careful to not be misleading.

 

How are companies responding to these messages?

For now, it does not look like they are listening. FACTSET has done a very detailed study that includes all the earnings releases for the Dow Jones Industrial Average companies for their most recent year-end. Their results are available at:

 

www.factset.com/insight/2016/03/earningsinsight_03.11.16#.Vw5yo2OPAQK

 

Their findings are very dramatic. For companies that released a non-GAAP earnings measure the difference between GAAP EPS and non-GAAP EPS from 2014 to 2015 widened from 11.8% to 30.7%. And that is just one of may statistics that highlight growing differences between GAAP and non-GAAP measures. Of course, the non-GAAP measures all seem to look better…

 

So, we suggest careful review by your audit committee and management of the use of non-GAAP measures. And, be sure to look back to the comments above and ask the questions Chair White asked:

 

  • Why are you using the non-GAAP measure, and how does it provide investors with useful information?
  • Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules?
  • Are your explanations of how you are using the non-GAAP measures – and why they are useful for your investors – accurate and complete, drafted without boilerplate?
  • Are there appropriate controls over the calculation of non-GAAP measures?”

As always, your comments and thoughts are welcome!

Carol and George

 

The SEC Comment Process – What if?

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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!

10-K Tip Number Two for 2016

10-K Tips, , , , , , , , , , , , , , , ,

 

The second tip from our January 7th One-Hour Briefing “PLI’s Second Annual Form 10-K Tune-up” (which will also be available in an On-Demand version soon) is under the category of New and Emerging Issues – PCAOB Auditing Standard 18 Related Parties (Release No. Release 2014-002, http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_18.aspx) and PCAOB Auditing Standard 17 Auditing Supplemental Information Accompanying Audited Financial Statements (Release No. 2013-008 http://pcaobus.org/Standards/Auditing/Pages/AS17.aspx)

A warning for those who see “PCAOB” and assume they can skip this one. AS 18 will require auditors to do more work, which could be significant depending on the facts and circumstances. This will likely trickle down to companies and their audit committees causing more work in the areas outlined below in the form of more inquiry, documentation, and testing, including ICFR. So read on…

AS 18

 

The PCAOB adopted AS 18 in Release 2014-002 mainly to strengthen auditor performance in the areas of:

Related party transactions,

Significant transactions that are outside the normal course of business, and

Financial relationships and transactions with executives

 

Collectively these areas are referred to as “critical areas”, essentially high-risk areas, and the new Audit Standards require specific audit procedures for each area. The adopting release cited increased risks of material misstatement and fraudulent financial reporting involving these areas as motivating factors in issuing AS 18.

 

AS 18 addresses:

 

  • Relationships and transactions with related parties: Related party transactions may involve difficult measurement and recognition issues as they are not considered to be arms-length transactions. Therefore these transactions could lead to fraud or misappropriation of assets, and in turn result in errors in the financial statements, and could increase the risk of a material misstatement.

 

  • Significant unusual transactions: Significant unusual transactions can create complex accounting and financial statement disclosure issues that could cause increased risks of material misstatement and fraud. Another risk cited is the potential for inadequate disclosure if the form of the transaction is disclosed over its substance.

 

  • Financial Relationships and Transactions with Executive Officers: Financial relationships and transactions with executive officers can create incentives and pressures for executive officers to meet financial targets, resulting in risks of material misstatement to the financial statements.

 

So, what hasn’t changed:

  • The definition of related party, which the PCAOB pegged to the definition in the applicable GAAP the company uses
  • The accounting for related party transactions
  • The financial statement or regulatory (SEC) disclosure requirements

 

So, what has changed?:

  • The procedures are more specific and risk-based
  • Additional required communications with the audit committee have been added, see paragraph 19 of Release 2014-002
  • Three matters were added to the auditor’s evaluation of significant unusual transactions (see paragraph AU 316.67 as amended by this AS, which is paragraph AS 2401.67 in the reorganized PCAOB Audit Standards)
  1. The transaction lacks commercial or economic substance, or is part of a larger series of connected, linked, or otherwise interdependent arrangements that lack commercial or economic substance individually or in the aggregate (e.g., the transaction is entered into shortly prior to period end and is unwound shortly after period end;
  2. The transaction occurs with a party that falls outside the definition of a related party(as defined by the accounting principles applicable to that company), with either party able to negotiate terms that may not be available for other, more clearly independent, parties on an arm’s-length basis
  3. The transaction enables the company to achieve certain financial targets.

 

What companies should do now:

  • Become familiar with AS 18
  • Document the company’s process and related controls over (see paragraph 4 of Release 2014-002) :
  • Identifying related parties and relationships and transactions with related parties,
  • Authorizing and approving transactions with related parties, and
  • Accounting for and disclosing relationships and transactions with related parties
  • Gather and document the information auditors are required to inquire about, (see PCAOB Release No. 2014 -002, page A1-3, starting at par. 5)

 

Audit committees should:

  • Become familiar with AS 18 and AS 17
  • Understand the company’s process and related controls over identifying related party transactions and
  • Be prepared for the auditor’s inquiry that is outlined in paragraph 7 on page A1-4 of Release 2014-002.

 

AS 17

 

The PCAOB adopted AS 17 to improve the quality of audit procedures performed and related reports on supplemental information that is required by a regulator when that information is reported on in relation to financial statements that are audited under PCAOB standards. The standard requires an audit for certain supplemental information, such as:

  • the schedules in Form 11-K (employee benefit plans) where the plan financial statements and schedules are prepared in accordance with the financial reporting requirements of ERISA, and
  • the supplemental schedules required by broker-dealers under SEC rule 17a-5

 

Paragraphs 3 & 4 of Appendix 1 specifies audit procedures that the auditor should perform, and paragraph 5 contains the management representations the auditor will be asking for. The auditor may provide either a standalone auditors report on supplemental information accompanying audited financial statements will or may include the auditor’s report on the supplemental information in the auditor’s report on the financial statements.

 

As always, your thoughts and comments are welcome!

 

 

 

Revenue Recognition Help From FinREC

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As you know the new FASB and IASB revenue recognition standards supersede all our existing revenue recognition guidance. Here in the US the new standard was such a major change that it was placed in a brand new codification section (ASC 606). One of the major changes with the new model is how it treats “specialized industries”. Many industries, such as software and construction, had specialized industry revenue recognition guidance. All those standards are also superseded. These industries now face many questions and uncertainties about how to apply the new revenue recognition model to unique and different transactions.

The new model, designed to make revenue recognition principles consistent across all industries, is much more general and does not include the detailed kind of guidance that old GAAP frequently provided. This potentially increases the risk that there could be diversity within industries in the application of the new standard.

FinREC, the Financial Reporting Executive Committee of the AICPA, and the AICPA’s Revenue Recognition Task Force have been working to help deal with these issues. They have established 16 industry groups and are developing a new “Accounting Guide for Revenue Recognition”. These resources will be developed with participation and review of standard setters, but will not be authoritative. The groups describe them as eventually providing “helpful hints and illustrative examples for how to apply the new Revenue Recognition Standard.”

They have published a list of potential implementation issues identified to date which you can find at:

www.aicpa.org/InterestAreas/FRC/AccountingFinancialReporting/RevenueRecognition/DownloadableDocuments/RRTF_Issue_Status.pdf

As always, your thoughts and comments are appreciated!