Tag Archives: MD&A

10-K Tip Number Six for 2016 – The SEC’s Disclosure Effectiveness Initiative

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As a starting point in this post, we want to be clear, the SEC continuously focuses on making disclosure effective. This is an important part of their mission, to provide information to investors. Over the years projects like Plain English and the MD&A guidance in FR 72 have clearly helped improve disclosure.
And, in large part thanks to the JOBS Act, disclosure effectiveness is a formal initiative at the SEC right now. This, of course, is why we included it as a hot topic on our 2016 Form 10-K Tune-Up, which is now available on-demand with CLE and CPE credit at:

www.pli.edu/Content/OnDemand/Second_Annual_Form_10_K_Tune_Up/_/N-4nZ1z116ku?fromsearch=false&ID=278540

 

The JOBS Act formalized this process with its requirement to study various S-K disclosures. Going beyond the JOBS Act, the SEC has sought comment on other matters including certain parts of Regulation S-X. Late last year the FAST Act created required next steps in this process. All of these projects, and the others that will come, will hopefully result in a modernization and refocusing of the whole disclosure process. You can read about all the different parts of this initiative at the Disclosure Effectiveness section of the SEC’s web page:

www.sec.gov/spotlight/disclosure-effectiveness.shtml

 

 

(If you would like to read more about the FAST Act check out this post:

seciblog.pli.edu/?p=515 )

 

 

These elements of the SEC’s process are clearly longer-term, and the regulatory steps involved need time for constituent input and careful consideration of the impact of possible change. This does not mean that there are not steps you can take right now to help make information better for investors. In fact, in numerous public forums the SEC Staff has consistently focused on three themes you can use right now to improve disclosure. They are:

Reduce repetition

 

Focus disclosure

 

Eliminate outdated and immaterial information

 

You can get the SEC’s perspective on these issues in this speech by Corp Fin Director Keith Higgins:

www.sec.gov/News/Speech/Detail/Speech/1370541479332

 

And this speech from December 2015 by Chief Accountant James Schnurr touches on things to do now, particularly using judgment:

www.sec.gov/news/speech/schnurr-remarks-aicpa-2015-conference-sec-pcaob-developments.html

 

 

One last issue – if you have questions about something such as a whether to continue a disclosure related to an SEC comment from prior years that is immaterial today, the staff actually encourages that you call them to discuss the issue!

 

As always, your thoughts and comments are welcome!

Form 10-K Tune-Up Tip Number Five for 2016

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The next topic from our 2016 Form 10-K Tune-up One-Hour Briefing is SAB 74 disclosures. You can listen to the briefing on-demand with CPE and CLE credit available at:

www.pli.edu/Content/OnDemand/Second_Annual_Form_10_K_Tune_Up/_/N-4nZ1z116ku?fromsearch=false&ID=278540

 
To begin, what does SAB 74, which is Topic 11-M in the SAB Codification, actually require? You can read the whole SAB at:

www.sec.gov/interps/account/sabcodet11.htm#M

 
Here are a few highlights.

First, it is clear that this disclosure is not required for all new Accounting Standards Updates:
“The Commission addressed a similar issue and concluded that registrants should discuss the potential effects of adoption of recently issued accounting standards in registration statements and reports filed with the Commission. The staff believes that this disclosure guidance applies to all accounting standards which have been issued but not yet adopted by the registrant unless the impact on its financial position and results of operations is not expected to be material.”
This part of the SAB dovetails very nicely with an important part of the SEC’s Disclosure Effectiveness Initiative, which is to eliminate immaterial disclosures that potentially “clutter up” a report and potentially obscure material information.
Here are two examples to explore this issue.

CocaCola did not mention recently issued accounting standards in their 2014 Form 10-K MD&A. They apparently made the judgment that there was no material impact in the current year from new accounting standards. They did include SAB 74 disclosures in their financial statements in note 1. You can check it out at:
www.coca-colacompany.com/content/dam/journey/us/en/private/fileassets/pdf/2015/02/2014-annual-report-on-form-10-k.pdf

 
Intel treated this disclosure in exactly the same way, and you can find their 2014 10-K at:
www.intc.com/secfiling.cfm?filingID=50863-15-15

 
So, the first theme for SAB 74 is focus on material information.

 

 

The second point to think about with this disclosure is what do we need to say about new standards that we believe will be material.

The SAB contains four disclosure requirements:

 
1. “A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier.

 
2. A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.

 
3. A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made.

 
4. Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.”

 

 

As you consider these disclosures, the first thing that arises is that over time there will be a progression in the detail of the disclosure.

For example, most companies at this point in time will not know which method they will use to implement the new revenue recognition standard. But, as we go through next year, we will get closer to that decision. When the decision is made, the disclosure should be updated to inform investors about which method will be used. The same issue applies to quantifying the impact of a change.

 
The fourth disclosure, the potential impact on other significant matters, points out that when such a situation exists, this information may not be appropriate to disclose in the financial statements, but would be disclosed in MD&A.

This means that this disclosure should not always be exactly the same in the financial statements and MD&A.
As a brief PS, we have blogged about this topic before and suggested some wording for SAB 74 disclosures about the new revenue recognition standard. You can read that post at:
seciblog.pli.edu/?p=171

 

As always, your thoughts and comments are welcome!

Known Trends in the News

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In this period of earnings releases we always watch for interesting disclosure examples. Microsoft has provided us with a great example of the “forward looking” disclosures about “known trends and uncertainties” that we discuss in our workshops.

As a reminder, this S-K Item 303 MD&A disclosure requirement says:

(3) Results of operations. (i) ………..

(ii) Describe any 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. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

In their most recent earnings release Microsoft reported a $7.5 billion goodwill impairment related to its acquisition of Nokia’s “Devices and Services” business, which they refer to as NDS. At issue here of course is that such an impairment rarely would ever come out of the blue in an unexpected way during the current quarter. In fact, the risk of impairment would almost always be known well before actually recording the impairment. And, if the company “reasonably expects” there will be an impairment in a future quarter, the company must disclosure this risk in MD&A.

On April 29, 2014 Microsoft completed the acquisition of substantially all of Nokia Corporation’s (“Nokia”) Devices and Services Business (“NDS”), which they reported in a new Phone Hardware segment.

Microsoft, which has a June 30 fiscal year end, said this in their Critical Accounting Estimates disclosure in their June 30, 2014 Form 10-K, which was of course shortly after the acquisition.

Goodwill

We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.

(some text omitted)

The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, it is possible that we may not realize our forecasts. Given the value assigned to goodwill in the purchase price allocation, we will closely monitor the performance of the business versus the long-term forecast to determine if any impairments arise.

They also had a robust risk factor disclosure which you can find in the 10-K.

This disclosure was essentially repeated in their first quarter Form 10-Q for the quarter ended September 30, 2014.

For the second quarter ended December 31, 2015, the disclosure was adjusted a bit to focus on the Phone Hardware segment:

The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, it is possible that we may not realize our forecasts. Given the value assigned to goodwill in the purchase price allocation, we will closely monitor the performance of the business versus the long-term forecast to determine if any impairments arise in our Phone Hardware reporting unit. Except as clarified above, we determined that none of our reporting units were at risk of impairment as of our most recent annual goodwill impairment testing date.

And, in their Form 10-Q for the third quarter ended March 31, 2015, this “known trend or uncertainty” became a bigger risk and was addressed directly:

“Goodwill

(Some text omitted)

We determined that none of our reporting units were at risk of impairment as of our most recent annual goodwill impairment testing date. The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the Phone Hardware business. In this highly competitive and volatile market, it is possible that we may not realize our forecast. Considering the magnitude of the goodwill and intangible assets in the Phone Hardware reporting unit (see Note 8 – Business Combinations of the Notes to Financial Statements), we closely monitor the performance of the business versus the long-term forecast to determine if any impairments exist in our Phone Hardware reporting unit. In the third quarter of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. We are currently beginning our annual budgeting and planning process. We use the targets, resource allocations, and strategic decisions made in this process as the inputs for the associated cash flows and valuations in our annual impairment test. Given its recent performance, the Phone Hardware reporting unit is at an elevated risk of impairment. Declines in expected future cash flows, reduction in future unit volume growth rates, or an increase in the risk-adjusted discount rate used to estimate the fair value of the Phone Hardware reporting unit may result in a determination that an impairment adjustment is required, resulting in a potentially material charge to earnings.”

(Emphasis added)

Blunt words to forewarn investors of the risk of impairment!

As always, your thoughts and comments are welcome!

 

10-K Tip of the Week – Annual Report to Shareholders vs Form 10-K

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In sort of a lighthearted way this week’s Tip is a “versus” tip. With big boxing matches coming up next week, or perhaps just remembering old movies with aliens and monsters, the issue of how the Form 10-K works versus how the Annual Report to Shareholders (ARS) works seems appropriate.

This question frequently comes up in our workshops, and many folks don’t know whether or not the ARS is actually required or where to find the ARS requirements. The ARS is actually a very distinct and separate document from the Form 10-K.

The Form 10-K is the Annual Report to the SEC. It is required by the rules of the SEC and is filed with the SEC. As such, it is not a document furnished directly to shareholders, although they clearly have an opportunity to use the information as it is publicly accessible.

The ARS is actually required by the proxy rules. Rule 14a-3, which deals with information that must be furnished to shareholders in the proxy solicitation process says:

“(b) If the solicitation is made on behalf of the registrant, other than an investment company registered under the Investment Company Act of 1940, and relates to an annual (or special meeting in lieu of the annual) meeting of security holders, or written consent in lieu of such meeting, at which directors are to be elected, each proxy statement furnished pursuant to paragraph (a) of this section shall be accompanied or preceded by an annual report to security holders …….”

When a company is having its annual meeting and will elect directors at this meeting, it must furnish each shareholder with the proxy statement containing information about the election and officers and directors, and also must furnish each shareholder the ARS.

The next logical question is what must be included in the ARS? Rule 14a-3 enumerates the requirements and they include, among lots of other information:

Financial statements
MD&A
Selected financial data

“a brief description of the business done by the registrant and its subsidiaries during the most recent fiscal year which will, in the opinion of management, indicate the general nature and scope of the business of the registrant and its subsidiaries”

For a complete list of all the required information in the ARS check out Rule 14a-3. It is on page 890 of our 2015 SEC Handbook and you can also find it here:

www.ecfr.gov/cgi-bin/text-idx?SID=8e0ed509ccc65e983f9eca72ceb26753&node=17:4.0.1.1.1&rgn=div5#se17.4.240_114a_63

Way back many years ago most companies did a separate ARS which was mailed in paper form to all shareholders along with the proxy statement. To see an example of this kind of traditional ARS check out this one from American Woodmark, a cabinet manufacturer:

files.shareholder.com/downloads/AMWD/107569654x0x673718/998BA1D0-743B-4BEC-A32F-8B7197D3B622/LowRes-13-10246_AWC-2013.pdf

The above link is to the ARS American Woodmark prepared for 2013, and it has wonderful photography and nicely typeset financial statements and MD&A. It is almost elegant in its presentation of information about the company. It is also a very expensive document to produce!

Because this kind of ARS is so expensive, many companies use a more cost effective ARS called the “10-K wrap”. This version of the ARS is actually a cover and perhaps a few pages of financial and company background “wrapped” around the Form 10-K. This approach works well because all the information required by rule 14a-3 that must be furnished to shareholders is in the Form 10-K.

American Woodmark switched to the 10-K wrap approach in 2014. You can find their 2014 ARS at:

files.shareholder.com/downloads/AMWD/107569654x0x766550/DAD863ED-7D03-468B-BCCE-E5117F2C1E43/LowRes-14-10531-FSC_AWC-FinalPDF.pdf

It would be interesting to know how much money American Woodmark saved going from the “pretty picture” ARS to the “10-K wrap” ARS!

To summarize, the Form 10-K is the formal annual report filed with the SEC as part of complying with the 34 Act, while the ARS is not filed with the SEC, it is actually furnished to shareholders.

(The proxy rules do require that copies of the ARS be sent to the SEC, one of the few paper filings companies still have to make.)

Lastly, if you are focusing on the words filed versus furnished in the above sentence, yes, they are very important and mean very different things! We will discuss that difference in our next post!

As always, your comments and thoughts are welcome and appreciated!

Comment of the Week – Its all About the Future!

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One of the most challenging disclosures we discuss in our workshops is the required forward-looking MD&A requirement to disclose “known trends”. (As a heads-up, this post contains some pretty long comments, but they raise some very important issues!)

This forward-looking information requirement is rooted in the overall objective of MD&A as articulated in FR 72. The relevant section of the release states that part of the objective of MD&A is:

“to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance” (emphasis added)

And, of course, this is done “through the eyes of management”.

You can find the whole release at:

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

From this objective it is clear that if management knows about something that means past performance is not going to be predictive of future performance and the information is material, it should be disclosed in MD&A. This is made clear in S-K Item 303(a) (3) (ii):

“Describe any 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. (emphasis added)

The SEC is watchful for companies that surprise the markets with disclosure of bad news, potentially driving down their stock price, where the companies have not said anything about the bad news issue in previous filings.

In many cases the Staff’s presumption is that the bad news did not surprise management, and that in fact they knew about the problem well before they disclosed it to investors. In that situation, management likely failed to meet the disclosure requirements in MD&A and S-K Item 303(a) (3) (ii) specifically.

In our workshops we discuss some of the classic enforcement actions where this has happened, including the “groundbreaking” cases against Caterpillar and Sony. The staff continues to search for problems in this area, and frequently starts with the comment letter process.

Here are example comments that were written to a grocery store chain that had decided to exit one of its “banners”. In this industry a “banner” is a brand name for the supermarket chain. Notice the subtle interaction of these comments from the initial letter:

  1. We note that you announced the sale and/or closure of all of your (name omitted) stores in May 2014. We further note that in the related press release, filed as Exhibit 99.2 to your March 29, 2014 Form 10-Q, your Chief Executive Officer stated, “The economic downturn over the last few years, coupled with an increased competitive footprint in the Minneapolis/St. Paul Market, has made it difficult for (the company) to keep the (name omitted) banner competitive.” We further note that the disclosures regarding negative factors impacting your business within this Form 10-K appear to broadly apply to your business and do not specifically refer to the (name omitted) banner. Please tell us how you determined additional disclosures were not required in this Form 10-K as it relates to your (name omitted) banner. In your response, specifically explain how you considered whether these stores were disproportionately impacted by any of the negative factors described in your disclosures, either in the periods of historical financial statements included in this Form 10-K or in your analysis of trends and uncertainties that you reasonably expected would have a material impact on your future results. If the decision to sell this banner was influenced by worse than expected results for this banner during the first quarter of 2014, then also apply this comment to your MD&A disclosures within your March 29, 2014 Form 10-Q. (emphasis added)

The first comment above puts the trend disclosure on the table. This next comment goes a bit further, clearly articulating the “does the past predicts the future?” requirement:

  1. We note your disclosures under the heading “Goodwill Impairment Charge.” Please tell us, and disclose in future filings, why your fair value declined such that you recorded this impairment charge. We remind you that one of the principle objectives of MD&A is to provide your investors with enough insight into the underlying factors that drove your historical results [so] that they can assess the likelihood that past results are indicative of future results. We also remind you of your obligation to describe known trends and uncertainties that have had or you reasonably expect will have a material impact on your results. (emphasis added)

The following comment directly quotes S-K 303(a)(3)(ii), asking some very challenging questions:

  1. We note you recorded $280.0 million of pretax goodwill impairment charges in the quarter ended September 27, 2014. Please tell us what consideration you gave to updating your goodwill critical accounting estimate disclosures in your September 27, 2014 Form 10-Q. In this regard, you refer your investors to the critical accounting estimates on goodwill contained in your annual report. Given the charge you recorded in the most recent quarter it would appear the assumptions used to assess goodwill for impairment have significantly changed. Further, you now have two reporting units as opposed to one reporting unit at December 28, 2013. Please advise. Additionally, given the significance of the impairment charges and the material amount of goodwill remaining on your balance sheet, please show us what critical accounting estimate disclosures you anticipate making in your upcoming Form 10-K filing. Please ensure your disclosures provide investors with sufficient information to assess the material implications of uncertainties associated with the methods, assumptions and estimates underlying this critical accounting estimate. Refer to Item 303(a)(3)(ii) of Regulation S- K, which requires a description of a known uncertainty and Section V of SEC Release No. 33-8350. (emphasis added)

After the company’s responses to the above comments, the staff wrote this follow-on comment in the second round of comments. Note the depth of the analysis asked for in the comment and the depth of the SEC’s review into material that was not even included in a 10-K or 10-Q!

 We have read your November 2014 “Company’s Investor Presentation” and note the strong growth in the Chicago Market with the ChicagoBanner’s format. Further, you highlight several differences between your Wisconsin and Illinois markets. For example, on slide five you point out the Chicago market has “2x the productivity of your Wisconsin stores.” The information presented on slide six indicates that your ChicagoBanner’s banner is a “highly differentiated food shopping experience.” You further indicate on slide seven the ChicagoBanner’s banner has 1) two times the average Wisconsin retail sales volume, 2) lower EBITDA margin and higher gross profit dollars, and 3) strong store-level ROIC. We also note on slide sixteen that ChicagoBanner’s represents a significant growth opportunity for the Company. It also appears from the disclosures in your filings and your response to our comments that your Wisconsin and Illinois markets were behaving differently during 2013 and 2014, leading you to “[shift] focus to stabilizing [your] Wisconsin market” in contrast to “growing [your] ChicagoBanner’s banner.” We further note a general trend of highly differentiated grocery stores having higher profit margins than value-oriented grocery stores. Based on this information, we continue to believe that your Wisconsin and Illinois markets likely have different current or future trends in per-store revenue and per-store profitability, and that the mix of stores between these two markets will therefore impact your consolidated results. Please explain to us in significantly more detail why the apparent differences between these types of stores were not addressed in your most recent Form 10-Q, either as part of your analysis of results of operations or as part of your discussion of trends and uncertainties, and also tell us how these matters will be addressed in your upcoming Form 10-K. 


So, the moral of this story, if you know of something that is reasonably likely to have a material impact on future results, don’t keep it secret! Even if you hope it will not be a problem, these MD&A requirements need to be carefully reviewed to determine when to share the information with investors!

As always, your thoughts and comments are welcome!