By: George M. Wilson & Carol A. Stacey
In our last post we reviewed a recent MD&A enforcement case focused on failure to disclose bad news. This forward looking “known-trend” disclosure requirement arises when management is aware of some “trend, demand, commitment, event or uncertainty” that could cause a material problem and fails to disclose this information to shareholders. The S-K Item 303(a)(3)(ii) language creating this requirement is:
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.
One of the challenging parts of this requirement is the “reasonably expects” probability threshold. What exactly does this mean? The Staff addressed this requirement in FR 36 with this language:
Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:
(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.
(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.
Each final determination resulting from the assessments made by management must be objectively reasonable, viewed as of the time the determination is made.
The language that makes this test challenging is the first part of paragraph (2). In essence, if management cannot make the assumption that a known trend is “not reasonably likely to come to fruition” in step one it must assume that it will come to fruition.
What would this mean if there were a 50/50 chance of something bad happening? As an example, suppose that your goodwill is not impaired this year-end, but the numbers in step one of the impairment test have been deteriorating with this trend:
2014 2015 2016
Fair value of reporting unit $3,000 $2,500 $1,900
Carrying value of reporting unit $1,800 $1,800 $1,800
Excess of FV over CV $1,200 $ 700 $ 100
There is clearly a trend here, and while management is likely doing all they can to make the business work, what if their assessment is that there is a 50/50 chance that the goodwill may be impaired next year? While there is no accounting recognition, the MD&A known trend disclosure requirement would say that this potential impairment, if it is material, should be disclosed.
This is not an easy determination, but the enforcement case in the last post makes it clear that it is crucial to get this disclosure right!
As always, your thoughts and comments are welcome!