SEC posts presentation regarding Staff Review of Common Financial Reporting Issues Facing Smaller Issuers
By Cydney Posner
The SEC has posted a new PowerPoint presentation regarding SEC Staff Review of Common Financial Reporting Issues Facing Smaller Issuers, presented by Wayne Carnall, Chief Accountant at Corp Fin, at PCAOB Forums on Auditing in the Small Business Environment. While the focus of the presentation was directed at smaller companies, much of the learning could be relevant for companies of any size.
Of particular interest is the section of the presentation focused on financial reporting issues frequently raised in comment letters. In addition to a variety of technical accounting comments (addressing matters such as revenue recognition, reverse acquisition and recapitalizations, fair value determinations, and embedded conversion options and freestanding warrants), the presentation also identifies common problems in MD&A, Items 4.01 and 4.02 8-K, internal control and other matters.
MD&A. In MD&A, companies are reminded that the staff generally recommends that they provide an overview highlighting both financial and non-financial key performance indicators as background to understanding the company’s overall performance for the periods. A discussion of the impact of current economic conditions should be included.
Estimates that have a material impact on the underlying financial statements and are subject to significant judgment and uncertainty should also be identified to provide insight into the quality and variability of the financial statements (including fair value measurements). Management should provide readers with an understanding of the methodology and underlying assumptions used to arrive at the estimate and should also analyze the impact that reasonable changes in the assumptions could have on the financial statements.
The staff often finds that companies do not adequately discuss the causal factors contributing to fluctuations in operating activities from period to period. The discussion of fluctuations should help readers understand the factors that contributed to changes in underlying line items and the magnitude of that impact.
Finally, companies tend to overlook the importance of a discussion of liquidity and capital resources. This discussion should focus on how the company has been able to meet its cash requirements in historical periods through a thorough analysis of the statements of cash flows (sources and uses of cash) and how the company expects to meet them in the future through a discussion of commitments, debt instruments and covenants, guarantees and significant contractual obligations.
Form 8-K. Forms 8-K reporting Items 4.01 and 4.02 are frequently reviewed by the staff. Comments regarding these items are generally focused on compliance with the item requirements. With regard to Item 4.01, the comments may ask for more information about the facts and circumstances surrounding the change in accountants, including whether the accountants resigned or were dismissed. The staff may also comment if the Exhibit 16 letter signed by the former accountants has not been filed in a timely manner. Finally, Item 4.01 8-Ks will usually need to be filed upon the consummation of a reverse merger or upon merger of the registrant’s accountants with another firm. For Item 4.02, companies should provide a description of the facts and circumstances leading to the restatement. The triggering event for the 8-K is the conclusion that previously issued financial statements can no longer be relied upon, not the restatement itself. Companies should also clearly state the periods for the unreliable financial statements and quantify the impact of that determination to the extent known. Note that reports Items under 4.01 and 4.02 must always be on Form 8-K and cannot be disclosed instead in a periodic report (as permitted with some other 8-K items). No "stealth restatements" are permitted.
Internal control over financial reporting. Reg S-K Item 308 requires a separate evaluation and assessment of ICFR that is distinct from the evaluation of disclosure controls and procedures. While there is some overlap between disclosure controls and procedures and ICFR, management is required to assess the effectiveness of each on an annual basis and only disclosure controls and procedures on a quarterly basis, including year-end.
For the management assessment under Item 308(a), all four elements must be addressed in disclosure, including a statement as to whether ICFR is effective or ineffective with no impermissible qualifying language or scope limitations. ICFR cannot be "effective" if a material weakness exists. When a material weakness exists, companies must discuss, in detail with specifics for each material weakness, the nature of the material weakness, its impact on the company’s financial reporting and ICFR, and current plans, if any, or actions already undertaken to remediate the weakness (changes could be included under Item 308 (c) of Reg S-K). Disclosures of material weaknesses should allow the reader to determine the pervasiveness and impact on the financial statements, perhaps indicating the individual line items that may be affected by the weakness, the potential magnitude of the impact as well as the likelihood. Companies should explain the identified weakness specifically, rather than limiting the discussion to identifying the impacted financial statement area (e.g., material weakness related to income taxes). That type of disclosure is not specific in identifying the internal control, nor does it consider the impact that the weakness could have on other financial statement line items. This issue often becomes evident in remediation disclosures, which may indicate that the company is improving internal controls that go well beyond the narrow material weakness disclosed.
Material weakness disclosures would be more useful if companies identified material weakness in advance by analyzing more carefully the likelihood that a deficiency could fail to prevent a material error, rather than waiting until they have found an error produced by the weakness. All issuers, other than newly public companies, registered investment companies and asset-backed issuers, are required to include management’s report on ICFR in their annual reports. If the auditor attestation is not required under Item 308(b), companies must include the disclosure specifically referred to in Item 308T advising of the absence of the attestation.
The staff has recently conducted targeted reviews of management’s assessment by non-accelerated filers that had performed an evaluation and assessment for the first time in 2007. A number of companies did not complete the evaluation because they were unable to finish due to insufficient time or resources, omitted it because they forgot or misunderstood whether it was necessary or performed the evaluation but did not disclose their conclusion regardless of whether they had disclosed material weaknesses or not. Companies that do not include management's report when required have deficient --and untimely--filings.
Disclosure controls and procedures. Item 307 of Reg S-K requires companies to clearly disclose whether disclosure controls and procedures are effective or ineffective. Companies may not characterize them instead as "adequate" or add exceptions or qualifications. Although a definition is not required, if one is included, it should be complete and conform to the definition in the rules. Companies should be aware that the definition of disclosure controls and procedures is more broad than ICFR, so it is possible that disclosure controls and procedures can be ineffective even while ICFR is effective. With regard to "reasonable assurance" language, companies should be sure that disclosure regarding design of the controls is consistent with the conclusions regarding disclosure controls.
Certifications. Certifications should not deviate from the specific form and content in Item 601(b)(31)(ii) of Reg S-K. To the extent that a deviation is necessary, management must include appropriate disclosures in the filing that allow management to sign the certifications as prescribed.
Audit report. If an audit report refers to the report of another auditor in expressing the opinion, that report must be included in the filing as well. For the purposes of any registration statement, each audit firm that has issued an opinion in an audit report included in the registration statement must consent to the inclusion of that report in the registration statement.
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