Critical Accounting Policies and How They Differ From Significant Accounting Policies

Critical AccountingIn an effort to help improve my client’s filings, and of course avoid SEC Comment Letters,  I am constantly reminding them that the disclosures required by SEC Rules Release 33-8098, contained in the MD&A, are considerably different than the significant accounting policies disclosed in the footnotes. Too frequently issuers simply cut and paste their summary of significant accounting policies into this section, which I believe will result in comments from the SEC if selected for a full review by Corp Fin.

I believe the intent of the critical accounting policies disclosures is for issuers to identify and disclose only those accounting policies that require significant judgment and estimation with a degree of uncertainty. Further, simply narrating the assumptions used in a Black-Scholes model for valuing stock options does not provide the appropriate information contained in the rules release. Disclosures related an issuers critical accounting policies (estimates) should include the methodology used in developing assumptions and the corresponding estimates, how the estimates impact the financial statements, and the effect of a change in the estimates and / or underlying assumptions.

The SEC provides two questions issuers need ask in making the “critical” determination:

  1. Did the estimate require making assumptions about matters that are highly uncertain?
  2. Would reasonably developed, different estimates / assumptions, at the time or in future periods, have a material impact on our financial statements?

When both questions are answered yes, it should be included in this section of the MD&A.

The included disclosures should not simply be boilerplate (like significant accounting policies tend to be) or be overly accounting technical (as “plain English” as possible). Further, the SEC expects varying numbers of critical accounting policies amongst issuers, but they have indicated three to five as a reasonable range.

The rules release provides several examples of disclosures that can help issuers develop the approach and content for appropriate inclusion in future filings.

SEC Extends ICFR for Small Issuers to 2010

Today, October 2, 2009, the SEC announced that independent audits of internal control over financial reporting has been extended for smaller reporting companies.  The press release indicates small companies will now need to be compliant beginning with annual reports for fiscal years ending on or after June 15, 2010.

Fair Value – Inactive Markets and Orderly Transactions

Recently issued “guidance” provides that when determining the fair value of certain assets (liabilities) it is only appropriate to use comparable transactions that were not fire (liquidation) sales where an active market exists.    The recent guidance (pre codification FSP FAS 157-4, codification 820-10-65-65-4), effective for interim and annual periods ending after June 15, 2009, simply provides additional items to consider for adding additional premiums or discounts when developing fair value estimates.

Further, the new guidance continues to reiterate the fair value definition that has been around for several decades, “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  Remember, the Company’s intent or ability to hold an asset should not be used in determining fair value as the estimate is market based and not entity specific.

In developing estimates, several factors provide an indication that significant adjustments to fair value (in this case quoted market prices – Level 1 inputs) may be necessary when market activity does not appear to be normal.  Some of those factors include:

  • Declines in recent transactions
  • Price quotations are stale or vary substantially, including significant bid-ask spreads
  • Indexes no longer correlate to values of individual assets or liabilities

After analyzing the market activity in general, the next step is to perform additional analysis to determine the transactions were not forced liquidations or distressed sales.  Factors to consider when a transaction may constitute a distressed sale include:

  • A recent transaction that appears to be an outlier compared to other recent transactions
  • Signs indicate the seller is experiencing significant financial difficulty, e.g. at or near bankruptcy
  • The asset (liability) was not marketed for an appropriate period or to multiple buyers

Three outcomes exist when analyzing transactions to determine if they fall within the fair value definition and require inclusion in estimates.  First, if the transaction is not orderly, it would likely hold little weight in estimating fair value.  Second, if the transaction is orderly, see above market activity analysis when determining how to include in fair value estimates including risk premiums.  Finally, there may not be enough information available to conclude whether the transaction is orderly, in which case, it should still be considered, but not the sole indicator of fair value.

The guidance recognizes that issuers need not undertake undue cost and effort in making these market determinations, but should not ignore information that may be readily available in the public domain.  Further, the degree of difficulty and subjectivity in developing risk premiums does not provide a sufficient basis to exclude risk adjustments to fair value.

At this point, you may be asking yourself – where does one obtain all of this information?  That is a very good question and I am out of time…anyone, anyone, anyone?.!

Proper Preparation Prevents Piss Poor Principal Auditor Performance

For certain individuals who have served this great country (thank you by the way) you may be familiar with what is known as the 7Ps (a vet just reminded me that the military version is 6Ps), and I thought it adapted to well to meeting your quarterly, annual, and seemingly non-stop compliance requirements as a public company.

For smaller reporting companies, or probably more fitting – smaller accounting departments, the “7Ps of SEC Accounting Compliance” couldn’t be more critical.

Midway through the third quarter (for calendar year ends) can be a good time to finish the interim reporting season strong and take significant steps towards preparing for year end and the dreaded audit, which by the way includes audits of internal controls over financial reporting for smaller reporting companies.

Since we are talking in 7s – here are 7 things to remember when preparing for your always positive, and happiness inducing audit experience:

  1. Make sure your auditor is not in denial about the integrated audit requirement for smaller reporting companies.  Chances are this will result in an increase of fees.  Up front fixed pricing is ideal for budgeting puropses, but this is not the norm for most firms (coincidentally this is something we live by).
  2. Get familiar with the codification.  It begins with the 3 rd quarter for calendar year ends so it is a good time to think about converting your summary of significant accounting policies into the SEC’s favorite “plain English” .  The cross reference tool is a great way to shorten the learning curve.
  3. Accept the fact that integrated audits are required for smaller reporting companies – get prepared and believe the additional paper gathering (documentation) will increase your frustration level.
  4. If you are a smaller reporting company and obtained any kind of debt or equity financing through anything other than traditional bank financing, now is a good to share the terms with your auditor.  The chances are generally high thay you have some complex accounting requirement that usually results in millions of dollars in surprise and meaningless liabilities.
  5. Don’t forget about the SFAS 157 fair value requirements particularly if you have level 2 and level 3 assets or liabillities.  Start documenting and don’t forget about the FSP “clarifications” for SFAS 157 and 115 (corresponding codification).
  6. Document supportable positions for other new and/or unusual transactions.  It seems like, in this market, all new transactions are unusual.
  7. Spend some time improving the non-financial portion of compliance documents.  The SEC provides great reports (report applies to 10-K as well as IPOs) to help avoid your own love letters from Corp Fin. 

Audit of ICFR for Small Reporting Companies

It appears the time has come for non-accelerated filers to obtain an audit of internal controls over financial reporting from their external auditor, likely in the form on an integrated audit with the filer’s financial statements.

To date, the SEC has not updated its most recent rules release on the requirement for non-accelerated filers to include an attestation report of their independent auditor on internal controls over financial reporting for fiscal years ending on or after December 15, 2009 (with certain exceptions for new registrants).

Recent remarks by both SEC Commissioner Luis Aguilar and SEC Chairman Mary Schapiro seem to indicate no additional extension will be granted, absent the SEC’s on-going cost-benefit study of SOX Section 404 indicating costs significantly out of line with the benefits.

In preparing for obtaining an audit report, which is as of the annual balance sheet date, it is a good idea to be familiar with a couple of different pieces of guidance.  The first of which is the COSO ICFR guidance for smaller reporting companies to ensure appropriately designed and implemented controls to detect and prevent material misstatement of financial information.  Secondly, to get an idea of the auditor’s approach, review the PCAOB’s Auditing Standard No. 5 and further the PCAOB’s staff views issued January 23, 2009.

Convertible Debt Showdown: SFAS 133 & EITF 00-19 VS. EITF 98-5 and EITF 00-27

The currently prevalent use of convertible instruments appears to highlight significant inconsistencies in the interpretation and application of the layers of US GAAP that must be navigated when simply trying to obtain the capital necessary to keep the doors open.

Most issuers that I see entering into these types of arrangements somehow find a way to treat embedded conversion features as equity, usually by ignoring the requirements of paragraphs 12-32 of EITF 00-19 and the recently implemented clarification contained in EITF 07-5for SFAS 133 exclusion.  These issuers appear to be at least acknowledging the embedded conversion feature by applying the guidance of EITF 98-5 and 00-27 and recognizing a debt discount that approximates the intrinsic value of the conversion feature, thereby increasing the effective interest rates of the debt, sometimes significantly.

The implementation of EITF 07-5 will almost always require derivative treatment under SFAS 133, particularly when the terms of the debt agreement contain holder protection (anti-dilution provisions) for future issuances of debt, equity, or equity linked instrument requiring adjustment to  the conversion price.

A few things to remember when analyzing a convertible instrument:

  • EITF 98-5 and 00-27 do not apply to instruments considered to be derivatives under SFAS 133 requiring bifurcation from the host contract.
  • Instruments accounted for under SFAS 133 require fair market valuation at the issuance date and re-valuation at the appropriate future cut-off dates in contrast to beneficial conversion features that are valued  at the intrinsic value onlyon the date of issuance.
  • Recognition of liabilities for embedded conversion features on the issuance date can result in significant gains in future periods.  Don’t get too excited about this as it is generally meaningless and usually means the issuer’s stock price is declining.

Don’t like any of this?  Have a look at SFAS 155…..

Do Your SEC Filings Paint the Appropriate Picture of the Company?

SEC Painting a Picture of Your BusinessDuring the recently completed filing season for calendar year-end Smaller Reporting Companies I frequently provide suggestions for improving the overall quality of the Form 10-K.  This generally includes suggestions to eliminate redundancy; provide concise and specific disclosures; provide useful analysis of historical results; and provide reasonable expectations related to future near term trends, commitments, liquidity, and other known material events and transactions.   These suggestions not only affect the financial statements, but they generally apply to other significant areas such as business overview, risk factors, and management’s discussion and analysis.

In my experience, issuers tend to rely on their attorneys for guidance on the non-financial statement portions of the Form 10-K.  Most attorneys that I have dealt with focus only on standard regulation compliance and lawsuit prevention.   While these things are obviously important, they generally do not improve the quality of the disclosures.  To be fair, most attorneys are not asked to help make improvements in order for issuers to somewhat manage attorney fees.

The SEC’s Corp Fin Staff recently published Staff Observations in the Review of Smaller Reporting Company IPOs at which provides a brief reminder for quality improvement and avoiding the comment process.  While these observations specifically relate to registration statements they are also applicable to Forms 10-Q and 10-K.

Some highlights:
Risk Factors – “Generic risk factor discussions that do not describe how a specific risk applies to the company or an investment are not helpful to understanding the risk.  Also, it is rarely helpful to state there can be no assurance of a particular outcome”

Description of Business – Reg. S-K requires a description of a company’s business development over the last three years and provides an overview of the material aspects of the business.  Further, “Where it was not clear what a company did to generate revenue or what its future growth strategy was, we (Corp Fin Staff) asked it to provide a discussion of its current or intended material sources of revenue”.  My experience is that several issuers focus on historical reverse merger and similar capitalization transactions while ignoring the current and near term future functional activities.

Management’s Discussion & Analysis – Financial based discussion should focus on “Any known material trends, demands, commitments, events, or uncertainties that will have, or are reasonable likely to have, a material impact on the company’s financial condition; short-term or long-term liquidity; and revenue or income from continuing operations”.  They further state this section should disclose “The past and future financial condition and results of operations of the company, with particular emphasis on the prospects of the future”.  I don’t believe that providing a narrative of the financial statements, by itself, meets the requirements of Item 303 of Reg S-K or provide any additional useful information.  The SEC’s observations indicate results of operations should “Disclose the reasons underlying the causes for the period to period changes”.

Financial Statements; Revenue Recognition – The SEC observations generally recommend an issuer’s revenue recognition policy discloses the “application of specific authoritative revenue recognition guidance for transactions within the scope of the appropriate GAAP literature; the nature and type of earned revenue; and separate revenue recognition policies for each type of earned revenue”.  I don’t think cutting and pasting the SAB 104 requirements or GAAP literature on its own meets these observations.
I realize compliance document improvement is probably not on the top of most Smaller Reporting Company’s priority list in today’s environment, but there is definite value in avoiding the SEC comment process.  Also, a Smaller Reporting Company’s SEC filings, to a certain extent, serve as the public face of the company and should reflect the high degree of professionalism the boards, officers, and employees of these companies possess.

EITF 07-5 Highlights

Financial IstrumentsIt appears the Emerging Issue Task Force (EITF) has provided some seemingly useful guidance as to the determination of the application of SFAS 133.  As I see more and more companies issuing various types of hybrid financial instruments in order to fund ongoing capital needs, I also see varying degrees of application of SFAS 133 and its next cousin EITF 00-19.

Sifting through the guidance and corresponding AICPA roadmap to properly account for these transactions seems to be the equivalent of ………  The recent issuance and 2009 implementation of EITF 07-5 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock seems to alleviate some of the confusion surrounding certain redundant conditions in most financial instrument agreements that we have seen.

For example, several recent issuers entering into convertible debt transactions, with certain similar terms, each have radically different balance sheet presentations.  Ignoring the SFAS 155 election (which is another matter of discussion), one issuer determined that SFAS 133 didn’t actual apply to the convertible debt and presented the standard convertible note payable; while another determined that SFAS 133 applied, jumped to EITF 00-19 to determine the classification of the derivative instrument requiring bifurcation, and concluded permanent equity treatment was appropriate; and the third issuer determined SFAS 133 in fact applied, required bifurcation, and treated the derivative instrument as an additional liability requiring periodic revaluation.

While having many recent discussions with CPAs, CFOs, University Professors, and anyone else that might have some insight, including the FASB Staff themselves, we were pointed to the seemingly useful guidance contained in EITF 07-5.  In the example above, I see most issuers spending most of the time reaching for non-application of SFAS 133 under the exceptions contained in paragraph 11(a) that states that “contracts issued that are both indexed to an entity’s own stock and classified in stockholders’ equity are not considered derivative instruments”.   If the complete blow off of SFAS 133 does not work, as in the case of the second issuer above, permanent equity treatment becomes the next best option under the general guise that the issuer has control over adjustments to conversion prices and amounts or that the likelihood of significant detrimental adjustment in the derivative value is de minimis.  This example, in particular, appears to be clarified by EITF 07-5.

For all instruments outstanding in fiscal years beginning after December 15, 2008 it appears the application of EITF 07-5 will correspond with increased application of SFAS 133.  The EITF guidance indicates several financial instruments are not actually indexed to a companies and stock and would infer SFAS 133 treatment (liability classification).  Paragraph 15 eliminates both common arguments against bifurcation:  i) the issuer has the ability to control any conversion adjustment and ii) the probably of making detrimental adjustments is de-minimis.  The paragraph further indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument, regardless of the probability or whether or not within the issuers’ control, is not indexed to the issuers own stock.

The inability to conclude that financial instruments are actually not indexed to the issuers own stock, thereby, significantly eliminating the derivative instrument exception paragraphs of SFAS 133 will likely result presentation changes of a large number of small reporting companies and may result in some interesting earnings swings.

Maybe the little used SFAS 155 election for financial instruments warrants further discussion?

SFAS 157 – How 'Fair is Fair' Value?

No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged.

No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged. What is a supportable fair market value that reflects an orderly transaction between two or more willing market participants?

The SEC’s recently issued “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting” concludes, amongst other things, that “..additional measures should be taken to improve the application and practice related to existing fair value requirements – particularly as they relate to both Level 2 and Level 3 estimates”. In the report, the SEC’s Committee on Improvements to Financial Reporting (CIFiR) further recommended the SEC issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments and include factors that it considers when making this evaluation, as well as that the PCAOB should also adopt a similar approach with respect to auditing judgments.

In light of these conclusions, and unlikely forthcoming judgment “guidance” for valuing financial instruments with primarily Level 2 and 3 inputs, it is important to gather all pertinent information and variables potentially used in building a valuation model. There are several keys to doing this including:

  • Monitor your investments and those similar throughout the reporting period, not just at the reporting date.
  • Stay in touch with general economic indicators.
  • Consider your true plans of instrument liquidation and whether the Company has the ability to wait out the market.
  • Get your non-accounting finance and analyst types involved as they are generally more comfortable with assumptions and judgment than most accounting types.
  • Provide your assumption documentation to your auditor as soon as possible – it is generally not difficult to audit the fair value model itself, however, getting reasonable documentation related to assumptions is where the time is spent, particularly when there is a difference in opinion as to what constitutes reasonable.
  • Try to keep it simple concise and as straightforward as possible. Tying certain assumptions to the lining up of the planets will likely not pass your auditor’s smell test.

By the way, the SEC’s Report concluded that the fair value accounting standards did not cause the bank failures of 2008.

Convertible Debt and Its Never Ending Financial Statement Destruction

While preparing for the next client argument, I mean discussion, involving the issuance of convertible debt I was reminded of the additional effects certain provisions of EITF 00-19 has on other outstanding financial instruments / derivatives.

As anyone with outstanding convertible debt is aware, the key point to simplifying the accounting for any conversion feature that appears to require derivative accounting is to force the feature into being classified as permanent

While preparing for the next client argument, I mean discussion, involving the issuance of convertible debt I was reminded of the additional effects certain provisions of EITF 00-19 has on other outstanding financial instruments / derivatives.

As anyone with outstanding convertible debt is aware, the key point to simplifying the accounting for any conversion feature that appears to require derivative accounting is to force the feature into being classified as permanent equity.   In general, the best way to classify the resulting derivative as permanent equity is to convince yourself, your auditor, and in most cases the SEC, that your debt qualifies as a “conventional convertible debt” as unclearly defined by paragraph 4 of EITF 00-19 and then by the equally obscure EITF 05-02. Continue reading “Convertible Debt and Its Never Ending Financial Statement Destruction”