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.

SOX 404(b) – The Tar Baby and the SEC

Br'er Rabbit and Tar-BabyAs a youngster the Song of the South stories penned by Joel Chandler Harris at the beginning of the 20th century and brought to life by Disney were some of my favorites. In one, Bre’r Fox and Bre’r Bear make a tar baby to catch Bre’r Rabbit. Bre’r Rabbit becomes offended when the inanimate tar baby doesn’t respond, strikes it and becomes stuck to it.  The more he struggles the more inextricably attached he becomes. It certainly seems that the SEC has found a tar baby in SOX 404(b) as it pertains to non-accelerated filers.

Recently the  SEC deferred the compliance date – once again. This time for 9 months. The reason for further deferral was explained as being necessary as the results of an on-line survey conducted by the SEC which was not completed in time. A survey, I venture, that was essentially unknown to virtually everyone it might have affected, so not having it available was irrelevant.

As you may recall the original rationalization for 404 included the premise it would reduce fraud while increasing investor confidence in the issuer’s reporting. Those interviewed for the survey above indicated they did not believe there had been any increase in investor confidence as a result of 404 applied by large filers.  Yet in his public comment, Commissioner Aguilar stated ” I join Chairman Shapiro in assuring investors that there will be no further extensions of the compliance deadline.” What am I missing? By the SEC’s own survey, investors don’t care! So why is it mandated? Certainly there can and have been benefits enjoyed by larger issuers. For them it is good governance in many cases, and worthwhile. But not for small companies.

There is essentially no benefit to most non-accelerated filers either actual or perceived in most cases, and the cost is proportionately greater than for larger companies. Both the SEC and the PCAOB have exercised common sense in promoting ‘scalability’ in other areas. They need to do so here as well by eliminating the requirement – one with no or negligible benefit and grossly disproportionate cost – for small non-accelerated issuers.

Will it reduce fraud in small companies? I seriously doubt it and I believe most public company audit partners would agree. The SEC has the weapon it needs to fight fraud in the 302 certifications.

Send this tar baby back to Congress and let the money be redirected for innovation and growth.

Oil and Gas Accounting and Disclosure Rules Revised under SEC Release 33-8995

Oil & Gas AccountingLast Friday, the AICPA released a discussion draft of the audit and accounting guide for Entities with Oil and Gas  Producing Activities. While not authoritative  it is anticipated to reflect the current standards being revised by both the Financial Accounting Standards Board which sets US GAAP, and the International Accounting Standards Board, all of which is being done in response to SEC Release 33-8995.

While the changes are too voluminous and complex to even summarize here, I’ve included links and welcome questions,comments to this post or phone calls to discuss the implications.

The definitions in Rule 4-10 have been significantly changed. The pricing mechanism for reserves has been defined as a twelve month average. The definition of what is and is not considered ‘oil and gas’ has been clarified to include bitumen and other saleable hydrocarbon resources (geothermal has been excluded); the definitions of ‘proved’ ‘unproved’, ‘developed’ and ‘undeveloped’ reserves has been amended and clarified; and the disclosure requirements under Regulation S-K has been expanded.

Additionally, the disclosure requirements within the financials and for the K’s and Q’s  have been expanded and clarified including the disclosure requirements for MD & A. The SEC continues to coordinate with the FASB and the IASB who continue to develop their standards for the oil and gas entities. Given the SEC has come to the party first, it’s hard to imagine the other standard setting bodies will do anything but comply.

Foreign filers using Form 20-F will be subject to the same disclosure as opposed to the previous disclosure requirements summarized under Appendix A. Canadian filers, however, will not be subject to the new disclosure rules given that the requirements under the Multi-Jurisdictional Disclosure System (MJDS) using form 40-F are already consistent.

Now some good news. The implementation date  for registrations filed and for annual reports on Forms 10-K and 20-F is for fiscal years ending on or  after January 1, 2010. While the implementation is mandatory, “a company may not apply the new rules to disclosures in quarterly reports prior to the first annual report in which the revised disclosures are required”.  Implementation may  be deferred as discussions between the SEC, FASB and IASB go forward.

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.

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. 

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

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”