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.

A Matter of Trust

Mexico InvestmentsA number of countries don’t allow foreign people (including foreign business entities) to own land in certain areas. The most well known of these countries is Mexico, but I have recently come across a similar situation in Canada, and know of cases in Great Britain. As a work-around, the land is usually held in trust for the foreign owner. This may not seem as though it creates any tax issues, but it does. Unfortunately foreign trusts have at times been used to try to shelter income off-shore in foreign tax havens, so the IRS has strict reporting requirements for foreign trusts… and the penalties for not filing the related forms are huge! (In some cases 35% of the trust assets per year).  Even if you don’t think of the trust as a “real trust” – the IRS probably will (they are commonly referred to as “Land Trusts” or “Mexican Land Trusts”). We recently enlisted the services of tax attorney, Jean Ryan at Sideman Bancroft, LLP, to analyze a Canadian land trust.  Although the client “never thought of it as being a real trust,” her answer was that it the IRS may treat it as trust, because of the language in the document. So if you own beachfront property in Mexico – lucky you, but in all seriousness, talk to your tax advisor to make sure that you don’t lose it all in penalties.

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?.!

Risky Business for Directors – How's your ERM?

Risky Business for DirectorsNot so many years ago, being elected to the Board of Directors of some companies essentially required you to act as a figurehead. Lunch in an expensive restaurant once a month, an annual retreat to a vacation resort to discuss corporate ‘strategy’ and a small stipend were all that was required in trade for the collective experience and informal leadership. That’s all changed with the increased exposure to liability now faced by corporate governance.  With the current state of our business environment, that exposure is greater this year than ever.

In an on-line article Executives Anticipate Rise in Fraud nearly two thirds of the executives polled anticipate an increase in fraud and misappropriation this year. In conjunction with auditors anticipating that nearly 25% of all firms may not be going concerns; the myriad of new regulatory requirements related to governance; and the corporate challenges fomented by a floundering economy this may not be a desirable year to be a Director. The current hot topic seems to be enterprise risk management.

While a long time focus of management, ERM has often been given little attention by the board. Recently, COSO published a document highlighting four critical areas that contribute to effective board oversight. It can be downloaded at www.coso.org.

As public company auditors and consultants we have observed the importance of an integrated approach to governance between the board and management. We regularly participate in joint meetings as frequently as allowed (we don’t charge for meetings with management and the board), for our own self-interest. Our best clients have the strongest most engaged boards. Boards of Directors are invaluable resources.  Take full advantage.

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 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.