SEC Scrutinizing Contingencies, MD&A, Segmentation in Letters

The Securities and Exchange Commission sent out several reminders to companies last year that it is keeping a watchful eye on their disclosures.

In several comment letters to issuers as part of its disclosure review process, the SEC alerted companies to concerns about reporting on everything from taxes to unconventional measures. Recent examinations of the comment letters indicate that the Commission is taking a harder look at revenue recognition, loss contingencies, segmentation reporting, risk factors, and other areas during the reviews.

Under the Sarbanes-Oxley Act, public companies have to undergo an SEC review of disclosures at least once every three years; pre-IPO companies need to do so as a condition of their registration. Some Big 4 firms—including Deloitte, PwC, and E&Y—are taking a look back at trends that emerged during 2013's reviews, predicting what's ahead this year, and offering suggestions for how to deal with the scrutiny.

Deloitte's analysis found a growing demand for clarity in registrants' disclosures. The leading source of comments came from the management discussion & analysis (MD&A) section. Other subjects frequently flagged: revenue recognition, taxes, loss contingencies, intangible assets, segmentation reporting, fair-value measurements, measures that don't conform to Generally Accepted Accounting Principles, and risk factors.

One of the more common questions SEC staff asked last year was about business segments, says Wayne Carnall, PwC partner and former chief accountant in the Division of Corporation Finance at the SEC. Among the questions: “Is the company presenting the proper segments, or should they be presenting more segments than they have done historically?”

The issue of “stranded cash” is also becoming more prevalent, Carnall says. Multinational companies have operations all over the world and when you look at their consolidated balance sheet it will look like they have lots of cash, he explains. “But some of that cash can be in countries that are tax havens and if they were to repatriate the cash they would incur a tax liability.” If there are no plans to repatriate that cash, permanently keeping it overseas, the SEC will ask companies to disclose the amount of cash and discuss the implications on  liquidity.

In general, tax issues are a growing concern at the SEC. The SEC has sought greater clarification from companies regarding their effective rate reconciliation and various tax structures that have been discussed in the press.

The SEC is also more frequently questioning companies on loss contingencies, especially potential losses from litigation. “A number of companies are trying to improve disclosure about their litigation environment, what type of clams have been made against them, and what is the reasonable, possible loss,” Carnall says. This is a challenge given the uncertainty of litigation, but, nevertheless, the SEC will demand answers.

Another source of questions:  guarantor disclosure. “If a company issues debt, they may have a subsidiary that guarantees that debt,” Carnall explains. “That guarantee is legally considered a security, so you have to provide additional disclosures about it.”

SEC Comment letters on cyber-security disclosures are also becoming more common, with the SEC selectively demanding specific breach details, not just hypothetical scenarios, he adds.

“By definition comments are going to be reactive and should not be stagnant. The information should evolve with changes in the overall economy, the industry in general, and the company specifically.”

—Wayne Carnall,

Partner,

PwC

The SEC also continues to issue substantial industry-specific comments, Deloitte's analysis finds. “The pharmaceutical and life sciences industry, for example, faced a fair share of revenue recognition concerns. Financial services industry registrants were more frequently asked about disclosures related to the credit quality of their assets,” the report states.

How to Respond

Each day, Olga Usvyatsky reads upwards of 200 SEC comment letters as part of her work as an analyst at Audit Analytics, a research firm that focuses on SEC disclosures. She compares the SEC comment letter process to a job interview: Be prepared for anything you said to encourage follow-up questions, she warns.

Companies cannot afford to fumble for an answer, she says. Most questions are routine, with the expectation that the company will respond within 10 business days by either amending a filing, providing the requested information, or advising SEC staff when the requested information will be provided.

Companies have the option of filing either an extension or confidentiality request. Most companies file an extension request for rather mundane reasons, she says, such as a vacationing CFO, for example. Confidentiality is also reasonable to protect sensitive company information that could tip a business strategy to competitors. But an overreliance on these requests can backfire, warns Usvyatsky, raising red flags for regulators and investors.

POPULAR COMMENTS

The following chart from EY summarizes the top 10 most frequent comment areas in 2012 and 2013.

Comment Area

Ranking: 12 Months Ended June 30, 2013

Ranking: 12 Months Ended June 30, 2012

Management's discussion and analysis

1

1

Fair-value measurements

2

2

Non-GAAP financial measures

3

8

Contingencies and commitments

4

4

Revenue recognition

5

6

Income taxes

6

5

Signature, exhibits, and agreements

7

3

Intangible assets and goodwill

8

10

Segment reporting

9

9

Executive compensation disclosures

10

7

Source: EY.

Some companies go a step too far, she adds, pointing to Bear Sterns in 2007 and 2008.  Its collapse, and buyout by JPMorgan Chase, was foreshadowed by foot-dragging that saw it take an additional 126 days to respond to one SEC comment letter, while ignoring another one completely.

Google also drew scrutiny recently when it tried to side-step questions about legal contingencies amid a Department of Justice investigation over false advertising claims. Asked by the SEC to justify and explain $500 million set aside in reserves for legal losses, and why this amount wasn't disclosed sooner, it sought to avoid an answer with four extension requests and four confidentiality requests over the course of eight months.

“There is nothing wrong with asking for additional time when you need to prepare all the relevant information,” Usvyatsky says. “You may need extra time to involve experts inside and outside the company. What I would not suggest is dragging the conversation on too long without a legitimate reason. It does not look good and it probably draws more attention than you need, or is justified.”

Her advice for companies when dealing with SEC comment letters and the questions they raise: Answer promptly and completely. “You want to minimize time and effort,” Usvyatsky says. “And you don't want to go through rounds and rounds of conversation.”

Companies can streamline the process by taking a company-wide approach, Usvyatsky adds, involving all relevant departments at once.  “If it is an accounting question, that does not mean only accounting personnel have to be involved,” she says. “You want to involve operational units or any other relevant expertise within the company. It can be very tempting to give a limited response, but the downside is that we see conversations go on for six months or more.”

While Usvyatsky advises companies to stay abreast of trends and how their peers respond to their publicly available comment letters, they should never try to mimic those responses, or worse, cut and paste those answers. Also, “if you promise the SEC that you are going to do something, please do it,” she says. “It does not look good when companies promise to add disclosure in a separate filing and don't do it.”