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SEC Insights - February 2010

 

Common Financial Reporting Issues Facing Smaller Issuers

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In December 2009 the SEC’s Division of Corporate Finance (“DCF”) presented an updated version of its Common Financial Reporting Issues Facing Smaller Issuers. The presentation discussed frequent issues encountered when reviewing the filings of smaller reporting companies. The following are some of the more common reporting issues discovered by the DCF:

  • Overall impact of the financial crisis on financial statements
  • Management’s Discussion & Analysis ("MD&A")
  • Reverse mergers & "back door" registrations
  • Business combinations
  • Valuation of equity transactions
  • Smaller reporting company status
  • Disclosure controls and procedures and internal controls over financial reporting

Overall Impact of the Financial Crisis on Financial Statements

The primary accounts impacted by the current financial crisis include goodwill, intangible assets, PP&E, accounts receivable, inventory and deferred tax assets.

Goodwill, intangible assets and other long-lived assets - GAAP requires that companies consider if an event has occurred that "would more likely than not reduce the fair value of a reporting unit below its carrying value." The DCF will consider certain publicly available information, as well as information obtained outside of filings to determine if such an event has occurred. The assumptions used to value goodwill should generally be consistent with those assumptions used in valuing other assets allocated to the same reporting unit, such as intangible and other long-lived assets. These assumptions should be consistent with other disclosures throughout the financial statement including liquidity in the MD&A and going concern.

Accounts receivable, inventory and deferred taxes – Due to the down economy, companies should revisit their estimates for reserving and writing off accounts receivable. These reserves are typically based on historical data, which may no longer be indicative of current market conditions, especially with delinquencies on the rise. Consumer spending has been significantly affected by the economic down turn, which has resulted in increased inventory levels for companies. Due to these increased inventory level and decrease customer demands, companies should be to closely monitoring the value of their inventory. With inventory turning more slowly, it raises concern for potential slow moving or lower of cost or market write-downs. Additionally, companies should consider the impact of the current financial conditions on the realizability of their deferred tax assets.

MD&A

The intended objectives of the Management’s Discussion & Analysis are to: provide a narrative through the eyes of management of the company's financial statements; to supplement the overall financial disclosures and provide the means in which financial information should be analyzed and provide information about the predictability of a company's earnings and cash flow, so that investors can understand the likelihood that past results could be indicative of future performance. To satisfy these objectives it is recommended for companies to provide a summary which includes both financial and non-financial key performance indicators and details what the material drivers were for the fluctuations. It is essential that the reader is able to gain a thorough understanding of the Company’s financial performance. Discussions in the MD&A also need to focus on liquidity and capital resources, with enhanced disclosure on the sources and uses of cash and the actual drivers of operating cash flows rather than reciting line items from the statement of cash flows.

Reverse Mergers and “Back Door” Registrations

A "Back Door" registration or Reverse Merger is, in essence, a method by which a private operating company arranges for its stock to be publicly traded following a merger or similar transaction with a publicly held shell company, pursuant to which the equity owners of the private company typically take control of the former shell company. The DCF presentation summarized the most frequent areas of comment related to these transactions and clarified the rules related to these comments. One of the popular comments related to Item 4.01 ("Changes in Registrant's Certifying Accountant") not being filed with the Form 8-K. Unless the same audit firm is used by both the registrant (the shell company), and the accounting acquirer (the private operating company), Item 4.01 must be filed. In accordance with Item 9.01(c) of Form 8-K, the financial statements must be filed within four (4) business days of the reverse merger transaction. The 71 day extension period, available to other types of Business Combinations, does not apply to reverse mergers. The new SEC registrant will not be considered current or timely for the purposes of using certain forms if this filing deadline is not met. In addition, the Form 8-K is required to include all necessary disclosures that the operating company or accounting acquirer would be required to present in a registration statement on Form 10 to prevent a gap in reporting.

As it relates to the Sarbanes-Oxley Section 404 compliance, once the reverse merger transaction has occurred, the entity is not theoretically a newly public company, as the legal issuer, (the shell company), has not changed. The DCF issued a Compliance and Disclosure Interpretation in order to provide guidance for companies who find themselves in this situation. The DCF acknowledges that companies might not always be able to properly assess internal controls over financial reporting ("ICFR") of the private operating or accounting acquirer’s internal controls over financial reporting. As such, there are certain situations that the DCF would not object to if the issuer omits management’s assessment of ICFR in the fiscal year in which the transaction occurred.

Valuation of Equity Transactions

According to the DCF, a common issue faced by smaller reporting companies relates to the valuation of equity transactions. When smaller companies incorrectly calculate fair value for equity transactions, it can lead to material misstatements. The DCF noted that these issues primarily arise when companies use a value different from quoted market price when the stock is traded on an active market. If the securities are not traded in an active market, the DCF encourages companies to look to contemporaneous equity transactions with third parties or to the fair value of goods or services provided. Absent an active market or the other measures mentioned above, management should use judgment and consider the fair value hierarchy, in determining a fair value that is supportable.

Smaller Reporting Company Status

The SEC adopted a new set of disclosure rules for smaller reporting companies effective February 4, 2008. These new rules are tailored to meet the needs and characteristics of smaller companies and their investors. The new rules allow companies that have a public float to only consider their float in the test; the revenue test only applies to companies unable to calculate public float. The transition rules are designed to be the most beneficial for exiting or entering smaller reporting companies. For example, if a company is required to exit smaller reporting company status, it will not be required to satisfy the larger reporting company disclosure requirements until the first quarter after the determined fiscal year. On the contrary, if a company qualifies as a smaller reporting company as of the last day of its most recently completed second quarter public float test, it is permitted to transition to reporting as a smaller reporting company in its next quarterly report.

Disclosure Controls and Procedures and Internal Controls Over Financial Reporting

The DCF staff continues to issue comments on the evaluation of disclosure controls and procedures ("DC&P"). Disclosures should clearly state the DC&P conclusion in clear language; it’s either effective, or not effective. Registrants should be aware that the scope of DC&P is broader than the definition of internal controls over financial reporting. Therefore, it is possible that DC&P can be deemed ineffective when internal controls over financial reporting are effective. However, the reverse would raise skepticism with the DCF staff.

For both accelerated and non-accelerated filers, the DCF staff continues to comment on the areas where material weakness disclosures can be improved. It is recommended for companies not to group multiple material weaknesses into general categories. Disclosures of material weaknesses are beneficial when they provide insight into how the financial statement is impacted by the weakness and how management plans to remediate it.

 
 
 
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