SEC Adopts Amendments to Modernize, Simplify, and Enhance Disclosure Requirements of Regulation S-K
By Leonard Lee, Senior Manager, Assurance Services
On November 19, 2020, the Securities and Exchange Commission (“SEC”) adopted amendments to modernize, simplify and enhance certain financial disclosure requirements in Regulation S-K (“Final Rule”). The amendments are intended to sharpen the focus of financial disclosures of material information for the benefit of investors, including Management’s Disclosure and Analysis (“MD&A”), while simplifying compliance efforts for registrants. The amendments, which also include conforming changes to the forms used by foreign private issuers when applicable, are part of the SEC’s disclosure effectiveness initiative.
The amendments reflect the Commission’s long-standing commitment to a principle-based, registrant-specific approach to disclosures. SEC Chairman Jay Clayton advised, “Today’s rules will improve the quality and accessibility of the disclosure that companies provide their investors, including, importantly, giving investors greater insight into information management uses to monitor and manage the business.”
Investors and registrants should be aware of the following, as pertains to the SEC’s final rule (Release No.33-10890):
- The SEC scaled back the requirement to provide selected quarterly financial data.
- The amendments eliminate the requirements for registrants to provide the selected financial data and contractual obligations tables (Regulation S-K, Item 301, Selected Financial Data).
- The amendments add objectives to the requirements for MD&A and change or clarify the requirements for a number of items such as liquidity and capital resources, known trends and uncertainties, critical accounting estimates and off-balance sheet arrangements (Regulation S-K, Item 303 MD&A of Financial Condition and Results of Operations).
- The rules can be applied 30 days after publication in the Federal Register, and compliance is mandatory 210 days after publication. Before the mandatory compliance date, registrants can choose which amended items to apply.
- The final rule will makes conforming changes to the forms used by foreign private issuers.
The changes to items 301, 302, and 303 of Regulation S-K sharpen the focus on material information by:
Eliminating Item 301 (Selected Financial Data)
The amendments eliminate the requirement in Item 301 of Regulation S-K for a registrant to present selected financial data for each of its last five years. The table has been required in registration statements and annual reports. The SEC noted that providing this data for years before those presented in the audited financial statements can create additional costs and complexity for companies, and the information is typically available in filings that can be found on the SEC’s EDGAR system.
- Smaller reporting companies are not required to provide Item 301 information. Emerging growth companies (“EGCs”) that are providing the information called for by Item 301 in a Securities Act registration statement need not present selected financial data for any period prior to the earliest audited financial statements presented in connection with the EGC’s initial public offering (“IPO”) of its common equity securities. In addition, an EGC that is providing the information called for by Item 301 in a registration statement, periodic report, or other report filed under the Exchange Act need not present selected financial data for any period prior to the earliest audited financial statements presented in connection with its first registration statement that became effective under the Exchange Act or Securities Act.
Streamlining management’s discussion and analysis
The SEC made a number of changes by streamlining item 302(a) Supplementary Financial Information and modernizing and simplifying the MD&A requirements of item 303 of Regulation S-K. Some of the key changes to these amendments are:
Selected Quarterly Financial Data
Revise item 302(a) to replace the current requirement for a quarterly tabular disclosure with a principle-based requirement for material changes. The amended item 302(a) of Regulation S-K will allow registrants to omit the table of selected quarterly financial data they currently provide for each quarter of the two most recent fiscal years and any subsequent interim period, unless there has been a material retrospective change (or changes that are material in the aggregate) affecting comprehensive income for any of the quarter within the two most recent fiscal years. While a first-time registrant undergoing an IPO is not required to provide these disclosures, it will need to do so “beginning with the first filing on Form 10-K” after its initial registration statement.
Objectives of MD&A disclosure
The amendments state the principal objectives of MD&A disclosures. The objectives focus on the disclosure of material information relevant to assessing a registrant’s financial condition, results of operations and cash flows. They address both historical and forward-looking information and refer to material financial and other statistical data that will enhance a reader’s understanding of the registrant’s financial condition, cash flows and other changes in financial condition and results of operations.
- Material changes – The amendments clarify and emphasize that registrants must provide a narrative discussion of the underlying reasons for material changes in financial statement line items from period to period in both quantitative and qualitative terms.
- Prospective information – The amendments require the disclosure of prospective information that is “reasonably likely” to have a material effect on the registrant’s future results of financial condition. In doing so, the SEC set a consistent threshold to replace the different thresholds that apply to various items under the legacy rules (i.e., the legacy rules require a known trend or uncertainty to be disclosed if a registrant “reasonably expects” it will have a material impact on revenue or income from continuing operations).
Amended items 303(a) (1) and (2) modernize, enhance and clarify disclosure requirements for capital resources. A registrant must discuss its ability to generate and obtain adequate amounts of cash to meet its requirements and plans for cash in the short term and long term. A registrant must also describe its material cash requirements, their general purpose and the anticipated source of the funds needed to satisfy them. While this change goes beyond the legacy requirement for disclosures about capital expenditures, the SEC said it does not expect registrants to substantially change current practice. Material cash requirements are intended to encompass capital expenditures as well as expenditures for human capital, intellectual property, contractual obligations, off-balance-sheet arrangements, and other requirements such as results of operations.
Contractual Obligation table
The amendment eliminates current item 303(a)(5), Tabular disclosure of contractual obligations, in light of the amended disclosure requirements for liquidity and capital resources and certain overlap with information required in the financial statements. Registrants are no longer required to include a contractual obligations table in MD&A. However, the amendments related to capital resources, including the requirement for registrants to discuss known contractual and other obligations on both a short-term and long-term basis, are intended to make sure that eliminating the table does not result in a material loss of information for investors.
Results of Operation
The amendment for items 303(a)(3)(ii – iv), Results of operations, encourage registrants to focus on material information that is tailored to a registrant’s businesses, facts, circumstances and eliminates the legacy requirements for inflation and price changes. Moreover, the amendments clarify the items requirement by using a disclosure threshold of “reasonably likely,” which is consistent with the Commission’s interpretative guidance on forward-looking statements (i.e., “2003 MD&A Interpretive Release”). Registrants will be required to discuss material changes in net sales or revenue rather than only material increases. The amendment will also require registrants to disclose known events that are reasonably likely to cause a material change in the relationship between cost and revenue, such as a known, reasonably likely future increase in the cost of labor or material or a price increase or inventory adjustments. Moreover, though the amendment has eliminated the inflation and price change disclosure under item 303, registrants are still required to discuss inflation and price changes if they are part of a known trend or uncertainty that has had, or is reasonably expected to have, a material favorable or unfavorable impact on net sales, or revenue or income from continuing operations.
Material changes in line items
The amendment to Instruction 4 in Item 303(a) enhances and clarifies the analysis in MD&A disclosure requirements by codifying existing Commission guidance on the importance of analysis in MD&A for material changes. The Commission’s adoption of the amendments is largely intended to enhance the analysis in MD&A, by moving a portion of current Instruction 4 to Item 303(a) to the main text of amended Item 303(b) and clarifying the provision requirements underlying reasons for material changes in quantitative and qualitative terms. Per the Commission’s observations, many companies provide excessive duplicate disclosures and disclose immaterial information.
The Commission has focused on improving the analysis in MD&A for many years. Yet, despite specific instructions in Item 303(a) that “the discussion shall not merely repeat numerical data contained in the consolidated financial statements,” the Commission has previously observed that many registrants simply recite the amounts of changes from year to year that are readily computable from their financial statements. The Commission also proposed to amend portions of current Instruction 4 to clarify that MD&A requires a narrative discussion of the “reasons underlying” material changes rather than only the “causes” for material changes. This proposal was intended to encourage registrants to provide a more meaningful discussion of the underlying reasons that may be contributing to material changes in line items. This includes registrants also discussing material changes within a line item even when such material changes offset each other, consistent with prior Commission guidance.
Off-balance sheet arrangements
The amendment replaces current item 303(a) (4), Off-balance sheet arrangements, with principles-based disclosure. The SEC replaced the more prescriptive legacy requirement to disclose off-balance sheet arrangements in a separate section with a principles-based instruction to provide the disclosure regarding off-balance sheet arrangements throughout MD&A whenever material. However, in accordance with Instruction 8 to Item 303(b), a registrant must disclose material off-balance-sheet arrangements as part of the Liquidity and Capital Resources discussion.
Critical accounting estimates
Item 303(b) (3) was amended to clarify and codify Commission guidance on critical accounting estimates. Specifically, the amendments require disclosure of quantitative and qualitative information to help investors understand the impact of estimation uncertainty on a registrant’s financial condition or operating results. To the extent material and reasonably available, such disclosure must include how much any critical accounting estimate has changed over a relevant period along with a sensitivity analysis. Although there are some differences between the new requirement and the interpretive guidance, the SEC said that it believes the principles are not materially different and the modifications are intended to clarify the required disclosures, facilitate compliance and improve disclosures.
The amended item 303(b), interim periods (amended item 303(c)) modernizes, clarifies and streamlines the item to allow for flexibility in the comparison of interim periods to help registrants provide a more tailored and meaningful analysis relevant to their business cycles. The amendments provide a registrant with the option to discuss its interim results by comparing its most recent quarter to the immediately preceding quarter rather than to the same quarter of the prior year. A registrant that chooses this option must provide summary financial information for the immediately preceding quarter or identify the EDGAR filing that includes the information. Registrants must continue to include a comparison of year-to-date results as well. A registrant that changes the period used in its comparison is required to explain the reason for the change and present both comparisons in the filing in which the change is announced.
Effective Date and Transition
As noted above, the final rule is effective 30 days after its publication in the Federal Register (effective date) and must be applied in a registrant’s first fiscal year ending on or after the date that is 210 days after such publication date (mandatory compliance date). Because the mandatory compliance date is based on the end of the registrant’s fiscal year, Forms 10-Q for quarterly periods in 2021 need not reflect the amendments. Early adoption on an item-by-item basis is permitted after the effective date; however, a registrant must fully comply with each adopted item in its entirety. In addition, the final rule must be applied if a registration statement or prospectus is initially filed with annual financial statements that reflect a period on or after the mandatory compliance date.