SEC Comment Letter Trends

By Jeremy Simons

It is that time of year when many public companies are in the midst of the financial reporting season and nearing the deadline to file audited financial statements with the SEC. Before putting the finishing touches on their Forms 10-K, companies and their financial advisors might find it helpful to understand the latest trends in SEC comment letters in order to enhance their documentation of accounting positions and their disclosure packages. The following sections discuss the areas of most frequent comment by the SEC staff, as well as a few of the SEC staffs disclosure tips. Even if a company does not encounter these specific issues, the SEC staffs comment approach for a particular topic often carries through to other areas.

Income Taxes

Realizability of deferred tax assets. The guidance under Accounting Standards Codification (ASC) Topic 740, "Income Taxes," requires a valuation allowance on deferred tax assets if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. A company must consider both positive and negative evidence when determining whether a valuation allowance is needed. When weighting available evidence, companies should consider how objectively verifiable it is.

The SEC staff frequently asks companies to explain how they have evaluated both the positive and negative evidence when reversing a valuation allowance, including-

* file magnitude and duration of past losses and the expected magnitude and duration of profitability;

* the factors leading to losses in prior periods and current profitability; and

* the accuracy of income (loss) forecasts in prior periods, as compared to actual results.

The SEC staff expects companies to provide disclosures explaining the circumstances that gave rise to the reversal of a valuation allowance.

Projecting future taxable income requires estimates and judgments about future events. Companies should consider how much actual results have deviated from forecasted results in the past. When significant deviations have historically existed, projections of future income might be less objectively verifiable and might deserve a lower weighting in the consideration of all available evidence. Companies should also ensure that projections used as positive evidence are consistent with projections used to support other account balances in the financial statements, such as in impairment assessments.

Foreign earnings. Companies can overcome the presumption in ASC Topic 740 that all undistributed foreign earnings will be transferred to the parent company. No income taxes should be accrued by the parent if sufficient evidence shows that the foreign subsidiary or foreign corporate joint venture has invested or will invest the undistributed earnings indefinitely.

The SEC staff frequently challenges companies' assertions that foreign earnings will be indefinitely reinvested. The SEC staff has asked companies to explain how they have overcome the presumption and to provide evidence of specific reinvestment plans for foreign earnings (e.g., past experience, working capital forecasts, long-term liquidity plans, capital improvement programs, merger and acquisition plans, investment plans). The inquiries surrounding permanent reinvestment are often accompanied by a request to reconcile a company's assertion with the discussion of liquidity in management's discussion and analysis (MD&A).

Reportable Segments

Consistent with the guidance under ASC Topic 280, "Segment Reporting," segment disclosures should be based on the "management approach" (i.e., aligned with a company's internal management reporting structure). As a result, the SEC staff often requests that companies provide a discussion of their internal structure, an organization chart, and examples of resource allocation decisions to support the identification of operating segments when responding to SEC comment letters. In addition, the SEC staff often asks to see file financial information that is provided to a company's chief operating decision maker (CODM), board of directors, and audit committee. When the CODM regularly receives reports that present discrete operating results for business units, the SEC staff presumes that the CODM uses these reports to manage and assess performance and allocate resources, thus implicating those business units as operating segments.

The SEC staff routinely expands its review of available public information about a company, including MD&A, press releases, earnings calls, websites, and industry or analyst presentations. The SEC staff has asked companies to explain any perceived inconsistencies between the manner in which their business is described in their segment disclosures and elsewhere.

When a company concludes that operating segments can be aggregated into a reportable segment, the SEC staff often requests the company to provide a detailed analysis of how the aggregation criteria were considered in reaching that conclusion. The SEC staff will challenge a company's conclusion to aggregate operating segments when historical or projected financial information suggests that the operating segments do not have similar economic characteristics, as defined in ASC Topic 280.

A company should consider how changes in its business might affect its segment reporting. For example, the SEC staff might want to understand how a significant acquisition or changes in performance among operating segments affected the segment reporting conclusions.

Goodwill Impairment

The SEC staff requests that companies discuss in MD&A the possibility of future impairment of goodwill for any reporting unit with an estimated fair value that does not substantially exceed its carrying value (i.e., the reporting unit is at risk of failing a future Step 1 impairment test under ASC Topic 350, "Intangibles- Goodwill and Other"). For these "at-risk" reporting units, the SEC staff asks for the following disclosures in MD&A:

* The carrying value of the reporting unit

* The percentage by which fair value of the reporting unit exceeded the carrying value for the most recent impairment test

* A description of the methods and key assumptions used to determine fair value and how the key assumptions were derived

* A discussion of the degree of uncertainties associated with key assumptions

* A discussion of any potential events, trends, or changes in circumstances that could reasonably be expected to negatively affect the key assumptions.

The SEC staff has recently requested supplemental information and additional disclosures in MD&A that better describe the timing of any impairment charges.

The ASC Topic 350 goodwill guidance allows companies to perform qualitative, rather than quantitative, impairment assessments under certain circumstances. The SEC staff has requested additional information surrounding those qualitative judgments when a company concludes that it is more likely than not that goodwill is not impaired.

Fair Value Measurements

The guidance under ASC Topic 820, "Fair Value Measurement," requires companies to disclose which level within the fair value hierarchy certain fair value measurements are categorized. This hierarchy is based upon the inputs used in valuation techniques, as follows:

* Level 1. Quoted prices (unadjusted) in active markets for identical assets and liabilities that the reporting entity can assess at the measurement date

* Level 2. Inputs other than quoted prices in active markets for identical assets and liabilities that are observable, either directly or indirectly

* Level 3. Unobservable inputs.

The SEC staff has questioned companies about their basis for classifying certain assets or liabilities in a particular category within the hierarchy when the fair value measurements are determined internally-for example, the SEC staff remains skeptical about the classification of certain instruments, such as loans and warrants, as Level 2 rather than Level 3.

The SEC staff often asks companies to provide more robust disclosures about the valuation techniques and inputs they use in determining fair value. They also question companies about fair value measurements determined using multiple valuation techniques and the weighting assigned to multiple valuation indications.

The fair value guidance requires companies to disclose the valuation processes related to their Level 3 measurements, quantitative information about the significant unobservable inputs they use in determining these fair value measurements, and a description of the sensitivity of the fanvalue measurements to changes in these significant unobservable inputs. The SEC staff has focused on the following:

* When companies disclose a wide range of significant unobservable inputs for a given class of assets or liabilities, disclosure of weighted-average information or expanded discussion of the reasons for this wide range, in order to provide additional context and understanding for investors

* When certain classes of assets or liabilities are valued using different methods, separate disclosure of the population valued under each method

* Enhanced disclosures about valuation processes, including how a company determines its policies and procedures and how it analyzes changes in fair value measurements from period to period

* Expanded descriptions of a fair value measurement's sensitivity to changes in unobservable inputs in order to address all of the unobservable inputs for which quantitative information is provided and to explain how the inputs significantly affect the fair value measurement.

Loss Contingencies

Despite the fact that the guidance for loss contingencies has existed for many years, the SEC staff continues to find noncompliance with its disclosure requirements (ASC 450-20); thus, companies might find it helpful to refresh themselves on that guidance. In particular, companies should remember to disclose 1) the amount or range of reasonably possible losses above the amount accrued, 2) that an amount above any amount accrued is not material to the financial statements (not just the balance sheet), or 3) that the amount or range cannot be estimated. The SEC staff does not object when companies disclose the amount or range of reasonably possible loss on an aggregate basis, which can help companies avoid disclosing prejudicial information.

Recently, the SEC staff has been challenging whether a company's disclosures evolve appropriately as loss contingency matters progress. A company's narrative should include how each matter has developed over time and how key developments have affected the disclosures or amounts recognized in the financial statements. The SEC staff has also focused on a company's process for developing an estimated loss or range of loss, particularly when the company has legal cases that remain open for several years. When a loss contingency is settled, the SEC staff will generally revisit prior-period disclosures to see whether they were adequate and whether the loss recognized at the time of settlement was recorded in the correct period. The SEC staff particularly challenges the lack of prior-period accruals or the disclosure of a range of probable losses when "surprise" settlements occur for long-standing legal matters.

Revenue Recognition

Gross versus net presentation. For some companies, determining whether revenue should be reported gross or net of certain amounts paid to others can be challenging. This reporting depends upon whether the company functions as a principal or agent in the revenue transaction. The guidance on principal and agent considerations under ASC 605-45 does not provide any bright lines on whether gross or net presentation is appropriate; rather, it provides indicators suggesting gross or net reporting that often require companies to apply considerable judgment to their specific facts and circumstances. Companies in service and technology industries that do not carry inventory are especially likely to be questioned by the SEC staff about gross versus net determinations.

The SEC staff frequently requests that companies provide their analyses of each of the indicators identified in the guidance to support their conclusions. The SEC staff has discussed companies' consideration of the two "strong" indicators of gross reporting: primary obligor and general inventory risk. The SEC staff has indicated that gross reporting is generally appropriate only when at least one of the two strong indicators is present. The SEC staff generally evaluates the arrangement and each of the indicators from the customer's perspective.

Multiple-element arrangements. The guidance under ASC 605-25 addresses the accounting for revenue arrangements with multiple deliverables-for example, a company may provide multiple products, services, or combinations thereof to its customers as part of a single arrangement. In such cases, the SEC staff frequently requests that companies do the following:

* Provide a complete description of rights and obligations, separate from the discussion of the accounting for those rights and obligations.

* Disclose the judgments made in concluding whether a deliverable is or is not a separate unit of accounting, and, if a deliverable is deemed to be perfunctory, disclose the reasons supporting this conclusion.

* Provide an analysis of how the total arrangement consideration was allocated to each unit of accounting, explaining how the estimated selling price for each was determined and any significant assumptions used in this determination.

* Provide a discussion of the timing and pattern of recognition for each unit of accounting.

Long-term contracts. The SEC staff requests that companies provide additional information in the notes to the financial statements and MD&A when they apply the contract accounting guidance under ASC 605-35. Specifically, the SEC staff asks companies to disclose more detailed information about changes in estimates associated with these arrangements.

MD&A

This continues to be the most frequent area of SEC staff comment, with disclosures of results of operations being the most frequent area of comment within MD&A. The SEC staff continues to request that companies disclose not only the significant changes that occurred in the results of operations, but also why they occurred. Companies should quantify and discuss the underlying factors that led to significant changes in financial statement line items.

In addition, the SEC staff also notes that disclosures about critical accounting estimates are often too general and should not merely repeat the disclosures already included in the significant accounting policies notes to the financial statements. Instead, they should give insight into management's judgments about accounting policies that are subject to the most uncertainty and complexity.

Companies should consider disclosing the amounts outstanding and available at the balance sheet date under each source of liquidity. These disclosures also should highlight the company's cash needs over the next 12 months, including any significant planned capital expenditures and whether these expenditures are necessary or discretionary.

In addition, the SEC staff commonly asks companies to explain why certain amounts have been excluded from the contractual obligations table. They have publicly stated that if uncertainties exist about the amounts and timing of certain contractual obligations (e.g., variable interest payments, unrecognized tax benefits, expected payments or contributions to benefit plans), a company may include those items within the table and disclose its assumptions about amounts and timing in an explanatory note to the table. Alternatively, the SEC staff would not object to a company disclosing uncertain items only in a footnote to the table. The footnotes also should be used to disclose which obligations have been included and excluded from the table.

Non-GAAP Measures

The SEC staff requests that companies modify or remove disclosures when they give greater prominence to non-GAAP financial measures than to GAAP measures. For example, the SEC staff objects to companies presenting full non-GAAP income statements. In addition, the SEC staff frequently comments on the requirement to reconcile a non-GAAP measure to the most directly comparable GAAP measure and disclose the usefulness of the non-GAAP measure to investors. They often question companies when their disclosure indicates that the non-GAAP measure is presented as a liquidity measure (e.g., used to assess ability to service debt, generate cash flows, or fund acquisitions and capital expenditures), but the non-GAAP measure is reconciled only to a performance measure, such as net income.

Additional Disclosure Tips

In addition to the disclosure improvement ideas gleaned from SEC comment letters, companies should consider the following advice provided by the SEC staff:

* Challenge existing disclosures to make them clearer and more transparent.

* Ensure consistency between matters disclosed within the financial statements and discussed elsewhere in the Form 10-K and within other information that is publicly available.

* Explain the timing of significant income and expense items.

* Use precise and defined language. Using terms that are not defined or understood in U.S. GAAP can confuse readers.

* Remove disclosures that relate to matters that are no longer material, including immaterial disclosures provided in response to prior SEC comment letters. The SEC staff believes disclosures that focus only on material items are more powerful.

* Eliminate excess information and redundancy by looking for ways to streamline disclosures.

* Provide a clear description of significant accounting policies when several alternatives are available under U.S. GAAP.

The SEC staff often asks companies to provide more robust disclosures about the valuation techniques and inputs they use in determining fair value.

Recently, the SEC staff has been challenging whether a company's disclosures evolve appropriately as loss contingency matters progress.

Jeremy Simons, CPA, is a partner, assurance services-professional practice, at Ernst & Young LLP, New York, N.Y. The view expressed here are his own and not necessarily those of Ernst & Young LLP.

Should the Accounting Profession Embrace Mandatory Audit Firm Rotation?

By Arthur J. Radin

The subject of mandatory audit firm rotation has been periodically discussed in the United States over the last 80 years, starting with the adoption of the Securities Acts in the early 1930s. Most recently, on August 16,2011, the PCAOB issued Release 2011-006, "Concept Release on Auditor and Audit Firm Rotation." Since then, the PCAOB has closed the hearings and has listed the issue on its 2014 agenda, the 10th of 12 such items. Congress rejected the concept when it passed the Sarbanes-Oxley Act (SOX) of 2002, although the law requested that the U.S. Comptroller General study a related issue: consolidation in the accounting profession. In 2013, with the passage of section 104 of the Jumpstart Our Business Startups (JOBS) Act, Congress specifically prohibited the PCAOB from requiring mandatory auditor rotation of companies covered by that law. Other countries are also considering or have adopted various forms of mandatory auditor rotation.

Members of the accounting profession have almost unanimously rejected the concept of mandatory auditor rotation, but I believe that we would be better served by accepting it. I find the arguments against mandatory rotation unconvincing. Given the never-ending skepticism the profession faces from the public, it should lobby for audit firm rotation. Our focus should be on the rules of rotation-that is, which are required to make rotation work and which are not needed? This discussion will focus on the general concept of rotation, rather than addressing specific details, such as for how many years an auditor may serve or when an auditor can return to an audit.

Addressing the Profession's Challenges

The auditing profession is facing many challenges that could be ameliorated by the required rotation of auditing firms, such as independence, lack of competition, and regulatory overload. Because our clients pay us, the public has always questioned our independence. This issue is a significant source of the "expectations gap." Engagements that last for many years add fuel to this public doubt. The lack of acceptance of auditor independence is supported by a belief that we are "in bed" with our clients, who have retained us for many years and have supported our incomes over that time. In an effort to eliminate this negative perception, we have imposed on ourselves, and have had imposed on us by laws and regulators, massive independence rules; however, these rules fail to address the psychological effect on audit partners who know that the loss of an important, substantial client would significantly affect their compensation and standing in the firm.

The profession is also impeded because the vast majority of public company audits is concentrated in the four largest firms. The "second tier" picks up a moderate number of public company audits, leaving many smaller audit firms with a very small number of public company clients. In addition, the profession is saddled with intra-profession peer review, PCAOB inspections, and regulators that write more and more detailed rules. We should restructure the profession to create a high level of public trust, which the current levels of independence rules and outside inspections have failed to achieve. To do this, I suggest we turn to mandatory firm rotation.

Concerns Expressed by Commenters

Why would firm rotation work? It would make many of the issues of independence irrelevant because it would force auditors to be highly skeptical and mentally independent. Members of the profession, as well as legislators and regulators, could then take the appropriate position that the auditor is psychologically independent, due to the awareness that in a number of years, a new replacement auditor will be in a position to expose any major mistakes or even minor cover-ups. Thus, there would be no reason for an auditor to "go along" with a client just to protect a long-term revenue stream.