Staff in the SEC’s Division of Corporation Finance explained the Commission’s priorities, disclosure trends and expectations, rulemaking and other recent developments during a panel presentation at the Conference on Tuesday morning – unveiling some surprises in the process.
Overall, the staff provided a good indication of some of the key areas for registrants to look out for in their 2022 year-end reporting. We present the highlights here, including the announcement of new guidance on non-GAAP financial measures, and timely year-end reminders on topics such as critical accounting estimates, segment reporting and crypto assets.
"In an actioned-packed update from the Division of Corporation Finance, the staff highlighted the many current economic and other recent developments that registrants should consider in their upcoming year-end filings. The session continued the high-level themes from Day 1 of the Conference, with an emphasis on transparency through robust, tailored disclosures that provide decision-useful information to investors."
— Erin McCloskey, KPMG Partner
New guidance on non-GAAP financial measures
Non-GAAP financial measures continue to be an area of concern to the SEC staff because in its view registrants continue to misapply the guidance. However, in introducing new and updated Compliance & Disclosure Interpretations (C&DIs), Lindsay McCord (Chief Accountant, Division of Corporation Finance) noted that the staff was not only clarifying certain questions, but also trying to be more transparent about what it considers in its reviews of non-GAAP measures.
"Non-GAAP financial measures continue to be a challenging area for companies. In updating its Compliance & Disclosure Interpretations, the staff is modernizing its guidance to provide clearer and more comprehensive information – giving registrants a more effective roadmap."
— Timothy Brown, KPMG Partner
McCord discussed the release of new and updated C&DIs to provide additional transparency on how the staff thinks about non-GAAP measures. The updates include recent examples and views that the staff has expressed as part of its filing reviews, including areas such as the prominence of presentation and characteristics that can make non-GAAP measures misleading.
This C&DI was updated to clarify that the staff considers the nature of a registrant’s business (e.g. strategy, regulatory environment) when evaluating if an adjustment is a normal, recurring, cash operating expense that may result in the measure being misleading. The update clarifies that even if a particular expense is infrequent, it may still be considered recurring.
This C&DI was updated to provide additional examples of what the staff views to be individually tailored accounting principles, specifically clarifying that this extends beyond just changing the pattern of revenue recognition, as some read the prior response to say.
This new C&DI provides guidance on how non-GAAP measures that are not appropriately labeled or clearly described may be misleading. This includes failing to identify the measure as non-GAAP or labeling a non-GAAP measure so that it closely resembles a GAAP measure.
This new C&DI specifies that a non-GAAP measure may mislead an investor in such a way that presenting the measure along with extensive disclosure would not cure a violation of Reg G.
This C&DI was updated to expand on how the staff views the prominence requirement. The updates provide additional examples of practices that result in a non-GAAP measure being featured more prominently than the GAAP measure (e.g. the non-GAAP measure preceding the GAAP measure, style of font, providing discussion and analysis on the non-GAAP measure).
Additionally, the updated C&DI provides examples of presentation practices when providing a non-GAAP reconciliation that may violate the prominence requirement (e.g. starting with the non-GAAP measure).
Lastly, the updates provide clarification that a non-GAAP income statement, which may violate prominence requirements when reconciling non-GAAP measures to the most relevant GAAP measures, is an income statement comprised of non-GAAP measures that includes all or most of the line items found in the GAAP income statement.
Questions to ask on critical accounting estimates
McCord stressed the need for registrants to be more investor-focused and specific in their disclosures of critical accounting estimates (CAE). The staff looks for both quantitative and qualitative information necessary to understand estimation uncertainty and its impact on CAEs.
She emphasized that CAE disclosures in MD&A should not be a regurgitation of accounting policies in the financial statement notes, but instead should be a thoughtful analysis that investors can understand.
She encouraged registrants to ask themselves some key questions about the disclosures, including but not limited to:
- Can investors understand why an estimate is critical?
- Has the estimate been quantified (that is, does the disclosure include amounts or percentages)?
- Can investors understand the sensitivity of the estimate?
Read about these disclosure requirements here.
Questions to ask on segment reporting
Melissa Rocha (Deputy Chief Accountant, Division of Corporation Finance) stated that the identification of operating segments continues to be an area of focus as registrants struggle to analyze these at an appropriate level of granularity. And again coming back to the needs of investors, she stressed that they want to see how management is running the business.
Definition of an operating segment
ASC 280 defines an operating segment as a component of a public entity that has all of the following characteristics:
- It engages in business activities from which it may recognize revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same public entity);
- Its operating results are regularly reviewed by the public entity’s chief operating decision maker (CODM) to make decisions about resources to be allocated to the segment and assess its performance; and
- Its discrete financial information is available.
In her remarks, Rocha focused on the second element of the definition of an operating segment – the operating results reviewed by the CODM. When evaluating this criterion, the staff performs actions such as listening to earnings calls and reading transcripts, and compares the segment disclosures with information provided outside of the filings. She provided two examples of registrants that purported to have a single segment, which couldn’t be supported once the staff probed the information reviewed by the CODM. She emphasized the need to consider the ‘total mix of information’ reviewed the CODM.
Based on the examples that Rocha cited, registrants should ask themselves the following questions in checking the level at which operating segments have been identified (not exhaustive):
- At what level does the CODM review information and does that align with the operating segments?
- What information is provided to the board?
- What reports are provided on a regular basis?
- What is the organizational structure and how does that inform the information reported?
- On what basis is compensation determined?
- What information is presented on earnings calls and on the company’s website?
Questions to ask on crypto assets
The SEC staff addressed the crypto markets by reminding registrants of their disclosure obligations if they have experienced or are affected by events that cause:
- material exposure to counterparties and other crypto asset market participants;
- risks to liquidity or the ability to obtain financing; or
- risks related to legal proceedings, investigations or regulatory impacts in the crypto markets.
The staff also noted the recent Dear CFO letter that provides sample comments it may issue to registrants involved in the crypto market. The sample comments relate to disclosures in several parts of a filing: business description, risk factors and MD&A. Cicely LaMothe (Acting Deputy Director of Disclosure Operations, Division of Corporation Finance) noted that registrants should use these sample disclosures to update their upcoming filings as well as shelf registration statements.
McCord re-emphasized a theme from Day 1 of the conference, namely that the appropriate accounting model(s) to apply to a crypto transaction hinges on the exact nature of the transaction and the related terms and conditions.
"The Dear CFO letter is in response to the recent distress in the crypto asset markets that has caused large investor losses. Transparency is key in a distressed market, which is why the SEC expects meaningful disclosure of the impact of the market’s developments on business and exposure to potential risks."
— Karmen Ward, KPMG Partner
Questions to ask on the current economic environment
LaMothe touched on the current economic environment – higher than normal inflation, supply chain difficulties and the effects of the Russia-Ukraine war – without it being a feature of the session. She encouraged enhanced, entity-specific disclosures that explain the effect of these pressures, and recommended that registrants revisit and update disclosures in MD&A and risks and uncertainties. Similar to remarks made on Day 1 during the cyber panel, LaMothe reminded registrants to consider whether certain risks, which may have previously been discussed hypothetically, should be framed differently given recent current events.
Reminders about recent rulemaking
LaMothe spoke about two recent rulemakings that significantly impact financial reporting and involve two important elements of quality financial reporting – materiality and transparency.
Clawback of erroneously awarded incentive compensation
This rule illustrates the continued importance of registrants appropriately applying the materiality standard. It requires registrants to have a compensation recovery policy that ‘claws back’ incentive-based compensation when an accounting restatement changes the financial reporting measures that affect the amount of such compensation received by certain executives.
The restatement that triggers a clawback can be either a ‘Big R’ or a ‘little r’. Materiality is an important concept in restatements, and registrants are reminded to evaluate the materiality of errors through the lens of a ‘reasonable investor’ – considering both qualitative and quantitative factors.
Read more about the rule here.
Pay versus performance rule
This rule illustrates the SEC’s emphasis on transparency in financial reporting. It requires registrants to disclose information about the relationship between executive compensation and company performance through the lens of four specified financial performance measures for the most recent five years (among other requirements).
Registrants will need to focus on providing the appropriate level of transparency to investors when preparing for these disclosures, taking into account any impact that may stem from the uncertain economic conditions.
Read more about the rule here.