The SEC's Division of Corporation Finance recently posted a set of slides addressing common financial reporting issues for smaller issuers. The slides were part of a presentation for a small business forum hosted by the PCAOB in December 2011 and, broadly speaking, summarize observations of the SEC staff (the Staff) on particular topics that arise frequently in the SEC's review of smaller companies. The slides are noteworthy because the Staff does not frequently assemble such a fulsome set of examples and guidance. The presentation is available at: http://www.sec.gov/news/speech/2012/spch020912co.pdf.
The slides provide background for the Staff's authority to conduct reviews and give some insight into the current areas of focus. The Staff has revised its review process, particularly with respect to smaller companies, and will no longer use formal categories, such as limited reviews and full reviews. Instead, the Staff will focus its attention on companies as necessary to ensure compliant disclosure. However, the Staff reaffirmed its commitment to fulfill the general mandate of Sarbanes-Oxley that every company be reviewed at least once every three years.
The presentation lays out areas of current focus and offers some commentary on each.
MD&A. The Staff noted that companies often do not adequately discuss the factors contributing to period-to-period operating result fluctuations beyond what is obvious from the financial statements. The Staff also observed that the liquidity discussion can be particularly important for a smaller, growing company, and suggested that, in particular, these companies should discuss sources and uses of funds, planned significant expenditures and potential sources of capital, as well as the consequences of failing to obtain adequate capital. In addition, the Staff may issue a comment if MD&A disclosure during prior periods does not cover a subsequently occurring event that appears to have been predictable during those prior periods.
Reverse Mergers/Back Door Registrations. These transactions, which are effected through the merger of a private operating company into a public shell company, present particularly complicated issues. The slides offer commentary on some of the attendant processes and guidance, using a detailed example to illustrate the Staff's areas of focus. For instance, these transactions often require audited financials for both the predecessor operating company and the successor company to be filed for the pre-merger period and in subsequent periodic reports.
Business Combinations. For business combinations generally, the slides offer insight into areas of possible comment and issues specific to smaller companies, such as the likelihood that transactions with family-owned or other privately held counterparties could be significant to the registrant. For example, the slides note that earn-out payments to stockholders of an acquired business who continue to be employed by the issuer may need to be treated as compensation rather than additional purchase price, which could significantly affect the reporting company's financial statements.
Predecessor Financial Statements. The Staff provided guidance regarding predecessor financial statement requirements, including an example illustrating Form 8-K and Form 10-K requirements.
Fair Value Determinations. If a smaller company incorrectly determines fair value for equity issued in a transaction, it can lead to material misstatements in its financial statements. The Staff suggests that issuers should first look toward the market price, but for issuers that do not trade in an active market, contemporaneous equity transactions with third parties, the fair value of the goods or services being purchased with equity or management's judgment may provide the most accurate fair value. The slides stress that the issuer should disclose the method used. Similarly, issuers should take care to ensure that they are accounting for warrants and conversion options correctly and assigning an appropriate valuation.
Disclosure Controls and Procedures. The slides outline issues surrounding disclosure controls and procedures and its subcategory, internal control over financial reporting. The Staff requires that, in each case, the company state a conclusion as to the effectiveness of its controls; the Staff will typically ask the company to amend any noncompliant filings. The Staff may issue a comment and request more information if the issuer concludes that disclosure controls and procedures are effective when internal controls over financial reporting are ineffective. The Staff also carefully considers disclosures regarding material weaknesses and remediation and may comment where it feels that disclosure can be improved.
U.S. GAAP Knowledge. For issuers whose operations are mainly conducted outside the United States, the Staff will focus attention on the issuer's familiarity with U.S. GAAP and will issue comments accordingly. In some cases, lack of U.S. GAAP knowledge can itself be a material weakness in internal control over financial reporting.
Form 8-K Items 4.01 and 4.02. The Staff will issue comments to fully understand the events prompting Form 8-K filings under Item 4.01 (change in accountants) and Item 4.02 (non-reliance on previously issued financials). The slides stress that issuers should carefully consider and comply with the item requirements and Staff guidance in its Compliance & Disclosure Interpretations and Financial Reporting Manual.
The slides serve as a helpful reminder of the framework of the review process and the Staff's current areas of emphasis for smaller issuers. While this presentation focused on smaller issuers and topics those companies frequently encounter, we would expect the Staff to consistently apply the noted standards to the filings of larger companies in the context of its regular review process.
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