January 11, 2007

Analysis: The Updated “Current Accounting & Disclosures Issues” Outline

As I blogged about a few weeks ago, Corp Fin’s Office of Chief Accountant has updated its “Current Accounting and Disclosure Issues” Outline. Below is some excellent analysis from Davis Polk as to what Corp Fin changed in its Outline. I just love this piece; it surely is an early contender for memo of the year:

Part I of the Corp Fin’s Outline provides a summary of recent SEC rulemaking and written guidance (both proposed and adopted). Part II of the Outline discusses the SEC staff’s views on other accounting and disclosure issues. Although posted by the SEC in December 2006, the updated Outline has a date of November 30, 2006. As a result, the Outline does not reflect the significant rulemaking by the SEC in December 2006.

The new or updated disclosure items contained in the Outline include the following:

Statement of Cash Flows – The SEC has added two new subcategories to Section II.C of the outline regarding the Statement of Cash Flows. One of the new subcategories addresses the treatment of Discontinued Operations and the other new subcategory addresses the treatment of Insurance Proceeds.

Discontinued Operations – In the outline subcategory related to discontinued operations, II.C.1., the SEC staff notes that registrants who have discontinued operations should carefully consider how to present disclosures about the cash flows of the discontinued operations within the Liquidity and Capital Resources section of MD&A. According to the SEC staff, management should pay particular attention to describing how cash flows from discontinued operations are reflected in their cash flow statements, and, if material, they should quantify those cash flows if they are not separately identified in those statements. In addition, management should describe how it expects the absence of cash flows, or absence of negative cash flows, related to the discontinued operations to impact the company’s future liquidity and capital resources. Management should also discuss any significant past, present or upcoming cash uses as a result of discontinuing the operation.

Insurance Proceeds – In the new outline subcategory related to insurance proceeds, II.C.2., the SEC staff notes that material cash insurance settlements should be discussed in MD&A. The discussion should inform investors of cash received and why it was received, what the company plans to do with the proceeds, how it is presented in the cash flow statement and the impact, if any, on reported earnings.

Contingencies, Loss Reserves and Uncertain Tax Positions – The SEC has also updated Section II.I of the outline regarding Contingencies, Loss Reserves and Uncertain Tax Positions. As part of the update of this section, the SEC staff has added a new subsection entitled “Discussion in MD&A.” In this new outline subsection, the SEC staff notes that the requirement to discuss uncertainties in MD&A encompasses both financial and non-financial factors that may influence the business, either directly or indirectly. According to the SEC staff, the need to discuss such matters in MD&A will often precede any accounting recognition when the registrant becomes aware of information that creates a reasonable likelihood of a material effect on its financial condition or results of operations, or when such information is otherwise subject to disclosure in the financial statements, as occurs when the effect of a material loss contingency becomes reasonably possible. The outline provides that if a registrant is unable to estimate the reasonably likely impact, but a range of amounts are determinable based on the facts and circumstances surrounding the contingency, it should disclose those amounts.

The SEC staff also notes that MD&A should include a quantification of the related accruals and adjustments, costs of legal defense and reasonably likely exposure to additional loss, as well as the assumptions management has made concerning those amounts. According to the SEC staff, a company should articulate the reasons the assumptions it used best reflect its exposure and the extent to which the resulting estimates of loss are sensitive to changes in those assumptions. The SEC staff also indicates that it believes that the need to address the underlying assumptions is especially important when there is a material difference between the range of reasonably possible loss and the amount accrued.

Segment Disclosure – The SEC staff has updated Section II.L.2. of the outline which discusses the aggregation of operating segments as permitted by FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”). The SEC staff has also added a new subsection, II.L.5, to discuss operating segments and goodwill impairment.

Aggregation of Operating Segments – In Section II.L.2 of the outline, the SEC staff notes that it has seen improper aggregation of operating segments in situations involving a quantitatively immaterial segment. For example, the SEC staff has seen instances where a quantitatively immaterial segment is aggregated with a reportable segment because it does not meet the quantitative thresholds requiring separate presentation under SFAS 131. According to the SEC staff, if the quantitatively immaterial segment does not share a majority of the aggregation criteria with the reporting segment, aggregation is inappropriate. The outline provides that in this situation, the quantitatively immaterial operating segment would best be placed into the “other” category.

Operating Segments and Goodwill Impairment – The SEC staff has added a new subsection, II.L.5, that discusses ramifications of FASB Statement No. 142, Goodwill and Other Intangible Assets, (“SFAS 142”) on segment reporting. Paragraph 18 of SFAS 142 requires that goodwill be tested for impairment at the reporting level. As part of this discussion, the SEC staff notes that given the impact the identification of reporting units can have on the determination of a goodwill impairment charge, registrants should consider providing disclosure in the critical accounting estimates section of MD&A. The SEC staff believes that this disclosure may be particularly important when the amount of goodwill is material. According to the SEC staff, the disclosure should address how the reporting units were identified, how goodwill is allocated to the reporting units and whether there have been any changes to the number of reporting units, or the manner in which goodwill was allocated. If such changes have taken place, they should be explained.

Disclosure of Off-Balance Sheet Arrangements – The outline includes a new section, II.N., entitled “Disclosure of Off-Balance Sheet Arrangements.” In this section, the SEC staff discusses the Item 303 of Regulation S-K requirement to provide, within MD&A, a separately captioned section that discusses off-balance sheet arrangements that have or are reasonably likely to have, a material current or future effect. The SEC staff notes that they have found many registrants’ compliance with this requirement to be deficient. In particular, the SEC staff notes that registrants often provide the disclosure required by Item 303 throughout MD&A and in the footnotes to the financial statements rather than in a separate section as required. In addition, the SEC staff feels that the disclosure provided is often boiler-plate.

The SEC staff urges registrants to review whether any of their business activities may have off-balance sheet implications and present descriptions of these arrangements in their MD&A in one section that is clearly labeled. The nature and business purpose (i.e., why the transaction was structured as off-balance sheet) of off-balance sheet arrangements, as well as the exposure to risk that results from the arrangements, should be discussed. The SEC staff requests that, in order to increase transparency for investors, registrants should also consider disclosing that they have no material off-balance sheet arrangements, if that is the case.

More on Mark Cuban’s Investment Strategies

Cleaning out old emails and came across this gem from Bruce Dravis of Downey Brand, who waxes on my blogs about entrepreneur Mark Cuban’s investment strategies:

“I think the interesting question about Mark Cuban’s shorting/reporting business model is not the short positions that he establishes, but what will happen when he changes those positions. This is not Foster Winans taking a position ahead of the news without disclosing that fact, or the “scalping” case in SEC v. Capital Gains Research of the investment adviser taking positions without letting his newsletter recipients know.

Cuban advertises the fact he took a position ahead of the news. That is more honest than the hedge fund manager who shorts a stock and then leaks his negative investment thesis to CNBC or the Wall Street Journal—readers have a chance to consider the interested nature of the source of the news. However, what happens when Cuban unwinds the position? Once he takes this public position—and explicitly or implicitly invites other investors to follow him—I could envision circumstances in which his own investment plans could turn into material non-public information.

Even in that case, if he announced publicly before he changed his investment position, so that investors who followed him into the short position had a chance to get out first, it would be hard to claim that he manipulated other investors into generating trades that advantaged his investment. There is plenty that could go wrong with the business model: What if one of his own reporters misappropriates the information to establish a position ahead of Cuban? What if someone in his organization tips an outsider ahead of Cuban publishing his position?

Still, Cuban seems like an intelligent, careful businessman with a sense of business ethics. He bankrolled the excellent Enron documentary “The Smartest Guys in the Room.” If he had been advocating shorting Enron on the basis of Bethany McLean’s original Enron reporting, who knows what the alternative history of Enron—and consequently of the Sarbanes Oxley Act—might have been.”