Securities Law and Tax Advisory

Transcription

1 March 6, 2003 Securities Law and Tax Advisory SEC Review of Filings by Fortune 500 Highlights Important Changes to Consider in Preparing Annual Disclosure Filings On February 27, 2003, the SEC s Division of Corporation Finance (the Division) issued a summary of the most common areas of comment addressed by the Division in its review of the periodic reports filed by Fortune 500 companies. 1 The Division s summary highlights numerous disclosure issues that reporting companies should consider when preparing their Annual Reports on Form 10-K. In addition to this summary released by the Division, the SEC recently has adopted a number of rules that affect a reporting company s preparation of its Annual Report on Form 10-K and annual meeting proxy materials. Certain other rules are not yet effective but will eventually impact Form 10-K and proxy statement disclosures; and some companies are choosing to comply with these rules prior to their effective date. Finally, the SEC has proposed various rules that are not yet final and has issued non-binding guidance that companies may want to consider in preparing their disclosures. This advisory includes a summary of the results of the Division s Fortune 500 project and a short discussion of new reporting requirements and other items to consider for the current Form 10-K and proxy season, including recently adopted rules that, although not yet effective, will affect future Form 10-K and proxy seasons, proposed rules and general guidance provided by the SEC. Results of SEC Fortune 500 Project In December 2001, the Division announced that it would monitor the annual reports filed by all Fortune 500 companies with the SEC in The Division screened all annual reports on Form 10-K filed by Fortune 500 companies and sent comment letters to over 350 companies. On February 27, 2003, the Division issued a summary of the principal subject matters on which it commented, focusing on disclosure that appeared to be critical to an understanding of each company s financial position and results, but which, at least on its face, seemed to conflict significantly with generally accepted accounting principles or SEC rules, or to be materially deficient in explanation or clarity. The most common comments related to disclosures in the Management s Discussion and Analysis (MD&A) section of the annual report. 1 Summary by the Division of Corporation Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies, (Feb. 27, 2003). 2 See SEC News Digest (Dec. 21, 2001).

2 General MD&A Criticism Regarding MD&A, the Division criticized disclosures that simply recited financial statement information without analysis or presented boilerplate analyses that did not provide any insight into the companies past performance or business prospects as understood by management. The Division reiterated requirements to disclose the existence of known trends and uncertainties and discouraged companies from providing rote calculations of percentage changes of financial statement items and boilerplate explanations of immaterial changes to these figures, encouraging them to include instead, a detailed analysis of material year-to-year changes and trends. Critical Accounting Policy Disclosure The Division noted that, in December 2001, the SEC encouraged companies to provide more discussion in MD&A about their critical accounting policies, including disclosures about their most difficult and judgment-based estimates, the most important and pervasive accounting policies they use, the areas most sensitive to material change from external factors, and a sensitivity analysis. 3 The Division indicated that a substantial number of companies did not provide any critical accounting policy disclosure and that the disclosure provided frequently did not adequately respond to the SEC s guidance. The Division called particular attention to the following areas: Revenue recognition; Restructuring charges; Impairments of long-lived assets, investments and goodwill; Depreciation and amortization expenses; Income tax liabilities; Retirement and post retirement liabilities; Pension income and expense; Environmental liabilities; Repurchase obligations under repurchase commitments; Stock-based compensation; Insurance loss reserves; and Inventory reserves and allowance for doubtful accounts. 3 Cautionary Advice Regarding Disclosure of Critical Accounting Policies, Securities Act Rel. No , Exchange Act Rel. No , Financial Reporting Rel. No. FR-60, (Dec. 12, 2001). 2

3 Non-GAAP Financial Information The Division generally asked companies either to remove non-gaap financial measures, because we believed they were misleading or susceptible to misinterpretation, or to present them less prominently with better explanation and disclosure that is more balanced. Financial services companies that presented managed basis 4 or normalized financial information and related discussions in MD&A were mentioned specifically. The Division was also critical of alternative or pro forma statements of operations and failure to provide GAAP-based performance discussions with equal or greater prominence than those based on non-gaap measures. 5 Revenue Recognition The Division frequently requested that companies clarify how they recognize revenue, including how their revenue recognition specifically complies with Staff Accounting Bulletin No. 101, 6 and expand their revenue recognition policy disclosures. The Division specifically noted issues common to certain industries. Computer software, computer services, computer hardware and communications equipment: revenue recognition for software and multiple element arrangements (e.g., providing software, hardware and services under the same agreement). Capital goods, semiconductor, and electronic instruments and controls: deferred revenue, revenue recognition for products with return or price protection features, requirements for installation of equipment and other customer acceptance provisions. Energy: material terms of energy contracts. Pharmaceutical and retail: product returns, discounts and rebates, and co-op advertising arrangements with retail companies. Restructuring Charges The Division asked many companies to justify or explain more fully their accounting for restructuring charges and to expand their disclosure of restructuring charges in both their financial statements and their MD&A. Companies were asked to include in their financial statements a period-by-period analysis of restructuring charges, including the original restructuring charge, the amount and timing of cash payments made and to be made, non-cash charges used, reversals or adjustments to the charges and non-cash 4 Managed basis information was described by the Division as GAAP-based information adjusted to reverse the sale of loans and other assets under securitization arrangements. 5 The Division also noted the SEC s recently adopted rules under Section 401(b) of the Sarbanes-Oxley Act of 2002, discussed below. 6 Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements, (Dec. 3, 1999). 3

4 write-downs (impairments, etc.), the amount, nature and reasons for adjustments or reversals of each material component of the total restructuring charges, and when the restructuring plan was expected to be completed. Companies were also asked to describe in their financial statement the facts and circumstances leading to the restructuring plan and a complete description of each component of total restructuring charges. Companies were asked to expand MD&A to include a reasonably detailed discussion of the events and decisions that gave rise to restructuring plans, the reasonably likely material effects of management s plans, the nature, amount and description for each material component of total restructuring charges, the periods in which material cash outlays are anticipated, the expected source of their funding, material revisions to the plans, and the timing of the plan s execution, including the nature and reasons for any revisions. Companies were also asked to disclose in MD&A the reasonably likely material effects on future earnings and cash flows resulting from the plans (for example, reduced depreciation, reduced employee expense, etc.) and to quantify and disclose these effects and to disclose when they expected those effects to be realized. Impairment Charges The Division s comments on impairment charges focused on long-lived assets, securities held for investment, and goodwill and other intangible assets. Long-Lived Assets. The Division asked companies about the timing of impairment charges, including why impairment charges were not recognized in prior periods, and requested identification in MD&A of material assets analyzed for impairment for which an impairment charge had not yet been recorded. The Division also asked for expanded disclosures in financial statements and MD&A regarding: The specific assets that were impaired, including whether those assets were held for use or held for sale; The facts and circumstances (specific events and decisions) that led to the impairment charge; and The assumptions or estimates used to determine the amount of the impairment charge. Securities Held for Investment. Many of the Division s comments related to treatment of investment securities with other-than-temporary losses, particularly where companies held investments that had significant unrealized losses for an extended period of time. The Division asked for explanation or justification of how these companies determined that these losses were still considered temporary under Staff Accounting Bulletin No. 59 and for expanded MD&A disclosure of the specific factors used to determine whether unrealized losses were considered to be temporary and when they were considered other-than-temporary. Goodwill and Other Intangible Assets. The Division commented on companies goodwill impairment tests after adoption of Statement of Financial Accounting Standards No. 142 (SFAS 142) and their determinations that intangible assets had indefinite lives. In certain cases, the Division asked 4

5 companies to revise their financial statements to reflect impairments and to more clearly describe their accounting policies for measuring impairment, including how reporting units are determined and how goodwill is allocated to those reporting units. The Division also asked companies to expand their MD&A to describe the methodology and assumptions or estimates used to test goodwill and other intangible assets for impairment and to highlight any reporting units for which goodwill impairment charges were reasonably likely to occur. Pension Plans. Another significant area of comment related to the assumptions companies use in determining the amount of pension income or expense to recognize, including the basis for and the reasonableness of long-term expected return assumptions for plan assets. The Division also asked for clearer disclosures about a wide range of pension plan matters. Segment Reporting. The Division issued comments dealing with how companies determine their operating segments in their financial statements and MD&A, including instances where multiple segments were inappropriately aggregated or where the basis for aggregation was not adequately explained. Securitized Financial Assets and Off-Balance Sheet Arrangements. The Division questioned how some companies described their sale of financial assets through securitizations, including how companies determined that they had surrendered control of the assets transferred. Consistent with the SEC s December 2001 statement regarding MD&A disclosures, 7 the Division asked companies to expand MD&A disclosures to describe the structure, business purpose and accounting for these transactions, including the significant assumptions used to determine a gain or loss from the sales of assets and the retained potential risk of loss. Environmental and Product Liability Disclosures. With respect to environmental and product liability disclosures, the Division noted that applicable accounting guidance generally provides that companies with environmental and product liabilities must disclose: The nature of any loss contingency; The amount accrued; An estimate of the range of reasonably possible loss; Significant assumptions underlying the accrual; and The cost of litigation. The Division also urged companies with material contingent liabilities to carefully review their disclosures under Staff Accounting Bulletin No. 92 and ensure that they include all required information. 7 See Alston & Bird LLP Securities Law Advisory, SEC Issues New MD&A Guidance, 0Issues%20New%20MDandA.pdf (Feb. 2002). 5

6 New Disclosure Requirements for Form 10-K and Proxy Statement In addition to the matters described in the Division s report on its Fortune 500 project, there are a number of new SEC requirements that will affect each reporting company s preparation of its Form 10-K and annual meeting proxy materials. Form 10-K Cover Page Accelerated Filers. On August 29, 2002, the SEC issued new rules requiring each accelerated filer to file its Forms 10-K and 10-Q more quickly. 8 Companies must now check a box on the cover page of their Form 10-K to inform investors whether or not they meet the definition of accelerated filer. Accelerated filing deadlines will be phased in beginning in Form 10-K Business Posting of SEC Filings on Web Site. Under new Regulation S-K Item 101(e), each accelerated filer must disclose its company Web site address (if it has a Web site) and whether it makes its periodic reports available free of charge through its corporate Web site. 9 Specifically, the disclosures must state whether or not, beginning on November 15, 2002, the company posted its periodic reports on its Web site as soon as reasonably practicable after filing them with the SEC. If a company does not make its filings available in this manner, it must disclose the reasons why it does not do so and whether it will voluntarily provide paper or electronic copies of its filings free of charge upon request. Form 10-K MD&A Pro Forma Information. The SEC s new Regulation G will apply to all subject disclosures as of March 28, Regulation G requires that any non-gaap financial measure included in any public disclosure (whether or not contained in a document filed with the SEC) be accompanied by the most directly comparable GAAP financial measure and a reconciliation of the non-gaap measure to the most directly comparable GAAP financial measure. Form 10-K Item 14 of Part III Disclosure Controls and Procedures. Under new item 307 of Regulation S-K, all reporting companies must disclose their CEO s and CFO s conclusions about the effectiveness of the company s disclosure controls and procedures as of a date within 90 days prior to the filing of the periodic report and whether or not there were significant changes to the company s internal controls or any other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies or material weaknesses See Alston & Bird LLP Securities Law Advisory, SEC Adopts Certification Regulations under Section 302 of Sarbanes-Oxley Act and Accelerates Deadlines for 10-K and 10-Q Filings By Large Issuers, 0Certification%20Regulations.pdf (Aug. 30, 2002); Alston & Bird LLP Securities Law Advisory, Reminder Website Access to SEC Reports, (Nov. 25, 2002). 9 See id. 10 See Alston & Bird LLP Securities Law Advisory, SEC Adopts Rules on Conditions for Use of Non-GAAP Financial Measures and Furnishing of Earnings Releases on Form 8-K, (Jan. 29, 2003). 11 See Alston & Bird LLP Securities Law Advisory, SEC Adopts Certification Regulations under Section 302 of Sarbanes-Oxley Act and Accelerates Deadlines for 10-K and 10-Q Filings By Large Issuers, 0Certification%20Regulations.pdf (Aug. 30, 2002). 6

7 Form 10-K Signature Page/Exhibits CEO & CFO Certifications. Under SEC rules adopted under Section 302 of Sarbanes-Oxley, all reporting companies must include CEO and CFO certifications as part of their Form 10-K signature page. 12 The separate Sarbanes-Oxley Section 906 certification need not appear on the signature page, but can be submitted either as correspondence accompanying the periodic report or as an exhibit to the periodic report. 13 Form 10-K/Proxy Statement Equity Compensation Plan Table. Regulation S-K Item 201(d) requires a new Equity Compensation Plan Table to be disclosed in the Form 10-K, and when stockholder action is to be taken on any compensation plan (whether or not involving equity), such disclosure must also be included in the associated proxy statement. Where a company would be required to include the table in both filings, it may be incorporated by reference from the proxy statement into the Form 10-K. The tabular disclosure must include all equity compensation plans, whether or not such plans have previously been approved by security holders. If a plan has previously been adopted without shareholder approval, it must be described and it must be filed as an exhibit under Regulation S-K Item 601, unless immaterial in amount or significance. Other Disclosure Matters to Consider Form 10-K MD&A Pro Forma Information. In addition to the Regulation G disclosure requirements described above, the SEC has also adopted final rules that amend Item 10 of Regulation S-K. 14 The new Item 10 amendments will require, in addition to the Regulation G disclosures, certain additional disclosures about non-gaap financial measures included in documents filed with the SEC, including a statement as to why management believes the measure is useful to investors. The new Item 10 amendments also will prohibit certain non-gaap measures from being included in SEC-filed documents. Although the new Item 10 amendments apply only to periodic reports covering fiscal periods ending after March 28, 2003, companies may want to consider complying with the new Item 10 amendments in their 2002 Form 10-K. Form 10-K MD&A Off-Balance Sheet Transactions. The SEC recently adopted rules that require disclosure and explanation of off-balance sheet arrangements under a separately captioned subsection of MD&A. 15 Although this disclosure requirement does not apply until the Form 10-K to be filed for the first fiscal year ending on or after June 15, 2003, some companies may elect to include these disclosures in this year s filings. 12 See id. 13 See Alston & Bird LLP Securities Law Advisory, Certification Requirements Under Section 906 of Sarbanes-Oxley Act of 2002 Raise Difficult Issues; SEC to Adopt Rules Under Section 302, (Aug. 6, 2002). 14 See Alston & Bird LLP Securities Law Advisory, SEC Adopts Rules on Conditions for Use of Non-GAAP Financial Measures and Furnishing of Earnings Releases on Form 8-K, (Jan. 29, 2003). 15 See Alston & Bird LLP Securities Law Advisory, SEC Adopts Final Rule Requiring MD&A Disclosure of Off-Balance Sheet Arrangements and Aggregate Contractual Obligations, (Feb. 7, 2003). 7

8 Form 10-K MD&A Tabular Disclosure of Contractual Obligations. The SEC recently adopted a rule requiring registrants to disclose in tabular format the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligations, for specified time periods. The registrant must provide the information as of the latest fiscal year end balance sheet date, and the table should be accompanied by footnotes necessary to describe material contractual provisions or other material information to the extent necessary for an understanding of the timing and amount of the contractual obligations in the table. Although this disclosure is not required until the Form 10-K for the first fiscal year ending on or after December 15, 2003, some companies may elect to include these disclosures in this year s filings. Form 10-K MD&A Critical Accounting Policies. The SEC has issued proposed rules that would require disclosure in MD&A of companies critical accounting policies. 16 The SEC had earlier issued cautionary advice recommending (but not requiring) substantially similar disclosures. 17 Companies might consider reviewing the critical accounting policy disclosures made by their peers. Form 10-K MD&A Related Party Transactions. In the present environment, a company s related party transactions are likely to be more closely reviewed by the SEC and the investing public. The SEC s January 2002 MD&A guidance release specifically recommended companies include expanded disclosures in MD&A about transactions with related parties. 18 In addition to expanded MD&A disclosures, when making disclosures pursuant to Regulation S-K Item 404, companies might consider disclosing any transaction that could possibly be considered related rather than meeting only the minimum disclosure requirements of Item 404. Form 10-K Code of Ethics. The SEC has adopted final rules under Section 406 of Sarbanes-Oxley that will require each company to disclose whether it has adopted a code of ethics that applies to its principal executive, financial and accounting officers and, if not, why not. 19 In addition, any such code will have to be made publicly available. A company may post the code of ethics on its Web site and disclose that fact in its Form 10-K, include the code as an exhibit to its Form 10-K, or make an undertaking in its Form 10-K to provide a copy of the code upon request. Although this disclosure is not required until the Form 10-K for the first fiscal year ending on or after July 15, 2003, companies that believe they will ultimately select Web site disclosure may want to post their code of ethics early and make early disclosure of that fact in this year s Form 10-K. 16 See Alston & Bird LLP Securities Law Advisory, SEC Proposes Rules Requiring MD&A Disclosure About Critical Accounting Policies, (May 13, 2002). 17 Cautionary Advice Regarding Disclosure of Critical Accounting Policies, Securities Act Rel. No , Exchange Act Rel. No , Financial Reporting Rel. No. FR-60, (Dec. 12, 2001). 18 See Alston & Bird LLP Securities Law Advisory, SEC Issues New MD&A Guidance, 20Issues%20New%20MDandA.pdf (Feb. 2002). 19 See Alston & Bird LLP Securities Law Advisory, SEC Adopts Regulations Regarding Corporate Codes of Ethics and Audit Committee Financial Experts, (Jan. 30, 2003). 8

9 Form 10-K/Proxy Statement Audit Committee Financial Expert. The SEC has adopted final rules under Section 407 of Sarbanes-Oxley that will require companies to disclose in Part III of Form 10-K (which may be incorporated from the annual meeting proxy statement) whether their audit committee has an audit committee financial expert and, if not, why not. 20 If there is one or more audit committee financial experts serving on the audit committee, the company must identify at least one by name. Although this disclosure is not required until the Form 10-K for the first fiscal year ending on or after July 15, 2003, companies with one or more audit committee financial experts may elect to include these disclosures in this year s filings. Form 10-K/Proxy Statement - Non-Audit Services. Item 9 of Schedule 14A (proxy statement) currently requires disclosure of fees billed by the auditor for the last fiscal year in three categories: audit fees, financial information systems design and implementation fees, and all other fees. The SEC has adopted final rules that will revise Item 9 to specify four disclosure categories ( audit fees, tax fees, audit-related fees, and all other fees ), eliminating one category ( financial information systems design and implementation which will now fall under all other fees ). 21 Revised Item 9 will also require disclosure of these fees for an additional prior fiscal year. Revised Item 9 is not mandatory until the Form 10-K filed for the fiscal year ending on or after December 15, 2003, but some companies may decide to modify their audit fee table for the upcoming proxy season. Proxy Statement Corporate Governance Disclosures. Some companies are starting to place their corporate governance disclosures (e.g., board committee discussions) under a separate caption in the proxy statement for ease of reference for investors and corporate governance rating agencies. Proxy Statement Compensation Committee Report. Companies should take care to ensure that the compensation committee report on executive compensation is not boilerplate. The report should describe all bases for compensation decisions. Both regulators and investors have a heightened interest in this area of disclosure and will want to know whether compensation decisions are based on more than compensation ranges at peer companies. Conclusion The Division clearly timed the release of its report on its Fortune 500 project to influence companies preparation of their annual reports during the current annual reporting season. Companies preparing their year-end disclosure filings should consider the matters highlighted in the Division s report, in addition to complying with new SEC requirements that are expressly applicable. 20 See id. 21 See Alston & Bird LLP Securities Law Advisory, SEC Issues Final Auditor Independence Rules, articles/final%20auditor%20independence%20rules.pdf (Feb. 12, 2003). 9

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