Important Financial Statements and Accounting Disclosures
Presentation to the
Practising Law Institute
March 3, 2017
Scott Bennett, LizAnn Eisen, Joe Kaufman, Nicole Pinder
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The material discussed in this program is for training and illustrative
purposes only and does not purport to reflect appropriate or
inappropriate disclosure or procedures that should be followed or
inquiries that should be made, if any, in any particular situation.
Warning
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Topics
● Working Effectively with Accountants
● Historical Financial Statements
● MD&A
● Acquired Company Financials
● Pro Forma Financial Information
● Non-GAAP Financial Measures
● Comfort Letters
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Historical Financial Statements: Audited Financials
● Required audited financial statements
– Balance sheets for two years
– Income statements for three years (two years for emerging growth companies)
– Cash flow statements for three years (two years for emerging growth companies)
– Statements of changes in stockholders’ equity for each income statement period
presented
– Footnotes for either two or three years depending upon the statement to which they
relate (two years for emerging growth companies)
– FAST Act (JOBS 2.0) provision for EGCs: An EGC may omit required financial
statements from its confidential submission or public filing of a registration
statement, so long as (i) the omitted financial information relates to a period that the
EGC reasonably believes will not be required to be included at the time of the
contemplated offering (i.e., effectiveness) and (ii) prior to the distribution of a
preliminary prospectus to investors, the EGC amends the registration statement to
include all financial information required to be included.
– This is most useful in avoiding having to provide an audited year that will
eventually not be needed (interims still necessary)
● Auditors are “experts” with respect to the audited financial statements for
Securities Act liability purposes
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Historical Financial Statements: Interim Financials
● Required interim financial statements
– A balance sheet as of a date within 135 days of the effective date of the registration statement
– An income statement for an interim period ending within 135 days of the effective date of the registration statement and for the corresponding prior-year period
– A cash flow statement for the current year-to-date period and for the corresponding prior-year period
– Condensed footnotes
● Interim financial statements are usually subject to a “SAS 100” review by the auditors, which is substantially more limited in scope than an audit
● Auditors express no opinion on unaudited interim financial statements and are not “experts” with respect to such financial statements for Securities Act liability purposes
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MD&A: Purpose
● Three principal objectives of MD&A disclosure: – To provide a narrative explanation of a company’s financial
statements that enables investors to see the company through the eyes of management
– To provide context within which financial information should be analyzed
– To provide information about the quality and potential variability of a company’s earnings and cash flow so that investors can ascertain the likelihood that past performance is indicative of future performance
● The SEC has a history of actively reviewing MD&A disclosure practices and issuing interpretive guidance with respect to MD&A disclosure
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MD&A: Basic Contents
● Discussion for the most recent three years (two years for emerging growth companies) of results of operations, liquidity and capital resources, financial condition and changes in financial position
● For interim periods, discussion of material changes in financial condition from the end of the preceding fiscal year to the date of the most recent balance sheet presented, and material changes in results of operations with respect to the most recent year-to-date period compared with the corresponding period of the preceding fiscal year
● Discussion on a current basis of, among other things, liquidity and capital resources and trends and uncertainties
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MD&A: Critical Accounting Estimates
● Designed to provide information about the quality of, and potential variability of, a company’s earnings
● Disclosure is appropriate when a company has made accounting estimates or assumptions where: – the nature of the estimates or assumptions is material due to
the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and
– the impact of the estimates and assumptions on financial condition or operating performance is material
● The disclosure should supplement, not duplicate, the descriptions of accounting policies that are already disclosed in the notes to the financial statements
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Financial Statements of Acquired Businesses
● Regulation S-X Rule 3-05 specifies the circumstances in which
separate audited financials of acquired businesses (or businesses
the acquisition of which is probable) are required to be included in
registration statements filed by an acquirer
● Whether separate statements of the acquired business are
required depends on the acquired business meeting any one of
three significance tests
– Note that requirements are more stringent if the offered securities are
being offered as consideration in the acquisition itself
● Practice note - Make sure the acquired company’s auditors
will participate in future transactions (e.g., consents and
comfort letters) – without them a new audit could be required
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Financial Statements of Acquired Businesses: Tests of Significance
● Tests of significance (based on latest annual financial
statements):
– Asset test--the percentage of the acquirer’s proportionate share
of the total assets of the business acquired or to be acquired
relative to the acquirer’s total consolidated assets
– Investment test--the percentage of the acquirer’s investments
in and advances to the business acquired or to be acquired
relative to the acquirer’s total consolidated assets
– Income test--the percentage of the acquirer’s equity in income
from continuing operations (before income taxes, extraordinary
items and the cumulative effect of an accounting change) of the
business acquired or to be acquired relative to such income of
the acquirer on a consolidated basis
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Financial Statements of Acquired Businesses: Tests of Significance
● Based on the results of the significant subsidiary tests, the largest
percentage relationship achieved results in the inclusion of audited
financials for the following periods:
– 20% or less - None (although specified financial statements are
required if the aggregate impact of individually insignificant
acquisitions since the date of the last audited balance sheet exceeds
50%)
– Over 20% - One year, plus any interim periods
– Over 40% - Two years, plus any interim periods
– Over 50% - Full financial statements specified in S-X Rule 3-01 and
S-X Rule 3-02
● Requirements apply if an acquisition has occurred or is “probable”
(requires significance at the 50% level)
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Financial Statements of Acquired Businesses: Timing
● S-X Rule 3-05 generally does not require separate audited financial statements until 75 days after an acquisition when the acquisition is below the 50% level for all three tests - if these requirements are met (less than 50% and less than 75 days), registration statements may be declared effective and shelf takedowns are permitted without inclusion of the acquired company financials
● Notwithstanding this permitted exception, materiality considerations may still dictate in favor of the inclusion of the acquired company financials (and pro formas) – Analysis will depend on the facts and circumstances
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Pro Forma Financial Information
● Pro Forma Financial Statements (S-X Article 11)
– Purpose is to supplement the historical financial statements to provide investors with necessary information for an investment decision
– Provides investors with information about the impact of particular transactions (proposed or consummated) by indicating how the transactions might have affected historical financial statements (income statement) had they occurred at an earlier date
– Pro forma financial statements are required for the most recent interim period (income statement and balance sheet) and prior year (income statement) (except for presentation of discontinued operations or a proposed reorganization of entities under common control, which require 3 year presentation)
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Pro Forma Financial Information: Contents
● Typical contents: – Introductory paragraph to explain the information and describe the
transaction
– A balance sheet as of the latest balance sheet date in the registration statement (treating the transaction as having occurred on that date)
– An income statement for the latest fiscal year and any subsequent interim period ending on the date for which a balance sheet is required (treating the transaction as having occurred on the first day of the fiscal year presented)
– Footnotes explaining the adjustments and related assumptions
● Permitted pro forma adjustments: – Must be directly attributable to the transaction
– Must be factually supportable
– For income statement adjustments, must have an ongoing impact (i.e., a continuing impact on the income statement for the twelve months following the transaction)
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Pro Forma Financial Information: Contents
● Common pro forma adjustments (ongoing in
nature):
– Interest expense
– Depreciation / amortization
– Fair value adjustments on balance sheet
– Establishment of goodwill and other intangible assets
– Taxes
– EPS (change for new pro forma results & equity structure)
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Pro Forma Financial Information: Contents
● Common pro forma disclosures include:
– Contingencies/liabilities included/assumed in purchase price
– Contingent consideration
– Basic amortization tables (if not straight-line)
– Useful lives
– Detailed schedule of underlying purchase price
– Effects of a variance in interest rates
– Estimates of cost elimination programs or duplicate costs
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Pro Forma Financial Information: Contents
● Common issues:
– Inclusion of interest income from use of proceeds
– Income statement presentation of gain/losses directly
attributable to the transaction
– Adjustments related to activities to be taken by
management after a business combination (e.g., a
proposed restructuring)
– Elimination of historical “unusual” charges such as
impairments or restructurings (i.e., don’t back them out)
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Pro Forma Financial Information: MD&A
● In some situations a registrant may include in its MD&A
a supplemental discussion of pro forma operating
results (e.g., a significant business acquisition)
– For example, for a registrant that had a significant
business combination in 2014, the SEC staff would
not object to providing a supplemental comparison
of 2015 historical results to 2014 pro forma results
● SEC Staff views are discussed in the April 9, 2008, SEC
Regulations Committee Meeting and reflected in
sections 9220.6 - 9220.8 of the Corporation Finance
Financial Reporting Manual
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Non-GAAP Financial Measures: Definition
● A “non-GAAP financial measure” is a numerical measure of an issuer’s financial performance, financial position or cash flows that: – excludes amounts, or is subject to adjustments that have the
effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP; or
– includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the comparable measure so calculated and presented
● Common examples – Adjusted earnings measures (e.g., “core”, “headline”,
“adjusted”, “underlying”, “on-going”)
– “EBIT,” “EBITDA”, “Adjusted EBITDA”, related ratios
– Revenue presented on a constant currency basis
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Non-GAAP Financial Measures: Definition
● Non-GAAP financial measures do not include:
– operating and other statistical measures; or
– ratios or measures that are calculated using only: (1) financial
measures calculated in accordance with GAAP and (2)
operating measures or other measures that are not non-GAAP
financial measures
● MD&A disclosure without “doing the math” does not
create a non-GAAP financial measure
● Also excluded: financial measures required to be
disclosed by GAAP, SEC rules or a system of regulation
of a government or self-regulatory organization that is
applicable to the issuer
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Non-GAAP Financial Measures: Reasons For Use
● Rationale
– Give investors additional insight into GAAP results
– Aid investors in evaluating ongoing financial performance or
condition absent unusual or non-cash accounting items
– Allow comparison of operating performance among companies
– Give useful indications of liquidity, debt service capacity and
covenant compliance
– Give investors insight into metrics used by management for
business planning
● Can be used as a liquidity measure or a performance
measure
– Use will depend in large part on the nature of the security being
offered
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Non-GAAP Financial Measures: Rules for Use
● The SEC regulates non-GAAP measures under two rules:
– Regulation G: applies to all public communications made by
companies (regardless of whether filed or furnished with the SEC);
antifraud provision prohibiting misleading use of non-GAAP measures
and requiring presentation of, and reconciliation to, corresponding
GAAP measures
– “Most directly comparable” measure depends on use
– Non-GAAP liquidity measures = amounts from statement of
cash flows
– Non-GAAP performance measures = net income or income
from continuing operations, from statement of operations
– Item 10(e) of Regulation S-K: more detailed; applies to use of non-
GAAP measures in SEC filings (and, in part, to quarterly earnings
releases that are furnished on Form 8-K); in addition to required
disclosures, includes prohibitions on certain disclosures and certain
adjustments
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Non-GAAP Financial Measures: Rules for Use
● Item 10(e) of Regulation S-K – Generally applies to all SEC filings
– Applies to same categories of non-GAAP financial measures as Regulation G, but with more detailed requirements and with substantive limitations on the calculation of the applicable measure
– Affirmative disclosure requirements
– Equal or more prominent presentation of GAAP measure
– Reconciliation (same rules as Regulation G)
– Statement of investor usefulness/management uses
– Affirmative requirements also apply to 8-K Item 2.02 furnished earnings releases
– Prohibited disclosures/adjustments
– Exclusion of cash charges from a liquidity measure (narrow exception for EBIT and EBITDA)
– Exclusion of certain recurring items
– Use in historical financial statements or required pro forma financial information
– Use of confusing titles
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Non-GAAP Financial Measures: Updated Staff Guidance
● SEC staff guidance updated in May 2016
● Guidance focuses on meanings of “misleading” and “equal prominence”
● Updated guidance provides examples of:
– Presenting non-GAAP measures that may be misleading
– Excluding normal recurring expenses
– Inconsistent presentation between periods without disclosure
– Excluding non-recurring charges while including non-recurring gains
– Individually tailoring accounting principles (e.g., revenue recognition) to calculate
earnings
– Measures that may have greater prominence than a comparable GAAP measure
– Omitting comparable GAAP measures from headline
– Using font to emphasize non-GAAP measures
– Presenting full income statement of non-GAAP measures
– Describing or displaying non-GAAP measures without equally describing or
displaying comparable GAAP measures
– Excluding quantitative reconciliation to comparable GAAP measure for forward
looking non-GAAP measures
– Including unbalanced discussion of non-GAAP v. GAAP presentations
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Non-GAAP Financial Measures: Updated Staff Guidance
● Clarified non-GAAP liquidity measures cannot be displayed
on a per share basis
● Described how income tax effects of non-GAAP measures
should be presented
– Liquidity Measures: May be acceptable to adjust GAAP taxes to
show taxes paid in cash
– Adjustments to arrive at non-GAAP measures should not be “net of
tax” –taxes should be shown as own line item
● SEC staff also updated guidance in January 2010
● SEC rules and interpretive positions did not change in
either set of guidance, but guidance shows SEC focus
areas
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Comfort Letters
● Under Section 11 of the Securities Act, an underwriter can be held
liable for a false and misleading statement in a registration
statement, subject to its due diligence defense
● Underwriters generally rely on independent accountants for
assistance in performing the due diligence review
● The comfort letter is a document that assists underwriters in
performing their "due diligence review"
● Accountants report procedures and findings in a manner similar to
an agreed-upon-procedures letter and provide negative assurance
on certain items
● Note that comfort letters do not “expertise” financial information
● SAS 72 is the principal guide on comfort letters
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Comfort Letters: Recipients
● Who can receive a SAS 72 letter?
– Generally delivered to offering participants with an obligation to
perform a “due diligence” type of investigation
– Underwriters in a registered offering
– Other “requesting parties” who affirm in writing that they
have a responsibility to perform a due diligence review
(e.g., initial purchasers or agents in connection with
Rule 144A offerings, private placements or Regulation S
offerings who deliver a representation letter stating that
their review process is “substantially consistent” with the
due diligence review process that would be performed if
the offering were registered)
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Comfort Letters: Timing
● Two letters delivered:
– At pricing of debt / equity – comfort letter on the preliminary
prospectus supplement ( the “reds”)
– Comfort on final prospectus, which is usually not available
at pricing and time of delivery of the initial letter, may be
accomplished in one of several ways
– At closing of debt or equity a few days later - bringdown
“update” comfort letter
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Comfort Letters: Contents
● A statement that the audited financials “comply as to
form in all material respects” with applicable SEC
requirements
● “Negative assurance” as to:
– Unaudited financial statements conformity with GAAP
– Unaudited financial statements compliance with SEC
requirements
– Changes in specified balance sheet and income statement
data since the date of the most recent financials
– Disclosure as to compliance with certain Regulation S-K
requirements
– Pro forma financial statements compliance with Article 11
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Comfort Letters: Contents
● Tickmark comfort
– Auditor performs procedures requested by underwriters (or other requesting party) on specified data in the offering document and uses tickmarks to report findings
– Generally limited to items derived from accounting records subject to internal controls
– Items that typically can’t be comforted:
– Forward-looking
– Legal (e.g., customer contracts or contract terms)
– Beneficial ownership
– Operational statistics
– Assumptions
– Sensitivity analysis
– Credit facilities
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Thank You
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