SEC Filing Review Process / Background
The SEC Division of Corporation Finance selectively reviews public filings by SEC registrants to monitor and evaluate compliance with applicable disclosure and accounting requirements. Each reporting entity is reviewed, in some respect, at least once every three years. SEC reviews focus on critical disclosures that may conflict with the agency’s rules, do not conform to applicable accounting standards or require further clarification.
What is a comment letter?
The SEC may provide a company with a public comment letter if they feel additional information is required, or to request that disclosures be revised. SEC comments can cover a range of issues depending on the particular filing under review.
Why do you care?
While many filing reviews are completed without comments, a comment letter can lead to delays in the filing process. Often, comments can be resolved without changes to accounting or disclosures. However, some require extensive follow-up with SEC staff to be resolved. This can lead to unexpected legal and accounting fees or missed funding opportunities. Because SEC letters are public, there is also the potential for reputational damage.
What should you do?
Comment letters cannot always be avoided, and companies should not make avoiding comments their first priority when preparing disclosures. However, management can anticipate potential comments and take proactive steps to improve the quality of filings. By keeping frequent topics of SEC comment letters in mind, management can be prepared to issue a timely response should a comment letter arrive.
Frequent comment letter topics
The new revenue recognition standard (ASC 606) is one of the most significant changes to GAAP in years and affects all companies that earn revenue from contracts with customers. Most public companies were required to adopt the standard in 2018, requiring extensive new disclosures. Because the standard is still relatively new, it is a common focus of many SEC comment letters. The following areas are central to the standard’s accounting and disclosure requirements and are often the subject of SEC comment letters:
1. Performance obligations: Nature of performance obligations – Descriptions of your contracts discuss several activities. How did you determine the company has only one performance obligation?
2. Performance obligations: Disclosure of remaining obligations – Describe your method for allocating revenue to unfulfilled performance obligations.
3. Variable consideration: Determination of transaction price – Describe how variable consideration estimates affect transaction price.
4. Recognizing revenue: When control transfers – Your contracts indicate consulting services are provided over a period of time. Is point in time revenue recognition justified?
5. Gross v. Net presentation: Control over goods and services – Explain how you determine whether you are a principal or agent in your contracts.
6. Disaggregated revenue: Inconsistent disclosures – You disclose sales by segment, however your investor presentations discuss sales by end market. Describe your reasoning.
Generally Accepted Accounting Principles help ensure that financial statement users are provided with information that is consistent and easily comparable. Comment letters may request removal or modification of non-GAAP metrics, which can be used to mislead investors. SEC comment letters may request additional clarification concerning:
1. Overuse of non-GAAP measures – Ensure non-GAAP measurement disclosures are preceded by equal GAAP measurement disclosures.
2. Usefulness to investors – Update disclosures to discuss how investors should evaluate your use of non-GAAP measures.
3. Clear description of non-GAAP measures – Your gross margin excludes depreciation and amortization and should be disclosed as a non-GAAP measure.
4. Reconciliation to comparable GAAP – Include a reconciliation of “core earnings” with net income and individually disclose all adjustments.
5. Misleading adjustments or “tailored accounting” to hide infrequent or unusual items – Non-GAAP adjustments for items occurring in the past two years or expected to reoccur in the next two years are not permitted.
Management’s Discussion & Analysis:
The SEC requires a Management’s Discussion and Analysis (“MD&A”) disclosure in quarterly and annual filings. The MD&A is a narrative of the company’s financial condition reflecting each registrant’s specific facts and circumstances. It is an opportunity for management to provide context to readers and help investors see the company through the eyes of management. Common SEC comments concerning the MD&A may include:
1. Analysis of results of operations – Provide additional information about components of operating expenses and the factors responsible for the changes.
2. Quantification of unusual events or economic changes – Quantify each of the variables you describe as factors for period-to-period changes.
3. Critical estimates and judgement included accounting policies – Critical accounting policies disclosed in the MD&A are duplicative of the notes to financial statements.
4. Liquidity: Cash flow – You state that you will need additional capital to meet obligations for the next 12 months. Disclose how long you expect to be able to continue operating without additional capital.
5. Liquidity: Inability to meet obligations – You disclose several instances of default, covenant violations, waivers, and amendments to debt agreements. Revise the MD&A to discuss steps you are taking to avoid default, the impact of default and alternate sources of funding.
Internal Control over Financial Reporting:
SEC annual reports require management’s assessment of the effectiveness of Internal Control over Financial Reporting (ICFR) for the most recent fiscal year. This assessment must state management’s responsibility for establishing and maintaining adequate reporting controls, describe the framework used in the evaluation and include an assessment of any material weaknesses identified.
1. Identification and disclosure of material weaknesses – Discuss your consideration of the previous restatement during ICFR evaluation and why it does not indicate the presence of a material weakness.
2. Management’s disclosure of effectiveness of ICFR – Explain how you determined the identified material weakness did not impact your conclusion regarding the effectiveness of your ICFR.
3. Lack of conclusion on effectiveness - File an amended form 10-K to specifically state your assessment of ICFR as either effective or ineffective.
While these four areas generate some of the most frequent comments, topics can vary significantly depending on the industry, size, and complexity of your company.
For assistance preempting or responding to SEC comment letters, contact your Friedman relationship partner to discuss your current and future accounting and disclosure requirements.