Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

Sciabacucchi v. Liberty Broadband Corporation (Del. Ch. 2017) involved Charter Communications, Inc.’s (“Charter” or the “Company”) acquisition of Bright House Networks, LLC (“Bright House”) and the merger with Time Warner Cable (“TWC”).  One of the complained of matters in the transaction was Charter’s issuance of equity to an insider, the largest stockholder of Charter, defendant Liberty Broadband Corporation.  The issuance was purportedly to finance the acquisitions in part.  The Liberty share issuances were approved in a single vote by the majority of the stock of Charter not controlled by or affiliated with Liberty Broadband, separate from the vote approving the merger with TWC.

The Defendants argued that the vote of the majority of unaffiliated stock in favor of the Liberty share issuances cleansed any breach of duty complained of, under the rationale of Corwin v. KKR Financial Holdings LLC.  Under Corwin, a fully informed, uncoerced vote of the majority of disinterested stock results in business judgment review attaching to the transaction so approved, leading to dismissal absent an adequate pleading of waste.

The stockholders were advised that the acquisitions of Bright House and TWC were expressly conditioned on stockholder approval of the Liberty share issuances on the terms presented. In other words, to get the clear benefit of the acquisitions of Bright House and TWC, the stockholders had to approve the Liberty share issuances.

The Court of Chancery noted that some method of financing is inherent in every transaction, and typically an informed vote of the majority of the stock in favor of the transaction ratifies the directors’ actions with respect to financing. According to the Court, if a deal cannot proceed absent adoption of a particular financing, an informed vote for such a transaction is cleansing with respect to the financing method chosen.

In this case however, the board did not determine that the acquisitions could be consummated only via the Liberty share issuances. The directors did not seek or receive a fairness opinion that the Liberty share issuances, standing alone, were fair to the Company or the stockholders.

The Court held Plaintiffs had pled facts making it reasonably conceivable that the vote was structurally coercive. Those facts, and related favorable inferences, indicate that the Defendant directors achieved value for the stockholders in the acquisitions. They then conditioned receipt of those benefits on a vote in favor of transactions extraneous to the acquisitions, the Liberty share issuances and other matters. Assuming that viable breaches of fiduciary duty inhere in the Liberty share issuances, they could not be cleansed by the vote, since that vote was not a free vote to accept or reject those transactions alone; it was a vote to preserve the benefit of the acquisitions. In other words, ratification can cleanse defects inherent in a transaction, because the stockholders can simply reject the deal. The Court stated fiduciaries cannot interlard such a vote with extraneous acts of self-dealing, and thereby use a vote driven by the net benefit of the transactions to cleanse their breach of duty.

Note that the Court reserved further judgement on this matter pending briefing on whether the claims asserted were derivative or direct. It also noted it did not make any findings that any wrongdoing occurred.

 

The Public Company Accounting Oversight Board adopted a new auditor reporting standard that will require more information about the audit. The new standard is subject to SEC approval.

The standard includes the communication of critical audit matters, referred to as CAMs, which will provide information about matters arising from the audit that required especially challenging, subjective, or complex auditor judgment, and how the auditor responded to those matters.

Communication of CAMs is not required for audits of emerging growth companies; brokers and dealers; investment companies other than business development companies; and employee stock purchase, savings, and similar plans.

Critical Audit Matters

The new standard requires the auditor to communicate in the auditor’s report any critical audit matters arising from the current period’s audit of the financial statements, or state that the auditor determined that there were no critical audit matters.

A CAM is defined as a matter that was communicated or required to be communicated to the audit committee and that:

  • Relates to accounts or disclosures that are material to the financial statements, and,
  • involved especially challenging, subjective, or complex auditor judgment.

When determining whether a matter involved especially challenging, subjective, or complex auditor judgment, the auditor takes into account certain factors, including the auditor’s assessment of the risks of material misstatement.

The communication of each CAM in the auditor’s report includes:

  • identification of the CAM;
  • description of the principal considerations that led the auditor to determine that the matter was a CAM;
  • description of how the CAM was addressed in the audit; and,
  • reference to the relevant financial statement accounts or disclosures.

An Example

Public companies are sensitive to disclosures about loss contingencies or possibilities of illegal acts for fear that they will encourage litigation. The final standard provides that each critical audit matter must relate to accounts or disclosures that are material to the financial statements.  According to the PCAOB, a potential loss contingency that was communicated to the audit committee, but that was determined to be remote and was not recorded in the financial statements or otherwise disclosed under the applicable financial reporting framework, would not meet the definition of a critical audit matter; it does not relate to an account or disclosure in the financial statements, even if it involved especially challenging auditor judgment. The same rationale would apply to a potential illegal act if an appropriate determination had been made that no disclosure of it was required in the financial statements; the matter would not relate to an account or disclosure that is material to the financial statements.

Liability Concerns

The PCAOB does not believe the new rule will lead to additional litigation against companies and their auditors. While mandating disclosure of critical audit matters will, by design, entail new statements in the auditor’s report, the Board noted that any claim based on these new statements would have to establish all of the elements of the relevant cause of action (for example, when applicable, loss causation and reliance).

In addition, the final standard provides that the auditor is not expected to provide information about the company that has not been made publicly available by the company unless such information is necessary to describe the principal considerations that led the auditor to determine that a matter is a critical audit matter or how the matter was addressed in the audit.

Further, any matter that will be communicated as a critical audit matter will already have been discussed with the audit committee, and the auditor will be required to provide a draft of the auditor’s report to the audit committee and discuss the draft with them. In addition, as the auditor determines how best to comply with the communication requirements, the auditor could discuss with management and the audit committee the treatment of any sensitive information.

Other Changes to the Auditor’s Report

The final standard also includes a number of other changes (the PCAOB describes them as “improvements”) to the auditor’s report that are primarily intended to clarify the auditor’s role and responsibilities related to the audit, provide additional information about the auditor, and make the auditor’s report easier to read:

  • Auditor tenure — The auditor’s report will include a statement disclosing the year in which the auditor began serving consecutively as the company’s auditor;
  • Independence — The auditor’s report also will include a statement that the auditor is required to be independent;
  • Enhancements to basic elements — Certain standardized language in the auditor’s report has been changed, including adding the phrase, “whether due to error or fraud,” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatements;
  • Standardized form of the auditor’s report — The opinion will appear in the first section of the auditor’s report. Section titles have been added to guide the reader; and,
  • Addressees — The auditor’s report will be addressed to the company’s shareholders and board of directors or equivalents (additional addressees also are permitted).

Effective Date

Subject to approval by the SEC, the final standard and amendments will take effect as follows:

  • All provisions other than those related to critical audit matters will take effect for audits for fiscal years ending on or after December 15, 2017; and,
  • Provisions related to critical audit matters will take effect for audits for fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirements apply.

Will the SEC Approve the New Standard?

Given the Trump administration’s regulatory posture and a new SEC Chair, it is perhaps anyone’s guess whether the SEC will approve the new standard. According to a Wall Street Journal article, PCAOB Chairman James Doty stated the board always consults with the SEC on such matters, and he was optimistic there won’t be any problems. “This is not a partisan issue,” he said. “We think we have done a good job of making this practical and rigorous.”

I recently wrote a blog on considerations for MD&A disclosures on adoption of the new revenue recognition standard. After learning a few Form 10-Qs had been filed by early adopters, I took a look to see if they lined up with my thinking.  All of the filings taken together supported my ideas in one way or another, but perhaps none implemented everything I wrote about, perhaps because of materiality.

It is also interesting to compare the early adopters predictions as to the impact of the adoption in their most recently filed Form 10-K prior to adoption to the actual impact disclosed in the first Form 10-Q after adoption.

Ford Motor Company

Ford used the modified retrospective method to transition to the new standard. In Footnote 1 to the financial statements, it discloses:

  • We expect the impact of the adoption of the new standard to be immaterial to our net income on an ongoing basis.
  • A majority of our sales revenue continues to be recognized when products are shipped from our manufacturing facilities. Under the new revenue standard, certain vehicle sales where revenue was previously deferred, such as vehicles subject to a guaranteed resale value recognized as a lease and transactions in which a Ford-owned entity delivered vehicles, we now recognize revenue when vehicles are shipped.
  • The new revenue standard also provided additional clarity that resulted in reclassifications to or from Revenue, Cost of sales, and Financial Services other income/(loss), net.

Footnote 2 discloses automotive revenue increased $333 million to $36,475 million in the first quarter as a result of the new standard, and net income increased $27 million to $1,594 million as a result of adoption.

There are no prominent disclosures in the MD&A regarding adoption of the new standard, which is likely the result of Ford’s view on materiality, or viewing MD&A discussion as being redundant to the financial statement disclosures.

In Item 4 under the caption “Controls and Procedures”, Ford discloses:

Beginning January 1, 2017, we implemented ASC 606, Revenue from Contracts with Customers.  Although the new revenue standard is expected to have an immaterial impact on our ongoing net income, we did implement changes to our processes related to revenue recognition and the control activities within them.  These included the development of new policies based on the five-step model provided in the new revenue standard, new training, ongoing contract review requirements, and gathering of information provided for disclosures.

I believe Ford was the only early adopter to address the foregoing point.

Footnote 3 to the Financial Statements in Ford’s 2016 10-K disclosed:

We will adopt the new revenue guidance effective January 1, 2017, by recognizing the cumulative effect of initially applying the new standard as an increase to the opening balance of retained earnings. We expect this adjustment to be less than $100 million, with an immaterial impact to our net income on an ongoing basis. Adoption of the new standard will also result in changes in classification between Revenues, Cost of sales, Non-Financial Services interest income and other income/(loss), net, and Financial Services other income/(loss), net.

It appears the actual adjustment in the first quarter was to increase opening retained earnings by $36 million.

General Dynamics

General Dynamics adopted the new revenue recognition standard “using the retrospective transition method”, but since they restated the first quarter of 2016 I assume they meant what many describe as the “full retrospective method.”  The MD&A discloses:

  • In the Aerospace group, we record revenue on contracts for new aircraft when control is transferred to the customer, generally when the customer accepts the fully outfitted aircraft. Revenue associated with the group’s completions of other original equipment manufacturers’ (OEMs) aircraft and the group’s services businesses are recognized as work progresses or upon delivery of services. Fluctuations in revenue from period to period result from the number and mix of new aircraft deliveries, progress on aircraft completions and the level of aircraft service activity during the period.
  • In the three defense groups, revenue on long-term government contracts is recognized generally over time as the work progresses, either as the products are produced or as services are rendered. Typically, revenue is recognized over time using an input measure (e.g., costs incurred to date relative to total estimated costs at completion) to measure progress. Operating costs for the defense groups consist of labor, material, subcontractor, overhead and G&A costs and are recognized generally as incurred. Variances in costs recognized from period to period reflect primarily increases and decreases in production or activity levels on individual contracts. Because costs are used as a measure of progress, year-over-year variances in cost result in corresponding variances in revenue, which we generally refer to as volume.

In the critical accounting policy section of the MD&A, General Dynamics discloses:

Accounting for long-term contracts and programs involves the use of various techniques to estimate total contract revenue and costs. Contract estimates are based on various assumptions to project the outcome of future events that often span several years. We review and update our contract-related estimates regularly. We recognize adjustments in estimated profit on contracts under the cumulative catch-up method. Under this method, the impact of the adjustment on profit recorded to date is recognized in the period the adjustment is identified. The aggregate impact of adjustments in contract estimates increased our operating earnings (and diluted earnings per share) by $50 ($0.11) and $58 ($0.12) for the three-month periods ended April 2, 2017, and April 3, 2016, respectively. No adjustment on any one contract was material to our unaudited Consolidated Financial Statements for the three-month periods ended April 2, 2017, and April 3, 2016.

Note Q to the financial statement discloses the quantitative effect of restating the first quarter of 2017 to comply with the new standard. Qualitatively, the note discloses:

The adoption of ASC Topic 606 had two primary impacts on our Consolidated Financial Statements. The impact of adjustments on profit recorded to date is now recognized in the period identified (cumulative catch-up method), rather than prospectively over the remaining contract term. For our contracts for the manufacture of business-jet aircraft, we now recognize revenue at a single point in time when control is transferred to the customer, generally when the customer accepts the fully outfitted aircraft. Prior to the adoption of ASC Topic 606, we recognized revenue for these contracts at two contractual milestones: when green aircraft were completed and accepted by the customer and when the customer accepted final delivery of the fully outfitted aircraft. The cumulative effect of the adoption was recognized as a decrease to retained earnings of $372 on January 1, 2015.

Note B to the financial statements has a detailed discussion on performance obligations and use of estimates, including variable consideration.

The MD&A included in the Form 10-K for 2016 includes a discussion of the Company’s implementation plan and the expected effect of the adoption of the new standard. The MD&A in the 10-K also:

  • Notes that the outlook for 2017 has been developed under Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers.
  • Includes a table showing restated results for 2015 and 2016 under the new standard.
  • Includes a useful cautionary note which says “The impact of ASC Topic 606 on our 2015 and 2016 operating results may or may not be representative of the impact on subsequent years’ results.”

Raytheon

Raytheon is another contract intensive company that adopted the new standard using the full retrospective method. The introduction to the MD&A includes a comprehensive update to the Critical Accounting Estimates section of the 10-K. Select disclosures include:

  • To determine the proper revenue recognition method for contracts for complex aerospace or defense equipment or related services, we evaluate whether two or more contracts should be combined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performance obligation. This evaluation requires significant judgment and the decision to combine a group of contracts or separate the combined or single contract into multiple performance obligations could change the amount of revenue and profit recorded in a given period.
  • We generally recognize revenue over time as we perform because of continuous transfer of control to the customer. For U.S. government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay us for costs incurred plus a reasonable profit and take control of any work in process. Similarly, for non-U.S. government contracts, the customer typically controls the work in process as evidenced either by contractual termination clauses or by our rights to payment for work performed to date plus a reasonable profit to deliver products or services that do not have an alternative use to the Company.
  • Due to the nature of the work required to be performed on many of our performance obligations, the estimation of total revenue and cost at completion (the process described below in more detail) is complex, subject to many variables and requires significant judgment. It is common for our long-term contracts to contain award fees, incentive fees, or other provisions that can either increase or decrease the transaction price. These variable amounts generally are awarded upon achievement of certain performance metrics, program milestones or cost targets and can be based upon customer discretion. We estimate variable consideration at the most likely amount to which we expect to be entitled.

Raytheon appears to go a mile more than what is required in the quarter of adoption. Rather than disclosing the effect of adoptions for the first quarter of 2016, it shows the effect for all three quarters in 2015 and 2016.

In its Form 10-K for 2016, Raytheon is ahead of the game again where it notes the unaudited effect of the adoption of the new standard in 2016 and 2015 on select income statement line items and per share amounts. Raytheon also notes:

The impact of adopting the new standard on our 2015 and 2016 total net sales and operating income is not material. The immaterial impact of adopting Topic 606 primarily relates to the deferral of commissions on our commercial software arrangements, which previously were expensed as incurred but under the new standard will generally be capitalized and amortized over the period of contract performance or a longer period if renewals are expected and the renewal commission is not commensurate with the initial commission, and policy changes related to the recognition of revenue and costs on our defense and commercial software contracts to better align our policies with the new standard, which may impact the timing of revenue. The impact to our results is not material because the analysis of our contracts under the new revenue recognition standard supports the recognition of revenue over time under the cost-to-cost method for the majority of our contracts, which is consistent with our current revenue recognition model. Revenue on the majority of our contracts will continue to be recognized over time because of the continuous transfer of control to the customer.

Other examples of early adopters include Alphabet, First Solar and UnitedHealth Group.

Hat tip to PLI’s The SEC Institute Blog for pointing out these filings.

The SEC has made clear its expectations regarding MD&A disclosure for periods prior to the adoption of the new revenue recognition standard. What has received less attention is the content of MD&A after the new revenue recognition standard has been adopted.  Set forth below are some guidelines to be considered.  While putting pen to paper to draft the first MD&A is still months away, public companies need to begin crafting disclosures controls and procedures so they will be in place when disclosures must be made.

Transition Method

The first step in drafting an MD&A will be to understand the company’s elected transition method to the new standard. The Financial Reporting Manual of the SEC’s Division of Corporation Finance described the transition choices as follows:

  • Retrospectively to each prior period presented, subject to the election of certain practical expedients (“full retrospective method”). A calendar year-end company that adopts the new revenue standard using this method must begin recording revenue using the new standard on January 1, 2018. In its 2018 annual report, the company would revise its 2016 and 2017 financial statements and record the cumulative effect of the change recognized in opening retained earnings as of January 1, 2016.
  • Retrospectively with the cumulative effect of initially applying the new revenue standard recognized at the date of adoption (“modified retrospective method”). A calendar year-end company that adopts the new revenue standard using this method must begin recording revenue using the new standard on January 1, 2018. At that time, the company must record the cumulative effect of the change recognized in opening retained earnings and financial statements for 2016 and 2017 would remain unchanged.

According to this Compliance Week article (subscription required), the new standard is rife with areas that can be critical estimates, including the identification of performance obligations, estimating certain stand-alone selling prices, and estimating variable consideration. We discussed the complexities to be considered under the new standard here when drafting new contracts, including key distinctions regarding the satisfaction of performance obligations over time or at a point in time.

The new revenue recognition standard requires robust footnote disclosures regarding significant judgments in the revenue recognition process that should be invaluable when drafting this part of the MD&A. The footnotes must disclose the judgments, and changes in the judgments, made in applying GAAP that significantly affect the determination of the amount and timing of revenue from contracts with customers. In particular, an entity must explain the judgments, and changes in the judgments, used in determining both of the following:

  • The timing of satisfaction of performance obligations.
  • The transaction price and the amounts allocated to performance obligations.

The new standard goes on to detail specific disclosure requirements for contracts where performance obligations are satisfied over time, or at a point in time, and outlines specific disclosures regarding matters related to the transaction price.

Other Disclosures

Appropriate MD&A disclosure will necessarily vary from company to company. The new standard includes almost five pages of required disclosures to be included in the footnotes to the financial statements.  The overall goal of the footnote disclosures is to provide sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.  Reviewing and understanding these disclosures as a whole will be a key step in crafting the initial and on-going MD&As.

The CFTC has issued final amendments to Regulation 1.31 which sets forth the form and manner in which all regulatory records must be kept by records entities. “Records entities” are persons required to keep records pursuant to the Commodity Exchange Act and related CFTC regulations.

Regulation 1.31 does not specify the types of regulatory records that must be kept. Rather the regulation specifies the form and manner in which regulatory records required by other CFTC regulations are maintained and produced to the CFTC.

The amendments modernize and make technology neutral the form and manner in which regulatory records must be kept, as well as rationalize the current rule text for ease of understanding. Under the proposed amendments, records entities would have greater flexibility regarding the retention and production of all regulatory records under a less-prescriptive, principles-based approach.

The amendments do not alter any existing requirements regarding the types of regulatory records to be inspected, produced, and maintained set forth in other CFTC regulations.

The CFTC has adopted final amendments to its whistleblower rules that will, among other things, strengthen the CFTC’s anti-retaliation protections for whistleblowers and enhance the process for reviewing whistleblower claims.

Based on a reinterpretation of the CFTC’s anti-retaliation authority under the Commodity Exchange Act (CEA), the CFTC or the whistleblower may now bring an action against an employer for retaliation against a whistleblower. The amendments also prohibit employers from taking steps to impede a would-be whistleblower from communicating directly with CFTC staff about a possible violation of the CEA by using a confidentiality, pre-dispute arbitration or similar agreement.

Specifically, the amendments make the following key changes or clarifications:

  • A person may not take any action to impede an individual from communicating directly with the Commission’s staff about a possible violation of the CEA, including by enforcing, or threatening to enforce, a confidentiality agreement or pre-dispute arbitration agreement with respect to such communications. [Rule 165.19]
  • The Commission has authority to bring an action against an employer who retaliates against a whistleblower, irrespective of whether the whistleblower qualifies for an award. A whistleblower continues to have the right to pursue a private cause of action against such an employer. [Rule 165.20; Appendix A to Part 165]
  • Actions that an employer took after a whistleblower reported internally but before providing information to the Commission may be relevant to whether prohibited retaliation occurred. [Rule 165.20(b)]

You can find further information in our analysis of the proposed rule here.

 

As we noted here, a shareholder of Intel sought a preliminary and permanent injunction and any other appropriate relief with respect to a stockholder vote to approve the amendment and restatement of Intel’s 2006 equity incentive plan to add 33 million shares to the plan and extend its term. The underlying premise of action was weak, based on a technical argument that the proxy statement did not include the information required by Item 10(a)(1) of Schedule 14A because of a perceived defect that not all classes of eligible participants of the plan were identified, despite informative disclosures being made by Intel.

The shareholder has now dismissed the case with prejudice. From the docket, you can’t rule out Intel from having entered into some sort of settlement agreement.  If they did, let’s hope it was less than modest, so that we can thank Intel for holding the line and not encouraging this behavior.

The Financial Accounting Standards Board has issued an Accounting Standards Update (ASU 2017-09; Topic 718) to clarify the accounting for modifications to outstanding share-based payment awards such as stock options and restricted stock.

Currently there is diversity in practice for accounting for modifications to equity awards. For instance, some entities apply modification accounting for modifications which are “substantive” and other entities apply modification accounting for any modification that is not administrative.

If modification accounting is required, it can be significant. Generally the entity must determine the incremental value of the award.  For vested awards, the incremental value if often recognized as an expense at the time of modification.  For unvested awards, the incremental value and any unrecognized compensation expense from the original award are recognized prospectively.

Under the principles announced by FASB, an entity should account for the effects of a modification unless all the following are met:

  • The fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the modified award is the same as the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the original award immediately before the original award is modified. If the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification.
  • The vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified.
  • The classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified.

The ASU is effective for all entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2017.

Hat tip to Broc Romanek of CompensationStandards.com for pointing this out here.

 

In remarks at the Annual SEC/NASAA Conference, SEC Commissioner Michael S. Piwowar focused on the suitability and adequacy of disclosure of a security known as a “SAFE” that has been used in crowdfunding transactions. SAFE is an acronym for “simple agreement for future equity.”  The terms of the security were outlined in a Virginia Law Review Online article authored by Joseph Green and John Coyle. The article describes the terms of the security as follows:

Although the SAFE resembles a classic seed-stage convertible note in most respects, it lacks the convertible note’s maturity date and does not accrue interest while it remains outstanding. It does not pay dividends, and the SAFE holder has no right to vote on matters submitted to shareholders. The SAFE is, in essence, a contractual derivative instrument that amounts to a deferred equity investment. It will prove valuable to the holder if, and only if, the company that issues it raises a subsequent round of financing, is sold or goes public.

The key problem with the use of SAFEs in crowdfunding is that many of the companies issuing them are unlikely ever to raise institutional venture capital. If a crowdfunding issuer never raises this type of capital, then the retail investors who hold that issuer’s SAFEs may find themselves in possession of a security that, in addition to granting the holder no voting rights or other investor protections, may never provide them with a return on their capital — or a return of their original investment amount — even if the company is successful.

As Commissioner Piwowar put it, “The terms of the SAFE, from the triggering events to the conversion terms, are typically designed to operate in the context of a fast-growing startup likely to need and attract future capital from sophisticated venture capital investors.”

Commissioner Piwowar described the challenges of using SAFEs in connection with a Regulation Crowdfunding transaction as follows:

In contrast to the sophisticated venture capital investors for whom SAFEs were originally intended, Regulation Crowdfunding is designed to serve as a new method of raising capital from a broad, mostly retail base of investors. Regulation Crowdfunding thus requires the intermediary facilitating the offering to provide investors with educational materials, including information about the types of securities offered and sold on the intermediary’s platform and the risks associated with each type of security.  Intermediaries face a real challenge in educating potential investors about this high-risk, complex, and non-standard security when the security itself is entitled “SAFE.” Companies and their intermediaries should think carefully about how they name or describe their securities. Securities marketed as “safe” or “simple” ought to be just that.

Sylvia E. Alicea, Professional Accounting Fellow, Office of the Chief Accountant, gave her views on implementation of the new revenue recognition standard at a conference dedicated to the topic.

Transition Disclosures Include Footnote Disclosures

Not surprisingly, Ms. Alicea reminded registrants on the continued importance of transition disclosures. Staff Accounting Bulletin No. 74 requires companies to provide transition disclosures of the impact that a recently-issued accounting standard will have on its financial statements when that standard is adopted in a future period.  Reiterating previous views, she noted when a company does not know, or cannot reasonably estimate the expected financial statement impact, that fact should be disclosed.  But, in these situations, the SEC staff expects a qualitative description of the effect of the new accounting policies, and a comparison to the company’s current accounting to aid investors’ understanding of the anticipated impact. It should also disclose the status of its implementation process and significant implementation matters yet to be addressed.

Ms. Alicea noted the changes in the new revenue standard will impact nearly all companies. Even if the extent of change on the balance sheet or income statement is not deemed to be material, the related disclosures may be material.

Ms. Alicea disagrees with the view that when SAB 74 refers to the “financial statements” it is concerned only with effects on the primary financial statements and not how disclosures in the notes to the financial statements may also be affected. She believes that such a view misses the definition of “financial statements,” which includes the accompanying notes.

Themes Noted by the Staff in Consultations with Registrants

The remarks also shared some observations from registrants’ consultations with SEC staff. Careful analysis of enforceable rights and obligations when evaluating contracts was urged.  For example, when one or both parties have a right to terminate a contract, a registrant would need to evaluate the nature of the termination provision, including whether the termination provision is substantive.  This requires the application of reasonable judgment and could affect the duration of the contract.

Ms. Alicea also discussed that the concept of a “deliverable” under existing revenue guidance should not be presumed to be the same as the concept of a “performance obligation” under the new revenue standard. The identification of a registrant’s performance obligation(s) requires a “fresh look” that begins with an evaluation of the contractual terms of contracts with customers. Registrants may ultimately determine – as a result of their “fresh look” – that there is no change in the unit of account.  She noted that in the fact patterns OCA has evaluated, most of the registrants’ conclusions regarding performance obligations happened to be consistent with their conclusions regarding deliverables under existing revenue guidance.  However, this does not obviate the need for a “fresh look.”

Ms. Alicea also noted that while the staff did not object to the registrants’ proposed accounting for the promised goods and services as a single performance obligation, the staff’s views were based on the registrants’ careful analysis of the promised goods and services and whether those goods and services were both “capable of being distinct” and “distinct within the context of the contract.”  A company must support its identification of performance obligations according to the core principles in the standard – including whether or not the promised goods and services are inputs to a combined output.  There are examples in the new revenue standard that are intended to illustrate application of the principles in the standard.  However, the examples do not eliminate (or obviate) the reasonable judgment required to apply those core principles.