Financial Reporting Issues Commonly Addressed in SEC Comment Letters

MD&A

Results of operations- Comments include the need for expanded disclosures related to events that happened during the period and the factors that contributed to material fluctuations in operating results.

Liquidity- The Staff often recommends enhanced disclosures related to sources of and uses of cash, prospective needs for additional capital, sources of capital and the potential for a going concern issue if future capital is not raised.

Early warning disclosures: Companies are required to disclose uncertainties that they expect will have a material impact on income from continuing operations in the future. If the company records a material impairment charge, the Staff often inquires about whether there were warning signs which should have been disclosed in earlier periods.

The Staff frequently comments on instances when a Form 8-K was required to be filed but was not filed, not filed timely or filed with insufficient disclosure. Common mistakes noted by the Staff include:

• Not filing an 8-K to disclose a change of accountants after a reverse merger

• Not filing the financial statements related to a reverse merger with a public shell within the required 4 business days or not including all the disclosures that the operating company or the accounting acquirer would be required to provide in a registration statement

• The operating company or accounting acquirer having a gap in their required reporting after a reverse merger rather than filing an amended 8-k to provide updated financial statements

The Staff has also noted instances when a reverse merger occurred with a trading shell but the operating company’s financial statements were not properly audited by a PCAOB registered firm or the audit was not performed in accordance with PCAOB standards.

The Staff frequently requests further discussion on whether or not management considered all factors provided in ASC 805-10-55-11 when they were determining who the accounting acquirer was in a business combination.

As it relates to the purchase price allocation, the Staff may have further inquires on whether management considered all separately identifiable intangible assets.  Comments often arise when there appears to be a disproportionate amount allocated to goodwill in the purchase price allocation.

Issues have been noted with management improperly determining whether the assets acquired and liabilities assumed constitute a business or should be accounted for as an asset acquisition.

The Staff may request additional information on management’s consideration of the guidance in FASB ASC 805-10-55-25 when determining whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or if the transaction should be accounted separately from the business combination.

Comments may arise to clarify whether a Company properly followed the financial information requirements of either Rule 3-05 or Rule 8-04 of Regulation S-X. Determination of whether Rule 3-05 or Rule 8-04 is applicable is based on whether or not the registrant is considered a smaller reporting company.

Upon the reporting of a significant impairment at year end, the Staff may question whether there were possible indicators of impairment that should have been considered at interim periods. The Staff often considers information in the Company’s filings as well as publically available information outside of the Company’s filings when determining whether it was likely that an event had occurred which may have been an indicator of impairment.

The Staff may raise questions related to segment reporting disclosures and whether the aggregation of the operating segments into reporting units, for use in the goodwill impairment test, is appropriate.  Oftentimes, when reviewing a filing, the Staff reviews not only materials in the MD&A section of the filing but also analyst reports and other publically obtainable information to consider whether the information is consistent with the segments that were reported.

When considering the assumptions used to value goodwill, the Staff may inquire whether the assumptions used are consistent with those used to value other assets included in the reporting unit.
If management concludes that an acquired intangible asset has an indefinite life, the Staff may inquire whether management considered the presence of factors provided in FASB ASC 350-30-35-3.
 
If a Company’s capitalization policies could materially impact their financial statements, the Staff may request expanded disclosure related to the policies.

The Staff frequently comments when predecessor financial statements are not included in the registration statement at the time of the transaction or are not included in subsequent periodic reports until the predecessor periods are no longer covered by the periodic report.

The Staff may also request that pre-transaction financial information be provided for the registrant unless only minimal income statement activity occurred.

Issues related to financial statements that are not consistent with Rules 3-01 and 3-02 or Regulation S-X or Rules 8-02 and 8-03 of Regulation S-X are often addressed by the Staff.

Equity transactions

The Staff frequently provides comments related to management’s determination of the fair value of equity instrument, particularly if the Company is traded in an active market and the fair value is different than the trading market price. The Staff, however, may permit discounts for trading restrictions (discounts for Lack of Marketability) in certain circumstances.

For equity traded in an inactive market, the Staff noted that while the trading market price may not be representative of the equity’s fair value, the quoted prices should still be considered when determining the fair value of the instrument. They also recommend considering contemporaneous equity transactions with third parties or the fair value of goods or services provided, if applicable.

Frequent comments include the need for expanded disclosure related to the methods used to determine fair value, the underlying assumptions and the impact that changes in the assumptions could have on the financial statements.

The Staff frequently comments on issues found in management’s identification, valuation and disclosure of embedded conversion features and freestanding warrants.

Issues often noted include problems with management’s determination of whether the contract is both indexed to the company’s own stock and classified in stockholder’s equity in order to determine if it achieves equity classification under ASC 815. Common pitfalls noted by the Staff included:

• Classifying an instrument with cash settlement provisions as equity.

• Improperly determining that a financial instrument is conventional convertible and achieves equity classification when it contains ratchet provisions that adjust the conversion price (other than standard anti-dilution provisions)

• Classifying an instrument as equity when the Company does not have sufficient authorized shares to settle the contracts after considering all other share-indexed obligations

• Classifying an instrument as equity when there is no explicit limit on the number of shares that can be delivered under the agreement

• Management not carefully evaluating all the provisions in their agreements and the related accounting implications

The Staff also frequently comments on the appropriateness of certain valuation methods and assumptions used to determine fair value when an instrument has multiple embedded features that require bifurcation. Issues noted by the Staff include use the of a valuation method which does not take into account all the unique features of the financial instrument being valued (e.g. use of Black Scholes to value a compound embedded derivative).

Additional comments include the need for expanded disclosure of key assumptions and significant estimates used to develop the fair value measurements and more robust disclosure on how the company evaluated the key provisions of the agreements to determine the accounting implications of the transaction.

Revenue Recognition

The Staff often recommends expansion of disclosures related to the Company’s revenue recognition policy and recommends providing specific disclosures rather than vague “boiler-plate” disclosures.

As it relates to revenue recognition under ASC Subtopic 605-25, the Staff may request additional information in situations where it is not clear whether the deliverables qualified as separate units of accounting. Staff comments may also include a request for expanded disclosure to include the method which was used to allocate revenue to the deliverables.

The Staff may inquire how a registrant evaluated each of the indicators in ASC 605-45 to determine whether the Company should report revenue gross or net of certain amounts paid to others. Questions often arise if the disclosures provided do not appear to support the method currently being used to recognize revenue.

The Staff may also request additional information to support that the accounting for transactions in which there are payments or other incentives provided by a vendor to customer aligns with the economic substance of the transactions.

Transition to Smaller Reporting Company Status

Although the new system of disclosure for smaller companies filing periodic reports and registration statements was adopted in 2008, the Staff continues to find companies that have not transitioned properly to the new disclosure requirements.

Provisions for proper transition include:

• Companies with a public float < $50 million on the last business day of the second quarter are considered smaller reporting companies. Revenues are not considered unless the Company does not have a public float in which case, the determining factor is based on whether or not the audited annual revenues are < $40 million.

• Companies with a public float equal to or greater to $75 million on the last business day of the second quarter are considered larger reporting companies. If the Company does not have a public float, then the determining factor is based on whether annual revenues are greater than or equal to $50 million.

• When a company meets the requirements and transitions to a smaller reporting company based on its public float, it can elect to provide the reduced disclosure in its next Form 10Q but it is still considered an accelerated filer until it files its Form 10K.

• If a Company transitions from a smaller reporting company to a larger reporting company, it may continue to provide the reduced disclosures through the filing of the Form 10K; however, it is still considered an accelerated filer for purposes of the filing deadlines and must include the attestation report on Internal Control over Financial Reporting for that period.

Disclosure Controls and Procedures

The Staff frequently comments if the DC&P conclusion does not clearly specify whether the controls were effective or not-effective or if inconclusive wording is used such as “adequate” or qualifying language such as “effective except for...”

The Staff may request additional support if the DC&P are considered ineffective while internal control over financial reporting is considered effective.

The Staff frequently comments if management has not reassessed the DC&P after filing an amendment to their financial statements.

If management provides a definition of DC&P in their disclosures, the Staff may issue a comment if the definition does not conform exactly to the one provided in Exchange Rule 13a-15.

Internal Control over Financial Reporting (“ICFR”)

The Staff frequently comments if the registrant does not explicitly state whether ICFR is effective or not-effective or qualifying language or scope limitations have been provided.

If companies do not separately evaluate ICFR and DC&P or if they do not provide their conclusions separately and distinctly, then the Staff will often request that they provide separate conclusions in their disclosure.

If all four elements of Item 308(a) are not disclosed by a company that is subject to the auditor attestation requirement, the Staff may inquire how management considered all four elements and request expanded disclosure; however, if the Company is a non-accelerated filer, then the disclosure is limited to all relevant elements.

If management’s conclusion of whether ICFR is effective or in-effective changes, but they do not properly disclose the changes, the Staff may not only comment on the lack of disclosure but they will often ask for additional support for management’s overall conclusion related to ICFR.

The Staff frequently asks for expanded disclosures related to material weaknesses including the impact the material weakness may have on the financial statements.

Form 8-K

The Staff frequently requests expanded disclosure in Form 8-k filings related to a Change in the Registrants Certifying Accountant or Non-Reliance on Previously Issued Financial Statements.

The Staff may comment is a Company receives an explanatory paragraph in their audit report related to uncertainties in the Company’s ability to continue as a going concern but they do not file a Form 8-k related to the uncertainties.

If the Company consummates a reverse merger or there is a merger of the registrant’s accountants with another firm and the Company has not properly disclosed these in an 8-k, they may receive a comment from the Staff.

Proper adoption of EITF 07-05

The Staff may comment if the Company has not properly considered whether financial instruments such as warrants and embedded derivatives that obtained equity classification at inception require bifurcation and accounting at fair value after adoption of EITF 07-05.

Fair value measurements and disclosures

The Staff may request expanded disclosures related to fair value measurements that use significant unobservable inputs (Level 3).

Goodwill impairment analysis (intangible asset or goodwill)

The Staff may request more robust disclosure related to the facts and circumstances that led to an impairment of goodwill and expanded disclosures related to the assumptions used in testing for potential impairment.

Evaluation of preferred stock under EITF D-109 and SFAS 133

If management does not provide clear disclosure of the terms of the preferred stock and a full analysis of why a conversion feature for redeemable preferred stock does or does not require bifurcation, they may receive a comment from the Staff to provide this additional disclosure.

Executive compensation disclosure

If benchmarking was used, the Staff may comment if the disclosure related to the peers is not sufficient or if performance targets have not been quantified.