Financial Reporting Challenges for 2012

Reflecting the continued uncertainty and volatility of the global economic environment, this year’s financial reporting challenges center around the identification, analysis and disclosure of risks and uncertainties. Those responsible for preparing, certifying, reviewing and/or signing their companies’ forthcoming annual reports on Form 10-K should be aware of recent disclosure guidance issued by the Securities and Exchange Commission (SEC)’s Division of Corporation Finance regarding two specific categories of risk – cyber security threats and exposure to potential European sovereign and private debt defaults. This disclosure guidance is the latest example of how, in this era of change, the SEC and its staff expect companies to apply a principles-based, holistic approach to analysis and disclosure of material risks and uncertainties of all kinds.

We discuss below the SEC’s key messages for the fiscal 2011 Form 10-K, distilled from written pronouncements, comments made by senior staff at major end-of-year conferences, and posted correspondence. We also discuss some key messages from the Public Company Accounting Oversight Board (PCAOB) aimed at independent auditors, which have reciprocal importance for audit committees. Broadly speaking, these messages – and the challenges they pose for public companies – are as follows:

• The need to identify and disclose material trends and uncertainties well before they harden into fact, and the continuing vitality, for this purpose, of the “two-pronged” test at the core of Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A);
• The need to make judgments on “materiality” from a qualitative as well as a quantitative perspective, as reinforced in 2011 by the courts;
• The need to provide investors with early and meaningful warning of material risks and uncertainties;
• The need to take a consistent and comprehensive approach to risk-related disclosures throughout the narrative and financial statement portions of periodic reports;
• The need to ensure that warnings of potential material litigation losses, and other material loss contingencies, evolve with the relevant facts and circumstances;
• The need to reassess the quality and reliability of long-standing assumptions and estimates used in the preparation of financial statements;
• The need to refresh disclosure controls and procedures (and, in the case of financial information, internal control over financial reporting) to adapt to changes in business, financial, legal and regulatory risks; and
• The need for audit committees to pay careful attention to “red flags” and to enhance their communications with the outside auditor.

We expect that, in 2012, the staff will continue to augment the review and comment process focused on individual registrants by broadly communicating views it considers of widespread importance. These communications include Compliance and Disclosure Interpretations (C&DIs), Staff Legal Bulletins (SLBs), the Division accounting staff’s occasional “Dear CFO” letter, the Financial Reporting Manual (FRM), which is updated at least quarterly, and the staff’s most recent innovation, Disclosure Guidance Topics addressing specific areas of staff concern. In addition, the staff has accelerated the public availability of comment letters, which offer useful insight into the staff’s thinking on discrete disclosure issues. These are now publicly available within 20 business days following the completion of a filing review. [1]

For some time now, the staff has been extending its review outside the four corners of SEC periodic reports, proxy statements and other filings to examine the content of various “informal” corporate communications that often are not filed with, or furnished to, the SEC – including company press releases and statements made by officials during company or third-party sponsored investor conferences – as well as analyst reports, news articles and blogs that give the staff a sense of how the market may be interpreting corporate disclosures. Reversing a “hands-off” policy instituted in mid-2005 in connection with the SEC’s adoption of major reforms under the Securities Act of 1933, as amended, the staff is seeking to keep abreast of capital market trends by examining prospectus supplements filed “after-the-fact” in connection with post-effective shelf offerings. To stay ahead of potential financial meltdowns, the Division has created a special review branch within its Operations group that is dedicated to monitoring large financial institutions, and is now engaged in almost continuous review of communications by and about these companies – which goes well beyond the minimum triennial review prescribed by the Sarbanes-Oxley Act of 2002. Whether or not this “continuous review” model will be applied to companies in other industries remains to be seen. But expect the unexpected from the staff, as well as the global financial markets, in 2012.

Endnotes

[1] Division of Corporation Finance Announcement, SEC Staff to Release Filing Review Correspondence Earlier (Dec. 1, 2011) (announcing that, beginning January 1, 2012, the staff will release comment letters and company responses no later than 20 business days after a filing review is completed, rather than no earlier than 45 days after completion, which had been the previous standard in place since May 2005), available at http://www.sec.gov/divisions/corpfin/cfannouncements/edgarcorrespondence.htm.
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