Subscribers to our blog know that we monitor EDGAR for new SEC comment letters and enjoy bringing attention to the more interesting ones. In today’s blog post, we bring you three new SEC comment letter exchanges.
- In the first, the SEC asks the registrant for more information related to a COVID-19-related adjustment in its non-GAAP financial measure.
- The second involves the SEC questioning, and eventually disagreeing with, the registrant’s materiality analysis under Staff Accounting Bulletin No. 99 (SAB 99).
- The third letter involves an offering document produced by South Korea.
SEC Staff Wants More Information about a COVID-19 Adjustment in Non-GAAP Net Income
We’ve previously blogged about COVID-19-related adjustments in connection with the presentation of non-GAAP financial measures, including the difficulty that some public companies may have in reasonably quantifying the extent to which incremental expenses were driven by the COVID-19 pandemic as opposed to other factors.
This recent SEC comment letter exchange hits on this topic and asks the registrant for more information concerning an adjustment to its non-GAAP net income titled “COVID-19 shelter in place restrictions on manufacturing activities.” For reference, the applicable earnings release at issue is linked here. The SEC Staff appeared to accept the company’s response as no further comments on this topic were issued, and the registrant continued to include this adjustment in its next quarter’s earnings release.
Form 8-K furnished on May 7, 2020
Use of Non-GAAP Financial Measures, page 7
- Please clarify the nature of the adjustment titled “COVID-19 shelter in place restrictions on manufacturing activities.” In your response, tell us how you reasonably quantified this adjustment, the length of time within the quarter that applied to its calculation, and the related amount applicable to the quarter ended June 30, 2020. We may have further comment upon reviewing your response.
The Company notes for the Staff that substantially all of its manufacturing activities were impacted by shelter in place restrictions that prevented its sites from operating at normal levels. The Company calculated the equivalent number of days of lost production at each site and quantified the costs associated with such impact (primarily compensation for idled employees, depreciation, utilities, and other fixed overheads). In total, the adjustment for COVID-19 shelter in place restrictions during the quarter ended March 31, 2020 of $3.3 million, represented lost production at seven (7) sites with an average of five (5) days of lost production. The amount of the non-GAAP adjustment was quantified by accumulated fixed overhead costs for the period factored by the percentage of lost production days. For the quarter ended June 30, 2020, the same calculation was performed and resulted in an adjustment of $2.8 million, representing lost production at ten (10) sites with an average of four (4) days of lost production.
The Company included the adjustments to its non-GAAP results as the charges resulted from the Company’s inability to operate its manufacturing activities during these days as a result of restrictions imposed by local or other governments. The Company had not closed its manufacturing operations or had production adversely impacted previously as a result of local government restrictions on employee movements and does not expect to incur such costs again during the next two years after the COVID-19 pandemic has passed. The Company’s adjustment included amounts that could be objectively quantified and excludes other operational costs (e.g., increased transportation and warehousing costs, increased cleaning costs, lower production levels and inventory markdowns) that could not be clearly separated from business conditions, changes in demand or Company actions.
SEC Staff Questioning, and Eventually Disagreeing with, the Registrant’s Materiality Analysis under Staff Accounting Bulletin No. 99 (SAB 99)
Another interesting comment letter exchange recently made public involves the SEC Staff questioning, and eventually disagreeing with, the registrant’s materiality analysis under SAB 99. Occasionally, when registrants correct errors relating to a prior period and the materiality or immateriality of the correction is not self-evident, the SEC Staff will issue a comment requesting the registrant to identify the factors it considered when assessing materiality with respect to current-period and prior period financial statements.
When the error is material, the financial statements can no longer be relied upon and will need to be restated, which is sometimes called a “Big R restatement.” A Big R restatement usually requires a registrant to do the following:
- File a Form 8-K under Item 4.02 stating that previously issued financial statements should not be relied upon.
- Revise previously issued financial statements through an amendment to the 10‑K or 10‑Q, as applicable, to correct the error in those previously issued financial statements.
When the error is immaterial, generally, the error may be corrected in a future 10‑K or 10‑Q, which is sometimes called a “Little r restatement.”
To evaluate the materiality of an error in accounting, the registrant usually considers the guidance in ASC 250-10-45 and ASC 250-10-S99, which incorporate the guidance in SAB No. 99 “Materiality” (codified in SAB Topic 1.M) and SAB No. 108 (codified in SAB Topic 1.N).
The registrant’s first response letter is linked here and the relevant comment/response is repeated below:
Form 10-K for Fiscal Year Ended December 31, 2019
Notes to Consolidated Financial Statements
Note 2. Summary of Significant Accounting Policies
Revision of Previously Issued Financial Statements, page 44
1. We note that you corrected an error related to the year ended December 31, 2017 you believed to be immaterial in the current December 31, 2019 10-K. As the quantitative disclosures on page 44 indicate that the change increased your net loss in 2017 by over 50%, it is unclear why you believe such error to be immaterial. Please provide us with your full materiality analysis and tell us your consideration of amending your December 31, 2017 10-K as well as filing an Item 4.02 8-K that such financial statements should no longer be relied upon. We may have further comment after review of your response.
The Company conducted an analysis under Staff Accounting Bulletin No. 99 and Staff Accounting Bulletin No 108 when the error was identified in the second quarter of 2019, and have included below both the quantitative and qualitative factors that we analyzed. Our analysis resulted in the conclusion that the adjustment was not material for the period ended December 30, 2017 (or any subsequent period until the adjustment was made).
In summary, the error identified had the following impacts to the financial statements for the year-ended December 31, 2017, with similar balance sheet impacts in subsequent periods through the date the error was corrected.
|Fiscal year-ended December 31, 2017 (Dollars in millions)|
% Change vs. as reported
|Loss on disposal of discontinued business||($70.0)||($105.2)||($35.2)||50%|
|Net loss from discontinued operations||($65.8)||($101.0)||($35.2)||53%|
|Assets of discontinued operations||$306.1||$270.9||($35.2)||(11%)|
|Total current assets||$648.9||$613.7||($35.2)||(5%)|
|Total shareholders’ equity||$419.3||$384.1||($35.2)||(8%)|
In addition to the above, for the period ended September 30, 2018 through the date of correcting the error, the adjustment also resulted in a reclassification within the Accounts payable and accrued expenses footnote of $35.2 million, within continuing operations, as a result of our receipt of advance cash proceeds from the buyer.
In addition to the quantitative impact, management considered the impact of the error from a qualitative standpoint, and concluded the following:
- The error was due to the inappropriate review and interpretation of consideration in the sale contract, resulting in an incorrect mathematical formula to calculate the estimated loss on disposal. The terms of the agreement, including adjustments to the consideration for debt related items, were understood by management and specifically considered when communicating forecasted net cash to be received from the sale transaction both internally (including with the Board of Directors) and externally with investors. However, the expected adjustment to the purchase price for the items defined as debt in the agreement, was inappropriately excluded from the estimated loss on sale calculation for the held-for-sale asset group, resulting in the error in the non-cash impairment charge.
- For the fiscal year ended December 31, 2017, the adjustment impacted the discontinued operations portion of our income statement only, assets of discontinued businesses and retained earnings and resulted from a non-recurring, non-cash charge in discontinued operations. For subsequent periods, the adjustment impacted only assets of discontinued businesses and retained earnings as well as the accounts payable and accrued expense footnote beginning in the period ended September 30, 2018. For all respective periods, the adjustment had no impact on earnings and earnings per share from continuing operations, EBITDA or free cash flow, which are the key performance measurements for our investors.
- When considering the impact of the error on trends, specifically trends in profitability, consideration was given to the loss on disposal of discontinued operations being first reported in the period the error occurred; therefore, there were no trends from prior period. However, in relation to net earnings which is inclusive of continuing and discontinued operations, this error also did not impact any trends due to the one-time nature of the error. Had the error been appropriately recorded in the 2017 results, it would not have changed profitability trends which continue to increase year-over-year. Further, the error related to discontinued operations only and did not mask a change in loss on disposal of discontinued operations, net loss from discontinued operations, nor net earnings inclusive of both continuing and discontinued operations. The adjustment did not change a cumulative gain on disposal into a loss as the sale was always calculated and communicated to result in a loss.
- We are confident that our investor base focuses on results from continuing operations and does not consider discontinued operations to be material to our operating performance or the valuation of our stock as, by their nature, those operations will not remain a continuing part of the Company. Our analysts set expectations on continuing operations results, including both GAAP and non-GAAP measures, as well as adjusted free cash flow. Further, the error had no impact on our cash balance or liquidity in the periods in which the error existed. Additionally, the adjustment had no impact on analyst consensus expectations in any period.
- From the announcement of the sale in November 2017, through the closure of the sale in September 2019, our investor base focused nearly exclusively on the timing of closing and our early and unconditional receipt of sale proceeds during the third quarter of 2018. Performance of the discontinued operations during the close period was not a focus of the investment community. Further, our investor base was particularly well-informed of the pending divestiture of those operations following a lengthy, but not uncertain, procedural process for which the buyer was solely responsible.
- The disclosures in the notes to the financial statements stated that the purchase price to be received was subject to certain adjustments as provided for in the Share Purchase Agreement. A copy of the agreement was filed with the November 20, 2017 Form 8-K announcing the sale transaction, and was publicly available and included the adjustments to the purchase price, including the items that caused the error. Although cash expected to be received from a disposal transaction is not a required footnote disclosure and expected future cash balances and future liquidity are not disclosed in the Form 10-K, we did include the disclosure in the 2017 Form 10-K and disclosed to investors the actual amount of the net cash expected to be received from the sale transaction (net of the expected adjustments to the consideration for the items defined as debt in the agreement) in various publicly filed Form 8-Ks and investor presentations/calls. The net cash impact of the sale communicated to investors consistently included the expected consideration adjustments for the items defined as debt in the agreement (the items that resulted in the error).
- The adjustment was not indicative of or related to any fraud. Rather, the adjustment related solely to this significant and unusual transaction, specifically the failure to completely reconcile the terms of a technical provision of the underlying sale agreement, which led to an incorrect mathematical formula to estimate the loss on disposal.
- This misstatement is specific to discontinued operations of the disposal group and therefore is not relevant to segment reporting information, as segment reporting is relevant for continuing operations only.
- The adjustment did not impact any of our debt covenants or other contractual agreements.
- The adjustment did not impact any of our incentive compensation plans or payments under those plans. Our annual cash incentive plan is based on continuing operations net sales and EBITDA. Our long term equity incentive plan is based on Total Shareholder Return (see investor comments above) and Adjusted Free Cash Flow over a three year period.
While we acknowledge that the error is quantitatively large, we gave specific consideration to the nature of the line items impacted, notably the results of discontinued operations (with the exception of the reclassification within the Accounts payable and accrued expenses footnote effective in the September 30, 2018 10-Q). We had evidence (with the benefit of hindsight) that analysts and investors have not focused on the results of the discontinued operations in 2017 or any period since. When concluding that a restatement was not required, we also took into account the fact that the 2018 interim and annual financial statements and the Q1 2019 interim financial statements, which were more current and relevant to users today than the older period of 2017, and these more recent financial statements were primarily only impacted on the balance sheet. We also considered our liquidity situation in 2017 and subsequent periods and concluded that the unrecorded adjustments to the non-cash impairment loss did not materially impact our cash and liquidity metrics. Finally, but importantly, we believe that when a business is being discontinued and disposed of, investors and other financial statement users are more interested in the amount of cash that will be received upon sale (and perhaps how and where that cash may be reinvested in the business) and less interested in the amount of any non-cash impairment loss that results when the business is classified as held for sale.
Based on the foregoing quantitative and qualitative analysis, management concluded that the previously issued annual and interim financial statements (included in the 2017 Form 10-K through the Q1 2019 Form 10-Q) were not materially misstated and did not require restatement. Management concluded that there was not a substantial likelihood that the error would have been viewed by a reasonable investor as having significantly altered the total mix of information made available. We determined that the historical error would be corrected in our June 30, 2019 Form 10-Q as an immaterial correction of prior period financial statements.
We also discussed the accounting, financial reporting, and disclosure considerations associated with this adjustment with external SEC counsel, our independent auditors and the Audit Committee of our Board of Directors, each of which supported management’s conclusions.
The SEC Staff considered the registrant’s response but ultimately disagreed with its materiality conclusion. However, the registrant continued to push back on the Staff’s request for an Item 4.02 8-K in this situation because the financial statements contained in the registrant’s 10-K filing for the year ended December 31, 2019 already included the financial impact of the error correction for all years presented in the 10-K. The SEC Staff appeared to accept the registrant’s position on this as no follow-up or 4.02 8-K was issued. The company’s second response letter is linked here, and the relevant comment/response is repeated below.
Form 10-K for Fiscal Year Ended December 31, 2019
Notes to Consolidated Financial Statements
Note 2. Summary of Significant Accounting Policies
Revision of Previously Issued Financial Statements, page 44
- We have considered your analysis to prior comment 1 in your response letter dated April 15, 2020. Given the quantitative significance of the error to net earnings, among other factors, we disagree with the company’s conclusion that the error was immaterial. Accordingly, we have concluded the financial statements for the fiscal year ended December 31, 2017 are materially misstated and an Item 4.02 Form 8-K should have been filed. Please file an Item 4.02 Form 8-K and, upon resolution of our comment below on internal controls, amend your 2019 Form 10-K to:
- label the financial statements for the fiscal year ended December 31, 2017 as restated;
- revise your discussion in Note 2 to identify the error as material; and
- revise your disclosures to address the effect of the identified material weakness on your prior conclusions that internal control over financial reporting and disclosure controls and procedures were effective in past periodic reports.
We note the staff’s conclusion and although, as we have discussed and outlined in our prior responses, we believed our approach disclosing the information related to the error in our previously filed Form 10-K for the year ended December 31, 2019 was appropriate, we will file a Form 10-K/A for the year ended December 31, 2019 to provide the requested information. As discussed with the staff, however, we do not believe that an Item 4.02 Form 8-K is required to be filed under these facts. The revisions that will appear in our Form 10-K/A will provide additional disclosures, including references that the error was material, and a revised audit report to make reference to the restatement. The financial statements contained in our original Form 10-K filing for the year ended December 31, 2019 already included the financial impact of the error correction for all years presented. As a result, we do not believe that these additional disclosure changes would result in the original Form 10-K being deemed unreliable. Accordingly, we believe that our previously issued and corrected financial statements can continue to be relied upon and, as a result, no disclosure under Item 4.02 of Form 8-K is required.
For additional information on restatements, including 2019 trends, see today’s blog over at corporatecounsel.net, link here.
SEC Staff Asks South Korea about COVID-19 and North Korea Relations
More so for interesting reading rather than practical application, this comment letter exchange between the SEC Staff and The Republic of Korea is pretty fascinating to the outside observer. While securities of the U.S. federal government are exempt from the registration requirements of the Securities Act, a foreign government cannot sell its securities to the U.S. public without registering the offer and sale. The applicable form for these foreign government debt offerings is a Schedule B.
Similar to the business discussion of a corporate issuer, South Korea’s Schedule B includes a general discussion of the country, including sections titled “Land and History,” “Government and Politics,” “The Economy,” “Principal Sectors of the Economy, “The Financial System, “Monetary Policy, “Balance of Payments and Foreign Trade,” and “Government Finance.” It would be quite interesting to read the disclosures of our own government if they were called to prepare its own Schedule B prospectus and held to the same disclosure standard and liability.
The SEC Staff’s comments are repeated below.
1. Please update any future filings, as necessary, to include any material updates relating to the impact of COVID-19.
The Registrant acknowledges this comment to update any of its future filings, as necessary, to include any material updates relating to the impact of COVID-19.
Relations with North Korea, page 6
2. Please update your discussion, as necessary, to reflect any material recent developments in your relations with North Korea.
The Registrant believes that all material recent developments in its relations with North Korea have been reflected in the Registration Statement. The Registrant plans to continue to monitor for any material developments in its relations with North Korea and will reflect such developments in any of its future filings.
If you have any questions regarding any of the topics covered in this blog post, please feel free to contact a member of our Corporate & Securities practice group or, if applicable, contact your primary Bass, Berry & Sims relationship attorney.
About Bass, Berry & Sims’ Corporate & Securities Practice
Public and private companies of all sizes across a variety of industries turn to Bass, Berry & Sims for counsel on a wide range of corporate matters, including mergers, acquisitions and dispositions, capital markets transactions, executive compensation issues, corporate governance and shareholder activism. We serve as primary corporate and securities counsel to approximately 35 public companies and have counseled on 150 deals ranging in size from $20 million to more than $15 billion over the past two years. Click here to learn more about the Corporate & Securities Practice at Bass, Berry & Sims.