financial reporting developments, including non-gaap

© 2018 Morgan, Lewis & Bockius LLP

GLOBAL PUBLIC COMPANY ACADEMY

FINANCIAL REPORTING DEVELOPMENTS, INCLUDING NON-GAAPFinn Murphy and George Yearsich

February 14, 2018

WELCOME

Topics to be Covered

• Expanded Auditor’s Report

• Recent Federal Income Tax Law Changes

• Segment Reporting

• New Revenue Recognition Standard

• Non-GAAP Staff Comments

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EXPANDED AUDITOR’S REPORT – IMPLEMENTED IN TWO PHASES

SECTION 01


1. New Auditor’s Report Format: First Phase of Implementation

– Changes to Auditor’s Report Format to Enhance Relevance and Usefulness to Investors

– Auditor tenure

– Independence requirement

– Financial statements free of material misstatements “whether due to error or fraud”

– Reordering of auditor report

– Opinion in first section

– Section titles added

– Addressed to company shareholders, as well as board of directors

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– Effective Date for Audit Report Format Changes

– Audits for fiscal years ending on or after December 15, 2017

– Audits for 2017 for calendar year companies

– PCAOB approved on June 1, 2017

– SEC approved on October 23, 2017

– Education of Company’s Audit Committee Now

– Center for Audit Quality “The Auditor’s Report: Considerations for Audit Committees” (December 2017) (“CAQ Report”)

– Proposed questions for Audit Committee to explore, especially as to the auditor’s tenure disclosures

– Recent changes

– Federal income tax

– Revenue recognition

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2. Auditor Report Discussion of Critical Audit Matters (“CAMs”): Second Phase of Implementation

– CAMs

– Communicated, or required to be communicated, to the Audit Committee

– Related to accounts or disclosures that are material to the financial statements, and

– Involved especially challenging, subjective, or complex auditor judgment

– Discussion in the Auditor’s Report

– Opportunity for auditor to communicate with investors

– Identify the CAM

– Describe the principal considerations that led the auditor to determine that the matter was a CAM

– Describe how the CAM was addressed in the audit

– Refer to the relevant financial statement accounts or disclosures

– Alternatively, state that the auditor determined that there were no CAMs

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– Effective Dates for CAM Requirements

– Large Accelerated Filers: fiscal years ending on or after June 30, 2019

– All other companies to which requirements apply: fiscal year ending on or after December 15, 2020

– Education of Company’s Audit Committee Now

– CAQ Report proposed questions

– National Association of Corporate Directors proposed questions

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RECENT FEDERAL INCOME TAX LAW CHANGES –SELECTED ISSUES

SECTION 02


1. The New Federal Income Tax Law

– The Tax Cuts and Jobs Act

– Signed into law on December 22, 2017

– Effectiveness

– Grandfathering rules for certain existing arrangements

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2. Selected Issues

– Deferred tax assets remeasurement/impairment (and deferred tax liabilities)

– Recent charges (benefits)/disclosures

– SEC Staff Accounting Bulletin 118 (ASC Topic 740) & CDI 110.02 (December 22, 2017)

– Repatriation of overseas earnings

– Prior SEC comments

– Recent disclosures

– Limitations on the deductibility of interest

– Effects on capital structures/cost of capital

– Recent disclosures

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– Repeal of the Section 162(m) performance-based compensation exception

– Effect on taxes for payments made after December 31, 2017

– Effects re plans/award design

– Disclosure issues

– Related disclosures

– Pay for performance

– Say on pay

– Pay ratio

– Corporate tax rate reduction

– Reduction in tax rates

– Effects of other tax law changes including repatriation tax, limitation on interest deduction, and Section 162(m) changes

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– Other issues of interest

– Reduced individual marginal rates

– Reduced withholding percentages

– Ordinary income and supplemental income

– Effect on cashless withholding on equity awards

– Non-GAAP post-tax measures

– CDI 100.04

– Presentation approaches and SEC comments

– Broker-dealer net capital rule

– Calculations

– SEC SIFMA letter

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SEGMENT REPORTING SECTION 03

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Segment Reporting (ASC 280)

• Identifying Operating Segments

• Aggregating Operating Segments into Reportable Segments

• Appropriate Disclosures

– General Information, Reconciliations related to products and services, revenues

• Non-GAAP measures for segments

• Internal Control over Financial Reporting

• SEC will consider public information and other parts of SEC filings to question consistency with segment footnote

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Segment Reporting – Identification of Operating Segments

• “Management Approach” to Identification of Operating Segments

– Chief Operating Decision Maker (CODM) function – key operating decisions

– Internal management reporting structure

– SEC will request org charts (identifying CODM), information on basis on which budgets and forecasts are prepared; how performance objectives are evaluated; how executive compensation is determined; financial information included in reporting package to CODM

– Discrete financial information CODM uses to asses performance and allocate resources

– Gross profit or other operating measures so used could suffice, even if shared costs

– SEC will challenge single operating segment and request disclosure that management assesses performance on consolidated basis and basis for that management approach

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Segment Reporting - Aggregation

• Consistent with objectives and principles of ASC 280

• Better informed judgments by improving understanding of performance and prospects

• Segments must be economically similar – historically and future

• Following five qualitative characteristics must be similar (SEC will ask to compare and contrast)

– Nature of products and services

– Nature of production processes

– Type or class of customer

– Methods used to distribute products/provide services

– Nature of regulatory environment

• Follows investor approach

– Consider industry reports and analysis to understand investor perspective

• SEC will also question inconsistency of internal reporting structures with aggregation

• Ongoing assessment - SEC will question when changes to business

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Segment Reporting - Disclosures

• General Disclosures

– Factors used to identify reportable segments, including whether aggregated

– Types of products and services for each segment

• Reconciliations

– Reportable segment’s total revenues, profit/loss, assets and other significant items to corresponding consolidated amounts

– “Other” line item – SEC will ask that any significant items be presented separately

• Non-GAAP

– Required segment disclosures, including measures used by CODM, exempt from non-GAAP rules

– SEC staff does challenge whether inappropriate non-GAAP measures are included in segment disclosure – i.e., consolidated column of segment measure of profit

• Entity-Wide Disclosures

– Disaggregated revenues by product and service, by geography and by significant customer

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NEW REVENUE RECOGNITION STANDARD

SECTION 04


1. ASC 606

– Changes

– SAB 74 (Topic 11M) surprises

– Effectiveness

– Full retrospective

– Modified retrospective

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2. Full Retrospective

– Timing of “recasting”

– Effect on period-over-period MD&A comparison

– Form S-3 Item 11(b) trap for the unwary

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3. Modified Retrospective

– “Lost” revenue issue

– Effect on period-over-period comparison

– GAAP MD&A disclosures

– Non-GAAP CDI 100.04 re “individually tailored” measures

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4. Effect on executive compensation performance measures

– Section 162(m) changes

– Plan/award adjustment provisions

– Disclosures

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NON-GAAP TRENDSSECTION 05

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Non-GAAP Trends

• May 2016 C&DIs

• Subsequent SEC Staff Comment Letters

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Non-GAAP

• Undue Prominence

– GAAP measure should appear before non-GAAP measure in any section (or heading)

– Reconciliations should begin with GAAP measure

– Non-GAAP measure should not be presented in more detail or with more emphasis

– Avoid qualitative descriptions of only non-GAAP measures – e.g., “record”

– Avoid implying that non-GAAP measure is superior to/more accurate than GAAPmeasure

– Length of respective discussions

– Should not present full non-GAAP income statement

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Non-GAAP

• Purpose and Use by Management

– Avoid boilerplate; substantive and specific to measure used and to company’s business and industry

– SEC Staff will question adjustments seemingly inconsistent with use/purpose

– Compensation, allocation of resources, management of business, debt covenants

• Clear Descriptions

– Consistent and clear use of titles and descriptions of measures and adjustments

– Similarity to titles or descriptions of GAAP measures; “Adjusted”, “Pro forma”

– Non-recurring

– Context

• Non-GAAP Liquidity Measures

– Reconciliation to most directly comparable GAAP measure (performance or liquidity measure)

– No per share figures

– No adjustments for items requiring cash settlement

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Non-GAAP

• Nature of Adjustments

– Recurring expenses settled in cash – e.g., professional fees, management fees, legal settlements Tailoring

– Adjustments creating non-GAAP version of revenue or other GAAP recognition and measurement principles (e.g., proportionate consolidation of equity investments)

– Inconsistent application between periods (“cherry picking”)

– Income tax effects

– Separately present income tax impact of adjustments and disclose how tax adjustments were calculated

– Constant currency measures – describe basis

– Present inconsistently in different fiscal periods or different treatment of similar items

– Excludes recurring cash operating expenses

– Tailors GAAP principles

• KPIs

– SEC Staff looking for similar disclosure to that for non-GAAP measures

– Clearly define; describe assumptions/limitations; balanced discussion; clearly describe how related to current or future results of operations; use and purpose to investors/management

– Discussed/used outside of periodic SEC filings

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Biography

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Finnbarr D. Murphy

New York

+1.212.309.6704

[email protected]

Finnbarr D. Murphy counsels issuers and underwriters on public and private securities offerings. These include initial, follow-on, and secondary public offerings, as well as Rule 144A and Regulation S offerings, registered “shelf” offerings, and tender and exchange offers. Finn also advises companies on mergers and acquisitions, joint ventures, corporate governance, and securities regulation and compliance. Frequently these representations involve foreign companies that turn to Finn for guidance on capital-raising transactions and general securities regulations in the United States.

Biography

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George G. Yearsich

Washington, D.C.

+1.202.739.5255

[email protected]

George G. Yearsich advises on and litigates corporate and securities law issues. He counsels corporations, investment funds, and broker-dealers on disclosure and securities law compliance issues, corporate governance, and transactions. These issues include mergers and acquisitions (M&A), and public and private securities offerings. He also provides guidance on stockholders’ agreements, hostile takeovers, and corporate restructurings. Corporations also turn to George for help with employee benefits plans and executive compensation.

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