SEC comments
and trends
Technology industry supplement
An analysis of current reporting issues
Issue 2: June 2009
Executive summary
The SEC staff provides registrants with comments on filings when it believes the filing could
be improved or enhanced. The reviews may result in outcomes ranging from additional
disclosure in future filings to restatement of previously-issued financial statements. This
publication summarizes recurring comments from recent SEC staff reviews of technology
companies, accompanied by a contextual discussion of these matters, in a manner designed
to familiarize registrants with these subjects of common interest. This publication should
be read in conjunction with our recent release, SEC Comments and Trends (SCORE No.
BB1589), issued in September 2008, which summarizes recent SEC staff comments
related to registrants’ filings across all industries. Although each registrant’s facts and
circumstances are different, and the SEC staff is clear that the letters set forth its position
limited to the specific facts of the filing to which the letters apply, a familiarity with the SEC
staff’s areas of focus may be helpful in the preparation and filing of reports with the SEC.
We hope that you find this publication’s insights helpful.
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SEC comments and trends Technology industry supplement, Issue 2: June 2009
Contents
Revenue recognition...................................................................................................... 2
Substantive renewal rate approach to establishing VSOE of fair value.............................. 2
Accounting for service contracts................................................................................... 3
Rights of return, stock rotation rights and price protection provisions in
relationships with resellers or distributors...................................................................... 4
Restructuring liabilities.................................................................................................. 6
Termination benefits.................................................................................................... 6
Management’s Discussion and Analysis (MD&A)............................................................. 7
Material changes in financial statement line items and liquidity and capital resources....... 7
Reporting issues............................................................................................................ 9
Prior period misstatements........................................................................................... 9
Disclosure of related party transactions.......................................................................10
Requirements to name experts....................................................................................12
SEC comments and trends Technology industry supplement, Issue 2: June 2009
1
Revenue recognition
Substantive renewal rate approach to establishing VSOE of fair value
Discussion of issues noted
Analysis of current issue
The SEC staff continues to challenge
technology companies on the establishment
of vendor specific objective evidence (VSOE)
of fair value for postcontract customer
support (PCS) using the Substantive Renewal
Rate Approach. The Substantive Renewal
Rate Approach is based on the notion that
a renewal rate specified in a contractual
arrangement is representative of VSOE of fair
value if that rate is substantive. The SEC staff
has asked registrants to provide information
regarding how the registrant has determined
that a renewal rate is substantive. The SEC
staff has also asked for documentation
regarding how renewal rates are set, whether
renewal rates are included in contracts and
what percentage of customers actually
renew at the specified renewal rate. Although
the SEC staff has addressed the substantive
renewal rate approach for a number of
years, more recently the SEC staff has also
focused on the effect of pricing pressures
on companies who may now be willing to
accept lower prices compared to the original
PCS renewal rate stated in the contract.
Therefore, given the current economic
environment, we believe that the increase in
customer requests to renegotiate the prices
of certain customer contracts could have an
affect on a company’s assertion that it will
renew at the stated rate.
Many believe that the Substantive Renewal
Rate Approach to establishing VSOE of fair
value of PCS differs significantly from the
Bell-Shaped Curve Approach. In fact, some
have interpreted this approach to mean that
if a renewal rate is specified in a contract
with a customer, that rate can be presumed
to be representative of fair value for that
arrangement. Even if a rate is specified
in a contract, we believe that when using
the Substantive Renewal Rate Approach,
vendors must demonstrate that the rate is
consistent with actual prices charged (within
a reasonably narrow range) when PCS is
sold separately to support an assertion that
VSOE of fair value exists.
Additionally, the SEC staff has questioned
companies that use different approaches,
such as the Bell-Shaped Curve Approach and
the Substantive Renewal Rate Approach,
for different classes of customers. In these
cases, the SEC staff has pressed registrants
to support the use of different approaches
for the different classes of customers.
2
Determining whether a renewal rate stated
in a contract is substantive will require
the exercise of professional judgment. For
software companies we generally would
be skeptical that any PCS renewal rate of
less than 10% of an initial software license
fee is substantive (this should not be
interpreted to imply that any rate greater
than 10% is, by definition, substantive).
However, in certain cases, if an analysis of
a company’s pricing practices indicates that
PCS is customarily priced below this level, a
company may be able to demonstrate why
such rates are substantive via reference to
the particular facts and circumstances of its
business and products.
To support and document its customary
pricing practices, a company should
perform an analysis demonstrating that
the range of prices that encompasses a
significant majority of actual PCS renewals
is narrow. If this analysis indicates that
the dispersion of prices in the range is
significantly wider than what would be
deemed acceptable when using a BellShaped Curve Approach to establish VSOE
of fair value, consideration should be given
to whether the vendor’s PCS renewal
pricing practices are sufficiently narrow
to conclude that a customary pricing
practice exists. This analysis may need to be
performed more often by any company that
has or expects to have more than minimal
variability in its PCS renewal rates, or that is
experiencing increases in pricing pressures
from its customers due to changing
economic conditions.
Oftentimes, facts and circumstances
around product pricing may change based
on changes in internal pricing practices
or external factors such as the economic
environment. For example, one common way
that companies have established VSOE of fair
value is based on a percentage discount off
of list price (or another static price metric).
Given the current economic environment,
companies may find themselves providing
higher discounts to customers as an
incentive to execute sales. For instance,
many companies are facing pressure to
reduce prices for annual maintenance
contracts. Registrants should carefully
consider whether these changes in facts and
circumstances will affect the assertion that
they have enough population in a sufficiently
narrow range to determine that VSOE of fair
value exists for each element. Registrants
should carefully document changes in pricing
practices and how these changes will effect
the assertion that VSOE of fair value exists
for each element.
SEC comments and trends Technology industry supplement, Issue 2: June 2009
Determining whether VSOE of fair value for
an element exists requires careful analysis
of the facts and circumstances. Judgment
must be applied to evaluate the extent of
variability in pricing, the appropriateness of
the stratification of the pricing population,
if any, and the reasons for prices outside
of the vendor’s range of VSOE of fair value
(i.e., outliers). Judgment is also required to
assess the effect of other qualitative factors
such as trends in pricing consistency over
time. For example, it may be relatively easier
for a vendor whose pricing consistency has
been improving over time to support an
assertion that VSOE of fair value exists than
one whose pricing consistency has been
deteriorating over time.
Given the often detailed nature of the SEC
staff’s comments, registrants should clearly
document the business rationale for each
type of judgment used in establishing VSOE
of fair value, including different approaches
used across different customer classes.
Resources
EY Financial Reporting Developments,
Software Revenue Recognition, an
Interpretation (Revised October 2008)
(SCORE No. BB1357)
EY Publication, Revenue Recognition Substantive Renewal Rate Approach
(SCORE No. DC0046)
Accounting for service contracts
Discussion of issues noted
Analysis of current issues
The SEC staff has continued to challenge
technology companies on the applicability of
the guidance under SOP 81-1, Accounting
for Performance of Construction-Type and
Certain Production-Type Contracts (SOP
81-1), for contracts related to the delivery
of services. The SEC staff has requested
that companies increase disclosures around
accounting for service-based contracts,
including the following:
In the recent past, certain registrants
incorrectly applied the provisions
of SOP 81-1 to account for service
transactions. Specifically, SOP 97-2,
Software Revenue Recognition, states that
the use of SOP 81-1 is appropriate only if
the arrangement to deliver software or a
software system, either alone or together
with other products or services, requires
significant production, modification or
customization of software. Additionally,
as stated in footnote 1 of SOP 81-1, the
guidance in the SOP “is not intended to
apply to ‘service transactions’ as defined in
the FASB’s 23 October 1978 Invitation to
Comment, Accounting for Certain Service
Transactions.” In its guidance “Current
Accounting and Disclosure Issues in the
Division of Corporate Finance,” the SEC
staff comments on the misapplication of
SOP 81-1 to service contracts and states
that the revenue recognition method used
for a service contract should reflect the
pattern in which the vendor’s obligations
are fulfilled. Accordingly, the revenue
recognition criteria in SEC Staff Accounting
•• The guidance followed for service-type
contracts
•• The method used in applying
proportional performance (e.g., output
and input-based estimates)
•• How input and output estimates are
determined
•• The types of arrangements where each
estimate is applied
Bulletin 104, Revenue Recognition,
which is based on the concepts relating
to revenue recognition found in FASB
Concepts Statement No. 5, Recognition and
Measurement in Financial Statements of
Business Enterprises, generally is applied
when accounting for service transactions
that are not specifically addressed by other
authoritative literature.
Depending on the service to be provided,
performance may occur with the execution
of a defined act or acts, or occur with the
passage of time. Accordingly, revenue
from service transactions generally
should be recognized using one of the
following methods:
•• Specific performance method —
Performance consists of the execution
of a single act and revenue is recognized
when that act takes place
•• Proportional performance method —
Performance consists of the execution
of more than one act and revenue is
recognized based on the proportionate
performance of each act in relation to all
acts to be performed
SEC comments and trends Technology industry supplement, Issue 2: June 2009
3
•• Completed performance method — In
certain cases, services may be performed
in more than a single act, but the
proportion of services performed in the
final act is so significant that the customer
realizes value from the transaction only
when and if the final act is performed.
In such cases, performance should be
deemed to have occurred, and revenue
recognized, when that act takes place
Generally, the most commonly used method
for accounting for service contacts is the
proportional performance method. The
proportional performance method can be
utilized only when the vendor’s pattern of
performance under the arrangement can
be determined. This method focuses on the
pattern in which service is provided to the
customer (i.e., based on vendor outputs)
and not the manner in which the vendor
incurs costs or expends effort. In certain
cases, an efforts-expended input measure
may provide a reasonable approximation of
a service provider’s pattern of performance.
Efforts-expended methods determine
progress based on the ratio of a unit of
measure (e.g., labor hours) expended on the
service arrangement to the total amount
of the unit expected to be expended on the
service arrangement through its completion.
However, no input measure based method
of revenue recognition should be used if
the measure that would be used does not
provide a reasonable approximation of the
service provider’s pattern of performance.
We understand the SEC staff will object to
revenue recognition on the basis of input
measures (such as labor hours) unless
the input measures are a reasonable
representation of contractual performance.
Additionally, we understand that the SEC
staff will object to set-up activities (activities
performed prior to commencing delivery of
the contracted service) being considered in
efforts-expended measures. Often it will be
difficult to identify a common performance
measurement for disparate services
included in a multiple-element arrangement.
The absence of such a measurement
may preclude a company’s ability to use
the proportional performance method
for revenue recognition. If no pattern of
performance is discernible, revenue should
be recognized on a straight-line basis over
the service period.
to be provided. However, it is inappropriate
to recognize the costs associated with the
services in the same manner. The costs of
providing services to a customer generally
should be recognized as incurred, even if
the costs are not incurred ratably as the
services are provided. The “smoothing”
of costs in a service transaction is not
appropriate. To do so for a service contract
accounted for using the proportional
performance method of revenue recognition
would effectively result in the application of
percentage-of-completion accounting as set
forth in SOP 81-1.
Resources
EY Financial Reporting Developments,
Software Revenue Recognition, an
Interpretation (Revised October 2008)
(SCORE No. BB1357)
EY Financial Reporting Developments,
Revenue Arrangements with Multiple
Deliverables – EITF Issue No. 00-21 (Revised
September 2008) (SCORE No. BB1185)
Application of the proportional performance
method to service transactions may result
in a revenue recognition pattern that is
essentially based on the percentage-ofcompletion of the total amount of services
Rights of return, stock rotation rights and price protection
provisions in relationships with resellers or distributors
Discussion of issues noted
Concluding that fees due under a reseller
arrangement are fixed or determinable can
often be difficult, especially when companies
provide such provisions as price protection
guarantees, stock rotation rights and
rebates, among other incentives. In today’s
environment, the practice of providing such
customer incentives will likely increase as
resellers and distributors are affected by the
global economic slowdown. The SEC staff
has asked companies to expand disclosures
4
in both the accounting policy footnote and
Management’s Discussion and Analysis
of Financial Condition and Results of
Operations (MD&A) on product returns, price
adjustments, price concessions, rebates and
other incentives. Specifically, the SEC staff
has asked registrants to disclose:
•• Greater detail regarding the material
terms of reseller arrangements, including
descriptions of product price adjustments,
return rights, price concessions or
incentives, as well as the time period
during which a distributor can return the
product or request a price concession
•• Whether the returns allowed or price
adjustments given are capped to a
certain percentage of the sales price
or margin, or how, for instance in
reseller arrangements, rebate or price
concessions with the end user affect the
rebate granted to the reseller
SEC comments and trends Technology industry supplement, Issue 2: June 2009
•• Whether any of the arrangements with
distributors would allow or require
companies to grant price discounts below
the cost of the product
•• Whether these rights result in deferral of
revenues until sale to the end user
•• How the contractual cap for returns
represents a reliable estimate of returns
as required by paragraph 6(f) of FASB
Statement No. 48, Revenue Recognition
when Right of Return Exists (Statement 48)
•• How actual returns have compared
to the contractual caps present in the
agreements
•• Discussion of the effect of the pricing
and return uncertainties on each
reported period
•• A rollforward of deferred income and
allowances on sales to distributors
liability account
•• The company’s methodology for
accounting for retailer returns in
accordance with Statement 48
Companies should carefully track the
instances of granting these rights to resellers
and distributors to ensure that they have
sufficient ability to estimate the amount
of these incentives. If a company loses the
ability to estimate these amounts, it will likely
cause delays in the recognition of revenue.
Analysis of current issues
Arrangements with resellers have been the
subject of a number of restatements by
registrants and certain SEC enforcement
actions. In many such situations, the vendor
recognized revenue at the outset of the
arrangement and then subsequently provided
concessions to the reseller. In hindsight,
these concessions provided evidence that the
risk of the product sale had not truly been
transferred to the reseller when revenue
relating to the sale was initially recognized,
and that the fee was not fixed or determinable
at the outset of the arrangement.
If a company provides a reseller return
and stock balancing rights, the amounts
of future returns or refunds resulting from
these rights must be reasonably estimable,
or the rights must lapse, before the
company may recognize any revenue under
the arrangement in accordance with the
provisions of Statement 48. The likelihood
of future concessions may preclude a
company from recognizing revenue on the
expiration of contractual return provisions.
If a company concludes at the outset of a
reseller arrangement that it cannot make
a reliable estimate of future returns, we
believe that revenue generally should be
recognized using the “sell-through” method
for the duration of the arrangement.
With respect to price protection, if
a company is unable to reasonably
estimate future price changes, or if
significant uncertainties exist about the
company’s ability to maintain its price,
the arrangement fee is not fixed or
determinable. Most companies operate
in extremely competitive environments
that may adversely affect their ability
to maintain the prices of their products.
Specifically, it may be difficult for a
company to reasonably estimate amounts
that it may have to remit to resellers
in the future under price protection
clauses. We understand that the SEC staff
shares the view that the current pricing
environment may place increased pressure
on a company’s ability to conclude that
arrangements containing price protection
clauses are fixed or determinable.
In certain cases, a company may agree to
provide an amount of price protection to a
reseller that is expressly limited (i.e., capped)
by the terms of the contractual arrangement.
In such situations, if the company (1) cannot
make a reasonable estimate of the amounts
that may be refunded to a reseller pursuant
to the price protection clause, (2) does not
have a history of granting concessions or
refunds in excess of the capped amount in
similar completed arrangements and (3) does
not intend to grant a concession relating to
the current arrangement, we believe that
the company may deem the arrangement
fees, net of the capped amount provided
under the price protection clause, fixed
and determinable.
The evaluation of reseller arrangements
requires a careful analysis of the facts
and circumstances of the transaction,
including an understanding of the rights and
obligations of the parties and the vendor’s
customary business practices in such
arrangements. Many companies rely on
historical trends as indicators of what the
level of refunds, returns, stock balancing,
price protection payments, rebates, sales
incentives and other such items will be in
the future. We also believe that there could
be an increase in requests for these items in
response to the global economic downturn.
As the ability to recognize revenue is
predicated on the company’s ability to
estimate the effect of these types of rights,
historical data may become less relevant
and a change in the frequency and amount
granted under such programs may hinder a
company’s ability to make reliable estimates
and call into question whether revenue
for transactions with resellers should be
recognized on a sell-in or a sell-through basis.
We believe this situation should be
closely monitored and that companies
should ensure they maintain adequate
documentation supporting their estimates.
In addition, companies should include
transparent disclosures in their financial
statement footnotes and in MD&A around
the rights granted to customers, the
estimates involved in providing for these
rights, and the effect of these rights on the
financial statements.
Resources
EY Financial Reporting Developments,
Software Revenue Recognition, an
Interpretation (Revised October 2008)
(SCORE No. BB1357)
SEC comments and trends Technology industry supplement, Issue 2: June 2009
5
Restructuring liabilities
Termination benefits
Discussion of issues noted
Many technology companies have
announced workforce reductions as a result
of recent market events. When and how
termination benefits, such as severance,
should be recognized is dependent on which
accounting literature is applied. The SEC
staff has frequently asked registrants to
provide the basis for which literature they
have applied. One of the critical questions
a company has to answer in making its
determination of how to recognize such
termination benefits is whether the
termination benefits are being offered
under a one-time or ongoing benefit
arrangement. This question is significant
as the answer will determine the particular
guidance that is applied and therefore
possibly affect the timing of recognition of a
termination liability. Technology companies
that have had prior restructurings should
carefully consider this topic.
Analysis of current issues
There are several different pieces of
authoritative literature that govern the
recognition of severance charges, including
FASB Statement No. 88, Employers’
Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for
Termination Benefits (Statement 88), which,
among others, applies to special termination
benefits such as a limited-time early
retirement offer; FASB Statement No. 112,
Employers’ Accounting for Postemployment
Benefits: an amendment of FASB Statements
No. 5 and 43 (Statement 112), which
applies to ongoing termination benefits;
and FASB Statement No. 146, Accounting
for Costs Associated with Exit or Disposal
Activities (Statement 146), which applies
6
to one-time termination benefits. Knowing
which literature applies is dependent on the
facts and circumstances of each specific
action and normally requires the exercise
of judgment.
The critical question for companies to
answer is which accounting literature to
follow, and that question is based, in part,
on answering whether the termination
benefits are provided under a one-time or
ongoing benefit arrangement. We believe
that one of the characteristics of an ongoing
benefit arrangement is the fact that benefits
can be determined or estimated in advance
from either the provisions of a document,
such as a formalized plan, an entity’s past
practices, or both. Accordingly, we believe
that the following factors should be taken
into consideration to determine whether an
ongoing benefit arrangement exists:
•• The existence of statutorily-required
minimum benefits to be provided in
the event of involuntary termination
or severance benefits documented in
an employee manual or labor contract.
This provision can frequently result in
an overall workforce reduction being
accounted for under both Statement 112
with respect to the statutorily-required
minimums, such as are common in
many European countries or in US labor
contracts, and Statement 146 for any
negotiated additional benefits, to the
extent they are not expected to recur
Resources
EY Financial Reporting Developments,
Accounting for Costs Associated with Exit
or Disposal Activities – Statement 146
(SCORE No. BB1072)
•• The frequency and regularity with which
an entity has provided termination
benefits related to exit or disposal
activities in the past. Footnote 7 to
Statement 146 states, “Absent evidence
to the contrary, an ongoing benefit
arrangement is presumed to exist if an
entity has a past practice of providing
similar termination benefits”
•• The similarity of the benefits to be
provided under the current termination
plan with termination benefits provided
under prior termination plans. For
example, consideration should be given
to, among other factors, the type of
benefits provided (e.g., severance
payments, outplacement job training),
the benefit formula used and the form
of payment (e.g., lump sum payments,
monthly payments)
SEC comments and trends Technology industry supplement, Issue 2: June 2009
Management’s Discussion and
Analysis (MD&A)
Material changes in financial statement line items and liquidity
and capital resources
Discussion of issues noted
Continuing a trend of the last few years,
technology companies are receiving more
SEC staff comments related to the quality
of their MD&A than any other category of
SEC staff comments, with the exception
of revenue recognition matters. Given
the current economic environment and
the negative implications for results of
operations, potential impairments, debt
covenant violations and going concern
considerations, we expect this level of
attention on the transparency of MD&A
disclosures to continue or even increase.
Recent SEC staff comments have focused on
two areas: (i) more meaningful and detailed
explanations of material period-to-period
changes and (ii) enhanced disclosures
around Liquidity and Capital Resources
(L&CR). This second point was emphasized
at the 2008 AICPA National Conference on
Current SEC and PCAOB Developments.
FR-72, Commission Guidance Regarding
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
(FR-72), provides the guidance to which
the SEC staff refers in the majority of these
comments. FR-72 was issued “… to avoid
boilerplate, and to embrace more meaningful
disclosure in MD&A.”
Specifically, MD&A should contain a
balanced, executive-level discussion that
identifies the most important themes
or other significant matters with which
management is concerned primarily in
evaluating the company’s financial condition
and results of operations. The SEC staff
believes that this discussion should reference
economic or industry-wide factors and
provide insight into material opportunities,
challenges and risks on which executive
management is most focused, including
those presented by known material trends
and uncertainties. This analysis also should
discuss the actions being taken to address
these opportunities, challenges and risks,
along with a detailed discussion of the
registrant’s ability to meet short-term and
long-term liquidity needs.
Overall, the SEC staff believes that the
purpose of MD&A is to provide “investors an
opportunity to look at the registrant through
the eyes of management by providing a
historical and prospective analysis of the
registrant’s financial condition and results of
operations, with particular emphasis on the
registrant’s prospects for the future.”
Analysis of current issues:
material changes in financial
statement line items
Instruction 4 to paragraph 303(a) of Item
303 of Regulation S-K requires companies
to discuss material changes in financial
statement line items from period to period.
The causes of material changes in financial
statement line items should be sufficiently
described to enable users to understand the
business as a whole. If a material change
is a result of multiple factors, each factor
should be described and quantified to the
extent practicable. This requirement to
disclose material changes applies to all
financial statements, not just the statement
of operations. The SEC staff typically
requests that registrants provide more
granular quantification and discussion about
the specific factors and underlying reasons
that contributed to material period-to-period
changes. For example, when MD&A cites two
or more qualitative reasons that contributed
to a material period-to-period change in a
financial statement line item, the SEC staff
requests that each reason be quantified and
analyzed to provide more robust disclosure.
The SEC staff also requests that MD&A
disclose whether the reasons contributing
to material changes represent trends that
are expected to have material future effects.
Overall, MD&A should provide information
about the quality and potential variability
of a company’s earnings and cash flows, so
that investors can ascertain the likelihood
that past performance is indicative of
future performance.
Analysis of current issues:
liquidity and capital resources
The SEC staff has identified the following
considerations for preparing the L&CR
disclosures:
•• Provide better analysis of the sources
and uses of cash — provide investors
with an overview of the liquidity and
capital resource concerns, including
expectations of differences regarding the
sources and uses of cash compared to
historical experience
SEC comments and trends Technology industry supplement, Issue 2: June 2009
7
•• Discuss changes in inflows and outflows
of cash from operating activities —
instead of providing a summary of the
statement of cash flows prepared using
the indirect method, the operating
activities discussion should provide
information on changes in cash received
from customers and other sources and
cash paid to suppliers, employees, etc.
•• Discuss any known trends and
uncertainties that could materially affect
the separate sources and uses of cash —
examples mentioned by the SEC staff
include new product releases, pricing
changes, maturing product lines, rising
costs and changes in credit terms
•• Evaluate capital expenditures and
anticipated funding sources — provide
transparency as to capital expenditures
that are discretionary versus those that
are nondiscretionary (e.g., new capacity
expansion versus maintenance of existing
capacity) and disclose the effect on cash
flows from customers associated with
reasonably likely reductions or delays in
capital expenditures
•• Explain the importance of the company’s
credit facility — the financing activities
discussion should outline the sufficiency
of unused availability under short-term
credit arrangements, the anticipated
circumstances requiring their use (e.g.,
seasonality of operations), any uncertainty
surrounding the ability to access funds
when needed and the implications from
being unable to access the funds
8
•• Discuss the company’s credit ratings,
credit rating prospects and implications —
rather than simply disclosing a
company’s credit rating from each of
the major credit rating agencies, a
company should discuss the factors
that might materially influence credit
ratings, the potential implications of
known or reasonably likely changes in
credit ratings (e.g., expected changes in
borrowing costs, costs of capital and the
future operating results of the company)
and management’s expectations about
credit rating prospects
Resources
EY Publication, Highlights: 2008 AICPA
National Conference on Current SEC and
PCAOB Developments (SCORE No. CC0271)
EY Publication, 2008 SEC Annual Reports —
Reports to Shareholders Form 10-K
(SCORE No. CC0267)
EY Publication, SEC in Focus – January 2009
(SCORE No.CC0273)
EY Checklist, SEC Annual Shareholders’
Report Checklist
•• Discuss the company’s compliance with
financial covenants and the material
implications of a breach — if material, a
company should discuss any uncertainty
or trends surrounding future compliance
with financial covenants. This discussion
might include likely credit ratings
downgrades and their effect on financial
covenants, and if a breach is reasonably
likely, then a company might discuss
whether it can avoid or cure the breach,
as well as the effect of the potential
breach on the company’s liquidity and
credit ratings
•• Discuss borrowing capacity, access and
sufficiency — a company should consider
discussing its capacity for additional
borrowing under its most restrictive
covenant, whether there is otherwise an
ability to raise these funds, whether this
amount would be sufficient or insufficient
for current and long-term needs and if
funding sources that have been available
in the past are no longer available
SEC comments and trends Technology industry supplement, Issue 2: June 2009
Reporting issues
Prior period misstatements
Discussion of issues noted
Companies may discover an error in
previously issued financial statements. The
SEC staff has frequently commented on a
registrant’s basis for assessing materiality
of prior period misstatements that may
or may not have resulted in a restatement
of financial statements. Specifically, the
SEC staff has requested registrants to
provide quantitative analysis, including an
evaluation on a line item basis, applying
the “rollover” and “iron curtain” methods,
and related qualitative considerations. In
the event prior period financial statements
are restated, the SEC staff has commented
on the transparency of disclosures and
the appropriateness of not filing a Form
8-K under Item 4.02, Non-Reliance on
Previously Issued Financial Statements or a
Related Audit Report or Completed Interim
Review.
Analysis of current issues
Materiality refers to the significance of
an item to users of financial statements.
Generally, a matter is “material” if there is
a substantial likelihood that a reasonable
person would consider it important. FASB
Concepts Statement No. 2, Qualitative
Characteristics of Accounting Information,
addresses the concept of materiality stating,
“[T]he omission or misstatement of an
item in a financial report is material if, in
the light of surrounding circumstances,
the magnitude of the item is such that
it is probable that the judgment of a
reasonable person relying upon the report
would have been changed or influenced
by the inclusion or correction of the item.”
Additionally, FASB Statement No. 154,
Accounting Changes and Error Corrections:
a replacement of APB Opinion No. 20
and FASB Statement No. 3 (Statement
154), requires that an error discovered
subsequent to the issuance of the financial
statements be reported as a prior period
adjustment by restating previously issued
financial statements.
The SEC staff has expressed its views with
respect to both quantitative and qualitative
factors to consider when evaluating the
materiality of an error in Staff Accounting
Bulletin (SAB) 99, Materiality (as codified
in SAB Topic 1.M). An analysis of a
misstatement’s materiality generally begins
with quantifying the potential misstatement.
In SAB 99, the SEC staff reminds registrants
that exclusive reliance on a percentage
or numerical threshold has no basis in
the accounting literature or the law. The
use of a percentage, such as 5%, as a
numerical threshold may provide the basis
for a preliminary assumption that, without
considering all relevant circumstances,
a deviation of less than the specified
percentage is unlikely to be material.
However, the SEC staff believes quantifying,
in percentage terms, the magnitude of a
misstatement is only the beginning of an
analysis of materiality. Such a quantitative
analysis is not a substitute for a full analysis
of all relevant considerations. SAB 99
provides a number of examples of factors
that may render material a quantitatively
small misstatement of the financial
statements, including a misstatement
that masks a change in earnings or other
trends, affects a segment or other portion
of the registrant’s business that has been
identified as playing a significant role in
its operations or profitability or affects the
registrant’s compliance with loan covenants
or other contractual requirements. The
examples listed by the SEC staff in SAB 99
are not intended to be all-inclusive.
SAB 108, Considering the Effects of Prior
Year Misstatements when Quantifying
Misstatements in Current Year Financial
Statements (as codified in SAB Topic 1.N),
further clarifies the quantitative aspect
of SAB 99 by specifically addressing
how to quantify uncorrected errors,
both individually and in the aggregate,
in the current year financial statements.
Specifically, a registrant must consider both
the “rollover” and “iron curtain” methods
in its materiality determination. The
“rollover” method quantifies misstatements
based on the effects of correcting the
misstatements that exist in the current
year income statement, including from the
reversal or correction of misstatements
that arose in prior years. The “iron curtain”
method quantifies misstatements based
on the effects of correcting misstatements
that exist in the balance sheet at the
end of the current year, regardless of
the misstatement’s year(s) of origin. In
addition, SAB 108 provides guidance on
the correction of misstatements, including
the correction of prior period financial
statements for immaterial misstatements.
SAB 108 does not specifically address
quantifying misstatements in interim
periods. However, we understand that the
SEC staff expects the guidance in SAB 108
to be applied to interim financial reporting.
As such, a registrant should correct any
known misstatements that arise in the
current interim period based on materiality
in relation to the current interim period, not
the estimated income for the full fiscal year.
However, a registrant also should consider
SEC comments and trends Technology industry supplement, Issue 2: June 2009
9
the additional interim period materiality
guidance in paragraph 29 of Accounting
Principles Board (APB) 28, Interim Financial
Reporting, which states “in determining
materiality for the purpose of reporting the
cumulative effect of an accounting change
or correction of an error, amounts should be
related to the estimated income for the full
fiscal year and also to the effect on the trend
of earnings. Changes that are material with
respect to an interim period but not material
with respect to the estimated income for the
full fiscal year or to the trend of earnings
should be separately disclosed in the interim
period.” We believe that the SEC staff may
publish additional guidance in the future
specific to materiality considerations in
interim reporting.
The SEC staff has stated that registrants
should use judgment in deciding the level
of detail to provide regarding an immaterial
correction of prior period financial
statements. Registrants should ensure that
transparent disclosure is provided about
the adjustments made. Statement 154
includes required disclosures for financial
statements that have been restated for the
correction of an error. However, consistent
with the application of FASB statements,
the provisions of Statement 154 need
not be applied to immaterial items. As a
result, the disclosures in Statement 154
are not required for immaterial errors.
Notwithstanding the immateriality of the
errors, registrants should disclose the fact
that they have corrected immaterial errors
in the prior period financial statements
and provide appropriate context for the
adjustments so that a reader is not confused
by the change. Registrants may wish to
put a notation on the face of the financial
statements, such as a reference to a
footnote that discusses the correction.
In the event that a registrant determines it
must correct previously issued interim or
annual financial statements for a material
error in those prior periods, it is the
registrant’s responsibility, in consultation with
its securities counsel, to determine whether it
is required to file a Form 8-K under Item 4.02.
However, the SEC staff frequently comments
when a registrant has not filed an Item 4.02
Form 8-K when its financial statements have
been restated to correct an error.
The SEC staff has acknowledged that an
Item 4.02 Form 8-K is not required for every
error correction affecting a registrant’s
previously issued financial statements (e.g.,
an immaterial restatement). However, in
these situations, the SEC staff has requested
that the registrant provide support for its
decision not to file an Item 4.02 Form 8-K, or
otherwise file a Form 8-K immediately.
Historically, some registrants have failed
to appropriately file a Form 8-K, based
erroneously on General Instruction B.3,
which provides that a Form 8-K need not
be filed if the registrant previously has
reported substantially the same information
as required by Form 8-K (e.g., in a timely
Form 10-Q or Form 10-K). The SEC staff
has reiterated its preference, consistent
with Question 1 of its November 2004 Form
8-K FAQs, that Item 4.02 events should be
reported using Form 8-K, irrespective of
whether the required information has been
disclosed in a periodic report or elsewhere.
Resources
EY Publication, SAB 108 Implementation
Guidance (available through GAAIT Online)
EY Publication, Compendium: 2006 AICPA
National Conference on Current SEC and
PCAOB Developments (SCORE No. CC0223)
Disclosure of related party transactions
Discussion of issues noted
We have observed an increase in the number
of comments received by registrants from
the SEC staff concerning the disclosure of
transactions with related parties. Historically,
the SEC has also undertaken numerous
enforcement actions against registrants
because of inadequate disclosure of the
existence of related party relationships
and transactions. The SEC staff believes
the disclosure of these transactions are of
significant interest to investors because
the economics inherent in a related party
10
transaction may not be reflective of what
would be achieved if the same transaction were
conducted with an unrelated party. Because
many technology companies conduct their
business, for instance, through collaborative
research arrangements, technology licensing
agreements, contract manufacturing and
other operational or administrative function
outsourcing, the transparency of required
related party disclosures should receive
appropriate attention.
Analysis of current issues
Transactions between unrelated parties
are presumed to be at arm’s length and,
thus, the substance of the transaction
can usually be evaluated on the basis
of objective evidence. In contrast, FASB
Statement No. 57, Related Party Disclosures
(Statement 57), indicates this presumption
cannot be justified in transactions
between related parties. As a result, it is
often difficult to objectively determine
the economic substance of related party
transactions. Accordingly, transactions
SEC comments and trends Technology industry supplement, Issue 2: June 2009
with related parties are generally not
required to be accounted for on a basis
different from that which would be required
if the parties were not related. It is for this
reason that transparent disclosures, as
required by Statement 57 and Item 404 of
Regulation S-K, Transactions with related
persons, promoters and certain control
persons (Item 404), are viewed as critical.
The definition of related parties within
Statement 57 includes concepts such as
(i) any party that controls, has significant
influence over or owns more than 10%
of the voting interests in an enterprise,
(ii) someone that can significantly
influence the management or operating
policies of the enterprise, management
of the enterprise or (iii) immediate family
members of any of these.
A registrant that enters into transactions
with a related party must disclose the
nature of the relationship, a description
of the transactions, the dollar amount of
transactions for each period for which
an income statement is presented and
the amount due to or from the related
party at the date of each balance sheet
presented. Furthermore, Rule 4-08(k) of
Regulation S-X, Related party transactions
which affect the financial statements,
requires that related party transactions
should be identified and the amounts stated
on the face of the balance sheet, income
statement or statement of cash flows.
Additionally, SEC Financial Reporting
Release No. 61, Commission Statement
about Management’s Discussion and
Analysis of Financial Condition and Results
of Operations, suggests that transactions
with certain other parties not within the
definition of “related parties” under US
GAAP or SEC rules, such as former senior
management, might require further MD&A
discussion to explain the importance of
relationships and transactions with these
certain other parties, if material.
Item 404 of Regulation S-K requires
certain transactions with related parties be
disclosed. The definition of related parties
within Item 404 contains concepts such as
directors, executive officers and beneficial
owners of more than 5% of any class of
voting stock, or immediate family members
of any of these. A registrant must disclose
the nature of any transaction with related
parties meeting the definition provided
by Item 404 if the transaction exceeds
$120,000. A registrant must also describe
its policies and procedures for the review,
approval or ratification of any transaction
required to be reported under Item 404
and identify any transaction required to be
reported if such policies and procedures did
not require review, approval or ratification,
or if such policies and procedures were
not followed. The information mandated
by Item 404 is required by Item 13 of
Form 10-K. This information is frequently
incorporated by reference from a
registrant’s proxy statement.
and SAB 79, Accounting for Expenses or
Liabilities Paid by Principal Stockholder(s)
(as codified in SAB Topic 5.T), generally
require expenses incurred on behalf of a
registrant by a parent company or principal
stockholder, respectively, to be reflected in
the registrant’s financial statements.
Resources
EY Publication, 2008 SEC Annual Reports —
Reports to Shareholders Form 10-K
(SCORE No. CC0267)
EY Publication, 2009 SEC Proxy
statements — An overview of the
requirements (SCORE No. CC0268 )
The SEC staff’s comments in this area
usually seek to understand a registrant’s
basis for excluding required disclosures
that describe the transaction fully
and transparently. While the SEC staff
frequently comments in this area,
management is typically sensitive to
additional disclosure given the nature
of the transactions. Notwithstanding
management’s concerns, the SEC staff
is often skeptical of these assertions and
wishes to see transparent disclosures.
It should be noted that management’s
sensitivity to disclosure of information that
it considers would cause competitive harm
for the registrant is the same standard that
would apply when a registrant requests
confidential treatment of confidential
trade secrets or confidential commercial or
financial information pursuant to Securities
Act Rule 406 and Exchange Act Rule 24b-2.
Stated differently, the SEC staff may be less
receptive to this assertion after the fact in
response to a comment letter, rather than
proactively in advance of the filing that
required the disclosure.
Finally, while the focus of financial reporting
for related party transactions is upon
transparent disclosure, SAB 55, Allocation
Of Expenses And Related Disclosure In
Financial Statements Of Subsidiaries,
Divisions Or Lesser Business Components Of
Another Entity (as codified in SAB Topic 1.B),
SEC comments and trends Technology industry supplement, Issue 2: June 2009
11
Requirements to name experts
Discussion of issues noted
The SEC staff has frequently commented on
filings that refer to an independent or thirdparty valuation or appraisal without naming
the preparer.
Analysis of current issues
In recent years, the SEC staff has requested
that registrants name any independent or
third-party valuation specialist or appraiser
whenever the registrant disclosed the use
of such an expert, regardless of whether or
not the disclosure stated that the registrant
took responsibility for any respective
statements or amounts. The SEC staff also
previously commented that the consent
requirements of Rule 436 of Regulation C
(Rule 436) apply to any reference to a third
party expert included in, or incorporated by
reference into, a Securities Act filing.
However, the SEC staff has recently relaxed its
previous position on this issue. In November
2008, the SEC staff published updated
Compliance and Disclosure Interpretations
(C&DI) relating to the Securities Act of
1933, which include clarifying guidance
about naming and obtaining the consent
of an expert in a Securities Act filing (e.g.,
Form S-1). Although the C&DI addresses this
question in the context of a Securities Act
filing, we believe the views expressed in the
C&DI also would apply to Exchange Act filings
(e.g., Form 10-K).
Question 141.02 of the C&DI states that
a registrant “has no requirement to make
reference to a third party expert simply
because the registrant used or relied on the
12
third party expert’s report or valuation or
opinion in connection with the preparation
of a Securities Act registration statement.”
Resources
EY Publication, SEC in Focus – January
2009 (SCORE No. CC0273)
The C&DI similarly concludes that the
requirements of Rule 436 to obtain and
file the consent of an expert depend on
the context of the disclosures about the
use of that expert. To the extent that any
statement or figure included or incorporated
by reference into a registration statement
is attributed to a third party expert (e.g.,
the financial statement notes disclose that
purchase price allocation figures were taken
from or prepared based on the report of
a third party expert), the C&DI notes that
Rule 436 would apply. On the other hand,
if the registrant merely discloses that it
“considered” or “relied in part” on the report
of a third party expert, or if the registrant’s
disclosures otherwise clearly attribute the
respective statements or amounts to the
registrant and not the third party expert,
the C&DI concludes that Rule 436 would not
apply. For example, the consent of the expert
would not be required if the registration
statement discloses that management or the
board prepared the purchase price allocations,
but in doing so, considered or relied in part
upon a report of a third party expert.
Consequently, when a registrant refers to
a third party expert, its disclosure should
make clear whether any related information
included or incorporated by reference into
the filing is a statement of the third party
expert, which would require the expert’s
consent, or a statement of the registrant,
which would not require the expert’s consent.
SEC comments and trends Technology industry supplement, Issue 2: June 2009
SEC comments and trends Technology industry supplement, Issue 2: June 2009
13
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