SEC Regulation S-X
SEC Regulation S-X- Today is the continuation in a Lawcast series discussing SEC disclosure requirements and in particular the 341 page Regulation S-K concept release and request for public comment issued by the SEC on April 15, 2016.
Although many aspects of disclosure are important, I believe none are quite as important as the financial information and future prospects. Regulation S-X contains the actual financial statement disclosure requirements, and Item 303 of Regulation S-K contains the narrative discussion requirements related to that financial information. This management, discussion and analysis called “MD&A” not only delivers an explanation of the financial statements, but provides a unique opportunity in SEC reporting for a company to illustrate its distinctiveness among a sea of other fish.
MD&A is intended to provide a narrative of a company’s financial statements and future prospects through the eyes of management. The Regulation S-K Concept Release clearly shows the SEC propensity to use a principles and materiality approach for MD&A and to steer away from a recitation of the financial statements themselves. The SEC also recognizes the concerns that a company has in presenting forward-looking information, and in particular, 10b-5 liability if the plans do not turn out as disclosed.
In recent years management has used MD&A to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies use MD&A to provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number often included by management in MD&A. The SEC is pushing back with the proliferation of the use of these non-GAAP numbers, and is considering strengthening Regulation G which governs the use of non-GAAP numbers and requires, among other things, a reconciliation to the GAAP number. The topic has been the subject of a multitude of recent trade journals and articles.
There are very valid reasons for using non-GAAP numbers, such as EBITDA, which is an established indicator of a company’s performance and ability to meet financial obligations. Likewise, certain non-cash balance sheet items, such as derivative liability related to options, warrants, and other convertible instruments, are confusing and often are never realized in a way that has an actual impact on a company’s performance. However, there can be a slippery slope with a company cherry-picking GAAP and non-GAAP numbers to create a picture of financial stability that may not be accurate. I hope that in reviewing this area, the SEC is not myopically stuck on the purity of its view of GAAP, but considers that if 90% of companies find a need to go outside the rules, perhaps the rules themselves need some adjustment.