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Seven key changes in annual reporting

Jim Brendel //February 7, 2012//

Seven key changes in annual reporting

Jim Brendel //February 7, 2012//

Regulators are favoring more disclosure in annual reports prepared for public companies for fiscal year 2011, but they are also bringing in a dose of reasonableness in regards to burdensome valuation requirements. Here are seven changes in annual reporting that you need to know for 2011 year-end reports:

1. Goodwill impairment evaluation – There are two changes in this area, one of which will give a little relief to companies that believe that yearly valuations of goodwill are onerous. Goodwill is the premium that the company paid over the value of the other assets when acquiring another company.

The first allows companies the option of assessing qualitative factors before performing step one of the two-step formal impairment evaluation. If, based on a review of the relevant facts and circumstances, it is unlikely that fair value of the reporting unit is less than its carrying value, the company can avoid obtaining an annual valuation.

For example, if the business environment is good and revenue and cash flows are increasing, there’s no reason to believe there is a potential impairment. On the other hand, if business conditions are adverse – say your union is giving you trouble, or there is increased competition that leads to pressure on margins – you probably need to go through a formal impairment evaluation process.

2. The second change, also a goodwill issue, relates to reporting units that have a negative book value. You see this most in cases in which a subsidiary has debt that exceeds the book value of its assets. In the past, some companies believed that in this circumstance, goodwill could never be impaired because the fair value of the reporting unit would always be greater than the negative net book value. The new rules require companies to evaluate the unit for potential impairment if the reporting unit has a negative book value, and qualitative factors exist that indicate it is likely that a goodwill impairment exists. If this is the case, companies will have to perform the required annual impairment analysis.

3. Fair value measurement disclosures – In order to provide more information to investors, significant additional disclosures are required for 2011 annual reports, including:
a. Disclose fair value measurements by “class” rather than “major category.” A class is generally a subset of a balance sheet line item. For example, equity investment holdings will be broken out into common and preferred stock.
b. Disclose transfers in or out of Level 1 and Level 2 class assets and the reason for them. Level 1 assets have quoted market prices with reliable measurement. Level 2 assets have some kind of valuation model with observable inputs that have to be applied; for example, real estate with comparable sales.
c. Level 3 assets, which use a valuation model that doesn’t have any observable inputs (such as stock in a private company) will require “roll-forward” disclosure, or both the prior and current year values.
d. Companies will have to disclose which valuation techniques and information are used in calculating fair value.

4. Use of third-party pricing services – The SEC has expressed concern about the level of reliance that some companies place on third-party pricing services to help them value financial instruments. According to Business Valuation Wire newsletter, “Valuation professionals stand apart from other significant contributors to the financial reporting process for…their lack of a unified identity,” said Paul Beswick, deputy chief accountant for the SEC. The fragmented nature of the profession creates an environment where expectation gaps can exist between valuators, management, and auditors, as well as standard setters and regulators, BV Wire said.

If you use these services, you can expect questions such as how you evaluated the pricing service’s valuation model, how you ensured that the data they used was accurate and complete, and that the assumptions they used are consistent with GAAP.

5. Employee stock options denominated in a foreign currency – Companies whose stock is listed on an exchange outside their home country often grant employee stock options with the exercise price based on the currency in the country where the stock trades. Typical example: A Denver-based mining company that trades on the Toronto Stock Exchange grants options to Canadian field employees with strike prices in Canadian dollars. Until recently, those options had to be recorded as a liability rather than as equity, and continually marked to market value. Under the new rules, the options can be treated as equity, and are no longer marked to market after issuance.

6. Loss contingencies – While no new rules have been issued, both the Financial Accounting Standards Board and the SEC are concerned about the level of disclosure given to loss contingencies (principally litigation) prior to settlement of the case. Companies should carefully consider their disclosures and accounting as litigation evolves over time, and should expect questions when there is an accrual for settled litigation if there has been little disclosure of the matter during the time leading up to the resolution of the matter. The SEC wants companies to disclose when material events occur in cases.

7. Risk factors – The SEC issued new guidance in October 2011 regarding disclosure of cyber-security risks and cyber incidents. The consequences of cyber incidents can be significant, and companies whose operations could be disrupted by a hacker attack, or have privacy law impacts, should carefully consider the disclosure guidelines in this release. Companies that own their own databases with sensitive data are particular targets of these new rules.