SEC streamlines and modernizes financial disclosure

The SEC has issued final rules to modernize, simplify and enhance certain financial disclosure requirements in Regulation S-K. These rules continue the SEC’s effort to implement a principles-based, registrant-specific approach to disclosure, intended to provide investors material information relevant to the financial condition and results of operations of the registrant and to allow investors to view the registrant from management's perspective. The rules are also intended to improve disclosure by enhancing its readability, discouraging repetition and eliminating information that is not material.

The primary changes in the new rules are:

• Eliminate the requirement to present selected financial data (Regulation S-K Item 301).
• Only require supplementary financial information (Regulation S-K Item 302(a)) if there have been certain changes that have retrospective effect on historical financial disclosure.
• Eliminate the requirement to present the contractual obligations table (Regulation S-K Item 303(a)(5)), which is replaced with the requirement to discuss such matters in the broader context of Management’s Discussion & Analysis of Financial Condition and Results of Operations (MD&A).
• Eliminate the requirement to discuss off-balance sheet arrangements under a dedicated caption (Regulation S-K Item 303(a)(4)), which is replaced with the requirement to discuss such matters in the broader context of MD&A.
• Permit registrants to compare their most recently completed quarter to either the corresponding quarter of the prior year (as is currently required) or the immediately preceding quarter (Regulation S-K Item 303(c)).

The rules also make numerous technical and conforming changes throughout MD&A, to Forms 20-F and 40-F for foreign private issuers, and to other SEC rules and forms.  This alert provides a detailed summary of the rules as well as two charts summarizing them.

Elimination of Selected Financial Data (Item 301)

The revised rule eliminates Item 301, which required registrants to furnish selected financial data in comparative tabular form. Acknowledging that the earlier two years currently required by Item 301 can help illustrate material trends, the SEC noted that this disclosure is typically available in prior filings and emphasized that material trend disclosure should appear in MD&A.

Simplification of Supplementary Financial Information (Item 302)

Although the SEC had proposed to eliminate Item 302, the final rule retains but simplifies Item 302(a). Disclosure is only required when there are one or more retrospective changes that pertain to the statements of comprehensive income for any of the quarters in the two most recent fiscal years and any subsequent period for which financial statements are included or required by Article 3 of Regulation S-X and that, individually or in the aggregate, are material.  “Retrospective changes” include, for example, corrections of errors, discontinued operations, reorganization of entities under common control, or a change in an accounting principle that requires retrospective application. When triggered, amended Item 302(a) requires registrants to provide an explanation of the reasons for such material changes and to disclose, for each affected quarter (which may be a single quarter), summarized financial information related to the statements of comprehensive income and earnings per share reflecting such changes.

Reorganization of MD&A (Item 303)

The SEC has reorganized and streamlined MD&A, essentially as follows:

• Newly issued Item 303(a) states the objectives of MD&A.
• Item 303(b), which renames and amends current Item 303(a), addresses full fiscal year disclosure, providing for three main requirements:
  • Item 303(b)(1) provides overarching disclosure requirements for liquidity and capital resources, with enhanced principles-based requirements focused on material short- and long-term cash requirements.
  • Item 303(b)(2) provides disclosure requirements for results of operations.
  • Item 303(b)(3) requires disclosure of critical accounting estimates.
• The instructions to Item 303(b) have been streamlined, notably to replace the disclosure of off-balance sheet arrangements in current Item 303(a)(4) with an instruction to discuss them in the broader context of MD&A.
• Item 303(c) addresses interim period disclosure, allowing registrants to determine whether to compare sequential or year-over-year interim periods. The instructions have also been streamlined.
• Current Item 303(a)(5), which required the inclusion of a contractual obligations table, has been eliminated, and current Items 303(c) and 303(d) are therefore eliminated as conforming changes.

A more detailed comparison of the current and amended structure of Item 303 is set forth below as Annex I.

Objectives of MD&A (Amended Item 303(a))

Amended Item 303(a) calls for the following disclosure, which the SEC believes will better allow investors to view the registrant from management’s perspective:

• Material information relevant to an assessment of the financial condition and results of operations of the registrant, including an evaluation of the amounts and certainty of cash flows from operations and from outside sources.
• Material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations as well as matters that are reasonably likely, based on management’s assessment, to have a material impact on future operations.
• The material financial and statistical data that the registrant believes will enhance a reader’s understanding of the registrant’s financial condition, cash flows and other changes in financial condition and results of operations.

Registrants should regularly revisit these objectives and consider ways to enhance the quality of the analysis, with an emphasis on a registrant’s future prospects, materiality and trend disclosures.

Reasons underlying material changes (Amended Item 303(b))

The SEC re-captioned current Item 303(a) as Item 303(b), which continues to apply to all MD&A disclosure, and included in Item 303(b) the portion of current Instruction 4 that requires, in the event that the consolidated financial statements reveal material changes from year to year in one or more line items, a description of the causes for such changes. The SEC emphasized the importance of providing a more meaningful discussion of the underlying reasons that may be contributing to material changes in line items. The final rule also clarifies that registrants should discuss material changes within a line item even when such material changes offset each other.

Segment information and other subdivisions (Amended Item 303(b))

Amended Item 303(b) adds “product lines” as an example of a subdivision of a registrant’s business that should be discussed where (and only where), in the registrant’s judgment, it is necessary to an understanding of the registrant’s business.

The SEC also adopted several amendments to streamline the text of Item 303, such as reorganizing and deleting instructions.

Capital Resources – Material Cash Requirements (New Item 303(b)(1) and Amended Item 303(b)(1)(ii))

The SEC amended Item 303(a)(2) as new Item 303(b)(1) and amended Item 303(b)(1)(ii) to require a description of a registrant’s material cash “requirements,” including commitments for capital expenditures, the anticipated source of funds needed to satisfy such cash requirements, and the general purpose of such requirements. In requiring disclosure of known material cash requirements beyond capital expenditures (which generally refers to capital investments in property, plant and equipment), Item 303(a)(2) is modernized for companies in which expenditures and cash commitments for matters such as human capital or intellectual property are increasingly important.

Results of Operations – Known Trends or Uncertainties (Amended Item 303(b)(2)(ii))

Amended Item 303(b)(2)(ii) provides that, when a registrant knows of events that are reasonably likely to cause (as opposed to “will” cause) a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials, price increases or inventory adjustments, such anticipated change must be disclosed. This “reasonably likely” threshold applies throughout Item 303, and it is based on “management’s assessment.”

The SEC’s final rule explains in detail how registrants should analyze and disclose information regarding known trends, demands, commitments, or uncertainties (“Known Trends”):

• If the Known Trend is reasonably likely to come to fruition and would have a material effect on the registrant’s future results or financial condition, disclosure is required.
• If management is unable to assess whether the Known Trend is likely to come to fruition, and it would be reasonably likely to have a material effect on the registrant’s future results or financial condition were it to come to fruition, disclosure is required if a reasonable investor would consider omission of the information as significantly altering the mix of information made available in the registrant’s disclosures.
• Disclosure is never required for immaterial or remote future events.

This approach does not require registrants to affirm the non-existence or non-occurrence of a material future event. Instead, it requires management to make a thoughtful and objective evaluation, based on materiality, including where the fruition of future events is unknown. In this regard, the SEC intentionally did not adopt the probability/magnitude test in Basic v. Levinson, to avoid the disclosure of high magnitude events of low probability.

Results of Operations – Net Sales and Revenues (Amended Item 303(b)(2)(iii))

Amended Item 303(b)(2)(iii) codifies prior guidance requiring disclosure of “material changes” in net sales or revenues, rather than “material increases” in these line items.

Results of Operations – Inflation and Price Changes (Current Item 303(a)(3)(iv), and Current Instructions 8 and 9 to Item 303(a))

The SEC eliminated Item 303(a)(3)(iv) and Instructions 8 and 9 regarding the impact of inflation and price changes to encourage registrants to focus their MD&A on material information that is tailored to their respective facts and circumstances.

Off-Balance Sheet Arrangements (New Instruction 8 to Item 303(b))

The SEC has eliminated Item 303(a)(4), which currently requires a separately designated section disclosing off balance sheet arrangements, and replaced it with a new Instruction to Item 303(b), which requires registrants to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on a registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources.

Contractual Obligations Table (Current Item 303(a)(5) and Amended Item 303(b)(1))

The SEC has eliminated Item 303(a)(5), which currently requires the disclosure of known contractual obligations in tabular format.  In addition, the SEC amended Item 303(b) to specifically require disclosure of material cash requirements from known contractual and other obligations as part of the registrant’s liquidity and capital resources discussion. Emphasizing a principles-based approach focused on material short- and long-term liquidity and capital resources needs, the amendments clarify that material cash requirements from known contractual and other obligations are part of those disclosures.

Critical Accounting Estimates (New Item 303(b)(3))

New Item 303(b)(3) explicitly requires disclosure of critical accounting estimates, which refers to those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant. Registrants must provide qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the critical accounting estimate has had or is reasonably likely to have on financial condition or results of operations to the extent the information is material and reasonably available. This information should include why each critical accounting estimate is subject to uncertainty and, to the extent the information is material and reasonably available, how much each estimate or assumption has changed over a relevant period, and the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation.

The item specifically references “assumptions” in addition to estimates to make clear that registrants have flexibility to provide appropriate context in the discussion of changes underlying a critical accounting estimate. This requirement, along with the required sensitivity disclosure, is intended to provide investors a greater understanding of the variability that is reasonably likely to affect the registrant’s financial condition or results of operations.

In addition, new Item 303(c) requires registrants to discuss material changes to the full fiscal year disclosures in discussion of interim periods.

Interim Period Discussion (Amended Item 303(c))

New Item 303(c) permits registrants to compare their most recently completed quarter to either the corresponding quarter of the prior year (as is currently required) or the immediately preceding quarter. If a registrant elects to discuss changes from the immediately preceding quarter, the registrant must provide summary financial information that is the subject of the discussion for that quarter or identify the prior EDGAR filing that presents such information so that a reader may easily access  the referenced prior quarter financial information. In addition, if in a subsequent Form 10-Q a registrant changes the periods used in its comparison from those presented in the immediately prior Form 10-Q, the registrant must explain the reason for the change and present both comparisons in the filing where the change is announced.  The SEC believes providing registrants flexibility as to the comparative periods to use in MD&A will enable registrants to provide more tailored and meaningful analysis that is relevant to their specific business cycles, while also providing investors material information to assess quarterly performance.

Additionally, the SEC adopted several amendments to further streamline the item and conform it to the other amendments adopted.

Safe Harbor for Forward-Looking Information (Current Item 303(c))

The SEC eliminated current Item 303(c) regarding safe harbors for forward-looking statements. With the integration of disclosure regarding off-balance sheet arrangements and contractual obligations into MD&A more broadly, the SEC believes the ambiguity that motivated its adoption of current Item 303(c) no longer exists. As a result, whether disclosure related to contractual obligations or off-balance sheet arrangements constitutes forward-looking statements that fall under the protections of applicable safe harbors would be evaluated consistently with other forward-looking disclosures in MD&A. The amendments do not alter the availability or scope of these safe harbors to any potion of Item 303.

Smaller Reporting Companies (Current Item 303(d))

Because of the elimination of current Items 303(a)(3)(iv) and (a)(5), the SEC also eliminated current Item 303(d), which contains requirements relating to smaller reporting companies.

Application to Foreign Private Issuers

The SEC also adopted corresponding amendments to Form 20-F, Form 40-F, and Item 303 references applicable to FPIs that choose to file on domestic forms.

Compliance Date

The final rules will become effective 30 days after publication in the Federal Register. Registrants will be required to apply the amended rules for their first fiscal year ending on or after the date that is 210 days after publication in the Federal Register (the “Mandatory Compliance Date”). Registrants must apply the amended rules in a registration statement and prospectus that, on its initial filing date, is required to contain financial statements for a period on or after the Mandatory Compliance Date.

Nevertheless, registrants are permitted to provide disclosure consistent with the amended rules any time after the effective date, so long as they provide disclosure responsive to an amended item in its entirety.

Conclusion

The SEC’s new rules are unlikely to have a major impact on the disclosure approach of most companies, but their simplifications will certainly impact disclosure.  In particular, registrants will need to disclose contractual obligations and off-balance sheet arrangements in the broader context of MD&A, rather than in a dedicated table or a separately captioned subsection, and delete selected financial data.  In addition, while registrants may usually delete supplementary financial information, they should develop disclosure controls and procedures that consider if retrospective changes may trigger disclosure of such information.  The many technical changes in rules and instructions will also require updating disclosure checklists and similar tools registrants use in connection with filings.

With the leadership changes at the SEC following the election, we are carefully monitoring all rule changes and SEC guidance.  For more information about how the developments may impact you, please contact the authors or your DLA Piper contact. 

 

ANNEX I

Summary of amendments to Item 303

Current Item or Issue	Summary Description of Amended Rules	Principal Objective(s)
Item 301, Selected financial data	Registrants will no longer be required to provide 5 years of selected financial data.	Modernize disclosure requirement in light of technological developments and simplify disclosure requirements.
Item 302(a), Supplementary financial information	Registrants will no longer be required to provide 2 years of tabular selected quarterly financial data. The item will be replaced with a principles-based requirement for material retrospective changes.	Reduce repetition and focus disclosure on material information. Modernize disclosure requirement in light of technological developments.
Item 303(a), MD&A	Clarify the objective of MD&A and streamline the fourteen instructions.	Simplify and enhance the purpose of MD&A.
Item 303(a)(2), Capital resources	Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements, and the general purpose of such requirements.	Modernize and enhance disclosure requirements to account for capital expenditures that are not necessarily capital investments.
Item 303(a)(3)(ii), Known trends or uncertainties	Registrants will need to disclose known events that are reasonably likely to cause a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments.	Clarify item requirement by using a disclosure threshold of “reasonably likely,” which is consistent with the Commission’s interpretative guidance on forward-looking statements.
Item 303(a)(3)(iii), Results of operations	Clarify that a discussion of material changes in net sales or revenue is required (rather than only material increases).	Clarify MD&A disclosure requirements by codifying existing Commission guidance.
Item 303(a)(3)(iv), Results of operations Instructions 8 and 9 (Inflation and price changes)	The item and instructions will be eliminated. Registrants will still be required to discuss these matters if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations.	Encourage registrants to focus on material information that is tailored to a registrant’s businesses, facts, and circumstances.
Item 303(a)(4), Off-balance sheet arrangements	The item will be replaced by a new instruction to Item 303. Under the new instruction, registrants will be required to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on such registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidated balance sheets.	Prompt registrants to consider and integrate disclosure of off-balance sheet arrangements within the context of their MD&A.
Item 303(a)(5), Contractual obligations	Registrants will no longer be required to provide a contractual obligations table. A discussion of material contractual obligations will remain required through an enhanced principles-based liquidity and capital resources requirement focused on material short- and long-term cash requirements from known contractual and other obligations.	Promote the principles-based nature of MD&A and simplify disclosures.
Instruction 4 to Item 303(a) (Material changes in line items)	Incorporate a portion of the instruction into amended Item 303(b). Clarify in amended Item 303(b) that where there are material changes in a line item, including where material changes within a line item offset one another, disclosure of the underlying reasons for these material changes in quantitative and qualitative terms is required.	Enhance analysis in MD&A. Clarify MD&A disclosure requirements by codifying existing Commission guidance on the importance of analysis in MD&A.
Item 303(b), Interim periods	Registrants will be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quarter. Registrants subject to Rule 3- 03(b) of Regulation S-X will be afforded the same flexibility.	Allow for flexibility in comparison of interim periods to help registrants provide a more tailored and meaningful analysis relevant to their business cycles.
Critical Accounting Estimates	Registrants will be explicitly required to disclose critical accounting estimates.	Facilitate compliance and improve resulting disclosure. Eliminate disclosure that duplicates the financial statement discussion of significant policies. Promote meaningful analysis of measurement uncertainties.

 

This table is based on the similar table presented on pages 8-9 of the SEC Release adopting the final rules.  The information presented is not comprehensive. It does not reflect all of the amendments or all of the rules and forms that are affected. This table should be read together with all changes discussed in their entirety in the Release.

 

ANNEX II

Comparison of current and amended structure of Item 303

Current Structure	Amended Structure
N/A	Item 303(a), Objective
Item 303(a), Full fiscal years	Item 303(b), Full fiscal years
Item 303(a)(1), Liquidity Item 303(a)(2), Capital resources	Item 303(b)(1), Liquidity and Capital Resources Liquidity Capital Resources
Item 303(a)(3), Results of operations Unusual or infrequent events Known trends or uncertainties Material increases Inflation and changing prices	Item 303(b)(2), Results of operations Unusual or infrequent events Known trends or uncertainties Material changes
Item 303(a)(4), Off-balance sheet arrangements Instructions 1, 2, 3, 4, and 5 to Item 303(a)(4)	Replace with Instruction 8 to Item 303(b)
Item 303(a)(5), Tabular disclosure of contractual obligations	Eliminate (with some content incorporated into Item 303(b)(1), Liquidity and Capital Resources, and Instruction 4 to Item 303(b))
2003 MD&A Interpretative Release, Critical accounting estimates	Item 303(b)(3), Critical accounting estimates
Instruction 1 to Item 303(a)	Instruction 1 to Item 303(b) (with amendments)
Instruction 2 to Item 303(a)	Eliminate (with content incorporated into Objective)
Instruction 3 to Item 303(a)	Eliminate (with content incorporated into Objective)
Instruction 4 to Item 303(a)	Instruction 2 to Item 303(b) (with amendments and some content incorporated into Item 303(b))
N/A	Instruction 3 to Item 303(b)
Instruction 5 to Item 303(a)	Instruction 4 to Item 303(b) (with amendments and content incorporated into Item 303(b)(1), Liquidity and Capital Resources)
Instruction 6 to Item 303(a)	Instruction 5 to Item 303(b) (with minor amendments)
Instruction 7 to Item 303(a)	Instruction 6 to Item 303(b)
Instruction 8 to Item 303(a)	Eliminate
Instruction 9 to Item 303(a)	Eliminate
Instruction 10 to Item 303(a)	Instruction 7 to Item 303(b)
Instruction 11 to Item 303(a)	Instruction 9 to Item 303(b) (with amendments)
Instruction 12 to Item 303(a)	Instruction 10 to Item 303(b) (with non-substantive amendments)
Instruction 13 to Item 303(a)	Eliminate
Instruction 14 to Item 303(a)	Eliminate
Item 303(b), Interim periods Material changes in financial condition Material changes in results of operations, Rule3‑03(b) of Regulation S-X matters	Item 303(c), Interim periods Material changes in financial condition Material changes in results of operations Material changes in results of operations (year-to-date) Material changes in results of operations (quarter comparisons)
Instruction 1 to Item 303(b)	Instruction 1 to Item 303(c) (with amendments to reference Instructions 2, 3, 4, 6, 8, and 11 to proposed Item 303(b))
Instruction 2 to Item 303(b)	Eliminate
Instruction 3 to Item 303(b)	Eliminate
Instruction 4 to Item 303(b)	Instruction 2 to Item 303(c)
Instruction 5 to Item 303(b)	Eliminate
Instruction 6 to Item 303(b)	Eliminate
Instruction 7 to Item 303(b)	Eliminate
Instruction 8 to Item 303(b)	Instruction 11 to Item 303(b)
Item 303(c), Safe harbor	Eliminate
Item 303(d), Smaller reporting companies	Eliminate

 

This table is based on the similar table presented on pages 26-28 of the Release.  The information presented is not comprehensive and is intended only to summarize the general structure of the current rules and final amendments. It does not reflect all of the amendments or all of the rules and forms that are affected. This table should be read together with all changes discussed in their entirety in the Release.