Is the Volume of Non-Financial Information Required under Regulation S-K Set to Increase?

Despite the current volume of non-financial information required under Regulation S-K, institutional investors are calling for more disclosure.

The burden of compiling the volume of non-financial information required under Regulation S-K often falls on the shoulders of the person responsible for compiling the financial information – the CFO – and the burden could be set to increase following the responses to a concept paper issued by the SEC in April.

Already the burden is a significant one. According to a survey conducted in March this year by software vendor CCH Tagetik, the non-financial information required under Regulation S-K (the “narrative”) accounts for 50% or more of the content in nearly half of financial reports – in some cases, the survey found, there is more than double the volume of non-financial information as there is financial information.

Typically, the narrative consists of an explanation of the results, a management and discussion analysis, and notes to the accounts. Whereas this level of narrative could be considered material non-financial information, institutional investors are calling for much more disclosure – so much more that concerns are being raised the volume of non-financial information that may be required under Regulation S-K could cause smaller investors an “information overload”.

CII Wants More Non-Financial Information Required under Regulation S-K

The SEC received more than 26,000 responses to the concept paper – among the bulk of them were letters calling for details to be disclosed about companies´ foreign subsidiaries and their sustainability plans – with many demanding that companies disclose their “human capital”. Brandon Rees, deputy director of the AFL-CIO’s Office of Investment, commented “Some two-thirds of the value of U.S. corporations comes from intangibles, and much of this comes from the employees, but if it’s not measured it’s not managed.”

Rees would like to see the disclosure of employee safety and health information, race and gender workforce composition, and employee turnover and retention rates; and Ken Bertsch, executive director of the Council of Institutional Investors (CII) agrees. Bertsch told “employees constitute one of the primary drivers of value in companies, and companies don’t have to disclose much about them.” Bertsch would also like to see reasons for a change of auditor and much tougher controls on non-GAAP reporting.

When addressed with the question that his members could suffer from “information overload”, Bertsch replied: “We just have not heard from our members that there’s huge concern about the volume of disclosures, other than that they’d like to see a better organized 10-K and that the proxy statement is too long.” However, Robyn Bew, director of strategic content development at the National Association of Corporate Directors, disagrees. She feels that enforcing a higher volume of non-financial information required under Regulation S-K could have a negative effect on smaller investors.

Bew said: “One of the things that we hear from investors is that an unintended consequence of mandatory disclosure rules is more boilerplate. Everybody wants disclosures to be more effective, but that can mean different things to different people. Larger investors can say ‘Give it all to us and we’ll figure out what we want,’ while smaller investors don’t have the resources to do that kind of data mining.” Bew concludes it would be more useful if companies and boards could do more of their own thinking without regulation.

Likely No Drastic Changes in the Near Future

The trend in financial reporting is for companies to err on the side of caution and burden SEC filings with disclosures that are not material. However, this may be an unnecessary overreaction to investor demands. In recent years the SEC has aligned its definition of what it considers necessary “material information” closer to that of the Supreme Court. Currently, financial and non-financial information is considered “material”:

“When used to qualify a requirement for the furnishing of information as to any subject, [materiality] limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”

Disclosure for the sake of disclosure can shift investor focus away from information that is actually material to company operations. Fortunately for CFOs who would rather see disclosures streamlined and the burden of narrative reporting eased, the SEC does not look as if it is going to act quickly on the calls for more non-financial information required under Regulation S-K.

The SEC is still attempting to fine-tune its Disclosure Effectiveness Initiative and, if the calls to disclose more non-financial information required under Regulation S-K are acted on by the SEC, this could undo the good work already accomplished by the Initiative and negatively impact investors by obscuring relevant information in company filings.

Are the SEC´s Rules for Non-GAAP Reporting Too Stringent?

An interesting debate is currently taking place at with regard to whether or not the SEC´s rules for non-GAAP reporting are too stringent.

In 2003, the Securities and Exchange Commission (SEC) enacted Regulation G requiring public companies to include in any disclosed non-GAAP financial measure a presentation and reconciliation of the most directly comparable GAAP financial measure. Prompted by a series of major corporate accounting scandals (Enron, AOL, Xerox, etc.), the objective of the Regulation was to prevent companies from presenting a rosier picture of their finances than was justified and to provide investors with a balanced financial disclosure.

In 2010 and 2016, the SEC issued compliance and disclosure interpretations that first (in 2010) relaxed prohibitions on excluding recurring expenses and then (in 2016) tightened interpretations of the Regulation in order to prevent non-GAAP measures being given greater prominence than comparable GAAP measures. The consequence of the 2016 update varies according to whose opinion you read. Some experts feel that the SEC´s rules for non-GAAP reporting are too stringent, while others feel they don´t go far enough.

The SEC´s Rules for Non-GAAP Reporting are Too Stringent

One expert clearly of the opinion that the SEC´s rules for non-GAAP reporting are too stringent is Charles Lundilius – Managing Director of the Berkeley Research Group. Mr. Lundilius disapproves of the rules for non-GAAP reporting that prohibit a company from recognizing revenue at the point when a customer is billed. Although claiming to understand the SEC’s concern about misleading revenue data, he finds it difficult to understand why this information cannot be provided as a non-GAAP metric.

“It merely reflects the fact that a bill was sent to a customer on a certain date”, Mr Lundilius argues on, “and it has a social benefit in that it provides a useful and comparable tool to analysts and other users of financial statements”. He continues his argument by claiming certain SEC´s rules for non-GAAP reporting prevent forensic accountants from monitoring and analyzing fraud, and concludes it with the statement – “The sales-as-billed prohibition is just one example of SEC overreach”.

The Rules are Needed to Keep Companies Honest

Two experts sharing opposing views are Jennifer Biundo and Kris Hutton. Ms. Biundo – a Senior Audit Manager at Mazars USA – argues that non-GAAP reporting can be relevant to help a company present critical operating measures of its business, but if not presented properly and consistently – and within the SEC´s rules for non-GAAP reporting – they can create ambiguities that can disrupt the true picture of a company´s financial health.

Both she and Kris Hutton – the Director of Product Management at ACL – believe the SEC´s rules are a response to faulty reporting standards. Mr. Hutton acknowledges traditional accounting metrics may not always be the most accurate way to judge a company’s value – especially in a fast-moving and evolving economy – but believes the SEC´s rules for non-GAAP reporting encourage better transparency, comparability, and consistency in non-GAAP disclosures.

Maybe it is Too Early to Decide

A fourth expert – Vincent Papa, the Interim Head of Financial Reporting Policy at the CFA Institute – joins the debate by commenting that it may be too early to tell whether the 2016 tightened interpretations of the SEC´s rules for non-GAAP reporting are too stringent. Although concurring with Charles Lundilius on the point that last year’s C&DIs may have adversely affected the usefulness of non-GAAP metrics, he adds that many investors expect sufficient regulatory oversight to ensure reporting is accurate.

The key appears to be balance. If companies only report such metrics to the extent management feels they are important for investors measuring the health of the business, this will likely create friction between analysts and company management. However, as Mr. Papa concludes his argument, the SEC objective of increasing transparency and pushing for greater comparability is aligned with investor interests and should continue – at least until the SEC ´s rules for non-GAAP reporting are universally considered too stringent.

CFO Concerns Ease about Brexit Impact on Business Environment

According to Deloitte´s quarterly CFO survey, the concerns of CFOs in the UK about the impact Brexit will have on the future business environment are easing.

In June last year, citizens of the United Kingdom voted narrowly to exit the European Union. The decision to leave – termed “Brexit” – created a sense of uncertainty across the business environment not only for companies in the UK, but also for companies within the EU and those who trade with the EU.

However, in Deloitte´s Q1 2017 CFO survey, financial concerns appear to be softening. 20% of the 130 CFOs surveyed were more optimistic about the financial prospects for their companies than they were three months ago, and there was a significant shift in focus from defensive strategies to expansionary strategies.

Expand while Credit Conditions Remain Benign

One of the reasons for the shift in focus is that credit remains cheap and easily available – although there is uncertain confidence it will remain that way after the United Kingdom leaves the European Union. The surveyed CFOs said that debt finance remained the most attractive source of funding for the present, and that equity issuance has become more appealing as the result of stronger equity markets.

In relation to the cost of borrowing, most CFOs expect the current Bank of England base rate to increase from 0.25% to 0.50% within a year – although some believe it could reach 1.25% even before the full implications of Brexit are known. Because of the expected increase in the cost of borrowing, the majority of respondents to the survey expressed an opinion that operating margins would fall over the next twelve months.

Researchers Identify Decline in the Perception of Risk

In each quarterly survey, researchers ask CFOs for their perception in risk in eight key areas. In six of the eight key areas – the impact of Brexit and subdued domestic demand among them – Deloitte reported a decline in the perception of risk. The two areas in which the perception of risk had increased were:

  • The prospect of higher interest rates and a general tightening of monetary conditions in the UK and US.
  • A bubble in housing and/or other real and financial assets and the subsequent risk of higher inflation.

David Sproul, Senior Partner and chief executive at Deloitte, remarked: “The UK’s exit from the EU is a long and uncertain process and business sentiment is changeable. But it is clear from this survey that the UK corporate sector enters the negotiation phase of Brexit in far better spirits than seemed likely in the months after last year’s referendum vote.”

Does Your Company Qualify for an R&D Tax Credit?

Changes to how the R&D tax credit is applied could have beneficial implications for companies of all sizes – provided they keep their documentation in order.

The Protecting Americans from Tax Hikes Act changed the way the R&D tax credit is applied. Effective for 2016 tax returns, companies that invest in research and development can factor a federal income tax reduction into their financial planning – rather than having to apply for it retrospectively – as the R&D tax credit is now a permanent fixture.

The changes to how the R&D tax credit is applied will save hundreds of thousands – or even millions of dollars – for companies of all sizes, and it is important to note that the credit is not limited to companies with recognized R&D departments. Any company that develops or improves products, software or processes could qualify subject to meeting the qualifying criteria.

Does Your Company Qualify for an R&D Tax Credit?

The qualifying criteria is vague and open to interpretation. It is suggested that any company that develops or improves products, software or processes seeks professional tax advice to ensure they qualify for the R&D tax credit, as this is one of the areas that comes under scrutiny during IRS audits. However, to be in the right area for a tax credit, a company has to invest in one of the following activities:

  • Technological experimentation in the fields of engineering, physics, chemistry, biology, or computer science.
  • The creation of a new or improved product or process that results in increased performance, function, reliability, or quality.
  • The elimination of a technical uncertainty about the development or improvement of a product or process.
  • Activities undertaken to eliminate or resolve a technical uncertainty that involve an evaluation of alternative solutions.

Costs that can be included in a tax return include salaries to employees involved in research and development, their managers and support staff. Related procurement, legal and computer leasing costs – including cloud computing services – can be included, as can a portion of payments made to U.S.-based contractors. Again, seek professional tax advice that relates to your specific circumstances.

If eligible, companies can claim the R&D tax credit retrospectively for the past three years (longer in some states with an extended tax statute) and carry forward credits if they have a zero tax liability or have previous made a loss. However, immutable documentation must be used to support the credit is essential, and it may save future headaches if you seek advice about what documentation is acceptable to support your claim.

CFO Role Expanding into Non-Financial Challenges

Results from several recent surveys suggest the role of the CFO is changing and expanding into new challenges such as cybersecurity and event response.

Following a tumultuous end to 2016, the business world is becoming more accustomed to unpredictability. Although there is reason to be cautious about what events will hold for CFOs during the remainder of 2017, there is also reason to be optimistic. A likely cut in corporation tax should bring a welcome boost to business, while technological advancements should help business leaders be better prepared for future unpredictability.

However, technological advancements alone will not enable a business to manage its way through a changing landscape, and CFOs – having the responsibility to ensure the financial stability of their companies – are having to step up and tackle many non-financial challenges such as HIPAA compliance and GDPR compliance. Indeed, according to one study by Adaptive Insights, 76% of CFOs report their finance teams track some non-financial KPIs today, and 46% of CFOs anticipate that number will increase in the next two years.

Cybersecurity the Biggest Challenge

As CFOs control the most sensitive data within companies, it could be argued it is the CFOs responsibility to control how the sensitive data is protected. Managing cybersecurity threats is a whole-of-company challenge but, as the finance function becomes more business-centric, CFOs are drawing on their risk management know-how and becoming more involved in risks assessments, addressing vulnerabilities, and breach recovery planning.

An increasing number of CFOs have been involved in cybersecurity since the Framework for Improving Critical Infrastructure Cybersecurity Version 1.0 was released in January 2014 and, in a recent Grant Thornton survey of 912 CFOs, 38% of respondents identified the CFO as the position most often responsible for cybersecurity, while 44% of finance leaders said they felt the most significant concern for their organization today is cybersecurity. 57% said undetected breaches were what worried them the most.

Adopting to Technology for Event Response

In addition to cybersecurity governorship, CFOs are having to educate themselves about technological advancements to help them measure and monitor business performance in a timely manner, without exposing the business to risk, but enabling it to take advantage of every possible opportunity. The technology allowing data to be processed in real time can help with identifying risks at an earlier stage and better decision-making, but many CFOs are encumbered by legacy systems that do not allow reporting teams to extract forward-looking insight from large, fast-changing data sets.

This challenge, and trends towards zero-based budgets and rolling forecasts, mean that CFOs have to be more agile. No longer is it enough to put an annual plan together and crunch the numbers month by month. EY’s DNA of the CFO survey reinforced this perception of a CFOs changing role when respondents to its survey said that skills that can help inspire and generate loyalty such as empathy, innovation and imagination becoming equally important as those used to manage finance teams.

Corporations Advised to Wait before Repatriating Cash

While uncertainty remains about future tax reforms and one-off tax discounts, corporations are being advised to wait before repatriating cash from overseas.

The news that two of Americas largest cash-rich companies – Microsoft and Apple – sold $27 billion of debt recently to fund their daily operations, repay maturing debt, and buy back shares, has got financial experts once again discussing potential tax reforms and President Trump´s pre-election pledge to offer a one-off tax discount to corporations repatriating cash from overseas.

The consensus of opinion is that whatever the future holds, corporations should refrain from bringing cash into the United States for the present, and follow the example of Apple and Microsoft – especially while borrowing rates remain close to their historic low of the last few years. This article explains the reasoning behind the consensus of opinion.

The Current U.S. Worldwide Tax System

Under the current arrangements for corporations with overseas operations, profits repatriated into the United States are subject to 35% tax, less a credit for any taxes paid in the overseas jurisdiction. For a corporation that returns a $100 million profit in an overseas jurisdiction with a 15% tax rate, this would mean a tax liability of $20 million if the funds were repatriated into the United States.

The current U.S. worldwide tax system is a disincentive for corporations to repatriate their profits if they are not required. The tax liability far exceeds the borrowing rate, which explains why Microsoft – with more than $100 billion on overseas cash assets – had to raise finance to complete the $26.2 billion acquisition of LinkedIn, and why Apple – with nearly twice as much hoarded overseas – borrowed $6.5 billion on 2015 to pay a dividend to company shareholders.

Would a Territorial Tax System be Any Better?

One of the options being discussed among a series of proposed tax reforms is a Territorial Tax System. This system would tax corporations on their domestic income only (as happens throughout much of the rest of the world), allowing corporations to repatriate cash from their overseas operations without having a tax liability other than in the jurisdiction in which the profit was made.

This proposal would seem to resolve Microsoft´s and Apple´s domestic cash issues, but it would be of no benefit to the Treasury – particularly if corporations removed money to low-tax jurisdictions to avoid paying the domestic rate of corporation tax. It appears that the only way a Territorial Tax System would work is if tax rates were significantly reduced to match those of overseas jurisdictions. Another loss to the Treasury.

Discounts Didn´t Work Before – Why Should They Now?

Among his pre-election pledges, President Trump was in favor of giving corporations a “one-time” tax discount on the cash they repatriated into the country. His plans included a 10% tax rate, followed by an end to the deferral of taxes on corporate income earned abroad. The tax revenues raised would help fund many other pre-election pledges and help create thousands of jobs.

Those with long memories may recall that, in 2004, the Bush administration passed the American Jobs Creation Act – an Act that permitted U.S. corporations to repatriate cash from overseas for a “one-off” discounted tax rate of 5.25%. The motive behind the Act was to “spur increased domestic investment”. In 2011, the U.S. Senate Permanent Subcommittee on Investigations reported there was no evidence of increased investment and that the money had gone into share buybacks, higher executive salaries and increased dividends.