The SEC’s Most Wanted

What does the regulator most want to see in future financial filings? Recent comment letters suggest that the Securities and Exchange Commission has a keen interest in goodwill impairments, fair-value measurements, and credit-risk disclosures.

Last fall the Securities and Exchange Commission promised to scrutinize the regulatory filings of the largest financial institutions. So it’s little wonder that many of the recent comment letters sent by the SEC to corporations focused on the more controversial accounting issues that cropped up during the current financial crisis, including valuations of financial instruments and other-than-temporary impairments of securities.

The regulator has also niggled nonfinancial firms, by asking finance executives to better explain how they worked through goodwill impairment testing. Brad Davidson, a partner at accounting firm Crowe Horwath who recently compiled a list of frequent topics cited by SEC staffers in comment letters, says finance executives should keep the points raised by SEC staffers in mind as they put the finishing touches on their next round of financial reporting.

The Crowe Horwath file covers letters sent during the third quarter of 2008 and the first quarter of 2009. According to the accounting firm, some recent letters have asked SEC registrants to better explain why securities with fair values significantly below cost are not considered other-than-temporary impairments, discuss how the company confirmed third-party valuations, provide breakdowns of credit risk in loan portfolios, and justify the movement between the observable and unobservable inputs used to calculate fair values.

SEC comment letters are a “routine” part of the financial-reporting process, says Davidson, and usually do not lead to restatements. The letters are addressed to either the company’s CEO or CFO, and are crafted to extract more data from management beyond the figures in financial statements. Generally, companies collect input from their outside auditors and general counsel before they respond, notes Davidson.

“The SEC is trying, in these letters, to understand what the companies are doing in terms of disclosures, and then trying to help them improve disclosures going forward,” he adds.

One pervasive issue among the SEC letters is that of goodwill impairment, which affects companies of all types that reported faltering business units. Indeed, as CFO.com previously reported, more than 400 public companies recorded goodwill impairment charges in the past 12 months, according to data retrieved from CapitalIQ.

While goodwill write-downs have no effect on a company’s cash holdings, they imply that the business overpaid for a previous acquisition, which resulted in a hit to earnings. Under generally accepted accounting principles, goodwill — the intangible asset representing the excess amount above book value that one company pays for another in an acquisition — must be tested at least yearly or more frequently when a “triggering event” occurs. The testing process requires companies to account for the reduced value of an asset when its market value is lower than the amount assigned to it on the balance sheet.

For many companies last year, the credit crisis could have been interpreted as a triggering event, as rapidly falling stock prices dragged down the values of deals made during the M&A heyday. Earlier this year, for instance, Sprint Nextel wrote down the last $1 billion of its goodwill impairment for its 2005 purchase of Nextel, reflecting a $1.6 billion total loss for one quarter.

In recent comment letters to its registrants, the SEC staff asked about the timing of the impairment tests and what type of thinking went into the process, which prompted companies to promise to do better with their disclosures about these evaluations next time.

For example, CFO Dominic Romeo had to defend Idex Corp.’s goodwill impairment testing after an SEC staffer inquired about the manufacturer’s annual analysis. In a March letter, the regulator requested more information about why none of the company’s 14 reporting units were impaired in the final months of 2008.

In his five-page response, which explained how the company’s financial projections play a role in how it assesses impairments and which reporting units needed a second round of testing, Romeo promised to share more information about Idex’s accounting policy in future annual filings. The company did not respond to CFO.com’s request for further comment.

Romeo’s letter was one of many recently published to the Edgar database — the SEC does not release the comment letters publicly until the back-and-forth correspondence with companies is complete — that touched upon goodwill impairments. In other letters, the SEC asked companies to explain how they analyzed the difference between a reporting unit’s market capitalization and its book value, the facts and circumstances that led to an impairment, and why they believe they’ve met the disclosure requirements under FAS 142, the goodwill accounting rule.

Companies that paid attention to speeches made by SEC staffers late last year couldn’t have been too surprised by the topics brought up in subsequent comment letters. The staff generally gives the public a head’s up on many of the issues they will focus on in the coming year. For instance, John White, former head of the SEC’s corporate finance division, put the largest U.S. financial institutions on notice last October, announcing that their annual reports would be reviewed. Staffers also pledged to pay particular attention to how companies meet disclosure requirements related to uncertainties, liquidity, and credit risks.

The SEC does not review every financial filing it receives but is expected, under the Sarbanes-Oxley Act, to look at one filing from each public company at least once every three years. The commission may pay particular attention to certain types of companies at any given time, as well as firms with the largest market caps or the most volatile stock prices.

 

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