SEC “Seeking Small Business Input”

In line with President Obama’s recent Executive Order relating to regulation and the regulatory environment the SEC is seeking input on topics that specifically impact smaller reporting companies. 

In the request for comments they state “We are particularly interested to hear your views on rules that affect smaller reporting companies, as well as smaller companies that are not subject to the Commission’s reporting requirements but seek to raise capital in the exempt markets.”

The SEC request is looking for comments within the following 3 areas where you can post and read comments posted by others:

• Regulations and Exemptions Relating to the Offer and Sale of Securities
• Disclosure and Reporting Requirements
• Updating Commission Rules to Promote Economic Growth

As of today there are very few comments posted and most of them relate to exempting smaller reporting companies from the XBRL requirements citing cost constraints. 

I urge everyone in the smaller reporting company arena to take advantage of the opportunity to make suggestions.

The Not-So-Great Smaller Reporting Company Fair Value Debate

My favorite question from clients that doesn’t appear to have a good answer, despite what we generally tell them, is “How do we account for this note payable that we just issued along with shares of stock?”  The simple non-useful auditor answer – “just account for the transaction at its fair value.”

This answer has sparked seemingly endless discussion amongst the team members in our firm along with our clients which we fondly refer to as the “Circle of Hate” discussions.  Consider the following example:

Company X issues a three year $100,000 note payable with a stated interest rate of 15% in a private placement transaction.  In order to get interest from potential investors, the Company also issues 1,000,000 shares of Rule 144 restricted common stock.  The quoted market price on the issuance date is $0.15 and the average daily trading volume is 5,000 shares.  Again, the question is what is the value of debt on the issuance date, and how does that value change as time passes through maturity?

Scenario 1

Probably the most popular amongst small issuers that I have seen, although not without significant flaws, is to value the shares first into APIC and assign the corresponding discount to the debt and begin accreting the debt.  The flaws(issues) with this methodology in the example above are significant.  Strictly adhering to the Level 1 input of the quoted price (in this example assume under GAAP the quoted market price is the most reliably measurable) the discount on the $100,000 debt is $150,000.  This leaves what we refer to as the “floating debit” of $50,000. 

Now what to do with the $50,000 has been of great internal debate with seemingly no winning choice.  The apparent precedent amongst issuers is to cap the value at the proceeds received of $100,000, ignore the remaining $50,000, and begin accreting the debt from zero.  One major problem with this approach is there is not a way to calculate an effective interest, as required by GAAP, to accrete from zero.  Issuers, however, seem to get around this by disclosing the following “we amortize the debt discount over the life of the loan using the straight line method which approximates the effective interest method”.  Since there really is not a way to calculate the effective interest rate I am not real sure how this can be the case, but seems to be working for several issuers.

A second option that does not appear to make sense, is to book the $50,000 as a prepaid loan cost of some sort and amortize it over the life of the loan.  Again, there appears to be some GAAP basis in that debt issuance costs are required to be amortized over the life of the loan.  This methodology just doesn’t pass the smell test.  Why?   The issuer has a $100k obligation which does not initially appear on its balance sheet, but $150k in assets($50k of which doesn’t generally meet the definition of an asset), $0 liability, and $150k increase in capital.  I can’t think of a way to make entering into a financial obligation look any better.

Another popular strategy, although difficult to support in most instances, is to discount the quoted market price of the stock.  Most issuers that I have had discussions with generally have great common sense arguments, but no clear GAAP basis or assumption / model development for such discounts.  Most arguments are something along these lines “if they try to sell 10,000,000,000 shares tomorrow when the average daily volume is 5,000 it will drive down the price”, therefore, a marketability and blockage dicount of XX% is appropriate, not to mention the stock is restricted under Rule 144.  The problem many issuers face is developing supportable assumptions for the XX% discount.  It would be nice to apply recently issued accounting literature related to inactive markets and non-orderly transactions, however, that guidance indicates various factors need to be considered – not how to apply them to fair value models.

Scenario 2

Estimate the fair value of the debt first and assign the remaining fair value to the stock issued.  Again there are significant difficulties in developing a supportable fair value with this methodology.  The first of which is determining an appropriate effective interest rate.  Since the Company in the example does not have, nor has it ever had, the ability to obtain financing without significantly sweetening deals with equity or other equity linked instruments there is not an internally comparable rate to base it on.  Also, other companies within its industry having similar traits are experiencing the same problem so there really isn’t any available Level 2 surrogate.  This leads to Level 3 inputs at best with little guidance on how to develop assumptions.

Scenario 3

Basically a hybrid of the above 2 not-so-great techniques.  Estimate the relative fair value of each component then develop a supportable basis to allocate the value of the total package.  This has the same issues as Scenario 1 and 2, but at least the Company has presumably considered each possibility.

Scenario 4 

Take the entire $100k from the note issuance and spend it on a valuation expert to “properly” account for the transaction.

All thoughts and comments on how to break the “Circle of Hate” are welcome and encouraged.

Hip Hip Hooray! Permanent exemption from 404(b) for Small Business is Possible!

Recently, the House Financial Services Committee passed H.R. 3817, the Investor Protection Act. The bill includes an amendment, which would permanently exempt small public companies from complying with Section 404(b) of the Sarbanes-Oxley Act of 2002. The bill must still be voted on by the entire House of Representatives, but it is nice to know that there is hope.

As noted in the October 19^th blog post by Mark Bailey, the 404(b) requirement for small business issuers is not beneficial in most cases and thus the passing of this act by the House Financial Services Committee is welcome news.

SEC Extends ICFR for Small Issuers to 2010

Today, October 2, 2009, the SEC announced that independent audits of internal control over financial reporting has been extended for smaller reporting companies.  The press release indicates small companies will now need to be compliant beginning with annual reports for fiscal years ending on or after June 15, 2010.

Proper Preparation Prevents Piss Poor Principal Auditor Performance

For certain individuals who have served this great country (thank you by the way) you may be familiar with what is known as the 7Ps (a vet just reminded me that the military version is 6Ps), and I thought it adapted to well to meeting your quarterly, annual, and seemingly non-stop compliance requirements as a public company.

For smaller reporting companies, or probably more fitting – smaller accounting departments, the “7Ps of SEC Accounting Compliance” couldn’t be more critical.

Midway through the third quarter (for calendar year ends) can be a good time to finish the interim reporting season strong and take significant steps towards preparing for year end and the dreaded audit, which by the way includes audits of internal controls over financial reporting for smaller reporting companies.

Since we are talking in 7s – here are 7 things to remember when preparing for your always positive, and happiness inducing audit experience:

1. Make sure your auditor is not in denial about the integrated audit requirement for smaller reporting companies.  Chances are this will result in an increase of fees.  Up front fixed pricing is ideal for budgeting puropses, but this is not the norm for most firms (coincidentally this is something we live by).
2. Get familiar with the codification.  It begins with the 3 rd quarter for calendar year ends so it is a good time to think about converting your summary of significant accounting policies into the SEC’s favorite “plain English” .  The cross reference tool is a great way to shorten the learning curve.
3. Accept the fact that integrated audits are required for smaller reporting companies – get prepared and believe the additional paper gathering (documentation) will increase your frustration level.
4. If you are a smaller reporting company and obtained any kind of debt or equity financing through anything other than traditional bank financing, now is a good to share the terms with your auditor.  The chances are generally high thay you have some complex accounting requirement that usually results in millions of dollars in surprise and meaningless liabilities.
5. Don’t forget about the SFAS 157 fair value requirements particularly if you have level 2 and level 3 assets or liabillities.  Start documenting and don’t forget about the FSP “clarifications” for SFAS 157 and 115 (corresponding codification).
6. Document supportable positions for other new and/or unusual transactions.  It seems like, in this market, all new transactions are unusual.
7. Spend some time improving the non-financial portion of compliance documents.  The SEC provides great reports (report applies to 10-K as well as IPOs) to help avoid your own love letters from Corp Fin. 

No Extension for Small Issuers ICFR Audit

Another month has passed and all signs continue to point to SOX Section 404(b) compliance for smaller-reporting companies for fiscal years ending on or after December 15, 2009.  In effect, this means that calendar year non-accelerated filers will need to obtain an opinion on the effectiveness of internal control over financial reporting from their independent auditor as of December 31, 2009.

On June 22, 2009 the SEC released No. 33-8934A as a technical amendment and specifically stated that the technical amendment does affect the current effective date for compliance as noted above. 

Stay tuned, but the reality of compliance should be setting in.  It might be a good time to look through the SEC Guidance on ICFR.

Audit of ICFR for Small Reporting Companies

It appears the time has come for non-accelerated filers to obtain an audit of internal controls over financial reporting from their external auditor, likely in the form on an integrated audit with the filer’s financial statements.

To date, the SEC has not updated its most recent rules release on the requirement for non-accelerated filers to include an attestation report of their independent auditor on internal controls over financial reporting for fiscal years ending on or after December 15, 2009 (with certain exceptions for new registrants).

Recent remarks by both SEC Commissioner Luis Aguilar and SEC Chairman Mary Schapiro seem to indicate no additional extension will be granted, absent the SEC’s on-going cost-benefit study of SOX Section 404 indicating costs significantly out of line with the benefits.

In preparing for obtaining an audit report, which is as of the annual balance sheet date, it is a good idea to be familiar with a couple of different pieces of guidance.  The first of which is the COSO ICFR guidance for smaller reporting companies to ensure appropriately designed and implemented controls to detect and prevent material misstatement of financial information.  Secondly, to get an idea of the auditor’s approach, review the PCAOB’s Auditing Standard No. 5 and further the PCAOB’s staff views issued January 23, 2009.