Questions and Notes for the Second Quarter Earnings Season
Since the start of the COVID-19 pandemic, public companies have faced the increased challenge of providing accurate disclosures in a constantly evolving and unpredictable environment. Fortunately, the Securities and Exchange Commission has provided guidance to help public companies. On March 25, 2020, the SEC’s Division of Corporate Finance (Division) issued CF Disclosure Topic No. 9, which we previously reported on here. On April 8, 2020, the chairman of the SEC and the director of the Division issued a joint statement highlighting the importance of forward-looking COVID-19 disclosures for investors and markets, which we previously reported on here. On June 23, 2020, the Division followed CF Disclosure Topic No. 9 with CF Disclosure Topic No. 9A, which can be found here, and also hosted a virtual roundtable on second quarter reporting on June 30, 2020, addressing COVID-19 and a host of other topics, a replay of which can be found here. Also, the SEC continues to issue to public companies comment letters related to COVID-19 disclosures (e.g., asking issuers to disclose specific impacts related to COVID-19 such as number of projects canceled and disruptions in supply chain in addition to the general impacts, even if such impacts are uncertain, and as time goes by, to disclose any known trends or uncertainties impacting financial results).
The earnings season for the quarter ended June 30, 2020 (Second Quarter), presents the same challenges that prior periods did, but also presents new challenges in developing clear, concise, and accurate disclosure. For example, the earnings season for the Second Quarter will likely be the first time that impacts of the COVID-19 pandemic have affected a full quarter, unlike the earnings season for the quarter ended March 31, 2020 (First Quarter), which was likely impacted by only approximately a month of COVID-19 effects. Risks, trends, and uncertainties that may have been hypothetical at the time the Form 10-Q for the First Quarter was filed may have become more certain, actually occurred, or evolved into new risk, or in some cases, may no longer be material. Additionally, public companies are facing new challenges and uncertainties. While the earnings season for the First Quarter likely addressed challenges such as current or looming shutdowns or transitioning to work from home, the challenges and uncertainties of the Second Quarter also include geographic flare-ups of COVID-19 and re-imposed shutdowns, transitions back to work, tightening credit and capital markets, and social unrest.
As public companies turn to the earnings season for the Second Quarter, it is important to continue to ask questions targeted toward clear, concise, and accurate disclosure using the SEC’s guidance. This client alert is intended to be used as a guide in updating and, in some cases, creating new COVID-19 disclosures for the Second Quarter earnings season that are consistent with the SEC’s guidance.
Quarterly Report on Form 10-Q
Disclosure regarding the impacts of COVID-19 will significantly affect the Second Quarter Form 10-Q, and will appear in a number of places. The following portion of this client alert addresses different sections of the Form 10-Q with questions that an issuer may want to ask when considering disclosure in the Form 10-Q.
Cautionary Note Regarding Forward-Looking Statements
One theme that persistently appears in the SEC’s guidance is the importance of forward-looking information regarding the effects of COVID-19. When providing forward-looking information, it is critical to have a well-drafted cautionary note for forward-looking statements, which serves the dual purposes of satisfying the Private Securities Litigation Reform Act of 1995 (codified in Section 27A of the Securities Act of 1933, as amended (Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act)), and the judicially created “bespeaks caution” doctrine. Companies should consider the following types of questions when reviewing their cautionary notes:
Does the cautionary note mention potential impacts of COVID-19 as a forward-looking statement?
Does the cautionary note mention potential risks and uncertainties related to the ultimate impact of COVID-19 as a factor that may cause actual results to be different from those contained in forward-looking statements?
Both Section 27A(c)(1)(A)(i) of the Securities Act and Section 21E of the Exchange Act provide that a person shall not be liable with respect to forward-looking statements if they are identified as forward-looking statements and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially. Therefore, it is important to both mention direct impacts of COVID-19 as a forward-looking statement (e.g., duration of work from home) and include risks and uncertainties related to COVID-19 (e.g., ability to achieve growth plans on a targeted schedule) when discussing the list of factors that may cause actual results to differ from forward-looking statements.
Does the cautionary note need to be updated to identify any new types of forward-looking statements (such as additional information on growth, strategy, future operations, financial position, estimated revenues and losses, projected costs, prospects, plans, objectives, and beliefs of management) that have been added to the Second Quarter 10-Q?
Does the company need to include additional identifying phrases (such as “may,” “should,” “likely,” “will,” “believe,” “expect,” “anticipate,” “estimate,” “continue,” “plan,” “intend,” and “project”) for additional forward-looking disclosures included in the Second Quarter 10-Q?
Does the list of factors that may cause actual results to differ from forward-looking information need to be updated or reordered, for example, for operational changes, liquidity changes or new risk factors, or certain factors becoming more significant?
Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
The MD&A section of the 10-Q is likely to have some of the most significant discussion of the impacts of COVID-19, which will appear in a number of places in the MD&A and in a number of contexts, both historical and forward looking, and both operational and financial. The SEC has stressed the importance of disclosing not only where a company stands presently but also its responses to COVID-19, how COVID-19 has impacted its historical financial statements and operations, and most importantly, expectations for future periods. All of these assist in the overarching goal that the MD&A provide investors with a level of insight that allows them to see key operations and financial considerations through the eyes of management. Companies should consider the following types of questions when reviewing their MD&A:
Are there any recent developments that should be highlighted in the beginning of the MD&A, such as capital markets transactions, bankruptcy filings, restructurings, amendments to credit agreements, acquisitions or dispositions, or other significant events?
Have any business objectives, plans, strategies, or goals changed, in either the short term or long term, as a result of COVID-19?
Does the company describe the operational impacts that it has experienced, and the operational responses that it has taken, as a result of COVID-19?
These will likely vary from company to company, but may include impacts to supply chain, marketing restrictions (e.g., restrictions on door-to-door marketing or retail locations), or modifications to customer contracts and customer payment terms. Responses may include instituting work from home or safety measures, work stoppages, limiting walk-in retail sales, and changes in supplier relationships.
Does the company describe the financial impact that it has experienced and the actions it has taken as a result of COVID-19?
The SEC has previously encouraged companies to include an executive-level overview that provides context for the remainder of the MD&A, which could include an introduction of what is discussed in more detail in the period-over-period comparison and liquidity sections of the MD&A as a result of COVID-19.
Does the company describe known challenges that lie ahead?
It is important for a company to disclose what known significant challenges, opportunities, and risks lie ahead as a result of COVID-19, as well as what actions it is taking or anticipates taking in response. These may include returning to the workplace, lifting of government-imposed restrictions that impact a key aspect of the business, and anticipated financial and liquidity challenges associated with decreases in sales and revenue in future periods.
This will vary significantly from company to company. For example, banks and bank holding companies are facing uncertainties on the short- and long-term effects to loan portfolios. To the extent those companies are taking actions in response, such as more frequent and proactive monitoring, loan modifications, and loan deferrals, those steps are the types of responses that the SEC would expect to see disclosed.
Results of Operations
To the extent results of operations were impacted by COVID-19 when compared with the prior year comparable period, is the impact disclosed and, to the extent practicable, quantified?
Both positive and negative impacts should be disclosed. To the extent a change is related to COVID-19 and other factors, the company should consider whether it is possible to quantify each impact. Even if overall results did not materially change period over period, if there were material changes within the results (such as a successful shift to online sales from retail location sales that changes the mix of revenue, or increased revenue in one product balancing decreased revenue in another), that should also be described.
To the extent results of operations were impacted, is this expected to be a trend in future periods, and if so, is that disclosed?
To the extent a trend is expected in future periods, is there an estimated time frame for that trend?
Is there an aspect of results of operations or a particular driver that the company has not discussed historically because it was immaterial, but that is now expected to be a material driver or indicative of future results due to COVID-19?
An example would be a shift to online sales due to COVID-19 away from traditional brick-and-mortar sales.
Are there any reasonably known events that would impact operations that are likely to occur in future periods (such as impairments, increases in loan loss provisions, restructuring charges, or other charges or expenses)?
Liquidity and Capital Resources
Would an overview of liquidity and capital resources be helpful?
Similar to an executive-level overview at the beginning of the MD&A, some companies provide an executive overview or summary at the beginning of the liquidity and capital resources section specifically addressing liquidity and capital resources. This summary can provide helpful background for the overall discussion of liquidity and capital resources and introduce broad concepts such as a going concern, changes to overall outlook, changes in sources and uses, recent steps taken to enhance liquidity, and anticipated liquidity problems.
Have anticipated uses of funds changed, or are they reasonably likely to change?
For example, have there been any changes to budgets or anticipated capital expenditures, or are any expected? Has the company suspended or reduced its dividend, sought relief or deferred payments under its credit agreement, or halted share repurchase programs?
Have sources of funds changed, or are they reasonably likely to change?
For example, has cash flow from operations been reduced as a source of funds? Has the company accessed lines of credit so that future borrowings are limited? Have historical sources of funding become more limited? Has the cost of funds changed? Have suppliers provided any sort of material financing support that will assist the company in preserving cash? Has the company adopted any measures to provide additional sources of liquidity, such as an at-the-market offering program? Has the company taken advantage of any government relief programs (e.g., the Paycheck Protection Program)?
To the extent that negative or material decreases in operating cash flows occurred or are reasonably likely, are they described?
These could arise, for example, due to decreased revenues or provision of concessions to customers. The SEC has said that if a company reports negative cash flows from operations, the disclosure provided in the MD&A should clearly identify this condition, discuss the operational reasons for the condition, and explain how the company intends to meet its cash requirements and maintain operations. See Section IV.B.1. of Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release No. 33-8350, available here.
Does the company adequately disclose potential restrictions that may impact future liquidity, including covenant compliance in debt instruments?
For example, are there restrictions or consent rights in debt instruments or other agreements that may limit a company’s ability to obtain liquidity in the future? Are the restrictive covenants in debt instruments adequately disclosed? The SEC has indicated that there are two circumstances where companies should consider whether discussion and analysis of material covenants related to their outstanding debt may be required: (1) where the company is, or is reasonably likely to be, in breach of such covenants and (2) where the covenants may impact the company’s ability to undertake additional debt or equity financing. See Section IV.C. of Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release No. 33-8350, available here.
Have the company’s contractual obligations changed in any material manner?
Although a company is not required to include the table of contractual obligations pursuant to Instruction 7 to paragraph (b) of Item 303 of Regulation S-K, it is required to include material changes outside the ordinary course of business. This may arise, for example, due to credit facility amendments that alter maturity dates, drawings under credit agreements, or issuances of debt securities.
Qualitative and Quantitative Disclosures About Market Risk
Has COVID-19 had any impact on market risk?
For example, has COVID-19 impacted interest rates or foreign currency rates in any material way?
Controls and Procedures
Has COVID-19 had any impact on internal control over financial reporting or disclosure controls and procedures?
For example, widespread work from home or the ability to obtain services from third parties may impact internal control over financial reporting or disclosure controls and procedures.
Have any new legal proceedings been instituted as a result of COVID-19, or have there been material developments in existing legal proceedings as a result of COVID-19?
The vast majority of public companies have included some disclosure of risk factors related to COVID-19, either in their annual report on Form 10-K, or more likely in their Form 10-Q for the First Quarter, or in a current report on Form 8-K. Accordingly, most public companies will be assessing updates to the risk factors previously disclosed.
Even if a company has previously disclosed risk factors related to COVID-19 and believes that there are no material changes to those risk factors, the risk factors should still be repeated in the Form 10-Q for the Second Quarter. While practice may vary, Form 10-Q requires a public company to set forth any material changes from risk factors previously disclosed in the company’s Form 10-K (not Form 10-K and subsequent Form 10-Qs), and, accordingly, risk factors should be repeated until incorporated into the next Form 10-K even if they would be duplicative of what was disclosed in a prior Form 10-Q.
Companies should consider the following types of questions when reviewing their risk factors:
Have risks that were hypothetical and phrased as “may” actually materialized? If so, what new challenges or risks arise as a result of that event occurring?
Did the company take any actions in response to COVID-19 that may create risk or increase the significance of existing risk?
For example, a company may increase its debt levels by borrowing under its revolving credit facility or issue a new class of preferred stock that has restrictive covenants and consent rights in order to manage liquidity concerns, and these may need to be analyzed as new risks. A company that participated in the Paycheck Protection Program following the filing of the First Quarter 10-Q could decide that the potential for litigation is a new risk.
How has the industry in which the company operates been affected by COVID-19?
While discussing generic risk factors is not appropriate, understanding industry impacts may assist a company in determining its own unique risk. Some industries, such as hospitality or travel, have been impacted more significantly than others.
How has the geographic area in which the company operates been impacted by COVID-19?
Given that COVID-19 has impacted different geographic areas differently and there have been different governmental responses in different states and cities, a company’s particular geographic area of operations may make it more vulnerable to certain types of risk.
Have there been any actions by third parties (suppliers, customers, etc.) or regulatory agencies that present risks to the company?
Is there a going concern (i.e., an ability to meet obligations as they become due within one year after issuance of the financial statements)?
Do you expect any material impairments (e.g., to goodwill, intangible assets, long-lived assets, investment securities)?
Have there been any changes in judgments in determining the fair value of assets?
Have you assessed the impact of material events that occurred after the end of the quarter for purposes of a subsequent-events footnote?
Have you incurred any loss contingencies as a result of COVID-19?
Non-GAAP Financial Measures
Public companies need to be particularly mindful of the SEC’s rules related to financial measures that are not presented in accordance with generally accepted accounting principles (non-GAAP financial measures). Non-GAAP financial measures may appear in a company’s Form 10-Q, earnings release, earnings call (oral), investor presentation (oral or in writing), or any combination of the foregoing. Non-GAAP financial measures continue to be a focus of the SEC, and public companies should take particular caution to understand how non-GAAP disclosures may be impacted by COVID-19. Companies should consider the following types of questions when reviewing their non-GAAP financial measures:
If attempting to quantify impacts of COVID-19, has the company done so in a way so as not to inadvertently create a non-GAAP financial measure?
When attempting to quantify impacts of COVID-19, it would be easy to inadvertently create a non-GAAP financial measure (e.g., “Net income, as adjusted for an impairment related to COVID-19, was $100 million.”). Careful phrasing can avoid potential non-GAAP disclosure issues (e.g., “Net income was $100 million, a decrease of $20 million from the prior quarter, which reflects an impairment related to COVID-19 of $20 million.”).
To the extent a company is intentionally creating a non-GAAP financial measure showing the impacts of COVID-19, does it comply with Item 10(e) of Regulation S-K and/or Regulation G?
The SEC has extensive rules relating to the presentation of non-GAAP financial measures, which generally require that the measure not be misleading, that it be a presentation of the most directly comparable financial measure calculated and presented in accordance with generally accepted accounting principles (GAAP), and that it be a reconciliation of the non-GAAP financial measure to the most directly comparable measure presented in accordance with GAAP. Depending upon whether the disclosure is subject to Item 10(e), additional requirements may be applicable, such as a statement disclosing the reasons why the company believes the non-GAAP financial measure is useful, and any other purposes for which the non-GAAP financial measure is used. Recent guidance from the SEC on non-GAAP financial measures can be found here.
Earnings Releases and Calls
While the bulk of the disclosure regarding the impacts of COVID-19 may be in the Second Quarter Form 10-Q, the earnings release and what is discussed on the earnings call are equally as significant. Investors are more likely to review an earnings release and listen to an earnings call than review a company’s Form 10-Q. Additionally, earnings calls offer an opportunity to provide an enhanced understanding of certain key aspects of a company’s results and more flexibility for discussing results, although the message should always be consistent across all disclosures. Companies should consider the following types of questions when reviewing their earnings releases and earnings call scripts.
Has the cautionary note in your earnings release been updated to reflect any changes in the Form 10-Q?
Does your earnings release disclose the same material information as the Form 10-Q as it relates to COVID-19, and in the same tone?
For example, if you describe COVID-19 as impacting results of operations for the quarter, is that disclosed in the 10-Q and the earnings release and discussed on the earnings call? If information is important enough to be disclosed in the earnings release or 10-Q, the company should consider whether it is important enough to disclose in both.
Has the company explained how previously disclosed mitigation efforts fared and how it is responding to the results (i.e., continuing on the same path or adjusting efforts to better meet the unique challenges faced)?
This will help tell a cohesive story for 2020 by connecting Second Quarter earnings to the issuer’s previously announced mitigation efforts, and will demonstrate the issuer’s ability to adequately respond to the perpetually shifting market conditions.
Considering the broader flexibility that a company has in its earnings call, is there any additional elaboration that would be helpful as it relates to the company’s resilience and adaptability, emphasizing supply chain management, community engagement, and human capital?
Other Important Notes About the Second Quarter
Inline XBRL Cover Page Tagging Now Required for Accelerated Filers
Beginning with the first Form 10-Q for the fiscal period ending on or after June 15, 2020, accelerated filers that prepare US GAAP financial statements will be required to tag all cover page data in Inline XBRL, or iXBRL, and file a separate Exhibit 104 (Cover Page Interactive Data File) to pick up any cover page data not embedded in the cover page. This means that calendar-year-end US GAAP accelerated filers will be required to comply with the iXBRL rules starting with their Form 10-Q for the Second Quarter. Additionally, after filing their first iXBRL-compliant Form 10-Q, accelerated filers will be required to comply with the iXBRL rules for all current reports on Form 8-K, quarterly reports on Form 10-Q, and annual reports on Form 10-K. The adopting release containing the iXBRL rules can be found here, and the SEC’s information guide to the iXBRL requirements can be found on its website here.
Reassess Smaller Reporting Company Status
Issuers should reassess whether they qualify as a smaller reporting company at the end of the Second Quarter, and if qualified, consider immediately taking advantage of the scaled disclosure requirements in their Second Quarter Form 10-Q. In general, the scaled disclosure requirements permit SRCs to include less-extensive narrative information than is required of other reporting companies, including in the description of executive compensation, and to provide audited financial statements for two fiscal years instead of three. SRC status is determined at the end of the second fiscal quarter based on the issuer’s public float calculated as of the last business day of the recently completed second fiscal quarter, and, as applicable, based on the issuer’s annual revenues as of the most recently completed fiscal year for which audited financial statements are available. For additional information on the thresholds to qualify as an SRC, please see our prior client alert here.
Accessing the Capital Markets
To the extent that a company is planning to access the capital markets using disclosures in its Form 10-Q, it would be well advised to consider what sort of disclosure underwriters or initial purchasers would expect to see (which may entail consultation with underwriters or initial purchasers when drafting its Form 10-Q disclosure). Additionally, the company should consider, for quantitative information, whether the auditors would be able to provide comfort on such information.
Insider Trading Concerns
Companies, as well as their insiders, need to exercise extra caution when trading in their own securities, even during open windows that would ordinarily occur after release of Second Quarter results. Given the constantly evolving nature of the COVID-19 pandemic, new developments that could become material nonpublic information in the hands of the company or insiders that has not been released to the public market, such as new material risks that develop after the Second Quarter 10-Q is filed, may arise quickly.
 The Quarterly Report on Form 10-Q for the Second Quarter is due on Monday, August 10, 2020, for large accelerated filers and accelerated filers, and Friday, August 14, 2020 for non-accelerated filers.
 See Section III.A. of Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release No. 33-8350, available here.