September 01, 2013


Although the SEC does not review every filing, the Sarbanes-Oxley Act of 2002 requires the SEC to review the filings of every public company at least once every three years. If the SEC staff identifies instances where they believe a company can enhance its disclosure or improve its compliance with the applicable disclosure requirements, they will issue a comment letter. The SEC staff “views [this] comment process as a dialogue with a company about its disclosures.”

Fair Value Measurements

Fair Value Measurements continue to be an important subject of SEC review comments, as indicated by the following from notes to an annual presentation by members of the SEC corporate finance staff on common financial reporting issues facing smaller issuers.

“When smaller companies incorrectly determine fair value for equity issued to consummate certain transactions, such as compensation arrangements and business combinations, it can often lead to material misstatements. [The Corporate Finance] Staff will frequently comment when a registrant has used a value different from quoted market price to value its equity if it is evident that the stock trades in an active market.”

The SEC staff will question whenever a blockage discount is applied to an investment in a publicly traded security.

“[Generally Accepted Accounting Principles] explicitly prohibits the application of blockage discounts. Discounts for trading restrictions may be appropriate in certain circumstances provided they are characteristics of the security and can be supported with objective evidence.”

The SEC staff may ask an issuer to explain how it determined the Fair Value of a security.

“We note that the carrying amounts on your senior secured notes and notes payable equal their fair value. Given the fact these are long term notes and appear to be accounted for at cost, please explain to us and revise the document as necessary to explain why the carrying amounts of these notes equal their fair value.”

Business Combinations

Purchase Price Allocations

Generally, the SEC staff will question a purchase price allocation where the issuer has allocated little, if any, of the purchase price to intangible assets other than goodwill.

“Please tell us why you did not recognize any intangible assets separately from goodwill. Please specifically address marketing-related intangible assets, customer-related intangible assets and contract-based intangible assets.”

The SEC staff may comment when an issuer’s disclosure or press release indicates an intangible asset was acquired, but no portion of the purchase price was allocated to the intangible asset.

“Based on your disclosures in your filings, it is unclear to us why the fair values of the customer relationships and acquired identified technology do not represent a significant amount of the total purchase price.

Please tell us why you have indicated that all acquired intangible assets are patents. In this regard, your narrative description of the assets acquired refers to patents, trademarks, and other
intangible assets.”

When no value is assigned to a trademark, the SEC staff may raise questions as to whether the issuer considered the defensive value of the trademark.

“Your response indicates that you assigned no value to the acquired … trademark because you do not intend to use this trademark. Please provide us with your analysis of whether this trademark is a defensive intangible asset. Refer to ASC 350-30-25-5 and ASC 350-30-55-28G through 55-28I. Additionally, please tell us how you considered the guidance in ASC 805-20-30-6 to value the acquired trademark at fair value reflecting its highest and best use, regardless of whether you intend to use that asset.”

When an asset that was described in an issuer’s public comments regarding an acquisition is not identified as an identifiable intangible asset, the SEC staff may request the registrant to provide an explanation and cite specific support for its position.

“Your response to comment one indicates that you acquired the … documentation related to clinical trials previously performed by [the Seller] on the acquired technology prior to abandonment of that technology by [the Seller]. Please provide us with your analysis of whether the research in the … documentation meets the definition of an identifiable intangible asset. Refer to ASC 805-20-25-10. If you believe the … documentation does not meet the definition of an intangible asset, explain in detail why not, including citing the specific paragraphs of the Codification upon which you relied. If you agree that the … documentation is an intangible asset, please tell us how you have valued this acquired intangible asset at fair value reflecting its highest and best use.”

The SEC staff may question the method used to measure the Fair Value of an intangible asset.

“We note that you have determined that fair value of the patents based upon the Company’s market value, as being the purchase price between market participants at the date of the acquisition, less the Company’s net assets at the time of purchase. It appears that you have used the residual method, which ASC 805-20-S99-3 states should not be used to value intangible assets other than goodwill. Please tell us how you considered ASC 805 which requires entities to separately measure the fair value of identifiable assets (i.e., the price that would be received to sell the asset in an orderly transaction between market participants at the measurement date). Also, tell us what consideration you gave to other valuation techniques (e.g., income approach). Refer to ASC 820-10.”

In some cases, the SEC staff has requested an issuer to review and revise their purchase price allocation.

“Please explain to us in detail how you determined the intangible assets that you had acquired and identify for us each type of intangible asset acquired and its fair value. If appropriate, please revise your purchase price allocation table for these matters.”

Contingent Consideration

The SEC staff often requests issuers to expand disclosures regarding the terms of contingent consideration. The SEC staff may ask registrants to disclose how contingent consideration was valued, including the valuation methodology used and significant assumptions.

“Please tell us the acquisition date fair value of the total consideration transferred, including an explanation of how you determined the fair value of the contingent consideration. Also, please tell us how you allocated the total purchase price to the acquired assets, liabilities and intangible assets.”

The SEC staff may ask whether contingent consideration is properly classified based on the form of the consideration to be delivered and may request expanded disclosure regarding the assumptions used to determine the Fair Value of the contingent consideration.

“We note that you have recorded contingent consideration of $3.7 million related to the acquisition of [the property], consisting of your obligation to issue additional shares of Class A preferred stock based on increases in value of the Development Property. Please tell us and disclose:

  • Your basis for classifying the contingent consideration as a liability rather than within equity,
  • The basis for and significant assumptions used to determine the additional $356,000 contingent consideration, included in the $3.7 million,
  • The period over which you will determine the increase in value of the Development Property, and
  • The valuation method and significant assumptions used to value the preferred stock issued.”

The SEC staff has also questioned whether a contingent payment is actually contingent consideration related to the transaction or is the result of a separate transaction.

“From both of these acquisition footnotes as well as the information in Note 15 (Contingent Consideration and Earn-out Payments), these acquisitions had contingent consideration that would be paid to the former shareholders if certain amount of performance measures were met. We also note in the Form 8-K (Item 8.01 – Other Events) dated November 15, 2011 on the … acquisition that an employment agreement was executed with the founder and former employee of the seller …. Please completely and clearly tell us your consideration of the guidance in ASC Topic 805-10-55-24 and 25 on why management believed that the contingent payments are contingent consideration in these business combinations and not the result of a separate transaction. Your response should include the nature of any other arrangements included within these acquisitions.”

The SEC staff will often request expanded disclosures as to the change in value of contingent consideration.

“Reference is made to the last sentence in this note whereby we note you recorded a reduction to contingent consideration of $900,000 in the year ended June 30, 2012. As this adjustment was significant to income from operations and net income, please expand your disclosure to state (i) the acquisition that was impacted by this adjustment; and (ii) the nature of such adjustment including why you originally recorded this contingent consideration and the reasons the amount is reversed into income during the 2012 fiscal year.”

Goodwill Impairment Testing

The SEC staff has commented frequently on issuers’ goodwill impairment testing. The staff may comment when an issuer has one or more indicators of goodwill impairment, such as declining revenues and market capitalization less than the issuer’s book value, yet has not recorded an impairment.

“[S]ince your market capitalization was and continues to be significantly less than your estimate of the fair values of your reporting units, please provide us the actual assumptions you used in assessing the primary metals reporting unit in 2011. Please help us more fully understand why you believe your market capitalization is not representative of the fair values of your reporting units.

In light of your conclusion that goodwill was not impaired during fiscal year 2011 or the first three quarters of fiscal 2012 despite your operating losses during those periods and the significant difference between market capitalization and stockholders’ equity at the evaluation date, please provide us with the analysis of your latest goodwill impairment test performed as of October 30, 2011 including the method by which you determined fair value. To the extent your method produces a higher value than market capitalization as of the same date, please help us understand the reason(s) for any difference. In your response, please quantify each reporting unit’s carrying value and fair value as of the testing date and tell us whether any of your reporting units were or are at risk of failing step one of the impairment test. Please note that a reporting unit is at risk of failing step one of the impairment test if it has a fair value that is not substantially in excess of carrying value. Please also tell us if any of your unamortizable intangible assets were or are at risk of impairment as of your most recent impairment testing date.”

Often, the staff will question the application of a control premium to determine Fair Value when testing whether goodwill is impaired and suggest additional disclosures, such as the following.

“We note your disclosure that you evaluated the decline in your market capitalization subsequent to your annual impairment test by applying a control premium and determined that the fair value of your reporting unit was not less than book value during fiscal 2012. Please tell us your consideration of providing the following disclosures:

  • the percentage by which fair value exceeded carrying value at the date of your evaluation;
  • the control premium applied to your market capitalization to determine fair value;
  • a more detailed description of the methods and key assumptions used in your annual impairment test and how the key assumptions were determined;
  • a discussion of the degree of uncertainty associated with the assumptions used in your annual impairment test; and
  • a description of potential events and/or changes in circumstances that could reasonably be expected to negatively affect the key assumptions.”

When a registrant determines goodwill is impaired, the SEC staff may review prior filings to ascertain whether the company had complied with SEC regulations and question the issuer’s previous disclosures.

“Given your disclosures throughout fiscal year 2012 it is unclear whether you provided investors with sufficient forewarning that your goodwill could be materially impaired, generating your first net loss in ten years. We note on page 40 of your Forms 10-Q for the quarters ended March 31, and June 30, 2012, you provide a risk factor for goodwill impairment. However, the risk factor at each period appears to be generic and did not appear to identify specific known risks and the amounts of corresponding assets whose recoverability was reasonably expected to be specifically impacted by those risks. Given your material and possibly unexpected goodwill charge, please tell us and disclose in future filings the events and circumstances that you consider in evaluating whether to test for impairment more than annually. Your discussion in future filings should identify negative trends and why such trends didn’t trigger a test for impairment. Refer to ASC 350-20-35-28. Please tell us whether you tested goodwill for impairment at March 31, and/or June 30, 2012, if not, please tell us the qualitative factors that suggested testing was not required.”

Embedded Derivatives

An embedded derivative refers to one or more terms within a contract that affect some or all of the issuer’s cash flows in a manner similar to a derivative. Accounting Standards Codification (ASC) 815 sets out the criteria to determine whether an embedded derivative within a contract should be bifurcated and reported at Fair Value. Determining whether a term is an embedded derivative is complex and requires detailed analysis under both ASC 815-15 and ASC 815-40. Examples of terms within preferred stock and debt the SEC has requested an issuer to determine whether or not such item is an embedded derivative include:

  • Conversion features
  • Anti-dilution provisions
  • Prepayment options
  • Mandatory and contingent redemption options

At a forum on Auditing in the Small Business Environment hosted by the Public Company Accounting Oversight Board, the SEC Staff noted:

“[T]he staff may issue comments to understand how freestanding derivatives and bifurcated embedded features have been measured. In many cases, there may be multiple embedded features or the features of the bifurcated derivatives may be so complex that a Black-Scholes valuation does not consider all of the terms of the instrument. … The staff may consider the reasonableness of assumptions and also whether the valuation technique used is appropriate. In some cases, we have found that the issues related to valuation arise from the terms and features not being properly defined or identified when considering the contractual agreements in their entirety.”

In addition, the presenters observed “that errors in this area are the result of companies not carefully considering and evaluating the accounting implications of provisions of their agreements.”

If a registrant discloses that an instrument includes an embedded derivative, the SEC staff may ask the issuer for details as to how the Fair Value of such embedded derivative was measured.

“[P]lease tell us in sufficient detail how you determined the fair values of the bifurcated embedded derivative on your convertible preferred stock and the derivative warrant liability. Please note that the fair values of your derivatives should be determined using appropriate valuation models, such as a lattice, binomial, and/or Monte Carlo simulation approach.”

Recently, the SEC staff has focused on the inclusion of the registrant’s hedging costs in determining the Fair Value of embedded derivatives.

“[W]e believe the disclosed valuation of the embedded derivative should not include “hedging costs” or other “transaction costs” of you or your affiliates arising from the issuance of the notes. We have observed that some issuers may use only a bidding process with unaffiliated third parties rather than internal pricing models to value the embedded derivative in the structured note. If you do not bid out the pricing of the embedded derivative to an unaffiliated third party or you use an internal pricing model to value the embedded derivative for any reason, the value of the embedded derivative should not include any hedging and other transaction costs of you or your affiliates. These costs should not be included because they are costs to you as the issuer separate from the value of the embedded derivative component.”

If the description of an instrument indicates the possibility it contains an embedded derivative, the SEC staff may request clarification.

“We note that the senior secured notes issued in April 2012 provide for the payment of a make-whole premium in the event that they are redeemed prior to May 15, 2015. Please tell us and revise the notes to your financial statements in future filings to disclose how you accounted for the embedded derivative associated with make-whole premium related to such notes in your financial statements. If no recognition of this embedded derivative was required in your financial statements, please explain why.”

Share-Based Payments

The SEC staff has often commented on issuers’ measurements of the Fair Value of share-based payments for compensation and disclosures of such arrangements. According to the SEC staff, the “[d]isclosure requirements under ASC 718 include information to enable users of the financial statements to understand items such as the nature and terms of the arrangements, the effect of compensation costs and the method determining Fair Value.”

Resources to which the staff will direct registrants include the AICPA Practice Aid “Valuation of Privately-Held-Company Equity Securities Issued as Compensation,” Financial Reporting Manual (“FRM”) 9520 “Stock-based Compensation in IPOs,” and FRM 7520 “Valuation of Privately-Held-Company Equity Securities Issued as Compensation.” FRM ¶7520.1 outlines considerations when equity awards are granted subsequent to an IPO and the Fair Value of the stock is substantially below the indicated IPO price.

When a registrant is planning an IPO, the SEC staff may comment on the valuation of shares issued by the company prior to the planned IPO and suggest expanded disclosures.

“Please expand your disclosure to address the following:

  • Discuss the significant factors, assumptions, and the specific methodologies used to determine enterprise fair value at each date;
  • Disclose how you determined a discount for lack of marketability of 10% was appropriate at each date in valuing your common stock;
  • Describe the factors contributing to significant change in the fair value of the underlying stock during 2012;
  • Once you can reasonably estimate the IPO price, qualitatively and quantitatively discuss each significant factor contributing to the difference between each valuation and the estimated IPO price;
  • Disclose the intrinsic value of the outstanding vested and unvested options based on the estimated IPO price and the options outstanding as of the most recent balance-sheet date presented in the registration statement;
  • Continue to update your disclosure for all equity related transactions through the effectiveness date of the registration statement.
  • Tell us whether the common stock valuations were contemporaneous or retrospective.”

The SEC staff may ask questions related to the differences in the company’s Fair Value measurements for share-based compensation purposes as compared to Fair Value measurements for goodwill impairment testing.

“[P]lease tell us how your aggregate parent equity valuation compares to total shareholder’s equity on your balance sheet at the most recent balance sheet date for which a valuation was performed. Please quantify these amounts as well as the fair value of the company determined as of your July 3, 2011 goodwill impairment test. To the extent that there are any material differences between the valuation of your company as determined in your goodwill impairment test and as determined in your equity valuations, please explain to us the reasons for the variances.”


Valuation for financial reporting can be daunting and often requires high levels of experience and expertise. The SEC staff has encouraged issuers to consider retaining the services of a valuation specialist if the issuer does not have the expertise to measure the Fair Value of assets, liabilities, and complex financial instruments. Given that accounting regulations are constantly evolving and many conceptually “gray” issues may be encountered, constant monitoring of SEC comment letters and participation in industry events is critical to stay in front of “hot topics” and avoid surprises during the SEC review process.