Regulatory filings, notes, MD&A and the audit report

Who writes the rules and who makes companies file?

Standard setters write the accounting rules; regulators require the filings and enforce them. The two are different bodies, and the exam likes the confusion.

The International Accounting Standards Board (IASB) writes International Financial Reporting Standards (IFRS), and the Financial Accounting Standards Board (FASB) writes US generally accepted accounting principles (US GAAP). Securities regulators, such as the Securities and Exchange Commission in the United States, require listed companies to prepare reports under specified standards and to file them. IOSCO , the International Organization of Securities Commissions, is the club of securities regulators: its members oversee more than 95% of the world’s capital markets. It has no power of its own to enforce anything, yet because its members sign up to shared principles, rules look broadly alike from country to country. The principles serve three core objectives:

1. protect investors;
2. ensure markets are fair, efficient and transparent;
3. reduce systemic risk (reduce, not eliminate).

Financial reporting oversightsetters write, regulators enforce, coordinators align

• Standard setters Memorize write the accounting rules
  • IASB IFRS
  • FASB US GAAP
• Regulators Memorize require filings and enforce
  • SEC United States; PCAOB oversees US auditors
  • National regulators in each EU state the EU requires IFRS for listed groups' consolidated accounts
• Coordinating bodies Know the idea no direct regulatory authority
  • IOSCO cooperation and common principles for securities regulators
  • ESMA coordinates EU supervision
  • European Securities Committee advises the European Commission

In Europe, each member state regulates its own markets, but since 2005 the EU has required IFRS for the consolidated accounts of listed companies. ESMA , the European Securities and Markets Authority, is the EU cross-border supervisor that coordinates national regulators, and the European Securities Committee advises the European Commission.

In the United States, three laws matter to a reader of reports. The 1933 Act requires registration when securities are first sold. The 1934 Act created the SEC and requires periodic reports. The Sarbanes–Oxley Act of 2002 set up the Public Company Accounting Oversight Board (PCAOB) as the auditors’ overseer, barred auditors from selling certain other services to the companies they audit, made senior executives sign off on the reports personally, and made management assess and report on internal control over financial reporting , with the auditor giving its own view.

Which SEC form holds what?

Pick the form by what you need and how fresh it must be. The annual and interim reports carry the numbers; the other forms carry events, votes and insider activity.

• Form 10-K is the annual report for US registrants, with audited statements, notes, risk factors and management’s discussion and analysis (MD&A). Form 20-F is the annual report for other non-US registrants, and Form 40-F for certain Canadian ones.
• Form 10-Q is the quarterly report for US companies, with unaudited statements and an MD&A. Many non-US companies file a semiannual Form 6-K instead.
• Form 8-K is the current report for material events: acquisitions or disposals, a change of auditor, management changes. Non-US filers use Form 6-K.
• The proxy statement (Form DEF 14A) goes to shareholders before a meeting. It covers proposals to be voted on, ownership by management and principal owners, director biographies and executive compensation.
• A registration statement is filed when a company sells new securities. It includes risk factors and recent audited statements, but not projections.
• Forms 3, 4 and 5 report holdings, changes and annual positions of insiders and owners of more than 10% of a class of equity. Form 144 gives notice of a proposed sale of restricted stock.

SEC filingschoose by what you need and how fresh it is

• Periodic Memorize on a schedule
  • Annual: 10-K, 20-F, 40-F US, other non-US, certain Canadian registrants
  • Interim: 10-Q (6-K) quarterly for US; semiannual 6-K for many non-US
• Event-driven Memorize when something happens
  • 8-K (6-K for non-US) acquisitions, auditor changes, management changes
  • DEF 14A proxy statement before shareholder meetings
  • Registration statement when issuing new securities
• Ownership Know the idea insiders and large holders
  • Forms 3, 4, 5 initial, changes, annual
  • Form 144 proposed sale of restricted securities

The glossy annual report to shareholders is not an SEC requirement. It overlaps with the 10-K, but it is a presentation, while the 10-K is a legal document.

What do the notes and segment data add?

The notes to the financial statements are part of the audited statements and explain the numbers. They state the basis of preparation, the accounting policies, methods and estimates, and detail behind almost every line item. They also cover segments, acquisitions, debt and other commitments, financial instruments and their risks, legal proceedings, related-party transactions and subsequent events.

Policy choices matter because both IFRS and US GAAP allow some flexibility. Say one airline assumes its aircraft last 20 years and another assumes 30: the second books a smaller expense each year for the same jet and looks more profitable. Only the notes reveal the assumption, so the analyst reads them before comparing.

An operating segment earns revenue and incurs expenses, is regularly reviewed by senior management, and has its own financial information. A segment becomes a reportable segment when it passes a size test, and the coverage test makes sure the reported segments explain most of the business.

$$s = \frac{S}{T} \ge 10\%$$

$$\frac{\text{external revenue of reportable segments}}{\text{total revenue}} \ge 75\%$$

If the reportable segments cover less than 75% of the total, the company adds segments (largest first) until they do. The remaining segments go into an “all other segments” line. A single customer worth 10% or more of revenue must be disclosed, though not named.

A customer worth 300 of 2,400 revenue is 12.5%, so it must be disclosed. Try other numbers: the exam asks this from every side.

What does management’s commentary add, and can you trust it?

It is the best starting point for understanding the numbers and the outlook, but it is management’s view. Management’s discussion and analysis (also called management commentary or the operating and financial review) is generally unaudited, apart from excerpts of the financial statements.

In the United States the SEC sets what an MD&A must cover. Expect to recognize the headings: trends, events and uncertainties that bear on liquidity, capital resources and results; how inflation and price changes hit the business; off-balance-sheet arrangements and contractual commitments; and the critical accounting policies where management makes subjective calls. Outside the United States, the IASB’s practice statement on management commentary is guidance, not a rule. It names five elements: the nature of the business, objectives and strategies, significant resources, risks and relationships, results, and critical performance measures.

Its forward-looking items, such as planned capital spending, new stores or divestitures, are useful for forecasting. Treat it as one input, not an independent opinion.

How far can you trust the audit report?

As far as reasonable assurance goes. The audit report is an independent accounting firm’s written opinion on whether the audited statements fairly present financial position, performance and cash flows under a stated set of standards. Auditors test samples, not every transaction, and many figures rest on estimates. So the opinion gives reasonable assurance : the statements are very probably free of material misstatement, but nobody promises they are exact.

Memorize

Choose the opinion from what the auditor found:

Opinion	What it says	Signal
Unqualified opinion (unmodified, clean)	Fairly presented in accordance with the standards (“true and fair view” internationally)	The one analysts want to see
Qualified opinion	Fairly presented except for a scope limitation or an exception to standards, explained in the report	“except for”
Adverse opinion	Materially departs from standards; not fairly presented	“do not present fairly”
Disclaimer of opinion	The auditor cannot issue an opinion, for example from a scope limitation	“do not express an opinion”

Audit opinionthe auditor's view on fair presentation

• Unqualified (unmodified, clean) Memorize fairly presented; "true and fair view"
• Modified opinions Memorize something is wrong or missing
  • Qualified fair, except for a scope limitation or a departure from standards
  • Adverse materially departs from standards; not fairly presented
  • Disclaimer of opinion auditor cannot form an opinion

For listed companies the report also describes the basis for the opinion and discusses key audit matters (international) or critical audit matters (United States): areas of higher misstatement risk or significant management judgment, such as revenue recognition estimates or impairment tests. They are a guide to where judgment lives, not a list of what matters most to investors. In the United States the auditor also opines on internal control, in a separate report or an added paragraph.

Exam tip ”Except for” means qualified. “Not fairly presented” means adverse. “No opinion” means disclaimer.

Pair opinions with wording, then match information needs to documents.

The annual report packageaudited core, then supporting material

• Audited Memorize covered by the opinion
  • Financial statements including the statement of cash flows
  • Notes policies, estimates, debt, leases, segments, related parties
• Generally unaudited Memorize management's own view
  • Management commentary (MD&A) trends, liquidity, outlook, critical accounting policies
  • Interim statements in the 10-Q
• Other filings Use it not part of the audit
  • Proxy statement executive pay, owners, directors, votes
  • 8-K material events

Go deeper Segment details and the profit test

For each reportable segment, the notes give revenue (external and from other segments), a measure of profit or loss, assets and liabilities if reviewed by senior management, interest revenue and expense, depreciation and amortization, other non-cash expenses, income tax and the share of equity-method profit. A reconciliation ties the segment totals to the consolidated statements. For the profit test, the absolute value of a segment’s profit or loss is compared with the greater of the combined profit of all profitable segments and the absolute combined loss of all loss-making ones. Segment definitions need judgment and companies change them, which can break comparisons over time.

Go deeper Audit committees and the other reports

Listed companies are often required to have an independent audit committee on the board overseeing the audit. International auditing standards come from the International Auditing and Assurance Standards Board (IAASB); in the United States, the PCAOB sets standards for public companies. Neither the audit nor the internal control report can catch everything, so the analyst still questions the numbers.