Chapter 19

Digging into Government Regulations

In This Chapter

Looking at the 10-Q

Getting acquainted with the 10-K

Evaluating internal controls

Checking out company compliance

Becoming familiar with the way the board works

Disclosing insider ownership

You've probably heard all kinds of complaints about the government bureaucracy involved in, and the paperwork required for, corporate reporting. Most corporate executives and managers responsible for answering to the government don't find pleasure in reading through government reporting requirements. This stuff doesn't make great bedtime reading, although some people do find these requirements good to read when they're having a hard time falling asleep — boring!

No matter how boring and frustrating corporate staff may find these government requirements, corporations have no way to bypass the rules. Actually, as a company outsider who needs to know what's happening behind closed doors, you should be glad such stringent regulations exist. Without them, you'd have no idea whether you're getting accurate reports about what the company does and what its growth prospects are.

If you're researching a company because you're considering investing in it or have already invested, you needn't depend solely on the information the company gives you in its annual and quarterly reports. Visit the Securities and Exchange Commission's (SEC) Edgar website (www.sec.gov/edgar.shtml) and read the details in the company's public reports it files with the government.

I find that one of the best ways to track news about particular companies and new SEC filings is by listing a mock portfolio on one of the financial news websites, such as Yahoo! Finance (finance.yahoo.com). Any news or SEC filing is linked to the opening page of each stock. An asterisk designates when something new is reported about a stock in your mock portfolio, so you know when new information about the company has been posted.

Checking Out the 10-Q

Every quarter, corporations must report their financial results to the SEC (which has primary responsibility for the U.S. government's oversight of public corporations) on Form 10-Q. The 10-Q isn't a blank form that needs to be filled in. Instead, the SEC provides general instructions for the information that must be included and the format in which it must be presented. The 10-Q includes two parts.

Financial information

The financial information required for Part I of Form 10-Q isn't much different from the info required for the annual reports. Four items are required:

• Item 1 — Financial statements: Included in this section are the balance sheet (see Chapter 6), income statement (turn to Chapter 7), and statement of cash flows (discussed in detail in Chapter 8).
• Item 2 — Management's discussion and analysis of financial condition and results of operations: This section includes a discussion and analysis by management of the company's liquidity, resources, and operations, its financial condition, and any changes that occurred during the quarter. I discuss the requirements for this section in greater detail in Chapter 5.
• Item 3 — Quantitative and qualitative disclosures about market risk: This section includes discussion about external conditions that impact the company's market, including the impact of inflation, economic conditions that could impact revenue, and competitive forces that may impact the company's future results.
• Item 4 — Controls and procedures: This section requires management to disclose the controls and procedures the company has in place to protect its assets and the accuracy of its financial reports. I discuss this requirement in greater detail in the section “Investigating Internal Controls.”

Other critical matters

Companies report other important corporation matters that don't fall under the topic of financial results in Part II of the 10-Q. This section contains several possible items, but companies need to include only the items relevant to the particular quarter being reported. Following are the items in Part II:

• Item 1 — Legal proceedings: Events involving legal proceedings must be reported only during the quarter in which they first became material and in any future quarters when information related to material developments is available. Material developments are proceedings that may have a significant impact on a company's finances.
• Item 1A – Risk factors: This section reviews the risks disclosed related to a company's business, financial condition, and cash flows, as well as results of operations that may be materially adversely affected by any of these risks. The trading price of the company's common stock may decline due to these risks.
• Item 2 — Unregistered sales of equity securities and use of proceeds: The company must report all equity securities sold by the registrant during the period covered by the report that were not registered under the Securities Act. Information about repurchases of securities also must be included.
• Item 3 — Defaults upon senior securities: If a company defaults on its payment of principal or interest on company debt and the default isn't cured within 30 days, the company must report it. The only type of default that doesn't need to be reported is one between a parent company and one of its subsidiaries.
• Item 4 — Mine safety disclosures: If applicable, information about mine safety violations or other regulatory matters is reported here.
• Item 5 — Other information: This item is a catchall for any issue that hasn't been previously reported on Form 8-K but needs to be reported. I discuss the requirements of Form 8-K in a later section called “Uncovering the Ways Companies Keep in Compliance.” A company doesn't have to file an 8-K for an issue reported on a Form 10-Q.
• Item 6 — Exhibits and reports on Form 8-K: Any compliance reports filed during the quarter must be attached as an exhibit (additional pages that provide this information) on the 10-Q.

Introducing the 10-K

Form 10-K is the official annual report form the SEC requires, and it's the report you're most likely to see as part of the glossy annual report that companies send out to investors. The 10-K includes four parts, which I discuss in this section.

Business operations

In Part I of the 10-K, you find the following details about business operations:

• Item 1 — Business: This section describes the company's operations with discussions about product lines, major classes of customers, industries in which the company operates, and details about domestic and foreign operations. “Risk factors” (Item 1A) and “Unresolved staff comments” (Item 1B) are also discussed in this section.
• Item 2 — Properties: This section describes the property the company owns.
• Item 3 — Legal proceedings: This section discusses any legal proceedings the company is involved in and the material impact the lawsuits may have on the company.
• Item 4 — Mine safety disclosures: If applicable, information must be provided regarding mine safety violations or other regulatory matters.

Financial data

Part II of the 10-K includes information related to any matters that impact the company's financial health. In this part, you find the following items:

• Item 5 — Market for registrant's common equity, related shareholder matters, and issuer purchases of equity securities: In this section, you find information about the market for the company's stock, which stock exchange the company is traded on, the quarterly low and high stock prices for the past two years, the approximate number of shareholders, the amount paid in cash dividends for the past two years, and discussion of any restrictions on the company's ability to pay future dividends.
• Item 6 — Selected financial data: In this section, you find a five-year summary of selected financial data, including net sales, income or loss from continuing operations (company activities that go on each year to make and sell products or services) on a per-share basis, total assets, long-term debt, cash dividends per share of common stock, and information about any redeemable preferred stock (stock that can be converted to debt).
• Item 7 — Management's discussion and analysis of financial condition and results of operations: In this section, management discusses the company's financial condition and any changes to its condition that have occurred in the past year. Management also discusses the results of operations and analyzes the company's liquidity, resources, and operations. If any major changes in the financial statements took place during the year being reported, the company also discusses those changes in this section.
• Item 7A — Quantitative and qualitative disclosures about market risk: This section is where you find management's discussion of external economic factors that impacted the company's operations, such as the effects of inflation. You also find discussion about the company's competition and any major risks to the industry as a whole.
• Item 8 — Financial statements and supplementary data: Here's where you find the balance sheet, income statement, and statement of cash flows, as well as all supplementary information for these documents, such as the notes to the financial statements (see Chapter 9) and the auditors’ report (see Chapter 5).
• Item 9 — Changes in and disagreements with accountants on accounting and financial disclosure: If the company has any disagreements with the auditors about what information must be presented on the financial statements and how to present it, this section is where you find discussion of the differences.
• Item 9A — Controls and procedures: Here you find information about the company's internal controls and procedures to avoid fraud and ensure accuracy in the financial statements. I discuss these requirements in greater detail in the section “Investigating Internal Controls.”
• Item 9B – Other information: This section includes any items that aren't reported on an 8-K during the year, as well as items that are reported on an 8-K but aren't reported elsewhere in the 10-K.

Information about directors and executives

Part III of the 10-K takes you behind the scenes of company operations and gives you information about the directors and top executives, including any special compensation packages they receive. Following are the items you can expect to find:

• Item 10 — Directors and executive officers of the registrant: Here's where you find out who sits on the company's board of directors, as well as who serves as the company's top executive officers.
• Item 11 — Executive compensation: The company must report the compensation packages for all its top executives in this section.
• Item 12 — Security ownership of certain beneficial owners and management and related stockholder matters: Here you find details about the stock owned by top executives, board members, senior managers, and any other major shareholders of the company.
• Item 13 — Certain relationships and related transactions and director independence: This section is where you find out about large related-party transactions, such as any transactions between the company and its top management team. Companies must also include information about significant transactions with subsidiaries or major shareholders.
• Item 14 — Principal accounting fees and services: Here's where you find details about the relationship between the company and its accountants. The company must report the fees billed for each of the past two fiscal years for professional services by the principal accountant for the audit of the company's financial statements, as well as for any services related to the audit. The company must also disclose fees for tax services by professional accountants for tax compliance, tax advice, and tax planning, as well as fees for any additional services that the principal accountant provides. In addition, the company must disclose the audit committee's preapproved policies and procedures related to the work of the principal accountant.

The extras

Part IV of the 10-K is the catchall for additional exhibits, including any financial statement schedules and any reports the company filed throughout the year and reported on Form 8-K.

Investigating Internal Controls

When filing Form 10-K with the SEC, companies must also include the management's report on internal controls (which includes rules for how company staff should do their work to avoid theft and fraud). This requirement was added as part of the sweeping changes mandated by the Sarbanes-Oxley Act of 2002, which I discuss in greater detail in Chapter 3.

The management's report on internal controls requires that companies provide the following:

• Statement of management's responsibility for designing, establishing, and maintaining an adequate internal control structure over financial reporting for the company
• Statement identifying the framework management used to evaluate the effectiveness of its internal controls
• Management's assessment, as of the end of the fiscal year being reported, of the effectiveness of the company's internal control structure and procedures for financial reporting
• Attestation report from the company's auditor regarding management's assessment of the internal controls’ effectiveness, which assures the 10-K reader that the auditor reviewed the assessment and found it effective

Management must report any weaknesses it finds in its internal controls over financial reporting. If management finds one or more material weaknesses within the company's internal control system, the company can't conclude that its internal controls are effective. The following are some of the key points management must guarantee for its internal control process:

• Maintenance of records that accurately detail and fairly reflect the transactions and dispositions of the company's assets
• Assurance that transactions are recorded as necessary to permit the company to prepare financial statements in accordance with generally accepted accounting principles
• Assurance that receipts and expenditures are made only in accordance with authorizations from management and company directors
• Assurance that management has controls in place to detect and prevent unauthorized acquisition, use, or disposition of company assets that may have a material effect on the financial statements

You may be thinking, “Shouldn't a company have all these controls in place and not need the government to tell it to put them there?” Well, investors who lost billions because of the financial shenanigans at companies like Enron, MCI, and others during the early 2000s sure wish the SEC had more strongly enforced these internal controls before they took their losses.

Uncovering the Ways Companies Keep in Compliance

Sometimes significant changes in a company's financial position occur between the times the company files its financial reports. When that happens, the company must file a special report called an 8-K, which reports any material changes (changes that may have a significant financial impact on the company's earnings) that happen between the times of the quarterly or annual reports.

The Sarbanes-Oxley Act of 2002 (see Chapter 3) mandates that the SEC review all its compliance requirements regarding financial reporting. In response to the legislation, the SEC issued new rules for Form 8-K, requiring companies to report any material changes within four days of the event. Critical events to be reported on Form 8-K include

• Business combination: Any agreement related to a business combination (such as a merger combining two companies or consolidating two major divisions into one) or other extraordinary corporate transaction that may be material to the company's financial position. This report must include this information:
  • Date of execution
  • Parties involved
  • Material relationship between the company or its affiliates and any other party involved in the agreement
  • Brief description of the terms and conditions of this agreement

  Companies don't need to disclose any nonbinding agreements or letters of intent, provided that they aren't material to the company.

• Agreement termination: Any termination of an agreement that was previously reported, such as the cancellation of a signed contract to provide a significant amount of the company's product to another company if this cancellation means a loss of significant future earnings.
• Bankruptcy or receivership: Any plans to declare bankruptcy or enter into receivership, a type of bankruptcy in which the company can avoid liquidating itself and instead work with a court-appointed trustee to restructure its debt with the intention of emerging from bankruptcy.
• Acquisition or disposition: Any acquisition or sale of major assets outside the course of ordinary business operations. For example, the acquisition of a new company fits the reporting requirement, but the acquisition of new equipment for continuing operations doesn't need a special report on Form 8-K.
• Financial results: Any earnings results related to earnings, company operations, or financial conditions that occurred between the quarterly or annual reports and were distributed by press releases or other public means.
• Financial obligations: Any direct financial obligations that are material to the company, such as the signing of a long-term debt or lease obligation. The company must include a brief description of the transaction and agreement.
• Disposal of assets: Any costs related to the disposal of long-held assets when the company enters into an agreement (usually called an exit agreement) to get rid of those assets. The company must also disclose termination of employees under an exit plan.
• Impairment of asset value: Any conclusion by the board or an authorized company officer that the value of an asset is significantly impaired — for example, when the value of goodwill is determined to be significantly less than what the company reports on the balance sheet.
• Changes in stock exchange listing: Any time the company gets notification that it may be delisted (removed) from a stock exchange, or if the company fails to meet the rules or standards set by the stock exchange it's listed on. It must also report any plans to change to a new stock exchange.
• Accountant change: Any change in the company's certifying accountant.
• Unreliable financial reports: Any conclusion by the company's board of directors, a committee of the board, or an authorized officer that a previously issued financial report can't be relied on for information. You've probably heard press reports indicating that a company plans to restate its financial reports because of an error. Many times those press reports are based on a press release and the Form 8-K.
• Changes in control of company: Any departures of directors or principal officers, election of new directors, or appointment of new principal officers.
• Changes in charter or bylaws: Any proposed change in the charter or bylaws and its impact on the company's operations.
• Changes in fiscal year: Any plans to change a company's fiscal year if the decision is made outside the vote of the shareholders or by amendment to its bylaws. The company must include the date of determination, the date of the new fiscal year, and the form on which the report covering the transition period will be filed.
• Temporary suspension of trading in the company's employee benefit plans: Any suspensions of employee benefit plans for a period of time. Most often such suspensions happen when the company changes from one benefit provider to another. However, this change can be a sign of a major decision impacting the company's stock, such as a pending announcement about company earnings, a stock split, a buyback of stock, or an issuance of new stock.
• Amendments to the company's code of ethics: Any significant changes to the company's code of ethics.

As you can see from this list, you'd never hear about most of these events if companies weren't required to report them. But this information may be critical to any decision you make about the stock you currently hold or may want to buy.

Digging into Board Operations

Since the passage of the Sarbanes-Oxley Act of 2002 (see Chapter 3), the SEC more closely scrutinizes a company's board operations and the interaction between its board and shareholders. The SEC staff continues to study the act's requirements and to issue new disclosure requirements as they identify problems. Two major changes adopted since initial passage involve these issues:

• Disclosure to investors about the board's nominating committee and the nominating process for new board members
• Disclosure about the means by which the holders of a company's securities can communicate with the board of directors

In most cases, this information appears on the company's website or with its annual reports.

Note that I refer to “security holders” in some cases and “shareholders” in other cases. Not all security holders are shareholders. Only shareholders have voting rights within the company. Bonds are a type of security, so although bondholders don't have voting rights like shareholders, they do have an interest in who serves on the board.

Understanding the nominating process

The newly adopted rules imposed by Sarbanes-Oxley regarding a public company's nomination process demand that the board specify the following in writing to its shareholders:

• Whether the nominating committee has a written charter and, if it does, whether it's available on the company's website. If the charter isn't available on the website, the company must print it as part of its proxy information once every three years.
• Whether the members of the nominating committee are independent (not directly involved in company operations).
• Whether the nominating committee accepts nominations from security holders. If the company allows nominations, it must include information about how security holders can nominate someone to be on the board. If the company doesn't have a policy to accept nominations from security holders, it must explain why the board has decided not to accept these nominations.
• Minimum qualifications that the nominating committee believes must be met by a person who's recommended for a position on the company's board of directors. In addition, the company must list any specific qualities or skills that the nominating committee believes are needed for one or more of the open director's positions.
• How the company evaluates director nominees, including ones recommended by security holders. If evaluation is different for committee nominees than it is for security holder nominees, the documentation must specify the differences as well.

After the nominations are set, the company needs to disclose to its shareholders whether the nominee was recommended by a security holder, a nonmanagement director, the chief executive officer, a third-party search firm, or some other source. The board doesn't have to disclose this information about nominees who are executive officers or directors standing for reelection.

The SEC reviews all proxies (paper ballots sent to shareholders) to see how the company presents the information concerning its nominating process. If the SEC determines that the company doesn't provide sufficient details, it can ask that the company expand its information.

Contacting board members

A company must put a process in place that permits security holders to send communications to the board of directors or supply a statement from the board explaining why it believes that not doing so is appropriate.

The board must make a public disclosure about its communications process with security holders that includes a description of how security holders can communicate with the board and, if applicable, a list of specific board members who deal with specific topics. If the board decides that not all security holder communications are to be sent directly to board members, it must specify how it selects which communications it sends to board members. It can make this disclosure on the company's website or in annual reports.

Finding Out about Insider Ownership

As an investor, tracking the ownership of stock by insiders can give you a good idea of how they feel about owning the company's stock. If most of the insiders buy the stock, it's usually a good sign — the insiders believe in the long-term performance of the company. But if you find that insiders primarily sell their holdings, trouble may be brewing.

Forms 3, 4, and 5 are used to file information about holdings by individuals or entities who are directors, officers, or major shareholders (holders of more than 10 percent of the stock). Keep your eye on these three important forms to find out what insiders think of the stock:

• Form 3: Filed when an individual or entity first takes ownership of stock
• Form 4: Filed when an individual or entity changes ownership of stock
• Form 5: Filed as an annual statement summarizing changes in stock ownership of directors, officers, or major shareholders

You can find forms filed with the SEC at www.sec.gov/edgar.shtml, but it's easier to use certain financial websites to track stock transactions made by company insiders. On Yahoo! Finance (http://finance.yahoo.com/), after you get to the main page for a particular company, you find a link in the left column for insider transactions. You can also get a list of major stockholders by using the link in the right column for major holdings.