- Kingsway Financial Services, Inc. [KFS] was forced to restate financial statements to correct revenue recognition errors related to adoption of ASC 606 and its effect on warranty subscriptions and commissions
- The restatement was triggered by a 15-letter comment letter conversation with the SEC which spanned over 194 days, more than four times the average length of comment letter conversations
- The Company also determined there was a material weakness in internal controls after being strongly encouraged to review controls in light of necessary revenue adjustment
- SEC also expressed concerns over potentially misleading non-GAAP adjustment that improved 2017 Adjusted Operating Loss by $7.2 million
On December 6, 2018, the SEC released a comment letter conversation with Kingsway Financial Services Inc. [KFS], an insurance carrier primarily based in Canada during the relevant period. Over the past few years, there has been an increase in negative events in the insurance industry, including an uptick in restatements and control weaknesses. And despite an overall downward trend of SEC comment letters for all registrants, in 2017, the insurance industry saw almost double the amount of comment letter conversations that occurred in 2016.
The comment letter conversation with Kingsway Financial was notable as it consisted of 15 letters and lasted 194 days, significantly longer than the average of 4 letters and 45 days for most SEC conversations, and because the conversation ended with the restatement of previously filed financial statements. So far, only 6 conversations in 2018 (including Kingsway Financial Services) ended with the acknowledgement that accounting treatment was an error and that financial statements need to be restated. In most cases, the comments are resolved by adding clarifying disclosure in future filings.
The initial comment letter from the SEC dated April 25, 2018 contained ten comments which addressed provisions for unpaid losses and loss adjustment expenses, intangible assets, fair value of financial instruments, and regulatory capital requirements. However, the comment that took the longest to resolve stemmed from revenue recognition and the adoption of ASU 2014-09 (Topic ASC 606) Revenue from Contracts with Customers.
As the adoption of ASC 606 became effective January 1, 2018 for companies with a calendar year end, there has been an increase in the number of comments issued by the SEC related to revenue recognition. Many of these comments request clarification on a company’s adoption of ASC 606 and, as mentioned in Compliance Week, the SEC has indicated that the first annual reports under the new standard will be heavily scrutinized. Since January 2017, 142 companies received ASC 606 comments and this number is likely to increase as SEC continues their push to add clarity to the ASC 606 disclosure.
For Kingsway Financial, the ASC 606 comment that eventually ended with a restatement was related to warranty subscriptions sold by the company’s two wholly-owned subsidiaries, Trinity Warranty Solutions, LLC (“Trinity”) and PWSC (that was acquired in October 2017). The SEC review initially started with questions about commissions earned by Trinity but expanded to PWSC and was eventually resolved by restating $990,000 in revenue recognized by PWSC.
To understand SEC concerns, let’s look at the chronology of events that led SEC to challenge the warranty accounting.
The disclosure that triggered SEC scrutiny was language that implied that Trinity is serving as an underwriter for the warranty contract. From an accounting perspective, underwriting the contracts would mean that the selling party is acting as a principal and the ongoing underwriting commitment would prevent the company from recognizing the warranty revenue upfront before fulfilling all the performance obligations (the emphasis is ours):
As a seller of warranty products, Trinity markets and administers product warranty contracts for certain new and used products in the HVAC, standby generator, commercial LED lighting and refrigeration industries throughout the United States. A warranty contract is an agreement between Trinity and the purchaser of such HVAC, standby generator, commercial LED lighting and refrigeration equipment to replace or repair, for a specific term, designated parts in the event of a mechanical breakdown. As a provider of equipment breakdown and maintenance support services, Trinity acts as a single point of contact to its clients for both certain equipment breakdowns and scheduled maintenance of equipment. Trinity will provide such repair and breakdown services by contracting with certain HVAC providers.
The comment letter questioned an apparent inconsistency regarding Trinity in the disclosure (the emphasis is ours):
Please tell us why it is appropriate to recognize commissions on product and new homebuilders warranties at the time of product sale and home certification, respectively. Reference for us the authoritative literature you rely upon to support your accounting. In your response, address the following:
• Tell us who is responsible for the guarantee underlying each type of warranty.
• Tell us how the commission portion is determined separately from the service component for each type of warranty.
• Explain how a commission is earned for the product warranties when it appears from disclosure in Business on page 8 that each warranty is a contract between your subsidiary, Trinity Warranty Solutions LLC, and the equipment purchaser.
• Explain to us your application of ASC 606 for these contracts such that revenue will not be materially different from that under ASC 605 as indicated in your disclosure in Note 3(b) on page 70.
In its response, the Company clarified that Trinity is acting as an agent and therefore the revenue can be recognized upon the sale of the warranty.
Although the initial comment only requested clarification of the differences between old and new revenue standards (which is not uncommon), in the follow up comments SEC used a stronger language to indicate that the warranty disclosure in the 10-K filing could be misleading:
Although you represent in your response that Trinity acts as an agent on behalf of third-party insurance companies that underwrite and guaranty the relevant warranty contracts, it appears from your disclosure in the third paragraph of the Extended Warranty Products section on page 8 of your 2017 Form 10-K that the warranty contract is an agreement between Trinity and the purchaser of the relevant equipment. Please provide us proposed revised disclosure to be included in future filings that removes the implication that Trinity underwrites the warranty products.
Trinity’s principal-agent accounting issue was resolved by providing additional clarifying language in subsequent filings. Yet, the follow-up SEC comments made it clear that the review of warranty accounting is still ongoing. On August 8, 2018, the SEC issued another comment requesting further clarification about the distinction between the Homebuilder warranty administrative fee and a Homebuilder warranty service fee and the allocation of transaction price in the PWSC unit.
To defend its methodology of adopting ASC 606, the Company’s August 13, 2018 response to the SEC provided further explanation of their current use of a residual method to estimate selling price of warranty administrative services performance obligations:
The Company receives a single warranty service fee as its transaction price at the time it enters into a written contract with each of its builder customers. The transaction price is then allocated to the two separate performance obligations identified, specifically the warranty administrative services and the other warranty services described in the paragraphs above, based on an estimated cost-plus margin approach.
However, the SEC noted an inconsistency in their response, and again requested clarification regarding performance obligations:
It is apparent from your response to prior comment 2 that you utilize the residual approach to allocate transaction price to the “warranty administrative services” by deducting the selling price of the “other warranty services” derived under the expected cost plus a margin approach from the overall transaction price. Please tell us why it is appropriate to use the residual approach when ASC 606-10-32-34c indicates that this method subtracts the sum of observable standalone selling prices or other goods or services promised in a contract from the total selling price and it does not appear that the selling price of your “other warranty services” derived under the expected cost plus a margin approach is observable.
It was not until the eighth letter in the conversation that Kingsway Financial acknowledged adjustments were necessary to the previously reported homebuilder warranty service fees and commission income to reflect the ASC 606 standard:
As described in our August 13, 2018 response to comment 2, the Company previously had developed a cost plus margin model to estimate the standalone selling price for its other warranty services performance obligation. Now that the Company has developed a cost plus margin model for each of the two distinct performance obligations in the PWSC warranty contracts, the Company is able to apply a cost-to-cost approach to estimate the standalone selling prices of the two performance obligations. The relative percentage of costs associated with the warranty administrative services performance obligation is applied to the transaction price to determine the estimated standalone selling price of the warranty administrative services performance obligation, which PWSC recognizes as earned at the time the home is enrolled and the warranty product is delivered. The relative percentage of costs associated with the other warranty services performance obligation is applied to the transaction price to determine the estimated standalone selling price of the other warranty services performance obligation, which PWSC recognizes as earned as services are performed over the warranty coverage period. As a result of the Company’s revised analysis, it was concluded that the cost-to-cost approach will result in the Company recognizing revenue more slowly compared to the previously calculated revenue recognition pattern.
Yet, even the acknowledgement of the need for adjustments did not end the Corp Fin review. Initially, in the eighth letter on October 3, 2018 the company argued that the adjustment is immaterial and proposed to correct the errors on a cumulative basis as an out-of-period adjustment in the September 30, 2018 quarterly report.
In the October 26, 2018 comment letter, the SEC explicitly asked for confirmation from the Company that their upcoming report for the period ended September 30, 2018 would include the error correction and revised financial statements for the affected periods. Additionally, the SEC requested that the Company reevaluate the effectiveness of their disclosure controls and procedures, in light of the identified error.
The quarterly report filed with the SEC on November 9, 2018, four days after the completion of the Corp Fin review, contained the revised financial statements. For the six months ended June 30, 2018, the Company disclosed a failure to appropriately allocate transaction price to two separate performance obligations, and as a result corrected the initial adoption of ASC 606 to reflect the applied expected cost-plus-a-margin approach to estimate standalone selling price for each performance obligation. The adjustment in methodology means that the Company will recognize revenue more slowly than the Company’s initial application of ASC 606. The error was corrected as a revision restatement that decreased net income by $990,000 for the Q1 and Q2 periods of 2018 (the only periods that were filed under the new revenue recognition method).
In the eleventh letter of the conversation, the SEC inquired about the effectiveness of the Company’s controls. Despite Kingsway Financial’s determination that the error was immaterial, the Company decided there was potential for material errors not to be detected. As a result of the suggested repeat-analysis, management concluded their disclosure controls and procedures were ineffective because of a material weakness in internal controls over financial reporting related to the adoption of ASC 606 during the revised periods.
To remediate the material weakness, the Company determined to engage an outside accounting expert to assist with reviewing the adoption process of new accounting standards.
In addition to ASC 606, there was another notable comment in the SEC review. In the first letter to the Company, the SEC requested clarification about normal, recurring, cash operating expenses that were removed to arrive at Adjusted Operating Loss; removing normal and recurring adjustments is prohibited under Question 100.01 of C&DIs and could potentially be misleading.
In response, the Company indicated that Corporate operating expenses are recurring in nature and agreed to remove this reconciling adjustment in future filings. The Corporate operating expenses improved the GAAP to non-GAAP difference by $7.2 million in 2017.
Although non-GAAP comments are not uncommon, only 8.09% of all non-GAAP reviews since January 1, 2016 reference Question 100.01 and 38.55% of the Question 100.01 comments end with a request to remove the misleading adjustment. Arguably, comments that request to remove specific adjustments are more serious in nature than the generic comments that request clarifying disclosure in future filings.
There are a few takeaways from the 15-letter SEC review of KFS. First, we are likely to see more difficult ASC 606 comments as the SEC extends the review to the annual reports; some of these comments may end with a restatement of previously filed financials or the discovery of material weaknesses. It is also notable that for Kingsway Financial, the new revenue guidance did not have an overall material impact since insurance contracts and investments are outside the scope of the standards. However, the lengthy SEC review indicates that the complexity inherited with the new standard may have negative consequences, even for industries such as insurance and financial sectors.
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