Significant adverse effects: warning signs for stocks

Investors need to recognize some important phrases as major red flags. Unfortunately, in documents and legal prototypes filed with the US Securities and Exchange Commission, companies often try to cover up these phrases in an attempt to reduce their impact on the market. Fortunately, by identifying a few key phrases, ordinary readers will be wary of some very important information that will help avoid investment errors. One of these keywords is “significant adverse impact.”

Here, we will look at the meaning of the statement and why investors should not ignore it.

Introduction to Material Adverse Effects

Significant adverse effects usually mean that profitability has been severely reduced or the company’s operations or financial conditions may be severely impaired. This is a clear signal to investors that there is a problem.

For example, suppose that the company Industrial Blowdart Inc. has a major customer that accounts for 25% of annual sales. If the customer conducts business elsewhere, the decision will have a material adverse effect on Blowdart’s sales, profitability, and ability to continue operations. The company’s material adverse effects may be as follows: “A customer accounts for more than 25% of our annual sales. This loss will have a material adverse effect on Blowdart’s profits and will continue to be watched.”

Or, suppose that Blowdart has a critical line of credit to finance working capital (ie, inventory or accounts receivable). If the bank refuses to renew the credit line, the difficulty or inability to find another lender will have a significant adverse impact on Blowdart’s operating cash flow and normal operating capacity, let alone continue as a viable business.

Generally Accepted Accounting Principles (GAAP) allow flexibility in determining what must be defined and disclosed as material adverse events. However, despite actions taken by the US Securities and Exchange Commission in 1999 and stricter scrutiny of companies, many companies continue to use their own definitions to manage revenue.

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Importance: If it is important, it is matter

This information is important if it can be reasonably expected that the disclosure of this information will affect the company’s stock price. Companies and their accountants continue to find ways to manage revenue by proposing their own definitions of importance. This involves establishing a numerical threshold (e.g. 5%) and deciding that anything below the threshold will not affect the bottom line and is irrelevant, so there is no need for discussion. There are also cases where companies are antagonizing each other in order to cover up their mistakes in order to stay below the digital threshold. The reason for this deception is earnings management.

In 1999, the SEC filed a lawsuit against WR Grace & Co., alleging that the company used $60 million in non-substantial item “reserves” from 1991 to 1995 to smooth out earnings-the company’s auditors were fully aware of. The SEC claims that the use of such reserves is not in accordance with GAAP. In 1999, WR Grace agreed to stop using this practice and paid $1 million to funds related to GAAP education.

Unfortunately, many companies continue to make net assets on non-material projects to achieve profitability goals. Netting occurs in the other income/expense line of the income statement. Items used for netting are investment gains/losses and restructuring reserves.

In 1999, the SEC tried to prevent companies from hiding important items by enacting the following rules:

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  • Intentional misstatement, even if the amount involved is not significant, it is material due to intentional misleading.
  • The digital threshold alone is unacceptable.
  • If the misstatement would obscure changes in earnings or involve key business units, management must also weigh qualitative issues.
  • The company cannot net items. Netting resulted in misstatement of the company’s financial statements.

Not a warning sign

Significant adverse effects are not warning signs, but the situation has deteriorated to a very bad stage. Usually, this is the result of events that accumulate over time that compound to the point where the critical limit is exceeded. Paying close attention to the company’s operating performance over time will alert investors to potentially significant adverse effects. This awareness requires a lot of effort, time and experience.

For example, suppose Blowdart’s financial situation has deteriorated to the point where it defaults on its loan contract. This is a major adverse event because it means that if the company and the bank cannot agree on how to restructure the loan, the loan may be recovered and needs to be repaid immediately. This will bankrupt Brodat.

If you follow Blowdart stock, you know it has problems. You must also dig into SEC documents to find the loan agreement, and then read these complex documents to find the relevant loan contract and the indicators used to determine whether the borrower is compliant or in default.

It is possible that Blowdart and its bankers could restructure loans and make the company through difficult times. Conversely, if the bank wants to withdraw from the relationship, Blowdart needs to find another lender, which may not be easy due to the company’s recent operating history or current unfavorable economic conditions.

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Under this hypothetical situation, investors need to look at the stock based on their degree of risk aversion. Although the result may even be that 60/40 is good for successful loan renegotiation, you may not want to deal with the increased risk. If so, sell the stock. However, if you have carefully studied the company and the industry and believe that there are some strong underlying reasons for holding the stock for a long time, you may decide to stick to it.

Where can I find a significant adverse impact statement

Government regulations require companies to disclose major events. The phrase “significant adverse effect” can be found in the following:

  • Notes to the financial statements (called footnotes) appear in the company’s 10-Qs and 10-Ks and the auditor’s opinion, and are related to issues that may cause significant adverse effects. For example, a material adverse effect statement will appear in Blowdart’s financial statement notes, which discuss the concentration of accounts receivable or customers and their debt and credit lines.
  • If the press release involves financing issues or the company announces a major event, the press release may contain a material adverse effect phrase.
  • The management’s discussion and analysis (MD&A) in the company’s annual report may contain some references to material adverse effects.

Bottom line

It is difficult to discuss every business detail in the company’s financial statements. A balance needs to be struck between the required disclosure and the burden of cumbersome reporting. Companies should be on the side of over-disclosure, because investors value transparency rather than the illusion of stable earnings.


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