In 2017, the Public Company Accounting Oversight Board (“PCAOB”) adopted a new standard for auditor’s reports that requires a description of critical audit matters (“CAMs”) designed to provide investors with information that relates to accounts or disclosures that are material to a company’s financial statements and involve especially challenging, subjective or complex auditor judgment. The CAM standard will be required for audits for fiscal years ending on or after June 30, 2019 for large accelerated filers.

On December 10, 2018, in anticipation of the implementation of the CAM standard, the Center for Audit Quality released a paper titled “Lessons Learned, Questions to Consider, and an Illustrative Example” highlighting observations made from practice dry runs of the CAM standard. The paper seeks to identify and provide clarity on the numerous factors that can influence an auditor’s CAM decision. The paper reminds audit committees that the determination of CAMs, and resulting disclosure, is not meant to be indistinguishable between companies but rather unique to each particular audit and company. Nonetheless, the following early themes noted in the paper from the practice dry runs should be valuable for audit committee members, auditors and financial executives as compliance becomes mandatory:

  • As the PCAOB standard requires a CAM to be material to a company’s financial statements, a relationship must exist between the CAM communicated in the auditor’s report and the accounts or disclosures in the financial statements to which the CAM relates.
  • An auditor may determine that certain critical accounting estimates or assumptions meet the definition of a CAM. The paper identifies legal contingencies as a critical accounting estimate that may be considered a CAM depending upon the facts and circumstances of the particular audit.
  • Not every significant risk will be subject of a CAM. The paper notes that fraud risks are considered significant but may not involve especially challenging, subjective or complex judgment and therefore may result in a CAM.
  • CAMs are most likely to relate to areas that involve a significant degree of estimation or assumptions that necessitate management judgment. The paper identifies auditing goodwill, impairment, intangible asset impairment, business combinations, aspects of revenue recognition, income taxes and fair valuation of financial instruments as areas that are likely to result in a CAM.
  • Most audits will identify at least one CAM, although the paper notes it is possible that an auditor may determine that no CAMs are present.

A copy of the full paper may be obtained using the below link: https://www.thecaq.org/critical-audit-matters-lessons-learned-questions-consider-and-illustrative-example

 

The Securities and Exchange Commission announced that it will hold an open meeting on December 19, 2018.  Among other things, the Commission will consider a rule requiring disclosure of hedging arrangements entered into by a reporting company’s directors and employees as required by Dodd-Frank Act Section 955, as well as whether to issue a comment request regarding the content of quarterly reports and earnings releases issued by reporting companies.  The latter has been the subject of significant media coverage since a Presidential tweet suggested that quarterly reporting contributes to short-termism (see our previous blog post).  The proposed package of legislation known as JOBS Act 3.0 contains a bill that would require that a study be conducted by the Commission regarding the requirement for quarterly reporting by smaller reporting companies.  See the meeting notice here: https://www.sec.gov/news/openmeetings/2018/agenda121918.htm.

 

Accounting Standards

Representatives from the Office of Chief Accountant discussed new accounting standards.  The Staff commented on the implementation of the new revenue recognition standard, which requires companies to provide a comprehensive view of revenue arrangements in their financial statements, including their disclosures.  The Staff intends to continue to monitor, and comment on, the implementation of the revenue standard.  The Staff noted that nearly all companies will be affected by the adoption of the new lease accounting standard, which will soon be effective.  To that end, representatives of the Staff have provided guidance on implementation of the standard, which, representatives of the Staff caution require significant time and effort.  Various representatives noted that steps for lease accounting implementation include:  understanding the accounting and disclosure requirements of the new standard; identifying relevant arrangements and leases within those arrangements; determining appropriate accounting policies, including applicable transition elections; applying the guidance to arrangements within the standard’s scope; preparing transition and ongoing disclosures; and establishing adequate and appropriate processes and controls to support implementing and applying the new standard, including preparing required disclosures.  Representatives noted that “it is crucial for each registrant to ensure its implementation plans include sufficient time to identify arrangements that are leases in their entirety or that include embedded leases….[i]t is also critical for companies to identify and resolve transition, application, and other implementation issues arising from the new leases standard.  A lesson learned from the implementation of the new revenue standard is that entities benefit from an early and thorough discussion of implementation issues with their auditors and audit committees.”

Audit Committee Oversight

Various Staff members noted the important role of the audit committee in connection with the implementation of new accounting standards.  To that end, the Staff noted that the audit committee should exercise oversight over management’s approach to implementation of new accounting standards, should establish appropriate controls and procedures over the transition; maintain appropriate controls and procedures over ongoing application of the new accounting standard; and should understand how the effects of the new standard are communicated to investors at transition and on an ongoing basis.

Internal Control over Financial Reporting

Various speakers addressed internal control over financial reporting.  In this regard, the speakers again emphasized the important role of audit committees.  Audit committees should have discussions of ICFR in all areas—from risk assessment to design and testing of controls, as well as the appropriate level of documentation.  The Staff noted the importance of identifying and communicating material weaknesses before these manifest in the form of a financial statement restatement.  The Staff noted there has been progress in the evaluation of the severity of internal control deficiencies.  The Staff encouraged audit committee training regarding “the adequacy of and basis for a company’s effectiveness assessment, particularly where there are close calls in the assessment of whether a deficiency is a significant deficiency (and reported to the audit committee) or a material weakness (and reported also to investors).”  Speakers also emphasized that the assessment of ICFR is especially important this year-end as a result of the implementation of new accounting standards, which also affects a company’s internal controls.

Material Weakness Disclosures

Representatives of the Staff noted improvement in the disclosures of a material weakness; however, suggestions were offered that are intended to make the disclosures more useful to investors.  One of the speakers suggested considering the following questions in evaluating the proposed disclosure:

  • Does the disclosure allow an investor to understand what went wrong in the control that resulted in a material weakness?
  • Is it sufficiently clear from the disclosure what the impact of each material weakness is on the company’s financial statements?  For example, is the material weakness pervasive or isolated to specific accounts or disclosures?
  • Are management’s plans to remediate the material weakness sufficiently clear?  For example, does disclosure of the remediation plans provide sufficient detail that an investor would understand what management’s plans are and how the remediation plans would address the identified material weakness?

Implementation Activities for Communicating Critical Audit Matters

The Staff also addressed implementation activities related to the CAM standard.  In order to prepare for the CAM standard implementation, the Staff encourages auditors and registrants to conduct a dry run this year with the auditors and audit committees, share implementation questions and issues with the Staff, and begin to focus on the differing disclosure requirements for MD&A critical accounting estimates and CAMs.

On Friday, the Chair of the Securities and Exchange Commission Jay Clayton, the Commission’s Chief Accountant Wes Bricker, and the Chairman of the PCAOB William Duhnke issued a statement reaffirming the significance to the capital markets of high quality and reliable financial statements, which, in turn, depend on the reliability of financial statements, quality audit services and effective regulatory oversight.  The statement notes the particular responsibility of U.S. regulatory agencies in monitoring audit-related information and in overseeing the regulatory framework for financial reporting.  The statement notes that U.S.-listed companies accounted for approximately 40% of the market capitalization of global public companies in 2017.

The Chairs of the Commission and the PCAOB and the Chief Accountant noted the formal cooperative arrangements that are in place between the Commission and foreign regulators and enforcement agencies, as well as the cooperative agreements in place between the PCAOB and foreign regulators allowing for the PCAOB to conduct joint inspections with such regulators or providing for the sharing of information.  Perhaps because of the increase in the number of China-based IPOs, the remarks focus on difficulties associated with obtaining access to information that would allow the PCAOB to do its work.  The remarks note that the laws of various countries include blocking statutes and data protection, privacy, confidentiality, bank secrecy, state secrecy, and national security laws that may create obstacles to cross-border flows of information between regulators and foreign-domiciled registrants.  In addition, the statement notes that the positions taken by some foreign authorities currently prevent or impair the PCAOB’s ability to inspect non-U.S. audit firms in certain countries.  The remarks then go on to address the issues affecting China-based companies:

“The Commission and the PCAOB currently face significant challenges in overseeing the financial reporting for U.S.-listed companies whose operations are based in China.  The business books and records related to transactions and events occurring within China are required by Chinese law to be kept and maintained there.  China also restricts the auditor’s documentation of work performed in the country from being transferred out of China.  China’s state security laws are invoked at times to limit U.S. regulators’ ability to oversee the financial reporting of U.S.-listed, China-based companies.  In particular, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers.  As a result, for certain China-based companies listed on U.S. stock exchanges, the SEC and PCAOB have not had access to the books and records and audit work papers to an extent consistent with other jurisdictions both in scope and timing.”

The statement also alerts market participants that the PCAOB publishes on its website a list of companies whose auditors are located in jurisdictions where there are obstacles to PCAOB inspections, which currently includes 224 issuers of which 213 have auditors based in China or Hong Kong.  The statement concludes with an expression of frustration regarding the inability to have made more progress in reaching agreements with China that would provide the Commission and the PCAOB access to the information needed for information sharing, inspections, and oversight.  Finally, the Chairs and the Chief Accountant note that the failure to enter into such arrangements results in investor protection issues.  In order to address these investor protection issues, the Commission may be required to adopt measures mandating additional disclosures or even to restrict new issuances.

On August 17, 2018, the US Securities and Exchange Commission (SEC) amended certain disclosure requirements that it determined to be redundant, duplicative, overlapping, outdated or superseded in light of other SEC disclosure requirements, US GAAP or changes in the information environment.  Our Legal Update highlights several key amendments, discusses related practical considerations for companies and provides a table listing the SEC rules, regulations and forms impacted.

Many recent press articles lamenting “short-termism” in corporate America blame research analysts for focusing on quarterly earnings.  In a recent paper titled, “Analyst Coverage and the Quality of Corporate Investment Decisions” authors Thomas To, Marco A. Navone and Eliza Wu demonstrate a causal connection between analyst coverage and good investment decisions.  The authors assess the impact of financial analyst coverage on corporate investments by evaluating corporate total factor productivity (or efficiency gains) for US listed companies from 1991 to 2013.  Their “information hypothesis” postulates that analyst coverage delivers information about companies to the market and may therefore provide those companies with access to funding that permits companies to make capital expenditures and other investments.  Also, as a result of analysts monitoring companies and revealing negative information and assessments to the market, it ensures that company management’s will undertake the most productive projects.  In this latter case, analysts effectively serve as monitors prompting companies to improve capital allocation efficiency.   The study also shows that a reduction in analyst coverage reduces capital expenditures and institutional monitoring.  In this light, perhaps the claims that analysts contribute to short-termism should be reevaluated.

Even before the Trump tweet, discussions regarding interim reporting requirements for U.S. public companies had been ongoing for several years.  In fact, going back to 2015, the Securities and Exchange Commission’s Advisory Committee on Small and Emerging Companies considered the advantages and disadvantages associated with discontinuing quarterly reporting.  In 2016, the Director of the Commission’s Division of Corporation Finance addressed the issue in a speech in Europe, noting that, “The United Kingdom has stopped mandating that companies provide quarterly financial reports to investors. Lately, some commentators have asked the Commission to re-think the need for quarterly reporting by U.S. issuers, which has been a staple of the U.S. regulatory system since 1970, advocating that this frequency leads to short-term thinking by investors and company management. These commentators note that financial reporting that focuses on short-term performance is not conducive to building sustainable businesses because it steers management to focus on short-term goals and performance.”  Flash forward a few years, and Title XXII Section 2201 of the JOBS Act 3.0 requires that the Securities and Exchange Commission conduct an analysis regarding the costs and benefits of quarterly reporting on Form 10-Q, especially for emerging growth companies.  This provision may have been influenced by a report published by various trade groups, including SIFMA, about which we recently blogged.  In that trade group report, a recommendation is made that emerging growth companies be given the option to issue a press release with their quarterly results rather than be required to file a quarterly report on Form 10-Q.  The trade group report states that quarterly reports have become longer and more detailed, and therefore producing such reports has become more expensive.  In the trade group report, the focus was on costs and reporting burdens.

At the same time, the debate relating to quarterly earnings guidance has been reinvigorated.  Some have argued that quarterly reporting distracts managers from focusing on long-term goals and observe that public companies are all too concerned with short-term gains at the expense of long-term investments. The same commentators have focused in particular on the potential detrimental effects of providing quarterly earnings guidance.  Perhaps these concerns are overstated.  It seems that over time, fewer and fewer companies continue to provide quarterly earnings guidance.  According to a recent study, approximately one-third of public companies issue quarterly earnings guidance.  Nonetheless, in a piece titled “Short-Termism is Harming the Economy,” Jamie Dimon and Warren Buffett joined the Business Roundtable in calling for companies to refrain from giving quarterly guidance. The National Association of Corporate Directors and the National Investor Relations Institute joined in the call to eliminate earnings guidance. However, the Business Roundtable report does not advocate terminating the filing of quarterly reports on Form 10-Q.  Regardless of whether quarterly reports on Form 10-Q are mandated or not, it would still be the case that companies would report quarterly results.  The two issues—quarterly filings and quarterly guidance—appear to have been conflated making it more difficult to parse the real issues.

The Securities and Exchange Commission has adopted amendments requiring the use of the Inline eXtensible Business Reporting Language (XBRL) format for the submission of operating company financial statement information and fund risk/return summary information. The amendments become effective 30 days after publication in the Federal Register (likely by the middle of August 2018) but provide a phased-in compliance period. Our Legal Update summarizes the new requirements and offers timing and other practical considerations.

The Securities and Exchange Commission’s Chief Accountant, Wesley Bricker, addressed attendees at a conference of the Institute of Management Accountants.  Mr. Bricker commented on the global nature of the capital markets.  He noted that “American investors are investing directly in the securities of foreign private issuers and companies based outside the United States and registered in non-U.S. jurisdictions.  At the end of 2016, U.S. investors had invested $9.9 trillion (of which U.S. mutual funds had invested over $4.3 trillion, and U.S. pension funds had invested over $1.3 trillion) in equity and debt securities listed in non-U.S. jurisdictions.”  In light of the interconnectedness of global markets, Mr. Bricker emphasized the importance of collaboration among organizations involved in financial reporting and the significance of promoting high-quality financial reporting.  Mr. Bricker commented on the importance of internal control over financial reporting, as well as on the role of preparers of financial reports.  Mr. Bricker also noted the role of auditors as gatekeepers.  He also touched on the role of the PCAOB and the role of audit committees.  Mr. Bricker outlined a number of questions that audit committee members ought to pose to a company’s external auditors, including the following:

  • In an audit of the financial statements, was the external auditor able to rely on a company’s internal control over financial reporting?
  • If not, which of the business processes included the internal controls on which the auditor did not (or could not) place reliance? What were the factors that prevented reliance?
  • Were any significant deficiencies or material weaknesses identified (and communicated in writing)?
  • How did management consider that feedback in preparing the financial statements, including in its period-end closing processes?

Mr. Bricker noted that communications between the audit committee members, the auditors and management regarding financial reporting and internal control over financial reporting should be candid.  The full text of his remarks is available here.

Today, the House Financial Services Committee advanced six bills for House consideration, including H.R. 5054, H.R. 5756, and H.R. 5877.

H.R. 5054, the Small Company Disclosure Simplification Act of 2018, which was introduced by Representative David Kustoff (R-TN), the “Small Company Disclosure Simplification Act of 2018” provides a voluntary exemption for emerging growth companies and other smaller companies from the requirements to use Extensible Business Reporting Language (xBRL) for financial statements and other periodic reporting.  The bill passed 32-23.

H.R. 5756, to require the Securities and Exchange Commission to adjust certain resubmission thresholds for shareholder proposals, which was introduced by Representative Sean Duffy (R-WI), H.R. 5756 requires the Securities and Exchange Commission to adjust certain resubmission thresholds for shareholder proposals.  The bill passed 34-22.

H.R. 5877, the Main Street Growth Act, which was introduced by Representative Tom Emmer (R-MN), the “Main Street Growth Act” amends the Securities Exchange Act of 1934 to allow for the registration of venture exchanges to provide a venue which will allow qualifying companies one venue in which their securities can trade.  The bill passed 56-0.