Category Archives: Hot Topic

Going Concern Reporting – The Gap in GAAP Versus GAAS – Part One

By: George M. Wilson & Carol A. Stacey

 

This is the first of three posts about an interesting conundrum in reporting that arose last year. The FASB, with ASU 2014-15, now requires disclosures by companies about going concern issues. However, there can be gaps between what companies are required to disclose and impact of going concern issues on the auditor’s report.

ASU 2014-15 added subtopic 205-40 “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” to the Accounting Standards Codification. This update became effective for periods ending after December 15, 2016. Previously there was no specific requirement for management to make these disclosures. (This is of course Generally Accepted Accounting Principles, or GAAP).

Auditors have had guidance in this area for many years courtesy of the PCAOB’s standard in AU section 341, which is now section AS 2415 in the PCAOB’s reorganized auditing standards. (This is Generally Accepted Auditing Standards, or GAAS).

 

To explore the gap between GAAP for companies and GAAS for auditors when reporting going concern issues we are going to present a series of three posts:

 

This first post will present an example of a going concern disclosure by a company and whether or not the auditor’s report was modified. (Spoiler – there was no mention in the auditor’s report!)

 

The second post will explore company disclosure requirements.

 

The third and last post will review auditor’s reporting requirements and detail the gaps between company and auditor reporting.

 

Sears Holdings, the retailer that owns Kmart and Sears, provided an example of this gap in their Form 10-K for the year ended January 28, 2017. In their financial statements Sears Holdings included this language:

We acknowledge that we continue to face a challenging competitive environment and while we continue to focus on our overall profitability, including managing expenses, we reported a loss in 2016 and were required to fund cash used in operating activities with cash from investing and financing activities. We expect that the actions taken in 2016 and early 2017 will enhance our liquidity and financial flexibility. In addition, as previously discussed, we expect to generate additional liquidity through the monetization of our real estate and additional debt financing actions. We expect that these actions will be executed in alignment with the anticipated timing of our liquidity needs. We also continue to explore ways to unlock value across a range of assets, including exploring ways to maximize the value of our Home Services and Sears Auto Centers businesses, as well as our Kenmore and DieHard brands through partnerships or other means of externalization that could expand distribution of our brands and service offerings to realize significant growth. We expect to continue to right-size, redeploy and highlight the value of our assets, including our real estate portfolio, in our transition from an asset intensive, historically “store-only” based retailer to a more asset light, integrated membership-focused company.

 

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements. However, we cannot predict, with certainty, the outcome of our actions to generate liquidity, including the availability of additional debt financing, or whether such actions would generate the expected liquidity as currently planned. In addition, the PPPFA contains certain limitations on our ability to sell assets, which could impact our ability to complete asset sale transactions or our ability to use proceeds from those transactions to fund our operations. Therefore, the planned actions take into account the applicable restrictions under the PPPFA.

 

If we continue to experience operating losses, and we are not able to generate additional liquidity through the mechanisms described above or through some combination of other actions, while not expected, we may not be able to access additional funds under our amended Domestic Credit Agreement and we might need to secure additional sources of funds, which may or may not be available to us. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Moreover, if the borrowing base (as calculated pursuant to the indenture) falls below the principal amount of the notes plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for the notes on the last day of any two consecutive quarters, it could trigger an obligation to repurchase notes in an amount equal to such deficiency.

 

Sears Holdings used the term “substantial doubt”, but indicated that they believed their plans mitigated this “substantial doubt”.

 

This was the report of Sear’s Auditors:

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sears Holdings Corporation and subsidiaries as of January 28, 2017 and January 30, 2016, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 28, 2017, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 28, 2017, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

No mention of a going concern issue at all in the auditor’s report! What is an investor to think? Historically, when the only concrete guidance was in GAAS, it was very rare to see this issue not discussed in both the financial statements and the auditor’s report.

 

This is, of course, part of the gap between GAAP and GAAS. In our next post we will begin to explore the space in this gap!

 

 

As always, your thoughts and comments are welcome!

Frequent Comment Update: Part Two – Cash Flows

By: George M. Wilson & Carol A. Stacey

 

In our blog post “Time Again for a Frequent Comment Update”, we listed the frequent comment areas that CorpFin Staff members have been discussing at our Midyear Forums. In that post, we also highlighted a number of recent comments about non-GAAP measures. In this post, we turn our attention to comments about the statement of cash flows.

 

In the last several years there have been a number of restatements related to the statement of cash flows, some undoubtedly related to comment letters. Additionally, the FASB and EITF have issued two ASU’s to address various issues in the statement of cash flows.

 

ASU 2016-15 in August 2016

Provides guidance on 8 specific cash flow issues

 

ASU 2016-18 in November 2016

Provides guidance on classification and presentation of restricted cash

 

 

There is much discussion about root causes for cash flow statement problems. Theories range from the idea that the statement is prepared late in the reporting process and perhaps tends to be a more mechanical, “do it the way we did it last year” process, to the fact that there are some areas that are ambiguous in the cash flow statement guidance. Whatever the causes, there is clearly a need for care and review in preparing the statement of cash flows.

 

This first comment is about being sure you are familiar with the statement of cash flow requirements and also addresses a frequent problem area of ASC 230, discontinued operations:

 

We note your presentation of the decrease in cash and cash equivalents from discontinued operations in one line item. Please note that ASC 230-10-45-10 requires that a statement of cash flows shall classify cash receipts and cash payments as resulting from investing, financing, or operating activities. Please revise your current presentation to classify the cash flows from discontinued operations within each of the operating, investing and financing categories.

 

Whether to show cash flows from financing activities on a gross or net basis is not a mechanical decision. It requires judgment about the substance of the financing as this comment demonstrates:

 

We note from your financing activities section in your statement of cash flows that you present net proceeds (repayments) of short-term borrowings rather than on a gross basis. Please explain to us your basis for this presentation. Refer to ASC 230-10-45-7 through 9.

 

Another interesting aspect of cash flow statement preparation is how to treat hybrid items that have an element of two different types of cash flows. This comment demonstrates this is not always a mechanical process:

 

We note your presentation of payments for the costs of solar energy systems, leased and to be leased. Given that approximately 61% of your revenues for the year ended December 31, 2015 and 64% of your revenues for the period ended June 30, 2016 represented solar energy systems and product sales, please tell us how you reflect the costs of solar energy systems sold on your statements of cash flows pursuant to ASC 230.

 

These last two comments are not strictly speaking financial statement comments. They are common MD&A comments, and definitely needs to be part of the statement of cash flows conversation. Frequently MD&A tries to explain operating cash flows with confusing or mechanical language relating to items in the indirect method reconciliation from net income to operating cash flows.

 

Note the mention of drivers in this comment:

 

We note that your discussion of cash flows from operating activities is essentially a recitation of the reconciling items identified on the face of the statement of cash flows. This does not appear to contribute substantively to an understanding of your cash flows. Rather, it repeats items that are readily determinable from the financial statements. When preparing the discussion and analysis of operating cash flows, you should address material changes in the underlying drivers that affect these cash flows. These disclosures should also include a discussion of the underlying reasons for changes in working capital items that affect operating cash flows. Please tell us how you considered the guidance in Section IV.B.1 of SEC Release 33-8350.

 

Lastly, note the focus on underlying reasons for change in this comment:

 

You say that in the statement of cash flows, you provide reconciliation from net loss to cash flows used in operating activities where you have provided quantitatively the sources of your operating cash flows. However, as you use the indirect method to prepare your cash flows from operating activities, merely reciting changes in line items reported in the statement of cash flows is not a sufficient basis for an investor to analyze the impact on cash. Therefore, please expand your disclosure of cash flows from operating activities to quantify factors to which material changes in cash flows are attributed and explain the underlying reasons for such changes. Refer to Section IV.B.1 of “Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations” available on our website at http://www.sec.gov/rules/interp/33-8350.htm for guidance. Provide us a copy of your intended revised disclosure.

 

 

As always, your thoughts and comments are welcome!

Fake SEC Filings and Enforcement in the Electronic Age

By: George M. Wilson & Carol A. Stacey

 

Over the many decades that equity securities have traded in the U.S., and over the centuries that equities have traded around the world, unscrupulous people have always tried to find ways to cheat others. From pump and dump schemes to fake analyst reports new ways are constantly evolving as less than ethical people look for a quick buck. One of the more recently developed sneaky tricks is to create a fictitious user ID in the SEC’s EDGAR system and try to manipulate a company’s stock with fake SEC filings such as tender offer documents. In a way this is kind of a “pump and dump” strategy, and it is all about fake news.

 

In February of this year an artist in Chicago used this trick to try and manipulate Alphabet’s stock. In May 2015, Avon stock was used in a similar scheme. In September 2015, a person used an SEC filing in the name of “LMZ & Berkshire Hathaway Co.” to try and manipulate Phillips 66 and Kraft Heinz. The report was signed with a false name.

 

That same false name was used on a filing to announce a fake tender offer for Fitbit in November 2017.

 

When there are new kinds of crimes, the SEC sets out to develop the right tools and techniques to find the perpetrators and protect investors and the markets from bad actors. They are making progress with this new kind of electronic and internet based crime. On May 19, 2017, fairly soon after the Fitbit false filing, the SEC announced an enforcement action against Robert W. Murray, the alleged perpetrator of this fraud, with a parallel criminal action by the U.S. Attorney’s Office for the Southern District of New York. Mr. Murry is a mechanical engineer based in Virginia.

 

According to the SEC Murray wove a tangled technical trail:

 

The SEC alleges that Murray created an email account under the name of someone he found on the internet, and the email account was used to gain access to the EDGAR system.  Murray then allegedly listed that person as the CFO of ABM Capital and used a business address associated with that person in the fake filing.  The SEC also alleges that Murray attempted to conceal his identity and actual location at the time of the filing after conducting research into prior SEC cases that highlighted the IP addresses the false filers used to submit forms on EDGAR.  According to the SEC’s complaint, it appeared as though the system was being accessed from a different state by using an IP address registered to a company located in Napa, California.

 

In the words of enforcement, this attempt to hide his actions did not work:

 

“As alleged in our complaint, Murray used deceptive techniques in a concerted effort to evade detection, but we were able to connect the dots quickly and hold him accountable,” said Stephanie Avakian, Acting Director of the SEC Enforcement Division.

 

For all his effort, and for the potential consequences, Murray’s ill-gotten gains in this scheme were only about $3,100!

 

Always fun to see how new ways to try and cheat don’t evade the consequences!

 

As always, your thoughts and comments are welcome!

 

Breaking News: Late last week, the PCAOB voted to make a significant change in auditing standards:

 

“The standard will create the first significant change to the standard form auditor’s report in 70 years, according to PCAOB Chairman James Doty.”

http://www.journalofaccountancy.com/news/2017/jun/pcaob-expands-auditor-reporting-duties-201716790.html

 

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Audit Committees and Financial Reporting 2017: Recent Developments and Current Issues

Co-Chairs: Catherine L. Bromilow – Partner, Governance Insights Center, PwC Linda L. Griggs – Consultant John F. Olson – Gibson, Dunn & Crutcher LLP

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Time Again for a Frequent Comment Update

By: George M. Wilson & Carol A. Stacey

Every six months, when we do our Midyear Forums in May and June and again when we do our Annual Forums in November and December, we discuss the SEC Division of Corporation Finance’s presentation of frequent comment areas. At our recent Midyear in Dallas the staff discussed the topics below, which are not in any particular order:

 

  • Non-GAAP Measures
  • Statement of Cash Flows
  • Segments
  • Income Taxes
  • Business Combinations
  • Fair Value
  • Goodwill
  • Revenue Recognition
  • Disclosure of Recently Issued Standards
  • Compensation
  • Internal Control over Financial Reporting

 

As usual the list contains many familiar topics and themes. In the next several weeks we will post about each of these topics.

 

For this first post, we’ve chosen non-GAAP measures which shouldn’t be a surprise. We are all likely familiar with the SEC’s focus on this area and the C&DI’s they issued in May 2016. For our review here we thought we would explore three of the more problematic C&DI’s and recent staff comments for each of them:

 

Question 100.01, which is about whether or not presentation of certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading,

 

Question 100.04, which is about attempts to build tailored accounting principles that are not in accordance with GAAP, and

 

Question 102.10, which discusses “equal or great prominence”.

 

 

When is an Adjustment Misleading, Even if it is Not Specifically Prohibited?

 

The full text of this C&DI is:

 

Question 100.01

 

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

 

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading. [May 17, 2016]

 

 

The idea of “normal, recurring, cash operating expenses” can be subjective. Here is an example where that C&DI is translated into a comment:

 

We note that you exclude pre-opening expenses as part of your calculation of Adjusted EBITDA. Please explain to us why these are not normal, recurring, cash operating expenses necessary to operate your business. In this regard, we note pre-opening expenses for all periods presented, along with your discussion throughout the Form S-1 that your growth strategy is to expand the number of your stores from 71 to 400 within the next 15 years. Please refer to Question 100.01 of the updated Non-GAAP Compliance and Disclosure Interpretations issued on May 17, 2016.

 

Here is another similar example:

 

Management’s Discussion and Analysis Earnings Before Interest, Taxes, Depreciation and Amortization (Non-GAAP measure)

 

Please tell us how you concluded that the amounts in the acquisition-related adjustments reconciling item were appropriately excluded from your non-GAAP measures (e.g., adjusted EBITDA, adjusted gross margin and adjusted SG&A) presented here and in your Item 2.02 Forms 8-K filed October 25, 2016 and December 8, 2016. It appears that in each period presented you may be reversing a portion of your GAAP rental expense and removing recurring cash operating expenses, like sponsor fees and other costs. Refer to Non-GAAP Financial Measures Compliance and Disclosure Interpretation, Questions 100.01 and 100.04, which can be found at:

 

http://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.

 

What is a Tailored Accounting Principle?

 

The full text of the C&DI is:

 

Question 100.04

 

Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?

 

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.   [May 17, 2016]

 

Here are two comments to illustrate that a company should not try to tinker with GAAP to create their own accounting principles. This first comment is an attempt to adjust revenue recognition so that a non-GAAP measure would include revenue that is deferred under GAAP:

 

  1. We note your response to prior comment 4. The adjustment “change in deferred amusement revenue and ticket liability” in arriving at your non-GAAP measure “adjusted EBITDA” appears to accelerate the recognition of revenue associated with the deferred amusement and ticket liability that otherwise would not be recognized in any of the periods for which adjusted EBITDA is presented. Accordingly, adjusted EBITDA substitutes a tailored revenue recognition method for that prescribed by GAAP and does not comply with Question 100.04 of the staff’s Compliance & Discussion Interpretations on Non-GAAP Financial Measures. Please remove this adjustment from your computation.

 

This second comment shows an attempt to undo business combination accounting:

 

Refer to the line items, ‘purchase accounting adjustments,’ and ‘purchase accounting amortization’ within the reconciliation of net income to adjusted income before income taxes. Please explain to us the basis behind these adjustments as they appear to portray tailored accounting principle under GAAP for business combination. Refer to the guidance under Questions 100.01 and 100.04 of C&DI on Non-GAAP Financial Measures.

 

What Does Equal or Greater Prominence Mean?

 

The text of this much-discussed C&DI is:

 

Question 102.10

 

Question: Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K.  Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?

 

Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:

 

Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;

 

Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;

 

Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;

 

A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);

 

Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;

 

Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;

 

Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and

 

Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence. [May 17, 2016]

 

This C&DI created perhaps the most confusion, or maybe consternation, raising issues of what is bolded and which measure is presented first. This first example comment is about a recent earnings release:

 

Your headline references “Record Q1 Non-GAAP Revenues and EPS, Growing 29% and 44% Respectively Year-over-Year” but does not provide an equally prominent descriptive characterization of the comparable GAAP measure. We also note several instances where you present a non-GAAP measure without presenting the comparable GAAP measure. This is inconsistent with Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016 (“the updated C&DI’s”). Please review this guidance when preparing your next earnings release.

 

This second example is from a recent MD&A:

 

Management’s Discussion and Analysis Non-GAAP Measures

 

Return on Invested Capital, page 47

 

Please present the comparable GAAP measure with equal or greater prominence and label the non-GAAP calculation as “adjusted” or similar. Refer to Item10(e)(1)(i)(A) and Question 102.10 of staff’s Compliance and Discussion Interpretation on Non-GAAP Financial Measures for guidance.

 

And this last comment is from a 2016 earnings release:

 

  1. We have the following observations regarding the non-GAAP disclosures in your fourth quarter 2016 earnings release:

 

  • Your statement of “net sales growth across all segments” in the earnings release headline is inconsistent with the segment results table on page 3 and appears to be based on pro forma adjusted results excluding foreign currency translation impact. In this regard, we note that both the Consumer and Other segments had a decrease in the reported net sales in 2016.

 

  •  It appears that you provide earnings results discussion and analysis of only non- GAAP measures in the body of the release without providing a similar discussion and analysis of the comparable GAAP measures.

 

  •  The measure you refer to as “free cash flow” is adjusted for items in addition to what is commonly referred to as free cash flow.

 

Please revise future filings to use titles or descriptions for non-GAAP financial measures that accurately reflect the amounts presented or calculated, and are not the same as, or confusingly similar to, GAAP measures. Also, to the extent you continue to discuss your results based on non-GAAP measures, you should also provide the comparative measures determined according to GAAP with equal or greater prominence. Refer to Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016.

 

Stay tuned for our next topic, the statement of cash flows next week, and as always, your thoughts and comments are welcome!

How Has the “Salman” Decision Changed Insider Trading Law?

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Chair: David I. Miller – Morgan, Lewis & Bockius LLP

In recent years, insider trading has been a critical area of criminal and civil enforcement, and it will likely remain so for some time to come. The Supreme Court issued its first insider trading opinion in nearly twenty years in the Salman appeal. Salman is significant and may assist the government in its ongoing insider trading enforcement efforts. Don’t miss out on this highly topical program where our experienced faculty will address the change in law, current and future areas of enforcement, and best compliance practices to prevent insider trading.

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Whither the Auditor’s Report?

By: George M. Wilson & Carol A. Stacey

 

Would you expect to find this language in an auditor’s report?

“We performed a full scope audit on seven components representing 99% of the Group’s revenue, 90% of the Group’s profit before tax and 90% of the Group’s net assets.

 

During our first year as auditor of the Group, we visited all significant locations. For our second year, we have implemented a rotational approach to these visits.”

Or how about a discussion of materiality such as this?

“We determined materiality for the Group to be £30 million.

We reported all audit differences in excess of £1 million.

 

We define materiality as the magnitude of misstatement in the financial statements that makes it probable that the economic decisions of a reasonably knowledgeable person would be changed or influenced.”

This language may sound like it is from the auditor’s internal conclusion memoranda, but in fact it is from the Deloitte report on the 2016 financial statements of an English company, Marks and Spencer.

Their annual report contains the expanded auditor’s report now required by UK Auditing Standards. The report is on pages 78 to 85 (Yes, it is that long!). It also enumerates several “Key Audit Matters”, describing how each such issue was dealt with in the audit.

While this might seem like an extreme example, there has been movement in international audit standard setting towards more tailored, descriptive audit reports. Here in the US the PCAOB began consideration of changes to the auditor’s report over 7 years ago.

In a May 24, 2017 news release the PCAOB announced that on June 1, 2017 they will consider adopting a new Standard on the auditor’s report. The proposal would eliminate the existing standardized form auditor’s report and replace it with a more tailored report which would include discussion of audit specific issues such as “Critical Audit Matters”. Also to be considered at the meeting are new standards about auditing estimates and using the work of specialists.

You can read about the auditor’s report project and review the most recent proposed version of the standard here.

 

As always, your thoughts and comments are welcome!

Do you represent a public company?

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Challenging Accounting Judgments, Principles Based Standards and ICFR

By: George M. Wilson & Carol A. Stacey

As you have undoubtedly heard from a variety of sources (including this post we made last December), the new revenue recognition, financial instruments impairment and lease standards all involve many new and sometimes complex accounting judgments and estimates.

 

Issues ranging from how to estimate current expected credit losses to what is stand-alone selling price confront us with new, difficult, and subjective judgment calls.

 

Even the Chief Accountant has discussed this issue in a recent speech, which we discussed in our blog. In his remarks, the Chief Accountant focused on ICFR, specifically mentioning:

 

“Having the requisite skills in the accounting and financial reporting area to make the many new, complex judgements required by these standards, and

 

Setting an appropriate tone at the top to assure these judgments are made in a reasonable, consistent and appropriate manner.”

 

To help us all deal with these challenges the Anti-Fraud Collaboration, a group made up of the Center For Audit Quality, FEI, NACD and IIA, has issued a report titled “Addressing Challenges for Highly Subjective and Complex Accounting Areas”.

 

This report is built on a foundation of detailed analysis of several SEC and PCAOB enforcement cases, a webcast and two workshops. The report has a robust discussion of several of the issues underlying these enforcement cases. One important conclusion drawn from this work is that a lack of controls surrounding subjective and complex accounting judgments is frequently a root cause underlying reporting problems. Based on this conclusion, the report includes a discussion of ways to help establish appropriate controls for such estimates and judgments. In fact, one of the enumerated objectives of the report is to:

 

“Facilitate a robust discussion about accounting policy, centering on highly subjective and complex accounting areas, and the design and operating effectiveness of ICFR”

In the report, there are several insights into ICFR issues surrounding complex judgments. For example:

 

Difficult Accounting Issues

 

Three accounting issues were problematic for companies under investigation: revenue recognition, loan impairment, and valuation. Both highly subjective and complex, these three areas were under stress during the financial crisis and therefore more prone to manipulation or error. The analysis of the AAERs also highlighted issues with the accounting policies pertaining to these areas. In the enforcement actions studied, the SEC cited that the companies either did not have an adequate accounting policy or procedure for the issue being investigated; the company was non-compliant with their existing policy or procedure; or that management acted to override the company’s accounting policy.

 

 

The report goes on to state:

 

For all members of the financial reporting supply chain, the importance of tone at the top cannot be overstated. In most cases of alleged financial fraud, the SEC names the CEO and/or the CFO in the complaint. Commission staff noted that the driver of earnings management—the catalyst for most fraud cases—is often top management, such that the focus on the CEO and CFO is not surprising. In cases the PCAOB has brought against individual auditors, it is usually the lead audit engagement partner or other senior members of an audit engagement team who are disciplined.

 

 

Hopefully, as you think about the design of ICFR over the new estimates and judgments required to implement the revenue recognition, lease and financial instrument impairment standards, you will find some helpful ideas in this report.

 

As always, your thoughts and comments are welcome!