Monthly Archives: October 2015

Evolution of the Audit Committee – Part Four

In three previous posts about audit committee evolution we explored:

A bit of history about how audit committee responsibilities have changed over time,

Situations where independence issues have resulted in enforcement involving      auditors and companies, and

How some issues, such as auditor independence, are not just matters for the auditor to monitor, but also may require audit committee involvement.

 

As history demonstrates, audit committees play a crucial role in oversight of the financial reporting process. An effective audit committee is a crucial part of assuring the reliability and reasonableness of financial information. Unfortunately, history also shows us that audit committees don’t always successfully fulfill their responsibilities.

Chair White expanded on these issues in a June 2014 speech to the Stanford University Rock Center for Corporate Governance Twentieth Annual Stanford Directors’ College. In that speech, after reviewing two enforcement cases which involved audit committee members she said:

I mention these cases because audit committees, in particular, have an extraordinarily important role in creating a culture of compliance through their oversight of financial reporting. As you know, under the Sarbanes-Oxley Act, audit committees are required to establish procedures for handling complaints regarding accounting, internal controls, and auditing matters, as well as whistleblower tips concerning questionable accounting or auditing practices. Audit committees also play a critical role in the selection and oversight of the company’s auditors. These responsibilities are critical ones and we want to support you. Service as a director is not for the faint of heart, but nor should it be a role where you fear a game of “gotcha” is being played by the SEC.

Clearly Ms. White is emphasizing the responsibility audit committees have as gatekeepers in the financial reporting process.

(You can read the whole speech at: www.sec.gov/News/Speech/Detail/Speech/1370542148863 )

All of this leads us to the SEC’s July 1, 2015 Concept Release POSSIBLE REVISIONS TO AUDIT COMMITTEE DISCLOSURES”. Attempting to perhaps incentivize audit committees to perform effectively, and even more importantly shed light on audit committee performance to help investors and other stakeholders understand whether audit committees are effectively fulfilling their oversight responsibilities are not simple issues, and this concept release begins a significant discussion.

What sorts of disclosures does the concept release propose to deal with these issues? The principle areas of focus are:

Audit Committee’s Oversight of the Auditor

Audit Committee’s Process for Appointing or Retaining the Auditor

Qualifications of the Audit Firm and Certain Members of the Engagement Team Selected By the Audit

In the summary of the concept release the commission makes their objective clear, stating:

Some have expressed a view that the Commission’s disclosure rules for this area may not result in disclosures about audit committees and their activities that are sufficient to help investors understand and evaluate audit committee performance, which may in turn inform those investors’ investment or voting decisions.

The reporting of additional information by the audit committee with respect to its oversight of the auditor may provide useful information to investors as they evaluate the audit committee’s performance in connection with, among other things, their vote for or against directors who are members of the audit committee, the ratification of the auditor, or their investment decisions.

Here is a quick outline of the areas addressed in the Concept Release:

  1. Auditor Committee’s Oversight of the Auditor
  2. Additional Information Regarding the Communications Between the Audit Committee and the Auditor
  3. The Frequency with which the Audit Committee Met with the Auditor
  4. Review of and Discussion About the Auditor’s Internal Quality Review and Most Recent PCAOB Inspection Report
  5. Whether and How the Audit Committee Assesses, Promotes and Reinforces the Auditor’s Objectivity and Professional Skepticism
  6. Audit Committee’s Process for Appointing or Retaining the Auditor
  7. How the Audit Committee Assessed the Auditor, Including the Auditor’s Independence, Objectivity and Audit Quality, and the Audit Committee’s Rationale for Selecting or Retaining the Auditor
  8. If the Audit Committee Sought Requests for Proposal for the Independent Audit, the Process the Committee Undertook to Seek Such Proposals and the Factors They Considered in Selecting the Auditor
  9. The Board of Directors’ Policy, if any, for an Annual Shareholder Vote on the Selection of the Auditor, and the Audit Committee’s Consideration of the Voting Results in its Evaluation and Selection of the Audit Firm
  10. Qualifications of the Audit Firm and Certain Members of the Engagement Team Selected By the Audit Committee
  11. Disclosures of Certain Individuals on the Engagement Team
  12. Audit Committee Input in Selecting the Engagement Partner
  13. The Number of Years the Auditor has Audited the Company
  14. Other Firms Involved in the Audit

As you can see, the areas the SEC is considering for disclosure are significant and would represent a major change in how much of the audit committee’s work is in the sunshine of disclosure. Along this evolutionary path it is important to remember that a Concept Release is essentially a discussion document. If the SEC does pursue rulemaking, the content of a proposed rule will be based on input received in response to the concept release. The SEC is always responsive to substantive comments, so if a rule is eventually proposed, it will differ from the proposed rule based on comments from constituents. This means we are early on in this process, and we can provide input to the process.

As a concluding thought, if you do want to comment on the Concept Release, here is where to do that:

www.sec.gov/cgi-bin/ruling-comments#

As always, your thoughts and comments are welcome!

 

SEC Comment of the Week – A Favorite Topic

 

It is hard to believe we are already in mid-October, and the fourth quarter of the calendar year is well underway. Many companies will soon start planning for year-end reporting and being aware of “hot button issues” is a key part of this process. To help in this planning process we are going to highlight key planning issues through our blog posts. Here is the first of these issues we think all companies should be thinking about as year-end approaches.

As we have watched comments in recent weeks, one of the areas that continues to be emphasized is the quantification of analysis in MD&A. The roots of this issue are deep. Way back in 1989 one of the examples in FR 36 laid out the framework:

Revenue from sales of single-family homes for 1987 increased 6% from 1986. The increase resulted from a 14% increase in the average sales price per home, partially offset by a 6% decrease in the number of homes delivered. Revenues from sales of single-family homes for 1986 increased 2% from 1985. The average sales price per home in 1986 increased 6%, which was offset by a 4% decrease in the number of homes delivered.

The increase in the average sales prices in 1987 and 1986 is primarily the result of the Company’s increased emphasis on higher priced single-family homes. The decrease in homes delivered in 1987 and 1986 was attributable to a decline in sales in Texas. The significant decline in oil prices and its resulting effect on energy-related business has further impacted the already depressed Texas area housing market and is expected to do so for the foreseeable future. The Company curtailed housing operations during 1987 in certain areas in Texas in response to this change in the housing market. Although the number of homes sold is expected to continue to decline during the current year as a result of this action, this decline is expected to be offset by increases in average sales prices.

You can find the release at:

www.sec.gov/rules/interp/33-6835.htm

 

In 2003 FR 72 emphasized the importance of understanding the causal factors underlying changes:

  1. Focus on Analysis

MD&A requires not only a “discussion” but also an “analysis” of known material trends, events, demands, commitments and uncertainties. MD&A should not be merely a restatement of financial statement information in a narrative form. When a description of known material trends, events, demands, commitments and uncertainties is set forth, companies should consider including, and may be required to include, an analysis explaining the underlying reasons or implications, interrelationships between constituent elements, or the relative significance of those matters.

You can find the release at:

www.sec.gov/rules/interp/33-8350.htm

 

And, here are a few very recent comments where the staff focuses on these requirements in MD&A. (We have added emphasis to highlight key issues.)

As previously requested, please disclose more detail about the underlying material factors contributing to the increases in comparable store sales in both your year-end and interim results discussions, such as any changes in selling prices, volumes or the introduction or discontinuance of popular products that had a significant impact on your revenue. Refer to Item 303(a)(3)(iii) of Regulation S-K. In this regard, your current disclosures such as stating that comparable store sales increase primarily due to “strong deals in electronics, pets and clothing” do not provide enough insight into the underlying factors that drove the increase in comparable store sales that investors can access the likelihood that past results are indicative of future results. To the extent that multiple offsetting factors influenced your comparable store sales, you should discuss the impact of each significant factor. For example, if “strong deals” indicates that you lowered average prices through increased promotional activity, this would appear to decrease revenue; however, these lower prices may have been more than offset by higher volumes of products being sold. In this case, both the decrease in pricing and the increase in volume should be described.

Throughout your discussion of the results of operations, you refer to various factors that have impacted your results without quantifying the impact of each factor. Where a material change is attributed to two or more factors, including any offsetting factors, the contribution of each identified factor should be described in quantified terms. For example, you attribute the decrease in net sales and unit sales for the (Product A) in 2014 as a result of growth in the Greater China and Japan segments offset by declines in all other segments with no quantification. As another example, you attribute the growth in the Americas segment in 2014 as a result of increased net sales of (Products B, C and D), Software and Services offset by a decline in net sales of (Product E and A) and weakness in foreign currencies but you do not quantify the effects of these individual factors. Please explain to us how you considered quantifying the sources of material changes and offsetting factors throughout your discussion. Refer to Item 303(a)(3)(iii) of Regulation S-K and Section III.D of SEC Release No. 33-6835.

(Bloggers note: The release mentioned here is FR 36 quoted above)

We note you attribute the changes in headcount to explain certain changes in your results of operations but the headcount does not appear to be quantified. Please tell us your consideration of quantifying the headcount at the end of each period as a factor to explain the changes for the line items that are impacted. We refer you to Item 303(a)(3)(iii) of Regulation S-K and Section III.D of SEC Release No. 33-6835.

 

As always, your thoughts and comments are welcome!

Audit Fee Disclosures –A Few Common Problem Areas in This Independence Disclosure

Over the last few weeks we have been blogging about auditor independence issues, a very “hot topic” in the current SEC reporting and enforcement environments. One disclosure focused on independence, audit fees, has been around for over 15 years. You would think that after 15 years it would be routine and perhaps even “ho hum”. However, like so many detailed disclosures, it has complexities that create questions and problems. Here are three examples:

In the disclosure where should fees related to 33 Act services such as comfort letters be included? Are these Audit Fees or Audit-Related Fees?

The Audit Fee disclosure uses the terminology “fees billed”. What is the appropriate treatment if the auditor has not fully billed for the audit?

Where should benefit plan audit fees be presented? Audit Fees or Audit-Related Fees?

We’ll answer these questions below, but first, lets briefly review how this disclosure sheds light on auditor independence. Investors can use this information to compare the magnitude of audit fees with non-audit fees. The key underlying question is “Could the amount of non-audit fees compared to audit fees in any way call into question or compromise auditor objectivity and independence?”

(In this post we won’t go into all the history of this disclosure. If you want to delve into the controversy and issues behind it google search “Enron audit fees.”)

It was a 2003 update to this disclosure that built the requirement with the four categories and two year format we use today. The current requirement, which is in Item 14 of Form 10-K and Schedule 14A for the proxy is:

(1) Disclose, under the caption Audit Fees, the aggregate fees billed for each of the last two fiscal years for professional services rendered by the principal accountant for the audit of the registrant’s annual financial statements and review of financial statements included in the registrant’s Form 10-Q (17 CFR 249.308a) or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those fiscal years.

(2) Disclose, under the caption Audit-Related Fees, the aggregate fees billed in each of the last two fiscal years for assurance and related services by the principal accountant that are reasonably related to the performance of the audit or review of the registrant’s financial statements and are not reported under Item 9(e)(1) of Schedule 14A. Registrants shall describe the nature of the services comprising the fees disclosed under this category.

(3) Disclose, under the caption Tax Fees, the aggregate fees billed in each of the last two fiscal years for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning. Registrants shall describe the nature of the services comprising the fees disclosed under this category.

(4) Disclose, under the caption All Other Fees, the aggregate fees billed in each of the last two fiscal years for products and services provided by the principal accountant, other than the services reported in Items 9(e)(1) through 9(e)(3) of Schedule 14A. Registrants shall describe the nature of the services comprising the fees disclosed under this category.

1933 Act Related Fees

These categories seem fairly self-explanatory, but at times can be confusing. For the question about where should fees related to 1933 Act services, including fees for services like comfort letters, be disclosed, you actually have to dig all the way back into commentary in the Final Rule Release. (While we don’t have to do this very often, it is always good to remember this step in the research process!)

While we might be tempted to think of them as “Audit Related”, these 33 Act fees are “Audit Fees”. The Final Rule states:

While the rules we are adopting continue to require issuers to disclose fees paid to the principal accountant for audit services, we are expanding the types of fees that should be included in this category to include fees for services that normally would be provided by the accountant in connection with statutory and regulatory filings or engagements. In addition to including fees for services necessary to perform an audit or review in accordance with GAAS, this category also may include services that generally only the independent accountant reasonably can provide, such as comfort letters, statutory audits, attest services, consents and assistance with and review of documents filed with the Commission.

To research the Final Rule Release you can find it at:

www.sec.gov/rules/final/33-8183.htm

 

The Terminology “Fees Billed”

In the category audit fees does the word “billed” mean that this should be on an as-billed basis or more accrual basis?

The Office of the Chief Accountant has provided guidance on these and similar questions in an FAQ document. However, that document is not with the Compliance and Disclosure Interpretations. It is at a separate location for information about independence issues. You can find all the independence documents at:

www.sec.gov/info/accountants/independref.shtml

In particular, the FAQ’s that deal with these issues are at:

www.sec.gov/info/accountants/ocafaqaudind080607.htm

These FAQ’s tell us that the amount should be the fee billed or expected to be billed for the audit. The principle of the disclosure is that we want the fees for the audit to compare with other fees, so regardless of when billed, show the cost of the audit:

Question 2 (issued January 16, 2001 revised 2004)

Q: In determining fees that are disclosed pursuant to Items 9(e) (1) – (e) (4) of Schedule 14A, should the disclosure be based on when the service was performed, the period to which the service applies, or when the bill for the service is received?

A: Fees to be disclosed in response to Item 9(e)(1) of Schedule 14A should be those billed or expected to be billed for the audit of the registrant’s financial statements for the two most recently completed fiscal years and the review of financial statements for any interim periods within those years. If the registrant has not received the bill for such audit services prior to filing with the Commission its definitive proxy statement, then the registrant should ask the auditor for the amount that will be billed for such services, and include that amount in the disclosure. Amounts disclosed pursuant to Items 9(e) (2) – (e) (4) should include amounts billed for services that were rendered during the most recent fiscal year, even if the auditor did not bill the registrant for those services until after year-end.

 

Benefit Plan Audits

And last, for benefit plan audits, the FAQ’s mentioned above state that these fees are “Audit Related”:

Question 7 (issued August 13, 2003)

Q: What fee disclosure category is appropriate for professional fees in connection with an audit of the financial statements of a carve-out entity in anticipation of a subsequent divestiture?

A: The release establishes a new category, “Audit-Related Fees,” which enables registrants to present the audit fee relationship with the principal accountant in a more transparent fashion. In general, “Audit-Related Fees” are assurance and related services (e.g., due diligence services) that traditionally are performed by the independent accountant. More specifically, these services would include, among others: employee benefit plan audits, due diligence related to mergers and acquisitions, accounting consultations and audits in connection with acquisitions, internal control reviews, attest services related to financial reporting that are not required by statute or regulation and consultation concerning financial accounting and reporting standards. Fees for the above services would be disclosed under “Audit-Related Fees.”

As usual, your comments and thoughts are welcome!

A Fall Return to Our Comment of the Week (or So) Blog Posts

Now that summer vacation is over, and we’ve gotten through a very busy September with lots of SECI programs, we are ready to resume our comment of the week blog posts.

One topic in the news, thanks to all the political campaigning underway, is taxes. As the candidates discuss their plans to reform the tax code, we thought it would make sense to explore in a bit more depth Corp Fin’s comments about tax issues. As you likely know this has been a “frequent comment” hot topic for a while.

Here is a first comment, and a frequent theme in comments, international taxes. As you’ll see, the staff frequently asks for more detail about reconciling items. All of this of course to help readers understand the likelihood of such rates being sustainable.

2. We note from your disclosure in Note 9 that there is a significant reconciling item in the effective income tax reconciliation due to differences between foreign and United States statutory rates, which are primarily attributable to your Luxembourg holding company structure and tax rulings received from Luxembourg tax authorities. Please tell us the nature of the items included in the reconciling line item titled “differences between foreign and U.S. statutory rates.” Also, please provide us with the pre-tax income, statutory rate, and effective tax rate in Luxembourg for all periods presented. Additionally, please tell us the nature of the factors that are driving the changes in this line item from year to year, including the nature of any significant tax rulings.

This second comment in the tax arena is about tax benefits, and even mixes international issues along with the recoverability issue. You can almost hear the next comment asking about “positive and negative” evidence.

  1. Please tell us the facts and circumstances associated with the extraterritorial income tax benefit recognized in each of 2014 and 2013, including the basis for the amount recognized and changes therein. Also, tell us the nature of the reserve applied against such benefits and the amount of the reserve for each year.

Notice how this comment combines domestic versus foreign tax issues along with the theme of disaggregation:

  1. Please revise to disclose the components of income before income taxes as either domestic or foreign. See guidance in Rule 4-08(h) of Regulation S-X. Also, we note that in your reconciliation between the federal statutory rate and the effective income tax rate disclosed in Note L, foreign and state income taxes are combined in one line item. Please note that if either of these items (foreign income taxes or state income taxes) affect the statutory tax rate by more than 5% (either positively or negatively) they should be separately presented on the reconciliation.

And, in this last comment, the significant question of the repatriating the earnings of foreign operations is murky and the staff asks for clarification in disclosure.

  1. You disclose in note 15 that the income tax provision in fiscal 2014 includes $33.7 million of U.S. income and applicable foreign withholding taxes on dividends of $473.7 million due to repatriating foreign subsidiaries earnings to the U.S. parent entity to fund the share repurchase program. You also disclose you have not provided for U.S. and foreign withholding taxes on $471 million of accumulated undistributed earnings of foreign subsidiaries at February 1, 2015 because you intend to reinvest these earnings for the foreseeable future. It is not clear from your present disclosures how management overcame the presumption that all undistributed earnings of subsidiaries will be transferred to the parent and therefore require the accrual of an income tax payable as outlined in ASC 740-30-25-3. Please tell us how you have determined that you have both the ability and intent to indefinitely prevent accumulated undistributed foreign earnings from being repatriated without tax consequences. See ASC 740-30-25-17 and 25-18. In doing so, tell us the following:
    • Explain the specific evidence (e.g. experience of the entity, definite future plans and past remittances, etc.) to substantiate the parent’s assertion of the indefinite postponement of remittances from foreign subsidiaries;
    • Identify the entities and periods where the parent claims permanent reinvestment;
    • Tell us why you have not disclosed that the remittance of undistributed earnings is postponed indefinitely as opposed to the foreseeable future, which is the point used in ASC 740-30-25-19 to describe when it is apparent that a temporary difference reverses and a deferred tax liability is required to be recognized; and
    • Tell us how your decision to repatriate the $473.7 million of funds during 2014 in order to fund your share repurchase program was considered as part of your determination that the $471 million of accumulated undistributed earnings of foreign subsidiaries referenced above continue to be permanently reinvested as of February 1, 2015.

 

Taxes! Well, for now, we will forgo any jokes about how inevitable they are. We do know that tax comments asking for more clarity in disclosure will continue!

 

As always, your thoughts and comments are welcome!

Audit Committee Evolution – Part Two

In our post last week we began a series focusing on audit committees. We briefly reviewed the history of audit committee requirements over the past 20 years or so hoping that understanding the past will help us understand what the future might hold. The current discussion about audit committee roles and responsibilities flows from this history. This discussion also has roots in several auditor/client events that have happened over the last several years.

This post discusses some of those recent events, primarily SEC Enforcement cases and related matters as they relate to auditor independence. Hopefully this will help provide context and yield more insight into what the future may hold.

One of the major themes in the SEC’s “Possible Revisions to Audit Committee Disclosures” Concept Release is audit committee oversight of independent auditors. Independence is clearly an important aspect of this oversight. Historically independence has been the auditor’s responsibility. When the SEC and the PCAOB have promulgated independence rules they have been directed primarily to the auditor, not the company or the audit committee.

It may be that it is time for this attitude to evolve and change.

Recent SEC enforcement cases provide several examples where the dividing line between the auditor’s and the company’s responsibility for auditor independence has been very fuzzy. (To be clear, in these cases it would not appear that there were many overt bad-actors who set out to break the rules. So, as you read the examples, ponder who should be in place to know the rules and assure compliance?)

A First Example

Sometimes independence problems are very simple. One of these foundational issues is that the auditor may not assist management in the preparation of financial statements. In fact, Regulation S-X Rule 2.01 states:

(4) Non-audit services. An accountant is not independent if, at any point during the audit and professional engagement period, the accountant provides the following non-audit services to an audit client:

(i) Bookkeeping or other services related to the accounting records or financial statements of the audit client. Any service, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements, including:

(A) Maintaining or preparing the audit client’s accounting records;

(B) Preparing the audit client’s financial statements that are filed with the Commission or that form the basis of financial statements filed with the Commission; or

(C) Preparing or originating source data underlying the audit client’s financial statements.

The idea here is that the auditor cannot really “audit” something they have prepared. This seems relatively straightforward, but when broker-dealers were first required to have their audits performed using the standards of the PCAOB and became subject to the SEC’s auditing requirements, this requirement was overlooked in a number of cases. Eight of these cases resulted in enforcement against auditors for helping their clients prepare financial statements.

You can read the details of the cases in this press release:

www.sec.gov/News/PressRelease/Detail/PressRelease/1370543608588

Now, as we described above, independence has usually been the bailiwick of the auditor. But, when there is an independence problem the company bears a harsh cost also, possibly even a new audit of the same period(s) by an auditor who is in fact independent. In a time of change such as using the PCAOB’s standards for the first time, would it be unreasonable to expect that the audit committee would be knowledgeable about these standards and as part of their oversight of auditing matters ask if there were any issues concerning compliance with the new standards? Is it possible that a strong audit committee could help avoid these problems?

Really, the deeper issue here is that a strong audit committee needs to monitor the financial reporting and auditing environment for changes and assure that management deals with these changes. Easy examples in today’s world include cybersecurity and oil prices.

As a postscript to this first example, the very first enforcement case brought by the PCAOB was over this very issue. It was “way back” in May of 2005. You can read the details at:

pcaobus.org/Enforcement/Decisions/Documents/05-24_Goldstein_and_Morris.pdf

 Second Example

The independence relationship can be very complex to track. Even firms with only a few professionals may not always be aware of all the business activities of all its professionals. For larger firms this can be a huge quality control and compliance challenge. In a recent enforcement a large firm was fined when its consulting affiliate maintained a business relationship with an individual who was a trustee and a board and audit committee member of three funds the firm audited.

Certainly there was a breakdown on the part of the firm in this case, but should the audit committees of the funds have been monitoring for such relationships? This is a complex issue, and the question should be addressed. As you will note in the press release linked below, the adequacy of the fund’s audit committee charter was called into question.

You can read the details of this case at:

www.sec.gov/news/pressrelease/2015-137.html

A Third Example

In this case an audit firm’s affiliate in Washington, DC provided lobbying services to companies that were also audit clients. Such advocacy services are always prohibited by the independence rules. And, again, the firm likely may have a quality control system issue to address tracking the myriad of business relationships in a large professional practice. But again the questions surrounding the client’s responsibility and the role of audit committees need to be addressed. It is not just the auditor who has a consequence in this situation. In a complex commercial world where business can happen so quickly, this issue is even more important.

You can read the details of this case at:

www.sec.gov/News/PressRelease/Detail/PressRelease/1370542298984

Concluding Thoughts

None of these cases are simple, and in each case the fact set behind the case makes it clear there were generally no overt bad-actors who were setting out to break rules. Which brings us back to the question, who is there to make sure that the rules are monitored and that companies comply? Is the audit committee part of that structure? We will see how the situation evolves!

As always, your thoughts and comments are appreciated!