Tag Archives: AM 100

ICFR Changes and the New Revenue Recognition, Leases, and Financial Instrument Impairment Transitions

SEC Hot Topic, , , , , , , , , , , , , , , , , , , , , ,

By: George M. Wilson & Carol A. Stacey

 

In his recent, much publicized speech, Chief Accountant Wesley Bricker discussed the transition to the new revenue recognition standard. A bit later in the speech he addressed a not so frequently discussed issue, the requirement to disclose material changes in ICFR as it relates to implementation of the new revenue recognition, leases, credit losses and other standards. Here is an excerpt:

 

Over the next several years, updating and maintaining internal controls will be particularly important as companies work through the implementation of the significant new accounting standards. Companies’ implementation activities will require careful planning and execution, as well as sound judgment from management, as I have mentioned earlier in illustrating areas of judgment in the new GAAP standards.

 

In his remarks, well worth the read, he also comments on two crucial ICFR concerns in these new standards:

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.

 

We did a post about reporting changes in ICFR in November 2016. To refresh your memory, or if you are not familiar with this area, here is a summary of the disclosures required for material changes in ICFR. This applies to material changes made to implement new accounting standards as well as any other material changes.

 

These requirements begin with Item 9A in Form 10-K and Part I Item 4 in Form 10-Q. They both refer to S-K Item 308(c):

 

(c) Changes in internal control over financial reporting. Disclose any change in the registrant’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of §240.13a-15 or 240.15d-15 of this chapter that occurred during the registrant’s last fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting.

 

With changes to ICFR for revenue recognition for information about contracts and estimates, like stand-alone selling price and when control transfers, and changes to ICFR for capitalization of all leases, these new standards could require material changes to ICFR. Are these the types of changes included in the S-K 308(c) disclosure requirement?

 

This is an excerpt from the ICFR C&DI’s, number 7, about SOX reporting which you can find here:

 

After the registrant’s first management report on internal control over financial reporting, pursuant to Item 308 of Regulations S-K or S-B, the registrant is required to identify and disclose any material changes in the registrant’s internal control over financial reporting in each quarterly and annual report. This would encompass disclosing a change (including an improvement) to internal control over financial reporting that was not necessarily in response to an identified material weakness (i.e. the implementation of a new information system) if it materially affected the registrant’s internal control over financial reporting. Materiality, as with all materiality judgments in this area, would be determined upon the basis of the impact on internal control over financial reporting and the materiality standard articulated in TSC Industries, Inc. v. Northway, Inc. 426 U.S. 438 (1976) and Basic Inc. v. Levinson, 485 U.S. 224 (1988). This would also include disclosing a change to internal control over financial reporting related to a business combination for which the acquired entity that has been or will be excluded from an annual management report on internal control over financial reporting as contemplated in Question 3 above. As an alternative to ongoing disclosure for such changes in internal control over financial reporting, a registrant may choose to disclose all such changes to internal control over financial reporting in the annual report in which its assessment that encompasses the acquired business is included.

 

 

The SEC Regulations Committee of the CAQ has also discussed a particularly intricate issue in this transition. What if you change your ICFR this year, but the change is for future reporting when you begin to report under the new standard next year? This issue is still in play, as this excerpt from the minutes discusses:

 

Changes in ICFR in preparation for the adoption of a new accounting standard

Item 308(c) of Regulation S-K requires disclosure of changes in internal control over financial reporting (“ICFR”) during the most recent quarter that have materially affected or are reasonably likely to materially affect the registrant’s ICFR. The Committee and the staff discussed how this requirement applies to changes in ICFR that are made in preparation for the adoption of a new accounting standard when those changes are in periods that precede the date of adoption and do not impact the preparation of the financial statements until the new standard is adopted.

 

The staff indicated that they are evaluating whether additional guidance is necessary for applying the requirements of Item 308(c) in connection with the transition to the new revenue standard.

 

So, as you begin implementing systems and processes for these new standards, don’t forget this part of the reporting!

 

As always, your thoughts and comments are welcome!

Revenue Recognition – Raytheon Sets the Pace!

Hot Topic, , , , , , , , , ,

By: George M. Wilson & Carol A. Stacey

 

Reed Wilson, our Form 10-K In-Depth Workshop leader, closely follows reporting by major companies. He found that Raytheon, in its fourth-quarter earnings release, announced it has adopted the new revenue recognition standard as of January 1, 2017, a full year before the required adoption date. Raytheon also elected the full retrospective adoption method. (Nice catch Reed!) You can find the earnings release here.

Here is an excerpt from the earnings release:

Effective January 1, 2017, the Company adopted the new revenue recognition standard utilizing the full retrospective transition method. Under this method, the standard was applied to each prior reporting period presented and the cumulative effect of applying the standard was recognized at the earliest period shown. The impact of adopting the new standard on the Company’s 2015 and 2016 net sales and operating income was not material. The 2016 net sales, effective tax rate and EPS from continuing operations in the financial outlook table below have been recast to reflect this change.

While it will obviously be a while until Raytheon reports a full quarter on the new method, this SAB 74 disclosure from its third-quarter Form 10-Q provides the story of the company’s adoption process. It provides an understanding of the steps in the process, and the depth of the process. Notice the comment about frequent reports over a two-year period! And all this work was in spite of the fact that the new standard did not have a material impact for Raytheon!

 

Note 2: Accounting Standards

 

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), which will replace numerous requirements in U.S. GAAP, including industry-specific requirements, and provide companies with a single revenue recognition model for recognizing revenue from contracts with customers. The core principle of the new standard is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The two permitted transition methods under the new standard are the full retrospective method, in which case the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of initial application. In July 2015, the FASB approved the deferral of the new standard’s effective date by one year. The new standard is effective for annual reporting periods beginning after December 15, 2017. The FASB will permit companies to adopt the new standard early, but not before the original effective date of annual reporting periods beginning after December 15, 2016.

 

In 2014, we established a cross-functional implementation team consisting of representatives from across all of our business segments. We utilized a bottoms-up approach to analyze the impact of the standard on our contract portfolio by reviewing our current accounting policies and practices to identify potential differences that would result from applying the requirements of the new standard to our revenue contracts. In addition, we identified, and are in the process of implementing, appropriate changes to our business processes, systems and controls to support recognition and disclosure under the new standard. The implementation team has reported the findings and progress of the project to management and the Audit Committee on a frequent basis over the last two years.

 

We have been closely monitoring FASB activity related to the new standard, as well as working with various non-authoritative groups to conclude on specific interpretative issues. In the first half of 2016, we made significant progress toward completing our evaluation of the potential changes from adopting the new standard on our future financial reporting and disclosures. Our progress was aided by the FASB issuing ASU 2016-10, Identifying Performance Obligations and Licensing, which amended the current guidance on performance obligations and provided additional clarity on this topic, and the significant progress of the non- authoritative groups in concluding on specific interpretative issues. We also made significant progress on our contract reviews and detailed policy drafting. Based on our evaluation, we expect to early adopt the requirements of the new standard in the first quarter of 2017 and anticipate using the full retrospective transition method.

 

The impact of adopting the new standard on our 2015 and 2016 total net sales and operating income is not expected to be material. We also do not expect a material impact to our consolidated balance sheet. The immaterial impact of adopting ASU 2014-09 primarily relates to the deferral of commissions on our commercial software arrangements, which previously were expensed as incurred but under the new standard will generally be capitalized and amortized over the period of contract performance, and policy changes related to the recognition of revenue and costs on our defense contracts to better align our policies with the new standard. The impact to our results is not material because the analysis of our contracts under the new revenue recognition standard supports the recognition of revenue over time under the cost-to-cost method for the majority of our contracts, which is consistent with our current revenue recognition model. Revenue on the majority of our contracts will continue to be recognized over time because of the continuous transfer of control to the customer. For U.S. government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay us for costs incurred plus a reasonable profit, and take control of any work in process. Similarly, for non-U.S. government contracts, the customer typically controls the work in process as evidenced either by contractual termination clauses or by our rights to payment for work performed to date to deliver products or services that do not have an alternative use to the company. Under the new standard, the cost-to-cost measure of progress continues to best depict the transfer of control of assets to the customer, which occurs as we incur costs. In addition, the number of our performance obligations under the new standard is not materially different from our contract segments under the existing standard. Lastly, the accounting for the estimate of variable amounts is not expected to be materially different compared to our current practice.

 

 

As always, your thoughts and comments are welcome!

Tone at the Top, History and COSO

Hot Topic, , , , , , , , , , , , , , , , , ,

By: George M. Wilson & Carol A. Stacey

 

First, a quick warning before you read this post. One of the authors of this post spent nine years teaching at a university which had one of the few undergraduate business programs in the country with a required course in business ethics. This post is perhaps a bit preachy!

We have seen some distressing examples in the news lately of organizations acting unethically. If you were around during the early 2000s these events evoke a strong feeling of déjà vu. The similarities in the “tone at the top” of the organizations in the news today compared to the tone at the top in the companies involved in the pre-SOX waves of fraud (such as WorldCom and Enron) is eerie!

In all of these frauds, the roots of unethical conduct which harmed shareholders were at the top of the organizations.

History, as it always seems to do, is repeating itself. Eventually defective tone at the top will always result in trouble and distress for the organization and investors. (Yes, that was one of the preachy parts!)

All this makes it seem like a great time to review a key element in the foundations of internal control, the control environment. Here is an excerpt from the Executive Summary of the 2013 COSO Framework:

 

“Control Environment

The control environment is the set of standards, processes, and structures that provide the basis for carrying out internal control across the organization. The board of directors and senior management establish the tone at the top regarding the importance of internal control including expected standards of conduct. Management reinforces expectations at the various levels of the organization. The control environment comprises the integrity and ethical values of the organization; the parameters enabling the board of directors to carry out its governance oversight responsibilities; the organizational structure and assignment of authority and responsibility; the process for attracting, developing, and retaining competent individuals; and the rigor around performance measures, incentives, and rewards to drive accountability for performance. The resulting control environment has a pervasive impact on the overall system of internal control. “

Building an effective control environment starts at the top of an organization with the executive leadership, board and Audit Committee. If the people in these roles place financial performance before integrity, if their attitude is about accomplishing objectives at whatever the cost, that is poison in the control environment.

Understanding, assessing and evaluating tone at the top and the other elements of the control environment is not easy.

In a telecom company where the message from the CEO is to make the numbers at any cost is there any surprise that the end result is one of the largest financial reporting frauds ever? Or that the fraud was carefully crafted to avoid detection by the auditors? And, when the perpetrators of the fraud are the leaders of the organization, who have the power to punish anyone who might call out the tone at the top issues, is it any wonder that it is easy for them to conceal the corruption in the control environment? Is it any surprise that the courageous internal auditors who eventually called out the fraud actually had to conduct their investigation in secret and at times wondered if they should be afraid for their lives?

 

In an energy trading company where the CFO was behind hidden issues involving off-balance sheet arrangements that were not on the up-and-up, is it any wonder that the first person to really escalate the issue did so in an anonymous letter?

 

In a bank where not making sales goals resulted in your termination, is there any surprise when rules are bent? Is there any surprise when people are fired when they attempt to raise the issue to their managers?

 

As another example, check out this 10-K for Hertz which includes a major restatement. In the “Explanatory Note” at the beginning of the document you will find this language:

 

As of December 31, 2014, we did not maintain an effective control environment primarily attributable to the following identified material weaknesses:

• Our investigation found that an inconsistent and sometimes inappropriate tone at the top was present under the then existing senior management that did not in certain instances result in adherence to accounting principles generally accepted in the United States of America (“GAAP”) and Company accounting policies and procedures. In particular, our former Chief Executive Officer’s management style and temperament created a pressurized operating environment at the Company, where challenging targets were set and achieving those targets was a key performance expectation. There was in certain instances an inappropriate emphasis on meeting internal budgets, business plans, and current estimates. Our former Chief Executive Officer further encouraged employees to focus on potential business risks and opportunities, and on potential financial or operating performance gaps, as well as ways of ameliorating potential risks or gaps, including through accounting reviews. This resulted in an environment which in some instances may have led to inappropriate accounting decisions and the failure to disclose information critical to an effective review of transactions and accounting entries, such as certain changes in accounting methodologies, to the appropriate finance and accounting personnel or our Board, Audit Committee, or independent registered public accounting firm.

 

This is another example of a fraud with its roots in tone at the top.

When frauds escalate to a material level there is a reasonable likelihood that it started with a problem with tone at the top, with the control environment.

So, where does all this lead? Assessing tone at the top is not easy. And a poisoned control environment will do everything it can to protect itself. The leaders of an organization with a defective control environment will use the power they wield to keep others from exposing the problem. Perhaps more protections for whistleblowers are a good thing in this regard. Tools to measure ethical behavior in an organization are difficult to find, subjective and imprecise. Enron in fact had a model code of ethics, but having something on paper does not mean that people will live by the code of ethics. The one thing that is clear is that this continues to be a complex area and continues to be at the root of many financial reporting frauds. We all need to focus on this area and work to develop a better understanding and better tools to assess the control environment.

We all need to focus on tone at the top and ethical behavior. Yes, it is not easy to measure, it is not easy for an outsider to observe, but it is clearly crucial to effective ICFR!

 

As always, your thoughts and comments are welcome!

 

 

Hot Topic Update – FASB’s Dramatic New Lease Accounting Standard

Hot Topic, , , , , , , , , , , , , , , , ,

 

The FASB’s new lease accounting standard presents complex accounting, internal control, system and implementation challenges. Learn the conceptual underpinnings, overall structure and details of the standard as it applies to both lessees and lessors. Register now for our live half-day seminar November 30th in San Francisco or December 15th in New York City, Implementing the FASB’s New Lease Accounting Standard Workshop 2016. Discussion includes implementation steps and system and ICFR issues.

http://www.pli.edu/Content/Seminar/Implementing_the_FASB_s_New_Lease_Accounting/_/N-4kZ1z10l1v?fromsearch=false&ID=300755

Year End Planning Topic 3 – The New Item 16 Form 10-K Summary (and Disclosure Philosophy!)

Comment of the Week, , , , , , , , , , , , , , , , , , , , , , , , ,

Everyone who works with SEC periodic reports knows that making changes to disclosure is not a simple process. Reporting involves so many stakeholders and so many approval points that without an early start it is almost impossible to make improvements (or even simple changes such as formatting!).

This post is about one possible change that will need some time for consideration, adding the new Item 16 summary. With this reminder hopefully you will have enough time to consider whether this optional item makes sense for you.

This kind of summary has always been permitted, or at least never prohibited. However, in the process of making periodic reports more about communication than compliance, the FAST Act required the SEC to formally put a summary into Form 10-K, hence new Item 16. You can read the text of Item 16 in this post.

Your Communication Philosophy

If you read a lot of Form 10-K’s (and what is more fun than that?) you will see a variety of communication styles. We discuss different communication styles or “philosophies” in our workshops. We encourage companies to articulate their “philosophy” of disclosure.

To simplify a bit, some companies adopt a very “compliance” based philosophy for disclosure. In this model companies disclose what the SEC requires to be disclosed and essentially nothing more. This can be done in a fairly mechanical fashion and is usually very simple and direct, if not almost terse.

At the other end of a disclosure spectrum some companies adopt a more “communications” based philosophy where they disclose more than the bare bones requirements in an effort to tell a more complete “story” of how their company operates.

A simple example of this difference can be found in Form 10-K Item 1. This is the description of the business and the required disclosures are in Regulation S-K Item 101. Nowhere in Item 101 is there any requirement to disclose a company’s business strategy. And many companies do not say anything about the strategic orientation of their business. And yet, many companies discuss their strategy at length. Check out the differences in these two companies:

Here is a very well done example for an SRC (Golden Enterprises) of the compliance approach. Golden makes snack foods and does a simple, direct presentation. (Also, best potato chips ever!)

Here is another well-done example of a company (Square) that uses a more communications oriented approach. Square is a payment processor and supports businesses in many ways.

To be clear, there is no right or wrong way in this discussion; we are talking about a judgment you need to make. So, why do some companies disclose more than the S-K requirement?   These companies are considering disclosure as more than a compliance process. They are using the reporting process as a communications tool.

If you are going to focus more on communication the SEC’s Interim Final Rule about a Form 10-K summary could be a new element in your communication strategy. Almost every business writer will suggest that an executive level overview for a long document is a good communication strategy.

FR 72 suggested this for MD&A way back in 2003:

Many companies’ MD&A could benefit from adding an introductory section or overview that would facilitate a reader’s understanding. As with all disclosure, what companies would appropriately include in an introduction or overview will depend on the circumstances of the particular company. As a general matter, an introduction or overview should include the most important matters on which a company’s executives focus in evaluating financial condition and operating performance and provide the context for the discussion and analysis of the financial statements. Therefore, an introduction or overview should not be a duplicative layer of disclosure that merely repeats the more detailed discussion and analysis that follows.

In recent remarks the SEC staff has said they are seeing more companies using their filings as communication documents and this trend certainly fits into the SEC’s disclosure effectiveness program.

So, as you get into your annual reporting process, be sure you articulate this overall strategy for disclosure, and if you think it appropriate, put consideration of the new Item 16 summary into your thought process.

As always, your thoughts and comments are welcome!

Get the Message: SEC Enforcement Case Deals With Evaluating ICFR Weaknesses!

Uncategorized, , , , , , , , , , , ,

By sending a clear message through the enforcement process, the SEC has come full circle in their concerns about whether ICFR audits are finding material weaknesses. The staff has said on numerous occasions that they see too many situations where a company identifies a control deficiency but the company’s analysis fails when assessing whether the control deficiency is in fact a material weakness.

Over the last few years the SEC Staff have emphasized their concerns in numerous speeches and other public settings. As they sometimes do when they don’t see companies listening, they have also emphasized this issue through enforcement.

This enforcement is dramatic, involving:

The company

Two company officers

The audit partner

The ICFR consulting firm partner (a surprise here!)

 

This excerpt from a December 2015 speech by Deputy Chief Accountant Brian Croteau summarizes the SEC’s concerns:

Still, given the frequency with which certain ICFR issues are identified in our consultations with registrants, I’d be remiss not to remind management and auditors of the importance of properly identifying and describing the nature of a control deficiency and understanding the complete population of transactions that a control is intended to address in advance of assessing the severity of any identified deficiencies.  Then, once ready to assess the severity of a deficiency, it’s important to remember that there are two components to the definition of a material weakness – likelihood and magnitude.  The evaluation of whether it is reasonably possible that a material misstatement could occur and not be prevented or detected on a timely basis requires careful analysis that contemplates both known errors, if any, as well as potential misstatements for which it is reasonably possible that the misstatements would not be prevented or detected in light of the control deficiency.  This latter part of the evaluation, also referred to as analysis of the so called “could factor,” often requires management to evaluate information that is incremental to that which would be necessary, for example, for a materiality assessment of known errors pursuant to SAB 99. The final conclusions on severity of deficiencies frequently rest on this “could factor” portion of the deficiency evaluation; however, too often this part of the evaluation appears to be an afterthought in a company’s analysis.  Yet consideration of the “could factor” is very important. 

The issue is clear; too often companies are finding a control deficiency but not appropriately evaluating the severity of the issue to determine if it is a material weakness.

In a “classic” example this SEC enforcement involves a company that performed its annual ICFR evaluation and stated in its form 10-K that ICFR was effective at year-end. Then, shortly after that report in their Form 10-K, the company restated its financial statements and disclosed the existence of a material weakness. It is very unlikely that the material weakness arose between the year-end of the Form 10-K and the date of the restatement.

You can read about the enforcement in this press release, which also has links to the SEC Enforcement Orders for the company and the individuals involved:

www.sec.gov/news/pressrelease/2016-48.html

 

The fact that the company and auditor were named is not surprising. What is surprising is that the firm the company retained to provide SOX 404 services, which included assisting “management with the documentation, testing, and evaluation of the company’s ICFR” and no external report, was included in the enforcement.

This is a loud and clear message to all participants in the process! Be thorough and complete in your evaluation of control deficiencies!

If you would like to delve a bit deeper into this issue one of our follow-up posts to this year’s Form 10-K Tune-Up One Hour Briefing focused on ICFR issues, including the issue raised in this enforcement case.

You can read our post at:

seciblog.pli.edu/?p=530

 

As always, your thoughts and comments are welcome and appreciated!

 

An Audit Committee Update

Uncategorized, , , , , , , , , , , , ,

We (that is Carol and George, your blog authors), frequently post about audit committee issues.  For audit committees that want to perform at the highest level possible, PLI has a great program in June.

 

PLI’s Audit Committees and Financial Reporting 2016: Recent Developments and Current Issues program will be presented June 21, 2016 in NYC.  It will be groupcast in several cities and also available via webcast.  Topics discussed will include current SEC reporting issues, audit committee oversight of the implementation of new accounting standards such as revenue recognition and leases, and PCAOB developments for the audit committee.

 

You can learn more about the detailed agenda and how to register at:

 

www.pli.edu/Content/Seminar/Audit_Committees_and_Financial_Reporting/_/N-4kZ1z11i36?fromsearch=false&ID=259781

 

As always, your thoughts and comments are welcome!

Ever Been to an SEC Event? Mark out April 13 for a webcast!

Uncategorized, , , , , , , , , , , , , , , , , , , , , ,

In our workshops we sometimes joke (a bit) about how fun it is to listen to a webcast of an SEC meeting. And yes, we do say the same thing about FASB meetings. (Total Geek-Out For Sure!)

These meetings are interesting in that you can observe the process the SEC Commissioners and the FASB follow. The depth of the discussions and their careful consideration of the issues is always fascinating to observe.

These meetings generally do not tell you what might happen in the short-term, but do provide a longer-term glimpse into the directions of policy-making and standard setting.

Disclosure effectiveness is a major longer-term initiative at the SEC right now. On April 13, 2016 the SEC is going to discuss “whether to issue a concept release seeking comment on modernizing certain business and financial disclosure requirements in Regulation S-K.”

As you know, this kind of change is something the SEC staff has wanted to do for years. In addition, provisions of both the JOBS Act and the FAST Act focused on disclosure effectiveness. And here is the logical next step – this meeting will likely help illuminate the future direction of disclosure effectiveness.

 

In addition, this meeting may offer ideas that you can implement now to help make your disclosure more direct and useful to investors.

 

So, perhaps this is the time to listen to one of the meetings? You could play it on your computer, have the sound coming out of your speakers, and think how many of your colleagues would join you and listen! SEC Party time perhaps? If you can’t make the live webcast, you can find all of the archived meetings at http://www.sec.gov/news/openmeetings.shtml

 

You can learn more at:

sec.gov/news/openmeetings/2016/ssamtg033016.htm

 

where the original meeting was announced and at:

www.sec.gov/news/openmeetings/2016/ssamtg041316.htm

where the date was changed from March 30 to April 13, 2016.

 

As always, your thoughts and comments are welcome!