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

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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!

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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!

More Whistleblower News and a Warning from the SEC

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In a recent post we discussed the “transformative effect” the SEC’s Whistleblower Program has had on SEC enforcement and reviewed the news that the SEC has now paid out more than $100 million to whistleblowers. We also, in an earlier post, walked-through both the Dodd-Frank and the SOX whistleblower programs and discussed some of their differences and similarities.

The most important thread running through all of this is the importance of whistleblowers in the detection and prevention of financial reporting fraud. The SEC’s Whistleblower Program affords “gatekeepers” a robust process for speaking out when they see something that isn’t right. The program is important in the detection of financial reporting fraud and is becoming an ever more important aspect of the SEC’s Enforcement program.

An important part of this program is sending messages to companies that they cannot act to harm whistleblowers. On two occasions thus far the SEC has acted strongly to punish companies who have sought to impede or retaliate against whistleblowers. The most recent case, in the words of the SEC, involved “firing an employee with several years of positive performance reviews because he reported to senior management and the SEC that the company’s financial statements might be distorted.”

The company paid a fine of half a million dollars.

Whistleblower situations are never simple. The issues involved are always grey. Whistleblowers can sometimes challenge areas where management has tried to make good decisions in complex situations. Loyalty is always an issue when someone blows the whistle. But even with these challenges the message from the SEC is clear; don’t retaliate when someone blows the whistle. Instead take steps to appropriately investigate and resolve the issues!

As always, your thoughts and comments are welcome.

Some Cybersecurity Risk-Management Support

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Cybersecurity Risk continues to be a huge and problematic issue. Processes and tools to respond to Cybersecurity incidents are constantly evolving. To help you keep up to date with these issues our “Cybersecurity 2016: Managing Cybersecurity Incidents” program will be offered on September 20 live in NY and via webcast.

 

Topics to be addressed will include:

 

Overview of the cyber insurance market and what to look for when purchasing

Cybersecurity provisions to include in vendor and business partner agreements

Managing a forensic investigation

Threat landscape: how can companies protect themselves?

Cybersecurity Act of 2015 and its ramifications for the private sector, plus SEC activity

EU developments on breach notification in the GDPR and NIS Directive

 

The program will also include these special features:

 

Cyberattack simulation

Hacker’s perspective: what are they seeking?

CISO and Regulators panel: strategies for global companies and guidance on sharing information with the government

 

You can learn more here.

 

As always, your thoughts and comments are welcome!