Tag Archives: auditor independence

Comment of the Week – The Mystery of Market Risk Disclosures

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Market Risk Disclosures are one area that many participants in our workshops seem to shy away from. This Item is one of the less well understood disclosures in Forms 10-K and 10-Q. The mechanics of writing the disclosure are, well, at best, mysterious.

With all the volatility in exchange rates, oil prices and other markets in the current environment these disclosures will likely become more important for many companies this year end. Because of this, we thought “going to go back to the basics” of this disclosure would be helpful in many companies’ year end process. So, this post includes a review of the objective of the disclosure and some tips to navigate the requirements in S-K Item 305 as you prepare the disclosure.

Since this is a comment of the week post, there are also some comments at the end of the post. If you are already comfortable with what market risk disclosures are about and how they work, you can skip to the end!

Objective of the Disclosure

To prepare these disclosures well it is crucial to understand their objective, what they are supposed to tell a reader. To understand this objective the first step is to understand what kind of risk the term “Market Risk” means. Market risk is a term that can be interpreted in a number of different ways ranging from the market for a particular product to market driven rates such as interest rates or commodity prices.

Deep in the body of Regulation S-K – Item 305, likely one of the most challenging reads in all of Regulation S-K, you find these instructions:

Instructions to paragraph 305(b): 1. For purposes of disclosure under paragraph 305(b), primary market risk exposures means:

  1. The following categories of market risk: interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market rate or price risks (e.g., equity price risk); and
  2. Within each of these categories, the particular markets that present the primary risk of loss to the registrant. For example, if a registrant has a material exposure to foreign currency exchange rate risk and, within this category of market risk, is most vulnerable to changes in dollar/yen, dollar/pound, and dollar/peso exchange rates, the registrant should disclose those exposures. Similarly, if a registrant has a material exposure to interest rate risk and, within this category of market risk, is most vulnerable to changes in short-term U.S. prime interest rates, it should disclose the existence of that exposure.

To paraphrase, these disclosures are not about the “market” for a product like computers or smartphones. They are about the risks a company faces from market driven prices like interest rates or commodity prices. So, while the market for smart phones could affect a company, the Market Risk Disclosures are about issues like how a change in interest rates could affect a company if the company has significant investments or borrowings.

And that brings us to the next step in understanding the objective of these disclosures. Once we know what sort of market risk we need to describe, what should we say about it?

In S-K Item 305(a)(1)(ii)(A) you will find this language:

“sensitivity analysis disclosure that expresses the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates”

In other words, this disclosure is designed to help a reader assess how much a change in a market driven price, such as an interest rate or a commodity price, would affect the business.

Conceptually what this disclosure is about is fairly easy to understand. However, the application of S-K Item 305 is complex. It requires both qualitative and quantitative information   Our review here is fairly brief. S-K Item 305 has a maze of detailed rules. If you will be drafting or reviewing the disclosure you should refer to the actual S-K language. Also, the comments below illustrate several of the complexities in this rule.

Qualitative Disclosures

The logical place to start drafting is with qualitative disclosures. Knowing what a company’s market risks are is necessary before quantitative information will make sense to a reader. Unfortunately, in Item 305, the qualitative disclosures are sort of hard to find, as they are not the first thing listed. You can find them in paragraph (b), which says:

(b) Qualitative information about market risk.

(1) To the extent material, describe:

(i) The registrant’s primary market risk exposures;

(ii) How those exposures are managed. Such descriptions shall include, but not be limited to, a discussion of the objectives, general strategies, and instruments, if any, used to manage those exposures; and

(iii) Changes in either the registrant’s primary market risk exposures or how those exposures are managed, when compared to what was in effect during the most recently completed fiscal year and what is known or expected to be in effect in future reporting periods.

This qualitative information is really pretty simple; say what market driven prices such as interest rates, exchange rates, commodity prices or other types of prices affect the company; talk about how you manage them; and tell if they have changed. Note that the rules do not require that a company manage these risks, so if you don’t manage them, you should disclose that, along with the other information in (b) (10) above.  (Here is one place to review Item 305 in detail, as this disclosure needs to be broken down in pretty specific ways by type and source of risk.)

Quantitative Disclosures

The second part of this disclosure is quantitative, and is designed to help a reader understand how much a hypothetical change in market prices or rates could affect the business. Again, this is a very detailed requirement, but in essence starts with a choice among three alternatives:

Tabular Disclosure

S-K Item 305(a)(1)(i)(A)(1) describes a tabular presentation of information related to market risk sensitive instruments. This information includes fair values of the market risk sensitive instruments and contract terms sufficient to determine future cash flows from those instruments, categorized by expected maturity dates. In essence you are providing a reader with the input they could use to build a spreadsheet, make a price change assumption, and see how much the price change would affect the company’s income, cash flows or fair values.

Sensitivity Analysis

S-K Item 305(a)(1)(ii)(A) describes a sensitivity analysis disclosure that expresses the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices over a selected period of time. In essence, in this disclosure you build your own spreadsheet and assume a hypothetical change in rates or prices and compute the impact.

Value at Risk Analysis

S-K Item 305(a)(1) (iii)(A) describes value at risk disclosures that express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments over a selected period of time, with a selected likelihood of occurrence, from changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices. This is actually a complex econometric modeling process, and we won’t discuss it any further in this post. If your treasury or risk management group already uses this technique to assess risk it may well be a good disclosure option.

Again, this is very complex disclosure. You can choose one of the three alternatives for different risks, however you must disclose the most significant impact based on future earnings, fair values, and cash flows. Therefore, you must calculate the impact of a price change on income, cash flows and fair value to determine which has the greatest change, and thus is disclosed. Of course, If future earnings had the greatest impact last year, and this year the greatest impact is in fair value, then you would need to recast the prior year. These are only some of the judgments necessary to prepare this disclosure.
One last note, as you can see this disclosure is very forward looking, and is another reason the 1995 Private Securities Litigation Reform Act safe harbors are so important!
Example Comments

Last but not least, as this is a comment of the week post, here are some comments. Notice the focus on simple compliance with the S-K Item 305 disclosure requirements!

Foreign Currency Fluctuations, page 37

  1. We note from your disclosure on page 28 and in Note 26 that a substantial portion of your cash is held by foreign subsidiaries and 46% of your net sales to unaffiliated customers for fiscal 2014 were attributed to your foreign subsidiaries, respectively. We believe your market risk disclosures should be enhanced to provide a more robust discussion of the effects of foreign currency risk on your results of operations and financial condition. Additionally, your discussion of this market risk does not appear to comply with the guidance outlined in Item 305 of Regulation S-K. Please revise to expand your discussion of foreign currency risk to comply with one of the disclosure alternatives in Item 305(a) of Regulation S-K.

Quantitative and qualitative disclosure about market risk, page 70

  1. Please tell us how you considered the disclosures required by Item 305(a) of Regulation S-K with respect to your term loan.

Item 7A. Quantitative and Qualitative Disclosure About Market Risk

Foreign Currency Risk, page 125

  1. Please tell us what consideration you gave to providing a sensitivity analysis for each currency (e.g., British Pounds and Euro) that may have an individually significant impact on future earnings.

Item 7A – Quantitative and Qualitative Disclosures About Market Risk, page 30

  1. We note your quantitative disclosure of interest rate risk associated with your investments in cash and cash equivalents and investment securities. We also note that your disclosure does not address market risk for other financial instruments such as the senior unsecured notes. Please revise to include qualitative and quantitative information about market risk in accordance with one of the three disclosure alternatives within Item 305 of Regulation S-K and that addresses the interest rate risk for the senior unsecured notes.

Evolution of the Audit Committee – Part Five – Voluntary Disclosures in the News

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Over the last two months we have done a series of blog posts about audit committee oversight and disclosure issues. One of the major topics under discussion within, among and about audit committees is what information should they disclose about their oversight of the audit, financial reporting and ICFR processes. Most observers agree that effective audit committee oversight is critical to success in these areas. And, many also believe that more information about how individual audit committees exercise this oversight will be valuable to investors and other stakeholders.

In our post on October 30 we reviewed the SEC’s Concept Release discussing possible incremental disclosures about this oversight. You can review it here:

seciblog.pli.edu/?p=462

Out in the real world it turns out that many companies are voluntarily making disclosures beyond those currently required by the SEC. On November 3, 2015 the Center for Audit Quality and Audit Analytics released their second “Audit Committee Transparency Barometer”. This “Barometer” is a survey of actual audit committee disclosures. Interestingly, this report shows that many companies are voluntarily going beyond required audit committee disclosures.

If you are not familiar with the CAQ you can read about it in our June 16, 2015 post at:

seciblog.pli.edu/?p=405

The press release about this second “Barometer” report and a link to the full report are at:

www.thecaq.org/newsroom/2015/11/03/second-annual-audit-committee-transparency-barometer-reveals-encouraging-disclosure-trends-for-public-companies-of-all-sizes

It makes for very interesting reading and provides valuable information in the search for “best practices” for audit committee disclosures. The report focuses on audit committee disclosures about external auditor oversight for companies in the S&P Composite 1500. As you read it you will see many companies voluntarily disclose information about topics ranging from issues considered in recommending the audit firm for appointment/reappointment to the audit committees role in selecting the engagement partner.

 

As always, your thoughts and comments are welcome!

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

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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!