Everyone in the SEC Reporting community has been waiting for the new leadership at the Commission to be confirmed. As a bit of a preview, here is a link to C-Span video of Chair nominee Jay Clayton’s confirmation hearing. Enjoy!
Tag Archives: FASB
Jeepers – More Whistleblower Enforcement Cases? – Do We Have the Message Yet?
By: George M. Wilson & Carol A. Stacey
Just a few weeks ago we did the latest in a series of posts about the SEC’s Whistleblower program. That post focused on two significant enforcement cases where companies attempted to impede whistleblowers. For other posts in our whistleblower series, see:
Our post discussing the background of the SOX and Dodd/Frank whistleblower programs
Our post about the total amount being paid-out to whistleblowers exceeding $100,000,000 (It is even more today!)
Our post discussing a company having to pay a $500,000 fine for firing a whistleblower
SEEMS LIKE THE MESSAGE SHOULD BE CLEAR BY NOW! Don’t try to limit how employees can blow the whistle.
But, the Enforcement Division is not done!
In a case announced on January 17 a company paid a $650,000 fine for including language trying to restrict whistleblower rights in over 1,000 severance arrangements. After removing the language the company also voluntarily agreed to conduct annual training for employees about their whistleblowing rights.
In a case announced on January 21 the SEC found a company that actively searched for a whistleblower, to the point of essentially threatening employees. The reason for the hunt was clear, the treasurer and the company had manipulated information related to hedge accounting and was actively trying to hide the fact that certain hedging relationships were not effective. When the SEC began to ask questions about the issue, the company suspected someone had blown the whistle. The company tried to ferret out the whistleblower, compounding their offenses. The company and the treasurer both paid fines.
There is a very important reason for these cases. In many situations a fraud would go undetected if it were not for the conscience and courage of whistleblowers.
It would seem that the SEC is actively searching for more enforcement cases to make the point that it is illegal for a company to try and prevent or impede employees from blowing the whistle.
Not to be too preachy, and hopefully to be a bit practical, here are two thoughts:
For all of us who may see a need to blow the whistle, know that this is never easy, and know that you have rights and protections.
For companies, don’t try to hide problems and make sure any agreements surrounding employee departures don’t have these kinds of restrictions!
As always, your thoughts and comments are welcome!
Non-GAAP Measures – The Saga Continues
By: George M. Wilson & Carol A. Stacey
The sometimes fuzzy distinction between non-GAAP liquidity measures and non-GAAP performance measures is a major concern of the SEC’s Non-GAAP Compliance and Disclosure Interpretations (C&DI’s) and the comment letters the Staff issues focused on this topic. In the middle of this grey question are EBITDA and “adjusted EBITDA”. Whether these measures are liquidity measures or performance measures can be a very complex, subjective question. To take some of the grey away the SEC included this C&DI in their May 2016 changes:
Question 103.02
Question: If EBIT or EBITDA is presented as a performance measure, to which GAAP financial measure should it be reconciled?
Answer: If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income. In addition, these measures must not be presented on a per share basis. See Question 102.05. (emphasis added) [May 17, 2016]
The last sentence in this answer is all about the potential confusion between EBITDA and cash flow from operations. GAAP and the SEC guidance specifically prohibit presenting cash flow per share because of the potential confusion between earnings per share and cash flow per share. (This goes all the way back to ASR 142 and old SFAS 95!) EBITDA, even when intended by management as an operations measure, is so close to this line that it cannot be presented on a per share basis.
In an interesting sequence of comment letters and responses the SEC has pushed its concerns about these kinds of non-GAAP measures to a new level. After a number of back and forth letters with a registrant focusing on whether a “non-GAAP adjusted net income” was a performance or liquidity measure the staff included this language in a late round comment:
Finally, in light of our discussions about this matter, we will evaluate the industry practices you described to us and consider whether additional comprehensive non-GAAP staff guidance is appropriate.
It is extremely unusual, as was even reported in The Wall Street Journal on February 13, 2017, to see a statement like this in a comment letter.
Even more eyebrow-raising is this comment in the SEC’s closing letter:
Although we do not agree with your view, in light of the circumstances, we have completed our review of your filing. We remind you that the company and its management are responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff. (emphasis added)
If you are presenting an EBITDA or similar measure it would be smart to review these letters.
You can find the first of the comment letter series here. The company’s responses (CORRESP documents) and the follow-up comment letters (UPLOAD documents) appear in this EDGAR list.
As always, your thoughts and comments are welcome.
Things Are Changing!
By: George M. Wilson & Carol A. Stacey
Two of the provisions of the Dodd Frank Act relating to disclosures by public companies are being considered for change in Washington, DC.
Conflict Minerals Disclosures
Acting Chairman Piwowar has directed the Staff to reconsider whether the 2014 guidance on the conflict minerals rule is still appropriate and whether any additional relief is appropriate. You can read his announcement including his formal statement and information he gathered on a trip to Africa here.
Resource Extraction Payment Rule
Congress has begun the process of revoking the Resource Extraction Payments provisions of the Act. The House passed this provision earlier and the Senate voted to revoke the provision Friday, February 3, 2017. You can read about the Senate vote here.
As always your thoughts and comments are welcome!
Revenue Recognition – Raytheon Sets the Pace!
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!
Why, Oh Why, Is It Always Segments?
By: George M. Wilson & Carol A. Stacey
If you have been involved with SEC reporting for more than say, five minutes, you have heard about or discussed with someone the SEC’s focus on operating segments. Segment related disclosures are included in several Form 10-K Items, including:
Item 1 – Description of the business,
Item 2 – Properties,
Item 7 – MD&A, and of course
Item 8 – Financial Statements.
Almost every SEC conference or workshop addresses the importance of segment disclosures.
The latest segment “message” from the SEC is in the November 7, 2016 Accounting and Auditing Enforcement Release dealing with PowerSecure.
It is the same familiar message we heard in the Sony case in 1998 and the PACCAR case in 2013. When companies avoid making proper GAAP disclosures for operating segments to try and bury problems in one part of a business with profits from another part of their business, trouble will result.
In the “classic” Sony case the company used profits from its music business to mask problems in its movie business. This case also has a great known trend disclosure problem and becomes an almost scary “double trouble” example. To escalate this case to “triple trouble” the SEC also made it clear that Sony’s assignment of MD&A to the IR manager was not appropriate by naming that person in the case and forcing Sony to reassign this responsibility to the CFO. With all that was going on with Sony the SEC went so far as to require the company to engage its auditors to “examine” MD&A. Surprisingly, under the attest standards, auditors can issue a full opinion report on MD&A!
In the PACCAR case problems in new truck sales were hidden with profits from truck parts sales. This SEC Complaint includes a very detailed summary of the operating segment disclosure requirements, discussing in detail how PACCAR’s management viewed the business and how, in the SEC’s judgement, PACCAR was not following the GAAP requirements. It includes this language:
“However, in reporting its truck and parts results as a single segment, PACCAR did not provide investors with the same insight into the Company as PACCAR’s executives.”
This story line repeats in PowerSecure. For the periods in question PowerSecure reported one segment when that was not how management actually viewed the business:
“PowerSecure also misapplied ASC 280 by concluding that its CODM – who was determined to be the Chief Executive Officer (“CEO”) – did not regularly review operating results below the consolidated level to make decisions about resource allocations and to assess performance. This was inconsistent with the way in which the CEO regularly received, reviewed, and reported on the results of the business and how the company was structured. On a monthly basis, the CEO received financial results that reflected a measure of profitability on a more disaggregated level than the consolidated entity. Further, on a quarterly basis, the CEO met with each business unit some of the business unit leaders had business unit level budgets and forecasts and received incentive compensation based, at least in part, upon the results of their business unit.“
The message is clear, don’t use segments to try and hide problems! As a last reminder, don’t forget that these disclosure requirements may go to an even lower level than operating segments in MD&A. Regulation S-K Item 303 makes this clear:
“Where in the registrant’s judgment a discussion of segment information or of other subdivisions of the registrant’s business would be appropriate to an understanding of such business, the discussion shall focus on each relevant, reportable segment or other subdivision of the business and on the registrant as a whole.”
As always, your thoughts and comments are welcome!
Revenue Recognition –Some Example Implementation Judgements and an Update on the AICPA’s Industry Task Forces
By: George M. Wilson & Carol A. Stacey
Some of the New Revenue Recognition Judgments
If you have begun your implementation work for the new revenue recognition standard you know that this one-size-fits-all, principles based model will require many new judgments for most of us. Among the challenging questions are:
- When does an agreement with a customer become legally enforceable and include the five elements that bring it in scope for revenue recognition?
- How do we properly account on the balance sheet for transactions with customers before there is an in-scope, legally enforceable contract?
- When does a product or service we deliver to a customer meet the new criteria of “distinct” and become a performance obligation, the unit of account for revenue recognition?
- How do we make the now required estimate of variable consideration and apply the new constraint?
- What will be the best method to make the required estimate of stand-alone selling price when it is not directly observable?
- When does control transfer to a customer now that delivery, ownership and risk of loss are no longer the points in time when revenue is recognized?
This list is, of course, in no way complete. Individual companies may find their judgments more or less extensive and complex.
While the FASB has produced all of these new principles and the related judgments, it has also included a fair amount of implementation guidance in the new standard and clarified several issues in updates to the ASU. There are a few more soon to be final technical corrections in another ASU that you can read about here.
AICPA Help for Specialized Industries
Since this new standard is a “one-size-fits-all” approach to revenue recognition and it supersedes all industry specific guidance we have today, industries like oil and gas, airlines and others face unique challenges. In addition to the FASB’s efforts to assist us in this process you may have heard that the AICPA has also formed special task forces to deal with industry specific challenges in implementing the new standard.
You can learn about the AICPA’s efforts surrounding the new revenue recognition task force here.
The industry groups are:
- Aerospace and Defense
- Airlines
- Asset Management
- Broker-Dealers
- Construction Contractors
- Depository Institutions
- Gaming
- Health Care
- Hospitality
- Insurance
- Not-for-Profit
- Oil and Gas
- Power and Utility
- Software
- Telecommunications
- Timeshare
There are over 100 specific position papers that have been put in process for the working groups and task forces which will ultimately be reviewed by FINREC. If you work in one of these industries, the links above will help you find the related working papers and their status.
As always, your thoughts and comments are welcome!
A Control Environment and History Follow-Up
By: George M. Wilson & Carol A. Stacey
This famous quote has been in our thoughts over the last several months:
“Those who cannot remember the past are condemned to repeat it.”
George Santayana, the poet and essayist, wrote these famous words in his book The Life of Reason. Many other people including Winston Churchill have thoughtfully incorporated this fundamental principle of life in speeches and remarks.
Another favorite variation of the idea comes from Mark Twain:
“History doesn’t repeat itself, but it does rhyme.”
The lesson here is that if we learn history we can hopefully avoid making the same or similar mistakes in the future. As we discussed a couple of posts back, recent public company news shows that many organizations have not been learning from the past.
One person who can help us learn about history we do not want to repeat is Cynthia Cooper. She was the WorldCom head of internal audit who built and lead the team that worked almost “under cover” to find the largest fraud ever discovered. This was a tone at the top fraud, involving the CEO, CFO and CAO. Her book is a sometimes-chilling story of how bad tone at the top results in fraud.
Sharron Watkins is another person who can help us learn how to not repeat history. She was the Enron Vice President, a direct report to Andy Fastow, who blew the whistle about Enron’s accounting irregularities. And we all know perhaps too much about that fraud which was even the subject of a book and related movie “Enron: The Smartest Guys in the Room”.
Corporate ethics will never be easy, but as history and current events show, it does matter. If leadership of an organization sends the message that making money is the most important thing an organization does, if it sends the message that if you don’t make money you will be fired, if it sends the message that other values can be sacrificed if you make money, the ultimate result is inevitable. In countless frauds over centuries, from Ivar Kreuger, the match king in the early 1900s, to Equity Funding in the 1970s, to Madoff, to Enron, to the companies we are talking about today, this lesson has been proven time and time again.
These stories can help us learn and avoid the mistakes others have made. They can be the focus of training and learning. They can be the foundation for building awareness and support for these issues in organizations large and small.
As always, your thoughts and comments are welcome.
Disclosure Effectiveness – The Saga Continues
By: George M. Wilson & Carol A. Stacey
A not so long, long time ago (OK, sorry Arlo Guthrie), and over a very reasonable period, the SEC began its Disclosure Effectiveness initiative. As you have likely heard (and can read about here), the Staff has sought comment and feedback about a variety of issues, including a lengthy release dealing with Regulation S-K and another dealing with various “financial statements of others” requirements in Regulation S-X.
The latest disclosure simplification development is a 26-page Staff report required by the FAST Act titled “Report on Modernization and Simplification of Regulation S-K”. It addresses a variety of areas ranging from properties to risk factors. Included are several interesting ideas such as requiring year-to-year comparisons in MD&A for only the current year and prior year and including hyperlinks to prior filings for prior comparisons.
The report is a thoughtful and interesting step in this challenging process.
As always, your thoughts and comments are welcome!
Tone at the Top, History and COSO
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!