Tag Archives: INTERNAL AUDITING

A Busy Summer for the SEC!

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The SEC has been busy on many fronts this summer. If you review the summary of proposed rules here on their web site you will see they have proposed five rules so far this summer and the summary of final rules here has another six rules issued in final form.

 

That is a busy summer!

 

The proposed rules contain some of the first concrete, early steps in the SEC’s disclosure effectiveness project. The proposal will “clean-up” some areas where the SEC’s rules overlap or are redundant with GAAP, IFRS or other guidelines. They also include a proposal to change the threshold to use the Smaller Reporting Company system to $250,000,000 in public float.

 

You can see the details of each proposal below:

 

Disclosure Update and Simplification

 

Amendments to Smaller Reporting Company Definition

 

Modernization of Property Disclosures for Mining Registrants

 

 

The final rules range from the final resource extraction payment rules required by Dodd/Frank, which replace the earlier version overturned in the courts, to the FAST Act 10-K summary.

 

You can see the details of each final rule below:

 

Disclosure of Payments by Resource Extraction Issuers

 

Adoption of Updated EDGAR Filer Manual

 

Form 10-K Summary

 

 

As always, your thoughts and comments are welcome!

Another Reason to do the Right Thing – Litigation is on the Rise!

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Our last post was about the on-going messaging from the SEC’s Enforcement Division to all of us to “do the right thing” for investors. Of course, another reason to do the right thing is the risk of litigation. And this risk, according to a report from the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research, shows that securities class action litigation is up substantially. According to the report filings are “up 36.7% from the first half of last year and up 16.6% from the second half of last year.”

 

In a startling statistic the report shows that on an annualized basis 6.4% of the S and P 500 were subject to class action filings.

 

Interestingly, the report indicates a substantial part of the increase relates to filings concerning merger and acquisition activity.

 

You can find a press release and the report here.

 

The Stanford Law School Securities Class Action Clearing house is a pretty scary website. If you would like to review it you can find it here.

 

Lastly, a great way to supplement what you read here on our blog and keep up with developments like this is to subscribe to the PLI Smart Brief, a periodic e-newsletter with lots of great information.

 

You can sign-up to receive the Smart Brief here.

 

As always, your thoughts and comments are welcome!

Do the Right Thing! – SEC Reminders for Auditors and Companies

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As they occasionally, (and at times frequently), do, the SEC has sent us a reminder to do the right thing.

 

This most recent reminder actually started with an action announced last September against a company that involved one of the classic financial fraud reporting areas, inappropriate revenue recognition. The complaint alleges significant self-dealing by officers and a variety of other inappropriate actions to fabricate financial results. The case was serious enough that the company’s registration was revoked. You can read the press release and find related documents here.

 

Whenever an action like this is announced, one of the questions we all ask is “where were the auditors?”

 

Usually an action against auditors happens separately from the related action against a company. Many times the two are hard to correlate. In this case the action against the auditor took almost nine months longer. It was formally announced on July 22, 2016. The SEC’s order against the auditor found that the auditor

 

“failed to perform sufficient procedures to detect the fraudulent sales in the company’s financial statements. (The Audit Firm) also failed to obtain sufficient audit evidence over revenue recognition and accounts receivable, identify related party transactions, investigate management representations that contradicted other audit evidence, perform procedures to resolve and properly document inconsistencies, and exercise due professional care.”

 

In the action the partner for this engagement paid a fine of $25,000 and was permanently suspended from practice before the SEC. This includes both auditing and working as a company accountant. The firm paid a $100,000 penalty and it can only begin accepting new public company clients again next year after an independent consultant certifies that the firm has corrected the causes of its audit failures. You can read the release and find related documents here.

 

As a final reminder about accountant’s and auditor’s role as gatekeepers the enforcement staff said:

 

“Auditors are supposed to act as gatekeepers to protect the integrity of our markets, but (The Audit Firm) failed to live up to their professional obligations”.

 

As always, your thoughts and comments are welcome!

Disaggregation – Comment Letters and the New Revenue Recognition Standard

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How often do you think of disaggregation in your financial statements? Generally, companies don’t present a lot of line-item details in their financial statements. Recently this issue has come up for us in two separate places.

 

If you have attended one of our large Midyear or Annual Forums you have had the fun of listening to Carol do an in-depth analysis of the comment letter process. She usually picks an interesting letter for a specific company and reviews both the overall process as well as the specific comments in the company’s letter.

 

In this year’s May and June Midyear Forms, Carol’s example letter included this interesting and “deep in the weeds” comment:

Consolidated Balance Sheets, page 33

  1. Please tell us how you have complied with Rule 5-02.20 of Regulation S-X. In this regard, we note your quantified disclosure of insurance liabilities and construction accruals. Please tell us whether there are any additional items included in other current liabilities that exceed five percent of total current liabilities.

The big theme here is of course disaggregation. Regulation S-X Article 5 has requirements about disaggregation for areas such as other current assets, other assets, other current liabilities and other liabilities. Generally, the requirements are that any individual account over 5% of the relevant total must be separately disclosed. Here is one example:

  • 210.5-02   Balance sheets.
  1. Other current assets. State separately, in the balance sheet or in a note thereto, any amounts in excess of five percent of total current assets.

There is also a similar requirement for components of revenue over 10% of total revenues:

  • 210.5-03   Income statements.

…………

(b) If income is derived from more than one of the subcaptions described under §210.5-03.1, each class which is not more than 10 percent of the sum of the items may be combined with another class. If these items are combined, related costs and expenses as described under §210.5-03.2 shall be combined in the same manner.

As you can see, the consistent theme is to provide appropriate detail so readers can understand appropriate issues in the F/S.

 

This theme of disaggregation is a topic of discussion in the FASB’s financial statement presentation project and also is an important issue in the disclosure requirements in the new revenue recognition standard:

Disaggregation of Revenue

ASC 606-10-50-5

An entity shall disaggregate revenue recognized from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. An entity shall apply the guidance in paragraphs 606-10-55-89 through 55-91 when selecting the categories to use to disaggregate revenue.

This new revenue recognition disclosure requirement will require substantial judgment to determine how much detail a reader will need to understand how the “nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors”. This is really the opposite of the S-X disclosure requirements above based on mechanical, quantitative 5% and 10% thresholds. The overall theme is the same though, be sure to consider how much detail readers really need to understand your financial condition, results of operations and cash flows.

 

As always, your thoughts and comments are welcome!

A Really Good Question – Form S-3 and the New Revenue Recognition Standard

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In a recent post we discussed a potential complication in the registration process and Form S-3 in particular if you retrospectively implement the new revenue recognition standard. You can review the post here. The issue arises if you file an S-3 in 2018 after you adopt the new revenue recognition standard but before your 10-K for 2018 is filed. The 2018 Form 10-K will have annual financial statements for 2018, 2017 and 2016 retrospectively applying the new standard. However, if you file an S-3, or have an S-3 shelf registration in place, before you file the 2018 Form 10-K, your S-3 would be required to have three fiscal years, now 2017, 2016 and 2015 that apply the new standard.

Thus, you could be required to report an extra year, 2015, on the new revenue recognition standard if you want to access the capital markets with an S-3, or an S-3 shelf registration, during 2018.

Whether or not the SEC can or will have any relief from this issue is not finalized. So stay tuned!

In our post we set up the example with an S-3 filed after the first-quarter 2018 form 10-Q is filed.

This all lead to a really great question from a reader:

 

In the hypothetical, if an issuer were to file an S-3 in the first quarter of 2018 (before its 3Q financials go stale and before the 2018 10-Q is filed), does Item 11 of Form S-3 require the company to file an 8-K with its recast 2015 financials reflecting the full retrospective adoption of the new standard before the issuer may take-down securities?

The answer to this question? Well, there is not a detailed rule anywhere that deals with the issue.

We researched the question and the closest guidance we could find was in the CorpFin Financial Reporting Manual Topic 11:

“Companies may transition to ASU No. 2014-09 and IFRS 15 (collectively, the “new revenue standard”) using one of two methods:

Retrospectively to each prior period presented, subject to the election of certain practical expedients (“full retrospective method”). A calendar year-end company that adopts the new revenue standard using this method must begin recording revenue using the new standard on January 1, 2018. In its 2018 annual report, the company would revise its 2016 and 2017 financial statements and record the cumulative effect of the change recognized in opening retained earnings as of January 1, 2016.

Retrospectively with the cumulative effect of initially applying the new revenue standard recognized at the date of adoption (“modified retrospective method”). A calendar year-end company that adopts the new revenue standard using this method must begin recording revenue using the new standard on January 1, 2018. At that time, the company must record the cumulative effect of the change recognized in opening retained earnings and financial statements for 2016 and 2017 would remain unchanged. The standard also sets forth additional disclosures required by companies that adopt the new standard using this method.

That language sure sounds like if you file after January 1, 2018, you need three years, 2015, 2016 and 2017 based on the new standard.

That said, stay tuned, we will all continue our research! And what is more fun than a really deep SEC research question?

As always, and especially with this one, your thoughts and comments are welcome!

Leases and the Five-Year Selected Financial Data in Form 10-K

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Within the required retrospective transition method for the new lease accounting standard is a very familiar question:

Will we be required to revise all five years of the selected financial data presented in Item 6 of Form 10-K?

As you may already know the SEC formally granted relief in the five-year summary for companies that use a full retrospective implementation for the new revenue recognition standard. For leases, they have done exactly the same.

 

At the March SEC Regulations Committee meeting of the CAQ this issue was addressed and if you read the minutes of the meeting you will see the SEC Staff’s announcement that:

“The selected financial data table should follow the transition provisions of the ASU (i.e., the new leasing standard should be applied as of the beginning of the earliest comparative period presented in the financial statements).”

Thank you letters may be appropriate!

As always, your thoughts and comments are appreciated!

Brexit and your Second Quarter 10-Q

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In the massive press coverage about “Brexit” one of the most frequently used words is “uncertainty”. While the impact of Brexit will differ from company to company it is important, as we come to the end of the June 30, 2016 quarter (or whenever your next quarter end will be), to think about whether the vote and the resulting uncertainty should be dealt with in your SEC reporting.

 

The two most straightforward issues are likely risk factors and MD&A known trends.

 

The risk factor disclosure in Part II Item 1A of 10-Q refers back to S-K 503(c) and requires disclosure of what makes owning your company’s securities “speculative or risky”. Companies should consider whether the uncertainties and already known impacts of Brexit increase risk and deserve mention in risk factors.

 

When a risk factor becomes more probable of having a material impact the risk factor should transmogrify into an MD&A “known trend” disclosure. This disclosure is required when there are “known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” (S-K Item 303). There are similar known trend disclosures for liquidity and capital resources. If you could be affected by market uncertainty, reasonably possible changes in exchange rates or other impacts of Brexit this disclosure may be necessary in MD&A. Lots of judgment here.

 

It is always important to remember that the “reasonably expects” probabilistic test in FR 36 requires disclosure if you cannot say the trend is “not reasonably likely” to come to fruition. (Sorry for the double negative, but it is in the test!). So if there is a 50/50 chance of a material impact, disclosure should likely be made.

 

Lastly, beyond these two issues there are a wealth of other possible accounting and disclosure ramifications, ranging from issues such as possible elevated risk of impairment to tax consequences, depending on your circumstances.

 

As always, your thoughts and comments are welcome.

Comment of the Week – Be Consistent in All Communications

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One of the themes we discuss in our workshops is how the SEC does not limit their review process to information in a company’s SEC filings. Here is an example of a comment (which also deals with known trends and uncertainties, another favorite topic) that demonstrates how the Staff finds issues by looking in places such as earnings releases, conference call recordings and web pages:

 

Results of Operations, page 23

 

  1. Please expand your discussion to address any known trends or uncertainties that are reasonably expected to have a material impact on revenue, cost of revenue, or income from operations. For example, we note that during your 2015 fourth quarter and full year earnings call on February 11, 2016, your management quantitatively described the volume increase, as well as discussed your customer mix changes by segment and certain trends in 2016. In addition, disclosure appearing on page 11 of your filing on Form 10-K under your risk factors indicates that extended periods of low fuel prices can also have an adverse effect on your results of operations and overall profitability, as well as on the valuation of inventory to the extent your hedges are not effective at mitigating fluctuations in fuel prices. However, you have not provided a discussion in your filing with respect to an analysis of known material trends, demands and uncertainties.

 

Refer to Section III of Financial Reporting Release No. 72, codified in FRC §501.12 and Item 303 of Regulation S-K.

 

It is important to assure that all the vehicles you use to communicate with your shareholders and the rest of the public are consistent and that issues raised in one place are appropriately dealt with across all communication channels.

 

As always, your thoughts and comments are welcome!

Getting the New Revenue Recognition Standard into Perspective

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As we all know, the new revenue recognition standard will be effective for public companies for periods beginning after December 15, 2017. This change will have challenges for everyone. Even if the new five-step, contract based model does not dramatically change the timing of your company’s revenue recognition, documenting how the new model applies in your case will require some time, and all of us will have to deal with the significant increase in disclosures, particularly the requirement to disaggregate revenues.

 

One place we see some confusion is about what these challenges will look like. This new standard is a complete departure from our old revenue recognition guidance and the detailed, rule based nature of the old standards. Some writers still talk about the “hundreds of pages” of guidance that must be dealt with. This makes it sound like the new standard is a large collection of detailed rules that simply replaces the large collection of detailed rules in the old revenue recognition GAAP.

 

This is not the case.

 

In the ASU the core of the new revenue model starts on page 14 and ends with the last of the disclosures on page 48.   Seems pretty short!

 

It is very principles base guidance! In our workshops, the broad, principles based nature of the new standard creates some of the biggest challenges for companies.

 

The whole standard is based on this principle, from paragraph 606-10-10-2:

 

“the core principle of the guidance in this Topic is that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

 

Notice the lack of language about an earnings process being complete or revenue being “realized or realizable”.

 

Each of the five steps and the disclosure requirements also start with a broad principle. Here is an example from step three, determining the transaction price (606-10-32-2):

 

“An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.”

 

On interesting aspect of this principle is that if there is variable consideration in a contract, it must be estimated! That is a whole new principle and each company will have to assess how to apply it to their circumstances.

 

Because this new revenue recognition model establishes a whole new set of principles, the FASB knew we would all need some help in how to interpret these principles. So, the standard, after the disclosure requirements, includes a number of implementation guidance discussions to explain what the principles are intended to mean. Terms such as “satisfied over time” and “distinct within the context of the contract” are explored. But you won’t find any detailed rules.

 

After the implementation guidance are a number of examples, and here you can find some actual interpretations of the principles which are very helpful. There are not too many of them.

 

As a last source of support for your process of learning about these principles and how to interpret and apply them don’t forget about the TRG. While the TRG does not issue formal guidance, their discussions are rich with examples of how some very experienced professionals are interpreting the standard. And, as you may have heard, the SEC Chief Accountant has said if companies depart from TRG discussions, they should be prepared to support such positions to the SEC staff. (You can read more about that in this speech.)

 

 

So, our tip for today, as you move through your implementation be ready to build an understanding of the principles and how to apply them to your specific circumstances!

 

As always, your thoughts and comments are welcome!

Audit Committee Learning Opportunity

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In a constantly changing world Audit Committee members know they need to be continuous learners to fulfill their responsibilities. To help them in this process PLI offers a variety of programs, and in June we will present:

Audit Committees and Financial Reporting 2016: Recent Developments and Current Issues.

The program is on June 21, 2016 and will be presented live in New York and via webcast.   You can find details here. The program features industry and SEC speakers, including Jim Schnurr the Chief Accountant.   The agenda includes:

SEC Developments You Need to Know About PCAOB Developments: What’s Happening in the Auditing Arena? Evolving Expectations for Audit Committees, including Audit Committee and Company Communications Financial Reporting Developments: What Audit Committees Need to Know Networking Break Risk Management & Compliance: What Audit Committees Need To Know Evolving Ethical and Liability Challenges for Audit Committee Advisors: 2016 Edition
As always, your thoughts and comments are appreciated!