On June 8, 2017, the SEC Chief Accountant, Wesley R. Bricker, gave a speech before the 36th Annual SEC and Financial Reporting Institute Conference. The speech, which this blog summarizes, was titled “Advancing the Role of Credible Financial Reporting in the Capital Markets.” As usual, I’ve included commentary throughout.
Introduction and Role of the PCAOB
The speech begins with some general background comments and a discussion of the role of the PCAOB. Approximately half of Americans invest in the U.S. equity markets, either directly or through mutual funds and employer-sponsored retirement plans. The ability to judge the opportunities and risks and make investment choices depends on the quality of information available to the public and importantly, the quality of the accounting and auditing information. Mr. Bricker notes that “[T]he credibility of financial statements have a direct effect on a company’s cost of capital, which is reflected in the price that investors are willing to pay for the company’s securities.”
The quality of financial statements begins with the company’s internal accounting and audit committees; however, an audit by an independent accountant provides investor confidence in the financial statements themselves. Mr. Bricker notes the importance of having an independent auditor that is thorough in their review and testing of the financial statements to ensure that they are accurate and do not contain any misstatements. In order to ensure that this process works, both the profession itself and regulators must be actively involved.
The Public Company Accounting Oversight Board (“PCAOB”) has broad oversight and responsibility related to the audit and auditors of public companies and broker-dealers. The PCAOB sets accounting standards, completes registration and inspection of audit firms and has enforcement authority. The PCAOB inspection process includes a review of audit files and of internal controls and processes of audit firms. The reports are made public via Staff Inspection Briefs and individual inspection reports. Also, a list of registered qualified PCAOB auditors is readily available on the PCAOB website.
The PCAOB completes an annual review of current and emerging audit issues and publishes and sets audit standards and changes. The PCAOB also publishes guidance for auditors and the audit process. As an example, the PCAOB recently proposed a new standard for audit reports. The proposed new standard would require auditors to describe “critical audit matters” that are communicated to a company’s audit committee. Critical matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.
The proposal would also add information to the audit report related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks. The SEC has yet to approve the rule. If/when approved, the new rule would be implemented for large accelerated filers beginning mid-2019 and for all other companies starting in 2021. Mr. Bricker notes that this proposed change is significant as the audit report is the document in which the auditor itself communicates to the public and investors.
International Collaboration
Mr. Bricker then discusses international collaboration with foreign regulators and standard setters. He notes that “in today’s interconnected world economy, investors depend on high quality auditing and auditing standards around the world,” also noting that “U.S. investors routinely invest in companies based outside the United States and listed in non-U.S. jurisdictions to diversify their portfolio.”
Turning to some facts and figures, U.S. investors invested $9 trillion in foreign equity and long-term debt, including through mutual funds. Investment in domestic equity and long-term debt comes in at $61.4 trillion. This number continues to increase. During the week ending May 17, 2017, U.S. investors added $9.9 billion to U.S.-based mutual and exchange traded funds which invest abroad. This was the largest weekly increase since July 2015.
It is important for investors to be aware of the processes, regulations, regulators and governance in place related to audits and auditing standards outside of the U.S. Although Mr. Bricker continues on the importance of international audit standards, and trust in the audit process, he does not refer to any specific initiatives or guidelines in that regard.
New GAAP Accounting Standards; Revenue Recognition
Recently there have been several changes to accounting processes and several other proposed changes. One that will have a material impact is related to revenue recognition. As requested by investors, businesses and the marketplace, FASB and IASB recently adopted new revenue-recognition standards which will be implemented over the next three years. Mr. Bricker does not get into the details of the new revenue-recognition standard but emphasizes that the audit committee and auditors need to participate in and have an understanding of how the company is implementing the changes, including a flow through to internal controls and procedures.
The following is my very high-level summary of the impact on contracts from the complex new revenue recognition standards. The revenue recognition changes are designed to assist an investor in understanding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts and customers. As revenue recognition is initially determined by the terms of a contract, it is important when drafting contracts to consider the financial statement impact. The new standard sets forth five steps to consider.
The first step is to identify the particular contract, which is an agreement between two or more parties that creates enforceable rights and obligations. The new standard requires that multiple contracts, between the same parties, entered into at or near the same time, must be combined and analyzed as one contract if (i) the contracts are negotiated as a package with a single commercial objective; (ii) the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or (iii) the goods or services promised in the contracts are a single performance obligation.
The second step is to identify the performance obligations, which is a promise in a contract with a customer to transfer to the customer either: (i) a good or service (or bundle of goods or services) that is distinct; or (ii) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A good or service is distinct if both of the following conditions are met: (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and (ii) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.
This step is vitally important as revenue is recognized when or as performance obligations are satisfied, and thus a contract must clearly identify those performance obligations. One blog I read gave a great example of where contract drafting can result in different revenue recognition—in particular, where a developer enters into a contract to build a completed building for a particular purpose for a customer. The contract may be written whereby parts of the delivered project have distinct and independent value, such as engineering, site clearance, construction, installation of equipment and finishing such that revenue is recognized upon delivery of these distinct elements. Contrarily the contract could be written such that the individual parts are not separately identifiable, but rather only the end product, such that revenue would not be recognized until such end product is provided.
The third step is determining the transaction price which is the amount of consideration to be paid in exchange for delivering the promised goods or services to a customer, excluding amounts collected on behalf of third parties. The two main considerations are: (i) variable consideration – if the consideration is variable, the company should estimate either the expected value or the most likely amount, depending on which will be the more likely; and (ii) constraining estimates of variable consideration – a company should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
Transaction price can also vary based on non-cash consideration, discounts, rebates, refunds, performance bonuses, penalties, contingent payments and the like. An example would be where a custom asset is being built and the price is contingent upon a delivery deadline, with a performance bonus for early delivery and penalties for later delivery. An additional complexity may be where the price is based on an independent appraisal at the time of delivery. Complex variables may prohibit revenue recognition until a contract is fully performed.
The fourth step is to allocate the transaction price to the performance obligations in the contract. This amount should reflect the amount a company would be entitled to in exchange for satisfying each performance obligation. To be able to recognize revenue based on allocation, the contract should clearly identify a particular distinct delivered good or service on a stand-alone selling-price basis. The allocation can be very complex and the amount of revenue recognized could end up differing from a stated value in a contract, which may be arbitrary.
The fifth step is to recognize revenue when or as the company satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when or as the customer obtains control of that good or service. Where a good or service is transferred over time, revenue may be recognized if one of the following conditions is met: (i) the customer simultaneously receives and consumes the benefits provided by the company’s performance over time; (ii) the company’s performance creates or enhances an asset that the customer controls as it is being created or enhanced; or (iii) the company’s performance does not create an asset with an alternative use to that company, and the company has an enforceable right to payment for performance completed to date (customized products or services).
Where performance and delivery are not over time, a company should consider the following as to when to recognize revenue: (i) the company has a present right to payment for the asset; (ii) the customer has legal title to the asset; (iii) the company has transferred physical possession of the asset; (iv) the customer has the significant risks and rewards of ownership of the asset; or (v) the customer has accepted the asset.
Also not included in Mr. Bricker’s speech is that some companies have chosen to adopt the new standards already, including Ford Motor Company, General Dynamics, Raytheon, Alphabet, First Solar and United Health Group. The MD&A for each of these companies contains a summary of the changes and how they impact their particular company and its financial statements.
Internal Control over Financial Reporting
Internal controls over financial reporting are controls designed to provide reasonable assurance that the company’s financial statements are prepared in accordance with GAAP. Internal controls provide the guidance and road map for management to effectively ensure timely and accurate financial reporting. All companies are required to maintain internal controls over financial reporting, whether or not such company is subject to the Sarbanes-Oxley Act.
Mr. Bricker advocates the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework for assessing the effectiveness of internal controls. The Treadway Commission is the National Commission on Fraudulent Reporting and has long been accepted as providing acceptable guidance on internal controls over financial reporting, and processes for management to assess same.
Mr. Bricker does not get into the specifics of the COSO framework for evaluating internal controls. However, I am providing a brief summary. In 1992 COSO developed a model for evaluating internal controls which has become the widely recognized standard for which companies measure the effectiveness of their systems of internal controls. COSO defines internal control as “a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance” of the achievement of objectives if the following categories: (i) effectiveness and efficiency of operations; (ii) reliability of financial reporting; and (iii) compliance with applicable laws and regulations.
From a very high level, COSO states that in an effective enterprise risk management (ERM) and effective internal control system, all of the following five components must be present:
- A Control Environment – which includes: (i) integrity and ethical values; (ii) a commitment to competence; (iii) a strong board of directors and audit committee; (iv) management’s philosophy and operating style; (v) organizational structure; assignment of authority and responsibility; and (vi) human resource policies and procedures;
- Risk Assessment – which includes: (i) company-wide objectives; (ii) process level objectives; (iii) risk identification and analysis; and (iv) managing change.
- Control Activities – which includes: (i) policies and procedures; (ii) security (application and network); (iii) application change management; (iv) business continuity/backups; and (v) outsourcing.
- Information and Communication – which includes (i) qualify of information; and (ii) effectiveness of communication; and
- Monitoring – which includes: (i) ongoing monitoring; (ii) separate evaluations; and (iii) reporting deficiencies.
Strong internal controls not only detect and prevent material errors or fraud in financial reporting but also contribute to better accountability and information flows. In other words, internal controls over financial reporting assist a company in better management and potential profitability in addition to the important reporting and securities-law matters. Where a company must disclose a material weakness in its internal controls, investors will discount the price accordingly, especially at the institutional level. Moreover, where a company has reported a material weakness and plan of remediation, and then executes on such plan, the investor response is very positive, including a reduced cost of capital and improved operating performance.
Although not discussed by Bricker, both the NYSE and NASDAQ consider reported material weaknesses in internal controls when reviewing an application for listing on the exchange.
Auditor Independence
Public trust in financial reporting is maintained by protecting the independence of the outside auditor. A company’s audit committee plays an important role in overseeing and communicating with the outside auditor. Bricker states that in order for the system to be effective, the audit committee must “own the selection of the audit firm, make the final decision when it comes time to negotiate the audit fee, and oversee the auditor’s independence.”
As part of the independent auditor selection, the audit committee should be open to the possibility of circumstances that might require adjustments to prior-period financial statements. Mr. Bricker includes as examples the reporting of discontinued operations, a retrospective application of an adoption or change in accounting principle, or the correction of an error.
Reminders to the Audit Profession
Mr. Bricker points out that audit firms themselves are organizations with the inherent pressures that personnel of any organization can face. Audit firms themselves must monitor and have internal controls in place to ensure quality audits and audit relationships. One pressure that definitely can impact the quality of an audit is a deadline. Bricker points out that audit firms need to plan and allocate resources to ensure that there is time to address potential issues under the deadline of SEC filing requirements. I note that the biggest complaint my clients make about their auditors relates to issue spotting at the last minute and requested material changes to financial statements, such as revenue recognition, right before a filing is due, without the time to properly research and address the matter.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
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West Palm Beach, FL 33401
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LAnthony@LegalAndCompliance.com
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Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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