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Adopting the new revenue recognition standard…are you ready?

As we move closer to 2018, more and more companies are facing challenges in adopting the new revenue recognition accounting standard, codified as ASC 606, Revenue from Contracts with Customers.  As a refresher, the adoption date of ASC 606 for publicly traded companies is for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period.  The effective date for all other entities is for annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019.

As the deadline to adopt ASC 606 approaches, in accordance with SEC SAB Topic 11-M, Disclosure Of The Impact That Recently Issued Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period, the SEC expects to see disclosures regarding both qualitative and quantitative information.  Following are examples of disclosure items to consider:

  • What is the potential impact of adopting the new standard?
  • Is adoption of the new standard expected to result in a material change or not to the financial statements?
  • What are the expected changes to existing accounting policies?
  • Where is the registrant in the implementation process?
  • Are there any significant issues not yet addressed by the registrant?
  • If it can be reasonably estimated, disclose the potential quantitative impact on the registrant’s financial statements.

Many companies may not be able to intelligently answer these questions and, for this reason, they will need to accelerate their preparations for adopting the new standard.

As I explained in a previous post, internal coordination among the various departments is a must in order to effectively assess the impact that ASC 606 will have on a registrant’s financial reporting.

 

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Improving the statement of cash flows financial reporting standards

In August 2016 the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force), which goes into effect for public business entities whose fiscal years begin after December 15, 2017.  The goal of ASU 2016-15 is to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other Topics.

With this goal in mind, this ASU addresses eight specific statement of cash flows (SCF) classification issues.  They include:

  1. Debt Prepayment or Debt Extinguishment Costs – Cash payments for debt prepayment or debt extinguishment costs should be classified as cash outflows for financing activities.
  2. Settlement of Zero-Coupon Debt Instruments or Other Debt Instruments with Coupon Interest Rates That Are Insignificant in Relation to the Effective Interest Rate of the Borrowing – At the settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, the issuer should classify the portion of the cash payment attributable to the accreted interest related to the debt discount as cash outflows for operating activities, and the portion of the cash payment attributable to the principal as cash outflows for financing activities.
  3. Contingent Consideration Payments Made after a Business Combination – Cash payments not made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability should be separated and classified as cash outflows for financing activities and operating activities.  Cash payments up to the amount of the contingent consideration liability recognized at the acquisition date (including measurement-period adjustments) should be classified as financing activities; any excess should be classified as operating activities.  Cash payments made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability should be classified as cash outflows for investing activities.
  4. Proceeds from the Settlement of Insurance Claims – Cash proceeds received from the settlement of insurance claims should be classified on the basis of the related insurance coverage (that is, the nature of the loss).  For insurance proceeds that are received in a lumpsum settlement, an entity should determine the classification on the basis of the nature of each loss included in the settlement.
  5. Proceeds from the Settlement of Corporate-Owned Life Insurance Policies, including Bank-Owned Life Insurance Policies – Cash proceeds received from the settlement of corporate-owned life insurance policies should be classified as cash inflows from investing activities.  The cash payments for premiums on corporate-owned policies may be classified as cash outflows for investing activities, operating activities, or a combination of investing and operating activities.
  6. Distributions Received from Equity Method Investees – When a reporting entity applies the equity method, it should make an accounting policy election to classify distributions received from equity method investees using one of two approaches: (1) cumulative earnings approach or (2) nature of the distribution approach.  These two approaches are further described within this ASU.  Disclosures related to changes in accounting principle may be required depending on an entity’s elections.
  7. Beneficial Interests in Securitization Transactions – A transferor’s beneficial interest obtained in a securitization of financial assets should be disclosed as a non-cash activity, and cash receipts from payments on a transferor’s beneficial interests in securitized trade receivables should be classified as cash inflows from investing activities.
  8. Separately Identifiable Cash Flows and Application of the Predominance Principle – The classification of cash receipts and payments that have aspects of more than one class of cash flows should be determined first by applying specific guidance in GAAP.  In the absence of specific guidance, an entity should determine each separately identifiable source or use within the cash receipts and cash payments on the basis of the nature of the underlying cash flows.  An entity should then classify each separately identifiable source or use within the cash receipts and payments on the basis of their nature in financing, investing, or operating activities.  In situations in which cash receipts and payments have aspects of more than one class of cash flows and cannot be separated by source or use, the appropriate classification should depend on the activity that is likely to be the predominant source or use of cash flows for the item.

Current GAAP is either unclear or does not include specific guidance on these eight SCF classification issues included in the amendments in this ASU.  With this in mind, the ASU is an improvement to GAAP because it provides guidance for each of these eight issues, thereby reducing the current and potential future diversity in practice.

Errors in the statement of cash flows

An interesting data point in the context of the SCF is that in the last five years the second most common issue cited in financial statement restatements related to errors in the SCF.  The following chart depicts SCF errors compared to six other common restatement issues between 2001 and 2015:

scf-restatements

As one can gather, these eight SCF classification issues may be perceived as addressing non-routine transactions.  According to the Audit Analytics August 2016 report on SOX 404 Disclosures, which I wrote about in a previous post, in 2015 approximately 5% of auditor attestations cited ineffective internal controls over financial reporting (ICFR) due, at least in part, to SCF classification issues.  Although this is a relatively small percentage compared to the total number of ICFR failures in 2015, these SCF classification issues typically related to non-routine transactions.

With the new guidance in ASU 2016-15, we can expect improvements in the disclosures related to the SCF; however, it’s unclear at this juncture what extent of influence the adoption of the ASU will have on mitigating ICFR failures going forward.

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Responding to accounting restatement risk

A fundamental tenet of financial reporting is that a company’s internal controls over financial reporting (ICFR) are sufficiently robust to ensure transactions are properly recognized and disclosed in its financial statements.  The appropriateness of financial statements hinges on the fair presentation in conformity with GAAP.  Furthermore, the concept of materiality is the deciding factor of what is “fair” and what is not.

However, at times companies misstate their financial statements.  In some situations these misstatements are simple, unintentional errors; whereas, in other cases they may be intentional.  When misstatements occur, companies must determine whether or not these misstatements result in materially misleading financial statements.  For purposes of clarity, an error is defined in ASC 250, Accounting Changes and Error Corrections as “[a]n error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of [GAAP], or oversight or misuse of facts that existed at the time the financial statements were prepared.”

Because identified misstatements that relate to the current period can be addressed by management without any required restatements, today’s post will address certain risk areas and requirements that companies will want to address in assessing misstatements in prior periods.

Materiality

In a previous post I wrote about materiality considerations, which should be considered in assessing whether or not the prior period financial statements are materially misstated.  Indeed, it is well established that calculating a quantitative threshold of materiality is an important step in a materiality assessment (such as 5-10% of pre-tax income).  However, companies should give consideration to qualitative factors as well.  The SEC’s staff issued SAB No. 99 to provide some guidance to considering qualitative factors.  Notwithstanding its guidance, SAB No. 99 does not address what might be considered not material.

Types of restatement

Depending on the outcome of a materiality assessment, companies may find themselves in one of two categories:

  1. Reissuance restatement – referred to as “Big R” restatement because this means the previously issued financial statements were materially incorrect and, therefore, are unreliable and must be reissued/restated.  In these cases, the prior period financial statements must be amended.
  2. Revision restatement – referred to as “Little r” restatement because, although there are errors in the previously issued financial statements, they were not material to the prior periods.  A company may choose to either make the error correction in the current period or it may recast its prior period financial results in connection with issuing its current period financial statements.  When a company elects to recast its prior period financial statements in connection with issuing its current period financial statements, it revises its financial statements.  In these circumstances, the prior period financial statements do not need to be amended.

Sarbanes-Oxley Act certification requirements

In the context of restatements, SEC registrants must be aware of risk exposure related to Sarbanes-Oxley Act (SOX) certification requirements.  As a refresher, as early as 2004 SEC registrants were required to implement certain provisions of SOX.  These provisions address requirements that the principal executive officer or officers (CEO or equivalent) and the principal financial officer or officers (CFO or equivalent) must certify.  The first requirement, Section 302, is found in SOX’s Title III – Corporate Responsibility.  The second requirement, Section 906, is found in SOX’s Title IX – White-Collar Crime Penalty Enhancements.

  • SOX Section 302 – In connection with filing of periodic financial reports with the SEC, the CEO and CFO (as signing officers) are required to certify in each quarterly and annual report:
    • the signing officer has reviewed the report;
    • based on the signing officer’s knowledge, the report doesn’t contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading;
    • based on the signing officer’s knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report;
    • the signing officers:
      • are responsible for establishing and maintaining internal controls
      • have designed such internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared;
      • have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report; and
      • have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date;
    • the signing officers have disclosed to the issuer’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function):
      • all significant deficiencies in the design or operation of internal controls which could adversely affect the issuer’s ability to record, process, summarize, and report financial data and have identified for the issuer’s auditors any material weaknesses in internal controls; and
      • any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls; and
    • the signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
  • SOX Section 906 – In connection with filing of periodic financial reports with the SEC, the CEO and CFO (as signing officers) are required to certify in each quarterly and annual report:
    • the periodic financial report containing the financial statements fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer.

Section 906 provides for criminal penalties if the CEO and/or CFO:

  • certifies any statement within Section 906 knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in Section 906 shall be fined not more than $1,000,000 or imprisoned not more than 10 years, or both; or
  • willfully certifies any statement as set forth in Section 906 knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in Section 906 shall be fined not more than $5,000,000, or imprisoned not more than 20 years, or both.

In light of these certification requirements and the potential criminal penalties, signing officers must be confident that their financial reporting controls are reliable.  With this in mind, when Big R restatement risk is heightened, companies should be cognizant of the regulatory and legal exposure associated with potential non-compliance.

Furthermore, when it comes to material misstatements in the company’s prior period financial statements, there is a rebuttable presumption that a material weakness in ICFR exists.  Another thing to keep in mind is that even though a Little r restatement may end up being the correct solution to addressing misstatements, the SEC registrant may end up concluding that a material weakness still exists in ICFR.  This gets at the concept of the “could” factor in assessing deficiencies in ICFR, which I previously wrote about.

Tips for companies

I recently listened to a webcast discussing 10 pitfalls to avoid when navigating a Big R restatement (replay link).  For convenience, I’ve listed these 10 pitfalls:

  1. Engaging inexperienced counsel and advisors for the investigation
  2. Forming a special committee when the audit committee might suffice
  3. The run-away or open-ended investigation
  4. Failing to keep auditors apprised of the investigation and errors found
  5. Indecisiveness and inability to reach conclusions
  6. Waiting too long to deal with wrongdoers
  7. Not self-reporting findings to the SEC
  8. Audit committee micromanagement of the restatement
  9. Failing to remediate
  10. Creating an unnecessarily detailed SAB 99 materiality analysis

In addition to these tips, companies should ensure they follow the standards governing accounting restatements in ASC 250 and that they assess misstatements for each reporting period.  Although certain misstatements may be insignificant in any given reporting period, they could aggregate to a material amount over time (such as the impact to the balance sheet).

When restatements arise, SEC registrants will need to disclose relevant information on SEC Forms 10-K/A and 8-K (for Big R) and SEC Form 10-K (for Little r).

Influencing the narrative

I’m going to fast forward the process of restating financial statements to communicating with outsiders what the facts are.  When management becomes aware of material misstatements in prior periods, the company should be clear and assertive with users of its financial statements about the nature and extent of the misstatements identified.  In connection with its assessment, management should be able to, at a minimum, address the following concerns:

  • explain the magnitude of the misstatement;
  • identify which accounts were affected;
  • describe what was done to remediate the misstatement (both in the financial statements and in ICFR);
  • explain what programs and controls have been put in place to avoid misstatements from occurring in the future; and
  • explain the implications of misstatements on the company’s future financial reporting and forecasts

It goes without saying that if companies do not take active measures to effectively management the risks I’ve discussed, users of their financial statements may call into question whether or not the root-causes in the company have been addressed.

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A Look-back: 12 years of SOX Section 404

Many companies became subject to the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) beginning for fiscal years ending on or after November 15, 2004.  Specifically, Section 404(a) requires public companies’ annual reports to include the company’s own assessment of internal control over financial reporting (ICFR).  Section 404(b) requires an independent auditor’s report on the effectiveness of the company’s ICFR.

Since the implementation of SOX 12 years ago, we have seen some interesting trends in financial restatement statistics and SEC enforcement trends, which I have written about recently (here and here).  In fact, a recent Audit Analytics report has highlighted some key take-aways related to Section 404 disclosures.

Effectiveness of ICFR requiring auditor attestation

SOX Section 404(b) states that accelerated filers (including large accelerated filers) must provide an independent auditor’s report on the effectiveness of the filer’s ICFR.  The following chart shows adverse auditor reports as a percentage of total auditor reports on ICFR on an annual basis within the last 12 years.

% Adverse Auditor Attestations

For clarification, according to PCAOB Auditing Standard No. 5 (AS 5), An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, an adverse opinion signifies that at least one material weakness exists within a company’s ICFR.

Naturally, one would expect the first year of implementation, 2004, to yield the least favorable results.  To also note is that because the SOX Section 404 requirements went into effect in late 2004, only a portion of companies whose fiscal years ended in 2004 were required to implement these requirements (i.e., those whose fiscal years ended on or after November 15, 2004).  This means that a smaller number of companies filed auditor attestations related to fiscal 2004 when compared to fiscal 2005.

What I find interesting about the above chart, and the Audit Analytics report discusses, is the historical “low” in the rate in 2010.  In 2010, the PCAOB inspection program began determining if audit firms had obtained adequate evidence to substantiate the auditor’s attestation of management’s assessment regarding the effectiveness of ICFR.  The impetus for this was the implementation of AS 5, which became effective in late 2007.

After initially reviewing audit firms’ implementation of AS 5 in 2008 and 2009, the PCAOB’s inspections began in 2010 to focus on inspecting for and reporting on whether firms obtained sufficient evidence to support their audit opinions on the effectiveness of ICFR.  Although somewhat unclear, we might gather from the above chart that the PCAOB’s scrutiny of audit firm compliance with AS 5 in 2010 may have re-focused the emphasis of audit firms on improving audit quality in 2011 (when compared to 2010).

Key areas of adverse auditor reports

Among those auditor reports with an adverse audit opinion on ICFR, the Audit Analytics report identifies the following internal controls issues with the highest frequency in 2015:

Ineffective ICFR issues

Total number of attestations

As % of total attestations citing ineffective ICFR
Material and/or numerous auditor and/or management adjustments

118

58%
Inadequate accounting personnel resources, competency, and/or training

105

52%
IT, software, security, and access controls

60

30%
Segregation of duties and/or design of controls

50

25%
Controls related to non-routine transactions

39

19%

As illustrated in the table above, the top reason for ineffective ICFR in 2015 was due to accounting issues which were known to materially misstate the financial statements.  Said differently, without recording the necessary adjustments, the financial statements taken as a whole would have been materially misstated.  The remaining top five reasons for ineffective ICFR in 2015 were due to internal controls issues (which either did or “could have” contributed to material errors in the financial statements).

Moreover, the Audit Analytics report lists the following accounting-related ICFR issues as most commonly cited in adverse audit reports in 2015:

Ineffective ICFR issues related to accounting

 Total number of attestations

As % of total attestations citing ineffective ICFR
Revenue recognition 47

23%
Income taxes

36

18%
A/R, notes receivable, investments, and cash

34

17%
Fixed assets and/or intangible assets

29

14%
Related parties and/or affiliates/subsidiaries

27

13%

Effectiveness of ICFR not requiring auditor attestation

In contrast to the requirements in Section 404(b) for accelerated filers, non-accelerated filers and smaller reporting companies need not comply with this provision, thanks to the Dodd-Frank Act of 2010, but they must comply with Section 404(a).  Furthermore, non-accelerated filers were not required to implement Section 404 until late 2007.

For clarification, a non-accelerated filer, as defined by SEC Rule 12b-2, is public company whose public float (as opposed to market capitalization) does not exceed $75 million as of the last business day of the company’s most recently completed fiscal Q2.  Furthermore, smaller reporting companies are those companies that meet the definition of a non-accelerated filer and had annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

Having said that, the following chart shows the percentage of adverse management-only assessments relative to total management-only assessments on an annual basis in the last 12 years.

% Mgmt-Only Reports

Interestingly, this chart shows a negative trend over the years, with a drop in 2015.

Key areas of adverse management-only assessments

The Audit Analytics report identifies the following internal controls issues with the highest frequency in 2015 in management-only assessments:

Ineffective ICFR issues

 Total number of assessments

As % of total assessments citing ineffective ICFR
Inadequate accounting personnel resources, competency, and/or training

985

79%
Segregation of duties and/or design of controls

893

72%
Ineffective, non-existent, or understaffed audit committee

388

31%
Inadequate accounting disclosure controls

246

20%
Material and/or numerous auditor and/or management adjustments

204

16%

To note is that two of the five top ICFR issues in the table above are also among the top five ICFR issues in adverse auditor attestations.  A key reason for the provision in the 2010 Dodd-Frank Act eliminating the requirement for non-accelerated filers and smaller reporting companies to comply with SOX Section 404(b) was due to cost of compliance.  Since we can see from the table above that overwhelmingly the two most common ICFR issues were inadequate accounting resources and segregation of duties/design of controls, it certainly seems reasonable to conclude that the cost of accounting resources is a relatively big factor for smaller public companies.  While understanding that these statistics describe ICFR issues for public companies, to my surprise is that the third most common issue deals with inadequacies of the audit committee.

With respect to accounting-related ICFR issues noted in management-only assessments, the Audit Analytics report lists the following most commonly cited in 2015:

Ineffective ICFR issues related to accounting

 Total number of assessments

As % of total assessments citing ineffective ICFR
A/R, notes receivable, investments, and cash

95

8%
Debt, quasi-debt, warrants and equity-related (beneficial conversion features)

53

4%
Income taxes

48

4%
Revenue recognition

38

3%
Related parties and/or affiliates/subsidiaries

24

2%

The above table demonstrates that the most frequently cited accounting-related issues in ICFR was similar between accelerated and non-accelerated filers and smaller reporting companies.  Furthermore, the Audit Analytics report indicates the top five accounting-related issues represented approximately two-thirds of the total accounting-related issues in 2015, both for adverse auditor reports and management-only assessments.

Summary

To put these findings into context for 2015, of those accelerated filers whose auditors issued an adverse SOX report, there was a pull toward ICFR failures due to accounting-related issues.  On the other hand, companies that issued management-only assessments citing ICFR failures experienced significantly higher rates of ICFR failures due to internal controls issues as opposed to accounting-related issues.

In addition, the ICFR failure rates reported by companies with management-only assessments were significantly higher than the ICFR failure rates reported by accelerated filers.  By applying a simple average over the last 12 years for accelerated filers and nine years for non-accelerated filers, the ICFR failure rates were 6.9% and 35.4%, respectively.

Finally, for additional context, I noted per review of the Audit Analytics report that in 2015 there were approximately 3,800 auditor attestations on SOX effectiveness filed with the SEC.  With regard to management-only assessments, there were approximately 3,500 management reports filed in 2015 with the SEC.  Therefore, the quantity of filings with the SEC between these two groups was comparable.

Source for charts:  Audit Analytics August 2016 report, SOX 404 Disclosures, a Twelve Year Review.

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Potentially costly accounting standards on the horizon

For a number of years we experienced a “lull” in significant accounting standards issued by the FASB.  However, just within the last two years, the FASB has issued two significant, complicated accounting standards that will have far-reaching implications for companies.

These two accounting standards affect how companies recognize revenues and recognize leases.  Based on my experience, I expect that just about every company whose financial reporting framework is U.S. GAAP will be affected by at least one, if not both, of these standards.  As such, today’s post will focus on what these two standards are and how they will affect companies.

Revenue recognition

In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606).  This standard is designed to achieve a number of goals.  First, the standard removes inconsistencies and weaknesses in revenue requirements and provides a more robust framework for addressing revenue issues.  Second, the standard improves comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets (particularly companies that have adopted IFRS).  Third, it provides more useful information to users of financial statements through improved disclosure requirements.  Finally, the standard simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The core principle of the guidance in Topic 606 is that an entity should 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.  With a move away from industry and more prescriptive guidance on recognizing revenue, this standard uses the following five-step model:

  1. Identify the contract(s) with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue when (or as) the entity satisfies a performance obligation

The desired goals of this standard seem nice on paper and I believe they are a significant step toward improved financial reporting.  However, what this means for companies is that they will need to apply a significant amount of resources and thought to achieving the objectives set forth in the standard.

ASU No. 2014-09 has been subsequently amended as follows:

Accounting for leases

Earlier this year the FASB issued ASU No. 2016-02, Leases (Topic 842).  The key change from the existing leasing accounting standard (Topic 840) is that, under the new standard, lessees will need to recognize lease assets and lease liabilities for leases classified as operating leases.  For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities.  If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.

This standard is effective for fiscal years beginning after December 15, 2018 for publicly traded companies.  Although 2019 seems like a long way into the future, many companies will need to make significant endeavors to effectively implement this accounting standard.

Internal coordination a must

It goes without saying that departmental decisions within a company tend to have an effect on accounting and financial reporting.  With this in mind, in implementing these new accounting standards companies will need to coordinate internally to ensure that all of the relevant facts and circumstances are gathered for accounting and financial reporting consideration.

In the spirit of coordinating between the accounting function and other departments to ensure that business operations are not adversely affected by adoption of these new accounting standards, following are things to consider:

  • Legal – In implementing the new lease standard, leases with terms greater than 12 months will be included in the balance sheet.  Companies will need to revisit their contractual terms, particularly with lenders, to ensure that the accounting changes on the balance sheet do not adversely affect compliance with debt covenants.  Further, companies will need to consider implications of adopting these two standards on securing financing.  Finally, companies may wish to revisit the terms and conditions, including pricing structure, in customer contracts and consider how adoption of the new revenue recognition standard may affect the timing of revenue recognition.
  • Financial planning and analysis – Companies will need to consider the timing of revenue recognition for internal budgeting and forecasts.
  • Information technology – Companies will need to revisit their accounting and operational systems and processes.  Specifically, systems and processes will likely need to be reconfigured and/or reports may need to be modified or created to obtain relevant data for appropriate accounting and more extensive accounting disclosures.
  • Human resources – Often times variable compensation is based on key financial metrics, such as revenues, earnings, and EBITDA.  With the adoption of the new accounting standards, because the timing of revenue recognition may change, companies will need to revisit their variable compensation arrangements with employees to ensure that targets are reasonable and achievable.  Moreover, companies will need to ensure there is adequate staffing with the right level of experience and technical skills to implement these standards.
  • Tax – With expected changes in the recognition of revenue, for example, companies will need to consider the impact on income taxes.
  • Investor relations – Companies will need to consider changes to guidance provided to the street on revenues, EPS, and non-GAAP measures (such as EBITDA) as these metrics will be affected by adoption of these new accounting standards.  Furthermore, companies will need to consider the nature and extent of communications with users of their financial statements regarding expected changes to business practices from adopting these standards.

As I indicated in a previous post, just like individuals, companies can procrastinate decision-making until it becomes costly.  Of particular concern in light of these two significant accounting standards is that companies may lack sufficient resources to effectively adopt them, either in terms of quantity or quality of headcount.

Likewise, companies may not provide adequate budgeting for additional resources needed to effectively adopt these standards.  Many companies, whether by choice or out of necessity, may find themselves hiring consultants carrying price tags higher than internal resources to accomplish the following two objectives.  First, they will need to meet the adoption requirements in the accounting standards.  Second, they will need to satisfy their external auditor of compliance with these accounting standards.

Potentially costly audits

In my line of business, hiring outside assistance to pass financial statement audits can become costly in a relatively short period of time.  With this in mind, in connection with an audit of financial statements, public companies should be mindful of the implications that the adoption of these standards will have on internal controls over financial reporting.

In essence, there are multiple “types” of internal controls:  IT general, application, automated, manual, and IT-dependent manual controls.  As is typical of significant changes in accounting and disclosure, the adoption of these new standards will likely require more manual-type controls to verify that financial reporting is reliable.

In light of this, companies will need to consider the increased risk of material misstatement that manual controls introduce to an audit.

Next steps

For these reasons companies should begin now planning for these scenarios.  In reality, these new accounting standards are a significant undertaking and companies should approach implementation of these standards with a high degree of determination.

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SEC settles charges with publicly-traded company for internal controls violations

Earlier this year the SEC announced that it had brought charges against a publicly traded company, Magnum Hunter Resources Corporation (MHR), a diversified natural gas, natural gas liquids and crude oil exploration and production company based in Texas.

The SEC’s charges are not based on material misstatements in MHR’s 2011 financial statements on Form 10-K. Rather, because of high growth arising from multiple business acquisitions, the company’s accounting staff could not keep up with the ever-increasing demands to maintain effective internal controls over financial reporting (ICFR).  As a result, the SEC claims there existed a material weakness in MHR’s ICFR and that MHR did not adequately disclose this in its 2011 SEC filing.

The SEC imposed a Cease-and-Desist Order on MHR in March 2016, which states in part:

This proceeding concerns failures by MHR and its management to properly implement, maintain, and evaluate [ICFR] for the fiscal year-ended December 31, 2011 and to maintain ICFR sufficient to keep pace with MHR’s growth from at least the fiscal year-ended December 31, 2011 through the quarter-ended September 30, 2013.

The SEC Order also states that this failure was, in part due to improper evaluations of the severity of internal control deficiencies by both MHR’s SOX consultant and external auditor.

Material Weakness

To put all of this into context, SEC Regulation S-X defines a material weakness as:

…a deficiency, or a combination of deficiencies, in [ICFR] such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis. [Rule 1-02(a)(4)]

This is consistent with the definition of a material weakness in U.S. auditing standards, which is:

a deficiency, or a combination of deficiencies, in [ICFR], such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. [PCAOB AU 325, par 3]

Note these definitions use the term “reasonable possibility” to describe the likelihood of a material misstatement occurring.  This term carries the same meaning as in ASC 450 (formerly SFAS No. 5), which I discussed in a previous post.

Charges by the SEC

In essence, the SEC’s charges hinge on the premise that, even though it did not find any material misstatement in MHR’s financial statements, because a material misstatement could have occurred, MHR should have made appropriate disclosures in its 2011 financial statements. Of interest is that MHR’s assessment of the effectiveness of ICFR concluded that a significant deficiency existed, not a material weakness.

In its audit work papers MHR’s external auditor documented that the control weaknesses arising from inadequate accounting staff did not rise to the level of a material weakness for the following key reasons: (1) the audit work did not identify material errors for the reporting period and (2) the auditor understood that MHR had recently hired additional accounting staff and that the existing staff, while overworked, was competent.

Despite the auditor’s documentation for its conclusion, the guidance in PCAOB AS No. 5 states that “[t]he severity of a deficiency does not depend on whether a misstatement actually has occurred but rather on whether there is a reasonable possibility that the company’s controls will fail to prevent or detect a misstatement.” (see par. 64)

Take-aways

Companies required to comply with SEC regulations should take note of these charges brought by the SEC. Further, companies should take seriously the requirements to maintain effective ICFR and disclose information that is pertinent to users of their financial statements.

In the end, it is the responsibility of the company’s management to not only prepare its financial statements, but to also maintain a system of ICFR sufficient to provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP (see SEC Exchange Rule 13(b)(2)(B) at 124).

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New going concern auditing standard proposed…so what?

Last week the AICPA’s Auditing Standards Board (ASB) released its exposure draft entitled “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.”  This proposed standard is designed to supersede SAS No. 126 (AU-C 570).  So, what should we learn from it?

To begin, the ASB made it clear that it wants to achieve three main goals with the exposure draft.  First, the ASB wishes to provide interpretative guidance on key aspects of the going concern assumption.  This interpretative guidance is, in part, designed to incorporate into the auditing standards the FASB’s ASU No. 2014-15 on going concern issued in 2014.  Second, the ASB wishes to converge the U.S. GAAS auditing standard on going concern (currently SAS No. 126) with International Standard on Auditing (ISA) No. 570 (revised).  And third, the ASB has designed this exposure draft to apply to different financial accounting standards, thereby necessitating a going concern standard written in a neutral accounting framework manner.

While the implications of this exposure draft may be varied depending on the circumstances in which it may be applied, I wish to focus today’s post on one aspect of this exposure draft–that of the definition of “substantial doubt.”

Substantial doubt

Paragraph A4 to this exposure draft reads:

A4. The FASB standards define substantial doubt about an entity’s ability to continue as a going concern as follows:

Substantial doubt about an entity’s ability to continue as a going concern exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). The term probable is used consistently with its use in topic 450 on contingencies.

Other applicable financial reporting frameworks may use different terms that are similar to substantial doubt. For example, International Financial Reporting Standards (IFRS) use the terms material uncertainty and significant doubt. Also, other applicable financial reporting frameworks may not use probable as their threshold. For example, IFRS uses “may cast significant doubt on the entity’s ability to continue as a going concern.” This SAS uses the terminology of the FASB standards and GASB statements; if an audit is performed under another financial reporting framework, the requirements and application guidance may need to be adapted as necessary. (emphasis added)

Clarification

Since the issuance of ASU No. 2014-15 there has been a disconnect in terms of the above definition of “substantial doubt” between U.S. accounting standards and U.S. auditing standards, which I discussed in a previous post.  In fact, this disconnect became a hot topic in one of my former consulting engagements of a Fortune 1000 company.  However, with the expectation that this definition will find its way in a new auditing standard on going concern, we should see agreement between these two sets of standards.  If adopted, the exposure draft will be effective for audits of financial statements for periods ending on or after December 15, 2017.

I find this a big step in the right direction to clarify auditing standards on this point.  Should practitioners take interest in this topic and wish to provide feedback to the ASB, comments are due on September 5, 2016.

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Changing the U.S. GAAP hierarchy over time

As accounting practitioners, we live and breathe accounting standards.  Without them we wouldn’t have a basis to record transactions or take supportable accounting positions.  So, it goes without saying that reliance on accounting standards are necessary for fair, consistent presentation of financial statements.  Those less familiar with accounting standards and the history behind them may make the mistake of assuming that any and all accounting standards are equally authoritative.  This is simply not the case and for this reason I will focus today’s post on the hierarchy of U.S. GAAP and how it has changed over time.

History

To begin, a little history lesson may be helpful.

1975

Way back in 1975 the AICPA issued SAS No. 5, The Meaning of “Present Fairly in Conformity With Generally Accepted Accounting Principles” in the Independent Auditor’s Report (SAS 5).  Beginning at ¶ 5, the Auditing Standards Board of the AICPA explained that there is no single source for U.S. GAAP standards, but that there are a number of resources, with Rule 203 of the AICPA Code of Professional Conduct requiring compliance with FASB standards, APB opinions, and AICPA accounting research bulletins.  The degree of authoritative GAAP sources trickled down from there.

1992

Next, in 1992 the ACIPA issued SAS No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles (SAS 69).  This auditing standard clarified the GAAP hierarchy by introducing four levels, (a) through (d).  As auditing practitioners implemented SAS 69, criticisms began to surface for a variety of reasons.  First, this standard, similar to SAS 5, only really applied to auditors, not preparers of financial statements.  Second, this standard was complex.  And third, the GAAP hierarchy ranked the FASB’s Financial Accounting Concepts (CON), which are subject to the same level of due process as FASB SFASs, below industry practices that are widely recognized as generally accepted but that are not subject to the same due process (see ¶ 10 and 11).

2008

In response to these criticisms, in May 2008 the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162).  The purpose of the standard was two-fold.  First, it was designed to improve financial reporting by identifying a consistent hierarchy for selecting accounting principles to be used in preparing financial statements presented in conformity with U.S. GAAP (for non-governmental entities).  Second, it was directed to entities (and not auditors) because it is the entity (not the auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.  In a manner similar to SAS 69, SFAS 162 identified four levels in the hierarchy of U.S. GAAP standards, beginning with level (a) and ending with level (d), as depicted in the chart below.  Once SFAS 162 was issued, the Auditing Standards Board of the AICPA withdrew SAS 69.

GAAP Hierarchy

Just looking at the above chart can spin one’s head because let’s assume, for instance, that a widely recognized and prevalent industry practice is identified.  This falls within level (d), the lowest level, in the above SFAS 162 GAAP hierarchy.  However, in order to perform a thorough due diligence of the matter, one needs to either be familiar with or go searching for other applicable guidance that may be more authoritative, falling into levels (a), (b), or (c).

2009

Only a year later, the FASB rolled out the Accounting Standards Codification (ASC), with an effective date for interim and annual periods ending after September 15, 2009.  Of interest is that the ASC makes it clear which accounting standards are “authoritative” and which are not.  Simply put, if an accounting standard is included in the ASC, then it is “authoritative.”  Conversely, if an accounting standard is not included in the ASC, then it is “non-authoritative.”  An exception to this is that SEC-issued rules and regulations, applying only to SEC registrants, are authoritative even if they are not included in the ASC.

Understanding the way things were

As a forensic accountant, I deal with litigation involving accounting issues from the past.  As I previously blogged about (see “Understand what standard or guidance was applicable at the time”), it’s imperative to put into context the accounting decisions that were made by knowing what accounting standard(s) applied a the time and, if multiple standards were in effect, which was/were most authoritative.  I think it’s helpful to frame the issue by asking some relevant questions:

  1. What time period(s) is/are relevant to the accounting or disclosure issue?
  2. Depending on the answer to question 1, which of the above U.S. GAAP hierarchy standards was in effect at the time?
  3. If the issue relates to transactions post-ASC implementation, have there been any Accounting Standards Updates (ASUs) related to the standard?  Although ASUs are not authoritative standards, it’s important to be aware of them.

Keep in mind that the FASB began issuing ASUs after the Codification went into effect.  ASUs are numbered in the following format:  Year first, then ASU number for that year (e.g., ASU 2009-14 was the 14th ASU to be issued in 2009).

By keeping the above understanding in mind practitioners can successfully apply the relevant GAAP standards to a historical transaction.

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The FASB’s comment letter process and why we need to understand it

Today I’m writing about the Financial Accounting Standards Board’s (FASB) comment letter process.  Prior to issuing authoritative accounting and disclosure standards, the FASB interacts with its constituents in a variety of ways to gather information that it may not have already considered.  Having a strong understanding of this process can provide practitioners with meaningful context to assist companies in their application of the FASB’s standards.

To begin, the FASB is a private organization overseen by the SEC.  The FASB sets standards, which become a part of U.S. GAAP accounting standards serving the broad public interest.  To note is that since September 15, 2009 the U.S. GAAP accounting standards have been codified in what is known as the Accounting Standards Codification (ASC).  In connection with setting these standards, the FASB has adopted an open decision-making process that provides for interaction between the FASB and its constituents.  This interaction takes many forms, including comment letters.  The FASB explains:

Comment letters are received from constituents in response to Discussion Papers, Exposure Drafts, and other discussion documents that are released to the public for comment.  Comment letters, which become an important part of a project’s public record, are an important source of information regarding constituents’ views on and experiences related to issues raised in a discussion document.

Comment Letter Process

The following summarizes the FASB’s standard-setting process, which is governed by the FASB’s Rules of Procedures:

The part I want to focus on in the above graphic is step number five.  When the FASB seeks to issue new authoritative accounting guidance, it commences by issuing exposure documents to solicit input.  These exposure documents may include Exposure Drafts (ED), Discussion Papers, Preliminary Views, and Invitations to Comment.  Often times the FASB issues an ED, but in some cases it may issue a Discussion Paper to obtain input in the early stages of a project.

The FASB typically issues EDs with a designated timeframe for respondents to reply, often in the form of comment letters, but also via public roundtable discussion and other due process activities.  Depending on the nature and extent of the feedback it receives, the FASB may redeliberate the proposed provisions to accounting and disclosure standards.  This, according to the FASB, is done at one or more public meetings.

Once all key concerns and issues have been considered and addressed, the FASB nears completion of its standard-setting process by issuing a final standard, in the form of an Accounting Standards Update (ASU).  The ASU describes the amendments to the ASC.

Resources

When litigation cases or accounting consulting engagements involve the interpretation or application of accounting and disclosure standards, it is critical to understand the thought process surrounding the decisions that become part of a standard.  Having a strong understanding of the FASB’s standard-setting process and knowing where to locate relevant information is key to building a strong position.

Practitioners have at their fingertips access to a host of FASB resources that can assist them in preparing arguments, opinions, or positions on a variety of accounting and disclosure topics.  Some helpful resources include:

  • Exposure documents previously issued by the FASB for comment, but are now closed for comment, unless otherwise stated.  This link includes FASB documents issued after 2002.
  • Responses received by the FASB in connection with its online comment letter process.  One can read specific comment letters the FASB receives from constituents, including public accounting firms, SEC filers, and other organizations taking a keen interest in the FASB’s exposure documents.
  • Unsolicited online comment letters from constituents.  This link includes related documents dating from 2002.
  • Exposure documents currently open for comment.  I suggest these types of documents are less valuable to preparing arguments, opinions, or positions.  However, understanding current deliberations may be applicable in certain engagements.
  • ASU documents.  Perusing certain aspects of these ASC amendments is a good way to obtain color and context to them.  I have found the following ASU sections to be particularly helpful in obtaining the understanding I may be seeking:
    • Why Is the FASB Issuing This Accounting Standards Update?
    • Who Is Affected by the Amendments in This Update?
    • How Do the Main Provisions Differ from Current U.S. Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?
    • Background Information and Basis for Conclusions

Application

I once worked on an engagement with a Fortune 1000 company that had become the center of a wave of negative media attention.  In a move that was anticipated, the external auditor raised challenging questions about the company’s application of a particular ASU in light of the negative media attention the company had received.  As an engagement team, in order to effectively address the external auditor’s concerns, we decided it was important to understand the details behind the ASU, including reviewing the comment letters the FASB received prior to issuing the ASU.  This exercise shed meaningful light on the implementation issues that multiple constituents predicted would, and indeed had occurred with the company.  Because of our ability to quickly look to relevant sources for reliable information, my firm was able to assist our client in navigating this challenge effectively and provide credible, supportable arguments to the company’s external auditor.

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Navigating the grey: Accounting judgments and estimates

Often times companies deal with business transactions that are subjective and require the use of judgment and accounting estimates.  For example, what is a reasonable useful life of a fixed asset for depreciation purposes?  What amount of warranty reserve should be booked for a new product?  Or, what accrued liability balance should be recorded at year-end related to repurchase obligations or guarantees?  The list goes on and on (see par 16 for some examples of accounting estimates).

FASB Statement of Financial Accounting Concepts No. 6 (CON 6) at ¶ 46 addresses the necessity of accounting estimates in financial statements:

A highly significant practical consequence of the features described in the preceding two paragraphs [regarding the effects of uncertainty in financial statements] is that the existence or amount (or both) of most assets and many liabilities can be probable but not certain. The definitions in this Statement are not intended to require that the existence and amounts of items be certain for them to qualify as assets, liabilities, revenues, expenses, and so forth, and estimates and approximations will often be required unless financial statements are to be restricted to reporting only cash transactions. (emphasis added)

Because an integral part of these accounting estimates are management’s judgments and estimates, which are susceptible to bias, error, and potentially fraud, it is imperative to understand how accounting estimates are established and what management considers in recording the estimates.

This may sound relatively straightforward; however, as an example public company auditors (who routinely review and audit accounting estimates as a profession) continue to struggle when it comes to adequately auditing and documenting their assessments of the reasonableness management’s accounting estimates and assumptions.  In fact, the PCAOB, the public company auditor’s regulatory body, summarized the results if its 2015 inspections, identifying certain recurring audit deficiencies, including (1) auditing internal control over financial reporting, (2) assessing and responding to risks of material misstatement, and (3) auditing accounting estimates, including fair value measurements.

Further, because accounting estimates are inherently susceptible to bias, error, and potentially fraud, they can often contribute to legal disputes.

Guidelines for assessing accounting estimates

From my experience as a former Big 4 auditor and as a forensic accountant on sometimes large, complex legal disputes, I have developed some questions that are helpful when assessing the reasonableness of significant assumptions or judgments used in accounting for estimates:

  1. What is the method used in making the accounting estimate, including model(s) used?
  2. What are the relevant key controls?
  3. Has management used an expert?  If so, what are the qualifications of the expert?
  4. What are the assumptions underlying the accounting estimates?  Are they based on reliable, relevant and accurate data?
  5. Did management consider alternative assumptions or outcomes?
  6. What was their reason for rejecting the other assumptions or outcomes?
  7. Has there been or ought there to be a change from prior period in the method(s) used for making the accounting estimates? If so, why?
  8. Has management performed a sensitivity analysis to assess the reasonableness of its assumptions?
  9. Did management assess the effect of estimation uncertainty? How so?
  10. Given the degree of uncertainty in their estimate, how did management get comfortable with their final conclusion?

While I don’t believe all of these questions need to be considered in all situations, they can be used as a guideline for assessing the reasonableness of accounting estimates.

Application

Once I assisted an expert in writing a report in a complex legal dispute.  The opposing expert opined that an error in accounting estimate in the defendant’s financial statements was material because of alleged reliance on inaccurate data in establishing the accounting estimate.  My team adapted some of the above guideline questions in the context of the dispute to rebut the opposing expert’s opinions.  By having a strong understanding of the assumptions employed by the opposing expert, we were able to decide (1) if they were based on reliable, relevant and accurate data or (2) if they were based on data that was not appropriate given the facts and circumstances of the dispute.

Ultimately my team constructed a strong position and our expert opined that number of the opposing expert’s assumptions were unreliable, irrelevant, and/or inaccurate.  In fact, to provide some insight into how drastically an accounting estimate could change depending on the assumptions and judgments applied, the opposing expert opined that the range of potential error caused by the alleged misstatement was from hundreds of millions to billions of dollars.  Our position was that the accounting estimate in the tens of millions of dollars was appropriate given the facts and circumstances.  Such a large range seems to be commonplace in legal disputes because of the grey area in applying assumptions and judgments.

In summary, reviewing accounting estimates requires professional judgment and experience.  Having a qualified professional who understands the accounting requirements and application of the standards can greatly assist a party to a legal dispute in protecting itself from potentially significant financial and reputational exposure.

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