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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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How to effectively identify a peer group

When writing expert reports I am often faced with the task of carefully benchmarking an entity against its peers. Disputes often deal with alleged accounting failures of an entity to recognize, disclose, or perform some other activity appropriately. Alternatively, financial statement preparers, users of financial statements, and/or auditors may wish to assess the reasonableness of management’s accounting recognition and disclosures against other entities.  For these reasons it is imperative that a careful benchmarking exercise be performed to assess the reasonableness of an entity’s accounting decisions in light of the decisions of peer entities. In this post I define peer entities as those entities that are most closely related to or aligned with the subject entity.

On the surface it may seem relatively straightforward to identify a peer group. However, when one peels back the onion the nuances begin to surface and, if not careful, practitioners may find themselves in a tough situation trying to defend their thought process in a rebuttal report, deposition or trial or trying to explain variances that prove to be irrelevant.  Today’s post will discuss some helpful tips to consider when selecting an appropriate peer group for benchmarking purposes.

To begin, a practitioner should have sufficient knowledge and understanding of the entity’s business and the industry in which it operates. Following are some items to consider to test ones knowledge and understanding of an entity’s business environment, not in any particular order:

  • What types of products or services does the entity offer?
  • Are any of these products or services different from other entities within its industry?
  • Does the entity operate in a regulated industry?
  • Is the entity publicly traded, or are the entity’s financial statements publicly available?
  • If so, what potential peer entities has the entity disclosed within its annual report (i.e., SEC Form 10-K) (more on this below)?
  • Can one easily identify the Standard Industrial Classification (“SIC”) code of the entity (more on this below)? Or, can one identify at least one potential peer entity that is similar to the entity, whose SIC code is readily available?
  • Do industry publications exist from a reputable source that may identify potential peer entities?

Screening considerations

Upon responding to the questions above, one focuses on a list of potential peer entities; however, it may still be necessary to screen the list further. I generally screen entities based on key financial metrics, which may include: assets, revenues, equity, net asset value, PP&E, headcount, or some other specific account or disclosure in the financial statements (depending on the nature of the research or litigation one is addressing).

Alternatively, one may look to segment disclosures in the financial statements, which often include disaggregated financial metrics based on geography, product line, or some other meaningful attribute. Furthermore, market capitalization may be meaningful; however, one should take caution with relying on this metric as it may be more volatile relative to other financial metrics.

In some cases, an entity may operate in a highly specialized industry. When this occurs and financial information of a direct competitor is not publicly available, one may consider selecting potential peer entities associated with the direct competitor that are upstream or downstream. In my view this is reasonable because upstream or downstream entities tend to have similar operations or business risks within the highly specialized industry.

Once a screening process is selected, one may also consider screening the same criteria for multiple periods to confirm that the selected screening criteria yield consistent results and, therefore, are reliable for benchmarking.

Annual Report Disclosures

SEC Regulation S-K Item 201(e) requires an SEC registrant to disclose a performance graph in its annual report (i.e., SEC Form 10-K filing).  This performance graph is relevant in the context of benchmarking because, depending on its business, an SEC registrant is required to construct a “peer group index,” which may identify potential peer entities of interest. The SEC guidance stipulates, “If the registrant uses a peer issuer(s) comparison or comparison with issuer(s) with similar market capitalizations, the identity of those issuers must be disclosed and the returns of each component issuer of the group must be weighted according to the respective issuer’s stock market capitalization at the beginning of each period for which a return is indicated.”

Care should be taken when relying on the SEC registrant’s selected peer group as the SEC guidance states, “If the registrant does not select its peer issuer(s) on an industry or line-of-business basis, the registrant shall disclose the basis for its selection.”  In the end, the judgments or assumptions applied by a practitioner in connection with a benchmarking exercise must be adequately considered and documented.

SIC Codes

The U.S. Bureau of Labor Statistics developed SIC codes to indicate an entity’s type of business.  SIC codes are categorized by major industry and sub-industry.  Public entities that file statements with the SEC include their SIC codes within their filings, which can be used for comparative analysis.

Application

The manner of execution of the benchmarking exercise can strengthen one’s position in a dispute.  Conversely, if left to inexperienced practitioners or lack of careful consideration, this exercise can create more problems than it was designed to solve. I’ve worked on a number of disputes wherein a robust benchmarking exercise was applied. In my experience well thought out benchmarking exercises have consistently played a critical role in persuasion of the arguments and opinions presented in the dispute.

In one such case a key allegation brought by an opposing expert dealt with inadequate accounting and disclosure of a particular FASB interpretation (“FIN”). My team carefully selected a peer group for comparison and we successfully demonstrated that diversity in practice existed with respect to peer entities complying with the disclosure requirements, which findings supported my client’s position.

In closing, I wish to reiterate that judgments or assumptions applied by a practitioner in connection with a benchmarking exercise must be adequately considered and documented for a successful outcome to occur.

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The power of walk throughs in investigations

As a former auditor, I performed walk throughs of certain key account processes or cycles to gain a complete understanding of a transaction from start to finish.  Sometimes it became quite cumbersome because certain processes were complex or lengthy.  However, after walking through a process I was able to gain a solid understanding of the areas of risk exposure and, most importantly, I could answer the question, “what could go wrong in this area.”  This informed me further in planning my audits and responding to risks.

As a basis for framing my post today, the PCAOB AU No. 5 at ¶ 37, describes a walkthrough as follows:

In performing a walkthrough, the auditor follows a transaction from origination through the company’s processes, including information systems, until it is reflected in the company’s financial records, using the same documents and information technology that company personnel use. Walkthrough procedures usually include a combination of inquiry, observation, inspection of relevant documentation, and re-performance of controls.

Although this guidance is intended to apply to audits of internal controls over financial reporting, implemented by an entity in preparing its financial statements, the principles gathered from walk throughs can be applied to a variety of circumstances.

As basic as they may seem, walk throughs I believe are the bedrock to understanding the flow of transactions in accounts, particularly complex ones.  Following are some powerful things that can be gathered from a walk through:

  • Build rapport with the interviewee through conversation that can be transitioned from “formal” (early on in the walk through) to “informal” or more “relaxed” (once enough questions have been discussed and the anxiety of meeting someone for the first time can be overcome)
  • Identify “types” of documentation not previously known
  • Assess the competency of an account owner/interviewee
  • Assess the body language of the interviewee and gather relevant information therefrom
  • Identify improper segregation of duties (custody, record keeping, and authorization/verification)
  • Identify exposures to fraud and/or error

To do effective walk throughs, it’s critical that the person conducting the meeting have sufficient experience to understand what types of questions to ask and, maybe more importantly, if answers are satisfactory or if probing is necessary.  Depending on the risks/allegations, a walk through may encompass a portion of or an entire process, including: initiation, authorization, recording, processing, and reporting.

I’ve found the following types of questions to be helpful in a walk through (of course, adapting the questions to the relevant facts/allegations and circumstances is critical to an effective discussion):

  • Please describe your role in this process.
  • Who else is involved in this process (preparers, reviewers, approvers, etc.)?
  • What happens when a transaction is not approved?
  • What systems (internal or external) do you use or rely upon to perform your duties?  This type of questioning can assist in identifying the areas of manual intervention, which often times are the areas of highest exposure to fraud and/or error.
  • Where do you understand the areas of judgment or estimate to be?
  • Have you or anyone you know been asked to override any controls?
  • If there were a questionable transaction or request, who would you go to for guidance or advice?

Depending on the situation, I recommend two interviewers in attendance.  For example, in an investigative scenario, it may be appropriate to have two persons in attendance, one to ask the questions and interact with the interviewee and another to take notes, but also to stand as a “witness” should allegations come back against the interviewer.

Sometimes a walk through may not be possible because access to the person(s) may be restricted.  In these scenarios, the best available information should be considered and, using an experienced professional’s understanding of the flow of similar business transactions, one should formulate an “expectation” for how transactions are processed and then refine that “expectation” as new information becomes available.

As a reiterative point, having an experienced professional involved in the process greatly increases the odds of a successful outcome (“successful” of course being a relative term) and is critical in sorting through what is relevant, what is not, and what may be an intentional diversion.

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Proving out cash and revenues

For many small business owners, ensuring that revenue and cash make sense when compared to each other is a critical exercise since cash is the most liquid account in the financial statements (which means it can be highly susceptible to theft) and revenue is often times the largest and/or one of the most important accounts to measure business performance.  How does one know if all cash receipts have been properly entered into the accounting system?  How does one verify that all revenues have been reported in the ledger for the period?

One such exercise can greatly help businesses to answer these questions, called a “proof of cash and revenue.”  By proving out cash and revenue, businesses can get comfortable that either (1) the accounting accurately reflects all business transactions or (2) there are transactions not appropriately accounted for, triggering additional investigation.

A proof of cash and revenue exercise is rather simple, although differing degrees of complexity in a business could complicate the exercise.  In essence a proof of cash and revenue exercise takes all cash receipts from an entity’s bank account statement and removes any non-revenue deposits (such as cash transfers from one bank account to another, proceeds from sale of equipment, bank account interest received, insurance reimbursements, and so forth) to arrive at what I will call “revenue deposits.”

Next, beginning-of-the-period accounts receivable, gross (make it a positive number) is netted against end-of-the-period accounts receivable, gross (make it a negative number).  The result is added to revenues from the general ledger (“G/L”).  The theory in adding beginning accounts receivable and subtracting ending accounts receivable is that the beginning accounts receivable is “assumed” to have been collected within the period, meanwhile the ending accounts receivable has not yet been collected, and, therefore, it will not show up in the bank account statement for the period.  I will refer to this calculation as “adjusted revenue per G/L”.

The final step is to compare “revenue deposits” to “adjusted revenue per G/L” and investigate any variance that exceeds what is considered to be an acceptable variance.

When done right, this exercise can uncover errors in accounting, missing deposits, or even fraud.  Although this exercise is fruitful for businesses that have standard revenue recognition practices, one can see that when customer sales exist with multiple elements, whereby “delivering” a service or a product to a customer doesn’t necessarily result in revenues (but rather some or all deferred revenue), a proof of cash and revenue is not likely to yield meaningful results.

Having said this, I’ve assisted a number of clients in performing this proof of cash and revenue analysis and clients gain valuable insight into their business practices and controls that they otherwise may not be aware of.

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Substantial doubt in assessing going concern

Today’s post will focus on a hot topic for some business entities—that of the “going concern” assumption. Let’s start by setting the foundation. The “going concern” assumption isn’t explicitly discussed as much as it is applied in financial statements. People tend to invest in or lend money to entities that are expected to continue to operate for the foreseeable future. This expectation is what I discuss as the “going concern” assumption.

For decades financial statements have been prepared under this assumption. However, from time to time, entities may face significant operational, regulatory, legal, or other setbacks that raise substantial doubt about their ability to continue to operate as a going concern for a reasonable period of time (generally 12 months) after they issue their financial statements.

This distinction is important, because if an entity’s ability to continue as a going concern is substantially doubtful, then the entity must address this by disclosing details in its financial statements.

Up until 2014, there has not been a clear definition of the term “substantial doubt” in the accounting or auditing literature. As I will touch upon later in this post as well as in a subsequent post (because this will be a lengthy topic), due to the issuance of the FASB’s Accounting Standards Update (“ASU”) No. 2014-15 (issued in August 2014) we now have a clear definition, which I believe could prove problematic for audit firms, which are required to comply with auditing standards.

History

When we look back in history, we find that an entity’s external auditor has historically been responsible for assessing an entity’s ability to continue to operate as a going concern for a reasonable period of time. Said another way, management of the audited entity has typically not performed its own assessment, but has “outsourced” this responsibility to its external auditor. Possibly, this is due to management’s inherent bias that its business is not expected to fail in the near future and, therefore, the auditor should make this determination based on the audit evidence it has obtained.

Auditing Standards

U.S. GAAS defines the auditor’s responsibility in conducting this assessment.  However, the term “substantial doubt” has never been clearly defined in auditing standards. Therefore, the interpretation and application of the auditor’s requirements to assess an entity’s ability to continue as a going concern has been largely left to the audit firm industry.

Accounting Regulator Seeks Comment from Industry

Anytime something is left to an industry where important decisions need to be made by applying professional judgment, naturally diversity in practice arises.  As one would expect, over time diversity in practice became more and more prevalent.  One way to gauge this is to review correspondence between the FASB and various audit firms regarding this very issue.  In the FASB’s 2013 exposure draft (“ED”) related to what ultimately became ASU No. 2014-15, the FASB asked a series of questions, including the following:

Question 19: The Board notes in paragraph BC36 that its definition of substantial doubt most closely approximates the upper end of the range in the present interpretation of substantial doubt by auditors. Do you agree? Why or why not? Assuming it does represent the upper end of the range of current practice, how many fewer substantial doubt determinations would result from the proposed amendments? If the proposed amendments were finalized by the Board and similar changes were made to auditing standards, would the occurrence of audit opinions with an emphasis-of-matter paragraph discussing going concern uncertainties likewise decrease and be different from what is currently observed? If so, by how much? Is such a decrease an improvement over current practice? Why or why not?

For reference, paragraph BC36 in the ED states:

BC36.  The Board decided to define substantial doubt in U.S. GAAP to reduce problems currently caused by different interpretations of its meaning in the auditing literature.  The Board decided that substantial doubt about an entity’s going concern presumption should exist when information about conditions and events indicates that it is known or probable that the entity will be unable to meet its obligations within 24 months after the financial statement date, after considering the mitigating effect of all of management’s plans.  This difference in considering management’s plans outside the ordinary course of business would appropriately distinguish the initial disclosure threshold from the substantial doubt assertion, and the Board believes that this definition most closely approximates the upper end of the range in the present interpretation of substantial doubt.  Accordingly, if the proposed amendments were adopted by the Board and similar changes were made to auditing standards, the Board expects that there would be a lower incident of audit opinions with an emphasis of matter discussing going concern than is currently observed in practice.  The likelihood threshold of probable is intended to have a consistent meaning with Topic 450, Contingencies.

A number of audit firms submitted responses to the FASB during the ED comment letter period, stating their positions regarding what the then existing industry practice was for auditors to define the “substantial doubt” threshold, which had been developed over years of application.  Here is a sampling:

BDO USA, LLP

We do not believe the definition of substantial doubt in paragraph BC36 necessarily represents the upper range of the present interpretation of substantial doubt. In many instances, it appears consistent with the matters we currently consider in assessing the ability of an entity to continue as a going concern….

From this comment letter one implies a threshold under auditing standards that is equal to probable because it states the definition is consistent.

CohnReznick LLP

While we agree that the proposed definition is at the upper end of the range in the present interpretation of substantial doubt by auditors, we do not believe it will result in fewer substantial doubt determinations. Any disclosure of substantial doubt regarding an entity’s ability to continue as a going concern is viewed by users of financial statements as a dire assessment with severe consequences. Accordingly, auditors currently do not make such disclosures unless they consider them to be absolutely necessary. This is understandable since such disclosures could have adverse consequences on the entity’s ability to execute the actions it considers necessary to continue as a going concern.

From this comment letter one implies a threshold under the auditing standards of probable.

Crowe Horwath LLP

It is not readily apparent what evidence the Board considered in making the determination that the proposed definition of substantial doubt most closely approximates the upper end of the range in present interpretation of substantial doubt. Assuming similar changes were made to the auditing standards…we believe there will likely be fewer required substantial doubt emphasis-of-matter paragraphs in practice.

From this comment letter one implies a threshold under the auditing standards that is lower than probable, but does not indicate the threshold.

Deloitte & Touche LLP

The Board’s intention for the substantial-doubt definition to represent the “upper end range” in the present interpretation is not clear. If that is the Boards intent, the definition should be revised to clarify such. Without performing a specific analysis based on the proposed guidance, it is not clear how the frequency of disclosures or audit opinions with an emphasis-of-matter paragraph discussing going concerns would be impacted under the proposed definition compared to current practice. However, given the frequency of disclosure about an entity’s ability to continue as a going concern will most likely increase, we would expect the frequency of audit opinions with an emphasis-of-matter will most likely increase also (assuming the audit and accounting literature are aligned in such a manner).

From this comment letter one implies a threshold under the auditing standards that is other than “probable,” but one cannot make a determination as to what that threshold is.  Perhaps the reason Deloitte stated that the frequency of going concern opinions “will most likely increase” is due to the Board’s proposal in paragraph BC36 to extend the look-forward period to 24 months from 12 months.

Grant Thornton LLP

We believe that the definition of substantial doubt in the proposed amendments does align with the upper end of the present interpretation of that term by auditors. Currently, we believe the lower end of the range for the requirement of going concern disclosures is somewhere between more-likely-than-not and probable.

From this comment letter one understands that the audit firm’s interpretation of the auditing standards is a range between “more likely than not” and “probable”.

KPMG LLP

We do not believe the proposed substantial doubt definition most closely approximates the upper end of the range in the present interpretation by auditors, but our views are limited to our experience in making such judgments. Accordingly, if the auditing standards were revised to define substantial doubt as a “probable” likelihood that the entity will not meet its obligations, we do not believe there would be a decrease in audit opinions with an explanatory paragraph. As proposed, we believe there would likely be an increase of explanatory paragraphs resulting from extending the current 12-month assessment period to 24 months.

From this comment letter one understands that audit firm believes the auditing standards have a different threshold than the proposed threshold in the ED, but the audit firm does not clarify.

Moss Adams LLP

We agree that the Board’s proposed definition approximates, and may exceed, the upper end of the range in the present interpretation of substantial doubt by auditors.

From this comment letter one implies a threshold under the auditing standards that is lower than “probable,” but does not indicate the threshold.

PricewaterhouseCoopers LLP

The auditing standards do not define substantial doubt. Therefore, auditors apply judgment based upon each company’s facts and circumstances which may result in diversity in practice. Auditors also have the ability to use an emphasis of a matter paragraph, pursuant to SAS 58, to highlight liquidity or other significant matters in their opinion, even if the substantial doubt threshold is not met. Therefore, it is difficult to calculate the impact of the proposed standard on all audit reports.

From this comment letter one understands there is diversity in practice, because the auditing standards do not define substantial doubt.

FASB issues ASU 2014-15

As mentioned previously, on August 27, 2014, the FASB issued ASU No. 2014-15 to communicate amendments to the FASB’s ASC 205-40, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.  The FASB acknowledged that:

BC11. The [FASB] Board received input indicating that because of the lack of guidance in GAAP and the differing views about when there is substantial doubt about an entity’s ability to continue as a going concern, there is diversity in whether, when, and how an entity discloses the relevant conditions and events in its footnotes. The Board also received input indicating that if auditors are required by U.S. auditing standards to consider disclosures in the financial statement footnotes, then management should be provided with guidance in GAAP about those disclosures. The amendments in this Update provide guidance in GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. In doing so, the amendments should reduce diversity in the timing and content of footnote disclosures.[1]

ASU 2014-15 clearly defines the term “substantial doubt” to exist “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…”  The ASU also clarifies that the term “probable,” as used in ASU 2014-15, is to be used consistently with its use in ASC 450 (“ASC 450”), Contingencies.  (See ASU No. 2014-15, p. 7)

Auditing Standards – No clear definition!

The FASB’s clarification via ASU 2014-15 is good, reliable literature.  Unfortunately, the PCAOB has not clarified what “substantial doubt” means in the context of going concern opinions.

Conclusion

Because audit firms are required to comply with auditing standards in conducting their audits, I foresee a disconnect in how auditors and management may approach this subject matter during year-end audits.  To add to this, I believe the next downward economic cycle could likely bring this issue to surface for a number of companies and their auditors.

Stay tuned for an upcoming post where I will take this issue further and look more closely at this disconnect between accounting and auditing standards as practitioners weigh in.

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“Probable” in Accounting Terms

Probable.  Every financial accountant under the sun has used this word in the context of financial statement accounting and disclosure.  Where does it come from (at least in the technical or accounting sense)?  The answer is SFAS No. 5, Accounting for Contingencies.  This accounting standard has been around for decades and has been applied in a variety of circumstances.  Within its pages we find some key definitions (see par. 3).

Probable.  The future event or events are likely to occur.

Reasonably possible.  The change of the future event or events occurring is more than remote but less than likely.

Remote.  The change of the future event or events occurring is slight.

As an accountant, there seems to be this insatiable urge to place “probable”, “reasonably possible”, and “remote” into numerical expressions, for example, on a scale of 0% to 100%.  It seems to me this can greatly assist accountants to normalize their views of how these terms are applied.  I have come across some interesting studies that do just that:

  • A 1990 research report published by J.E. Bortiz, PhD, FCA, summarizes findings that a rough correspondence between verbal expressions of probability and numerical values indicates the words “remote” and “probable” to be associated with average values of 10% and 70%, respectively. [Boritz, J., Approaches in Dealing with Risk and Uncertainty (The Canadian Institute of Chartered Accountants 1990), p. 24]  Based on these numerical values, one would conclude that “reasonably possible” would fit in between 10% and 70%, however the report identifies a 60% average value associated with this expression.
  • A study of accountant practitioners found that, based on survey results, “probable” meant an 85% likelihood of something occurring.  [Stickney, C. and Weil, R., Financial Accounting: An Introduction to Concepts, Methods, and Uses (Thomson: 12th ed. 2007), p. 806]

Although these data points are not considered GAAP for financial reporting purposes, they provide insight that I believe can be helpful when dealing with accounting issues.  Stay tuned for an upcoming post, where I will apply this research in the context of going concern.

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Materiality — consolidated level vs. segment level

I often work on litigation consulting engagements where the concept of materiality is front and center.  A key question that I have encountered is, for a consolidated entity, whether or not materiality is to be assessed at the consolidated level or at the segment level from a financial reporting disclosure perspective.

Materiality

The guidance is clear that materiality is supposed to be assessed in the context of the “financial statements taken as a whole”, or at whatever level the issuer is reporting its financial statements.  However, there are some items for consideration that can provide some color to this discussion and that can assist those involved with these types of decisions to understand the implications of making materiality decisions at a level lower than the consolidated level.

Auditor Considerations

When the external auditor opines, the auditor refers to the highest level of financial statements, typically the “consolidated” financial statements, presenting fairly, in all material respects, the financial position/results of operations/cash flows, etc.  When the auditor plans and performs an audit, the auditor considers “materiality”, which, according to auditing standards, is also based on the “financial statements taken as a whole” concept.

Auditing Standard (AU) No. 312 titled “Audit Risk and Materiality in Conducting
an Audit” addresses materiality for particular items of lesser amounts than the materiality level determined for the financial statements taken as a whole.  Paragraph 31 states:

When establishing the overall strategy for the audit, the auditor should consider whether, in the specific circumstances of the entity, misstatements of particular items of lesser amounts than the materiality level determined for the financial statements taken as a whole, if any, could, in the auditor’s judgment, reasonably be expected to influence economic decisions of users taken on the basis of the financial statements. Any such amounts determined represent lower materiality levels to be considered in relation to the particular items in the financial statements.

Paragraph 32 provides some items for consideration by the auditor.  However, at the end of the audit, as I’ve explained previously, the auditor generally opines on the financial statements taken as a whole.  This is important to remember.

Issuer Guidance

SFAS 131, Disclosures about Segments of an Enterprise and Related Information, discusses disclosure requirements for segments of a filer.  Within par. 78, it states:

Paragraph 125 of Concepts Statement 2 states that “. . . magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment.” That guidance applies to segment information. An understanding of the material segments of an enterprise is important for understanding the enterprise as a whole, and individual items of segment information are important for understanding the segments. Thus, an item of segment information that, if omitted, would change a user’s decision about that segment so significantly that it would change the user’s decision about the enterprise as a whole is material even though an item of a similar magnitude might not be considered material if it were omitted from the consolidated financial statements. Therefore, enterprises are encouraged to report information about segments that do not meet the quantitative thresholds if management believes that it is material. Those who are familiar with the particular circumstances of each enterprise must decide what constitutes material.  (emphasis added)

It seems the FASB intentionally made the requirement to disclose something at the segment level a higher standard than the requirement to disclose something at the consolidated/enterprise level, for the reason that the focus should be on the “financial statements taken as a whole” and not at the level of a segment.

Interpretation

In the end, the question as to whether materiality is to be assessed at the consolidated level or at the segment level from a financial reporting disclosure perspective more clear.  Decisions regarding materiality at a lower level than at the consolidated level, barring an exceptions (as described in SFAS 131), tend to get swallowed up in materiality at the reporting, or consolidated, level.  Users of financial statements, including forensic accountants, should keep these concepts in mind.

Applicability

When a dispute or allegation comes forth that accuses an entity of not disclosing something that perhaps it should have, these concepts should be reviewed.  SAB No. 99 also provides some color and should be consulted.  I assist clients with these complex issues on a regular basis and often the answer is not black or white.  The specific facts and circumstances should be understood, particularly the more macro factors (such as industry peer disclosures).  In the end, professional judgment should be applied in a manner that is well-thought out, documented, and defensible.

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Materiality in financial statements

All too often the concept of materiality in the context of financial statements is not black and white, as some like to think.  Over and over again my experience has been that materiality is commonly misunderstood and misapplied.  Those dealing with disputes who don’t have a solid understanding of materiality can find themselves fighting a tough uphill battle.

Definition

So, to begin, what is “materiality”?

When I was a financial statement auditor, my engagement team would compute a quantitative threshold and call it overall materiality.  This was typically 5% of the audit client’s pre-tax income from continuing operations for profit-oriented entities, or, if pre-tax income from continuing operations was volatile or perhaps a loss was realized in one year and a gain in another year, we would sometimes compute an alternative materiality, taking into account other financial statement metrics (such as revenues, assets, equity, etc.) and apply judgment in deciding on a quantitative threshold (SAS No. 107 at ¶ 4).  This overall materiality calculation was the starting point in planning the audit, assessing risk, and performing audit testing.  Although qualitative factors are considered in audits, the quantitative threshold is often the primary tool to measure the significance of misstatements.

However, in the context of a litigation, contractual dispute, or other matter, materiality is more broad than a simple quantitative threshold.  The SEC Staff elaborated (in 1999) on this concept of materiality in Staff Accounting Bulletin No. 99, Materiality, stating:

The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.

This formulation in the accounting literature is in substance identical to the formulation used by the courts in interpreting the federal securities laws. The Supreme Court has held that a fact is material if there is –

a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

Under the governing principles, an assessment of materiality requires that one views the facts in the context of the “surrounding circumstances,” as the accounting literature puts it, or the “total mix” of information, in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical or percentage terms of the misstatement, it also includes the factual context in which the user of financial statements would view the financial statement item…

The FASB has long emphasized that materiality cannot be reduced to a numerical formula.

Rules of Thumb

The SEC Staff also weighed in on the common 5% threshold that many market participants applied in the past.  Although this SEC Staff guidance has been publicly known and relied upon for over 16 years, I still find this mentality:

The staff is aware that certain registrants, over time, have developed quantitative thresholds as “rules of thumb” to assist in the preparation of their financial statements, and that auditors also have used these thresholds in their evaluation of whether items might be considered material to users of a registrant’s financial statements. One rule of thumb in particular suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management. The staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.

The SEC also acknowledged widespread use of a 5% – 10% threshold range, which was referenced to FASB’s Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, at paragraph 167.

Deeper Understanding

There are some key phrases in SAB No. 99, namely “surrounding circumstances” and “total mix of information.”  I’d like to touch upon these key phrases next.

Although something may be perceived as immaterial on the surface, particularly quantitatively small misstatements, the following, at a minimum, should be considered:

  • whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate
  • whether the misstatement masks a change in earnings or other trends
  • whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise
  • whether the misstatement changes a loss into income or vice versa
  • whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability
  • whether the misstatement affects the registrant’s compliance with regulatory requirements
  • whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements
  • whether the misstatement has the effect of increasing management’s compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation
  • whether the misstatement involves concealment of an unlawful transaction.

The Staff made sure that users of this guidance understood that this above list “is not an exhaustive list…”  All relevant facts and circumstances should be considered.  By the way, I want to mention that a key criticism of SAB No. 99 is that it does not clearly define what is not considered to be material.  This “gap,” of course, can be an area of frustration for registrants.

Applicability

Another thing I want to make clear is that all of this talk about materiality is, unless specific contractual terms dictate otherwise, in the context of “the financial statements taken as a whole.”  Further, the same context applies to auditors when they plan and perform audits (SAS No. 107 at ¶ 7 and 11d).  For those who like to refer to the “old school” auditing standards, SAS No. 47, which was superseded by SAS No. 107, has similar language (see ¶ 3, 8).

Recently I assisted an expert take a firm, reliable position that materiality must be considered in the context of the financial statements taken as a whole and not on a subset of a subset of the financial statements.   The litigation I refer to involved allegations that the defendant client materially misstated its financial statements such that one of its primary users relied on allegedly materially misstated information.  Having a strong grasp of materiality and how to assess specific transactions, disclosures, or business segments for materiality is a game changer for clients involved in disputes or investigations.  Attorneys should seek out practitioners that have a solid understanding of these materiality concepts.

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Anticipating Biases

Once I listened to a lecturer, who happens to be an expert in the field of jury persuasion, discuss various types of “bias” and how they may influence a juror.  I thought there were some great parallels to make in the context of the work that expert witnesses do.  Today’s post will discuss some key considerations regarding juror bias and how to anticipate and plan for issues before they arise.

Bias

Anticipating the following types of bias that jurors will likely have is critical to ensuring a bullet-proof expert testimony:

  • Availability bias – what one spends the most time on or emphasizes contributes to what information is perceived as most important.
  • Confirmation bias – one’s life experiences and prior knowledge shape one’s view/bias.
  • Belief perseverance bias – early impressions and early narratives are crucial to shaping one’s understanding of an issue.

To emphasize or not

I do want to expand more on the first type of bias.  You may already be able to connect the dots between availability bias and using good judgment in emphasizing facts, analyses, or opinions.  Key points that influence one’s opinion should be emphasized in a judicious manner, not taking up too much time in testimony or space on a report, but conveyed in such a manner that the trier of fact will pick up on the degree of importance that the expert witness intends to convey.  In the moment it can be really difficult to craft one’s delivery.  Therefore, expert witnesses should consider (in collaboration with counsel and, if appropriate, the client) how to deliver.

Applicability

If I am given only a few minutes to explain to a listener how an individual or entity fraudulently misrepresented its top-line revenues over a period of time to achieve certain results, how should I spend my time doing this, knowing that my desired outcome is to convince the listener that my opinion is the best answer?  Here are some considerations:

  • Should I assume the listener has a comprehensive understanding of the environment surrounding the matter (e.g., generally accepted accounting principles, financial statements, users of financial statements, responsibility of management vs. external auditors, etc.)?  How do I emphasize or de-emphasize?
  • Should I assume the listener understands what guidance or standard is applicable to the matter (e.g., revenue recognition)?  How do I emphasize or de-emphasize?
  • Should I spend more time talking about how things “should be” done (how revenue should be recognized), how things “were” done (how revenue was recognized), or keep it balanced?
  • Should I explain the details of what I did to arrive at my opinion or just keep it general?  What “material” facts should I emphasize?
  • Keep complex issues simple
  • Think about the logical steps to arrive at my conclusion.
  • How do I keep the listener’s interest and attention?
  • What do I want the listener to remember?
  • Teach, don’t just conclude.

Although this example is intended to be straightforward to get my point across, the principles can be applied to many scenarios.  Availability bias must be understood and planned for such that the message the expert witness conveys to the trier of fact is delivered concisely (without giving too much information to confuse or lose interest) and that it flows such that, to the extent complex issues must be explained, the steps taken are logical and progressive.

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