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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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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.

Photo credit – Craig Jewell Photography

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Significant vs. critical accounting policies

Securities and Exchange Commission (SEC) registrants following SEC rules and regulations must disclose their significant and critical accounting policies in their filings with the SEC.  For those well versed in the financial reporting profession, the disclosure requirements may, on the surface, seem the same.  However, I can’t tell you how many people, even some heavily experienced in the industry, that do not understand the difference between these two disclosure requirements.

The SEC has released guidance and insight on the distinguishing factors registrants should consider between these two disclosure requirements.  Today’s post will generally cover the disclosure requirements for both policy definitions.  I’ll also address the reason why understanding the differences between these disclosure requirements is critical for forensic accountants assisting their clients in determining whether or not a registrant complied with SEC regulations.

Regulation S-X and disclosure of significant accounting policies

SEC Regulation S-X governs the form and content of annual financial statements not only for SEC filings but also for shareholder reports of SEC registrants.  This regulation is comprised of 12 articles, with Article 3 discussing the general instructions for financial statements.

Accounting Principles Board (APB) Opinion No. 22, Disclosure of Accounting Policies, adopted in 1972 states in paragraph 12:

Disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods.  (emphasis added)

The next paragraph states,

Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive.

Another relevant accounting standard is Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties, issued in 1994.  Paragraphs 1 and 2 state:

The central feature of this SOP’s disclosure requirements is selectivity: specified criteria serve to screen the host of risks and uncertainties that affect every entity so that required disclosures are limited to matters significant to a particular entity. The disclosures focus primarily on risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term or the near-term functioning of the reporting entity. The risks and uncertainties this SOP deals with can stem from the nature of the entity’s operations, from the necessary use of estimates in the preparation of the entity’s financial statements, and from significant concentrations in certain aspects of the entity’s operations.  (emphasis added)

Significant accounting policies are to be disclosed in the notes to the financial statements in accordance with Regulation S-X.  Notice the emphasis on materiality (in APB 22), inferred in SOP 94-6 by the use of the word “significantly.”  However, there is no mention of an integral component to classify a policy as “critical”, which I will discuss next.

Regulation S-K and disclosure of critical accounting policies

SEC Regulation S-K governs qualitative information about the registrant, such as the nature of its business, its properties, legal proceedings, its executives and officers (including executive compensation), and management’s discussion and analysis of the results of operations (MD&A).  In May 2002, the SEC issued a proposed rule called Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies.  As far as I can tell, the proposed rule has not been adopted by the Commission.

In summary, if adopted, the scope of disclosures related to critical accounting estimates within a registrant’s MD&A section would broaden beyond those contemporaneously required. The SEC summarized the proposed rules, in part, stating:

The proposals would encompass disclosure in two areas: accounting estimates a company makes in applying its accounting policies and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation. Under the first part of the proposals, a company would have to identify the accounting estimates reflected in its financial statements that required it to make assumptions about matters that were highly uncertain at the time of estimation.  (emphasis added)

Notice the words “highly uncertain” describing accounting estimates.  The SEC proposed that a company would have to answer two questions, with a “yes” to both questions, in order to conclude that an estimate meets the disclosure criteria of a “critical accounting estimate.”

  1. Did the accounting estimate require us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made?
  2. Would different estimates that we reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, have a material impact on the presentation of our financial condition, changes in financial condition or results of operations?

In essence, the above proposal encapsulates what the SEC believed back in 2003 must be established to qualify an accounting estimate as “critical.”

The following year in December 2003, the SEC released an Interpretation titled Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations as a means of improving the disclosures by registrants with respect to critical accounting estimates, among other things.

Specifically, the SEC’s guidance on preparation of disclosure of critical accounting estimates is that companies consider:

whether they have made accounting estimates or assumptions where the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and the impact of the estimates and assumptions on financial condition or operating performance is material.  (emphasis added)

If these criteria are met, companies should disclose the details within their MD&A.

The SEC made it clear that, “[s]uch disclosure should supplement, not duplicate, the description of accounting policies that are already disclosed in the notes to the financial statements. The disclosure should provide greater insight into the quality and variability of information regarding financial condition and operating performance. While accounting policy notes in the financial statements generally describe the method used to apply an accounting principle, the discussion in MD&A should present a company’s analysis of the uncertainties involved in applying a principle at a given time or the variability that is reasonably likely to result from its application over time.”

Understand what standard or guidance was applicable at the time

This should go without saying, but forensic accountants must always keep in mind the “date stamps” associated with (1) accounting standards, (2) SEC rules and regulations, (3) SEC proposed rules, and (4) SEC interpretations.  Understanding the timing of authoritative (or even non-authoritative, as in the case of a proposed rule) guidance relative to the facts and circumstances in a dispute is critical to assessing whether or not a client adequately complied with the rules at that point in time.

Applicability

Disclosure of accounting estimates deemed significant means the estimates have a pervasive or material impact on the financial statements (e.g., revenues, fixed asset depreciation, inventory pricing).  Critical accounting estimates, however, reflect subjective, judgmental, highly uncertain, susceptible to change accounting estimates. Therefore, the threshold to disclose critical accounting estimate policies is different than the threshold to disclose significant accounting estimate policies.

I recently assisted a defendant in a litigation matter that dealt with, among other allegations, allegations that the defendant did not adequately disclose sufficient details with respect to certain accounting estimates stemming back a few years prior to the financial crisis of 2008.  The plaintiff’s counsel argued that the accounting estimate was both “critical” and material and should have been treated as such from a disclosure standpoint.  I assisted the client defendant in putting together a case that it was not possible at the time to know that the accounting estimate would be material.  If you recall, one of the requirements of a critical accounting estimate has to do with materiality.  Although the accounting estimate was potentially subjective and susceptible to high estimation uncertainty, I assisted the client in formulating a position that the accounting estimate did not meet the materiality requirement for disclosure as a critical accounting policy.

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