Accounting Standards Transition

On December 1, 2017, the SEC’s Division of Corporation Finance updated its Financial Reporting Manual for the following changes:

  • Revising guidance related to the pro forma impact of adopting new accounting standards (Sections 3250.1(m)-(n)), including clarifying that if a registrant:
    • acquires a significant business, and such business adopts a new accounting standard as of a different date and/or under a different transition method than the registrant, than the registrant must conform the date and method of adoption of the acquired business to its own date and method in its pro forma financial information; however, the guidance suggests that the SEC Staff will consider requests for relief from this requirement; and
    • retrospectively adopts a new accounting standard on January 1, 2018, makes a significant acquisition in September 2018, and later files a Form 8-K that includes pro forma financial information for the year ended December 31, 2017 and the six months ending June 30, 2018, than the registrant does not need to apply the new accounting policy to the pro forma information for periods prior to adoption until it has reflected the new standard in the historical financial statements for those periods; however, if the registrant believes the effect of the new standard on 2017 historical information will be material, it should make appropriate disclosure to that effect in the notes to the pro forma financial information.
  • Revising guidance to address the adoption of new or revised financial accounting standards after an EGC loses its EGC status (Section 10230.1), clarifying that:
    • EGCs that take advantage of an extended transition period provision are encouraged to review their plans to adopt accounting standards upon losing EGC status and to discuss with the SEC Staff any issues they foresee in being able to timely comply; and
    • generally, if an EGC loses its status after it would have had to adopt a standard absent the extended transition, the issuer should adopt the standard in its next filing after losing status, but depending on the facts and circumstances the SEC Staff may not object to other alternatives.
  • Clarifying the effective dates for ASU No. 2014-09 “Revenue from Contracts with Customers” and ASU No. 2016-02 “New Leasing Standard” for certain public business entities (Sections 11100 and 11200).

The updates to the Financial Reporting Manual are available here.

On October 16, 2017, Clermont Partners released a survey on the reliance of active investors on non-GAAP versus GAAP reporting, intangible assets and non-financial metrics.  Unlike passive investors who invest in index funds, active investors select securities to buy and sell.  Fifty-six active investors, focused on a variety of industries and investment strategies, participated in the 14-question survey.  Highlights of the survey include the following:

  • 74% of the respondents rely on non-GAAP more than GAAP reporting when evaluating a company’s performance.
  • 44% of the respondents believe that non-GAAP measures have become more important over time.
  • 90% of the respondents will frequently make their own adjustments to a company’s GAAP results based on what they believe is relevant in evaluating performance.
  • 64% of the respondents believe that intangible assets are important factors in evaluating performance.

The results of the survey suggest that non-GAAP metrics are viewed more favorably by active investors as they buy and sell securities and that the SEC rules emphasizing GAAP metrics are largely ignored by active investors.  A copy of the survey is available here.

On August 22, 2017, Stephen Deane, CFA, Investor Engagement Advisor, Office of the Investor Advocate, gave a speech addressing two proposed updates issued by FASB in 2015 (one that would apply to GAAP and the other that would apply to FASB’s Conceptual Framework) that refer to materiality as a legal concept, or rather rely on courts to provide the definition of materiality.  FASB held a public roundtable on the proposed updates in March 2017, but they still remain under consideration.

In the proposed updates, FASB cited the Supreme Court’s definition of materiality in the context of the federal securities laws (i.e., information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information).  In contrast, FASB’s current definition of materiality, as provided in Concepts Statement Number 8 (“Con 8”), states that information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.  Although FASB described its proposed updates as clarifications to make them consistent with U.S. law and not intended to change any specific disclosure requirements, investor groups have expressed concerns, including that the proposals were based on the mistaken premise that investors were suffering from an overload of information, the proposals would shift decision-making from accountants to lawyers, and that the Supreme Court’s definition of materiality arose in the context of alleged securities fraud and thus may not be suitable in the context of accounting standards.

Mr. Deane described the Investor Advocate’s alternative approach proposed in a letter sent to FASB in July 2017.  This alternative approach combines FASB’s prior definition of materiality in Concept Release Number 2 (“Con 2”) with SEC Staff Accounting Bulletin 99 (“SAB 99”).  Mr. Deane noted that Con 2 essentially adopted the Supreme Court’s definition of materiality, but emphasized that “[m]ateriality judgments are concerned with screens or thresholds” and “[t]he more important a judgment item is, the finer the screen should be.”  Mr. Deane noted that SAB 99 approvingly references Con 2 for “stat[ing] the essence of the concept of materiality” and then links the Con 2 definition to the Supreme Court’s definition and provides a helpful framework for evaluating materiality decisions in preparing or auditing financial statements, emphasizing that companies must take into account quantitative factors as well as qualitative factors and offering examples of how misstatements of relatively small amounts that come to the attention of auditors could have a material effect on financial statements.  As a result, this alternative approach would harmonize FASB’s concept of materiality with the Supreme Court’s definition and the SEC’s approach as well as the PCAOB’s auditing standards, while responding to investor demands for a framework or guidance on how to apply the definition of materiality by drawing on the exposition and illustrative examples in SAB 99 and Con 2.  If the SEC were to move forward with its disclosure effectiveness initiative, as is expected, any changes to disclosure requirements and guidance regarding required disclosures would likely address the concept of “materiality.”  A copy of the speech is available at: https://www.sec.gov/news/speech/deane-speech-rulemaking-process.

On June 8, 2017, SEC Chief Accountant Wesley Bricker gave a speech titled “Advancing the Role of Credible Financial Reporting in the Capital Markets” at the 36th Annual SEC and Financial Reporting Institute Conference. Mr. Bricker emphasized the importance of reliable accounting and effective control over financial reporting in protecting investors and the capital markets. Mr. Bricker also discussed the key roles played by audit committees and independent external auditors in providing assurance to investors that financial statements are disclosed without material misstatements or omissions. Highlights of the speech include the following:

  • The PCAOB’s Important Role:  Bricker noted the recent adoption by the PCAOB of a new standard for auditor’s reports that requires a description of “critical audit matters,” for purposes of providing investors with information regarding the most challenging, subjective or complex aspects of the audit. Mr. Bricker also noted that regardless of where, or whether, prior years of service of an audit firm is disclosed, the years of experience may be one of the many factors considered by audit committees in their selection and oversight of the external auditor.
  • Revenue Recognition:  Mr. Bricker mentioned that the new revenue disclosures may require the disclosure of different data and information than previously provided, potentially necessitating updates to existing processes and controls. For those companies that anticipate applying the standard as required in 2018, robust transition disclosures as described in SEC Staff Accounting Bulletin 74 and the related September 2016 SEC staff announcement should be made to enable investors to understand the anticipated effects of the new standard.
  • Other New Standards:  Mr. Bricker also discussed implementation activities related to the leases, financial instruments and new credit losses standards. The new leases standard, which will be effective beginning in 2019, will result in lessees recognizing most leases on the balance sheet. This new standard will require companies to first ensure they, first, evaluate their arrangements in relation to the scope of the new standard and transition provisions and, second, update their system of internal control over financial reporting arising from the impact of the standard. Mr. Bricker encouraged companies to evaluate the scope paragraphs in these standards to identify relevant transactions and accounts for an assessment and to provide transition disclosure of the anticipated effect of the new standards. Mr. Bricker also cautioned against a purely sequential implementation process for the new standards.
  • Internal Control Over Financial Reporting:  Bricker noted that companies that apply the COSO framework for assessing the effectiveness of internal control over financial reporting might find its five components and related concepts and principles useful in developing a structured approach for implementation and meeting related documentation expectations. Each of the five COSO components must be present and operating to conclude that internal control over financial reporting is effective under the COSO framework.
  • Auditor Independence:  Mr. Bricker noted that while audit firms are generally more active in bringing independence issues to the SEC staff, audit committees and management may also address with the SEC staff independence matters that impact their filings or other interpretive questions. Audit committees and management should also keep in mind that the SEC staff does occasionally reach out to the audit committee to understand its position about an independence matter that has been submitted to the SEC staff for its consideration. When selecting a successor auditor, an audit committee should request information to be satisfied that the successor is independent at the start of the audit and professional engagement period, and audit committees should consider circumstances that might require the company to make adjustments to prior period financial statements (e.g., the reporting of discontinued operations, a retrospective application of an adoption or change in accounting principle, or the correction of an error).
  • Reminders to the Audit Profession:  Mr. Bricker noted that just as management needs to allocate sufficient time and resources to the preparation of their books and records (with good internal controls), so too should public accounting firms work with the audit committee and management to agree on appropriate deadlines and audit fees to ensure that audit quality is consistently maintained.
  • Continuing to Advance Through Innovation:  Mr. Bricker noted that there have been significant advances in technology in recent years with an accompanying increase in the use of technology by auditors, which has the potential to enhance audit quality and the auditor’s detection capabilities. Mr. Bricker also mentioned that some ratings agencies and data aggregators now utilize data scraping technology and machine learning to review SEC filings and analyze trends over time, which has the potential to help auditors and users of the financial statements identify inappropriate bias in financial statements.

A copy of the speech is available at: https://www.sec.gov/news/speech/bricker-remarks-financial-reporting-institute-conference-060817.

In a pair of recent speeches, SEC Chief Accountant Wesley R. Bricker emphasized the importance of reinforcing and advancing credible financial reporting through effective audit committees and effective internal control over financial reporting (“ICFR”).  Mr. Bricker highlighted several ways to advance the role and effectiveness of audit committees, including the following:

  • Audit committees should understand the businesses they serve and the impact of the operating environment – the economic, technological, and societal changes – on corporate strategies.
  • Balancing audit committee workload is critical given the need for audit committees to stay current on emerging issues, whether financial, ICFR, or disclosure related through continuing education and other means.
  • Audit committees should consider training and education programs to ensure that their membership has the proper background and stays current as to relevant developments in accounting and financial reporting, including the recently-issued accounting standards relating to revenue recognition, leasing, financial instruments and credit losses.

With respect to ICFR, Mr. Bricker noted that management’s ability to fulfill its financial reporting responsibilities significantly depends on the design and effectiveness of ICFR.  Companies should also be aware that certain areas of ICFR may be impacted by the transition to the new revenue standards and that they should take appropriate steps to ensure the effectiveness of ICFR, including the following:

  • Refreshing other components of internal control over financial reporting, including professional competence.
  • Considering whether the existing controls support the formation and enforcement of sound judgments (regarding the nature of revenue recognition, the economic substance of revenue arrangements, whether to report revenue on a gross or net basis, etc.) or whether changes are necessary.
  • Making sure they have appropriate resources to evaluate revenue arrangements and properly apply the principles of the new standards.
  • Considering whether their reporting systems are designed to accurately capture the effects of changes to customer contracts and other information required for compliance with the new standards.
  • Keeping in mind that the effectiveness of any changes to internal controls is predicated on a comprehensive and timely assessment of risks that may arise as a result of applying the new standards. Appropriate identification and assessment of risks may require involvement of management and employees from both the accounting and financial reporting functions and other functional areas of a company.

Mr. Bricker’s speeches are available at: https://www.sec.gov/news/speech/bricker-remarks-annual-life-sciences-accounting-and-reporting-congress-032117 and https://www.sec.gov/news/speech/bricker-university-tennessee-032417.

The Chair of the Securities and Exchange Commission Mary Jo White recently commented on the significance of high-quality accounting standards.  The speech noted the need to support continued work toward the globally accepted accounting standards.  In recent months, representatives of the Office of the Chief Accountant within the Commission had noted that the effort to move toward IFRS was not considered a near-term priority.  Chair White offered compelling statistics.  For example, she noted that U.S. investors invest directly in the securities of many foreign private issuers that apply IFRS in filings with the Commission.  As of September 2016, these companies alone represented a worldwide market capitalization in excess of $7 trillion across more than 500 companies.  As a result, Chair White noted that work toward continued convergence of standards and priorities between the FASB and the IASB should be encouraged.   See the full speech at:  https://www.sec.gov/news/statement/white-2016-01-05.html.

On May 17, 2016, the staff of the SEC Division of Corporation Finance (the “Staff”) issued 12 new Compliance & Disclosure Interpretations (“C&DIs”) on the use of non-GAAP financial measures, which has recently been an area of concern for the SEC.  The C&DIs cover a variety of topics, including compliance with Rule 100(b) of Regulation G, compliance with Item 10(e) of Regulation S-K, and the use of EBIT and EBITDA.  Highlights of the C&DIs include, among other things, the following guidance:

  • Certain adjustments, although not explicitly prohibited, may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading.
  • A non-GAAP measure be misleading if it is presented inconsistently between periods.
  • Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G.
  • The prohibition under Item 10(e) of Regulation S-K of adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual is based on the description of the charge or gain that is being adjusted.
  • Item 10(e) of Regulation S-K recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure.
  • The deduction of capital expenditures from the GAAP financial measure of cash flows from operating activities would not violate the prohibitions in Item 10(e)(1)(ii) of Regulation S-K. However, companies should provide a clear description of how this measure is calculated, as well as the necessary reconciliation, should accompany the measure where it is used.
  • Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the Staff would consider the following examples of disclosure of non-GAAP measures as more prominent:
  • Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;
  • Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;
  • Presenting a non-GAAP measure using a style of presentation that emphasizes the non-GAAP measure over the comparable GAAP measure;
  • A non-GAAP measure that precedes the most directly comparable GAAP measure;
  • Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;
  • Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;
  • Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) of Regulation S-K without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and
  • Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.
  • A registrant should provide income tax effects on its non-GAAP measures depending on the nature of the measures.
  • If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP.

A copy of the new C&DIs is available at: http://www.mofo.com/~/media/Files/PDFs/160518NonGAAPCDIs.pdf

On May 5, 2016, SEC Deputy Chief Accountant Wesley Bricker and the SEC Division of Corporation Finance’s Chief Accountant Mark Kronforst spoke at the 2016 Baruch College Financial Reporting Conference. Deputy Chief Accountant Bricker identified several specific concerns with non-GAAP reporting practices.  First, the use of individually tailored accounting principles to calculate non-GAAP earnings fails to help the investor understand and analyze core operating results.  Second, companies that opt to provide per-share data for non-GAAP performance measures that look like liquidity measures are frequently higher than per-share GAAP earnings and do not necessarily represent accurate measures of what could be distributed to investors.  Third, recent company practices regarding the use of non-GAAP tax expense have caused concern.  Fourth, recent company practices related to operating metrics also have caused concern.  Chief Accountant Kronforst, echoing comments made at a Northwestern University legal conference on April 28, 2016, also critiqued companies’ calculation of the tax impact from non-GAAP financial measures.

Deputy Chief Accountant Bricker also made a few recommendations.  First, issuers should consider how their disclosure controls and procedures apply to the disclosure of non-GAAP financial measures.  Second, investors are encouraged to refer back to a company’s financial statements to place non-GAAP figures in the proper context.  Third, audit committees should review the use of non-GAAP financial measures and the required related disclosures in order to consider the appropriateness and reliability of such non-GAAP financial measures.  Deputy Chief Accountant Bricker also noted that the SEC will be sharing its observations on non-GAAP financial measures in various forums and might consider recommendations for rulemaking in this area, but companies should seize this opportunity to review their practices and make any necessary changes.

Deputy Chief Accountant Bricker’s “Remarks before the 2016 Baruch College Financial Reporting Conference” on May 5, 2016 are available at: https://www.sec.gov/news/speech/speech-bricker-05-05-16.html