Auditing Considerations and Financial Reporting Thomas J. Linsmeier FASB Member

Transcription

1 Auditing Considerations and Financial Reporting Thomas J. Linsmeier FASB Member 2016 Deloitte / University of Kansas Auditing Symposium May 20,

2 Recent Financial Reporting Areas (Potentially) Influenced by Auditing Considerations Application of Materiality to Disclosure Decisions GAAP vs. Non-GAAP Presentation Use of Accounting Conventions vs. Full Compliance with GAAP Insurance Loss Development Tables Going Concern 2

3 Application of Materiality to Disclosure Decisions 3

4 Disclosure Framework: Two Components Improving the effectiveness of notes requires both: Consistent considerations by the Board in each standard-setting activity Appropriate exercise of judgment by reporting entities when assessing disclosure requirements Phase I: Board s Decision Process Phase II: Entity s Decision Process 4

5 Entity s Decision Process Field Study Provided Insights on Effectiveness of notes after applying two different criteria for non-compliance with GAAP Materiality Entity-specific Relevance Constraints of reporting system on entity s ability to exercise judgment Audit Regulatory Legal Copyright 2015 by Financial Accounting Foundation, Norwalk, CT. For non-commercial, educational/academic purposes only. 5

6 Entity s Decision Process Provide disclosure to the extent material Proposed Changes to the Codification Eliminate language that limits judgment Add guidance on applying materiality 6

7 Proposed Guidance on Applying Materiality Applied individually and in the aggregate Legal concept Quantitative and qualitative Omission not an accounting error The last item was proposed because Non-compliance with disclosure requirements that are more than clearly trivial but are less than financial reporting materiality are reported to the audit committee (AC) as an error Entities generally indicate that they prefer to provide these disclosures rather than to have discussions with the AC to justify their exclusion This lowers the threshold for disclosure and is a source of potential disclosure ineffectiveness 7

8 Defining Materiality in Financial Reporting CON 2 AS 14 SAB 99 CON 8 8

9 Defining Materiality in Financial Reporting CON 2/ SAB 99 / AS 14 generally define materiality based on whether there is a substantial likelihood that inclusion of information would make a difference in reasonable users decisions CON 8 generally changed the threshold to whether there is a reasonable expectation that inclusion of the information could make a difference in reasonable users decisions CON 8 change was made in 2010 to converge with IFRS and resulted in no observable increase in disclosures in the U.S. Recent proposed change to CON 8 definition of materiality was made to reconcile FASB s definition of materiality with that of the SEC and PCAOB. Language generally conforms with original CON 2 definition. 9

10 Materiality -Comment Letter Feedback Legal Concept Lawyer involvement Accounting concept Anti-fraud Omission Not Error Support for the statement Reduced communication concerns Burden of proof Prove materiality for inclusion? Definition Concerns over departure from CON 8 Absent from Codification 10

11 Next Steps Issue Exposure Drafts Applying Board s Decision Process to Disclosures on - Income Taxes - Inventory Hold Roundtable on All Aspects of Project Redeliberate Materiality and Deliberate its Application to Interim Considerations Redeliberate Proposed Concepts in the Disclosure Framework Defined Benefit Plans Fair Value Measurement Income Taxes Inventory Redeliberate Proposed Revisions to Disclosures in 4 areas on this slide 11

12 GAAP vs. Non-GAAP Presentation 12

13 Proliferation of Non-GAAP Earnings According to Jack Ciesielski s, 2015 two-part Analyst s Accounting Observer report entitled The Non-GAAP Earnings Epidemic Non-GAAP earnings reports were issued by 67% of S&P 500 companies in 2014 The reported adjustments resulted in a net increase of 22.2% in non-gaap earnings when compared to GAAP earnings Seventy-six percent of the adjustments increased reported results - Query: Could this directional bias in the adjustments be related to the fact that non-gaap earnings are not subject to audit or attestation? 13

14 SEC Guidance on Non-GAAP Reporting: Reg G Regulation G, requires public companies that disclose non-gaap financial measures to include, in that disclosure - A presentation, with equal or greater prominence, of the most directly comparable GAAP financial measure - A reconciliation of the disclosed non-gaap financial measure to the most directly comparable GAAP financial measure Regulation G also requires disclosure of further material information, if any, as may be necessary to make the non-gaap measure not misleading - Misleading measures contain either an untrue statement of a material fact or omit to state a material fact 14

15 SEC Guidance on Non-GAAP Reporting: Item 10 of Regulation S-K and Regulation S-B Prohibits, amongst others - Adjusting a non-gaap performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when (1) the nature of the charge or gain is such that it is reasonably likely to recur within two years, or (2) there was a similar charge or gain within the prior two years - Presenting non-gaap financial measures on the face of financial statements prepared in accordance with GAAP or in the accompanying notes - Using titles or descriptions of non-gaap financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP measures Requires a statement disclosing why management believes presentation of the non-gaap financial measure provides useful information to investors regarding financial condition and results of operations - Justification for the use of the measure must be substantive 15

16 Examples of Issues for Audit Committees to Consider If the justification for reporting a non-gaap measure is provide a cash measure of operating earnings, is it misleading to report a non-gaap measure that makes adjustment for the following items only? - Depreciation/amortization - Stock-based compensation Are there not other revenues and expenses included in operating earnings this period for which the associated cash flows occurred in other than the current period? Is it misleading to report over time a measure of cash operating earnings that never includes deductions for the operating assets purchased? If the entity buys back stock this period to pay the stock-based compensation, is that not the same as a cash cost incurred this period? 16

17 Examples of Issues for Audit Committees to Consider, cont d If instead the adjustments (on the prior slide) are reported to provide a non-gaap measure of current period operating cash flows - Is that non-gaap measure being reconciled to GAAP operating cash flows (not GAAP operating earnings), which is the most directly comparable GAAP financial measure? - If that non-gaap measure closely tracks operating cash flows, is that non- GAAP measure being reported on a per share basis? Recall GAAP precludes presentation of a per share operating cash flow measure To avoid being misleading, if nonrecurring expenses or losses are being added back to arrive at a non-gaap measure of recurring net income - Are adjustments being made for all nonrecurring items (revenues, expenses, gains and losses) or are only certain expenses and losses being reversed? - Are these adjustments being made net of tax? 17

18 Use of Accounting Conventions vs. Full Compliance with GAAP 18

19 Longstanding Accounting Conventions Accepted in Applying U.S. GAAP Capitalization policies for PP&E and intangibles Reporting royalty revenue earned on a 1 month lag Ignoring the need to amortize basis differences when applying the equity method 19

20 Why Was Standard Setting (Rather than an Accounting Convention) Needed Here? Exception in IFRS 16 from balance sheet recognition of leases of lowvalue assets Exemption in Topic 606 from assessing whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer Practical expedient in Topic 751 that allows an employer with a fiscal year-end other than a month-end date to measure defined benefit plan assets and obligations as of the month-end date that is closest to the employer s fiscal year-end (alternative measurement date) 20

21 Use of Accounting Conventions vs. Full Compliance with GAAP Queries: Are recent audit considerations that focus on the documentation of judgments and/or on the adequacy of internal controls creating a demand for changes in how financial reporting guidance is written rather than relying on accounting conventions that permit non-compliance in immaterial situations? If not, what is the reason for the change? 21

22 Insurance Loss Development Tables 22

23 Update , Disclosure about Short- Duration Insurance Contracts Requires, for annual reporting periods, that an insurance entity disclose in a tabular format, as of the date of the latest statement of financial position presented, undiscounted information about claims development by accident year, including separate information about a. Incurred claims and allocated claim adjustment expenses b. Paid claims and allocated claim adjustment expenses. The disclosure should be provided for the number of years for which the claims incurred typically remain outstanding, but need not exceed 10 years All claims development years should be presented together to best communicate development trends to users 23

24 Auditing Considerations All periods presented in the disclosure about claims development that precede the most recent reporting period shall be considered supplementary information This decision is in response to independence concerns that might arise, upon a change in auditor, if the new firm had to audit all of the years included in the claims development tables - Independence issues would arise for auditors that provided consulting services to the entity in the predecessor years, limiting the ability to bid on the audit The Board did not prescribe a particular location for presenting the supplementary information - Required supplementary information may be presented as a schedule outside the audited notes or within financial statement notes accompanied by a clear distinction between supplementary information and other disclosed information The Board did not preclude the entire development tables from being audited 24

25 Going Concern 25

26 GAAP for Basis of Accounting Continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements until the entity s liquidation becomes imminent When an entity s liquidation becomes imminent, financial statements are prepared under the liquidation basis of accounting Even if an entity s liquidation is not imminent, there may be conditions or events that raise substantial doubt about the entity s ability to continue as a going concern - In those situations, financial statements should continue to be prepared under the going concern basis 26

27 Going Concern: Auditing Standards and Securities Laws Require that an auditor evaluate whether there is substantial doubt about an entity s ability to continue as a going concern for a reasonable period of time not to exceed one year beyond the date of the financial statements U.S. auditing standards also require an auditor to consider the possible financial statement effects, including footnote disclosures on uncertainties about an entity s ability to continue as a going concern The SEC also has guidance on disclosures that it expects from an entity when an auditor s report includes an explanatory paragraph that reflects substantial doubt about an entity s ability to continue as a going concern 27

28 ASU : Presentation Of Financial Statements Going Concern ASU requires management (rather than auditors) to assess an entity s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. Specifically, it - (1) provides a definition of the term substantial doubt - (2) requires an evaluation every reporting period - (3) provides principles for considering mitigating effect of management s plans - (4) requires certain disclosures when substantial doubt is alleviated as a result of consideration of management s plans, - (5) requires an express statement and other disclosures when substantial doubt is not alleviated - (6) requires an assessment for a period of one year after the date that the financial statements are issued (or available to be issued). 28

29 My Dissent: Reason #1 Requiring management to disclose when it has substantial doubt about the entity s ability to continue as a going concern is outside the scope of the disclosures that should be required in notes to financial statements Instead, future oriented disclosures about an entity s overall ability to continue as a going concern should continue to be - Required in SEC filings as part of management s discussion and analysis - Subject to a safe harbor for forward-looking information This view is consistent with the FASB s recent proposed Concepts Statement, Chapter 8: Notes to Financial Statements - This document proposes that future-oriented assumptions and expectations that do not affect the measurement of numbers recognized in financial statements generally should not be considered by the Board for disclosure in the notes to the financial statements 29

30 My Dissent: Reason #2 Requiring disclosure only when it is probable that an entity will be unable to meet its obligations will provide information about going concern uncertainties that is too late to be of significant benefit to users Users indicate that when disclosures are provided only when it is probable, they typically already know about the uncertainty - Making the disclosures at best confirmatory - Providing little or no predictive value Any disclosure about the financial reporting implications of a going concern uncertainty should be required when going concern issues are - At minimum, more likely than not and - Preferably even earlier when those issues become reasonably likely The PCAOB appears to have similar concerns 30

31 My Preference We should not have brought auditing guidance on going concern into GAAP by making management also responsible for making the going concern assessment Instead when it is reasonably likely that an entity will not have the ability to continue as a going concern, we should have required disclosure about how that uncertainty bares on estimates and assumptions used as inputs to measurements recognized in financial statements - For example, if there is substantial doubt that an entity will have the ability to continue as a going concern, this uncertainty should be required to be Discussed in the accounting policy footnote for PP&E in relation to estimated useful lives 31

32 Concluding Remarks During my time on the FASB, auditing considerations have had increased importance to financial reporting and standard setting decisions This might suggest that the FASB and U.S. auditing standard setters should explore mechanisms to - Promote consistent consideration of auditing issues in our standard setting activities - Facilitate more timely discussion so we do not find ourselves in disagreement with auditing standard setters As is potentially the case currently with the PCAOB relating to the threshold for reporting going concern issues 32

33 Questions 33