Issues In-Depth. December 2013

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1 Issues In-Depth December 2013

2 Contents Accounting and Reporting Matters 2 Disclosure and MD&A Best Practices 3 Division of Corporation Finance Areas of Focus 3 Income Taxes 3 Pensions and Other Post-Retirement Benefits 4 Business Combinations 5 Segment Identification and Aggregation 5 Goodwill 6 Non-GAAP Financial Measures 6 Other Financial Statements and Financial Information for Subsidiaries 7 Operations in China and Other Foreign Jurisdictions 8 Industry Specific Issues 8 Current Accounting Practice Issues 9 Foreign Private Issuers 11 Cross-Border Transactions 12 Audit Quality Model and Interactive Data 12 Internal Controls over Financial Reporting 13 COSO Update 14 Auditor Independence 15 Accounting Standards and Financial Reporting Developments 16 Reducing Complexity in Accounting Standard Setting 16 IFRS and U.S. GAAP Convergence 16 FASB and IASB Joint Convergence Projects 17 Other Accounting Standards and Guides 17 Audit Quality and the Role of the Auditor 18 PCAOB Standard-Setting Activities 19 Other PCAOB Auditing Standards 20 PCAOB Inspection Trends and Continued Areas of Focus 21 Legislation, Rulemaking, and Enforcement 21 Dodd-Frank and JOBS Act Rulemaking 21 Crowdfunding 21 Pay Ratio Disclosures 21 Conflict Minerals Reporting 22 Enforcement Update 23 Appendix I: Index of Published Speeches 25 Appendix II: Acronyms 26

3 Issues In-Depth December 2013, No AICPA National Conference on Current SEC and PCAOB Developments The 2013 AICPA National Conference on Current SEC and PCAOB Developments was held December 9 11, 2013, in Washington, D.C. The conference addressed developments at the SEC, PCAOB, FASB, and IASB, as well as other accounting, financial reporting, and audit topics. Speakers included representatives from the SEC, PCAOB, FASB, IASB, CAQ, AICPA, preparers and auditors, and a keynote address by the Honorable David Walker, former U.S. Comptroller General. This edition of Issues In-Depth discusses highlights from the conference. Key Points of Focus SEC Staff in the Division of Corporation Finance encouraged preparers to simplify and focus disclosures in regulatory filings; SEC and FASB representatives discussed the need to reduce complexity in accounting standards; SEC Staff in the Office of the Chief Accountant emphasized the need for management to increase its focus on internal control over financial reporting; PCAOB representatives spoke about new and proposed auditing standards, including changes to the auditor s reporting model; and SEC Staff provided updates on Dodd-Frank and JOBS Act rulemakings. As always, speakers from the SEC, PCAOB, FASB, and IASB stated that their views are their own and do not necessarily reflect the official views of their respective organizations.

4 Accounting and Reporting Matters SEC Staff encouraged registrants to take a fresh look at their disclosures to eliminate unnecessary or immaterial matters. SEC Chief Accountant Paul Beswick emphasized the need for continued focus by registrants on internal control over financial reporting (ICFR) and said that investors have benefited from the improvements in reliability of financial reporting from ICFR required by the Sarbanes-Oxley Act. He also discussed a number of policy considerations and provided an update on the SEC s evaluation of whether to incorporate IFRS into the U.S. financial reporting system for U.S. registrants. He noted that the Commission has been focused on rule making under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the Jumpstart Our Business Startups Act (JOBS Act). That doesn t mean we think it s any less important, and we are in a position where we are continuing to work on the decision, and hopefully we can get to it in the near team. Mark Kronforst, Chief Accountant in the Division of Corporation Finance (DCF) and other SEC Staff (Staff) encouraged registrants to take a fresh look at their disclosures with an eye to eliminating unnecessary or immaterial matters. For instance, they suggested removing disclosures arising from historical Staff comments to the extent the facts and circumstances of registrants have changed or if the disclosure is no longer material. Mr. Kronforst and other Staff cited the following disclosure areas that registrants may want to review: Critical accounting estimates, which often repeat information in significant accounting policies in the Notes to the Financial Statements. Litigation matters, which are often repeated in sections of the 10-K, including Legal Proceedings, MD&A, Risk Factors, and the Notes to the Financial Statements. Stock compensation disclosures, including those in an initial public offering, to focus on providing meaningful and concise information. New accounting pronouncements, particularly when the expected impact to the company is immaterial. 1 Ted Yu, SEC s Senior Counsel to the SEC Director of the DCF, said that as required by the JOBS Act, the Staff is studying Regulation S-K requirements to determine if they can be simplified and modernized. Although the study specifically focuses on emerging growth companies, results may assist the Staff in simplifying disclosures for all registrants. 2 Mr. Yu noted that the study results are expected to be made public soon. SEC Chair Mary Jo White gave a speech, The Path Forward on Disclosure, at a U.S. leadership conference on the issue of disclosure overload, and discussed considerations on how to approach modernizing and simplifying disclosure requirements, and how to improve investors access to disclosures. 1 SEC Topic 11M, Disclosure Of The Impact That Recently Issued Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period, available at 2 The term emerging growth company means an issuer that has not had an initial equity offering on or before December 8, 2011, and had total annual gross revenues of less than $1 billion during its most recent completed fiscal year. See Section 2(a) of the Securities Act of 1933, as amended by the JOBS Act. 2

5 Disclosure and MD&A Best Practices The Staff shared the following filing review observations as best practices: Focus on effective disclosures of matters that significantly impact operating results; Disclose policy elections when the accounting guidance allows optionality; Clearly explain known trends and uncertainties; Evaluate filings for internal consistency; and Use precise terms as defined in U.S. GAAP when labeling amounts and in discussion and analysis. A former DCF Director and representatives from two large registrants shared their views on best practices for preparing high-quality and meaningful MD&A. Keep the overview section clear and concise, focus on key activities for the period, use bullet points, and avoid duplication. A good overview may be the most important discussion in the document. Focus MD&A on why something occurred, in addition to what, when, and how it occurred. Use plain English, keeping in mind MD&A is the key source of information for investors with limited accounting knowledge. Present data in tables and limit jargon. Quantify each factor when more than one factor (e.g., price, volume, foreign exchange) is used to explain a change from prior year results. Review peer company MD&A and SEC comment letters. Avoid using overly generic risk factors and provide transparency when negative events have already happened rather than disclosing them as potential events. Division of Corporation Finance Areas of Focus Craig Olinger, Deputy Chief Accountant, DCF, moderated a panel of SEC Staff that addressed areas of particular Staff focus. As detailed below, these areas include both accounting and disclosure matters and highlight relevant requirements and Staff guidance. Income Taxes Frequent Staff comments about income taxes include the income tax rate reconciliation, valuation allowances, and indefinitely re-invested earnings. Income Tax Rate Reconciliation. The Staff recommended the following: Clearly label items within the rate reconciliation and disclose the underlying nature of material reconciling items; Disclose each material foreign jurisdiction, its associated tax rate, and the amount of tax when there are material reconciling items; Do not aggregate or offset material reconciling items; Ensure consistency of reconciling items disclosed in the rate reconciliation with amounts reported elsewhere in the filing; and Evaluate whether adjustments presented as changes in estimates are better characterized as an error (e.g., a significant rate adjustment resulting from comparing the income tax return to the income tax provision). 3

6 In instances where registrants have either initially recognized or reversed an existing valuation allowance, the Staff is likely to question the timing and judgments involved Valuation Allowance. The Staff cautioned registrants about the use of boilerplate disclosures about the valuation allowance in critical accounting estimates. For example, registrants often disclose that they considered the four sources of income in determining the realizability of deferred tax assets (DTAs). 3 However, this disclosure often is too vague because it does not give readers sufficient information about the key judgments made in deciding whether to establish, adjust, or release a valuation allowance. A better disclosure would provide the relative magnitude of each source of taxable income that contributed to supporting the realizabilty of the DTAs as well as an evaluation of the negative evidence. In instances where registrants have either initially recognized or reversed an existing valuation allowance, the Staff is likely to question the timing and judgments involved, particularly the key changes in the registrant s circumstances from previous periods. Indefinitely Reinvested Foreign Earnings. All evidence should be considered when registrants assert that un-repatriated earnings will be indefinitely reinvested, particularly the parent s liquidity needs. The Staff frequently identifies omitted financial statement disclosures such as the cumulative amount of indefinitely reinvested earnings and the unrecognized deferred tax liability as well as a discussion of the events that would cause the reinvested earnings to become taxable. If estimating these amounts is not practicable, registrants should make that statement. Pensions and Other Post-Retirement Benefits The Staff continues to focus on pension and other post-retirement benefits (OPEB) disclosures in the financial statements and emphasized the need for clear disclosure of policy elections such as the: Method of amortizing actuarial gains or losses and whether the corridor method was applied; Periods over which actuarial gains and losses are amortized; and Expected return on plan assets (EROA) and whether the return is based on fair value or calculated value of the plan assets. Furthermore, if the calculated value was used, disclose how it was determined including the period over which the difference between expected and actual return is amortized. The Staff also reminded registrants that ASC paragraph d requires specific disclosures of how EROA was determined. The Staff frequently requests that MD&A disclosure provide: A sensitivity analysis of how a change in EROA would impact the results of operations; The range of alternative assumptions for the EROA; The historical performance of the plan assets, both in recent years and over a longer period of time as well as disclosure of any significant limitations to the historical information used; Both the geometric mean and arithmetic mean (compounded return versus simple return, respectively) if there is a significant difference in determining historical performance; and An explanation of changes in the EROA. 3 FASB ASC Topic 740, Income Taxes, available at 4

7 The Staff continues to issue comments related to whether an acquisition constitutes an asset or a business. SEC Staff: We are serious about segment reporting. At times, defined benefit plan pension accounting can result in unusual or unexpected relationships in the financial statements such as recognizing pension income in a period when the actual return on plan assets is negative. The Staff expects clear disclosure in MD&A of circumstances leading to an unexpected or unusual relationship (e.g., significant plan contributions may obscure a negative return on plan assets, or contributions of registrants own stock may not be clearly disclosed as a non-cash item). Business Combinations Business versus Asset Acquisition. The Staff continues to issue comments related to whether the transaction is an acquisition of an asset or a business. This analysis can be complex, especially in the biotech and real estate industries where the Staff cited examples involving the acquisition of residential or commercial properties with existing lease arrangements such as nursing homes. The conclusion can result in significant differences in the accounting for contingent consideration, goodwill, acquisition costs, and inprocess research and development. For example, the Staff indicated that in determining whether a lease or other contractual arrangement constitutes a process (which is important to the conclusion that the acquired set meets the definition of a business under ASC Topic 805), companies should apply a market participant view. 4 Measurement-Period Adjustments. The Staff reminded attendees that it is appropriate to characterize an adjustment to assets acquired or liabilities assumed in a business combination as a measurement-period adjustment (as opposed to a correction of an error) only if: The acquirer obtains new information about facts and circumstances that existed at the time of the acquisition that, if known then, would have impacted the amounts recognized; The company s initial disclosures indicate that the accounting for the acquired assets and assumed liabilities is incomplete; and The measurement period has not ended. The Staff clarified that the measurement period ends when the acquiring company obtains the necessary additional information or determines that additional information is unobtainable. In either case, the measurement period cannot exceed one year from the acquisition date. Segment Identification and Aggregation The Staff continues to focus on the identification and aggregation of operating segments, particularly aggregating segments in different geographies, and highlighted a recent enforcement case involving inappropriate identification of operating segments. 5 Aggregation may not be appropriate if the operating segments historically have not experienced similar economic margins, and convergence is not expected in the near term. The Staff noted that we are serious about segment reporting. In response to a question, Dan Murdock, Deputy Chief Accountant, Office of the Chief Accountant (OCA), acknowledged that advancements in technology and financial reporting systems over recent years have changed the way a Chief Operating Decision Maker (CODM) reviews financial information at a company, and as such, that the Staff will continue to ask questions about segment information reviewed by the CODM. 4 FASB ASC Topic 805, Business Combinations, available at 5 SEC Accounting and Auditing Enforcement Release No. 3462, available at 5

8 Goodwill When the components of newly created goodwill are not obvious from other disclosures, registrants should provide additional insight. For example, the expectation of synergies may explain why a premium was paid in an acquisition. When there are significant indications of impairment, such as an adverse business change or when market capitalization falls below book value and no impairment charge has been recognized, the Staff will likely comment. The Staff recommended consulting Financial Reporting Manual (FRM) Section 9510 for disclosure considerations when there is uncertainty about the recoverability of goodwill. 6 Disclosure about critical accounting estimates should put investors on notice about the potential for a future material impairment charge and describe the types of changes in circumstances or assumptions that could reasonably be expected to affect the impairment conclusion. The Staff reminded registrants that in periods when an impairment is recognized, disclosures should specify the change in circumstances that caused the impairment because the Staff will often ask why now? When impairment is not recognized for at-risk reporting units, the Staff is interested in how close a reporting unit is to failing Step 1 of the impairment test. The Staff recommend the following disclosures: Percentage by which fair value exceeded carrying amount as of the date of the most recent test; Amount of goodwill allocated to the reporting unit; Description of the methods / key assumptions used and how the assumptions were determined; Discussion of the degree of uncertainty associated with key assumptions; and Description of potential events that could affect key assumptions. Non-GAAP Financial Measures The Staff reminded attendees that non-gaap disclosures should be clearly labeled to avoid confusion. Registrants should not use common U.S. GAAP terms in their non-gaap disclosure in a manner that is inconsistent with the definition in U.S. GAAP. For example, the Staff has observed instances in the oil and gas industry where they believe companies have labeled adjustments for derivative gains and losses in a way that may lead investors to believe that the adjustments have been calculated in accordance with commonly understood U.S. GAAP when that may not be the case. In the mining industry some companies have reduced production costs of a primary good with revenue derived from by-product sales when computing their non-gaap cost-per-unit extracted. The resulting non-gaap cost-per-unit of the primary good can be low (or even negative) if by-product revenue is material. The Staff expects full disclosure about the measure, including how it is calculated, and will allow a with and without by-product revenue disclosure. If by-product revenue from more than one source is material, they should be separately disclosed. 6 SEC Financial Reporting Manual, Section 9510, Goodwill Impairment, available at 6

9 The Staff also addressed certain non-gaap disclosures related to pensions, such as an adjustment labeled non-cash pension expense. In the Staff s view this is unclear because pension liabilities typically settle in cash. Also, non-gaap adjustments that eliminate actuarial gains or losses should be clearly labeled and disclosed. The Staff expressed concern that the non-gaap amount may be adjusted to include the expected return instead of the actual return, even though these returns may be significantly different. If companies present these non-gaap disclosures, the Staff expects a statement that the GAAP amounts reflect: The immediate recognition of all actuarial gains and losses in the income statement while the non-gaap amount does not; and An actual return of $X and X percent along with the corresponding non- GAAP measures. The Staff provided an example of a company that immediately recognizes actuarial gains and losses and presents a non-gaap financial measure that eliminates the actual return on plan assets from operating income. Although the company s actual return on plan assets was a loss of 3 percent and the expected return was a gain of 8 percent, the company adjusted its GAAP operating income by 11 percent (i.e., the difference between the expected return and the actual return). The Staff observed that this type of non-gaap measure can be confusing and encouraged disclosure that the GAAP measure reflected an actual loss on return on plan assets of 3 percent (and $ amount), and that the non-gaap measure reflected the expected return of 8 percent (and $ amount). Other Financial Statements and Financial Information for Subsidiaries The Staff discussed the application of Rule 3-10 of Regulation S-X, which allows a registrant with guaranteed public debt to present condensed consolidating financial information in the footnotes of the parent company s financial statements if certain conditions are met. 7 To qualify for this relief, the subsidiary guarantor must be 100 percent-owned and the guarantee must be full and unconditional. The Staff stated that it will question whether a subsidiary disclosed as wholly-owned qualifies because Rule 1-02(aa) of Regulation S-X defines a wholly owned subsidiary as one for whom its parent owns substantially all, rather than all, of its voting shares. That is, to qualify for the relief provided under this rule, a subsidiary must be 100 percent owned and the term wholly owned could mean something less than 100 percent. 8 Additionally, when a subsidiary guarantees registered debt issued by its parent and the subsidiary s guarantee is released automatically under any circumstance, the guarantee does not meet the technical definition of full and unconditional. However, as discussed in FRM Section 2510, the Staff will allow a company to apply the relief in Rule 3-10 if the release provision is customary and the rule s other requirements are met. 9 The Staff expects clear disclosure of the circumstances under which a guarantor could be released. The Staff emphasized that these disclosures should be provided for all periods that the debt is outstanding. 7 SEC Regulation S-X, Rule 3-10, Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered, available at 8 SEC Regulation S-X, Rule 1-02, Definition of terms used in Regulation S-X, paragraph (aa), available at 9 SEC Financial Reporting Manual, Section 2510, available at 7

10 Companies are encouraged to consult with the Staff if they are required to file financial statements and they believe that the results of the significance tests are impacted by unusual circumstances. In response to a question, the Staff encouraged registrants to perform significance tests as written in Rules 3-05 and 3-09 of Regulation S-X to determine whether separate financial statements are required to be filed with the SEC. 10 Registrants are encouraged to consult with the Staff if they are required to file financial statements and they believe that the results of the significance tests are impacted by unusual circumstances. Operations in China and Other Foreign Jurisdictions The Staff noted that it is important to disclose information that allows investors to understand the judgments, assumptions, and risks related to consolidation conclusions for foreign variable interest entities (VIEs), particularly in China, but also in other jurisdictions such as Russia and India where there are foreign ownership restrictions. Disclosures should provide information about how contracts convey power and economic benefits, and should include significant contract terms, such as when the arrangements expire, mutual consent provisions, and revocability clauses. If there is uncertainty about the agreement s enforceability, the Staff stated that registrants should disclose how these uncertainties affect the consolidation analysis and the potential consequences if the evaluation would change. The Staff also suggested disclosing the following risk factors specific to China: Substantially all operations are concentrated in China; The holding company relies on contractual agreements to consolidate a VIE; Uncertain legality with respect to China s approval of these structures; Potential for conflicts of interest; Limited legal protections available to companies and investors; and Cash transfer and exchange restrictions into and out of China. The Staff expects disclosures in MD&A about restrictions on transferring cash in and out of China. Industry Specific Issues The Staff noted that the use of metrics (e.g., number of active Web site users, comparable store sales) can vary between different industries, but regardless of their industry, registrants should: Clearly define the metric, describe how it is calculated, and describe any limitations in the calculation; Consider whether risk factor disclosures are necessary if there are limitations; and Provide a balanced discussion of the metric that clearly correlates to results, and explain how the metric impacts revenues and operating results. The Staff highlighted a speech by SEC Chair Mary Jo White in which she cautioned that the use of metrics needs to have a connection to a company s consolidated profit in order to provide meaningful information to investors. See SEC Chair Mary Jo White s speech, Knowing Your SEC: A Tribute to the SEC Staff. 10 SEC Regulation S-X, Rule 3-05, Financial statements of a business acquired or to be acquired, and Rule 3-09, Separate financial statements of a subsidiaries not consolidated and 50 percent or less owned persons, both available at 8

11 The Staff highlighted a speech by Chair Mary Jo White in which she cautioned that the use of metrics needs to have a connection to overall profit in order to provide meaningful information to investors. Real Estate. The Staff discussed many changes made to FRM Section 2300, which addresses the acquisition or probable acquisition of real estate within the definition of Rule 3-14 of Regulation S-X. 11 The Staff noted that the purchase of a REIT or operating company falls within the definition of a business under Rule 3-05 of Regulation S-X. 12 High Technology. Companies that sell virtual goods (e.g., enhanced player capabilities such as strength, health, or speed sold within online games) are encouraged to provide clear disclosures about whether revenue for these arrangements is recognized on a gross or net basis. The Staff expects disclosures within critical accounting estimates to describe the nature of virtual goods sold (i.e., whether consumable or durable), how the virtual goods are distinguished, the timing of revenue recognition, and the significant assumptions used in estimating the lives of the virtual goods. Utilities. The Staff has frequently identified disclosures that indicate acquired regulatory assets are recorded at the previous owner s carrying amount. Because U.S. GAAP requires recognition of assets acquired in a business combination at fair value, the Staff has asked for supplemental information to support the accounting conclusion, including details on estimated cash flows and the underlying discount rate. The Staff encourages companies with similar circumstances to ensure that acquisition disclosures are sufficiently robust to clarify why recognition at the previous carrying amount complies with U.S. GAAP. Retail. Some retailers highlight sales through online e-commerce channels as a high-growth area for their business without discussing how the online sales impact the retailer s operating results and strategy. To provide context, the Staff encourages retailers to disclose why online sales channels are important to their business. Additionally, when retailers discuss growth rates of their online sales channels, the Staff recommends that the amount of online sales revenue also be disclosed. Oil and Gas. The Staff discussed changes to FRM Section 2065 and situations when the Staff will accept abbreviated financial statements for acquisitions of plain vanilla oil and gas properties that meet specific criteria. 13 Current Accounting Practice Issues Mr. Murdock highlighted the areas of most frequent accounting consultations with the OCA: Revenue recognition, specifically gross versus net presentation and multiple-element arrangements; Business combinations, specifically push-down accounting and the definition of a business; Consolidation, primarily related to variable interest entities and the determination of a primary beneficiary; and Financial assets, in areas such as the allowance for loan losses, impairment, and valuation. 11 SEC Financial Reporting Manual, Section 2300, Real Estate Acquisitions and Properties Securing Mortgages, and SEC Regulation S-X, Rule 3-14, Special instructions for real estate operations to be acquired, both available at 12 SEC Regulation S-X, Rule 3-05, Financial statements of businesses acquired or to be acquired, available at 13 SEC Financial Reporting Manual, Section 2065, Acquisitions of Selected Parts of an Entity, available at 9

12 A panel of representatives from two accounting firms and a financial advisory firm also discussed some of these same areas, in addition to current practice issues related to goodwill impairment, income taxes, and instruments with characteristics of debt and equity. Revenue Recognition. In determining a best estimate of selling price for a good or service, the panelists noted that a common practice is to use a range instead of a point estimate. They recommended that preparers consider the following if using a range to determine their best estimate of selling price: The range should not be arbitrary but should be the result of a thoughtful analysis with supporting documentation; The range should not be so wide that it results in material differences compared to the use of a single point estimate, which is inconsistent with the objective of determining a best estimate of selling price; and If any single point within the range is a better estimate of selling price than other points within the range, consider whether using a range is appropriate. The panelists also discussed the significant judgments required in determining whether to present revenue on a gross or a net basis for service arrangements. 14 The evaluation includes an assessment of several indicators, with an emphasis on who is the primary obligor in the arrangement and which party is deemed to have inventory risk. The panelists believe it is critical to determine what the customer is purchasing and who the customer believes is responsible for fulfilling the contract. The analysis also may consider how the contract is written, how deliverables are presented in marketing materials, and whether an organization s logistics or marketing department interacts with suppliers, which may support a supplier or customer relationship. Goodwill Impairment. A change in the annual impairment evaluation date for goodwill represents a change in an accounting principle that requires an assessment of the preferability of the new date. The panelists cited the following factors that are often used to justify preferability: The new date coincides more closely with annual budgeting or strategic planning; and Resource constraints in connection with year-end financial reporting. When an impairment evaluation is performed on the first day of the quarter and goodwill is determined to be impaired, panelists recommend evaluating whether the impairment existed in the prior quarter. Panelists acknowledged that ASC paragraph requires companies to report a change in accounting principle through a retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. When using a qualitative assessment to evaluate goodwill for impairment, also referred to as Step Zero, panelists recommend that companies develop a structured process to gather all relevant information, including the assumptions that drive the fair value of the reporting unit and the weight that should be attributed to the information used in the analysis. Additionally, panelists reminded companies to implement internal controls over the assessment process. 14 FASB ASC Subtopic , Revenue Recognition Principal Agent Considerations, formerly EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, available at 10

13 Income Taxes. The panelists referenced the FASB Emerging Issues Task Force s recent final consensus on Accounting for Investments in Qualified Affordable Housing Projects (Issue13-B) and raised questions about whether deferred taxes should be provided on investments in affordable housing projects. The view expressed by the panelists was that deferred taxes do not need to be recognized. Panelists also recommended companies have ICFR that monitors both tax law changes and court rulings. For more information about EITF Issue 13-B, see Defining Issues No Instruments with Characteristics of Debt and Equity. The panelists provided an overview of the complexities in the accounting standards related to debt and equity instruments. The panelists also discussed the lack of authoritative accounting literature for a modification of equity classified warrants. General practice analogizes to the measurement guidance on accounting for modifications of share-based payment awards where the value of the award immediately before the modification is compared to the value of the award immediately after. 15 The panelists noted that understanding the reason for the modification is paramount in determining whether the modification should be recognized through the income statement or as an adjustment to equity. Foreign Private Issuers The Staff discussed IFRS application issues for foreign private issuers (FPI) that frequently generate Staff comments: Income tax related disclosures clarify the components of the rate reconciliation and the nature of and changes to deferred tax assets and the reasons for any unrecognized tax assets; Loss contingencies enhance the discussion about (1) significant judgments surrounding the contingency, and (2) the estimation of the timing and amount of anticipated cash outflows; Operating segment disclosures provide greater transparency of segment profit and loss and how amounts reconcile to consolidated net income and ensure entity-wide disclosures over major customers and geographic locations are not omitted; Asset impairment losses clarify valuation assumptions and the source of the discount rate; Goodwill provide greater transparency about the level at which goodwill is measured and allocated to cash generating units (CGUs) or groups of CGUs for impairment testing; Consolidation provide greater transparency about consolidation conclusions; and Revenue recognition when revenue streams are highlighted outside the basic financial statements (i.e., MD&A) as growing or important to the registrant, provide details of the revenue stream within the significant accounting policies footnote and disclose the methods used to measure and recognize the revenue. The Staff gave these additional reminders about FPI reporting issues under IFRS. An explicit statement that the financial statements are prepared using IFRS as issued by the IASB must be included. 15 FASB ASC Subtopic , Compensation Stock Compensation Awards Classified as Equity, available at 11

14 Subsidiaries that were previously proportionately consolidated [under IFRS] may need to be accounted for using the equity method and should be evaluated for significance under Rule 3-09 to determine whether separate financial statements of the entity are required. Audit reports that emphasize a going concern risk must use the substantial doubt language from PCAOB standards (as opposed to the suggested language contained in the International Auditing Standards). Opening balance sheets required to be presented alongside audited financial statements must also be audited. Transition to IFRS 11 is required for most calendar-year IFRS reporting entities at the beginning of Investees that were previously proportionately consolidated may be accounted for using the equity method and should be evaluated for significance under Rule 3-09 to determine whether separate financial statements of the entity are required. Cross-Border Transactions There has been a recent increase in the volume of cross-border transactions involving a newly created parent entity (Newco) domiciled in a favorable tax jurisdiction (e.g., the Netherlands, Cayman Islands, Bermuda) that holds both a U.S.-based operating company and a foreign-based operating company. A panel of DCF Staff, an accounting firm representative and a securities lawyer shared important financial reporting considerations: Will the resulting Newco qualify for foreign private issuer status under SEC regulations based on the nature of Newco s ownership structure and operations? The financial reporting requirements for FPIs differ in many ways from those for domestic registrants. For example, reporting under IFRS is only available for FPIs and they generally are not subject to quarterly reporting requirements. Where will Newco be listed? Will it be listed on a single exchange or dual listed on two exchanges? Newco may be subject to ongoing reporting requirements under both U.S. GAAP and IFRS. Who is the accounting acquirer? If the foreign target is the accounting acquirer, this can complicate the development of both the predecessor and post-acquisition financial statement accounting framework. Will pre-acquisition financial statements of the acquired entity be required under Regulation S-X Rule 3-05? As a reminder, an audit for Rule 3-05 must be performed under PCAOB standards or U.S. GAAS, therefore a foreign target may need to be re-audited under those standards. Will pro forma financial information be prepared under SEC rules or the local country requirements, or both? Audit Quality Model and Interactive Data Dr. Craig M. Lewis, SEC s Chief Economist and Director, Division of Economic and Risk Analysis, spoke about the audit quality model (AQM), which is a data analysis tool being developed by the SEC. The AQM will accumulate and analyze data across industries to identify outliers or anomalies and would score filings based on specific flags and risk factors. Mr. Lewis noted that although the AQM is still in its development stage, there may be many uses for such a tool, and specifically identified DCF and Enforcement Staff as potential users. Mr. Kronforst also spoke about the potential use of the AQM in the comment letter process, noting that Staff will incorporate the analytical results of AQM to focus on potential issues. 16 IFRS 11, Joint Arrangements. 12

15 Paul Beswick, SEC Chief Accountant: Let s not lose ground. Let s stay focused on the importance of ICFR. Brian Croteau, SEC Deputy Chief Accountant: at least some of the PCAOB s inspection findings related to the audits of internal control over financial reporting are likely indicators of similar problems with management s evaluation of ICFR, and thus potentially also indicative of risk for unidentified material weaknesses. Mr. Lewis also discussed an initiative to make publicly available a database of aggregated interactive data, which will allow investors, researchers, academics, and others to better analyze the interactive data. At the September 2013 CAQ SEC Regulations Committee meeting, the SEC staff discussed the Financial Reporting and Audit Task Force and the use of the AQM to flag high-risk activities. Internal Controls over Financial Reporting In emphasizing the continued focus by management on ICFR, Mr. Beswick said, Let s not lose ground. Let s stay focused on the importance of ICFR. He noted that maintaining ICFR must be an iterative and ongoing process with the appropriate involvement of management and support throughout the company. Brian Croteau, Deputy Chief Accountant, OCA, highlighted the coordinated effort between the SEC s different offices and divisions and the PCAOB on ICFR matters. As we maintain or increase the intensity of our focus in this area I remain convinced that at least some of the PCAOB s inspection findings related to the audits of ICFR are likely indicators of similar problems with management s evaluation of ICFR, and thus potentially also indicative of risk for unidentified material weaknesses. He observed that it is surprisingly rare to see management identify a material weakness in the absence of a material misstatement and questioned whether this could be a result of deficiencies not being identified or whether their severity is not being evaluated appropriately. For instance, comment letters may be issued by the Staff to better understand how registrants consider ICFR when they observe corrections of errors or changes in internal controls. Mr. Murdock also noted that if registrants consult with the Staff on an accounting issue on a post-filing basis, and the Staff objects to the accounting conclusion, they may be interested in how registrants evaluate any potential deficiencies in ICFR. The Staff also reminded attendees that any material change to internal controls should be disclosed under Item 308(b) of Regulation S-K. 17 In emphasizing the importance of a public company s maintenance of disclosure controls and procedures, Mr. Croteau highlighted the SEC s recent action against a large financial institution that resulted from the failure to maintain effective disclosure controls and procedures, internal accounting controls, and filing inaccurate reports with the SEC. 18 You should expect that financial reporting and disclosure investigations going forward are likely to continue to include taking a close look at the adequacy of internal accounting controls as well as evaluations and conclusions about both internal control over financial reporting and disclosure controls and procedures, said Mr. Croteau. David Woodcock, Regional Director of Enforcement, echoed Mr. Croteau s remarks and noted that weak ICFR can lead to a material misstatement and increases the risk of accounting fraud. He also encouraged registrants to stay focused on ICFR. 17 SEC Regulation S-K, Item 308, Internal Control over Financial Reporting, paragraph (b), available at 18 SEC Accounting and Auditing Enforcement Release No. 3490, available at 13

16 Consistent with his comments at the prior year s conference, Mr. Croteau again referred to the SEC s 2007 management guidance on ICFR, and encouraged management to dust off the SEC s 2007 interpretive guidance and compare management s ICFR evaluation process to the SEC guidance to see if improvements are in order. 19 The extent of the transition effort to the 2013 Framework will depend on how well the company s design and documentation of internal control have kept pace with the changing business environment, internal changes, and how well companies have responded to internal control comments and findings from the SEC and PCAOB. COSO Update In May 2013, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) released its updated Internal Control Integrated Framework (2013 Framework). 20 The 2013 Framework updates the original COSO Framework released in COSO Chairman Robert B. Hirth, Jr. stated that the update was necessary due to significant changes in companies business and operating environments. Businesses are now more technology driven, global, and subject to increased regulatory requirements. The following table summarizes the updates included in the 2013 Framework. What is not changing Core definition of internal control Three categories of objectives and five components of internal control Each of the five components of internal control are required for effective internal control Important role of judgment in designing, implementing, and conducting internal control, and in assessing its effectiveness What is changing Changes in business and operating environments should be considered Operations and reporting objectives expanded Fundamental concepts underlying the five components are articulated as 17 principles Additional approaches and examples relevant to operations, compliance, and non-financial reporting objectives added The panelists believe the extent of the transition effort to the 2013 Framework will depend on how well the company s design and documentation of internal control have kept pace with the changing business environment, internal changes, and how well companies have responded to internal control comments and findings from the SEC and PCAOB. According to panelists, one of the practical implications of the 17 principles articulated in the 2013 Framework may be a renewed focus on four components: Control Environment, Risk Assessment, Information and Communication, and Monitoring. Companies may have historically focused their assessment efforts on process-level and management-review controls within the Control Activities component and may have lost focus on the other four components. These four components may require the most effort by companies transitioning to the 2013 Framework. This effort also could identify gaps in the system of internal control, and by focusing more attention on them companies may prevent, or detect in a timelier manner, material weaknesses. 19 SEC Release No , Commission Guidance Regarding Management s Report on Internal Control over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, available at 20 COSO 2013 Internal Control Integrated Framework, available at 14

17 Leaving the affiliate identification and analysis to the auditor without evaluation by management and the audit committee of how the auditor s assessment compares to the company s own assessment increases the risk of violations. The panelists offered views about other areas that might require additional attention by management and auditors during transition including: A robust risk assessment process that is performed every year; The interaction of general information technology controls with automated controls; and Increased documentation to support the assessment about internal controls. Mr. Croteau noted that the SEC has not set a transition date, but reiterated that the Staff is more likely to question registrants using an outdated framework with the passage of time. He indicated that registrants should specify in their filings which framework they are using, and in response to a question, the Staff noted the disclosure would be included in management s report as required under Item 308(b) of Regulation S-K. For more information about the 2013 Framework and the transition date, see KPMG s Defining Issues No and KPMG s Defining Issues No Auditor Independence Mr. Croteau emphasized that auditor independence in both fact and appearance is the foundation of an audit, and is required to increase auditor objectivity and credibility. Violations in independence can call into question the reliability of a company s financial reporting and the effectiveness of the audit committee s oversight of the auditor, potentially leading to unplanned auditor changes and costly re-audits. While auditors are responsible and held accountable for their independence from their audit clients, Mr. Croteau reminded management and audit committee members about their shared responsibilities. Rule 2-01 of Regulation S-X, requires auditors to be independent from their audit clients, including affiliates. Mr. Croteau encouraged companies to reflect on improvements to policies and procedures to (1) ensure that non-audit services to be provided by a company s auditor are appropriately evaluated by management and the audit committee before the commencement of the services, and (2) validate the completeness of the affiliate population and identify changes to that population as they occur. Leaving the affiliate identification and analysis to the auditor without evaluation by management and the audit committee of how the auditor s assessment compares to the company s own assessment increases the risk of violations. Mr. Croteau also noted the potential consequences of applying the SEC s independence rules in light of the advancement of overseas legislation requiring mandatory firm tendering or rotation, not only for foreign companies listed in the United States, but also for U.S. companies with foreign subsidiaries. Because the SEC s independence rules do not contemplate transition relief for auditor changes, he emphasized that proper planning is necessary to identify potential independence conflicts. For instance, identifying a new auditor may need to occur well before the commencement of the audit period and the beginning of the professional engagement period to ensure that independence matters are appropriately addressed. Registrants considering an auditor change were reminded about the importance of maintaining the independence of their predecessor auditor. For example, if management restates previously issued financial statements, a predecessor auditor can only audit the restatement if it is independent when the restatement occurs. It may be in registrants best interest to preserve, to the extent possible, independence with their predecessor auditor in case the company s financial statements need to be restated. 15

18 Accounting Standards and Financial Reporting Developments Paul Beswick, SEC Chief Accountant: We have considered alternatives taken from whole cloth rather than focusing on targeted improvements. Mr. Beswick highlighted the FASB s increased focus on investor outreach in the standard-setting process. The FASB has increasingly looked at how information is used by investors, resulting in significant positive changes to some proposed standards. He encouraged the FASB to perform additional outreach when setting its agenda. Reducing Complexity in Accounting Standard Setting Reducing complexity, both in revisiting current standards and future standardsetting projects, likely will receive more attention from the FASB. Mr. Beswick said that when addressing major projects, We have considered alternatives taken from whole cloth rather than focusing on targeted improvements. He indicated that this has led to complex problems that require significant implementation efforts. Mr. Beswick advocated targeted improvements and avoiding replacing one set of challenges with another. FASB Chairman Russell Golden indicated that liability and equity accounting, hedge accounting and goodwill impairment are examples of possible areas of U.S. GAAP that may be overly complex. FASB staff also indicated that the private company provisions proposed by the Private Company Council for consideration by the FASB are causing the Board to consider whether similar changes should be made to accounting requirements for public companies (e.g., the amortization of goodwill, the testing of goodwill for impairment only when a triggering event occurs, and testing for impairment at the entity level rather than the reporting unit level). IFRS and U.S. GAAP Convergence IASB Chairman Hans Hoogervorst and Mr. Golden presented their views on standard setting for IFRS and U.S. GAAP. Mr. Hoogervorst observed that there is continued global expansion of IFRS and a growing footprint in the United States. When asked about IASB and FASB cooperation following completion of the current convergence projects, Mr. Hoogervorst quipped that it takes two to tango and believed that it was ultimately in the enlightened self-interest of the United States to fully adopt IFRS. Mr. Golden discussed the FASB s agenda after the convergence projects on revenue recognition, leases, and financial instruments are completed. He said that the FASB will perform pre-agenda research for each potential topic and noted the following three initiatives that will form its agenda: Foundational projects such as revisiting the U.S. conceptual framework; Projects to improve transparency in recognition, measurement, and presentation (e.g., accounting for pension obligations); and Projects to reduce complexity in current accounting guidance. Mr. Golden also discussed the FASB s plan to create transition resource groups to help implement new standards and educate constituents about them. Each transition group will meet in public and will include both FASB and IASB participation. The FASB will establish its first transition group in 2014 when the new revenue standard is issued. 16