Financial reporting: What happened, what's ahead
In financial reporting, 2013 was a year of slow progress in overhauling accounting for revenue and leases, updating internal control standards, shining light on the use of conflict materials, heightened focus on financial statement fraud and a call for more accountability and transparency by auditors.
The year also saw a lack of progress in the movement towards combining world accounting standards under one umbrella as the powerful U.S. Securities and Exchange Commission sent mixed messages to the financial world on the issue. As ever, at least it seems, every effort to make life simpler for companies makes it more complex and expensive. Here’s my annual recap of what happened in 2013 and what companies should look for in 2014.
Update on international convergence - The U.S. Financial Accounting Standards Board (FASB) and International Accounting Standards Board continued their work on two joint projects to converge accounting rules for revenue recognition and leases. Among many proposed changes, the new revenue standard will change the way contract modifications are treated. This could cause difficulties for companies with contracts that have been in place for many years when they attempt to apply the new rules retrospectively. GE technical controller Russell Hodge said applying the standard would be "overwhelming" for a company with $150 billion in revenue (Journal of Accountancy). The new standard will require a greater use of judgment in estimating selling prices, as well as using a cost-to-cost approach for long term contracts, which may currently use the units of delivery method.
The revenue recognition standard is expected to be finalized in early 2014, to be effective for public companies in 2017 and for private companies the following year. Adoption will be retrospective, however, which means that public companies will need to look back to at least 2015 to adopt the standard.
The leases standard, which essentially causes companies to capitalize lease obligations, has met more resistance and the boards have gone back to the drawing table to address concerns over cost and complexity.
Meanwhile, the SEC staff, which have been relatively silent on the topic of incorporating international judgment-based standards into U.S. financial statements since the July 2012 issuance of a work plan for IFRS adoption, put the issue back on the table with a public statement that while the SEC still considers convergence to be an important issue, the time devoted to rule-making required by the JOBS Act and the Dodd-Frank Act had prevented the Commission from devoting attention to convergence.
New framework for reporting on internal control – The Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) issued an updated internal control framework in May 2013. COSO’s original framework was issued in 1992 and is the most commonly used framework used by public companies to design and implement their internal control systems and evaluate their effectiveness. Management’s evaluation of the effectiveness of internal control – basically a personal sign-off on control evaluation by company officers - was mandated by the Sarbanes-Oxley Act.
During the 20 years since the original COSO framework was released, business and operating environments have changed dramatically, becoming more complex, technologically driven and global in scale. For example, the explosion of use of the Internet and mobile devices for business created a new security control environment. The new framework represents a more principles based approach to internal control.
For companies that already have effective internal control systems, the transition to the new framework might be primarily aligning the documentation and evaluation of the control system to the new guidance. However, companies with less robust internal control systems may have more work to do. The 1992 framework will be considered superseded as of December 15, 2014.
While the SEC has not mandated a specific date for companies to adopt the new framework, the staff indicated that the transition should occur as soon as feasible, and that the longer companies continue to use the 1992 framework, the more likely it will become that they will raise questions.
Because there are now two frameworks in existence, companies should clearly indicate which one they have utilized in reporting management’s assessment in their Form 10-K.
Conflict minerals reporting – As part of the Dodd-Frank Act, Congress mandated that public companies make disclosures about the use of “conflict minerals.” The term conflict minerals is used to describe certain minerals (tin, tungsten, tantalum and gold) that are mined in the Democratic Republic of the Congo (DRC). The law does not prohibit companies from using these minerals, or impose a penalty for doing so. However, Congress believed that public disclosure would discourage U.S. companies from their use, which may indirectly fund the armed groups in the DRC. Companies that use these minerals in their manufacturing processes and supply chain will be required to file a report on Form SD by May 31, 2014 for the 2013 calendar year.
The U.S. Chamber of Commerce and a manufacturing industry association have filed litigation seeking to modify or repeal the conflict minerals rule on the grounds that it is overly burdensome, unworkable and ineffective. A federal judge rejected the challenge, but an appeal is pending. In the absence of a successful appeal, companies will need to be ready to file Form SD by May 31, 2014.
Disclosure of payments by resource extraction issuers - Another rule from the Dodd-Frank Act, this requirement that public companies disclose government payments made to further the commercial development of oil, natural gas or minerals was also challenged by industry groups. A federal judge found that the SEC’s rule was invalid. However the law itself is unchanged, so the SEC will need to rewrite and revise the rule. Until then, oil and gas and mining companies do not need to make these disclosures.
The SEC’s “Robocop” – In a speech nominating Mary Jo White as the new chairman of the SEC, President Obama said, “You don’t want to mess with Mary Jo.” That statement has proven to be true, as the SEC announced new initiatives intended to crack down on financial reporting fraud through the use of advanced analytical tools and technology. The SEC’s newly formed Financial Reporting and Auditing Task Force rolled out its Accounting Quality Model (AQM). The AQM, which has come to be known as “Robocop,” combs through company filings seeking risk factors that the SEC believes to be associated with earnings management. High-risk filers will be selected for further investigation of potential fraud by SEC enforcement teams.
Potential changes to the auditor’s report - The Public Company Accounting Oversight Board (PCAOB) proposed substantial changes to the standard auditor’s report, in response to feedback from investor groups seeking more information. The biggest change would be the addition of a “critical audit matters” section of the report, in which the auditor would describe the most difficult, subjective or complex judgments made in the course of the audit.
If adopted, this would be the largest change to the audit report since the 1940s. The PCAOB will be holding public meetings in 2014 to gather input on this proposal, which some fear could expose auditors and companies to additional litigation. If adopted as proposed, the new report could be effective as early as 2016. In preparation, companies should consider engaging in a discussion with their auditors about which items might be considered critical audit matters for their company.
Proposal to require disclosure of the audit engagement partner – In an effort to bring greater transparency to public company audits, the PCAOB is examining a proposal to require disclosure in the audit report of the name of the engagement partner and any other accounting firms used in the audit. In addition to providing more information to investors and other users of the financial statements, some believe that naming the partner would serve to make them more accountable.