AICPA Conference Recap - Investor Info & Audit Quality

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A goal of keeping markets safe for investors

Keynote speakers SEC Commissioner Luis Aguilar and PCAOB Chairman James Doty set the tone for the conference by calling upon accountants, as financial statement preparers and auditors, to step up to their special responsibility to strengthen investor confidence in financial reporting and thereby help keep the markets trustworthy and safe for investors.

As a background for the discussions, Commissioner Aguilar cited studies showing startling declines in market statistics: Only 17% of Americans trust the stock market. Average daily trades in US stocks are only about half their 2008 peak. US initial public offerings of smaller companies have never fully recovered following the bursting of the technology bubble in 2000.

To restore the vitality of the markets, Commissioner Aguilar said, individual investors must have confidence that the markets are fair, the rules are enforced effectively, and the information available is meaningful, accurate and complete. There can be no doubt in the hearts and minds of investors about the reliability and integrity of the audited financial statements.

January 2013

From the AICPA’s Annual SEC/PCAOB Current Events Conference: Investor Information and Audit Quality

Challenge: What are the best ways to leverage the PCAOB’s inspection findings and promote the high level of audit quality that investors want and need?

Commissioner Aguilar pointed out that, since its inception in 2002, the PCAOB has accumulated a wealth of information about audits conducted by the firms registered with the Board. He suggested this knowledgebase could be used to help identify areas for improvements in audit quality, and he said it was important for the PCAOB to continue exploring a wide range of potential approaches for improving audit quality for the benefit of investors.

What to expect: Several speakers commented on initiatives underway in these areas.

a. PCAOB Chief Auditor Martin Baumann noted that inspections in the US and other countries have indicated a lack of professional skepticism in independent audits. Initiatives in this area are a priority in today’s complex and rapidly changing environment. The independent auditor’s questioning mind and critical approach to audit evidence are especially important in view of the increasing judgment and complexity in financial reporting and the issues posed by the current economic environment, with the result that regulators are trying to encourage and enforce higher levels of professional skepticism. What will this mean for auditors and preparers of financial statements?


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• For auditors of financial statements, an increased emphasis on professional skepticism may lead to more scrutiny of their firm’s internal quality control systems so as to ensure corrective actions are taken when necessary.

• For preparers of financial statements, (including controllers, those in accounting policy or operations and other corporate executives), an increased emphasis on skepticism may lead to more rigorous questioning of management’s assertions and estimates. “When your auditor questions your assertions,” said Mr. Baumann, “he or she is not being difficult. They’re just doing their job.”

b. PCAOB Chairman Doty said companies and firms can expect to see more summary reports on insights gleaned from inspections in the coming months and years. A key objective is to better equip audit committees of boards of directors to serve as champions of audit quality. The PCAOB will also initiate a project in 2013 to identify audit quality measures with a longer-term goal of tracking such measures over time and across firms and networks of firms. Chairman Doty said he has already seen dramatic improvements in audit quality in response to inspection findings when firms accept the findings and undertake a rigorous root cause analysis.

c. Acting SEC Chief Accountant Paul Beswick made several observations and suggestions about approaches that would be especially valuable for investors.

• Potential changes in the content and form of the auditor’s report could help to improve audit quality by providing more relevant, tailored, and useful information for investors.

• An analysis of the risks related to growth in

the consulting practices of major accounting firms could be helpful. Mr. Beswick said this growth weakens the appearance of auditor independence and does little to promote audit quality, and there is a risk that this trend could weaken public trust in the capital markets.

• The challenge for accounting firms that are faced with stagnating audit fees is to effectively manage conflicting objectives and balance any revenue and profit pressures with the accountant’s obligation to the public trust.

d. SEC Deputy Director Brian Croteau reinforced the need for stronger linkage between inspection results and audit quality improvement and supported initiatives designed to provide a “more robust performance feedback loop.” He pointed out that the PCAOB has incorporated this goal into its 2012-2016 strategic plan. He also suggested that audit committees should encourage audit firms to compete on quality by making engagement quality considerations a key element of every hiring or retention decision. He added that he expects the project aimed at improving the standard auditor’s report will gain momentum in 2013, and public input will be important as the PCAOB hones in on a potential approach in 2013.

e. Cindy Fornelli, Executive Director of the Center for Audit Quality (CAQ) said the CAQ is firmly opposed to mandatory auditor rotation as a way to improve audit quality. But it supports other approaches, particularly those related to enhancing audit committee effectiveness, fostering good-auditor-audit committee communications, promoting professional skepticism, and developing measures of audit quality. Together with the National Association of Corporate Directors and other organizations, the CAQ provides webinars and other resources that are described in the appendix to this Messenger.

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Challenge: What are the best ways to manage risks that threaten to undermine audit quality?

Commissioner Aguilar expressed concern that any efforts to roll back or limit the requirement for auditor attestation of internal control over financial reporting could dilute the effectiveness of reforms put in place by the Sarbanes-Oxley Act. In particular, the Dodd-Frank Act has permanently exempted smaller reporting companies from the auditor attestation requirement, and the JOBS Act has exempted emerging growth companies. He suggested the SEC and PCAOB should monitor the financial reporting and internal controls of issuers that have already been exempted, and the Commission should not hesitate to call for the reinstatement of that obligation if necessary to promote capital formation and protect investors.

What to expect: Several regulators commented on initiatives underway to manage the risks.

a. PCAOB Board member Jeanette Franzel summarized the PCAOB’s near-term priorities for auditing standard-setting. She said these priorities include the goal of assessing and responding to audit risk as a way to enhance investor protection. Toward this end, the PCAOB issues staff audit practice alerts and other publications. Concurrently with the conference, the staff issued an alert on professional skepticism during the audit process. This alert is described in the Attachment to the Messenger. Franzel added that the PCAOB has a “substantive and ambitious standard-setting agenda” for the first six months of 2013 and this will likely result in an unusually high volume of PCAOB publications in 2013. The Board plans to issue and maintain standard-setting work plans for six months intervals. The work plan for the first half of 2013 includes projects on related parties, reorganization of PCAOB standards, the auditor’s reporting

model, audit transparency or identification of the audit partner, and the auditor’s responsibilities with respect to other accounting firms, individuals, and specialists.

b. PCAOB Chief Auditor Martin Baumann discussed PCAOB Auditing Standard No. 16 (AS 16) on “Communications with Audit Committees.” At the time of the conference, AS 16 had not yet been approved by the SEC, but approval was expected by the end of 2012. The standard is intended to be effective for public company audits of fiscal periods beginning after Dec. 15, 2012. But Mr. Baumann said some firms are planning to adopt its communications principles early, starting with audits of financial statements for calendar year 2012.

c. Helen Munter, Director of the PCAOB’s Division of Registration and Inspections summarized the PCAOB’s report on Findings related to the application of PCAOB Auditing Standard 5, An Audit of Internal Control Over Financial Reporting that is Integrated with An Audit of Financial Statements. She noted that management plays a key role in internal control over financial reporting, and she encouraged dialogue between auditors and preparers on the controls that exist, how they are documented, and how they address the identified risks.

d. David Landsittel discussed COSO’s project to update its “Internal Control Integrated Framework.” Mr. Landsittel serves as Chair of COSO, a leading provider of guidance to public and private companies and other organizations on internal control, enterprise risk management, and fraud deterrence. He said the updated Framework incorporates 17 principles to describe the components of internal control. Discussions at the conference indicated that these principles will likely affect a company’s documentation of internal


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MHMMessengercontrol, for example, to show how the company’s controls reflect the principles. Although there is no required adoption date, panelists said companies that do not adopt the updated Framework may well be asked why they haven’t done so. Releases of the Framework and several important companion documents are expected in the spring of 2013. The companion documents include a compendium of approaches and examples and an illustrative tool for assessing the effectiveness of a system of internal control.

Practical advice for 2012 reporting

The presenters at the conference provided practical advice on how to make financial reporting more useful to investors. Highlights of the personnel changes announced, advice offered, and resources mentioned throughout the conference are recapped below, and a reference guide to key contacts and documents is provided in the appendix.

Practical tip: Stay flexible. Changes in leadership at the SEC could influence policy and rulemaking in the coming months.

There have been a number of important departures from the leadership of the SEC. The decisions about when and how the resulting vacancies will be filled may have an impact of the direction of future policies and the pace of rule-making activities.

Most notably, Chairman Mary Schapiro left the Commission in December 2012. Commissioner Elisse Walter has been appointed by President Obama to take the Chair for an interim period until the empty seat on the Commission is confirmed by Congress. This leaves only four Commissioners, including two from each major political party, making it more difficult to achieve a majority vote on contentious issues.

In addition, there has been turnover in several senior staff positions. Chief Accountant James Kroeker left the SEC in July 2012. Paul Beswick has been serving as Acting Chief Accountant. Subsequent to the conference, the SEC announced Mr. Beswick’s appointment as the agency’s Chief Accountant. The SEC also announced that Division of Corporation Finance Director Meredith Cross will be leaving the SEC. Lona Nallengara was appointed Acting Director of the Division. He replaced Ms. Cross after her departure from the SEC at the end of 2012.

Practical tip: Don’t overlook any last-minute rulemaking or interpretations for recently enacted laws with near-term effects.

The Division of Corporation Finance responded quickly with the initial guidance needed for the JOBS Act and the lion’s share of the Dodd-Frank Act. But some rulemaking and interpretations related to these wide-reaching laws remained unfinished at the time of the conference, and the Office of General Counsel was still compiling interpretive guidance on compliance with the Iran Threat Reduction and Syria Human Rights Acts of 2012. The advice provided at the conference included the following:

a. Iran Act. The Iran Threat Reduction Act requires new disclosures of certain business activities related to Iran by issuers and affiliates. The reporting requirement takes effect with periodic reports required to be filed after February 6, 2013. It requires issuers to disclose the nature and extent of the activity, the gross revenues and net profits attributable to the activity, and whether the issuer or affiliate intends to continue the activity. The SEC staff provided a number of clarifications about compliance with this Act during the conference. But participants raised many additional questions, some of which were addressed to former Director of the Division of Corporation Finance, Brian Lane, who provided the insights of a corporate


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securities lawyer as part of a panel discussion on MD&A. Here are some of the clarifications and open questions:

• Clarification by SEC staff: Companies cannot avoid the disclosures by filing their reports before February 6, 2013.

• Clarification by SEC staff: An “affiliate” refers to a person or entity that is directly or indirectly controlled by the registrant.

• Open question: How is “controlled” defined for purposes of this Act? Does it include a company that is only 10 or 20 percent owned by the registrant? Mr. Lane indicated that, based on his discussions with SEC staff, the Act includes affiliates that are less than 51% owned, but more clarification is needed from the SEC.

• Clarification by Mr. Lane: The disclosure requirements apply to the period covered by the report. For example, they would apply to all 2012 activity in a Form 10-K for a calendar-year company with a December 31, 2012 year-end. But there would not be a required three-year lookback to prior periods presented in the financial statements.

• Clarification by Mr. Lane: The Iran Act applies to foreign private issuers as well as domestic registrants.

The SEC incorporated answers to some of the open questions in the CD&Is on December 4, 2012. A link to the CD&Is is provided in the appendix to this Messenger.

b. JOBS Act. A panel of staff members of the Division of Corporation Finance summarized the key provisions of the JOBS Act, which provides certain accommodations to companies that

qualify as Emerging Growth Companies (EGCs). The staff advises EGC registrants that they need to continuously monitor their filing status. This is important because loss of EGC status will result in more extensive and more costly filing requirements, and once a company loses its EGC status for any reason, it generally cannot come back into the filing system for EGCs. Several clarifications about the accommodations for EGCs were provided at the conference:

• EGCs are permitted to delay the adoption of new or revised accounting standards by using the effective dates for non-issuers rather than issuers. This permission is limited to accounting standards issued by the FASB after April 5, 2012. It provides flexibility in determining when a standard may be adopted, but not which standards may be adopted. This flexibility does not mean an EGC can apply private company accounting standards.

• Delays in adoption dates of accounting standards are voluntary. If an elective decision is made to adopt this accommodation, that policy needs to be prominently disclosed. Once made, the election applies across-the-board to the adoption dates for all new accounting standards. If the EGC elects private company adoption dates, it can switch to public company adoption dates at a later time. However, once an EGC elects to use public company adoption dates, that election is irrevocable.

• EGCs are also provided with an election to opt out of the requirement for auditor attestation over internal control. It is possible that a company may meet the definition of an accelerated filer and also qualify as an EGC. In these cases, the registrant is not required to have an audit of its internal controls.


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• When an EGC crosses a disqualifying threshold (such as $1 billion in annual revenues), it will lose its EGC status immediately and it will need to obtain an audit of its internal controls in the year it crosses the threshold. For example; if a calendar-year company passes the threshold on December 31, 2012, it must file as a non-EGC and it will be required to have an audit of its internal controls for 2012. If the registrant feels this requirement is impossible to meet, it can contact the SEC staff to discuss a possible exemption for the reporting period during which the threshold is passed.

c. Dodd-Frank Act. The conflict minerals rules are arguably the highest-profile and most controversial rules related to the Dodd-Frank Act. The staff advised participants that the applicable audit standards are those of the GAO’s “yellow book” standards. Companies have several options for obtaining the required audits of conflict minerals reports. One option is to use the same auditor that audits the company’s financial statements. The staff said this would not be inconsistent with independence requirements, but the company must disclose the fee in the “all other” category of its proxy statement. Another option is to use a firm other than the company’s audit firm. The yellow book standards will also permit a non-CPA to perform the required independent private sector audit of the conflict minerals report provided the auditor uses performance audit standards as opposed to the attestation engagement standard in the yellow book. The staff has issued a small entity compliance guide for conflict minerals. But they are still getting many inquiries, including complicated chemical questions. The staff respectfully suggests that the chemistry questions be directed to an appropriate expert rather than the SEC staff. The expectation at the time of the conference was that more

guidance on other aspects of the rule would be forthcoming from the SEC staff, perhaps as FAQs or C&DIs.

Additional interpretations of the above laws and rules are available on the SEC’s website. Links are provided to key documents on the appendix to this Messenger.

Practical tip: Be mindful of the “frequent areas of comment” in filing reviews by the Division of Corporation Finance.

The Director of the Division of Corporation Finance and a panel of SEC staff members provided the following advice based on an analysis of topics mentioned frequently in SEC comment letters and responses from registrants.

a. Responses to comment letters. Corporation Finance Director Meredith Cross said the comment letters from the SEC to registrants are getting more targeted, more meaningful, and harder for the companies to respond to. At the same time, the comment letters are getting posted to the SEC’s website faster, but no earlier than 20 days following the completion of the filing review. These factors are focusing more attention on the correspondence and the wording of the registrant’s replies in the media. In view of this expanded visibility, Ms. Cross cautions that companies need to exercise an appropriate amount of care when wording their responses. Some companies may want to obtain legal reviews that are every bit as rigorous as those obtained for their filings. Federal law (18 U.S.C. § 1001), in effect, makes it a crime to lie to the government. This law could expose the company to liability if any of the statements in its replies are inconsistent with other statements made as part of the company’s disclosure record or are not 100% accurate.


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b. MD&A. A panel discussion on MD&A provided insights from corporate executives. The executives noted that the MD&A can be a challenge to write for several reasons, including the need to find the right balance between transparency and information overload and the fact that the guidance is spread across multiple sources. In effect, writing a good MD&A, said one corporate participant, is more a matter of complying with the “spirit” of the regulations than one of complying with the letter of the law. Perhaps, not surprisingly, a panel of SEC staff members from the Division of Corporation Finance noted that MD&A is at the top of the list of frequent topics for SEC staff comment letters. Since it is the single most frequent area of comment, MD&A was the subject of a number of observations and advice, including the following:

• Within MD&A, the SEC staff comments focus most frequently on the company’s results of operations, followed by liquidity and critical accounting estimates.

• The staff notes that information in the MD&A sometimes repeats information presented in the financial statements or it uses boilerplate language. As a result, many SEC comments ask for more information. For example, companies may be asked to identify, quantify and discuss the factors that led to changes in financial statement line items.

• The SEC believes it is critical for companies to answer the question “Why?” For example, “Why did revenues increase?” The disclosures should identify the underlying causes of any increase in the volume of sales. The reasons for any changes in the mix of revenues by segment may also need to be discussed.

• In light of the current economic environment, some companies are being asked to disclose the effects of events in Europe on the results of operations, including segment sales, margins, and any effects on significant suppliers or customers that may have a material impact on results of operations. If there are material offsetting impacts, the staff advises that all material impacts should be discussed, even if the net effect on a line item is immaterial.

• The staff recommends the use of metrics to help companies tell their story. The metrics should not be measures that would be considered non-GAAP measures, but they may be industry-specific, such as comparable store sales in the retail industry.

• The MD&A has a forward-looking focus, and registrants are required to disclose any known trends and uncertainties that the company reasonably expects will have a material effect on income, either favorable or unfavorable. The staff points out that this is sometimes the most informative disclosure in the MD&A.

• The table of contractual obligations provides some flexibility in the handling of items involving uncertainties. However, the footnotes to the table should discuss what is included in the table and what is not, and the commentary should link back to the liquidity discussion.

• Recommended reference materials include the SEC’s 2003 MD&A Interpretive Release and Topic 9 of the SEC’s Financial Reporting Manual.

c. Segment reporting. Another frequent area of comment involves the identification of operating segments and their aggregation into reporting segments. Registrants are urged to tell a complete


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story when responding to comment letters to provide an understanding of the judgments involved. For example, the discussion of segments might include information about how the chief operating decision maker makes allocation decisions or assesses performance. Companies are also advised to continually monitor the facts and circumstances that affect segment reporting. The FASB and IASB are currently conducting post-implementation reviews of their standards for segment reporting. The SEC staff said it is too soon to comment on what effect this might have on their filing review or their future comment letters.

d. Income taxes. The SEC staff noted that a decision to establish or reverse a valuation allowance for deferred income tax assets often requires considerable judgment including an evaluation of the relevant facts and circumstances. However, they reminded registrants of their view that it would be difficult to conclude that losses due to an economic downturn would be an aberration that did not justify a need to establish a valuation allowance. They also reminded registrants that cumulative losses in recent years represent significant negative evidence that is difficult (but not impossible) to overcome when assessing the realizability of deferred tax assets (DTA). As more registrants have returned to profitability this year, questions have arisen about when a valuation allowance can be reversed. The short answer is that it can be reversed when the positive evidence outweighs the negative. Because this can be a difficult determination, the staff’s comments often focus on the question of “Why now?” Factors to consider in weighing the evidence include the magnitude and duration of past losses, magnitude and duration of current profitability, whether the current profitability is sustainable, and management’s forecast. It is important to choose factors that are independently verifiable, and any forecasts used in connection with valuation

allowances for deferred tax assets should consider their reliability by taking into account an assessment of how management’s forecasts have compared with actual results in the past and whether the forecast used to evaluate the DTA is consistent with the other forecasts used in the registrant’s financial statements, including forecasts used to evaluate impairment of goodwill, long-lived intangible assets or to assess the going concern uncertainty.

e. Loss contingencies. In recent years, SEC staff comments have focused on both the content and the timing of disclosures about reasonably possible ranges of losses. These comments relate to the requirement that companies must disclose an estimated loss or range of losses when it is at least reasonably possible that a loss has been incurred. This is another area of accounting that involves significant judgment and the SEC comments are intended to ensure the company tells the full story. The staff cautioned registrants to keep in mind that, even if the SEC clears a loss contingency in one year, it may make comments in future years if there are changes and the disclosures do not appear to be evolving in a timely manner.

f. Revenue recognition. The SEC staff comments on revenue recognition have been focusing on the question of whether collection is reasonably assured, which may not be the case for certain transactions, including revenues from sales to customers in the Eurozone. In addressing this question, registrants should consider a number of factors, including their historical past-due collection practices and write-off history, as well as any track record of unfavorable resolutions in collection disputes or any history of modifying payment terms or of not enforcing liens.

g. Goodwill impairment. Recent SEC staff comments about goodwill impairment have focused on a perceived gap in disclosures from period to period, particularly in the period of impairment.


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The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation. Please contact your MHM service provider to further discuss the impact on your financial statements.

Reasons such as “soft market conditions” or an “economic downturn” are considered overly vague in light of the number of periods spanned by the weak economy. If the company conducted an interim impairment test, that fact should be disclosed, along with the factors that triggered the interim test, even if no impairment was identified. Additionally, the staff expects disclosures from companies that are at risk of failing step 1 of the goodwill impairment test and they expect reasons for impairment that answer the question of “Why?” Specifically, registrants should consider the following questions: What happened in a specific period that gave rise to the impairment charge in that period rather than earlier or later? How were key assumptions affected? Why did those changes occur? Is the impairment a result of known trends that are expected to affect income?

h. Non-GAAP measures. The staff continues to issue comments about the use of non-GAAP measures. Registrants are reminded that presentation of misleading non-GAAP income statements is prohibited in earnings releases furnished to the SEC on Form 8-K, as well as in filings with the SEC. Misleading non-GAAP measures violate Regulation S-K, even if the measure is reconciled to a GAAP measure. Use of non-GAAP measures with adjustments for pension-related items can be especially troublesome. This practice was discussed at the June 2012 joint meeting of the AICPA’s CAQ SEC Regulations Committee, and additional information is available in the meeting highlights on the CAQ’s website.

i. Other areas. Additional areas of advice from the SEC staff include pro forma financial information, consolidation of variable interest entities,

disclosures about cybersecurity, and Rule 3-10 issues involving disclosure requirements for guarantors of registered securities and the effect of subsidiary guarantee release provisions. They also include various issues related to specific industries and auditor considerations. The SEC has issued guidance on the MD&A disclosures related to cybersecurity risks and the circumstances that may constitute customary subsidiary release provisions. Links to these resources are provided on the appendix to this Messenger. The staff discussed two issues related to auditor considerations:

• Registrants should consider including risk factors in their filings when they have material operations in non-PCAOB inspected jurisdictions.

• References to the “standards of the PCAOB” in auditors’ reports for issuers should not be termed simply “auditing standards.” This term is too limiting and does not include the other PCAOB standards, such as independence standards, with the result that the term may imply the auditor did not comply with the standards other than auditing standards. References to auditing standards may, however, be appropriate in auditors’ reports for non-issuers conducted in accordance with standards issued by the AICPA and known as US Generally Accepted Auditing Standards (US GAAS). These standards might be applicable in certain situations when the financial statements of an acquired entity are presented under Rule 3-05 of Regulation S-X.

AICPA Conference Recap - Investor Info & Audit Quality

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