Auditing Considerations and Financial ReportingThomas J. LinsmeierFASB Member

2016 Deloitte / University of Kansas Auditing SymposiumMay 20, 2016

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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

Recent Financial Reporting Areas (Potentially) Influenced by Auditing Considerations

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Application of Materiality to Disclosure Decisions

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Improving the effectiveness of notes requires both:

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Disclosure Framework: Two Components

Appropriate exercise of judgment by reporting entities when assessing disclosure requirements

Phase II: Entity’s Decision Process

Consistent considerations by the Board in each standard-setting activity

Phase I: Board’s Decision Process

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

Entity’s Decision Process

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Field Study Provided Insights on

Copyright 2015 by Financial Accounting Foundation, Norwalk, CT. For non-commercial, educational/academic purposes only.

Proposed Changes to the

Codification

“Provide disclosure to the extent material”

Eliminate language that limits judgment

Add guidance on applying materiality

Entity’s Decision Process

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Applied individually and in the aggregate

Legal concept

Quantitative and qualitative

Omission not an accounting error

Proposed Guidance on Applying Materiality

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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

CON 2

SAB 99

AS 14

Defining Materiality in Financial Reporting

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CON 8

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.

Defining Materiality in Financial Reporting

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• Lawyer involvement• Accounting concept• Anti-fraud

Legal Concept

• Support for the statement• Reduced communication concernsOmission Not Error

• Prove materiality for inclusion?Burden of proof

• Concerns over departure from CON 8• Absent from CodificationDefinition

Materiality -Comment Letter Feedback

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Defined Benefit Plans

Fair Value Measurement

Income Taxes

Inventory

Next Steps

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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

Redeliberate Proposed Revisions to Disclosures in 4 areas on this slide

GAAP vs. Non-GAAP Presentation

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Proliferation of Non-GAAP Earnings

According to Jack Ciesielski’s, 2015 two-part Analyst’s Accounting Observerreport 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?

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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

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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

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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?

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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?

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Use of Accounting Conventions vs. Full Compliance with GAAP

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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

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Why Was Standard Setting (Rather than an Accounting Convention) Needed Here? Exception in IFRS 16 from balance sheet recognition of leases of low-

value 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)

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Use of Accounting Conventions vs. Full Compliance with GAAPQueries:

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?

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Insurance Loss Development Tables

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Update 2015-09, 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 expensesb. 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

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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

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Going Concern

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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

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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

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ASU 2014-15: Presentation Of Financial Statements – Going Concern ASU 2014-15 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).

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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

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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

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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

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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

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Questions

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