SEC Chief Accountant Speaks On

Financial Reporting
On June 8, the SEC chief accountant, Wesley R. Bricker, gave a speech before the 36th Annual
SEC and Financial Reporting Institute Conference. The speech was titled Advancing the Role of
Credible Financial Reporting in the Capital Markets.

Introduction and Role of the PCAOB

The speech begins with some general background comments and a discussion of the role of the
PCAOB. Approximately half of Americans invest in the U.S. equity markets, either directly or through
mutual funds and employer-sponsored retirement plans. The ability to judge the opportunities and
risks and make investment choices depends on the quality of information available to the public and
importantly, the quality of the accounting and auditing information. Bricker notes that [T]he credibility
of financial statements have a direct effect on a companys cost of capital, which is reflected in the
price that investors are willing to pay for the companys securities.

The quality of financial statements begins with the companys internal accounting and audit
committees; however, an audit by an independent accountant provides investor confidence in the
financial statements themselves. Bricker notes the importance of having an independent auditor that
is thorough in their review and testing of the financial statements to ensure that they are accurate
and do not contain any misstatements. In order to ensure that this process works, both the
profession itself and regulators must be actively involved.

The Public Company Accounting Oversight Board (PCAOB) has broad oversight and responsibility
related to the audit and auditors of public companies and broker-dealers. The PCAOB sets
accounting standards, completes registration and inspection of audit firms and has enforcement
authority. The PCAOB inspection process includes a review of audit files and of internal controls and
processes of audit firms. The reports are made public via staff inspection briefs and individual
inspection reports. Also, a list of registered qualified PCAOB auditors is readily available on the
PCAOB website. The PCAOB completes an annual review of current and emerging audit issues and
publishes and sets audit standards and changes. The PCAOB also publishes guidance for auditors
and the audit process. As an example, the PCAOB recently proposed a new standard for audit
reports. The proposed new standard would require auditors to describe critical audit matters that
are communicated to a companys audit committee. Critical matters are those that relate to material
financial statement entries or disclosures and require complex judgment. One of the purposes of the
proposed change is to require the auditor to communicate to investors, via the audit report, those
matters that were difficult or thought-provoking in the audit process and that the auditor believes an
investor would want to know.

The proposal would also add information to the audit report related to the audit firm tenure, and the
auditors role and responsibilities. Tenure can be an important factor in an audit, including an
auditors experience and thus understanding of a companys business and audit risks. The SEC has
yet to approve the rule. If/when approved, the new rule would be implemented for large accelerated
filers beginning mid-2019 and for all other companies starting in 2021. Bricker notes that this
proposed change is significant as the audit report is the document in which the auditor itself
communicates to the public and investors.

International Collaboration
Bricker then discusses international collaboration with foreign regulators and standard setters. He
notes that in todays interconnected world economy, investors depend on high quality auditing and
auditing standards around the world, also noting that U.S. investors routinely invest in companies
based outside the United States and listed in non-U.S. jurisdictions to diversify their portfolio.

Turning to some facts and figures, U.S. investors invested $9 trillion in foreign equity and long-term
debt, including through mutual funds. Investment in domestic equity and long-term debt comes in at
$61.4 trillion. This number continues to increase. During the week ending May 17, U.S. investors
added $9.9 billion to U.S.-based mutual and exchange traded funds which invest abroad. This was
the largest weekly increase since July 2015.

It is important for investors to be aware of the processes, regulations, regulators and governance in
place related to audits and auditing standards outside of the U.S. Although Bricker continues on the
importance of international audit standards, and trust in the audit process, he does not refer to any
specific initiatives or guidelines in that regard.

New GAAP Accounting Standards; Revenue Recognition

Recently there have been several changes to accounting processes and several other proposed
changes. One that will have a material impact is related to revenue recognition. As requested by
investors, businesses and the marketplace, FASB and IASB recently adopted new revenue-
recognition standards which will be implemented over the next three years. Bricker does not get into
the details of the new revenue-recognition standard but emphasizes that the audit committee and
auditors need to participate in and have an understanding of how the company is implementing the
changes, including a flow through to internal controls and procedures.

The following is my very high-level summary of the impact on contracts from the complex new
revenue recognition standards. The revenue recognition changes are designed to assist an investor
in understanding the nature, amount, timing and uncertainty of revenue and cash flows arising from
contracts and customers. As revenue recognition is initially determined by the terms of a contract, it
is important when drafting contracts to consider the financial statement impact. The new standard
sets forth five steps to consider.

The first step is to identify the particular contract, which is an agreement between two or more
parties that creates enforceable rights and obligations. The new standard requires that multiple
contracts, between the same parties, entered into at or near the same time, must be combined and
analyzed as one contract if (i) the contracts are negotiated as a package with a single commercial
objective; (ii) the amount of consideration to be paid in one contract depends on the price or
performance of the other contract; or (iii) the goods or services promised in the contracts are a single
performance obligation.

The second step is to identify the performance obligations, which is a promise in a contract with a
customer to transfer to the customer either: (i) a good or service (or bundle of goods or services) that
is distinct; or (ii) a series of distinct goods or services that are substantially the same and that have
the same pattern of transfer to the customer. A good or service is distinct if both of the following
conditions are met: (i) the customer can benefit from the good or service either on its own or
together with other

resources that are readily available to the customer; and (ii) the entitys promise to transfer the good
or service to the customer is separately identifiable from other promises in the contract.

This step is vitally important as revenue is recognized when or as performance obligations are
satisfied, and thus a contract must clearly identify those performance obligations.
One blog gave a great example of where contract drafting can result in different revenue
recognitionin particular, where a developer enters into a contract to build a completed building for
a particular purpose for a customer. The contract may be written whereby parts of the delivered
project have distinct and independent value, such as engineering, site clearance, construction,
installation of equipment and finishing such that revenue is recognized upon delivery of these distinct
elements. Contrarily the contract could be written such that the individual parts are not separately
identifiable, but rather only the end product, such that revenue would not be recognized until such
end product is provided.

The third step is determining the transaction price which is the amount of consideration to be paid in
exchange for delivering the promised goods or services to a customer, excluding amounts collected
on behalf of third parties.

The two main considerations are: (i) variable consideration if the consideration is variable, the
company should estimate either the expected value or the most likely amount, depending on which
will be the more likely; and (ii) constraining estimates of variable consideration a company should
include in the transaction price some or all of an estimate of variable consideration only to the extent
it is probable that a significant reversal in the amount of cumulative revenue recognized will not
occur when the uncertainty associated with the variable consideration is subsequently resolved.

Transaction price can also vary based on non-cash consideration, discounts, rebates, refunds,
performance bonuses, penalties, contingent payments and the like. An example would be where a
custom asset is being built and the price is contingent upon a delivery deadline, with a performance
bonus for early delivery and penalties for later delivery. An additional complexity may be where the
price is based on an independent appraisal at the time of delivery. Complex variables may prohibit
revenue recognition until a contract is fully performed.

The fourth step is to allocate the transaction price to the performance obligations in the contract.
This amount should reflect the amount a company would be entitled to in exchange for satisfying
each performance obligation. To be able to recognize revenue based on allocation, the contract
should clearly identify a particular distinct delivered good or service on a stand-alone selling-price
basis. The allocation can be very complex and the amount of revenue recognized could end up
differing from a stated value in a contract, which may be arbitrary.

The fifth step is to recognize revenue when or as the company satisfies a performance obligation by
transferring a promised good or service to a customer. A good or service is transferred when or as
the customer obtains control of that good or service. Where a good or service is transferred over
time, revenue may be recognized if one of the following conditions is met: (i) the customer
simultaneously receives and consumes the benefits provided by the companys performance over
time; (ii) the companys performance creates or enhances an asset that the customer controls as it is
being created or enhanced; or (iii) the companys performance does not create an asset with an
alternative use to that company, and the company has an enforceable right to payment for
performance completed to date (customized products or services).

Where performance and delivery are not over time, a company should consider the following as to
when to recognize revenue: (i) the company has a present right to payment for the asset; (ii) the
customer has legal title to the asset; (iii) the company has transferred physical possession of the
asset; (iv) the customer has the significant risks and rewards of ownership of the asset; or (v) the
customer has accepted the asset.

Also not included in Brickers speech is that some companies have chosen to adopt the new
standards already, including Ford Motor Company, General Dynamics, Raytheon, Alphabet, First
Solar and United Health Group. The MD&Afor each of these companies contains a summary of the
changes and how they impact their particular company and its financial statements.
Internal Control over Financial Reporting

Internal controls over financial reporting are controls designed to provide reasonable assurance that
the companys financial statements are prepared in accordance with GAAP. Internal controls provide
the guidance and road map for management to effectively ensure timely and accurate financial
reporting. All companies are required to maintain internal controls over financial reporting, whether
or not such company is subject to the Sarbanes-Oxley Act.

Bricker advocates the Committee of Sponsoring Organizations of the Treadway Commission

(COSO) framework for assessing the effectiveness of internal controls. The Treadway Commission
is the National Commission on Fraudulent Reporting and has long been accepted as providing
acceptable guidance on internal controls over financial reporting, and processes for management to
assess same.

Bricker does not get into the specifics of the COSO framework for evaluating internal controls. In
1992, COSO developed a model for evaluating internal controls which has become the widely
recognized standard for which companies measure the effectiveness of their systems of internal
controls. COSO defines internal control as a process, effected by an entitys board of directors,
management and other personnel, designed to provide reasonable assurance of the achievement
of objectives if the following categories: (i) effectiveness and efficiency of operations; (ii) reliability of
financial reporting; and (iii) compliance with applicable laws and regulations.

From a very high level, COSO states that in an effective enterprise risk management (ERM) and
effective internal control system, all of the following five components must be present:

1. A Control Environment which includes: (i) integrity and ethical values; (ii) a commitment to
competence; (iii) a strong board of directors and audit committee; (iv) managements philosophy and
operating style; (v) organizational structure; assignment of authority and responsibility; and (vi)
human resource policies and procedures;

2. Risk Assessment which includes: (i) company-wide objectives; (ii) process level objectives; (iii)
risk identification and analysis; and (iv) managing change.

3. Control Activities which includes: (i) policies and procedures; (ii) security (application and
network); (iii) application change management; (iv) business continuity/backups; and (v) outsourcing.

4. Information and Communication which includes (i) qualify of information; and (ii) effectiveness of
communication; and

5. Monitoring which includes: (i) ongoing monitoring; (ii) separate evaluations; and (iii) reporting
deficiencies.

Strong internal controls not only detect and prevent material errors or fraud in financial reporting but
also contribute to better accountability and information flows. In other words, internal controls over
financial reporting assist a company in better management and potential profitability in addition to
the important reporting and securities-law matters. Where a company must disclose a material
weakness in its internal controls, investors will discount the price accordingly, especially at the
institutional level. Moreover, where a company has reported a material weakness and plan of
remediation, and then executes on such plan, the investor response is very positive, including a
reduced cost of capital and improved operating performance.

Although not discussed by Bricker, both the NYSE and NASDAQ consider reported material
weaknesses in internal controls when reviewing an application for listing on the exchange.
Auditor Independence

Public trust in financial reporting is maintained by protecting the independence of the outside auditor.
A companys audit committee plays an important role in overseeing and communicating with the
outside auditor. Bricker states that in order for the system to be effective, the audit committee must
own the selection of the audit firm, make the final decision when it comes time to negotiate the audit
fee, and oversee the auditors independence.

As part of the independent auditor selection, the audit committee should be open to the possibility of
circumstances that might require adjustments to prior-period financial statements. Bricker includes
as examples the reporting of discontinued operations, a retrospective application of an adoption or
change in accounting principle, or the correction of an error.

Reminders to the Audit Profession

Bricker points out that audit firms themselves are organizations with the inherent pressures that
personnel of any organization can face. Audit firms themselves must monitor and have internal
controls in place to ensure quality audits and audit relationships. One pressure that definitely can
impact the quality of an audit is a deadline. Bricker points out that audit firms need to plan and
allocate resources to ensure that there is time to address potential issues under the deadline of SEC
filing requirements.