Developments in Auditing and Accounting

In 2019 the board of directors, and especially the audit committee, at nearly every company will face a few continuing issues from the world of accounting and auditing that have had a lot of attention in recent years. But there are also a handful of sleeper issues that are emerging more slowly and whose impact is not yet clear.

The Marquee Items for 2019

“Critical Audit Matters” 

In 2017 the Public Company Accounting Oversight Board (“PCAOB”) amended its standards for audit reports, and the most important of these changes will require the auditor to report on Critical Audit Matters (“CAMs”). For a large accelerated filer with a December fiscal year, the disclosure will first appear in the 2019 10-K in early 2020, but for companies with fiscal years ending earlier in the second half, the first 10-Ks with CAMs will appear in late 2019.

Auditors will have to identify matters that are communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involve especially challenging, subjective, or complex auditor judgments.

CAM reporting will require close coordination between the auditor, management and the audit committee, and it may well require management to develop new disclosures that are consistent with what the auditor will disclose in its report. To frontload this coordination audit firms have been pushing companies to conduct “dry runs” to identify CAMs now and tune up the related disclosures in the 2018 10-K.

New Accounting Standards

For several years now, the preparation of financial statements has been complicated by the adoption and implementation of major new accounting standards – especially ASC 606 on revenue recognition and ASC 842 on lease accounting.

The implementation cycle is long, and each phase of the cycle involves the board of directors in a different way. Before effectiveness, when the company is learning how to apply the standard, the audit committee should be encouraging early consideration and disclosure of its likely impact; the SEC has been insisting that this element of oversight is an important governance issue. This is where the leasing standard currently stands, and this year disclosures on its impact will need to become increasingly specific. The leasing standard will have a dramatic impact on some balance sheets and may also have covenant implications for some companies.

After effectiveness – this is where revenue recognition stands in 2019 – the audit committee might consider asking how management’s application of the new standard compares with other companies, and whether SEC comment letters to other companies have implications for decisions management made in applying it.

Non-GAAP Financial Measures

During the course of 2018, the SEC’s intense campaign to rein in company use of non-GAAP measures started to look like old news. Speeches by the Staff and Commissioners, and a sharp drop in comment letters, may have suggested it was safe to go back in the water. Then in the last week of December, the SEC announced an enforcement action against the alarm company ADT for failing to give equal prominence to GAAP measures in its earnings releases. This would be a good time for the audit committee to make sure the company is complying with the non-GAAP rules, particularly in earnings releases.

Emerging Areas to Watch in 2019

Meanwhile, there are some less obvious issues gathering steam that may affect boards and audit committees in the medium term. In the background of all these developments is the increasing pressure on auditing firms from enforcement proceedings, PCAOB inspections, litigation costs, and other regulatory attention. (In May 2018 a parliamentary commission in the United Kingdom even called for rules to break up the Big Four auditing firms.) All this can contribute to a more adversarial atmosphere between the independent auditor and the company and its audit committee.

PCAOB Supervision of Non-U.S. Audit Firms

Many of the major enforcement cases against auditors involve non-U.S. member firms of international auditing networks. In 2017 and 2018, there were major PCAOB or SEC cases involving auditors in Brazil, China, Hong Kong, Korea, Mexico, Malaysia, South Africa, Spain and Turkey. These cases highlight a delicate aspect of how audits are conducted: the principal auditor of a multinational enterprise relies on work done by multiple separate firms (whether or not under the same brand) in different countries.

The cases also highlight a very challenging feature of the PCAOB’s mission, which is to regulate audit activity wherever it occurs, if the parent reports to the SEC. Now the best-publicized example of that challenge is back in the news, because the SEC and the PCAOB went public in December 2018 with their complaints that the PCAOB is unable to conduct adequate inspections of Chinese audit firms. Apparently the modus vivendi worked out in 2016 is no longer satisfactory.

For companies with extensive operations outside the United States, this is an area the audit committee should be watching closely.

Changing Priorities at the PCAOB

The PCAOB has been regulating auditors since 2002, and in 2018 it had a kind of midlife crisis: the Board turned over completely in December 2017, important senior staff were replaced in 2018, and the new Board led by former Senate staffer William Duhnke published a new strategic plan in November 2018. Some of the projects under way at the new PCAOB would be significant if they ultimately lead to new regulation. These include a project on how the auditor should address instances of illegality (referred to as non-compliance with laws and regulations, or NOCLAR); and a project on how auditors are involved in disclosures other than the financial statements, including earnings releases and the use of non-GAAP financial measures.

Shareholder Opposition to Auditor Ratification

In 2018, attention focused on the General Electric shareholders meeting where, after the proxy advisory firms recommended against ratifying KPMG as auditor, ratification won only 65% of the vote. GE was coming off major accounting problems (and approximately $143 million in audit fees) in 2017. There were a handful of other companies where ratification received significantly lower votes than before, and at one UK company a majority opposed ratification. The interesting questions for 2019 will be what happens in “year two” at a company like GE, how the proxy advisory firms approach ratification (Glass Lewis has already revised its guidelines), and whether opposition spreads to other companies.

Increasing Attention to Audit Committee Disclosures

Several signs point to growing focus on how audit committees perform their oversight of the financial reporting process and the auditors, and how companies disclose that performance. Among these were an April 2018 report by IOSCO (an international organization of securities market regulators from multiple countries, often under SEC leadership) on good practices for audit committees, and a November 2018 report from the Center for Audit Quality recommending better disclosure of audit committee practices.