Financial Reporting and the Law

Morgan Lewis’s Financial Reporting and the Law blog discusses legal and accounting issues that impact public companies, audit committees, auditors, and their advisers. It provides insight regarding matters at the intersection of law and accounting, paying particular attention to SEC developments, accounting and auditing standard setting activities, and relevant case law. The primary contributors are Linda L. Griggs and Sean M. Donahue.

FASB Defers the Revenue Recognition Standard’s Effective Date

By Linda Griggs and Sean Donahue // April 2, 2015

On April 1, the FASB decided to defer the effective date of the new revenue recognition standard to interim periods of public entities within their annual reporting periods that begin after December 15, 2017. Early adoption is permitted, but only for interim periods within annual periods that begin after December 15, 2016, which is the standard’s original effective date for public entities.

The FASB will issue a proposed Accounting Standards Update that sets forth the FASB’s decision on the effective date. Although the FASB could change its approach to the deferred effective date as a result of comments it receives during the 30-day comment period on the proposed Accounting Standards Update, we believe that the FASB will not likely change its mind on providing entities with more time to get ready to implement the new revenue recognition standard. Not only have entities advised the FASB that they need additional time to evaluate the impact of the standard on, and make any required changes to, their systems and processes, but the FASB also decided at earlier meetings to issue proposed Accounting Standards Updates to improve additional guidance. The FASB will issue a proposed Accounting Standards Update to provide additional guidance with respect to licenses of intellectual property, the identification of performance obligations, and noncash consideration and collectability.

In addition, the FASB decided at a prior meeting to provide relief relating to the transition to the requirement in the revenue recognition standard, ASU 2014-09, that sales taxes collected from customers be excluded from the transaction price.

FASB’s Amended Consolidation Standard Requires Reassessment of Certain Consolidation Decisions

By Linda Griggs and Sean Donahue // April 1, 2015

The FASB’s Accounting Standards Update No. 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, issued in February,

  • reduces the number of applicable consolidation models from four to two: the voting interest model and the variable interest entity (VIE) model (except that consolidation may also be required for entities controlled by contract);
  • eliminates the indefinite deferral from the VIE consolidation analysis for certain investment companies and similar entities;
  • eliminates the presumption that a general partner should consolidate a limited partnership, and eliminates the consolidation model specific to limited partnerships;
  • expands the circumstances for when a limited partnership or a similar entity is considered a VIE;
  • eliminates three of the six criteria for when fees paid to a decision maker (such as an asset manager) or a service provider are considered to be variable interests;
  • reduces the effect of related party interests in the evaluation of the controlling financial interest criteria for consolidating a VIE; and
  • exempts holders of interests in money market funds and entities subject to requirements similar to those applicable to money market funds from the consolidation requirements.

ASU 2015-02 addresses stakeholders’ concerns that asset managers’ consolidation of managed entities required the presentation of deconsolidated information so that investors in the asset managers could understand the asset managers’ results. Although the FASB believes that the amendments simplify the consolidation determination by reducing the number of consolidation models, the amendments’ implementation may impose costs because general partners of limited partnerships and entities that hold an interest in a limited partnership, an investment company, a VIE, or a company in which the equity holders lack decision-making rights will need to reassess whether consolidating such an entity is required.

Limited partnerships and similar legal entities will need to be evaluated as VIEs unless they provide partners with either substantive kick-out rights or substantive participating rights over the general partner. A partner in a limited partnership that qualifies as a voting interest entity will consolidate the limited partnership only if it has a controlling financial interest, which can be achieved through holding a limited partner interest that provides substantive kick-out rights.

Fees paid to a decision maker, such as an asset manager, will not be considered a variable interest in a VIE if they are “customary and commensurate with the level of effort required for the services provided.” If the fees are considered a variable interest, then the entity will consolidate the VIE if its variable interest or variable interests represent a controlling financial interest in the VIE.

If no single party has a controlling financial interest in the VIE, related party relationships will be considered indirectly on a proportionate basis in evaluating whether a single decision maker has a controlling financial interest in the VIE. The consolidation analysis ends after this evaluation except in two circumstances. If the related parties and the decision maker are entities under common control that, together as a group, have characteristics of a primary beneficiary, the primary beneficiary among those related parties would consolidate the VIE. If substantially all of the VIE’s activities are conducted on behalf of a single variable interest entity other than the decision maker in a related party group that has the characteristics of a primary beneficiary, the single variable interest holder in the related party group would consolidate the VIE as the primary beneficiary.

In connection with eliminating the indefinite deferral for certain investment funds from the consolidation analysis, the FASB adopted an exception from the consolidation analysis for investments in money market funds required to comply with Rule 2a-7 of the Investment Company Act of 1940 and other entities that operate in accordance with requirements similar to those in Rule 2a-7. Entities with investments in investment companies other than money market funds, including mutual funds organized in a series structure, will need to reconsider their consolidation decision with respect to those investees.

The effective date of ASU 2015-02 for public companies is fiscal years that begin after December 15, 2015 and interim periods within that year. Early adoption is permitted, and entities may apply the amendments using a modified retrospective approach or a retrospective approach.

FASB Eliminates Extraordinary Items Reporting

By Linda Griggs, Rani Doyle and Sean Donahue // February 19, 2015

In January, the FASB adopted a final Accounting Standards Update that eliminates the requirement that preparers report events that meet the criteria for extraordinary classification separately in an income statement, net of tax and after income from continuing operations. Not only was the classification of an event as extraordinary time consuming and somewhat complex for preparers, but users advised the FASB that the extraordinary item classification was rare and not very useful. The FASB’s action was part of its Simplification Initiative, which is intended to reduce costs and complexity while “maintaining or improving the usefulness” of financial information to users. Through this action, the FASB eliminated an inconsistency with International Financial Reporting Standards’ IAS 1, “Presentation of Financial Statements,” which prohibits the presentation and disclosure of extraordinary items on an income statement.

The existing accounting standards define an extraordinary event as one that meets both of the following criteria and is material when compared to income before extraordinary items, the trend of annual earnings before extraordinary items, or some other appropriate criteria:

  1. Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be clearly unrelated to, or only incidentally related to, an entity’s ordinary and typical activities taking into account the environment in which the entity operates.
  2. Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.

The existing standard excludes various gains and losses, such as the write-down or write-off of receivables, inventories, and other intangible assets; foreign currency gains and losses; gains or losses from the disposal of a component of an entity or the sale or abandonment of property, plant, or equipment; and gains and losses from the effects of a strike, including those against competitors and major suppliers. Examples of events that meet the current standard are gains or losses that are a direct result of a major casualty, such as an earthquake or an expropriation.

The elimination of the extraordinary item classification will not reduce information about events that would have been classified as extraordinary. Preparers of financial statements will need to report separately in the income statement as a part of income from continuing operations, or, alternatively, report in the notes to the financial statements events that previously would have met the definition of an extraordinary item. This requirement is consistent with the requirement in existing GAAP for preparers to report the nature and financial effects of material events that are “unusual in nature” or of a type that indicates “infrequency of occurrence,” as each of those terms is explained in the current definition of an extraordinary item noted above.

Accounting Standards Update No. 2015-01 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A preparer may adopt the standard early, as long as the preparer adopts the standard from the beginning of its fiscal year. In addition, a preparer may adopt the standard on a retrospective basis.

SEC Accounting Staff Speeches at Annual AICPA Conference

By Linda Griggs and Sean Donahue // December 11, 2014

On December 8 and 9, staff members of the SEC’s Office of the Chief Accountant, including the SEC chief accountant in his first published speech since he arrived at the SEC, discussed various accounting and financial reporting matters at the American Institute of CPAs’ annual conference, including the following:

  • International Financial Reporting Standards (IFRS)—The chief accountant noted that “it appears that U.S. constituents generally are not supportive of full adoption [of IFRS] for a variety of reasons” and have concerns about providing an option to U.S. companies to present IFRS-based financial statements. Therefore, “in the coming months,” he hopes to begin discussions with the SEC commissioners about alternative ways for U.S. issuers to use IFRS, such as by presenting IFRS-based financial information supplementally without the disclosures and reconciliation required for non-U.S. GAAP financial measures.
  • Further Convergence of IFRS and U.S. GAAP—The chief accountant noted that he favors convergence of standards and encourages the FASB and the International Accounting Standards Setting Body (IASB) “to continue to work towards converged standards, including on lease accounting.”
  • Revenue Recognition—The chief accountant noted that there are various implementation issues that the FASB and the IASB are addressing, including the identification of performance obligations and the accounting for licenses. Some may require additional guidance from the FASB or the SEC staff, which may affect the effective date of that standard.
  • Audit Committee Disclosures—The chief accountant noted that he “has devoted substantial time” to Chair Mary Jo White’s request that the staff consider whether improvements to audit committee reporting requirements should be made. He noted that the enhancements that some audit committees have made to their disclosures may be partially responsive to investor requests but are not being made consistently.
  • Segment Reporting—An SEC deputy chief accountant made the following points:
    • “[T]he staff will be taking a refreshed approach when reviewing operating segment disclosures[.]”
    • Most companies have more than one operating segment.
    • The chief operating decision maker may not be the chief executive officer.
    • The identification of operating segments requires considering not only a company’s organizational structure and the package of information given to the chief operating decision maker, but also other factors, such as the way a company prepares budgets and forecasts and determines executive compensation.
    • The aggregation of operating segments requires
      • similar economic characteristics, where there is no bright line test, and
      • an analysis of each of the five areas identified in the accounting standard. Recently, the staff disagreed with a company’s aggregation of segments based on the staff’s analysis of the type or class of customer, which is one of those five areas.
  • Additional Information Available to Audit Committees—A deputy chief accountant noted that audit committees’ discussions with their auditors about performance criticisms included in PCAOB inspection reports could benefit from a new appendix that has been added to PCAOB inspection reports. The appendix identifies particular auditing standards that are the subject of performance criticisms in the inspection report.
  • Internal Control Over Financial Reporting—Once again, the SEC staff discussed its concerns that material weaknesses in internal control over financial reporting are not being identified on a timely basis, either because the weakness is not being identified at all or because the severity of the weakness is not being evaluated appropriately. A deputy chief accountant noted that the SEC staff’s efforts in the area of internal control over financial reporting are “ongoing, coordinated and increasingly integrated into [the staff’s] consultation, disclosure review and enforcement efforts.”

SEC Will No Longer Require an Acquired Entity to Use “Pushdown” Accounting upon a Change in Control

By Linda Griggs, Rani Doyle and Sean Donahue // November 26, 2014

On November 18, the SEC’s Division of Corporation Finance and the Office of the Chief Accountant (the Staff) rescinded Topic 5.J. of the Staff Accounting Bulletin Series. Topic 5.J. required an SEC registrant that became substantially wholly owned by another entity, except in certain circumstances, to apply “pushdown” accounting, under which it would reflect in its financial statements the acquirer’s new basis of accounting for the assets and liabilities of the acquired entity. In addition, Topic 5.J. addressed the circumstances in which the acquired entity’s financial statements should reflect the acquirer’s borrowings used to acquire substantially all of the common stock of the acquired entity as well as related interest expense and allocable debt issuance costs.

The Staff explained that its action was necessary to conform its guidance to recent accounting guidance issued by the FASB in Accounting Standards Update No. 2014-17 (the Update). The Update is a consensus of the FASB’s Emerging Issues Task Force that the FASB ratified in October. The Update provides that an acquired entity, regardless of whether it is an SEC registrant, has the option (but is not required) to use pushdown accounting as long as an acquirer has obtained control of the acquired entity. For this purpose, “control” means ownership of more than 50% of the outstanding voting shares of another entity or the power to control with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or court decree.

The Update also provides that an acquired entity may apply pushdown accounting for the reporting period in which the change-in-control event occurred. Pursuant to the Update, if the acquired entity elected to apply pushdown accounting, it would reflect in its separate financial statements as of the acquisition date the new basis of accounting established by the acquirer for the acquired entity’s assets and liabilities under GAAP. If the acquirer did not establish a new basis of accounting for the acquired entity’s assets and liabilities because it was not required to do so by GAAP (such as when the acquirer is an investment company), the acquired entity may nevertheless still elect to apply pushdown accounting by reflecting in its separate financial statements the new basis of accounting that the acquirer would have applied if it had been subject to the GAAP requirement to apply a new basis of accounting for the acquired entity’s assets and liabilities.

The acquired entity that elects to apply pushdown accounting must recognize in its separate financial statements any acquisition-related liability incurred by the acquirer only if the liability represents an obligation of the acquired entity in accordance with other applicable GAAP. In addition, the acquired entity must provide various disclosures intended to enable users of its financial statements to evaluate the effect of pushdown accounting, including a qualitative description of the factors that make up the goodwill recognized. If, in accounting for the acquisition of control, the acquiring entity recognizes any bargain purchase gains, however, the acquired entity may only recognize the gains as an adjustment to its additional paid-in capital.

An acquired entity that does not elect to apply pushdown accounting for the reporting period in which the change-in-control occurred may elect to apply pushdown accounting in a subsequent reporting period. When such an election is made, the acquired entity must describe the election as resulting in a change in accounting principle and comply with the GAAP applicable to a change in accounting principle. The acquired entity must apply pushdown accounting as of the acquisition date of the change-in-control, regardless of when the election is made.

A subsidiary of an acquired entity may elect to apply pushdown accounting regardless of whether its parent, the acquired entity, elects to apply pushdown accounting.

Whenever an entity determines to apply pushdown accounting, the decision is irrevocable.

As a result of the Update, both public and private entities will follow the same guidance for pushdown accounting and may elect to apply pushdown accounting to any transaction occurring after November 18 or before November 18 but within a reporting period for which financial statements have not yet been issued by the entity, unless the entity treats the election to apply pushdown accounting as a change in accounting principle.

Disclosure Effectiveness: ABA Business Law Section Committees Suggest Financial Reporting Revisions

By Linda Griggs, Rani Doyle and Sean Donahue // November 19, 2014

In response to the SEC’s request for input on how to improve the effectiveness of public company disclosure, the American Bar Association’s (ABA’s) Business Law Section’s Federal Regulation of Securities and Law and Accounting Committees recently submitted a comment letter to the SEC suggesting, among other things, specific revisions to certain provisions of Regulation S-X and the management discussion and analysis (MD&A) requirements.

The committees noted that, in formulating their suggestions, they “kept in mind that a key objective of the [SEC’s] Disclosure Effectiveness initiative is obtaining better—not necessarily less—disclosure.”

The comment letter contains a number of specific suggestions for the SEC to consider, including the following:

  • Regulation S-X Rule 1-02(w)—replace the significance tests applicable to nonregistrant financial information requirements with revenue and fair value tests.
  • Regulation S-X Rule 3-05—reduce the need for three years of financial statements of an acquired business; eliminate the requirement for separate financial statements for individually significant acquisitions in Securities Act registration statements, provided the registrant makes other disclosures; and, when audited financial statements are not available, simplify the required financial presentation and reduce the “blackout” period for capital-raising activities, provided the acquiring company meets certain conditions.
  • Regulation S-X Rules 3-09 and 4-08(g)—reduce the need for separate financial statements of an equity investee; require disaggregated summarized financial information for all equity investees that are significant at the 10% level; and require aggregated summarized financial information for individually insignificant investees only when they are significant in the aggregate at the 20% level.
  • Regulation S-X Rule 3-10—require financial data for either the nonguarantor group or the guarantor group, rather than condensed consolidating financial information, and expand the circumstances when narrative disclosure about guarantors is enough to include guarantors that are “wholly owned subsidiary” and parent companies that have independent assets and operations.
  • Regulation S-X Rule 3-14—eliminate Regulation S-X Rule 3-14 and further revise Regulation S-X Rule 3-05 to set forth requirements related to acquired real estate operations.
  • Regulation S-X Rule 3-16—permit the presentation of summarized financial information for entities that provide security in registration statements as well as annual financial statements instead of separate financial statements.
  • Regulation S-X Article 11 (and Form 8-K Items 2.01 and 9.01)—permit additional adjustments in pro forma financial information under certain circumstances; permit pro forma financial information for two fiscal years; and conform the Form 8-K requirements for dispositions to those for acquisitions.
  • Regulation S-K Item 303—adopt a requirement for meaningful critical accounting estimate disclosures in the MD&A and eliminate the off-balance sheet and market risk disclosure requirements.

The committees also requested that the SEC codify the interpretations, relief, and waivers that its Staff regularly provides with respect to Regulation S-X to facilitate compliance by registrants and reduce the need for registrants to seek the Staff’s views in such instances.

Finally, the comment letter urges the SEC, in working with the FASB, to coordinate their respective disclosure improvement projects to ensure that any recommendations “for streamlining financial disclosure requirements to eliminate redundancy do not have the unintended effect of unnecessarily increasing liability exposure for registrants.”

The committees note that the letter focusing on Regulation S-X and other financial disclosures is the first in a series of comment letters that the committees expect to submit to the SEC regarding its Disclosure Effectiveness initiative.

PCAOB’s Standard-Setting Agenda: No New Adoptions of Substantive Audit Standards

By Linda Griggs and Sean Donahue // October 2, 2014

The PCAOB’s Chief Auditor issued a new standard-setting agenda on September 30 (the Updated Agenda), which notes the following future requests for comments, but no substantive adoptions, between October 2014 and March 2015.

Issuance of a Staff Consultation Paper on the Going Concern Auditing Standard

The existing auditing standard requires auditors to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time, which the auditing literature defines as a period of up to one year after the date that financial statements were audited. The auditor’s report must include an explanatory paragraph if the auditor concludes that there is substantial doubt. The auditor must evaluate the adequacy of disclosures in the financial statements regarding the uncertainty about the entity’s ability to continue as a going concern, even if the auditor concludes that substantial doubt does not exist.

The Updated Agenda states that the staff will issue a staff consultation paper to seek comment on “potential approaches to improving the performance and reporting requirements” in the existing standard, taking into account the FASB’s new going concern accounting standard, comments from the PCAOB’s two advisory committees, and academic research. The Updated Agenda notes that the staff is also monitoring standard setting related to this area by other standard setters.

The PCAOB staff noted in slides that it provided to the Standing Advisory Committee for its June meeting the following issues and alternative approaches:

  • Issues
    • Less disclosure under the FASB standard
    • Lack of consensus on whether there should be an “earlier warning about going concern uncertainties than current practice” or an alignment of auditing and accounting standards in the area
  • Alternative approaches
    • Retain auditing standard
    • Conform auditing standard to FASB standard
    • Adopt a new auditor reporting threshold
    • Adopt one of the preceding alternatives and require an emphasis paragraph in certain circumstances

Reproposal of an Auditor’s Reporting Model

The 2013 proposal would revise the auditor’s report to discuss, among other things, critical audit matters and the auditor’s responsibilities for, and the results of, the auditor’s evaluation of information outside the financial statements.

The Updated Agenda states that the staff is drafting a reproposal based on its analysis of comments, including those expressed at a public meeting in April.

Issuance of a Supplemental Request for Comment on the Transparency Proposal

The 2013 proposal, which was a reproposal, would require the auditor’s report to disclose (1) the name of the engagement partner and (2) the names, locations, and extent of other audit participants’ involvement.

The Updated Agenda states that “[t]he staff is drafting for the Board’s consideration a supplemental request for comment that takes into account comments received on the reproposal, including comments related to liability and an alternative location for the disclosure.”