This memorandum outlines certain considerations for foreign private issuers ("FPIs") in preparation for the 2018 annual reporting season. Part I of this memorandum discusses new developments and practical action items for the 2018 reporting season, and Part II includes a discussion of potential regulatory developments and pending rulemaking initiatives.
Part I. New Considerations and Action Items for the 2018 Reporting Season
Below are certain disclosure considerations and technical updates relevant to FPIs in connection with the upcoming annual report filing obligations.
New Revenue Recognition Accounting Standard
For FPIs that report using US GAAP, new revenue recognition accounting standard, ASU No. 2014-091 , went into effect for fiscal years beginning after December 15, 2017. Companies transitioning to the new revenue recognition standard may use either a full retrospective method (i.e., applying it retrospectively to each prior period presented) or a modified retrospective method (i.e., applying it to contracts that are initiated after the effective date and contracts that have remaining obligations as of the effective date, without restating the prior period financials to reflect adoption of the new standard).
- Transition Disclosures—Staff Accounting Bulletin No. 74 ("SAB 74") requires that companies include robust transition disclosures in their annual reports to enable investors to understand the anticipated effects of the new standard. The SEC has emphasized the importance of these transition disclosures2, indicating that it will focus on (i) disclosure of the impact that adoption of the new standard is expected to have on the company's financial statements, or a statement that such impact is not known or reasonably estimable, and a qualitative description of the effect of the new policies and a comparison to the company's current accounting; (ii) disclosure of the status of the company's implementation process for the new standard and significant implementation matters yet to be addressed; and (iii) involvement of the audit committee in the process to ensure that its SAB 74 disclosures are timely identified and subject to effective internal control over financial reporting.
- SEC Comments for Early Adopters—Comment letters from the SEC's Division of Corporation Finance ("Corp Fin") on revenue recognition standard disclosures thus far indicate the following trends: (i) early adopters have been asked to clarify considerations made for operationalizing different aspects of the standards3 , (ii) the SEC has been requesting more robust SAB 74 disclosures for periods ending December 31, 2016 for companies using the full retrospective method; and (iii) several companies have disclosed incorrect effective dates for the standard. The emphasis of the comments was on the adequacy of disclosure and seeking to understand how the company made judgments in applying the new principles-based standard.
The SEC stressed that it will monitor revenue-related disclosures carefully, and if companies have questions about the standard, Corp Fin is willing to work with them collaboratively to help resolve those issues.
PCAOB Auditing Standard 3101
In October 2017, the SEC unanimously approved4 the Public Company Accounting Oversight Board's ("PCAOB") proposal to adopt a new auditing standard, AS 3101, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and related amendments to other auditing standards (collectively, the "New Standard"). The New Standard will significantly revise the auditor's report by: (i) requiring disclosure of the communication of critical audit matters ("CAMs"), and (ii) implementing additional content requirements and formatting changes to improve the utility, organization and readability of auditor reports. A CAM is defined as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective, or complex auditor judgment. The New Standard includes guidance for auditors in determining whether a matter rises to the level of a CAM due to its involving especially challenging, subjective, or complex auditor judgment.
The changes other than communication of CAMs are effective for all audits relating to fiscal years ending on or after December 15, 2017. CAM requirements will be phased-in for large accelerated filers for audits relating to fiscal years ending on or after June 30, 2019, and for all other companies for audits relating to fiscal years ending on or after December 15, 2020. Auditors may voluntarily comply early. CAM requirements will not apply to audit reports of emerging growth companies ("EGCs"), certain brokers and dealers, investment companies other than business development companies and benefit plans, but will apply to audit reports of FPIs.
The New Standard will require an auditor's report to disclose any CAMs arising from the current period's audit, or to state that the auditor determined that there were no CAMs for that period. For any CAMs, the auditor must disclose in its report the principal considerations that led the auditor to determine that the matter is a CAM and how the CAM was addressed in the audit, and must refer to the relevant financial statement accounts or disclosures.
The PCAOB staff has released guidance, including an annotated example of the new auditor's report highlighting the key changes, followed by explanations5, to aid auditors in complying with the new standard.
In preparation for compliance, given the complexity and sensitivity of the issues involved, companies should consider taking the following steps:
- Begin working with auditors now—Start a dialogue with auditors with respect to how they expect to approach the CAM requirements in the context of their particular company, what matters may merit this designation and what disclosures the auditors would anticipate making in their auditor's reports.
- Establish CAM notification procedures—Establish a process for receiving timely notification from the auditors of any intention to disclose a CAM and the information that the auditor intends to include in its report about the matter. Once the New Standard is implemented, ensure sufficient time is allocated for the audit committee, other executives and legal counsel to discuss and review the auditor's report.
- Monitor Disclosures—Disclosure of a CAM by the auditor in its report could result in disclosure of original information, which may compel the company to provide its own disclosure. Management should pay close attention to any differences between the CAM disclosures in the auditor's report and management's disclosures in its filed documents concerning the same matters. In addition, given that the new auditor's report discussion will reflect the auditor's perspective, which is inherently different from management's perspective, management may wish to revise or supplement its own disclosures on a matter in order to ensure that an accurate and complete picture is disclosed.
- Consider Enhanced Disclosure—Companies with long-tenured auditors may consider enhanced disclosure addressing the benefits of having a long-term relationship with their auditor, such as institutional knowledge and higher quality audits, as well as how the audit committee monitors auditor independence.
Audit Committee Disclosures
In 2015, the SEC issued a concept release6 soliciting comments on possible revisions to existing disclosure requirements with respect to an audit committee's responsibilities for the oversight of independent auditors. There has been an increase in voluntary audit-related disclosures, which has helped establish the scope of audit committees' oversight role, and an overall trend towards more robust discussion of the role of the audit committee. According to an analysis by Ernst & Young LLP7 of the 2017 proxy statements of 75 Fortune 100 companies that filed proxy statements each year from 2012 to 2017, voluntary audit-related disclosures continued to trend upward in a number of areas: 56% of companies disclosed factors considered by the audit committee when assessing the qualifications and work quality of the external auditor (up from 48% in 2016 and 17% in 2012); 73% stated that the audit committee believed that the choice of external auditor was in the best interests of the company and/or the shareholders (up from 72% in 2016 and 3% in 2012); 87% explicitly stated that the audit committee is responsible for the appointment, compensation and oversight of the external auditor (up from 81% in 2016 and 45% in 2012); and 43% provided information about the reasons for changes in fees paid to the external auditor (up from 31% in 2016 and 9% in 2012) (under current SEC rules, companies are required to disclose fees paid to the external auditor, but are not required to discuss the reasons for any changes in fees).
Although no further action has been taken by the SEC in connection with the 2015 concept release, given the continued investor interest in audit committee disclosures, companies should consider improvements to audit committee communications and expansion of current disclosures.
Possible Updates to Risk Factor Disclosures
When reviewing risk factors for this reporting season, companies should consider:
- Cybersecurity—In light of recent cybersecurity breaches at several high-profile companies, as well as at the SEC itself, there is increasing recognition that cybersecurity poses both economic and security threats that can impact any company. SEC guidance8 notes that material cybersecurity risks must be disclosed to avoid potential incomplete or misleading disclosures and companies should carefully analyze whether they need new, revised or expanded cybersecurity disclosure.
- Climate Change and Sustainability—These issues have been receiving increased attention, and risk factor disclosure could be necessary to address the impact of existing or pending legislation on a company's business, as well as the effects of increasing public consciousness and activism related to climate change and sustainability issues. Potential changes in climate regulation could also pose specific risks to certain companies.
- Shareholder Activism—As companies become increasingly aware of the prevalence of activism and the potential downside of being a target, shareholder activism is being included as a risk factor in some companies' periodic reports. In the first half of 2017, 65 companies included such a risk factor, representing more than a fivefold increase from 2014. This disclosure can take the form of a stand-alone risk factor describing how the company's business could be impacted by the actions of activist shareholders (such as by causing the company to incur substantial costs, including litigation, diverting management attention and resources, or creating uncertainty that impacts retention of employees or customers) or adding shareholder activism to a list of factors that could hinder investment or other business activities and impact a company's stock price.
- Brexit—While the full effect of the United Kingdom's withdrawal from the EU may not be seen for several years, approximately 600 companies have disclosed Brexit-related risk factors in their Forms 10-K and 20-F filed between September 1, 2016, and April 30, 2017. Brexit has been referenced in risk factors on currency exchange rate risks, cross-border trade and labor, international operations risks and global economic conditions, and risks related to political and regulatory uncertainty. As Brexit negotiations progress, impacted companies should continue evaluating whether Brexit poses a material risk to their business, what level of Brexit-related disclosure is appropriate and whether any prior Brexit risk factor disclosures require updates.
Presentation of Non-GAAP Financial Information
2016 guidance from Corp Fin9 clarified the SEC's position on complying with key aspects of Regulation G and Item 10(e) of Regulation S-K relating to the use of non-GAAP financial information. Subject to limited exemptions10, FPIs are required to comply with Regulation G with respect to any public announcements of material information that contain non-GAAP financial measures and are subject to the requirements of Item 10(e) of Regulation S-K with respect to any filings under the Securities Act of 1933 (Securities Act), such as registration statements on Form F-1 or F-3, and the Securities Exchange Act of 1934 (Exchange Act), such as annual reports on Form 20-F. Because reports of FPIs on a Form 6-K are generally "furnished" rather than "filed" with the SEC, unless a Form 6-K is expressly designated as being "filed" or is incorporated by reference into a Securities Act registration statement or an annual report on Form 20-F, Form 6-Ks are not subject to the Item 10(e) "equal prominence" requirements or the related SEC guidance thereon.
Since this guidance was released, the SEC has issued numerous comment letters on non-GAAP measures directed at companies with improper disclosure (656 in the first half of 2017, compared to 429 in the first half of 2016). Some of the most common comments focus on the undue prominence of non-GAAP information, including lack of comparable GAAP metrics, or presentation of the non-GAAP metric ahead of the comparable GAAP number. Although the pace of comments on these issues has been declining, companies should continue to closely monitor their non-GAAP financial disclosures to ensure they are compliant with the requirements.
- XBRL Exhibits Now Required for IFRS Filers—FPIs that prepare their financial statements in accordance with IFRS are now required, beginning with annual reports on Form 20-F filed in 2018 relating to fiscal years ending on or after December 15, 2017, to provide a version of their financial statements in interactive data format using eXtensible Business Reporting Language ("XBRL") in addition to providing financial statements in their traditional format. Previously, FPIs could voluntarily file financial data in XBRL format, although they were not required to comply with XBRL reporting, because the SEC had not specified a taxonomy specifically applicable to IFRS.
- Inline XBRL—The SEC has not yet issued final rules following its proposed rules that would require companies to provide their financial statements in the Inline XBRL format. Inline XBRL allows filings to be made that integrate XBRL data directly into HTML filings, rather than requiring a copy of the filing to be attached as a separate XBRL exhibit11. Currently, public reporting companies can voluntarily file their structured financial statement data in inline XBRL format.
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1 Available www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176164076069&acceptedDisclaimer=true.
2 See, for example, speeches by Wesley Bricker, Chief Accountant of the SEC, available here and here; and Sagar Teotia, Deputy Chief Accountant of the SEC, available here.
3 The SEC focused its comments on the following areas: (i) accounting for sources of variable consideration, including refund liabilities and reassessment of variable consideration; (ii) accounting for rebates paid to customers; (iii) disclosing the nature of changes in contract balances, including how the timing of payments and satisfaction of performance obligations impact contract assets and liabilities; (iv) substantiating the method used to recognize revenue on over-time performance obligations; (v) determining that costs obtaining a contract are incremental, and thus eligible to be capitalized; (vi) determining of the appropriate amortization period for commissions costs, with consideration to contract renewals; and (vii) disclosing remaining unsatisfied performance obligations.
4 The SEC's order can be found here.
5 Available at pcaobus.org/Standards/Documents/Auditors-Report-Staff-Guidance.pdf. The guidance also notes that questions pertaining to AS 3101 and related amendments may be directed to the staff in the PCAOB's Office of the Chief Auditor via the standards' help line at (202) 591-4395 or may be submitted through a web form.
6 The concept release can be found here.
7 The Ernst & Young report can be found ey.com/Publication/vwLUAssets/ey-audit-committee-reporting-to-shareholders-in-2017/%24FILE/ey-audit-committee-reporting-to-shareholders-in-2017.pdf. A review of S&P 500 companies' proxy statements conducted by The Center for Audit Quality (CAQ) and Audit Analytics revealed similar trends. That survey is available here (thecaq.org/2017-audit-committee-transparency-barometer).
8 The SEC's Disclosure Topic 2 is available here.
9 See Non-GAAP Financial Measures Compliance and Disclosure Interpretations (C&DIs), Questions 100.01–100.04, 102.01–102.03, 102.05, 102.07, 102.10, 102.11 and 103.02
10 Item 10(e) permits FPIs to use a non-GAAP financial measure that it is otherwise prohibited under Item 10(e) if: (1) the non-GAAP financial measure relates to the GAAP used in the FPI's primary financial statements included in its filing with the SEC; (2) the non-GAAP financial measure is required or expressly permitted by the standard-setter that is responsible for establishing the GAAP used in such financial statements; and (3) the non-GAAP financial measure is included in the annual report prepared by the FPI for use in the home jurisdiction or for distribution to its security holders. Regulation G does not apply to a disclosure of a non-GAAP financial measure that is made by or on behalf of an FPI if the following conditions are satisfied: (1) the securities of the FPI are listed or quoted on a securities exchange or inter-dealer quotation system outside the US; (2) the non-GAAP financial measure is not derived from or based on a measure calculated and presented in accordance with US GAAP; and (3) the disclosure is made by or on behalf of the FPI outside the US, or is included in a written communication that is released by or on behalf of the FPI outside the US. The exemption applies notwithstanding the existence of one or more of the following: (1) a written communication is released in the US, as well as outside the US, so long as the communication is released in the US contemporaneously with or after the release outside the US and is not otherwise targeted at persons located in the US; (2) foreign journalists, US journalists or other third parties have access to the information; (3) the information appears on one or more websites maintained by the FPI, so long as the websites, taken together, are not available exclusively to, or targeted at, persons located in the US; or (4) following the disclosure or release of the information outside the US, the information is included in a submission by the FPI to the SEC made under cover of a Form 6-K.
11 The SEC's order can be found www.sec.gov/rules/exorders/2016/34-78041.pdf
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