SEC Approves PCAOB’s Auditing Standard No. 18, Related Parties

On October 21, 2014, the SEC approved Auditing Standard No. 18, Related Parties of the Public Company Accounting Oversight Board (PCAOB), as well as amendments to certain PCAOB auditing standards regarding significant unusual transactions and other related amendments to PCAOB auditing standards. Auditing Standard No. 18 supersedes the PCAOB’s auditing standard AU sec. 334, Related Parties, which was issued in 1983. Auditing Standard No. 18 is designed to “strengthen auditor performance requirements for identifying, assessing, and responding to the risks of material misstatement associated with a company’s relationships and transactions with its related parties.”

The new auditing standard requires the auditor to:

  • Perform specific procedures to obtain an understanding of the nature of the relationships between the company and its related parties and of the terms and business purposes, if any, of transactions involving related parties.
  • Evaluate whether the company has properly identified its related parties and relationships and related party transactions by testing the accuracy and completeness of management’s identification, taking into account information gathered during the audit.
  • Perform specific procedures if the auditor determines that a related party or relationship or transaction with a related party previously undisclosed to the auditor exists.
  • Perform specific procedures regarding each related party transaction that is either required to be disclosed in the financial statements or determined to be a significant risk (i.e., a “risk of material misstatement that requires special audit consideration”).
  • Communicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties, and other significant matters arising from the audit regarding the company’s relationships and transactions with related parties.

The new auditing standard and amendments are effective for audits of financial statements for fiscal years beginning on or after December 15, 2014.

PCAOB Adopts New Auditing Standard No. 18, Related Parties

On June 10, 2014, the Public Company Accounting Oversight Board (PCAOB) adopted Auditing Standard No. 18, Related Parties, as well as amendments to certain PCAOB auditing standards regarding significant unusual transactions and other related amendments to PCAOB auditing standards. Auditing Standard No. 18 superseded the PCAOB’s auditing standard AU sec. 334, Related Parties, which was issued in 1983. The new auditing standard and amendments will be effective, subject to approval by the SEC, for audits of financial statements for fiscal years beginning on or after December 15, 2014.

Generally, under the new standard, auditors will be required to engage in a detailed analysis of transactions with related parties and inquire of management regarding:

a.         the names of the company’s related parties during the period under audit, including changes from the prior period;

b.         background information concerning the related parties (for example, physical location, industry, size, and extent of operations);

c.         the nature of any relationships, including ownership structure, between the company and its related parties;

d.         the transactions entered into, modified or terminated, with its related parties during the period under audit and the terms and business purposes (or the lack thereof) of such transactions;

e.         the business purpose for entering into a transaction with a related party versus an unrelated party;

 f.         any related party transactions that have not been authorized and approved in accordance with the company’s established policies or procedures regarding the authorization and approval of transactions with related parties; and

 g.        any related party transactions for which exceptions to the company’s established policies or procedures were granted and the reasons for granting those exceptions.

In addition to obtaining information regarding related party transactions from management, auditors will be required to inquire of others within the company regarding their knowledge of the foregoing matters. The auditor is expected to identify others within the company to whom inquiries should be directed, and determine the extent of such inquires, by considering whether such individuals are likely to have knowledge regarding such matters as:

a.         the company’s related parties or relationships or transactions with related parties;

b.         the company’s controls over relationships or transactions with related parties; and

c.         the existence of related parties or relationships or transactions with related parties previously undisclosed to the auditor.

The audit committee, or its chair, will also be questioned by the auditor regarding:

a.         the audit committee’s understanding of the company’s relationships and transactions with related parties that are significant to the company; and

b.         whether any member of the audit committee has concerns regarding relationships or transactions with related parties and, if so, the substance of those concerns.

The auditor will be required to communicate to the audit committee the results of the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties, as well as other significant matters arising from the audit regarding the company’s relationships and transactions with related parties including, but not limited to:

a.         the identification of related parties or relationships or transactions with related parties that were previously undisclosed to the auditor;

b.         the identification of significant related party transactions that have not been authorized or approved in accordance with the company’s established policies or procedures;

c.         the identification of significant related party transactions for which exceptions to the company’s established policies or procedures were granted;

d.         the inclusion of a statement in the financial statements that a transaction with a related party was conducted on terms equivalent to those prevailing in an arm’s-length transaction and the evidence obtained by the auditor to support or contradict such an assertion; and

e.         the identification of significant related party transactions that appear to the auditor to lack a business purpose.

New Revenue Recognition Standard Adopted

The Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) issued jointly written revenue recognition standards on May 28, 2014.  The new guidance standardizes how companies should recognize revenue in financial statements under both U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). This new revenue recognition standard will replace most of the current revenue recognition guidance, including much of the industry-specific guidance that exists under GAAP today.

 The new guidance aims to:

 1.  Remove inconsistencies and weaknesses in revenue requirements.

 2.  Provide a more robust framework for addressing revenue issues.

 3. Improve comparability of revenue recognition practices across entities, industries,  jurisdictions, and capital markets.

  4.Provide more useful information to users of financial statements through improved disclosure requirements.

  5.Simplify the preparation of financial statements by reducing the numberof requirements to which an entity must refer.

 The core principle of the new guidance is that “an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” The guidance contains the following five step process:

           Step 1: Identify the contract(s) with a customer.

           Step 2: Identify the performance obligations in the contract.

           Step 3: Determine the transaction price.

           Step 4: Allocate the transaction price to the performance obligations in the contract.

           Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.

 Public companies using GAAP will be required to apply the new revenue recognition standard for annual reporting periods beginning after December 15, 2016, including interim reporting periods therein. Public companies are not permitted to apply this new standard early.

 

Update to Nasdaq Proposed Rule Relating to Internal Audit Function

As we discussed previously in our recent Up to Date  issue, the Nasdaq Stock Market recently proposed a rule that would require Nasdaq listed companies to establish and maintain an internal audit function. The proposal provides that each company listed on Nasdaq on or before June 30, 2013 establish an internal audit function by no later than December 31, 2013. Companies listed after June 30, 2013 would be required to estab­lish an internal audit function prior to listing. The SEC was scheduled to approve or disapprove such proposed rule on or before April 22, 2013. However, on April 18, 2013, the SEC designated June 6, 2013, as the date by which the SEC should either approve or disapprove or institute proceedings to determine whether to disapprove the proposed rule change.

ISS Releases 2013 Updates to Proxy Voting Guidelines

On November 16, 2012, the ISS released its final 2013 Updates to its U.S. Corporate Governance Policy. ISS also will release a FAQ document in December 2012 for further guidance. The Updates will be effective for meetings on or after February 1, 2013.

Highlights of the 2013 Updates include:

• Stock Pledges/Hedges: In response to comments, ISS will be taking a case-by-case approach in determining whether pledging of company shares rises to a level of serious concern for shareholders. Also in response to comments, ISS is including significant pledging of company stock as a failure of risk oversight and thus considered a governance failure for which directors should be held accountable (rather than communicating concern through a say-on-pay recommendation as originally proposed). However, hedging of company stock, through covered call, collar or other derivative transactions, will be considered a problematic practice warranting a negative voting recommendation on the election of directors.

• Failure to Act on Shareholder Proposals: ISS will keep its current policy in effect for 2013, with some modifications: ISS will recommend a negative vote for individual directors, committee members or the entire board, if the board failed to act on a shareholder proposal that received the support of either (i) a majority of the outstanding shares or (ii) a majority of the votes cast in the last year and one of the two previous years. Beginning in 2014, ISS will recommend a vote negative vote if the board failed to act on a shareholder proposal that received the support of a majority of shares cast in the previous year. Under the Update, the ISS now has the flexibility to recommend a negative vote on members of the board as deemed appropriate, not necessarily the full board. The ISS also has included more guidance on the case-by-case examination of the sufficiency of a company’s action in response to a majority-supported shareholder proposal.

• Peer Groups: The new methodology incorporates information from companies’ self-selected pay benchmarking peer groups in order to identify and prioritize Global Industry Classification Standard (GICS) industry groups beyond the subject company’s own GICS classification. The methodology draws peers from the subject company’s GICS group as well as from GICS groups represented in the company’s peer group, while maintaining the approximate proportions of these industries in the final peer group where possible. The methodology additionally focuses initially at an 8-digit GICS resolution to identify peers that are more closely related in terms of industry. Finally, when selecting peers, the methodology prioritizes peers that maintain the company near the median of the peer group, are in the subject company’s peer group, and that have chosen the subject company as a peer. The peer group methodology maintains its focus on identifying companies that are reasonably similar to the subject company in terms of industry profile, size, and market capitalization. Other changes to the peer group methodology include using slightly relaxed size requirements, especially at very small and very large companies, and using revenue instead of assets for certain financial companies.

• Realizable Pay: Realizable pay is being added to the research report for large capitalization companies. Realizable pay will consist of the sum of relevant cash and equity-based grants and awards made during a specified performance period being measured, based on equity award values for actual earned awards, or target values for ongoing awards, calculated using the stock price at the end of the performance measurement period. Stock options or stock appreciation rights will be revalued using the remaining term and updated assumptions, as of the performance period, using the Black-Scholes Option Pricing model. The realizable pay consideration may mitigate or exacerbate the CEO’s pay for performance concerns.

• Voting on “Say on Golden Parachute” Proposals: The Update will (i) include existing change-in-control arrangements maintained with named executive officers rather than focusing only on new or extended arrangements and (ii) place further scrutiny on multiple legacy problematic features (e.g. single trigger equity, tax gross –ups, etc.) in change in control agreements.

SEC Provides Further Relief in the Wake of Hurricane Sandy

On November 14, 2012, the Securities and Exchange Commission announced  the issuance of an order providing regulatory relief to publicly traded companies, investment companies, accountants, transfer agents and others affected by Hurricane Sandy.  To address compliance issues caused by the hurricane and its aftermath, the order conditionally exempts affected persons from the requirements of the federal securities laws with respect to:  (i) Exchange Act filing requirements for the period from October 29, 2012 to November 20, 2012 (and imposes a new deadline of November 21, 2012 for missed filings); (ii) proxy and information statement delivery requirements for companies attempting to deliver materials to affected areas; (iii) Investment Company Act requirements for the transmittal to shareholders in affected areas of annual and semi-annual reports during the period of  October 29, 2012 to November 20, 2012; (iv) transfer agent compliance with certain Exchange Act requirements for the period from October 29, 2012 to December 1, 2012; and (v) auditor independence requirements as they relate to reconstruction of previously existing accounting records of clients. 

The Commission has also directed the SEC staff generally to take the position that filings subject to and filed in compliance with the regulatory relief granted by the order be considered timely for the purposes of eligibility to use Form S-3 (and well-known seasoned issuer status, which is based in part on Form S-3 eligibility), and to consider companies making such filings to be current in their Exchange Act reporting requirements for purposes of Form S-3 and Form S-8 eligibility and availability of current public information under the Securities Act Rule 144.  The Commission has also directed the staff to take similar positions with respect to various investment company and investment adviser filing requirements.

Financial Reporting Manual Has Been Updated

Yesterday, the SEC posted its updated Financial Reporting Manual, which was revised as of June 30, 2012 (search for the date tag, “Last updated: 6/30/2012,” to view the changes).   The SEC added a note regarding Title I of the Jumpstart Our Business Startups Act (JOBS Act) to the manual, but the note did not add any new guidance regarding the financial reporting and other requirements for emerging growth companies and just referred to the existing SEC guidance regarding the JOBS Act at http://www.sec.gov/divisions/corpfin/cfjobsact.shtml.

The remaining revisions to the Financial Reporting Manual clarify the following matters:

  • proxy statement requirements for the disposal of a business;
  • auditor association with amounts from inception in development stage companies;
  • application of PCAOB auditor requirements in connection with  a reverse merger; and
  • reporting requirements in a reverse acquisition with a domestic registrant that is not a shell company.

New PCAOB Standard for Communications with Audit Committees

On August 15, 2012, the Public Company Accounting Oversight Board (PCAOB) adopted Auditing Standard No. 16, Communications with Audit Committees.  This standard sets forth matters that the auditor should discuss with audit committees prior to the issuance of the auditor’s report.  Standard No. 16 supersedes PCAOB’s interim standards AU sec. 380, Communication with Audit Committees, and AU sec. 310, Appointment of the Independent Auditor.  The PCAOB expects Standard No. 16, which is subject to the SEC approval, to be effective for audits of fiscal years beginning on or after December 15, 2012.  In addition, the PCAOB will request, subject to the SEC’s separate determination, that this standard apply to the audits of emerging growth companies established under the JOBS Act.

Standard No. 16 enhances certain existing auditor communication requirements and adds new communication requirements that provide the audit committee with additional information about the audit, including the following:

  • an overview of the overall audit strategy, including timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy or identified risks;
  • information about the nature and extent of specialized skill or knowledge needed in the audit, the extent of the planned use of internal auditors, company personnel or other third parties, and other independent public accounting firms, or other persons not employed by the auditor that are involved in the audit;
  • the basis for the auditor’s determination that he or she can serve as principal auditor, if significant parts of the audit will be performed by other auditors;
  • situations in which the auditor identified a concern regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective and might have a significant effect on future financial reporting;
  • difficult or contentious matters for which the auditor consulted outside the engagement team;
  • the auditor’s evaluation of going concern;
  • departure from the auditor’s standard report; and
  • other matters arising from the audit that are significant to the oversight of the company’s financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor’s attention during the audit.

PCAOB Issues Release About its Inspection Process to Assist Audit Committees

On August 1, 2012, the Public Company Accounting Oversight Board (PCAOB) issued Release No. 2012-003, Information for Audit Committees about the PCAOB Inspection Process.  This release was issued to assist audit committees in understanding the PCAOB’s inspection process of audit firms and gathering useful information about those inspections.  The release also includes certain questions an audit committee may want to ask their audit firm about the PCAOB inspection.  These questions include the following:

  • Was the company’s audit selected for PCAOB inspection?
  • Did the PCAOB identify deficiencies in other audits that involved auditing or accounting issues similar to issues presented in the company’s audit?
  • What were the audit firm’s responses to the PCAOB findings?
  • What is the audit firm changing to address any quality control issues?
  • What is the progress of the quality control remediation process?
  • What are the inspected years about which the PCAOB has made a final determination about the audit firm’s remediation efforts and what is the nature of that determination?
  • Has the PCAOB provided initial indications that the audit firm may not have sufficiently remediated any items?

The release can be obtained from the following link:

http://pcaobus.org/Inspections/Documents/Inspection_Information_for_Audit_Committees.pdf

Financial Accounting Standards Board Shelves Efforts to Revise Loss Contingency Disclosure Rules (Finally!)

On July 9, 2012, the Financial Accounting Standards Board (FASB) finally decided to shelve its efforts to revise the disclosure requirements for loss contingencies under FASB Accounting Standards Codification™ Topic 450.  Since 2007, the FASB had been considering expanding and enhancing the disclosures required with respect to loss contingencies to address concerns of investors and other users of financial statements that the existing disclosures do not provide enough information, soon enough, to help them evaluate the possible outcome of a loss contingency, such as a lawsuit or liability for an environmental clean-up.  The proposed changes would have lowered the threshold for reporting loss contingencies to include certain remote contingencies and would have required additional qualitative and quantitative disclosures.   

There was overwhelming opposition to the proposed changes.  Much of the opposition related to concerns that the additional financial statement disclosure would prejudice reporting company’s efforts to defend against lawsuits and other claims.  In addition, some users of financial statements commented that changes were unnecessary because the real issue is not the absence of a disclosure requirement, but rather the lack of compliance with the existing disclosure requirements. 

While FASB may have decided to shelve its current efforts to revise the disclosure requirements for certain loss contingencies, reporting companies should nonetheless remain vigilant about their reporting of loss contingencies, especially since the SEC continues to comment on loss contingency disclosures.