Tag Archive: accounting

Boardroom Implications for the New Revenue Recognition Standard

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It’s all a matter of time—at least when it comes to recognizing revenue at public companies. The Financial Accounting Standards Boards (FASB) and the International Accounting Standards Board (IASB) in 2014 developed an accounting rule that is set to change how companies approach revenue recognition. The rules, available here, go into effect for public companies with fiscal years beginning after December 15, 2017, and will have major consequences for financial reporting in many industries.

To address the executive-compensation implications of the revenue recognition standard, NACD, executive compensation advisory firm Farient Advisors, and law firm Katten Muchin Rosenman cohosted a meeting of the Compensation Committee Chair Advisory Council on April 4, 2017. During that meeting and its related teleconference, Fortune 500 companies’ compensation committee chairs came together to discuss leading practices and key considerations related to the impact of the new revenue recognition standard. Jose R. Rodriguez, partner in charge and executive director of KPMG’s Audit Committee Institute, joined council delegates for the discussion. The meeting was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.

About the New Standard

A 2014 press release from FASB explained the rationale behind the new standard, noting that revenue is an important metric that investors use when trying to understand how a company has performed and its potential for future performance. Previous accounting standards from the International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP), however, were somewhat at odds, according to the press release. Those inconsistencies between IFRS and GAAP meant that different industries that had very similar types of transactions were accounting for revenue in sometimes very different ways. The revenue recognition standard aims to bring more consistency to accounting done for similar types of transactions.

A key part of the new standard is that revenue can only be recognized—among other requirements—once customers actually benefit from the services or goods that the company has already provided them, as noted in the Journal of Accountancy. The Journal continues that if a company provides a customer with goods or services over time, such as a yearlong service contract, the company can recognize revenue as the customer receives benefits in the contract period. For more information on the standard, see this four-page overview and in-depth guide from KPMG.

Key Questions Directors Should Ask
While the level of disruption that the revenue recognition standard will cause varies by industry and company, four questions important for all boards emerged from the Advisory Council meeting:

  1. How will the new revenue recognition standard affect our company specifically?
  2. Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?
  3. How will compensation plans be affected?
  4. How will our disclosures need to change?

How will the new revenue recognition standard affect our company specifically?

Impact of the new standard will vary widely for a few reasons.  First, sales and service contracts can differ significantly depending on industry—consumer products, health care, manufacturing, IT, and so on. Additionally, the types of sales contracts—and, therefore, the way revenue is recognized—can differ even within a single company, depending on the types of products and services sold. The company’s suppliers and vendors are a third factor influencing change: “Even if the standard doesn’t affect our core business, we could be working with partners and vendors that are affected,” said one director. “One of my companies has hundreds of millions of dollars in service contracts,” another delegate commented. “Our whole income statement is going to change.”

“Every company’s finance department has been looking at this,” Rodriguez said. “Ask your CFO to brief the board about the major income-statement changes that will occur for the company. What will be affected across all revenue lines? How are key reporting processes changing to accommodate the new standard?”

Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?

Rodriguez said that a pitfall for many companies is not investing enough time upfront in ensuring compliance with the new standard. “Some companies are finding that this is a bigger lift than they thought [to adopt the standard], so they are having to scramble to coordinate.”

Rodriguez shared several steps that companies can take to prepare:

  • Forming cross-functional task forces that integrate finance, accounting, IT, legal, and HR to ensure activities are coordinated.
  • Designating a revenue group to analyze contracts in different regions and locations to ensure all jurisdictions are covered.
  • Devoting sufficient time and resources to make required changes and upgrades to IT and reporting systems, especially in companies that have multiple legacy systems in place.
  • Developing a communication plan to explain to affected employees (especially on sales teams) how the changes will impact their work. “This is actually a huge change-management process,” one council delegate said. “You have to re-train sales people about how they design contracts and agreements.”

How will compensation plans be affected?

Council delegates agreed that compensation committees need to have a clear understanding of how the new standard will affect the key metrics that drive compensation for all levels of employees, from rank-and-file to the C-suite (For more information on incentives and risk taking, please see NACD’s brief, Incentives and Risk Taking). Changes to the way revenue is reported could have a major impact on the numbers used in annual bonus plans, as well as on long-term incentive plans that are already in place.  “With multi-year incentive plans that are in mid-cycle, the effects could be quite complex,” said Dayna L. Harris, partner at Farient Advisors. “For compensation committees, it will be important to ensure incentives are paid out in a way that’s appropriate to what was originally intended to keep consistent with the compensation philosophy the board has devised.”

Compensation committees can ask the following questions:

  • Is the company adopting the new standard prospectively or retrospectively, and how will that change our revenue numbers?
  • Which compensation plans will be affected beyond the CEO and named executive officers (e.g., sales staff at multiple levels)?
  • What do we anticipate will be the impact on the peer groups we use to benchmark executive compensation?

Rodriguez suggested that compensation committees schedule a briefing session with the external auditor, audit committee chair, CFO, and compensation consultant to discuss these and other questions. Members of the audit committee can also be invited to the briefing.

How will our disclosures need to change?

As noted in the Report of the NACD Blue Ribbon Commission on Board-Shareholder Communications (p. 17), “Directors have a general responsibility to oversee the company’s disclosure programs. They also need to take special care in reviewing certain specific disclosures—notably the company’s regular financial disclosures, such as the proxy statement, 10-Ks, 10-Qs, and 8-Ks, as well as any securities registration statements filed with the [U.S. Securities and Exchange Commission (SEC)].” A director observed, “In addition to the changes to reports, we need a strategy to communicate with our major investors. They will be asking questions about why compensation payouts appear to have ‘changed.’”

The SEC will task review teams with scrutinizing public companies’ financial disclosures, 10-Ks especially, to determine if the statements include information on the revenue recognition standard, Bloomberg BNA reports. Mark Kronforst, chief accountant of the SEC’s Division of Corporation Finance, told Bloomberg BNA, “I don’t think that we will be shy about issuing comments if we don’t see the disclosures.”

“Accounting changes should not interfere with a good business decision, performance outcomes on incentives, and appropriate incentive payouts,” said Harris. “With an accounting change in the middle of a performance period, compensation committees will need to provide full transparency into incentive payout decisions, especially if they appear larger than expected under the new accounting. There’s a whole list of ramifications if that transparency is lacking, from proxy advisors’ criticisms to activist investors’ reproach.”

And there’s no time like the present to understand those ramifications and ensure that management stays on top of key milestones.

Surviving a Restatement: Ten Pitfalls to Avoid

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Bradley J. Bondi

In 2013, the Securities and Exchange Commission (SEC) formed the Financial Reporting and Audit Task Force to detect fraudulent or improper financial reporting, and since then has brought more than 300 issuer reporting and disclosure cases. One area of focus is a company’s restatement of financial statements and company actions connected with the restatement.

The audit committee plays an important role in navigating a restatement—from investigating errors and their origins to overseeing the restatement process. A mishandled restatement can lead to a prolonged SEC investigation, increased exposure to liability in civil litigation, loss of confidence by lenders, and potential delisting by an exchange.

To survive a restatement, audit committees should avoid the following pitfalls.

  1. Engaging inexperienced counsel and advisors for investigation. A restatement is commonly precipitated or accompanied by an independent investigation overseen by the audit committee. Proper investigation of accounting errors is critically important, and inexperienced counsel could fumble the investigation—and restatement—from the beginning by incorrectly scoping the investigation, failing to obtain the relevant information, or losing credibility with regulators.Four qualities are essential for counsel tasked with conducting independent investigations into accounting errors.
    • First and foremost, counsel must be independent from management. Counsel must not have done prior work for the company or have any significant ties to the management.
    • Second, counsel should be experienced with conducting independent investigations for boards and board committees.
    • Third, counsel should understand accounting and disclosure issues, and have experience with the nuances of accounting investigations. Nonetheless, counsel should also be expected to engage experienced, outside forensic accountants to aid in the investigation.
    • Finally, counsel and their team must be respected by regulators and have a reputation of conducting appropriately thorough and complete investigations.
  2. Forming a special committee when the audit committee might suffice. While a special committee might be necessary in certain rare investigative circumstances, the board should avoid forming one if its audit committee is composed of independent and disinterested directors who are suited for the task. A special committee must be disbanded at some point (usually once the investigation is completed and before the restatement process begins), and the disbanding could become a complicated news item.In contrast, if the audit committee oversees the investigation, then, once the investigation is complete, the audit committee can pivot back to its normal role, which would include overseeing the actual restatement process. Investigations overseen by the audit committee also benefit from the positive relationship that the chair usually has with the company’s outside accounting firm.
  3. The run-away or open-ended investigation. Incorrectly scoped investigations can lead to burdensome legal fees, continued business disruptions, and inadequate investigatory results. Importantly, an independent investigation does not mean that counsel is independent of the client. The “client”—i.e., the audit committee—should discuss the scope and budget of the investigation with outside counsel and together tailor the investigation to the circumstances.
  4. Failing to keep auditors apprised of the investigation and errors found. Keeping auditors in the dark regarding the progress and results of the investigation could delay the restatement and result in the resignation of the auditor. The audit committee’s counsel should maintain a good relationship with the company’s auditors and keep them appropriately apprised of the investigation through periodic calls or meetings. If the auditor is conducting a shadow investigation, this dialogue will aid it in confirming that appropriate remedial measures occur (e.g., a restatement) and that the company’s professional practice group, risk, or forensic functions are informed.
  5. Indecisiveness and inability to reach conclusions. Indecisiveness can delay the investigative process, allow misconduct to persist unchecked, and create the damaging perception among investors, regulators, and the plaintiffs’ bar that the company’s problems extend beyond financial reporting. To minimize these effects and maximize potential cooperation credit, the audit committee, in conjunction with counsel, should reach conclusions concerning accounting errors as promptly as possible.
  6. Waiting too long to deal with wrongdoers. Once an investigation has made conclusions about individual conduct, any wrongdoers should be disciplined and, when necessary, removed from their position—either by terminating their employment or forcing their resignation. When determining cooperation credit, the SEC and Department of Justice (DOJ) will focus on whether the responsible individuals are still with the company, and, if so, whether they are still in the same positions. Removing wrongdoers clears the path for the audit committee to share investigation results with management so it can correct errors and implement remedial actions.
  7. Not self-reporting findings to the SEC. Whenever a restatement is made, the SEC will inquire whether the underlying accounting error was intentional. It also may inquire about the root cause of the error; how, when, and by whom it was discovered; the reporting periods impacted; how the error is being corrected; and the impact on the company’s financial control environment.The SEC expects a registrant to voluntarily share the results of its investigation. If the SEC learns of misconduct from a source other than the company, or if the company fails to make its investigative findings available to the SEC, the company could become ineligible for cooperation credit associated with self-reporting. The incentives in the SEC’s whistleblower bounty program provide additional motivation for companies to be proactive in promptly and thoroughly self-reporting.
  8. Audit committee micromanagement of the restatement. Management is ultimately responsible for financial reporting, and the audit committee must maintain its supervisory role and refrain from stepping into the role of management to correct errors. Once an accounting error has been identified, it must be assessed to determine whether the affected financial statements are materially misstated. Quantifying the errors is a critical step in determining materiality, and Staff Accounting Bulletin (SAB) 108 contains guidance.The audit committee counsel should assist management, as appropriate, in understanding the nature of the errors and how to correct them. This is also a good time for the audit committee to request that management re-evaluate the enterprise-wide risk assessment process and the design and effectiveness of internal controls over financial reporting.
  9. Failing to remediate. If accounting errors lead to a restatement, then the company may have deficiencies in internal controls. In addition, inadequate or ineffective internal controls often raise issues that should be investigated by the audit committee relating to the certifications by the CEO, CFO, and outside auditor. Failure to remediate gaps in internal controls and to address certification issues provides the opportunity for additional misconduct and could damage the company’s credibility with regulators. The SEC in particular will focus on what steps the company took upon learning of the misconduct or control weaknesses, whether the company took immediate corrective action, and what new and more effective internal controls or procedures the company plans to adopt to prevent a recurrence. When documenting remedial actions, the company should avoid characterizing them as other than what they are—improvements in internal control procedures. This neutral approach might help to mitigate potentially harmful collateral impacts in civil litigation.
  10. Creating an unnecessarily detailed SAB-99 materiality analysis. Shareholder class actions inevitably follow restatements. The audit committee should resist the impulse to create an unnecessarily detailed SAB-99 materiality analysis that will be discoverable in litigation against the company and could provide a roadmap for private plaintiffs. To the extent additional details regarding the materiality analysis are necessary, oral discussions with auditors are often sufficient.

Bradley J. Bondi is a partner with Cahill Gordon & Reindel LLP. He advises financial institutions and global corporations, boards of directors, audit committees, and officers and directors of publicly-held companies in significant corporate and securities matters, with particular emphasis on internal investigations and enforcement challenges, including those related to restatements. Michael D. Wheatley, a litigation associate at Cahill, assisted with this article.

Jonathan T. Marks, CPA, CFE, a managing director with Navigant Consulting, Inc. in its global disputes and investigations practice, and Michael Pesce, an associate director with Navigant, contributed to this article.

Michael Woodford: CEO Turned Whistleblower

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Today marked an anniversary for former Olympus Corp. President and CEO Michael Woodford: the day he was fired from the camera and medical products manufacturer. What brought him to that day is a series of events that kicked off when Woodford had no choice but to blow the whistle on his own company after discovering a serious fraud.

Before being asked to assume the role of president–which he very gladly accepted–Woodford had a 30-year career at Olympus. Nevertheless, he knew that he wanted to make changes within the company, and soon into his presidency, an article in a business magazine titled Facta, ran an article about odd acquisitions Olympus had made and the high fees it paid a management consultancy.

When Woodford raised the issue with two managers in Japan about the article, he was told that CEO Tsuyoshi Kikukawa had advised them not to bring it up to Woodford. After demanding to speak to Kikukawa and Executive Vice President Hisashi Mori about the questionable acquisitions, Mori told Woodford that he worked for Kikukawa and that he was loyal to him.

Seeing no other option to raise the issue, Woodford wrote letters to the Olympus board and management and copied their auditor, Ernst & Young, on two of the letters. Instead of addressing the issue of the dubious acquisitions, the board unanimously ousted Woodford.

For more on the Olympus fraud, read an NACD Directorship magazine interview with Woodford from the March/April issue: http://www.directorship.com/exposing-fraud-at-any-cost/.