Now that the U.S. Securities and Exchange Commission (SEC) has released an order approving the Public Company Accounting Oversight Board’s (PCAOB) new rules on the auditor’s report, what items should the audit committee and shareholders look for there?
The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, released by the PCAOB June 1 and approved by the SEC October 23, contains five main changes, including one that requires careful reading between the lines.
As NACD summarized in a recent brief to its members, the new PCAOB standard will require auditors to:
Standardize the format of the auditor’s report, placing the auditor’s opinion in the first section of the auditor’s report, followed by the basis for the opinion. This change makes the auditor’s opinion easier to find in the auditor’s report.
Disclose the auditor’s tenure, stating when the audit firm began its current service to the company. This new requirement comes in lieu of limiting audit firm tenure through mandatory audit firm rotation, a concept NACD and others have rejected in the past.
State that the auditor is required to be “independent.” This requirement is intended to strengthen shareholder confidence in the auditor’s report, possibly as an offset to the tenure disclosure, if it reveals that the auditor has been serving the client for more than a quarter century, for example.
State that the financial statements are free from material misstatements “whether due to error or fraud.” This change aligns with other recent or pending regulations on error vs. fraud, such as the proposed executive pay clawbacks rule still pending under Dodd-Frank, which mandated disgorgement of performance-based pay after financial restatements even if restatements were due to error rather than to fraud.
Report on critical audit matters (CAMs), defined as “matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.” A number of commenters said that the CAMs mandate is “redundant” with existing reports, which already reveal the required information. See for example NACD’s comment to the PCAOB or State Street’s comment.
The key letter in CAM is M, for material. For those who may wonder what may be “material” to the financial statements, join the club. The SEC has still never defined this term, leaving this job to the courts as they interpret federal securities laws.
The going definition of “material” is more than 40 years old. The SEC release cites TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976), in which the U.S. Supreme Court states that a fact is material if there is “a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” In that same case, the Supreme Court said that determining materiality requires “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him . . .”
Such wisdom is not lost on the PCAOB and SEC. In its June 1 release, the PCAOB cites as CAMs the auditor’s evaluation of the company’s “goodwill impairment assessment” and, more broadly, the auditor’s assessment of the company’s “ability to continue as a going concern.” These two examples are material to financial statements. By contrast, the following two examples are not material to the financial statement: a loss contingency already discussed with the audit committee and “determined to be remote;” and a “potential illegal act.”
Audit committees need to ensure that their auditors are in a position to recognize critical audit matters, and to learn from those matters. But this does not mean looking for problems where there are none.
Significantly, SEC Chair Jay Clayton had this to say about the new standard:
“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.
I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”
To Chairman Clayton’s point, the SEC makes this point in its approval order:
“As the [PCAOB] notes, in order to succeed, any claim based on these new statements would have to establish all of the elements of the relevant cause of action (e.g., when applicable, scienter, loss causation, and reliance). Moreover, as discussed above, CAMs could be used to defend as well as initiate litigation. …However, because of these risks and other concerns expressed by commenters, we expect the Board to monitor the Proposed Rules after implementation for any unintended consequences.“ (SEC approval order , pp. 32–33)
Shareholders and others should read between the lines of auditor’s report (appreciating the regulations behind it), but they should not expect auditors to “look under rocks” to find problems. That is the job of management, internal control, and the audit committee. The auditor’s job is to focus on the audit of the financial statements to ensure that they conform to generally accepted accounting principles (GAAP). Given the complexity of GAAP, that is a big enough job as it is.
The CAM standard can’t be mastered overnight and won’t be required any time soon. Auditors of large accelerated filers will not be required to adopt CAM changes until audits of fiscal years ending on or after June 30, 2019—with audits of all remaining filers to adopt CAM changes for fiscal years ending on or after December 15, 2020.
By contrast, all the other changes will apply to audits of fiscal years ending on or after December 15, 2017. That mean, essentially that auditors must work on this immediately, since most companies they are working with right now have fiscal years ending December 31, 2017. (According to Audit Analytics, 71 percent of public companies have a fiscal year ending December 31.)
So now is the time to prepare for the changes! In its above-cited report on the new rule, NACD prepared questions for directors to ask, along with related resources.
Questions for Boards
For which fiscal year will our auditor first be required to report on CAMs?
What areas during the audit do we anticipate our auditor will find challenging, subjective, or complex—and how can we preemptively address those concerns?
How will the auditor’s insights in the newly expanded report affect our ongoing work as we prepare the audit committee report for the proxy and review risk disclosures in the annual report on Form 10-K?
In April 2017, the U.S. Securities and Exchange Commission’s (SEC’s) Division of Corporate Finance announced it will not recommend enforcement action for companies that disclose, but do not further investigate usage of conflict minerals which may be from the Democratic Republic of Congo (DRC). Any company manufacturing or contracting to manufacture products using such minerals had previously been required to conduct extensive due diligence on its supply chain and make this diligence publicly known with a note that its products contained minerals which “have not been found to be ‘DRC conflict free.’” However, following a series of partial losses in court, the SEC appears to be backing off the rule—for now.
The Conflict Minerals Rule and Disclosure Requirements
A provision in the Dodd-Frank Act aims to cut off funding sources for armed rebel groups in the DRC and surrounding countries in central Africa. It requires companies manufacturing products containing certain minerals to conduct supply chain audits and disclose if those minerals were known to have originated in the DRC or adjoining countries. The SEC, as the enforcer of this provision, issued a rule requiring issuers of securities who filed reports with the SEC under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 and who manufactured or contracted to manufacture a product in which the defined conflict minerals were a necessary part, to file a separate special disclosure form, Form SD. Although these obligations were placed on manufacturing issuers, in practice, the diligence requirement was imposed on others in the supply chain because many manufacturers required their supply chain partners to certify origin of minerals and compliance with the rule.
When Form SD was first issued, items 101(a) and (b) required companies using conflict minerals to attempt to identify the country of origin of those minerals. If after conducting a “reasonable country of origin inquiry” the company determined that the country of origin was neither the DRC nor an adjacent country, it had to disclose this finding (and a description of the country of origin inquiry conducted) on its website as well as to the SEC. Per item 101(c) of Form SD, if a company’s minerals may have originated in either the DRC or its neighboring countries, the company was required to conduct additional, more extensive due diligence, and then file and publish a conflict minerals report. This report had to include a description of the company’s due diligence efforts, certified results of an independent private audit, and a list of planned changes as a result of the audit. In the report and on its website, companies also had to describe which products had “not been found to be ‘DRC conflict free,’” although for the first two years of enforcement they could use the label “DRC conflict undeterminable.”
The National Association for Manufacturers challenged these regulations on both procedural and constitutional grounds. After the district court granted the SEC summary judgment, the Association appealed to the DC Circuit of Appeals. Ultimately, the appeals court found that forcing companies to note whether or not their products are DRC conflict free was unconstitutional under the First Amendment. The case was remanded to the U.S. District Court for the District of Columbia, which issued its final judgment in April 2017 and set aside the part of the rule that requires companies to add language that their products are “DRC conflict free” or “have not been found to be ‘DRC conflict free.’” Citing both the court decision and the unclear efficacy of the rule, SEC Chair Michael Piwowar reopened comments and the SEC stayed the compliance portions of the rule pending the conclusion of litigation. The SEC announced it would not pursue enforcement actions against companies who only complete Form SD items 101(a) and (b) and do not pursue more extensive diligence on sourcing or secure an independent audit. The SEC has taken the view that the purpose of item 101(c) of Form SD and the related conflict minerals reports was to determine the status of conflict minerals by requiring the “conflict free” or “not conflict free” labels, and that these measures and the requirements for more detailed due diligence are in need of re-evaluation and clarification given recent court rulings on this matter.
Although companies are not currently expected to conduct the extensive due diligence envisioned by item 101(c) of Form SD, they are still expected to conduct in good faith a reasonable country of origin inquiry and disclose this information to the SEC and the public. Companies and boards still need to ensure there are effective diligence programs in place that allow reasonable inquiry into supply chain partners and components, particularly if conflict minerals are necessary to any product the company manufactures. By statute, the SEC is required to issue a rule relating to due diligence for conflict minerals. Although the “conflict free” labeling requirement has been eliminated, the question remains whether conflict minerals reports, in their current form, are otherwise valid. The SEC is currently developing its future enforcement recommendations with respect to the rule.
In the interim, companies should continue to ensure effective supply chain diligence mechanisms are in place that allow them to confirm where components, particularly conflict minerals, are sourced. To the extent that auditing or diligence measures had already been put into place prior to the final judgment and SEC announcement, companies may want to continue to implement these measures given the lingering uncertainty about future application of the rule. Companies also have the ability to submit comments on the rule to the SEC and should make their views known to influence future enforcement on this issue.
At Baker & McKenzie, Joan Meyer is a partner and chairs the North America Compliance, Investigations & Government Enforcement Practice Group. Reagan Demas is a partner and Maria McMahon is a professional support lawyer in the North America Compliance, Investigations & Government Enforcement Practice Group in Washington, DC.
To learn more about strategy and risk, attend the 2017 Global Board Leaders’ Summit where you will have the opportunity to explore emerging risk issues with peers. A detailed agenda of NACD and Marsh & McLennan’s Board Committee Forum on strategy and risk, can be found here.
“It ain’t over ‘til it’s over.” Truer words were never spoken when it comes to the new pay ratio rule.
A key chapter in pay regulations closed August 5, 2015 when the U.S. Securities and Exchange Commission (SEC) issued its final rule on the pay ratio disclosure mandated by the Dodd–Frank Wall Street Reform and Consumer Protection Act. This final rule capped a two-year comment period intended to resolve many thorny issues around exactly when and how to calculate the two numbers involved in the ratio—namely median employee compensation/CEO compensation. (To see NACD’s comment letter, visit the NACD Resource Center on Corporate Governance Standards and click on our Comment on Pay Ratio.) The NACD comment letter, like some others, noted that the “annual total compensation” figure can be misleading, and suggested solving this problem by asking the SEC to permit the use of industry averages, to limit employees to full-time domestic employees, and to permit supplemental notes. In its final rule, the SEC did not make these changes but did address concerns about total annual pay by allowing companies to use any “consistently applied compensation measure” (CACM) to calculate median annual compensation for employees.
This concept of a CACM led to questions, however. So on October 18, 2016, the SEC’s Division of Corporation Finance addressed them by updating its C&DI for Regulation S-K, one of the 32 “Compliance and Disclosure Interpretations” (C&DIs) the staff maintains on its most complex regulations. Although the five questions raised are technical rather than strategic, and represent only a tiny fraction of the many issues raised by the final rule overall, they still merit board attention. Therefore, this blog presents, in simplified English, the five ratio-relevant Q&As in the newly updated C&DI (codified under Section 128 C) and provides a key question and a final “takeaway” for boards.
Summary of the SEC’s Five Questions and Answers
Summary of Question 1: If a company does not use annual total compensation to identify the median employee, how should it choose another consistently applied compensation measure (CACM) to do so?
Summary of Answer 1: SEC’s updated C&DI assures companies that a CACM can be any measure that “reasonably reflects the annual compensation of employees,” but asks that companies explain their rationale for the metric they choose. An appropriate CACM will depend on “particular facts and circumstances,” says the SEC. For example:
Total annual cash compensation can work as a CACM, unless the company has also made a wide distribution of annual equity awards for the same period.
Social Security taxes withheld would likely not be an appropriate CACM unless all employees earned less than the Social Security wage base.
Summary of Question 2: May a registrant exclusively use hourly or annual rates of pay as its CACM?
Summary of Answer 2: No. Although an hourly or annual pay rate may be a component used to determine an employee’s overall compensation, the use of the pay rate alone generally is not an appropriate CACM to identify the median employee.
Summary of Question 3: When a registrant uses a CACM to identify the median employee, what time period may it use?
Summary of Answer 3: The SEC’s answer to this question says that the company must select a date within three months of the end of its most recent fiscal year to determine the population of employees from which to identify the median employee. The CACM need not be contemporaneous. In fact, it can come from the prior fiscal year, as long as there has not been a material change in the registrant’s employee population or employee compensation arrangements—that is, a change that would “result in a significant change of its pay distribution to its workforce.”
Summary of Question 4: What about furloughed employees?
Summary of Answer 4:The SEC’s response clarifies that the final rule identifies four classes of employees: full-time, part-time, temporary, and seasonal. It does not define or even address furloughed employees, because a furlough could have different meanings for different employers. It is a matter “facts and circumstances” and provides additional guidance on the matter.
Summary of Question 5: What about independent contractors? Under what circumstances can their pay be included in the CACM for the employee?
Summary of Answer 5:The final rule had stated that “leased” workers are excluded from the definition of employees “as long as they are employed, and their compensation is determined, by an unaffiliated third party.” The SEC’s answer preserves this distinction, and gives some flexibility. In determining when a worker is an “employee,” the company “must consider the composition of its workforce and its overall employment and compensation practices.” So a company should include workers whose compensation it (or a subsidiary) determines “regardless of whether these workers would be considered ‘employees’ for tax or employment law purposes.”
Are you familiar enough with compensation patterns in your company to know whether a chosen CACM “reasonably reflects” the compensation in your company? If not, you may wish to meet with the officer responsible for employee pay below the executive level to get a better sense of this important issue.
Compensation committees have traditionally focused on executive compensation, leaving employee compensation to management. In the past few years, however, several factors have combined to broaden the committee’s purview, including concerns about pay disparity, and the new requirement to disclose compensation risk. Therefore, more compensation committees are overseeing enterprise-wide pay. For example, in its 2016 proxy statement, WPX Energy disclosed that in the past year “With the oversight of our Compensation Committee, we conducted a risk assessment of the Company’s human capital with a focus on enterprise-wide compensation programs.” (Emphasis added.)
The key word in all of these questions and answers is “reasonably.” It is exactly the right word for compensation committees to use as they oversee this disclosure, as well they should.
Alexandra R. Lajoux is chief knowledge officer emeritus at the National Association of Corporate Directors.