Wesley Bricker Deputy Chief Accountant, SEC
Credible, reliable, and useful financial reporting for investors requires not only high-quality accounting and auditing standards, but also robust application of those standards by management and auditors. Today I would like to provide observations on the ongoing transition period activities for the new standards on revenue recognition and leases, as well as FASB’s financial instruments credit impairment proposal. I would also like to address certain non-GAAP reporting practices.
The Transition Period for New Standards
To provide perspective on the magnitude of the transactions addressed by the new standards, consider the following: In 2014, the S&P 1,500 companies, which cover approximately 90% of U.S. market capitalization, recognized revenue in their financial statements of over $12.8 trillion. The new standard will enhance reporting and will certainly enhance disclosures for the vast majority of those revenue transactions by providing comprehensive guidance that will apply across industries and across registrants, whether domestic or foreign. For leases, the magnitude is also significant. In 2005, the SEC staff estimated the value of lease obligations of SEC registrants at that time to total $1.25 trillion. Under the new standard, these lease obligations and assets will be reported on the balance sheet.
Given the pervasiveness of these changes, now is a really important time for companies to focus on investor outreach. Revenue is the starting point for performance measures such as operating income, net income, and earnings per share; for key analytical ratios, such as margins, return on equity, return on assets; and for valuation metrics such as revenue multiples and price-to-earnings. As a result, the new revenue standard has the potential to change not only the top line, but also the bottom line and the analysis that depends on the financial statements. While all industries will likely be impacted, investors should pay particular attention to those companies with complex business models, such as those with long-term contracts or multiple performance obligations within a single contract, since the new guidance could significantly impact the timing and the amount of reported revenue.
I also encourage investors to understand the company-specific impacts of the new guidance. This may include the following questions: Does a company have an implementation plan for adopting the new standards? If so, how will the audit committee monitor the company’s progress? What changes will be made to the company’s accounting policies? How will the standards affect the company’s corporate policies and practices, such as sales commissions, compensation plans, and contracting approaches? What are the income tax accounting implications?
The SEC staff has long advised that a registrant should provide disclosures to investors of the impact that a recently issued accounting standard will have on its financial statements. Without adequate transition disclosures, investors may not be prepared to fully understand the changes in a company’s financial performance from one period to the next and the impact of adopting a new accounting standard. Investors should expect the level of disclosures to increase as companies make further progress in their implementation plans and, when necessary, engage with company management to understand the disclosures.
The importance of timely investor education and engagement is highlighted by examples from past standards. During the transition period for the FASB standards on consolidation and transfers of financial assets, certain financial institutions disclosed the anticipated impact of bringing substantial amounts of assets and liabilities back onto the balance sheet in multiple reporting periods leading up to the effective date, and they did so without adverse market reaction. By contrast, a change to the revenue recognition rules in 2010 resulted in a registrant reporting financial results that surpassed analyst expectations by billions of dollars. Although the registrant was complying with the new accounting rules, after-hours trading of the stock was temporarily halted in order to give investors time to digest the news.
As companies apply the new revenue recognition standard to their specific revenue arrangements, interpretive questions may arise. The FASB’s Revenue Transition Resource Group [TRG] has addressed a number of questions to date, and I continue to encourage management, auditors, and others to refer interpretive issues to the TRG.
Application of the new standard also requires preparers to make judgments that will later be evaluated by auditors, regulators, and investors. The SEC staff will continue to respect well-reasoned and practical judgments when those judgments are grounded in fact and in the principles of the standard, and when they consider the utility of the resulting information to investors. Conversely, aggressive interpretations that appear to be taken to preserve existing reporting will not be well received, particularly when the outcome is inconsistent with the principles of the new standard.
Because of its importance, the SEC staff has been, and will likely continue to be, focused on reporting of revenue arrangements and related disclosures. So I encourage consultation with the OCA, particularly when a registrant has an unusual, complex, or innovative transaction for which no clear guidance exists. I would also encourage consultation when a preparer finds that its application of guidance is done differently from the way the TRG believed the guidance should be applied.
Without adequate transition disclosures, investors may not be prepared to fully understand the changes in a company’s financial performance from one period to the next and the impact of adopting a new accounting standard.
Proposed Credit Impairment Standard
I’m very pleased that in making decisions about their proposed standard on credit impairment on financial instruments, FASB has solicited and received broad input from investors, including at a recent credit impairment TRG meeting. If finalized as proposed, the standard would incorporate concepts that are consistent with current guidance. First, management should be positioned to make a best estimate and communicate that estimate to users of financial statements. Next, management is required to use all available information without misusing or overlooking available information when forming their best estimate. And third, documentation and procedural discipline, including the identification of relevant data, assumptions, and methodologies, will be required to ensure that the estimate is adequately supported.
I’ve heard some suggestions that management will need to look to their auditor, for example, to determine what processes are required. I find these suggestions rather troubling, since management should be looking first to the accounting standard, to their books and records requirements, and to the company’s own internal control requirements. This approach should also facilitate the audit process and help avoid the perception that auditors are directing management’s processes through the audit, which of course could lead to other questions about internal controls or auditor independence.
Auditors will certainly have a role in working through new applications of existing standards for auditing management’s credit impairment estimates. I understand that the AICPA Depository Institutions Expert Panel is already evaluating the guidance, the application questions and approaches, and illustrative examples. OCA will continue to actively monitor these efforts, much like we have done with the revenue recognition standard.
Recent examples of company practices related to non-GAAP measures have caused concern, including the use of individually tailored accounting principles to calculate non-GAAP earnings, providing per-share data for non-GAAP performance measures that look a whole lot like liquidity measures, and non-GAAP tax expense. Revenue adjustments do more than just adjust from GAAP—they change the very starting point from which performance analyses flow. As the staff monitors current practices and implementation of the new revenue standard, we will be looking to see if the reporting concepts within those standards are supplanted by company-specific non-GAAP alternatives. If you present adjusted revenue, you will likely get a comment. Moreover, you can expect the staff to look closely and very skeptically at the explanation.
I think it’s important to reiterate four points that have been made about non-GAAP measures in recent months. First, preparers should consider how their disclosure controls and procedures apply to the disclosure of non-GAAP measures. Second, despite the fact that GAAP measures sometimes get forgotten once the analysts and the press start commenting on a company’s results, investors should refer back to the financial statements so that the non-GAAP measures are put in proper context. Third, audit committees should pay close attention to the non-GAAP measures a company presents, including the required related disclosures and the processes that it follows to consider both the appropriateness and the reliability of measures. And last, I would note that [SEC] Chair [Mary Jo] White has mentioned the possibility of future rulemaking in this area. In the meantime, the staff will be sharing its observations on non-GAAP measures in various forums. If necessary, the staff will consider recommendations to the commission for rulemaking in this area. But I hope companies will seize the opportunity to review their practices and make any necessary changes.
Recent examples of company practices related to non-GAAP measures have caused concern, including the use of individually tailored accounting principles to calculate non-GAAP earnings.
I look forward to working with the accounting profession as we collectively embark on this period of change and implementation. Preparers, auditors, audit committees, regulators, and standards setters all play an important role in providing investors with high-quality, decision-useful information that allows for informed investment decisions and facilitates capital formation. While the magnitude and the pervasiveness of the forthcoming challenges are significant, I remain confident that the profession can meet them.
Marc Siegel Board Member, FASB
As a former analyst, I was surprised when joining FASB to learn that the sequence of discussions started with scope, then recognition and measurement, and only then presentation and disclosures. That seemed a little backwards to me, because the only information an analyst or an investor has is what’s presented and disclosed. What I want to talk about today is the proliferation of non-GAAP metrics, as well as how the notes to the financial statements are used to communicate to investors. I will also discuss the implications of these items for the future agenda of the FASB.
I fear that perhaps we don’t all have the same thing in mind when we’re talking about non-GAAP measures. The final rule from 2003 has a very specific definition of non-GAAP measures, and it’s more narrow than I believe the general population considers: a non-GAAP metric is only one if it’s started from a GAAP figure and amounts were included or excluded from that GAAP figure. That’s why reconciliation to the comparable GAAP figure is such an important component of the rule. But an analyst might have a more broad definition in mind. Items such as backlog or samestore sales—these are measures that absolutely can and do move stocks when they’re disclosed by companies. They’re financial in nature. They don’t appear in the GAAP statements. However, they don’t qualify as a non-GAAP measure, and therefore don’t have to be reconciled to any numbers in GAAP.
Whether it is increasing or not, the reporting of non-GAAP information is far from new. Many studies embrace the idea of “let the investor beware” when it comes to the non-GAAP measures. And I personally agree with that. But at the same time, this does not mean that the non-GAAP metrics are always uninformative. In my experience, the combination of non-GAAP data with information from the audited financial statements is more impactful than either on its own. The non-GAAP information in a company’s communications with investors often provides insights into how management views its performance.
As a former analyst, I attempted to do a thorough review of the financial statements and notes to establish whether the picture painted by the audited metrics corresponded with the view from the non-GAAP metrics. The more correlated the GAAP and the non-GAAP metrics, the more comfort I felt. On the other hand, if the non-GAAP measures pointed to an improving picture, but the GAAP amounts painted a less rosy picture, I would consider it a red flag. As a result, I always found the combination of the two sets of information to be a powerful analytical tool in understanding the underlying business.
While empirical research does not indicate that non-GAAP information points to a fundamental problem with financial accounting recognition and measurement, I think the proliferation points to a need to consider how similar information might be better organized or presented in the income statement. As such, the FASB staff is undertaking a project on financial performance reporting. Our goal is to increase the understandability of the performance statement by breaking out certain items that may affect the amount, timing, and uncertainty of an organization’s cash flows differently. The hope is that this would improve the dialogue between companies and users of financial statements about the performance and the core underlying operations of the business.
The Notes to the Financial Statements
For the past several years, the notes to the financial statements have truly been a hot topic. By any objective measure, the financial statements and the regulatory filings have grown much larger over the last 20 years. While the FASB certainly has a role in increased disclosure requirements, I think it’s fair to say that there could be many reasons for this observed increase—things like people worrying about second-guessing from their auditors, regulators, and attorneys, and just inertia. However, I would not personally call what we have today disclosure overload. I think there’s more to the story.
For example, while there is ample evidence about the expanding size of notes, there hasn’t been a lot of study about the volume of voluntary disclosures. Today, in a typical quarterly earnings release by a financial institution, there’s usually a press release, a supplemental reporting package that could be dozens of pages long, a PowerPoint deck, and then maybe an hour-long conference call with investors. That huge amount of information doesn’t compare to what was released voluntarily 15 years ago.
Wharton recently published a study called “Guiding Through the Fog: Financial Statement Complexity and Voluntary Disclosure.” One of their findings shows the skyrocketing amount of information that companies put out of their own volition. There has been a revolution in the availability of information. That has ramifications for note disclosure, but it also plays out in the voluntary information communicated between companies and their investors. A discussion about disclosure overload should focus on what’s required to be disclosed, as well as what is voluntarily disclosed.
FASB has added a project to our agenda back in 2009 called the “disclosure framework.” The objective is to make financial disclosures more effective. The first way is by creating a framework for the board to use to more consistently develop disclosure requirements. The second way is by facilitating an entity’s ability to communicate what is most important to their users, which is what we call the entity’s decision process. When we issued the proposal around the board’s decision process, many preparers were concerned that we were expanding the boundaries of possible disclosures and cautioned us to slow down. When we issued the proposals around materiality in the context of notes, investor organizations challenged us to think about adding disclosures and cautioned us to slow down.
There needs to be a foundational reset in the system if we want to accomplish the goal of making disclosures more effective. We have to shift from thinking of the notes as a compliance document, and instead think about them as a communication document. What do I mean by that? I think notes today are sometimes prepared and reviewed in a binary, checklist type of way. This approach ensures that you have complied with the requirements for the disclosures, but doesn’t facilitate the most effective communication.
Some companies have decided not to wait for FASB and others to change the rules. I applaud these companies for taking the initiative and taking ownership of their financial reporting packages. General Electric has added a 10-K summary, and they critically reviewed several of their notes and tried to make them more communicative. When we have talked to companies that have been successful, the common theme is that management set the initiative as a corporate objective. It seems that once the C-suite and the audit committee are on board with the idea to make disclosures more effective, some of the obstacles slip away.
At FASB, we have more work to do. We need to continue to road test the board decision process, and we’re looking at pension disclosures, fair value, inventory, and income tax disclosures. In some cases, we are proposing to cut disclosure requirements, and in others we’ll propose to add them. We are also still processing the feedback we got about materiality. We will come together on all of these and hold a roundtable this fall in order to decide the best path forward. In the interim, I think that companies have the ability to critically look at their notes and make judgments about how to best communicate information to their investors. Hopefully, the feedback has been good at those companies who have taken that step, and more will be willing to try.
Bricker and Siegel presented the opening remarks at Baruch College’s 15th Annual Financial Reporting Conference, held on May 5, 2016. The following is an edited transcript of their remarks. The views expressed are their own and not necessarily those of the SEC, the commissioners, or the staff.