In remarks before the UCI Audit Committee Summit at the end of October, SEC Chief Accountant James Schnurr addressed the importance of the oversight role that audit committees play, providing specific advice on inquiries that audit committee members should pursue. He focuses on four areas: the SEC’s concept release on audit committee disclosures; internal control over financial reporting; implementation of the new revenue recognition standard; and disclosure effectiveness.  (See also this PubCo post for a discussion of PCAOB recommendations for audit committees members.)

Concept Release on Audit Committee Disclosures

Schnurr observed that some investors have requested more information from audit committees about how they perform their roles. In addition, some audit committees have voluntarily chosen to enhance their public reporting beyond the existing rules.  At the same, other jurisdictions have mandated changes in the scope of required audit committee disclosures. In that light, the SEC  issued its concept release on Possible Revisions to Audit Committee Disclosures.  (See this PubCo post.)  The concept release sought comment on the adequacy of current disclosures, as well as on potential changes to required disclosures that would address the audit committee’s responsibilities with respect to the appointment, compensation, retention, and oversight of the work of the accounting firm and better inform investors about how the audit committee executes those responsibilities.

Schnurr notes that responses to the concept release have been mixed about the need for additional mandatory disclosures, with some commenters supporting additional disclosure in certain areas, while others  (primarily audit committee members and issuers) urging that enhanced disclosure be voluntary only.  Apparently, some commenters questioned whether, if the SEC failed to mandate additional disclosures, companies that provide the disclosures voluntarily might shift back to their previous minimal practices.  Some commenters favored principles-based disclosure mandates, expressing concern that disclosure examples in the Concept Release would, if adopted, “lead to a checklist approach and boilerplate reporting aimed primarily at ensuring compliance and minimizing risks, including risks of litigation.  In this respect, I would like to observe the Concept Release published by the Commission did not constitute a proposal or endorsement of any particular disclosure requirements or the manner of their implementation.”  Some commenters also suggested expanding the report beyond auditor oversight to include oversight of financial reporting by management, oversight of internal control and oversight of the internal audit function.  Some also suggested strengthening the definition of  “audit committee financial expert.” Other commenters raised issues regarding potential litigation risk, effects of disclosure on communication between audit committees and independent auditors and the committees’ growing workload.

Internal Control over Financial Reporting

Matters related to ICFR deficiencies and weaknesses “require careful consideration by both management and the independent auditor and may involve a significant amount of judgment,” and oversight of these judgments and  conclusions are important audit committee responsibilities.

Schnurr reminded the audience of the prevalence recently of SEC staff speeches questioning whether material weaknesses in ICFR are being “properly identified, evaluated, and disclosed.” In that regard, issues have surfaced in PCAOB inspections regarding ICFR deficiencies, questioning the adequacy of auditing procedures to evaluate “the design of controls, in particular management review controls, or the effective operation of the control.”  (See this Pubco post, which discusses issues regarding the reporting of material weaknesses  in connection with – but not prior to — the issuer’s disclosure of a related restatement or an adjustment. ) As a result, various stakeholders have raised questions regarding the underlying issues, including some that are fact specific.  In that regard, Schnurr sees room for additional involvement by audit committees:

“[A]udit committees are in a unique position to gain valuable insights into both management’s financial reporting process and internal controls and the work performed by the independent auditor.  I encourage you to engage in a dialogue with your auditors regarding matters such as the auditors’ risk assessment decisions, selection of key controls, and approach to testing these controls in the context of existing guidance from the SEC and the PCAOB.  You may seek understanding of the critical audit decisions from both the engagement team and, if necessary, request that the concerns or disagreement between management and the engagement team be elevated to others at the audit firm who may be in a better position to articulate certain aspects of the firm’s audit approach and methodology. I believe that more effective communication between audit committees, management, and independent auditors will help alleviate some of the concerns raised.”

Revenue Recognition

In his remarks, Schnurr reminded  the audience of audit committee members of their important role in overseeing implementation of the new revenue recognition standard, including understanding the planned transition method (full or modified retrospective) and anticipated disclosures.  In addition, members should be concerned with whether adequate resources have been dedicated to analyzing the impact of the new guidance and whether additional internal or external resources may be needed; the work involved in implementation could “put pressure on resources for reporting earnings and preparing periodic reports.”

The new revenue recognition standard will require companies to develop detailed implementation plans, and Schnurr advises audit committees  to review and critically evaluate management’s implementation plan.  Schnurr also suggests that, in reviewing the changes to be implemented, audit committee members should “ask management to identify and explain why the changes are occurring or in some cases why changes are not occurring.  In particular, I would suggest that you inquire whether there are differing views within the industry on how to implement the new standard and if so how have management and the auditor concluded that the company’s approach was appropriate. I also suggest you challenge the auditors on conclusions that do not appear to reflect the core business of the company.” In that regard, Schnurr indicated that he is “concerned there may be interpretations that are overcomplicating the financial reporting of transactions.”

Disclosure Effectiveness

The SEC is in the midst of its disclosure effectiveness project, including consideration of ways to update the existing requirements in Regs S-K and S-X.  As part of that project, the SEC is currently requesting comment on financial disclosures under Reg S-X about acquired businesses, affiliated entities and guarantors.  (See this PubCo post.)  And FASB has recently issued two exposure drafts regarding the concept of “materiality” in the context of disclosures, clarifying that “omitting a disclosure of immaterial information would not be an accounting error.” (See this PubCo post.)  However, Schnurr admonishes, “there is nothing to stop preparers from performing their own disclosure effectiveness analysis.”

Audit committee members play critical roles in oversight of effective financial disclosure.  In that regard, Schnurr encourages audit committee members “to set the tone for the organization – one that expects effective disclosure and robust judgments on preparing it.  Empower management and embrace efforts to focus on disclosure effectiveness.”  Alternatives to consider might include, among other things, using more “tables and graphs, removing outdated disclosures when appropriate and increasing the use of hyper-links and cross-references instead of repeating the same disclosure in multiple places.” Audit committee members should also

“actively participate in the dialogue, not only around the ‘volume’ of disclosure but, more importantly, around the quality of those disclosures.  Consider the various users of the financial statements and think about better ways to convey information to them.  Effective disclosures are not static.  Rather, what is important to investors may change over time.  As facts and circumstances change, you may need to re-evaluate whether existing disclosures continue to be relevant and applicable to your current situation. Finally, omitting immaterial financial statement disclosures will often require significant judgement. The accounting literature allows for appropriate, well-supported judgments around disclosure.  Well-reasoned, practical judgments to omit immaterial disclosures should be grounded in the objectives and principles of the relevant guidance and companies should have appropriate processes and controls to evaluate those judgments.  As part of its oversight, audit committees should encourage this dialogue.  Developing appropriate processes to enhance disclosures – and judgments for deciding which disclosures can be omitted – naturally requires coordination with the audit committee.  Being an active and willing participant in the process is a key step as we collectively work to achieve disclosure effectiveness.”