On October 16, 2017, Clermont Partners released a survey on the reliance of active investors on non-GAAP versus GAAP reporting, intangible assets and non-financial metrics. Unlike passive investors who invest in index funds, active investors select securities to buy and sell. Fifty-six active investors, focused on a variety of industries and investment strategies, participated in the 14-question survey. Highlights of the survey include the following:

  • 74% of the respondents rely on non-GAAP more than GAAP reporting when evaluating a company’s performance.
  • 44% of the respondents believe that non-GAAP measures have become more important over time.
  • 90% of the respondents will frequently make their own adjustments to a company’s GAAP results based on what they believe is relevant in evaluating performance.
  • 64% of the respondents believe that intangible assets are important factors in evaluating performance.

The results of the survey suggest that non-GAAP metrics are viewed more favorably by active investors as they buy and sell securities and that the SEC rules emphasizing GAAP metrics are largely ignored by active investors. A copy of the survey is available here.

On August 22, 2017, Stephen Deane, CFA, Investor Engagement Advisor, Office of the Investor Advocate, gave a speech addressing two proposed updates issued by FASB in 2015 (one that would apply to GAAP and the other that would apply to FASB’s Conceptual Framework) that refer to materiality as a legal concept, or rather rely on courts to provide the definition of materiality. FASB held a public roundtable on the proposed updates in March 2017, but they still remain under consideration.

In the proposed updates, FASB cited the Supreme Court’s definition of materiality in the context of the federal securities laws (i.e., information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information). In contrast, FASB’s current definition of materiality, as provided in Concepts Statement Number 8 (“Con 8”), states that information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. Although FASB described its proposed updates as clarifications to make them consistent with U.S. law and not intended to change any specific disclosure requirements, investor groups have expressed concerns, including that the proposals were based on the mistaken premise that investors were suffering from an overload of information, the proposals would shift decision-making from accountants to lawyers, and that the Supreme Court’s definition of materiality arose in the context of alleged securities fraud and thus may not be suitable in the context of accounting standards.

Mr. Deane described the Investor Advocate’s alternative approach proposed in a letter sent to FASB in July 2017. This alternative approach combines FASB’s prior definition of materiality in Concept Release Number 2 (“Con 2”) with SEC Staff Accounting Bulletin 99 (“SAB 99”). Mr. Deane noted that Con 2 essentially adopted the Supreme Court’s definition of materiality, but emphasized that “[m]ateriality judgments are concerned with screens or thresholds” and “[t]he more important a judgment item is, the finer the screen should be.” Mr. Deane noted that SAB 99 approvingly references Con 2 for “stat[ing] the essence of the concept of materiality” and then links the Con 2 definition to the Supreme Court’s definition and provides a helpful framework for evaluating materiality decisions in preparing or auditing financial statements, emphasizing that companies must take into account quantitative factors as well as qualitative factors and offering examples of how misstatements of relatively small amounts that come to the attention of auditors could have a material effect on financial statements. As a result, this alternative approach would harmonize FASB’s concept of materiality with the Supreme Court’s definition and the SEC’s approach as well as the PCAOB’s auditing standards, while responding to investor demands for a framework or guidance on how to apply the definition of materiality by drawing on the exposition and illustrative examples in SAB 99 and Con 2. If the SEC were to move forward with its disclosure effectiveness initiative, as is expected, any changes to disclosure requirements and guidance regarding required disclosures would likely address the concept of “materiality.” A copy of the speech is available at: https://www.sec.gov/news/speech/deane-speech-rulemaking-process.

On June 8, 2017, SEC Chief Accountant Wesley Bricker gave a speech titled “Advancing the Role of Credible Financial Reporting in the Capital Markets” at the 36th Annual SEC and Financial Reporting Institute Conference. Mr. Bricker emphasized the importance of reliable accounting and effective control over financial reporting in protecting investors and the capital markets. Mr. Bricker also discussed the key roles played by audit committees and independent external auditors in providing assurance to investors that financial statements are disclosed without material misstatements or omissions. Highlights of the speech include the following:

  • The PCAOB’s Important Role: Bricker noted the recent adoption by the PCAOB of a new standard for auditor’s reports that requires a description of “critical audit matters,” for purposes of providing investors with information regarding the most challenging, subjective or complex aspects of the audit. Mr. Bricker also noted that regardless of where, or whether, prior years of service of an audit firm is disclosed, the years of experience may be one of the many factors considered by audit committees in their selection and oversight of the external auditor.
  • Revenue Recognition: Mr. Bricker mentioned that the new revenue disclosures may require the disclosure of different data and information than previously provided, potentially necessitating updates to existing processes and controls. For those companies that anticipate applying the standard as required in 2018, robust transition disclosures as described in SEC Staff Accounting Bulletin 74 and the related September 2016 SEC staff announcement should be made to enable investors to understand the anticipated effects of the new standard.
  • Other New Standards: Mr. Bricker also discussed implementation activities related to the leases, financial instruments and new credit losses standards. The new leases standard, which will be effective beginning in 2019, will result in lessees recognizing most leases on the balance sheet. This new standard will require companies to first ensure they, first, evaluate their arrangements in relation to the scope of the new standard and transition provisions and, second, update their system of internal control over financial reporting arising from the impact of the standard. Mr. Bricker encouraged companies to evaluate the scope paragraphs in these standards to identify relevant transactions and accounts for an assessment and to provide transition disclosure of the anticipated effect of the new standards. Mr. Bricker also cautioned against a purely sequential implementation process for the new standards.
  • Internal Control Over Financial Reporting: Bricker noted that companies that apply the COSO framework for assessing the effectiveness of internal control over financial reporting might find its five components and related concepts and principles useful in developing a structured approach for implementation and meeting related documentation expectations. Each of the five COSO components must be present and operating to conclude that internal control over financial reporting is effective under the COSO framework.
  • Auditor Independence: Mr. Bricker noted that while audit firms are generally more active in bringing independence issues to the SEC staff, audit committees and management may also address with the SEC staff independence matters that impact their filings or other interpretive questions. Audit committees and management should also keep in mind that the SEC staff does occasionally reach out to the audit committee to understand its position about an independence matter that has been submitted to the SEC staff for its consideration. When selecting a successor auditor, an audit committee should request information to be satisfied that the successor is independent at the start of the audit and professional engagement period, and audit committees should consider circumstances that might require the company to make adjustments to prior period financial statements (e.g., the reporting of discontinued operations, a retrospective application of an adoption or change in accounting principle, or the correction of an error).
  • Reminders to the Audit Profession: Mr. Bricker noted that just as management needs to allocate sufficient time and resources to the preparation of their books and records (with good internal controls), so too should public accounting firms work with the audit committee and management to agree on appropriate deadlines and audit fees to ensure that audit quality is consistently maintained.
  • Continuing to Advance Through Innovation: Mr. Bricker noted that there have been significant advances in technology in recent years with an accompanying increase in the use of technology by auditors, which has the potential to enhance audit quality and the auditor’s detection capabilities. Mr. Bricker also mentioned that some ratings agencies and data aggregators now utilize data scraping technology and machine learning to review SEC filings and analyze trends over time, which has the potential to help auditors and users of the financial statements identify inappropriate bias in financial statements.

A copy of the speech is available at: https://www.sec.gov/news/speech/bricker-remarks-financial-reporting-institute-conference-060817.