Update
No. 30 June-July 2016
AUDIT COMMITTEE AND AUDITOR OVERSIGHT UPDATE
In This Update:
SEC Adopts Resource Extraction Payment Disclosure, Version 2.0
CAQ Issues Audit Committee NonGAAP Measures Oversight Tool
This Update summarizes recent developments relating to public company audit committees and their oversight of financial reporting and of the company's relationship with its auditor.
SEC Adopts Resource Extraction Payment Disclosure, Version 2.0
Shareholder Proposal Calling for Report on Periodic Audit Engagement Re-Bidding Won't Be in the Proxy Statement
New Lease Accounting Implementation May Be Challenging
Five Ways to Strengthen the Audit Committee -- And What to Look for In Selecting a Chair
Investor Demand for ESG Reporting is Growing, and the SEC and PCAOB Want to Help
Prepared by:
On June 27, under federal court pressure to expedite action, the SEC issued a release adopting a new rule requiring disclosure of payments made by "resource extraction issuers" to governments. Securities Exchange Act Rule 13q-1 will require public companies that engage in the development of natural resources to file a report with the SEC disclosing payments to the U.S. federal government or to foreign governments for the commercial development of oil, natural gas, or minerals. Resource extraction issuers must comply with the rule for fiscal years ending on or after September 30, 2018. For calendar year companies, the first reports will be due at the end of May, 2019.
This is the SEC's second attempt at resource extraction payment disclosure. As discussed in the January 2016 Update, the 2010 Dodd-Frank Act required this disclosure, and the Commission initially adopted Rule 13q-1 in 2012. The 2012 rule was judicially challenged by the American Petroleum Institute and the U.S. Chamber of Commerce. In 2013, the U.S. District Court for the District of Columbia vacated the rule on the ground that the SEC's reasons for requiring Rule 13q-1 reports to be available to the public (as opposed to filed confidentially with the SEC) were arbitrary and capacious. In particular, the court held that the SEC had given inadequate consideration to the fact that, in some cases, public disclosure would violate the law of the country in which the resource extraction payment was made.
Daniel L. Goelzer
+1 202 835 6191 [email protected]
New Rule 13q-1 is generally similar to the 2012 version. Resource extraction payments disclosure will be included in public filings on Form SD (the same form as is used for conflict minerals disclosure). Some key points of the new rule include
Disclosure is required of all payments (including those made by subsidiaries) to a foreign government or to the U.S. federal government to further the commercial development of oil, natural gas or minerals. "Commercial development" means exploration, extraction, processing, and export, or the acquisition of a license for any of those activities.
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Discloseable payments also include taxes, royalties, fees (including license fees), production entitlements, and bonuses. In addition, community and social responsibility (CSR) payments that are required by law or contract, dividends, and payments for infrastructure improvements are included. (CSR payments are intended to further social purposes, such as the construction of schools.)
All payments that are not de minimis must be disclosed. "Not de minimis" means any payment or series of related payments that equals or exceeds $100,000 during a fiscal year.
A foreign government includes a department, agency, or instrumentality of a foreign government, or a company owned by a foreign government. It also includes foreign state/provincial and local governmental units. However, in the U.S., only payments to the federal government are subject to disclosure.
Although resource extraction payment disclosures will be public, companies may seek confidentiality on a case-by-case basis by showing that, absent relief, the company will suffer substantial commercial or financial harm.
Resource extraction issuers may comply with Rule 13q-1 by using "alternative reports" that is, reports that meet the requirements of other bodies -- provided the Commission determines that the requirements applicable to those reports are substantially similar to the SEC's rules. The Commission has determined that the current reporting requirements of the European Union, the Canadian Extractive Sector Transparency Measures Act, and the U. S Department of the Interior's US Extractive Industries Transparency Initiative meet this standard.
Comment: The SEC estimates that 775 reporting companies will be affected by the new rule 192 of which will be subject to similar resource extraction payment disclosure rules in other jurisdictions. Although further litigation challenging the rule is possible, audit committees of companies that will potentially be required to make resource extraction payment disclosure may wish to discuss with management the steps it is taking to prepare for compliance. This may include creating the necessary data collection procedures and instituting disclosure controls to make sure that the company will be able to file accurate and complete reports. Covered companies may also want to promptly determine whether they are already subject to an alternative disclosure regime.
CAQ Issues Audit Committee Non-GAAP Measures Oversight Tool
As discussed in the April 2016 Update and May 2016 Update, the SEC and its senior officials have issued a series of statements expressing concern about the misleading use of non-GAAP financial measures and have urged audit committees to become actively involved in the selection and presentation of non-GAAP data. The SEC defines a non-GAAP financial measure as a numerical measure of historical or future financial performance, financial position or cash flows that excludes amounts that are included in, or includes amounts that are excluded from, the most
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directly comparable measure calculated under Generally Accepted Accounting Principles.
On June 28, the Center for Audit Quality (CAQ) released a tool to help audit committees assess management's presentation of non-GAAP measures. The CAQ publication, Questions on Non-GAAP Measures: A Tool for Audit Committees, contains a series of sample discussion questions regarding transparency, consistency, and comparability of non-GAAP measures. The CAQ states that the objective of the tool is "to assist audit committees in asking questions to help determine: (1) that management is complying with the SEC rules and related interpretations as to non-GAAP measures, and (2) that non-GAAP measures are aiding analysts and investors in understanding the business and its performance."
The CAQ's discussion questions are organized into three categories. The objectives of each category are summarized below:
Transparency (11 suggested questions). "Non-GAAP measures should be presented to supplement the GAAP measures, and their purpose and calculation should be clear to investors. NonGAAP measures included in filings with the SEC (e.g., Forms 10K, 10-Q), or furnished to the SEC (e.g., press releases) should be clearly labeled as non-GAAP and not given any more prominence than their closest GAAP measures. Non-GAAP measures should supplement, not supplant, the GAAP measures."
Consistency (6 questions). "Audit committees should consider asking questions of management to determine whether nonGAAP measures are consistent indicators that provide accurate insight into a company's performance--and not calculations solely aimed at showing the company in a favorable light."
Comparability (4 questions). "There is no authoritative framework that defines the calculation of each non-GAAP measure. This enables the non-GAAP measure calculations to be tailored from one company to the next. The more tailored the calculation, the less comparable the measure may be across an industry. The less comparable the measure, the more confusing it may be to investors."
The tool also includes seven "procedural questions" that are applicable to all three categories. These questions focus on management's oversight of non-GAAP measures, the sources of information used to calculate non-GAAP measures, controls over non-GAAP calculations and disclosures, involvement of legal counsel, and management's consideration of SEC guidance. In addition, the tool briefly summarizes the role that auditors play with respect to non-GAAP measures and recommends that the audit committee ask management to describe the level of involvement the auditors have with the company's non-GAAP measures and any auditor comments or reactions.
Comment: In light of the SEC's critical focus on the use of non-GAAP measures, all pubic company audit committees should be aware of the non-GAAP measures their company is disclosing and of the rationale for those measures. The audit committee should be able demonstrate that it is aware of the issues and concerns regarding non-GAAP reporting and
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that it is exercising appropriate oversight. The new CAQ publication provides an excellent framework for a dialogue with management on this important topic.
Shareholder Proposal Calling for Report on Periodic Audit Engagement Re-Bidding Won't Be in the Proxy Statement
On June 17, the SEC staff rejected another effort by Canadian investment advisory firm Qube Investment Management to require the inclusion in a company's proxy statement of a shareholder proposal aimed at encouraging the audit committee periodically to consider changing auditors. In a letter to General Mills, the staff informed the company that there "appears to be some basis for your view" that Qube's proposal could be excluded on the ground that Qube failed to provide documentation that it had held the minimum required amount of shares for at least one year. Qube's proposal states: "RESOLVED Shareowners request that the Board of Directors issue a report to shareholders by December 2017, at reasonable cost and omitting proprietary information, which evaluates options for a regular competitive review process on the selection of the audit firm for the annual audit engagement."
As discussed in the February-March 2016 Update, Qube previously submitted proposals to 28 companies which, if approved by shareholders, would have required the audit committee to request bids for the performance of the company's audit no less frequently than every eight years. The Commission's rules permit companies to omit from their proxy statement shareholder proposals that address ordinary or routine business matters. Consistent with its longstanding view that the selection and engagement of a company's independent auditor is a matter relating to the company's ordinary business operations, the SEC staff permitted those companies to omit the resolution.
Rather than directly requiring that the audit committee periodically request proposals, the resolution submitted to General Mills would only require the that the board prepare a report evaluating "options" for periodic auditor requests for proposals. Qube's statement in support of the report resolution is essentially the same as that in support of its earlier series of resolutions: `'Having the audit committee issue a regular request for proposal on the audit engagement is a compromise to a forced rotation. * * * It is our belief that competitive market forces will prevail, audit fees will reduce (or at least hold constant), while valuable governance and oversight increase."
The SEC staff did not comment on whether it would have required the proposal to be included in the company's proxy statement if Qube had documented its share ownership. However, the staff has in the past agreed to the exclusion of proposals calling for reports if the subject of the report is a matter that relates to the company's ordinary business operations.
Comment: As noted in the February-March 2016 Update, shareholders generally cannot use shareholder proposals as a vehicle to force audit committees to rotate auditors or periodically solicit tenders. Nonetheless, interest in the issue of rotation remains high among some investors. As noted in several prior Updates (see, e.g., December 2015
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Update, October-November 2015 Update, and July 2015 Update), there is considerable pressure for expanded audit committee disclosure concerning the committee's reasoning as to whether to retain the auditor or solicit proposals from other firms. In addition, as discussed in the May 2016 Update, the PCAOB's new auditor reporting model proposal would require the audit opinion to include disclosure of the length of the auditor's tenure.
New Lease Accounting Implementation May Be Challenging
As described in the February-March 2016 Update, the Financial Accounting Standards Board has adopted new standards governing financial reporting about leasing. ASU No. 2016-02, Leases (Topic 842), which is summarized in the December 2015 Update, will require lessees to recognize assets and liabilities for leases with terms of more than 12 months and will affect the financial statements of most companies that engage in significant leasing, whether as lessees or lessors. For public companies, the ASU will take effect for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other organizations, it is effective for fiscal years beginning after December 15, 2019, and for interim periods beginning after December 15, 2020.
Because of the widespread use of leases, the new standards potentially impact financial reporting at many companies. However, following the pattern set by the implementation of the FASB's new revenue recognition standards (see August-September 2015 Update), it appears that some companies are off to a slow start on implementing the leasing standards and anticipate difficulty. A poll of 5,400 professionals conducted in March by Deloitte & Touche (see also Deloitte press release) found that only 8.6 percent of respondents considered their company to be "extremely prepared" for the new leasing standards (1.9 percent) or "very prepared" (7.8 percent); in contrast, 35.7 percent said that their company was either "not too prepared" (26.1 percent) or "not prepared at all" (9.6 percent). The highest percent of respondents 34.4 percent said that their company was "somewhat prepared," while 20.2 percent didn't know whether the company was prepared or not (or regarded the question as not applicable).
Other poll questions and responses include:
How easy or difficult do you think it will be for your company to implement the new leasing standards? Nearly half of respondents thought that implementation would be either somewhat difficult (41.2 percent) or extremely difficult (5.8 percent). 1.5 percent thought compliance would be extremely easy, and 13.6 percent thought it would be somewhat easy.
Will your organization invest in technology to comply with the new standards? 27.6 percent of respondents said that investments in either software upgrades or new software would be necessary. 31.3 percent thought that their current software would be adequate, while the plurality of respondents didn't know if software expenditures would be needed (or regarded the question as not applicable).
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Which areas will pose the largest implementation challenges for your company's lease accounting compliance efforts during the next 12 months?
o Collecting necessary data on all organizational leases in a central, electronic inventory 33.4 percent.
o Developing and instituting processes to evaluate quarterly adjustments/reassessments for the balance sheet and P&L as required 20.5 percent.
o IT systems upgrades 8.3 percent.
o Educating investors and internal stakeholders on the impact on the financial statements 6.7 percent.
o Complying with both IASB and FASB standards simultaneously 6.2 percent. (The International Accounting Standards Board also adopted new leasing standards. Although the IASB and FASB initially sought to converge their leasing standards, there are some differences between the two final standards.)
Comment: As noted in the February-March, 2016 Update, companies that engage in any significant amount of leasing should analyze the challenges that the new standard will pose and formulate an implementation plan as soon as possible. In the press release announcing the poll results, Deloitte suggests the following "early steps" to evaluate the implications of the leasing standards:
Assess your organization's current lease landscape, discerning lease volumes and types, availability of electronic lease data and data gaps within them, as well as any potential accounting, tax, and process-related challenges.
Develop a cross-functional project management team to coordinate implementation activities with necessary resources to support it.
Build a granular implementation plan to manage efforts that may span various business units, file types, IT systems, languages, and geographies.
Plan to invest time in lease data abstraction, as culling contracts to get to details needed for lease accounting and disclosure will require a plan and resources of its own.
Determine if your organization's IT infrastructure can support compliance with the new standard(s) with which it must comply, including comprehension and management of new storage, calculation, and reporting requirements.
Audit committees may want to monitor the company's progress on leasing standard implementation in order to avoid last-minute surprises.
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Five Ways to Strengthen the Audit Committee -And What to Look for In Selecting a Chair
Two recent publications offer insight into how to enhance audit committee effectiveness. The Center for Audit Quality (CAQ) has released a summary of the discussion during an April 2016 panel convened by the CAQ and the John L. Weinberg Center for Corporate Governance at the University of Delaware to explore the composition of the audit committee of the future. In addition, executive search firm Heidrick & Struggles (H&S) has issued a report on the characteristics of effective audit committee chairs.
The Audit Committee of the Future
The CAQ's panel discussion summary, The Audit Committee of the Future, identifies five "recurring themes" that the panelists believed would lead to stronger audit committees:
Tighten the audit committee financial expert definition: The CAQ's report suggests that the panelists were divided on this issue. Some were concerned that a stricter definition could lead to "single issue directors" or deprive boards of the flexibility to pick audit committee members that are appropriate for the company's specific circumstances. Others stressed the importance of a high standard with respect to audit committee members' understanding of GAAP so that committee members could assess the auditor's responses to questions.
Enhance voluntary audit committee disclosure: Panelists agreed that audit committees should be making more disclosure to investors and other external parties concerning their qualifications and attributes. "[V]oluntary disclosure is a critical first step to improving communication around audit committee composition and expertise, particularly given that some audit committees may not be adequately disclosing the expertise they already have." The CAQ has long been an advocate of voluntary enhanced audit committee disclosure. See December 2015 Update and November-December 2013 Update.
Foster robust internal communication and engagement: Panelists also agreed that audit committees, particularly audit committee chairs, need to focus on internal communications, such as with the external auditor, internal audit staff, CFO and controller.
Prioritize continuing education: The panel emphasized the importance of continuing professional education for audit committee members, particularly in light of the "growing complexity of accounting standards and financial reporting rules."
Address the "kitchen sink" challenge: As noted in several prior Updates (see January 2016 Update and February 2014 Update), audit committee overload the tendency to assign additional duties, often only tangentially related to financial reporting, to the audit committee is widely recognized as a problem. The CAQ/Weinberg panelists also voiced this concern and urged
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against "blurring the committee's focus" on the core function of financial reporting.
The Role of Audit Committee Chair
The H&S report, Life in the hot seat: Filing the role of the Audit Committee Chair, finds that "today's audit chair must have two basic qualifications financial and compliance capability and an understanding of operational and strategic issues."
As to financial capability, H&S notes that 39 percent of Fortune 100 audit chairs are, or have been, CEOs (and 71 percent of those CEOs began their careers in finance); an additional 30 percent are active or retired CFOs, and 22 percent have been partners in a Big Four accounting firm.
As to strategy, audit committee chairs should "know the company's industry, business model, and strategy as thoroughly as possible" and should be "fully attuned to the company's risk appetite -- and not only in matters of finance but also in all areas of risk within the purview of the committee." The chair must also have "vision--the ability to understand trends that will affect the risk profile of the company and the foresight to ensure that appropriate actions are put in place to mitigate the impact of those risks and safeguard the company's assets."
In addition to the basics of financial and strategic competency, H&S identifies three other characteristics of outstanding audit committee chairs:
They lead teams adroitly. Audit committee chairs "must effectively use the company's outside auditor, consult closely with the CFO and the financial-leadership team, and keep the full board informed about their work. And when the audit chair lacks competency or knowledge about a particular issue, he or she must be willing to depend on other committee members who do have the requisite knowledge."
They are independent and collegial. "[T]he chair must act not only out of conviction but also with the grace that encourages others to speak up, that persuades rather than confronts, and that gets results."
They are courageous. "If, in the course of the audit committee's work, unwise or questionable practices on the part of management come to light, the audit chair must have the courage to speak up * * * even in the face of resistance from management. Conversely, audit chairs must have the courage to back the CEO or management when they think management is right, despite criticism from the press, the public, or shareholders."
Comment: While many of these observations and suggested attributes are fairly general, together they could serve as a high-level checklist of success factors that audit committees and their chairs might want to consider as part of the annual self-assessment process.
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Investor Demand for ESG Reporting is Growing, and the SEC and PCAOB Want to Help
During the next several years, one of the most hotly-debated issues in public company reporting is likely to be whether and if so, how companies should be required to report on their performance with respect to environmental, social, and governance (ESG) issues. Many public companies already engage in this type of disclosure, often referred to as sustainability reporting, on a voluntary basis. There is growing evidence that mainstream, economically-motivated, professional investors use sustainability information in their decision-making. See April 2016 Update and August-September 2015 Update. As a result, the SEC, and possibly the PCAOB, are considering whether they have a role to play in sustainability reporting.
Two recent surveys shed light on the level of investor interest in sustainability disclosures. On May 23, the New York Hedge Fund Roundtable, which promotes ethics and best practices in the alternative investment industry, released the results of a survey of attendees at its Sustainability Investment Leadership Conference. Key findings, as reported in the Roundtable's press release, include:
54 percent of respondents said sustainability reporting is a factor their firms consider when choosing where to invest, while 46 percent said it is "not something they worry about."
60 percent of respondents believe that sustainability reporting is worth the added cost and time. In contrast, 31 percent thought that it is "still too early to know whether investors will eventually hold it against companies that don't report on their sustainability efforts," and 9 percent believed that the focus on sustainability will be "short lived."
49 percent of respondents said that companies realize that sustainability reporting has become important to investors and is in the company's best interest, while 25 percent thought that regulatory requirements are necessary for market-wide sustainability reporting.
43 percent of respondents thought that companies that don't produce sustainability reports risk the loss of investor support, while 20 percent thought that investors remain uncertain about how such reporting can translate to stronger long-term performance. The remaining respondents thought that sustainability reports will need to become "more uniform and concise" before they become a "critical factor" for investors (33 percent) or that such reporting is "merely a fad that is unlikely to gain long-term traction" (4 percent).
The Roundtable did not disclose the number of survey participants. However, the breakdown by profession was fund managers (20 percent); "allocators" [presumably of capital to hedge funds] (12 percent); risk management or trading (18 percent); service providers (32 percent); CPAs (14 percent); and other industry participants (4 percent).
On May 11, MIT Sloan Management Review and The Boston Consulting Group (MIT Sloan/BCG) released a study that is generally consistent
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with the Hedge Fund Roundtable survey. The MIT Sloan/BCG research report, Investing for a Sustainable Future, finds:
Managers' perceptions of investors are out of date: 75 percent of senior executives in investment firms believe that a company's sustainability performance is "materially important when making investment decisions." 60 percent of managers in publicly traded companies share this belief.
Investors believe that sustainability creates tangible value: 75 percent of investor respondents cite improved revenue performance and operational efficiency from sustainability as reasons to invest. Roughly 60 percent believe that "solid sustainability performance" reduces a company's risks and lowers its cost of capital.
Investors are prepared to divest: 60 percent of investment firm board members are "willing to divest from companies with a poor sustainability footprint."
There is a lack of communication within corporations and investment firms and between them: Over 80 percent of investment firm board members "believe that their companies engage in responsible investing," while 73 percent of middle managers and 62 percent of front-line employees hold that belief. In corporations, nearly 80 percent of board members and 85 percent executives state that they are "fully informed about their organization's sustainability efforts;" 51 percent of senior managers and 31 percent of middle managers say the same.
Sustainability indices are losing their luster: 36 percent of investor respondents said that being included on a major sustainability index is an important factor in their investment decisions.
Although a sustainability strategy is considered important, few companies have developed one: Nearly 90 percent of respondents said that a "sustainability strategy is essential to remaining competitive," but only 60 percent of corporations have such a strategy.
The MIT Sloan/BCG received survey responses from 7,011 respondents in 113 countries; however, the research report is based on a sub-sample of 3,057 respondents from commercial enterprises. 579 of these survey respondents self-identified as investors. Of these investor respondents, 39 percent were strategic, 24 percent institutional, and 11 percent retail.
As discussed in the April 2016 Update, the apparent increase in investor interest in sustainability disclosure has caused the SEC to consider whether it should adopt disclosure requirements in the area. In April, the SEC published a concept release inviting comment on potential improvements to its business and financial disclosure requirements, including whether the Commission should mandate public company sustainability reporting. SEC Chair Mary Jo White elaborated on this issue in a June 27 speech to the International Corporate Governance Network. Chair White acknowledged that "there are those who do not believe that our materiality-based approach to sustainability disclosure
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goes far enough" and encouraged comments on "whether changes are needed, and if so, what specifically should be changed." She added:
"There is, in short, more work and thinking to be done on sustainability reporting at the SEC, and by companies and investors, including on whether, when, where, and how to provide disclosure and what precisely should be provided. The issue has our attention."
At the same conference, Public Company Accounting Oversight Board Member Steve Harris also addressed sustainability reporting. In his remarks, he predicted that more "comprehensive, higher quality ESG reporting" was inevitable, particularly as to the impact of climate change, in light of the "needs of investors and the momentum created by so many other countries throughout the rest of the world." He then raised the issue of whether ESG disclosures should be subject to independent verification that is, whether they should be audited. He urged investors to "work with all the relevant parties in the United States, namely the SEC, the FASB, the PCAOB, and corporate America to address the sustainability issues you have so forcefully brought up and discussed during this conference, including whether such information should be subject to independent verification."
Comment: As noted in the April 2016 Update, voluntary sustainability reporting is becoming the norm for large public (and many smaller and private) companies. It is likely that, over time, sustainability disclosures of various types will be mandatory, either as a result of SEC action or Congressional mandates, such as the Dodd-Frank disclosure requirements regarding the use of conflict minerals and resource extraction payments. For audit committees, these types of disclosures will pose challenges involving oversight of compliance with new and possibly complex reporting requirements and of controls and procedures to assure the accuracy and reliability of these nontraditional disclosures.
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Update June-July 2016
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