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Financial Reporting and Regulatory Update

Second Quarter 2018

From the SEC

New Smaller Reporting Company Definition

On June 28, 2018, the SEC voted to expand the “smaller reporting company” (SRC) definition to include entities with public float of less than $250 million, which is an increase from the previous public float threshold of $75 million. This means that more entities will qualify for the SRC scaled disclosure accommodations. The SEC did not change the threshold for the definition of “accelerated filer,” which includes the requirement for an auditor attestation of management’s assessment of internal control over financial reporting (ICFR). Accordingly, for those entities with public float between $75 million and $250 million, Section 404(b) of the Sarbanes-Oxley Act of 2002 (Sarbanes- Oxley) (that is, the auditor attestation of ICFR) remains applicable.

Additionally, for entities with no public float or with public float of less than $700 million, those entities will qualify as an SRC if annual revenues are less than $100 million during its most recently completed fiscal year.

SEC Chair Jay Clayton has directed the SEC staff to consider providing further relief on Section 404(b) of Sarbanes-Oxley.

Draft Strategic Plan

On June 19, 2018, the SEC released its draft strategic plan and requested comment to guide the agency in its priorities through fiscal year 2022. The plan outlines the following three goals along with initiatives to achieve each goal:

  • Focus on the long-term interests of Main Street investors.
  • Recognize significant developments and trends in evolving capital markets, and adjust SEC efforts to ensure effective resource allocation.
  • Elevate the SEC’s performance by enhancing its analytical capabilities and human capital development.

Comments are due July 25, 2018.

Auditor Independence for Certain Lending Relationships

On June 20, 2016, the SEC issued a no-action letter to an investment management company stating that, if certain conditions were met, the SEC would not recommend enforcement action even though the company’s funds were not in compliance with the “Loan Provision” found in Rule 2-01 of Regulation S-X. The provision specifically relates to determining whether an auditor is independent when the auditor has a lending relationship with certain shareholders of the audit client. Subsequent to the release of the no-action letter, registrants and auditors continue to seek clarification from the SEC on various aspects of the provision.

On May 2, 2018, the SEC proposed a rule, “Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships,” that would revise guidance on the Loan Provision. Covering both the audit and professional engagement periods, the proposal would revise the analysis to determine independence as follows:

  • Center only on beneficial ownership, thus removing the owners of record (such as financial institutions and broker-dealers that register shares for the benefit of customers) from the analysis.
  • Establish a new “significant influence” test to replace the 10 percent bright-line shareholder ownership test.
  • Add a “known through reasonable inquiry” standard to identify beneficial equity owners.
  • Revise, for a fund, the definition of “audit client” to exclude funds that would be considered affiliates of the audit client.

Comments were due July 9, 2018.

Corp Fin Deficiency Letters for Certain Registration Statements

On June 12, 2018, Corp Fin announced that it will be releasing letters that identify certain registration statements and offering documents as seriously deficient earlier than in the past. To promote transparency, within 10 calendar days of issuing a letter that identifies a registration statement or offering document as not minimally compliant with regulatory requirements, it will be released to the public through the company’s filing history on EDGAR. This process began with letters issued on June 15, 2018.

Non-GAAP Measures

The SEC’s Division of Corporation Finance (Corp Fin) updated its Compliance and Disclosure Interpretations (C&DIs) on Non-GAAP Financial Measures on April 4, 2018, by adding two questions related to business combinations. The new answers clarify when certain forecasts disclosed by registrants would not meet the definition of a non-GAAP measure.

Speeches and Testimony

Tax Reform and Major Accounting Standards – Sagar Teotia, Deputy Chief Accountant

On June 7, 2018, Deputy Chief Accountant Sagar Teotia, in the SEC’s Office of the Chief Accountant (OCA), addressed the 37th Annual SEC and Financial Reporting Institute Conference in Los Angeles. In his remarks, he covered the following topics:

  • Tax reform and SAB 118
    • SAB 118 does not provide an option to defer application of the income tax accounting guidance. Instead, issuers should complete their analysis of the effect of the Tax Cuts and Jobs Act. While the SEC understands that some entities could not immediately analyze all the effects of the act and allows the measurement period alternatives to be taken in those cases, the SEC does not view this as permission to wait a full year before analyzing the effects. The SEC expects issuers to progress through the analysis in good faith, and timing will vary depending on facts and circumstances. Furthermore, the disclosures about the effects for which the accounting is incomplete should not be overlooked. The OCA remains open for consultations on any application issues.
  • Revenue recognition (Topic 606)
    • Teotia covered the activities that his office has undertaken with respect to Topic 606 implementation, including the speeches OCA staff made during 2017 on revenue recognition implementation matters.
  • Lease accounting (Topic 842)
    • Echoing his previous speeches, Teotia re-emphasized that lease accounting implementation will take time and require numerous steps. He focused on the identification of all arrangements that include leases, or embedded leases, saying that, “it may require time to complete.”
    • He noted agreement with the FASB to not form a TRG for lease accounting, unlike the board’s decision for revenue and credit losses. Even without a TRG, the FASB has moved quickly to address implementation issues by issuing one accounting standard and two proposed standards. Registrants, audit committees, and auditors are responsible for ensuring that any implementation issues are identified and resolved with the appropriate parties.
  • Credit losses (Topic 326)
    • Teotia summarized the OCA’s involvement with credit loss implementation including consultations discussed in a previous OCA staff speech. He also noted the work of the TRG for Credit Losses.
  • Other new accounting standards
    • Specifically noting the cash flow statement and recognition and measurement standards, he reminded the audience not to forget about the other new standards that became effective on Jan. 1, 2018, as well as other standards such as those about hedging that will become effective soon.

FASB Role, New Standards, Non-GAAP, Market Risk Disclosures, Audit Firm Governance – Wesley Bricker, SEC Chief Accountant

Bricker addressed the 2018 Baruch College Financial Reporting Conference on May 3, 2018. He began by sharing his view on the objective of general purpose financial reporting and how the FASB’s general purpose financial reporting standards are formulated to meet that objective. He then contrasted general purpose financial reporting with special purpose financial reporting – noting that the latter fulfills more limited purposes – and observed that both types of financial reporting best serve their intended purpose when their objectives are kept separate.

He next touched on the new accounting standards on revenue, leases, and credit losses as well as the SEC staff guidance related to income tax reform, discussing how these changes will strengthen the overall financial reporting system. In addition, he briefly mentioned the new requirement to record the fair value changes of equity securities in the income statement rather than through other comprehensive income (OCI) as a result of ASU 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities,” which is effective for public companies beginning in 2018. For companies that choose to present non-GAAP information related to this change, he emphasized “non-GAAP reporting may supplement but is not a substitute for GAAP reporting.”

Further, on non-GAAP measures, Bricker noted the requirement to have disclosure controls and procedures that would “prevent error, manipulation, or mischief with the numbers” and “a policy that addresses how any changes in the non-GAAP measure will be reported and how corrections of errors will be evaluated.” He encouraged audit committees that do not already do so to “review the [non-GAAP] metrics to understand how management evaluates performance, whether the metrics are consistently prepared and presented from period to period, and the related disclosure policies.”

In light of the recent rise in market interest rates, he reminded both audit committees and management of the market risk disclosure requirements, noting that some companies’ financial statements are particularly sensitive to market factors including market liquidity and pricing.

Bricker asked the audience to consider commenting on the May 2 rule proposal on auditor independence, known as the “Loan Provision.” The proposal seeks to identify lending relationships between the auditor and the equity owners of audit clients that could impair or appear to impair auditor objectivity and impartiality.

On the topic of audit firm governance, Bricker noted the need for constant efforts to “maintain and nurture trust.” He observed the largest accounting firms have appointed or are appointing independent directors or advisory council members and voluntarily produce audit quality reports to communicate “about the design of an audit firm’s governance and culture.”

Financial Reporting – Wesley Bricker, SEC Chief Accountant

In his address to the Institute of Management Accountant’s 2018 Annual Conference and Expo on June 19, 2018, SEC Chief Accountant Wesley Bricker covered topics similar to his June 6, 2018, speech. Referencing the new financial reporting illustrations on the SEC’s website, he discussed the financial reporting process and the involvement of all participants in the process including management, auditors, audit committees, and the external auditor. Regarding the financial reporting responsibilities of management, he emphasized the importance of strong ethics and culture as well as financial training and literacy. He concluded with the topic of emerging technologies.

Financial Reporting and Innovation – Wesley Bricker, SEC Chief Accountant

On June 6, 2018, in London, Bricker addressed the Institute of Chartered Accountants in England and Wales. He covered the following topics:

  • Highly connected global investing markets
  • Financial reporting information available in markets, including information other than what is in the financial statements
  • Financial reporting processes, including reference to the “U.S. Financial Reporting Structure for Public Issuers” that illustrates the financial reporting structure in three different ways
  • Critical role of audit regulators and audit standard-setters
  • Critical role of auditors, including auditor choice and audit quality, and the auditors of tomorrow

Culture at Financial Institutions – Jay Clayton, SEC Chairman

In Clayton’s address at the Federal Reserve Bank of New York conference on governance and culture reform in New York on June 18, 2018, he shared several ideas related to corporate culture at financial institutions and the SEC:

  • Culture is not an option. Every organization has a culture.
  • Know your culture. In order to effectively manage a firm, you must know its culture.
  • Culture is a collection of countless internal and external actions. Culture is not related solely to the words of management; rather, it is a collection of all the actions carried out within the organization at every level on a daily basis.
  • Culture is preserved and enhanced through a clear and constant mission. The SEC’s mission is furthering the interests of long-term retail investors.
  • Culture goes beyond the law and regulations. “The law may not prohibit all forms of lying, but your culture should reject it.”
  • The SEC does not expect perfection; it does expect commitment and action. People will make mistakes, and those mistakes should be assessed to determine what remediation efforts are needed.

Digital Asset Transactions – William Hinman, Corp Fin Director

In Corp Fin Director William Hinman’s address to the Yahoo Finance All Markets Summit on June 14, 2018, he covered the application of aspects of the securities laws to digital assets. He addressed whether a digital asset offered as a security can, over time, become something other than a security. He shared his views related to certain specified circumstances in which a digital asset can no longer be a security – that is, when there no longer is any central enterprise being invested in or when the digital asset is sold only to be used to purchase a good or service available through the network on which it was created. He also provided factors to consider when determining whether a digital asset is a security or whether it is structured more like a consumer item (such as a good or service to be purchased).

Congressional Testimony on Corp Fin Activities – William Hinman, Corp Fin Director

On April 26, 2018, Hinman testified before the U.S. House of Representatives about Corp Fin activities. He covered the filing review process as well as recent initiatives and upcoming priorities for Corp Fin.

Hinman said that upcoming priorities for Corp Fin include the following recommendations for the SEC:

  • Raise the “smaller reporting company” (SRC) threshold from $75 million to $250 million in public float, or if no public float, less than $100 million in revenue (which would be an increase from $50 million), which would allow more companies to apply the scaled disclosure requirements for SRCs. See earlier section, “New Smaller Reporting Company Definition.”
  • Update and simplify disclosure requirements in Regulations S-X and S-K, including industry guides.
  • Extend the “test the waters” provision from the Jumpstart Our Business Startups Act to nonemerging growth companies, which would allow companies to communicate with potential investors meeting certain criteria before or following the filing of a registration statement.

Commissioner and Personnel Updates

Nomination of New Commissioner

On June 4, 2018, President Donald Trump nominated Elad L. Roisman to be a commissioner of the SEC for a five-year term. Roisman would replace outgoing Commissioner Michael Piwowar, who announced his resignation in May.

Corp Fin Senior Adviser for Digital Assets and Innovation

On June 4, 2018, the SEC named Valerie A. Szczepanik as the senior adviser for digital assets and innovation for Corp Fin Director William Hinman. This new position was created to focus on emerging digital asset technologies and innovations, including initial coin offerings and cryptocurrencies, and coordinate work across the SEC on these matters. Most recently, Szczepanik was an assistant director in the Division of Enforcement’s Cyber Unit.

Chief Risk Officer

On May 31, 2018, the SEC announced that Julie A. Erhardt has been named as the acting chief risk officer as the SEC searches to fill this newly created position. Erhardt joined the SEC in 2004 as a deputy chief accountant in the Office of the Chief Accountant, and she continues to hold that position.