IFRS – Time to Panic?

IFRS is a ticking time bomb!In recent months the focus of discussions related to adoption of the International  Financial Reporting Standards have centered on differences with US GAAP (such as LIFO inventory), timing and implementation. I don’t want to debate the necessity of adopting a world standard given our weakening  influence over the world economy, or the esoteric benefits or detriments.  My concerns are much more basic. Without tort reform in the United States, IFRS is a time bomb with a very short fuse resulting in a cataclysmic disaster waiting to happen.

Currently, US GAAP is a rules based set of standards. While the end result of their application frequently results in worthless unsupportable financial reporting, the issuer and their auditor have but to point to the ‘rules’ in defense. On the other hand, IFRS is principles based, and simpler to apply.  But it can and frequently does require the issuer and his auditor to exercise judgment.  Judgment that can be questioned, criticized and  litigated.

Please don’t misunderstand.  Professionally in my opinion the quality of financial reporting will be significantly improved by the application of sound principles. IFRS is long overdue. Without liability reform, however, I fear financial reporting and assurance services will quickly follow the health care industry in terms of cost to the providers.

Maybe I’m just paranoid in my advancing years.

Oil and Gas Accounting – SEC Issues SAB 113

Oil & Gas IndustryThe Office of the Chief Accountant through Corp Fin recently published Staff Accounting Bulletin 113.  There are four main areas of focus within this SAB which will likely affect everyone to some degree:  valuation methodology of oil and gas reserves; clarification of methodology related to write-offs of excess capitalized costs under the full cost method; extending appliability of guidance to include unconventional methods of extracting oil and gas from sand and shale;  and removing information from the guidance which is no longer necessary.

For the most part SAB 113 is pretty straight forward, however, as is the case with many of the SABs, hidden in the minutiae are land mines for the unwary or uninformed.  Correspondingly you would be well served to skim through it for any matters that might affect your company, and then discuss them with your audit firm.

Additionally, on October 26, 2009 additional Oil and Gas Rules were released.  These compliance and disclosure interpretations (C & DIs) relate to Regs S-X and S-K.  There is some important information here which is very relevant and brief!

Critical Accounting Policies and How They Differ From Significant Accounting Policies

Critical AccountingIn an effort to help improve my client’s filings, and of course avoid SEC Comment Letters,  I am constantly reminding them that the disclosures required by SEC Rules Release 33-8098, contained in the MD&A, are considerably different than the significant accounting policies disclosed in the footnotes. Too frequently issuers simply cut and paste their summary of significant accounting policies into this section, which I believe will result in comments from the SEC if selected for a full review by Corp Fin.

I believe the intent of the critical accounting policies disclosures is for issuers to identify and disclose only those accounting policies that require significant judgment and estimation with a degree of uncertainty. Further, simply narrating the assumptions used in a Black-Scholes model for valuing stock options does not provide the appropriate information contained in the rules release. Disclosures related an issuers critical accounting policies (estimates) should include the methodology used in developing assumptions and the corresponding estimates, how the estimates impact the financial statements, and the effect of a change in the estimates and / or underlying assumptions.

The SEC provides two questions issuers need ask in making the “critical” determination:

  1. Did the estimate require making assumptions about matters that are highly uncertain?
  2. Would reasonably developed, different estimates / assumptions, at the time or in future periods, have a material impact on our financial statements?

When both questions are answered yes, it should be included in this section of the MD&A.

The included disclosures should not simply be boilerplate (like significant accounting policies tend to be) or be overly accounting technical (as “plain English” as possible). Further, the SEC expects varying numbers of critical accounting policies amongst issuers, but they have indicated three to five as a reasonable range.

The rules release provides several examples of disclosures that can help issuers develop the approach and content for appropriate inclusion in future filings.

Oil and Gas Accounting and Disclosure Rules Revised under SEC Release 33-8995

Oil & Gas AccountingLast Friday, the AICPA released a discussion draft of the audit and accounting guide for Entities with Oil and Gas  Producing Activities. While not authoritative  it is anticipated to reflect the current standards being revised by both the Financial Accounting Standards Board which sets US GAAP, and the International Accounting Standards Board, all of which is being done in response to SEC Release 33-8995.

While the changes are too voluminous and complex to even summarize here, I’ve included links and welcome questions,comments to this post or phone calls to discuss the implications.

The definitions in Rule 4-10 have been significantly changed. The pricing mechanism for reserves has been defined as a twelve month average. The definition of what is and is not considered ‘oil and gas’ has been clarified to include bitumen and other saleable hydrocarbon resources (geothermal has been excluded); the definitions of ‘proved’ ‘unproved’, ‘developed’ and ‘undeveloped’ reserves has been amended and clarified; and the disclosure requirements under Regulation S-K has been expanded.

Additionally, the disclosure requirements within the financials and for the K’s and Q’s  have been expanded and clarified including the disclosure requirements for MD & A. The SEC continues to coordinate with the FASB and the IASB who continue to develop their standards for the oil and gas entities. Given the SEC has come to the party first, it’s hard to imagine the other standard setting bodies will do anything but comply.

Foreign filers using Form 20-F will be subject to the same disclosure as opposed to the previous disclosure requirements summarized under Appendix A. Canadian filers, however, will not be subject to the new disclosure rules given that the requirements under the Multi-Jurisdictional Disclosure System (MJDS) using form 40-F are already consistent.

Now some good news. The implementation date  for registrations filed and for annual reports on Forms 10-K and 20-F is for fiscal years ending on or  after January 1, 2010. While the implementation is mandatory, “a company may not apply the new rules to disclosures in quarterly reports prior to the first annual report in which the revised disclosures are required”.  Implementation may  be deferred as discussions between the SEC, FASB and IASB go forward.

SEC Extends ICFR for Small Issuers to 2010

Today, October 2, 2009, the SEC announced that independent audits of internal control over financial reporting has been extended for smaller reporting companies.  The press release indicates small companies will now need to be compliant beginning with annual reports for fiscal years ending on or after June 15, 2010.

Fair Value – Inactive Markets and Orderly Transactions

Recently issued “guidance” provides that when determining the fair value of certain assets (liabilities) it is only appropriate to use comparable transactions that were not fire (liquidation) sales where an active market exists.    The recent guidance (pre codification FSP FAS 157-4, codification 820-10-65-65-4), effective for interim and annual periods ending after June 15, 2009, simply provides additional items to consider for adding additional premiums or discounts when developing fair value estimates.

Further, the new guidance continues to reiterate the fair value definition that has been around for several decades, “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  Remember, the Company’s intent or ability to hold an asset should not be used in determining fair value as the estimate is market based and not entity specific.

In developing estimates, several factors provide an indication that significant adjustments to fair value (in this case quoted market prices – Level 1 inputs) may be necessary when market activity does not appear to be normal.  Some of those factors include:

  • Declines in recent transactions
  • Price quotations are stale or vary substantially, including significant bid-ask spreads
  • Indexes no longer correlate to values of individual assets or liabilities

After analyzing the market activity in general, the next step is to perform additional analysis to determine the transactions were not forced liquidations or distressed sales.  Factors to consider when a transaction may constitute a distressed sale include:

  • A recent transaction that appears to be an outlier compared to other recent transactions
  • Signs indicate the seller is experiencing significant financial difficulty, e.g. at or near bankruptcy
  • The asset (liability) was not marketed for an appropriate period or to multiple buyers

Three outcomes exist when analyzing transactions to determine if they fall within the fair value definition and require inclusion in estimates.  First, if the transaction is not orderly, it would likely hold little weight in estimating fair value.  Second, if the transaction is orderly, see above market activity analysis when determining how to include in fair value estimates including risk premiums.  Finally, there may not be enough information available to conclude whether the transaction is orderly, in which case, it should still be considered, but not the sole indicator of fair value.

The guidance recognizes that issuers need not undertake undue cost and effort in making these market determinations, but should not ignore information that may be readily available in the public domain.  Further, the degree of difficulty and subjectivity in developing risk premiums does not provide a sufficient basis to exclude risk adjustments to fair value.

At this point, you may be asking yourself – where does one obtain all of this information?  That is a very good question and I am out of time…anyone, anyone, anyone?.!

Audit of ICFR for Small Reporting Companies

It appears the time has come for non-accelerated filers to obtain an audit of internal controls over financial reporting from their external auditor, likely in the form on an integrated audit with the filer’s financial statements.

To date, the SEC has not updated its most recent rules release on the requirement for non-accelerated filers to include an attestation report of their independent auditor on internal controls over financial reporting for fiscal years ending on or after December 15, 2009 (with certain exceptions for new registrants).

Recent remarks by both SEC Commissioner Luis Aguilar and SEC Chairman Mary Schapiro seem to indicate no additional extension will be granted, absent the SEC’s on-going cost-benefit study of SOX Section 404 indicating costs significantly out of line with the benefits.

In preparing for obtaining an audit report, which is as of the annual balance sheet date, it is a good idea to be familiar with a couple of different pieces of guidance.  The first of which is the COSO ICFR guidance for smaller reporting companies to ensure appropriately designed and implemented controls to detect and prevent material misstatement of financial information.  Secondly, to get an idea of the auditor’s approach, review the PCAOB’s Auditing Standard No. 5 and further the PCAOB’s staff views issued January 23, 2009.

EITF 07-5 Highlights

Financial IstrumentsIt appears the Emerging Issue Task Force (EITF) has provided some seemingly useful guidance as to the determination of the application of SFAS 133.  As I see more and more companies issuing various types of hybrid financial instruments in order to fund ongoing capital needs, I also see varying degrees of application of SFAS 133 and its next cousin EITF 00-19.

Sifting through the guidance and corresponding AICPA roadmap to properly account for these transactions seems to be the equivalent of ………  The recent issuance and 2009 implementation of EITF 07-5 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock seems to alleviate some of the confusion surrounding certain redundant conditions in most financial instrument agreements that we have seen.

For example, several recent issuers entering into convertible debt transactions, with certain similar terms, each have radically different balance sheet presentations.  Ignoring the SFAS 155 election (which is another matter of discussion), one issuer determined that SFAS 133 didn’t actual apply to the convertible debt and presented the standard convertible note payable; while another determined that SFAS 133 applied, jumped to EITF 00-19 to determine the classification of the derivative instrument requiring bifurcation, and concluded permanent equity treatment was appropriate; and the third issuer determined SFAS 133 in fact applied, required bifurcation, and treated the derivative instrument as an additional liability requiring periodic revaluation.

While having many recent discussions with CPAs, CFOs, University Professors, and anyone else that might have some insight, including the FASB Staff themselves, we were pointed to the seemingly useful guidance contained in EITF 07-5.  In the example above, I see most issuers spending most of the time reaching for non-application of SFAS 133 under the exceptions contained in paragraph 11(a) that states that “contracts issued that are both indexed to an entity’s own stock and classified in stockholders’ equity are not considered derivative instruments”.   If the complete blow off of SFAS 133 does not work, as in the case of the second issuer above, permanent equity treatment becomes the next best option under the general guise that the issuer has control over adjustments to conversion prices and amounts or that the likelihood of significant detrimental adjustment in the derivative value is de minimis.  This example, in particular, appears to be clarified by EITF 07-5.

For all instruments outstanding in fiscal years beginning after December 15, 2008 it appears the application of EITF 07-5 will correspond with increased application of SFAS 133.  The EITF guidance indicates several financial instruments are not actually indexed to a companies and stock and would infer SFAS 133 treatment (liability classification).  Paragraph 15 eliminates both common arguments against bifurcation:  i) the issuer has the ability to control any conversion adjustment and ii) the probably of making detrimental adjustments is de-minimis.  The paragraph further indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument, regardless of the probability or whether or not within the issuers’ control, is not indexed to the issuers own stock.

The inability to conclude that financial instruments are actually not indexed to the issuers own stock, thereby, significantly eliminating the derivative instrument exception paragraphs of SFAS 133 will likely result presentation changes of a large number of small reporting companies and may result in some interesting earnings swings.

Maybe the little used SFAS 155 election for financial instruments warrants further discussion?

IFRS – No Big Deal!

Judging by the material that is coming out from the Big 4 accounting firms, it seems that accounting as we know it is about to disappear and a new behemoth called IFRSs are about to invade the US accounting scene.  Recently the office managing partner of one of those firms admitted to me that they viewed the issue as a consulting opportunity rather than a threat.  I agree.

Judging by the material that is coming out from the Big 4 accounting firms, it seems that accounting as we know it is about to disappear and a new behemoth called IFRSs are about to invade the US accounting scene.  Recently the office managing partner of one of those firms admitted to me that they viewed the issue as a consulting opportunity rather than a threat.  I agree.  Fear mongering is a great way to generate revenue for the consultants.  Just look at the millennium bug.

IFRS are already here and have been for quite some time. Most of the standards that have been issued since in the past four years have been designed to bring US GAAP standards and international GAAP standards (IFRS) closer and closer together.  This is commonly referred to as ‘convergence’.   FASB 141 (R) for business combination’s and FASB 160 on minority interests are typical examples. FASB has issued  standards that are  consistent with the international standards.  The International Accounting Standards Board (IASB) is doing the same thing as the FASB. They are issuing standards to bring them closer to US GAAP alternative over time where US GAAP is deemed preferable to IFRS. This convergence process has been going on for years and is nothing new.

What is new is the “road map” that has been put in place by the SEC, and it changed again recently. Foreign listers on the US exchanges are already allowed by the SEC to use IFRS. A limited group of about 100 US companies will experiment with early adoption of IFRS in the US in 2009. Most of these companies are already using IFRS for significant parts of their international operations anyway so they don’t need much outside help. For the rest of us, the SEC will make a decision in 2011 on whether to move to require all US listed companies to follow IFRS by 2014. Unless we get some xenophobic idiots appointed to the SEC  this is a done deal.  Although the new SEC Chairperson, Mary Shapiro, has announced that she is considering slowing down the process, it probably won’t change the FASBs agenda.

Is this a major issue? I don’t think so. By 2014, all of the major differences between US GAAP and IFRS will almost certainly have been eliminated. There are some problem issues to be resolved. Some are straightforward like the use of LIFO for inventory accounting. The problem here is that tax accounting in the US is impinging on real accounting. We will have to find some tax solution to unbundle the inbuilt tax problem that LIFO has created for many companies.

Other issues are more difficult and highly technical. The ugly issue of derivatives is always at the forefront here. Almost nobody understands the US standard FASB 133 and the same is true that almost nobody understands its international equivalent. All we know is that they have some differences and the financial institutions don’t like either of the standards anyway.

Some issues appear more frightening. For example, with IFRS we will lose those “bright line” guidelines that US accountants love so much. For example, the four tests for a capital lease that lawyers love to circumvent will be no more. Greater judgment will be required. This is an issue because you may have to get up in a court of law to defend your judgment. Looking on the bright side, at least you wont get tripped up by some smart trial lawyer because you did not follow some little known paragraph of one of the 14 FASs, 6 INTs, 10TBs, 2FASBSPs and about 25 EITFs that currently relate to leases in US GAAP. They will be gone as authoritative documents.

For non-listed companies, there are some proposals on the table on how to apply IFRS to smaller entities. Personally I don’t like the proposals because I don’t like having two-tier GAAP for large and small enterprises. Again, whatever changes occur will drift in over time largely unnoticed by most.  If you have any experience with IFRS please comment.

Proactively Controlling Your Audit Fee

For many firms it is that time of year.  The annual invasion of that group of  mind numbing, routine interrupting, standards spouting unwelcome invaders – your independent auditors!  And they are expensive!  Reflectively they can make you want to trade their presence  for an unannounced three month visit from your cantankerous incontinent father-in-law who never speaks directly to you and who for fifteen years has  referred to you only  as “him / her”.  An article published in cfo.com, Auditor Angst, has some great points to not only help you survive, but to reduce the expense at the same time.  While the article primarily focuses on what the company can/should do there is obviously a lot the auditors can do as well. Continue reading “Proactively Controlling Your Audit Fee”