Audit Committee Excellence Series Achieving excellence: Overseeing financial reporting

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1 pwc.com/us/centerforboardgovernance Audit Committee Excellence Series Achieving excellence: Overseeing financial reporting May 2014 PwC s Audit Committee Excellence Series (ACES) provides practical and actionable insights, perspectives, and ideas to help audit committees maximize committee performance. This edition addresses overseeing a company s reported financial results.

2 This ACES module discusses overseeing a company s reported financial results, including: 1. Why financial reporting oversight is critical to audit committees 2. Earnings releases deserve full attention 3. Tips for reviewing reported results o Understanding the financial reporting process Disclosure controls and procedures The closing process Key estimates and complex areas SEC comment letters o Reviewing actual filings Current developments in the business Concentrating on changes Unusual/nonrecurring transactions Changes to estimates

3 1. Why financial reporting oversight is critical to audit committees One very important responsibility of an audit committee is oversight of the company s financial reporting. For public companies, that includes the quarterly Form 10-Q and annual Form 10-K that the company files with the SEC. What are some of the challenges? They can include meeting filing deadlines, especially in situations where companies do not have a streamlined process to gather the information it needs to close its books. Deadlines differ depending on the size of companies market capitalization. But in all cases they require that management, the external auditors, and the audit committee perform their roles within a compressed timeframe. The filing document itself can be long and complex. It s not unusual for 10-Ks to approach 100 pages in length and for financial services companies they can exceed 300 pages. 10-Qs are usually shorter, but some are still over 200 pages long. Given that audit committees usually receive draft Ks and Qs a week or less before their committee meeting (along with other reports from the CFO, internal audit, compliance officer, and external auditors), they can face a substantial challenge to efficiently and effectively review the materials. Are there techniques to help audit committees review reported results effectively? And are there ways the entire process can be more efficient? The answer to both questions is yes. But before describing the practices that can help audit committees with their review of reported financial results, a related matter needs to be addressed. Most public companies first release their quarterly and annual financial results (referred to as preliminary results ) in earnings press releases often days or even weeks before filing their Ks and Qs. Earnings releases can significantly impact the company s stock price (often more than the actual filing of the results themselves). That s one of the reasons it is so important that the reported results are accurate, even though they may be described as preliminary. 2. Earnings releases of preliminary results deserve full attention Typical earnings releases are short and sweet compared to SEC financial statement filings. They generally include the basics: balance sheet and statements of income and cash flows for the quarter and year-to-date, with comparisons to the comparable periods of the preceding year. No footnotes and only limited discussion of results are included. They often discuss certain non- GAAP measures and special items included in the reported results. Analysts pay a great deal of attention to earnings releases; frequently the company s stock price will move if the reported earnings are different from what the Street expected. Once the stock price has reacted to the earnings announcement, there are reasons and pressure not to subsequently adjust those reported results, including investor relations concerns. Audit committees typically hold a meeting to discuss and approve the draft earnings release. These meetings are often held via conference call and are generally short. It is not uncommon that audit committees receive a copy of the draft release only a day or two before the meeting. Earnings releases covering preliminary results can be sensitive to events occurring after their issuance ( subsequent events ). Sometimes, an event occurs or new information becomes known after the date of the earnings release but before the actual filing. It could be the settlement of a major lawsuit or the bankruptcy of a significant customer for whom the company had not fully reserved a receivable. If the event or new information is significant and relates to facts and circumstances existing at the balance sheet date, management will have to evaluate whether to disclose it and whether to adjust the previously reported preliminary results. Each subsequent event needs to be evaluated on its merits for the possible impact on already reported earnings and current disclosures. Audit committees should anticipate the possible risks associated with having limited time to review the earnings release and the delay between its release and the date of the actual filing. The longer the period of time between when a company issues the preliminary earnings release and when it files its 10-K or 10-Q, the greater the likelihood that some material subsequent event could occur. This increases the potential that the company will have to update the preliminary results initially reported and re-release earnings. Although this rarely happens, it is a risk. Because the earnings release typically is not timed to coincide with the SEC filing, it s unlikely that the external auditors will have finished their audits (for Ks) or reviews (for Qs). Thus, there is a chance that results of additional testing or a subsequent event alters the auditors perspective on the previously reported preliminary results. This also could result in the need to amend those reported results. Achieving excellence financial reporting oversight 3

4 Once the stock price has reacted to the earnings announcement, there are reasons and pressure not to subsequently adjust those reported results, including investor relations concerns. Audit committee considerations: Review the draft earnings release carefully, in particular noting how the operating results are described. Be sensitive to the impact preliminary results may have on the company s stock price. Discuss the status of the external auditors work before the earnings release. Although an audit committee may ask if its external auditors are comfortable with the results the company is about to release, the reality is that auditors cannot provide final approval until their work is completed. Assess the risk that some event or finding could come to light before the actual filing date that could impact the preliminary results to be reported in the earnings release. Audit committees should consider the company s history, management experience, and the facts and circumstances. Pay attention to special items and non-gaap measures - particularly in the earnings release. The SEC supports companies providing non-gaap measures if those measures help users better understand a company s operations and results. Some measures, like EBITDA, are widely used and accepted. But it can be tempting for executives to highlight as a special item all the unfortunate events the company faced, despite the fact those events recur periodically or regularly and thus are not necessarily special. Even if the company does not back such items out of earnings in a non-gaap presentation, the general expectation is that the analysts will do so. Often, these special items and non-gaap measures are not included in the actual filing with the SEC. Audit committees should look for balanced and consistent reporting, including special item callouts and non-gaap measures that could be misleading. For example, if including the impact of foreign currency changes in an adjusted earnings number helps the company meet analysts expectations, the audit committee should consider whether the company s approach has been consistent quarter over quarter and year over year. Because these types of disclosures are not addressed by GAAP, there is no relevant authoritative guidance for the company or its external auditors to reference. For any major developments occurring after the earnings release date, discuss whether/how management plans to record and disclose them. Audit committees should discuss these items with the external auditors as well, and then decide whether they are comfortable with management s approach. Discuss the time period between the company s earnings releases and filings. If that period is extended, understand the company s reasons. Sometimes an early earnings release date is driven by a desire to align the reporting of a company s results with its peers. Probe the practical implications of either postponing the release date, filing earlier, or both. Listen to the company s earnings calls with analysts. This will help audit committee members understand which issues company analysts are focused on. It will also give some insight into the executives grasp of the issues and how they react under pressure. Audit committee members may also want to listen, at least periodically, to analysts calls with peer and competitor companies to get better insight into the industry. It can be tempting for executives to highlight as a special item all the unfortunate events the company faced, despite the fact those events recur periodically or regularly and thus are not necessarily special. 3. Tips for reviewing reported results Understanding the financial reporting process Disclosure controls and procedures Public companies are required to maintain disclosure controls and procedures ( DC&P ) and certify their effectiveness quarterly. DC&P need to enable management to timely collect and evaluate information that is potentially subject to disclosure. There are two common approaches to support the DC&P certifications, often used in tandem: sub-certifications and disclosure committees. 4 Audit Committee Excellence Series

5 Getting representatives throughout the company to sign and submit sub-certifications can be highly effective, if done right. Ideally, finance executives in each business unit would certify that the results they ve reported to the head office are complete and accurate, reflect only valid company transactions, and are reported in accordance with the company s accounting policies. Some companies also ask for sign-off on other matters, such as compliance with the Foreign Corrupt Practices Act or with company policies. The sub-certification forms should allow the finance executives to indicate if they have any reporting concerns or issues they aren t sure about. The head office must ensure that everyone who should submit a certification has done so, follow-up on missing certifications, and address and resolve any concerns noted. Many public companies have management-level disclosure committees that meet at the end of the quarter to discuss financial reporting issues. Committee composition usually includes representatives from the company s financial reporting, accounting, legal, internal audit, compliance, investor relations, and finance groups. Typically, meeting minutes are maintained; external auditors may or may not attend. The closing process how difficult is it? At the end of every reporting period, there are a series of processes to accumulate information across the company. Highly automated processes may result in a faster close and less risk of a manual error. It s important that audit committees understand the nature and extent of significant top-side entries made by management. Key estimates and complex accounting areas taking the deep dive Management has to use judgment to record a number of estimates that significantly impact reported results (e.g., loan loss reserves). Audit committees should understand what those key estimates are and how they were developed. This typically requires a robust discussion about the judgment/estimation process, key inputs to determining estimates, the sensitivity of changing a variable, and management s historical accuracy. Audit committees should also consider when and how the external auditors should be part of the discussion. Certain areas of a company s accounting and reporting are often more complex (e.g., revenue recognition or accounting for income taxes). Many companies will provide their audit committee with a deep dive into certain of these areas once or twice a year. This can be done on a rotational basis at a regularly scheduled meeting. The discussion can include the business aspects of the area, how finance personnel record transactions, and how internal and external auditors approach their testing of the related accounts and controls. SEC comment letters be aware The SEC staff periodically reviews company filings and often sends a comment letter with any identified accounting or disclosure questions. Audit committees should be informed of likely areas of interest and, when a letter is received, the issues that have been raised and how management plans to respond. Usually disclosure changes are made in future filings; occasionally the SEC staff asks a company to amend a past filing. A few items are noteworthy. The SEC staff s comment letters and the company s response letters will be posted on the SEC s website where investors, competitors, and the media can see them. It is important for management to respond in a measured, appropriate manner. Companies should not take their responses lightly or rush to respond. They should take the time to fully understand the underlying concern, consult with advisors (including auditors and securities counsel, if needed) and prepare a high-quality response that will satisfy the SEC staff with the first answer. Hurried or inadequate responses could generate additional comment letters and sometimes lead to an investigation. It s also helpful for audit committees to understand the nature of comment letters the SEC staff is issuing to companies generally, particularly in their industry. Audit committee considerations: Periodically ask management to describe its financial reporting process, including its use of subcertifications. Ask about any significant concerns raised in the sub-certification process and how management is addressing them. If there is a disclosure committee, understand how it functions and who attends the meetings. Have management describe significant transactions or events that were discussed in the quarterly meeting. Understand any non-boilerplate representations in management s letter of representation to the external auditors. In addition to normal ongoing representations, external auditors sometimes add non-standard items to address unusual transactions or events that occurred during the period. Request that these special representations be highlighted. This will promote a better understanding of some of the more sensitive issues the auditors thought were important enough to have management put in writing. Assess whether the audit committee would benefit from educational sessions or a deep dive to better understand how management accounts for particularly complex or judgmental areas. Achieving excellence financial reporting oversight 5

6 Reviewing actual filings Understanding current developments in the business is a must Many CEOs regularly communicate with directors about the current state of the business. This includes developments in the competitive and economic environment and how they are impacting the company. Such communications can be helpful to audit committees by providing the context they need to form their own expectations of what the period s financial results should look like. Audit committees should then compare their expectations to the reported financial results and disclosures much like auditors do. Plus, this added insight allows audit committees to probe whether management has, or should, alter assumptions and factors used in developing key estimates. Concentrating on changes can enhance efficiency and effectiveness Some management teams do a great job helping audit committees understand what has changed in the current report. They also emphasize how significant new events and developments are reflected in the filings. We ve seen this done a few ways. One is to highlight disclosures that are new or different so the committee can concentrate on the issues. Another is to provide a cover memo describing the developments or changes and referencing the page in the filing that includes the new or altered disclosures. Management should also highlight whether the filing has changed in response to an SEC staff comment letter. Awareness of unusual/nonrecurring transactions is essential Quarterly results often include significant transactions that are not of an ongoing or recurring nature. Sometimes these transactions may be included in the analysts models used to develop the Street s consensus estimates. However, many times they are not. The audit committee must understand the impact of these items on the quarter to ensure appropriate disclosure and to truly understand management s performance. Management can provide a summary of material, unusual, special, or nonrecurring items each quarter with explanatory comments and the quantified impact of the items. For example: Description Write-down of obsolete inventory Impact on pretax income Impact on net income $15M $10M 2 Impact on earnings per share Changes to estimates can significantly impact reported results Even if the audit committee understands how key accounting estimates and judgments are developed through periodic deep dives or other means management should inform the committee if key assumptions have changed. It should also summarize the impact of such changes to period-over-period earnings and earnings per share, similar to the illustration above. For example, when it comes to pension and other postretirement benefits, even small modifications to the expected long-term rate of return on plan assets can have a significant impact on the amount of the reported net liability. Management can provide a summary of material, unusual, special, or nonrecurring items each quarter with explanatory comments and the quantified impact of the items. Audit committee considerations: If the audit committee believes it needs more information about how the company has performed during the quarter, discuss this with management and fellow directors. Follow-up on any significant disclosures or results that do not match expectations. If the audit committee is not currently doing so, ask management for help in better understanding what has changed in the current filing by using highlights. Consider requesting schedules quantifying the impact of both unusual transactions and significant revisions in estimates occurring and reflected in the current quarter. Discuss major developments and new information that became available between the earnings release date and the filing date. Through discussions with management and the auditors, determine that the necessary disclosures have been made. Also, ensure that the potential impact on previously released preliminary earnings has been considered. Restructuring charges $60M $40M 8 6 Audit Committee Excellence Series

7 How PwC can help To have a deeper discussion about how this topic might impact your business, please contact your engagement partner or a member of PwC s Center for Board Governance. Mary Ann Cloyd Leader, Center for Board Governance (973) mary.ann.cloyd@us.pwc.com Catherine Bromilow Partner, Center for Board Governance (973) catherine.bromilow@us.pwc.com Don Keller Partner, Center for Board Governance (512) don.keller@us.pwc.com Other topics Other Audit Committee Excellence Series topics include: Assessing the company s forward-looking guidance practices and the potential risks of consensus estimates (March 2014) Find more information at Download our ipad app at PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.