Remarks before the 12th Annual Life Sciences Accounting and Reporting Congress
James V. Schnurr, thoughts and perspectives on the continuing transition activities
|Wednesday, March 23, 2016|
By James V. Schnurr, Chief Accountant, SEC Office of the Chief Accountant
March 22, 2016
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.
Today, I would like to share some of my thoughts and perspectives on the continuing transition activities for the new revenue standard, the important dialogue among preparers, auditors, and others on internal control over financial reporting, and concerns related to trends on non-GAAP reporting measures.
Revenue recognition policies
In May 2014, the FASB and IASB accomplished a major achievement in the Boards’ joint efforts to improve this important area of financial reporting when they issued a converged standard on recognizing revenue (Topic 606 and IFRS 15). The new guidance is intended to improve existing revenue requirements by eliminating industry-specific guidance, provide a more robust framework for addressing revenue issues, and require additional disclosures to users of financial statements.
I consider the new converged revenue standard to be an important step forward in financial reporting for preparers and investors, both domestic and foreign. These changes will impact all companies and all industries, but the extent of the impact will differ from industry to industry.
Although most companies will begin reporting under the new standards in 2018, when they do so, companies who elect a full-retrospective approach (rather than the modified-retrospective approach, which is also permitted) will need to apply the standards to the prior years’ comparative revenue amounts. As an example, a calendar-year reporting company with a three-year comparative income statement presentation who chooses a full-retrospective approach would apply the new standard in reporting revenue in each of the years presented, that is, 2016 to 2018. Accordingly, the revenue numbers that companies report this year and next, 2016 and 2017, will possibly change when those same companies apply the new standard in 2018; a point that is relevant for both the companies implementing the new standard and users who analyze the financial statements.
I would like to provide a few examples from the life sciences industry to illustrate the importance of evaluating the impact of the new standard.
As you know, many companies in the life sciences industry are involved in research and development arrangements. Those arrangements highlight an important scoping decision — if the arrangement is a collaboration, the new revenue guidance does not apply. If, on the other hand, the arrangement represents a contract with a customer (because, as an example, the company is being paid by a third party to conduct research on their behalf), the new guidance would apply. Further, some arrangements may include both a contract for collaboration and a contract for the transfer of goods and services to a customer; in this case, the arrangement may be partially in the scope of the new standard. This example illustrates the need for companies to carefully analyze their arrangements and evaluate them in the context of the scope of the revenue standard, which further defines when an arrangement should, and should not, be reported as revenue.
Another example where the new standard will impact life sciences companies relates to variable pricing terms that are common in various research, development and royalty contracts that life sciences companies have with their customers. Under the new revenue guidance, variable pricing terms, such as performance bonuses, milestone payments, and guarantees, will need to be re-evaluated as the timing of revenue recognition and content of disclosures could differ as compared to current U.S. GAAP. Because the new guidance does not permit unconstrained recognition, there is an important judgment about the likelihood of revenue reversal that must be made prior to recognizing revenue.
As a final example, rights of return are common in the life sciences industry, as are agreements to cover distributor carrying costs, guarantees of distributor profits, and other concessions. Under both the current guidance and the new revenue recognition standard, these types of agreements require close evaluation to determine the appropriate timing and amount of revenue recognition. The core principle of the new revenue recognition standard is that companies will recognize revenue to depict the transfer of promised goods to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods. I expect management to implement — and the audit committee to oversee — controls to prevent the inappropriate recognition and reporting when a company sells products through a distribution network. The SEC staff will continue to monitor the sales practices and reporting of these types of arrangements.
An important aspect of the revenue recognition standard is that the application requires judgments by the preparer that will be later evaluated by auditors, investors, and regulators. I encourage companies to develop the judgments with appropriate knowledge of the new standard and a careful assessment of all relevant facts and circumstances surrounding their transactions. The assessment will often need to include an understanding of the contract terms (both written and oral), the economic substance of the arrangement, and attention to any contingencies such as those that can impact amounts recognized. Of course, documentation of the judgments will be critical to the application of the standard and should be reflective of the complexity and materiality of the arrangement.
Status of the revenue TRG
While I am optimistic that the key practice issues that require standard setting have been identified through the implementation activities of preparers, auditors and standard setters, I am concerned that there are still a number of questions that would benefit from the TRG process. In this regard, the FASB has scheduled TRG meetings for 2016 and intends to continue to address implementation issues that may arise. The IASB, on the other hand, announced in January that it has no plans to schedule further meetings until it determines there are additional implementation questions that warrant a meeting of their TRG. Instead, the IASB will continue to monitor the activities of the FASB TRG to determine if the issues should also be addressed by their TRG. Without joint participation of the IASB’s TRG in the coming scheduled FASB TRG meetings, there is a concern that IFRS 15 may be interpreted through a U.S. GAAP lens without the perspective of IFRS preparers. I encourage IFRS preparers to provide input to the FASB staff and the FASB TRG participants to the extent they believe they have important factors that should be considered for discussion by the FASB TRG.
My staff and I will continue to participate as observers in the TRG meetings, particularly in light of the purpose for the meetings of providing a transparent forum for stakeholders to learn about the guidance, with due process around the submissions. The discussions at TRG meetings are designed to foster comparability in application by registrants, whether domestic or foreign. As a result, the SEC staff will be informed by the TRG discussions when evaluating the reasonableness of registrant revenue recognition policies, whether established under U.S. GAAP or IFRS.
Accordingly, I would expect registrants to monitor the TRG discussions and meeting minutes to inform their selection and implementation of reasonable policies. I would also strongly encourage a registrant, whether domestic or foreign, to consult with the Office of the Chief Accountant if the registrant intends to select and implement an accounting policy for revenue that is inconsistent with TRG discussions.
Status of registrant implementation
In a survey conducted by PricewaterhouseCoopers LLP (PwC) and the Financial Executives Research Foundation in the fall of 2015, 75% of responding companies indicated that they had not completed their initial impact assessment and, of those, 27% had not begun their assessment at all. Other firms have conducted similar surveys with consistent results, all of which lead to the observation that implementation efforts appear to be lagging at many companies.
Implementation of the new standard requires significant effort by companies, including analyzing contracts and designing new systems, processes and controls. Given the importance of high quality application of the standard, I believe executive management, the audit committee, and the company’s external auditor should discuss implementation status and plans, as well as the allocation of sufficient resources with appropriate skill sets to execute the plan.
Auditors have an obligation under PCAOB standards to communicate with the audit committee about any concerns regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective and might have a significant effect on future financial reporting.
In September 2015, my deputy chief accountant, Wes Bricker, expressed concerns about timely submission of challenging implementation questions to the TRG and others. Industry groups have continued to make progress since then. I acknowledge and appreciate the significant effort required for this endeavor. However, I believe there is still more work to do.
I encourage industry task forces to identify issues and seek consistency in material conclusions. Where consistency is not achieved by task forces, I encourage members to escalate issues to the TRG for further discussion. To the extent that a registrant has an interpretative question that may not be appropriate for the TRG, either because it is not likely to be pervasive or is specific to a particular set of facts, OCA is available for consultation.
Investors have an opportunity to participate during the transition phase as well — they don’t have to wait until adoption. Companies disclose the anticipated effect of new accounting pronouncements that have been issued, but not yet adopted. I encourage investors to monitor and use the disclosures to understand a company’s transition method and the effect of the new standard on revenue upon adoption.
The SEC staff is looking forward to reviewing more detailed disclosures about the expected effect the new standard will have on those financial statements. If that effect is still unknown, then in addition to making a statement to that effect, a registrant may consider advising investors when that assessment is expected to be completed. The disclosures should be designed to provide useful information to investors who need time to analyze the impact on companies.
Status of OCA activities
Because the FASB’s and the IASB’s new revenue standards are largely converged, we would expect domestic and foreign private issuer registrants to have converged (consistent) reporting outcomes for identical transactions. In cases where there are different views on the application of the new standard, the SEC staff will carefully consider the support for the different outcomes and whether the respective outcomes are consistent with the language in the standard and the Boards’ intent when they deliberated the standard. The SEC staff will respect the different reporting outcomes that are appropriately supported by the words in the standard and the intent of the Boards.
The staff is also consulting with registrants on their specific revenue recognition policies. As designed, the consultation process includes collaborating with the FASB, IASB and other securities regulators. In forming our views, the staff considers the basis for the standard setters’ conclusions, as well as the implementation discussions at the TRG. The staff also considers how the new revenue standard was intended to change existing practices, as well as the consistency of proposed revenue recognition for similar transactions within and across industries.
The staff is also evaluating the effect of the new revenue standard on existing Commission and SEC staff guidance. For example, at the recent March 3rd EITF meeting, the SEC staff announced that prior SEC staff observer comments included in the FASB’s codification related to freight services in process, shipping and handling fees and costs, gas-balancing arrangements, and the presentation of expenses related to “free” goods and services would no longer apply upon a company’s adoption of the new revenue standard. We continue to evaluate other Commission and SEC staff guidance on revenue recognition.
Management review controls, in particular, have been an important element of that discussion over the past year, which is not surprising given the important role that some of these controls play and the amount of judgment that they may involve. I believe the implementation of the new revenue standard provides an opportunity to be proactive and improve the design and operation of management review controls that may exist within a company’s revenue recognition process, including with reference to the various estimates and judgments that the new revenue standard may require. Therefore, as you evaluate your contracts with customers, it would be appropriate to take a fresh look not only at your historical accounting policies and how they may need to change but also at the design of the related controls (both existing and new) to ensure they are designed to operate in a manner that is sufficiently sensitive or precise to prevent or detect a material misstatement in the financial statements.
For example, when designing a management review control around estimates of royalties and milestone payments to be included in the transaction price, it will be important to specify: (i) the objective of management’s review, (ii) the frequency and granularity with which management’s review is performed, and (iii) the specific thresholds for investigating deviations from expectations as well as how those expectations are developed. It will also be important to consider the interactions between the review control and other controls, including controls over the reliability of the information used to perform the review. And last, but not least, maintaining appropriate documentation of the effective operation of these controls will be key to their assessment by auditors.
Speaking of taking a fresh look at ICFR, while implementation of the new revenue standard will obviously require taking a fresh look at business process-level controls, it is also important to keep in mind the other four components of internal control over financial reporting, including control environment and risk assessment. For example, availability of competent resources trained to exercise sound judgment will be essential to the consistent, reliable application of the new revenue recognition guidance.
ICFR also continues to be a point of focus more broadly. Over the past year, we have devoted a significant amount of time and effort to understanding and providing initial responses to concerns of various constituents regarding the ICFR assessments by companies, their interaction with the audits of ICFR and related inspection findings of the PCAOB. As you know, the PCAOB continues to identify deficiencies in the audits of ICFR. Our involvement in a number of registrant matters related to ICFR would also suggest that some of these audit deficiencies may be, at least in part, indicative of deficiencies in management’s design or operation of controls, including management review controls.
The PCAOB, with my staff and me observing, has conducted a number of outreach meetings with preparers, auditors and other constituents to better understand the concerns and challenges in this area. We continue to encourage regular discussions between management, auditors, and audit committees on existing and emerging issues in assessments of ICFR. We plan to continue this important dialogue in 2016 in order to assess progress and stay informed of new issues that might emerge.
The Commission adopted rules in 2003 addressing the disclosure of non-GAAP financial measures, both generally and with respect to inclusion in SEC filings. While the Commission’s rules allow companies to provide non-GAAP measures to investors as alternative measures that supplement information in the financial statements, the rules are clear that the non-GAAP measures must not be misleading. The SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover.
Non-GAAP measures are intended to supplement the information in the financial statements and not supplant the information in the financial statements. However, when the financial news networks report quarterly earnings, they very frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings, often not even identifying it as having been adjusted. In addition, I am particularly troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation. In my view, preparers should carefully consider whether significant adjustments to profitability outside of customary measures such as EBITDA or non-recurring items or other charges to the business, such as the sale of portions of the business in order to provide the user with an understanding of how these events impact trends and future performance, are appropriate. As it relates to cash measures, I believe those measures should be reconciled to cash flow from operations.
Staff in the Division of Corporation Finance continues to monitor non-GAAP disclosures as part of its selective review process and regularly issues comments on this issue. The staff also provides guidance on the application of Commission rules through speeches and other mechanisms — and of course, staff comment letters are publicly available. You can expect that the staff will continue to be vigilant in their review of the use of these measures for compliance with the rules.
The proliferation of non-GAAP reporting measures among registrants, and reliance and reporting by analysts, should warrant increased focus by management and the audit committee. I believe the focus should go beyond determinations that the measures comply with the Commission’s rules and include probing questions on why, in contrast to the GAAP measure, the non-GAAP measure is an appropriate way to measure the company’s performance and is useful to investors. In addition, companies should ensure that the measure is prepared in a manner that includes appropriate controls and oversight procedures.
Given that relevant and reliable financial reporting is of utmost importance to investors, it is critically important that ICFR be robust and that the audit of their effectiveness be of high quality. Finally, considering the importance of financial reporting, it is incumbent that alternative non-GAAP measures merely supplement GAAP measures and are not a substitute for them.
I appreciate the opportunity to speak with you today. Thank you for your attention.