For well over a decade, the PCAOB has been unable to fulfill its SOX mandate to inspect audit firms in “Non-Cooperating Jurisdictions,” or “NCJs,” including China. To address this issue, in December 2020, the Holding Foreign Companies Accountable Act, was signed into law. The HFCAA amended SOX to prohibit trading on U.S. exchanges of public reporting companies audited by audit firms located in foreign jurisdictions that the PCAOB has been unable to inspect for three sequential years. (See this PubCo post.) The U.S.-China Economic and Security Review Commission reported that, as of March 31, 2022, Chinese companies listed on the three largest U.S. exchanges had a total market capitalization of $1.4 trillion. As a result, the trading prohibitions of the HFCAA could have a substantial impact. Years of negotiation to resolve the deadlock over audit inspections notwithstanding, China and Hong Kong have still not permitted PCAOB inspections, largely because of purported security concerns. (Interestingly, the WSJ reported that, in a “departure from what officials have said previously, the Chinese stock regulator said on Friday that audit working papers generally do not contain state secrets, individual privacy, companies’ vast user data or other sensitive information.”) In May, in remarks to the International Council of Securities Associations, YJ Fischer, Director of the SEC’s Office of International Affairs, indicated that, although there had been progress, “significant issues remain[ed],” and reaching an agreement would be only “a first step.” In other words, there was still “a long way to go.” On Friday, however, the PCAOB took that first step by signing a Statement of Protocol with the China Securities Regulatory Commission and the Ministry of Finance of the People’s Republic of China governing inspections and investigations of audit firms based in China and Hong Kong. According to a statement from SEC Chair Gary Gensler, the “agreement marks the first time we have received such detailed and specific commitments from China that they would allow PCAOB inspections and investigations meeting U.S. standards.”
In this July report, Responses to the SEC’s Climate Proposal, KPMG discusses various themes and observations that it gleaned from its review of comment letters on the SEC’s 510-page comprehensive and stunningly detailed climate disclosure proposal issued in March. As you probably recall, the proposal was designed to require disclosure of “consistent, comparable, and reliable—and therefore decision-useful—information to investors to enable them to make informed judgments about the impact of climate-related risks on current and potential investments.” KPMG found that the sentiment about climate standard-setting as a general concept was favorable, with 29% of those commenting very supportive and 50% supportive of the concept. Only 21% had a negative response—12% very unsupportive and 9% generally unsupportive. But that positive attitude toward the general concept did not necessarily translate to support for the specific proposal from the SEC.
Earlier this week, the President signed into law the historic Inflation Reduction Act. Along with important provisions regarding climate and healthcare, the IRA contains several significant tax provisions, including a 15% alternative minimum tax for corporations and a 1% excise tax on corporate stock buybacks. Want more information? Read this Cooley Alert, Tax Implications of the Inflation Reduction Act, from our terrific Cooley Tax Department.
At the end of last week, the SEC approved the PCAOB’s updated standards for audits that involve multiple auditing firms. SEC Chair Gary Gensler said that the amended standards “will strengthen the requirements for lead auditors who supervise other auditors in an audit, helping to enhance audit quality and protect investors.” Why were these updates necessary? According to Gensler, the globalization and increasing complexity of public company operations has meant that auditors must increasingly “rely on other auditors—working across different firms, countries, and even languages—in completing an audit. Last year,” he said, “26 percent of all issuer audit engagements used multiple auditors, and more than half of large accelerated filer audits used multiple auditors. Given the challenges that such multi-firm audits present, it is important that there be robust standards for how lead auditors supervise, communicate with, and coordinate with other auditors on the audit engagement.” Gensler noted that the updates enhance the standards “across two broad areas. First, the amended standards specify certain procedures for lead auditors to perform when supervising other auditors. Second, they require lead auditors to prioritize their supervisory activities around higher-risk areas in the audit.” PCAOB Chair Erica Williams observed that companies “continue to increase their global presence. As a result, the use of other auditors has become more prevalent in the conduct of an audit, which can create additional challenges for the lead auditor. Adding other auditors into the process requires careful consideration and clear communications between all auditors involved in the audit. And when miscommunication occurs or when there are misunderstandings about the nature, timing, and extent of the other auditor’s procedures, audit quality will likely suffer.” It’s worth noting that some aspects of the new amendments will affect communications with the audit committee. The amendments will be effective for audits of financial statements for fiscal years ending on or after December 15, 2024.
More financial information about human capital? FASB looks to require disaggregation of expenses on the income statement
In June, the Working Group on Human Capital Accounting Disclosure, a group of ten academics that includes former SEC Commissioners Joe Grundfest and Robert Jackson, Jr. and former SEC general counsel, John Coates, submitted a rulemaking petition requesting that the SEC require more disclosure of financial information about human capital. According to the petition, there has been “an explosion” of companies “that generate value due to the knowledge, skills, competencies, and attributes of their workforce. Yet, despite the value generated by employees, U.S. accounting principles provide virtually no information on firm labor.” (See this PubCo post.) The Group may be about to have its wishes granted—at least in part—but not by the SEC. Rather, the FASB is hard at work on a project to disaggregate income statement expenses, and high on all of the FASB board members’ lists was the need to separately disclose labor costs/employee compensation. Of course, as reported by Bloomberg (here and here), there has been a push for disaggregation of expenses on the income statement since at least 2016, but in 2019, the FASB voted (5 to 2) “to put its once-high priority financial reporting project on pause.” It’s been quite a lengthy pause, but, in February 2022—perhaps hearing the call from investors and others—the FASB decided to restart work on the project to “improve the decision usefulness of business entities’ income statements through the disaggregation of certain expense captions.” It seemed from the FASB Board discussion that the Board members were favorably inclined to proceed with a disaggregation requirement—especially with respect to labor costs.
SEC Chair Gary Gensler may just have some paternal affection for SOX, especially on the week of its 20th birthday. In these remarks to the Center for Audit Quality, he recalls having “a front-row seat” for the negotiations and signing of the bill, working as Senior Advisor to the late Senator Paul Sarbanes on this legislation. The bill passed the House almost unanimously and the Senate by a vote of 99 to 0—hard to imagine that ever happened, let alone only 20 years ago. In giving SOX its 20-year review, he discusses the significant role SOX played in restoring public trust in the financial system after the Enron and WorldCom scandals, but also offers some, let’s say, opportunities for improvement. (He also drops the hint that the SEC may be taking a “fresh look at the SEC’s auditor independence rules.”)
For several years, the SEC staff and advisory committees, credit rating agencies, investors, the Big Four accounting firms and other interested parties have been making noise about a popular financing technique called “supply chain financing.” It can be a perfectly useful financing tool in the right hands—companies with healthy balance sheets. But it can also disguise shaky credit situations and allow companies to go deeper into debt, often unbeknownst to investors and analysts, with sometimes disastrous ends. Currently, there are no explicit GAAP disclosure requirements to provide transparency about a company’s use of supply chain financing. That may be why Bloomberg has referred to supply chain financing as “hidden debt.” In December, the FASB announced that it had issued a proposed Accounting Standards Update intended to help investors and others “better consider the effect of supplier finance programs on a buyer’s working capital, liquidity, and cash flows.” The proposed ASU would require the buyer in a supply chain financing program to “disclose sufficient information about the program to allow an investor to understand the program’s nature, activity during the period, changes from period to period, and potential magnitude.” On Wednesday, the FASB finalized the details of the plan and gave the go-ahead to draft the new ASU (which is expected to be available later this year). The new ASU would apply to both public and private companies. Although the final ASU has not yet been issued and is still subject to a final ballot, companies with supply chain financing programs may want to take note of this anticipated new requirement now. According to Bloomberg, there “will be a shorter turnaround than usual for complying with new FASB requirements”; compliance will be required retrospectively for fiscal years beginning after December 15, 2022, i.e., the first quarter of 2023.
SEC Acting Chief Accountant cautions again about auditor independence concerns, especially the “checklist compliance mentality”
Auditor independence—or rather the potential absence of same—is apparently still a cause of significant agita at the SEC’s Office of Chief Accountant. In October last year, Acting Chief Accountant Paul Munter issued a statement regarding the importance of auditor independence—a concept that is “foundational to the credibility of the financial statements.” That statement was prompted largely by the trend at that time toward the use of “new and innovative transactions” to access the public markets, such as SPACs, together with the potential effect on independence of increasingly complex tangles of business relationships among audit firms, audit clients and non-audit clients. (See this PubCo post.) But that caution seems not to have been enough to slay the dragon. In this June statement, Munter again addresses auditor independence. The SEC, he observes, “has long-recognized that audits by professional, objective, and skilled accountants that are independent of their audit clients contribute to both investor protection and investor confidence in the financial statements.” This time, Munter focuses his statement on the critical importance of the general standard of auditor independence and recurring issues in recent auditor independence consultations. He also addresses the value of firms’ treating accounting as a profession, one that fosters “a culture of ethical behavior in all their professional activities, but especially with respect to auditor independence.” Munter appears to be especially concerned about the “decreased vigilance” and “ethical deterioration” that may arise out of “checklist compliance mentality,” an unfortunate state of mind he highlights in several contexts. It is important for companies to keep in mind that violations of the auditor independence rules can have serious consequences not only for the audit firm, but also for the audit client. For example, an independence violation may cause the auditor to withdraw the firm’s audit report, requiring the audit client to have a re-audit by another audit firm. As a result, in most cases, inquiry into the topic of auditor independence should certainly be a recurring menu item on the audit committee’s plate.
Do companies disclose enough information about investments in their workforces? Not according to the Working Group on Human Capital Accounting Disclosure, a group of ten academics that includes former SEC Commissioners Joe Grundfest and Robert Jackson, Jr. and former SEC general counsel, John Coates. The Working Group has submitted a new rulemaking petition requesting that the SEC require more disclosure of financial information about human capital. According to the petition, there has been “an explosion” of companies “that generate value due to the knowledge, skills, competencies, and attributes of their workforce. Yet, despite the value generated by employees, U.S. accounting principles provide virtually no information on firm labor.” The petition requests that the SEC “develop rules to require public companies to disclose sufficient information to allow investors to assess the extent to which firms invest in their workforce”—in the same way that “SEC rules have long facilitated analysis of public companies’ investments in their physical operations.” Asked about the petition, Grundfest told Bloomberg that it “aims to move the accounting treatment of a company’s workforce to the same level as its physical capital….’Current accounting rules give us more information into the economic consequences of buying or leasing a drill press than of hiring and training a software engineer….How much sense does that make in today’s world?’”
While the proposed requirement to disclose material Scope 3 greenhouse gas emissions seems to be one of the most contentious—if not the most contentious—element of the SEC’s climate disclosure proposal (see this PubCo post and this PubCo post), two of the SEC’s Democratic Commissioners, Allison Herren Lee and Caroline Crenshaw, told Bloomberg that they think it still doesn’t go far enough. They are advocating that Scope 3 GHG emissions data be subject to attestation—like the proposed requirement for Scopes 1 and 2—to ensure that it is reliable. This discussion might just be a continuation—or perhaps a reinvigoration—of an internal debate that reportedly led to delays in issuing the proposal to begin with. As previously discussed in this PubCo post, the conflicts were reportedly between SEC Chair Gary Gensler and the two other Democratic Commissioners, Lee and Crenshaw, about how far to push the proposed new disclosure requirements, especially in light of the near certainty of litigation. One major issue at the time, Bloomberg reported, was whether to mandate disclosure of Scope 3 GHG emissions, which, some companies contended, is not under their control and “unfairly makes companies vulnerable to shareholder lawsuits and government enforcement actions.” Another major point of contention was reportedly was whether to require that auditors sign off on the emissions disclosures. The current proposal may reflect a compromise on these issues, but apparently one that does not sit comfortably with Lee and Crenshaw.