Prepare for a Grilling by Auditors During This Year's Close

‘Tis the season for financial statement preparers to begin planning for the year-end close, and it could be a rocky one.

With the economy still inching forward in fits and starts, plenty of accounting assumptions hang on hard-to-hit forecasts and estimates. That means many companies are likely to have sometimes difficult conversations with auditors over the accuracy of those assertions. Meanwhile, regulators are pounding on auditors and preparers for more documentation and more support.

“Valuation is going to be huge at this year-end close,” says Peter Bible, a partner-in-charge of the public companies practice at audit firm EisnerAmper. Companies have spent the past few years convincing auditors that fair values, often steeped in judgments and estimates, could still hold up because blips in various economic indicators have not been normal. “I don't know if you can say that anymore,” Bible says. “Is stagnant economic growth the new normal? What does that mean for the valuation of plants, property, equipment, goodwill, and intangibles? That's probably going to be the single biggest thing that is going to be discussed up and down the line this year.”

Mike Santay, a partner at Grant Thornton, says any financial statement assertion that is based on estimates or judgments will be hit hard by auditors this year. “The recovery still seems like it is muddling along, so there is still going to be pressure on earnings,” he says. “So we will look intensely at the support for estimates. Anywhere there are subjective estimates that companies are using to support future growth or profitability, there will be pressure.”

The Securities and Exchange Commission and the Public Company Accounting Oversight Board have called significant attention to specific areas in recent months that are sure to drive the year-end planning discussions, says Chris Wright, managing director at consulting firm Protiviti. Audit firms that have been criticized in recent inspection reports—and that includes every major firm—will be performing more substantive testing and demanding more documentation around a number of critical accounting areas, he says.

Issues inspectors have hammered on extensively in the latest round of inspection reports—revenue recognition, impairments, allowances for loan losses, subjective accruals, and others—will attract significant attention, says Wright. “The regulators will drive behavior for the auditors, which will drive what companies need to do,” he says.

For the SEC's part, companies have seen a great deal more focus in recent months on gross vs. net revenue recognition, says Wright. That follows the SEC's bust on Groupon for overstating revenue as it prepared to go public. The analysis of Groupon's accounting for revenue led to some new questions about how companies recognize revenue when they rely on distributors to put products into the hands of the ultimate consumers. “The issue has been around for years, but it's been finding its way into SEC comment letters more frequently in the last year or so,” he says. As such, it is sure to become a point of discussion between preparers and auditors at year-end, he says.

“Is stagnant economic growth the new normal? What does that mean for the valuation of plants, property, equipment, goodwill, intangibles?”

—Peter Bible,

Partner-in-Charge,

EisnerAmper

Companies also can expect close scrutiny from auditors on the going concern question, says Dale Jensen, a partner with audit firm Weaver in Dallas, because of persistent economic uncertainty and the pressure on estimates. “Until we see some more consistency in the overall market, this is going to be an issue,” he says. What will it take for an auditor to get comfortable enough that a company can continue with no going concern issues?”

Focus on Impairments

Preparers also should expect significant year-end focus on impairments of goodwill and certain intangible assets, not just because of the judgments and market pressures but also because of a change in accounting standards, says Chris Smith, a partner with audit firm BDO USA. Most preparers are just starting to get some practice with a new preliminary step added to the impairment testing process.

Companies now are allowed to conduct initial qualitative analysis regarding the likelihood of an impairment—known as “step zero”—before they are required to do any calculations to determine if an impairment is necessary, and they are not required to proceed to the full impairment test if the qualitative factors provide comfort in themselves.

GOODWILL FOR IMPAIRMENT UPDATES

Below is a summary from FASB's ASU 2012-02 Intangibles Impairment Testing, which summarizes the reason for amending the standard.

Why Is FASB Issuing This Accounting Standards Update (Update)?

During the outreach performed before the issuance of Accounting Standards Update No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment, the Board received input from many financial statement preparers about the recurring cost and complexity of performing a quantitative impairment test for indefinite-lived intangible assets other than goodwill, especially when the facts and circumstances indicated a low likelihood of impairment. Additionally, many stakeholders noted that as a result of the recent amendments to the guidance on testing goodwill for impairment, indefinite-lived intangible assets would be the only category of long-lived assets subject to an annual quantitative impairment testing requirement, which would be inconsistent with that of goodwill and other long-lived assets.

The objective of the amendments in this update is to reduce the cost and complexity of performing an impairment test for indefinite-lived intangible assets by simplifying how an entity tests those assets for impairment and to improve consistency in impairment testing guidance among long-lived asset categories. The amendments permit an entity first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, Intangibles—Goodwill and Other—General Intangibles Other than Goodwill. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.

Previous guidance in Subtopic 350-30 required an entity to test indefinite-lived intangible assets for impairment, on at least an annual basis, by comparing the fair value of the asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an entity should recognize an impairment loss in the amount of that excess. In accordance with the amendments in this update, an entity will have an option not to calculate annually the fair value of an indefinite-lived intangible asset if the entity determines that it is not more likely than not that the asset is impaired. Permitting an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance in Update 2011-08.

Source: FASB.

Preparers and auditors alike are feeling their way through how much qualitative evidence is necessary to arrive at a comfortable assertion that no impairment or markdown is warranted, says Smith. “If you don't have to go through the quantitative aspects of the test, there's a lot of blood, sweat, tears, and specialists you can avoid,” he says. “It will save some time and money, but auditors have to gain a comfort level that they agree with the judgments in that area.”

The SEC also has taken careful note in recent months on where companies may have inconsistencies in their story as it is portrayed in management discussion and analysis, footnotes, proxy disclosures, or other published statements, according to both Wright and Santay. Auditors will be watching just as regulators have to assure the messaging is consistent through financial statements and other published remarks, they say. “There's a continued focus on transparency,” says Santay. “Are investors able to connect the dots? We are spending a lot of time discussing this with our teams.”

Typically when companies begin thinking about year-end reporting issues, they spend a good deal of time focusing on new accounting pronouncements that are just being implemented, says Wright. However, the flow of new standards has been slow this year, perhaps in part because the Financial Accounting Standards Board is still spending considerable time on major new standards for financial instruments, leasing, and revenue recognition that have not been completed.

There are a few to point out, however, says Smith. The new preliminary steps for impairment testing are primary among them, but companies also should be paying attention to some new fair-value disclosure requirements, he says. The requirements focus on expanded quantitative and qualitative disclosures about fair-value measurements, focused primarily on measurements based heavily on estimates and judgments. They went into effect for interim reports in 2012, but Smith says many companies may still need to review the new requirements. “You can't just roll over last year's disclosures and expect to be compliant,” he says.