Annual reports for calendar year-end companies have now just about all been issued. While it may seem that this reporting season has been relatively quiet, behind the scenes, it has had its share of tough issues, new developments, and even a big surprise.  

While there weren't any major new accounting standards to incorporate or developments that affected large numbers of companies, some familiar issues continued to cause headaches.  

A recurring problem for years has been determining whether revenue should be recognized on a gross or net basis. It hits resellers, who need to determine whether they should recognize revenue for the full price of the item they are reselling, or only for their margin, and companies that make payments to their customers for goods, services, or other reasons, who must determine whether the payments to customers should be treated as costs or reductions of revenue from the customer. Every year, many companies stumble upon this issue, sometimes a year or two later than they should have.

Another common revenue-related issue is how to take into account uncertainties such as variable payment arrangements, quality and effectiveness promises, and the possibility of contract changes. The assumption that it's OK to make your best estimate and adjust later is often wrong.

Distinguishing debt from equity also remains a tough area, as well. It remains the case that many ostensibly equity-based warrants and options can't be accounted for as equity. Either they are indexed to something in addition to the stock price, or they give the holder rights beyond those afforded to shareholders, both of which require liability classification. The offending provisions are often buried in long agreements and are easily missed.

Accounting for income taxes continues to be far more complicated than many believe it should be, particularly when dealing with unusual transactions such as inter-company sales and dividends. And judgments about the need for a valuation allowance also continue to bother many companies.

The list of repeat problem spots goes on: goodwill impairments, loss contingency disclosures, and, of course, derivatives. Nothing new here, except to the companies that had never faced these issues before.

Something Old

Among the reporting requirements brought about by the Sarbanes-Oxley Act were limits to the use of pro forma measures. Before Sarbanes-Oxley, companies were making adjustments to remove all kinds of costs, including actual employment taxes on stock option exercises, normal strategic consulting and restructuring costs, and costs from developing and introducing new products, even though those activities happened constantly. The result was the presentation of earnings without some very necessary and recurring expenses.

The SEC's rules on what are now called non-Generally Accepted Accounting Principles (non-GAAP) measures put a halt to those fairy tale numbers, but also caused companies to stop reporting useful non-GAAP measures. Over time, companies have started once again to report non-GAAP measures that provide insight, such as those excluding truly unusual gains and losses, and measures like EBITDA and free cash flow in industries in which such measures are commonly used by analysts.

I'm concerned, however, that things are on the verge of going too far again. Consider the frequency of non-GAAP adjustments for “non-cash” items that aren't non-cash at all. Depreciation and amortization of long-term assets have long been described as non-cash even though they aren't—they are just income statement charges that occur years after the cash was spent to purchase the assets. These days I often see amortization of debt issuance costs and debt discounts adjusted as non-cash items, even though they absolutely affected the cash proceeds of the financing transaction. I sometimes see deferred compensation charges lumped into non-cash items as well, even if they will be settled in cash down the road.

In the past, classification or netting errors that did not affect net income were considered to be less important, and auditors did not search for or propose adjustments for such errors unless they were extremely large.

Then we have a new kind of smoothing adjustment. Companies that now recognize changes in the value of pension assets and obligations as they occur are sometimes providing a non-GAAP measure to smooth out those fluctuations. I also hear of companies “normalizing” all kids of other measures like investment returns and effective tax rates. I understand the logic of trying to smooth out bumps in net income, but the fact is that net income is bumpy.  These aren't artificial accounting entries that are being adjusted out, but current economic events that directly affect cash, the value of investments, and other outputs.

And then, once a company has adjusted for these and other items that bear no resemblance or similarity to one another, they report non-GAAP net income and earnings per share. At best, these non-GAAP bottom-line numbers are described as representing something like “core earnings,” a nebulous concept if there ever was one. Some would say that investors and analysts will weed out the meaningless or deceptive non-GAAP measures. I'm not so sure. And I don't think the SEC is likely to just trust that the market will weed this stuff out either.

Something New

The biggest surprise to me during this past reporting season has been a change in auditing. It seems that auditors have increased their testing and the proposal of audit adjustments in response to feedback from the Public Company Accounting Oversight Board. In the past, classification or netting errors that did not affect net income were considered to be less important, and auditors did not search for or propose adjustments for such errors unless they were extremely large. 

I understand that there has been a change, and that these errors are now treated almost the same as those that affect net income. The effects are significant:

Some audit tests are designed to allow smaller misclassifications to be detected, resulting in more audit work.

Potential classification or netting errors that in the past were simply not investigated now are, again resulting in more audit work.

Classification or netting errors that were not proposed for correction now are added to the proposed adjustment list that auditors present to their clients.

That list must be presented to the audit committee, and management must then explain and justify additional errors.

Some auditors have concluded the assessment of whether identified errors are material must be the same whether the errors affect net income or not.

With errors that don't affect net income now more likely to be flagged by the auditor, additional internal controls are expected to be in place to prevent and detect such errors. This means more control documentation, more control testing, and a likely increase in control deficiencies.

Most troubling about this development is that I believe that many of the changes go beyond what the PCAOB intended.

This issue begins with Auditing Standard No. 11, Consideration of Materiality in Planning and Performing and Audit, which notes: “To determine the nature, timing, and extent of audit procedures, the materiality level … needs to be expressed as a specified amount.” AS 11 describes “tolerable mis-statement” as an amount that reduces to a “low level the probability that the total of uncorrected and undetected mis-statements would result in a material mis-statement.”  Tolerable mis-statement is typically used as the amount that determines whether identified errors are proposed for correction.

Although often not formally documented, auditors have often used a threshold higher than “tolerable mis-statement” for determining whether to propose correction of errors that don't affect net income. It is that practice that PCAOB inspectors, as I understand it, objected to. Correcting it would involve points 3 and 4 in the list above. Those points, while the most visible to management, are the least burdensome on the list.

Auditors took the next steps and decided that if errors that don't affect net income should have the same threshold for proposing corrections, controls over such errors should be just as strong as those over errors that affect net income. They then decided to perform tests to identify much smaller netting and classification errors than they used to. While those may seem like logical next steps, I think they went beyond what the PCAOB intended. PCAOB inspectors had looked at the audit and control testing and did not criticize those aspects of the audits; they only criticized the decision on proposing errors for correction. All the PCAOB wanted was for auditors to start suggesting that their clients correct all errors exceeding tolerable mis-statement, not just those that affect income. Every other change is, I believe, unintended.

In particular, I know the PCAOB couldn't have intended that auditors evaluate whether financial statements were materially mis-stated without differentiating between errors that affect net income and those that don't. Doing so would require ignoring the fact that materiality assessments used in planning and performing an audit are made for a different purpose than those used for evaluating whether financial statements are materially correct in accordance with Generally Accepted Accounting Principles. Evaluating whether financial statements are materially mis-stated must, under guidance published by the Securities and Exchange Commission and the Financial Accounting Standards Board, consider the nature of an error, not just its amount. The PCAOB would not suggest otherwise.

I hope we haven't heard the last of this matter. If some of the changes in the audit go further than the PCAOB meant them to go, the auditing profession and its regulator ought to be able to sort this out. Auditors shouldn't spend their time on unimportant matters, and companies shouldn't have to pay them to do so.

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