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FASB issues standard on income statement expenses sought by investors

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The Financial Accounting Standards Board released an accounting standards update Monday to improve financial reporting by requiring public companies to disclose, in their interim and annual reporting periods, more information about certain expenses in the notes to financial statements.

The standard comes in response to demand from investors for more detailed, disaggregated information about expenses.

“This has been an effort that we’ve been working on for quite some time, certainly prior to my tenure, but it’s been a high priority by investors for a long period of time,” FASB board member Fred Cannon told Accounting Today. “It was something we heard both in 2016 and 2021 in our agenda outreach, that it was their highest priority during this time period, and we had to work with all stakeholders to come up with what I believe is a practical solution that provides critical information to investors. From my standpoint, it’s exciting to get this moving forward and find something that is both workable but provides critical information.”

During the agenda consultation and other outreach, investors told FASB that expense information is critically important in understanding a company’s performance, assessing its prospects for future cash flows, and comparing its performance over time and with that of other companies. They indicated that more granular expense information would help them better understand an entity’s cost structure and forecasting future cash flows.

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FASB offices

Patrick Dorsman/Financial Accounting Foundation

“This project was one of the highest priority projects cited by investors in our extensive outreach with them as part of our 2021 agenda consultation initiative,” said FASB chair Richard Jones in a statement. “We heard time and again from investors that additional expense detail is fundamental to understanding the performance of an entity and we believe that this standard is a practical way of providing that detail.”

The ASU addresses this feedback by requiring public companies to disclose, in the notes to financial statements, specified information about certain costs and expenses at each interim and annual reporting period. Specifically, they will be required to:

1. Disclose the amounts of (a) purchases of inventory; (b) employee compensation; (c) depreciation; (d) intangible asset amortization; and (e) depreciation, depletion, and amortization recognized as part of oil- and gas-producing activities (or other amounts of depletion expense) included in each relevant expense caption.
2. Include certain amounts that are already required to be disclosed under current GAAP in the same disclosure as the other disaggregation requirements.
3. Disclose a qualitative description of the amounts remaining in relevant expense captions that are not separately disaggregated quantitatively.
4. Disclose the total amount of selling expenses and, in annual reporting periods, an entity’s definition of selling expenses.

“Essentially, what the standard will do is it will require firms to break out in a footnote certain components of the income statement line items including compensation, purchase of inventory, depreciation, depletion and amortization, to the extent that those are included in that line item on the income statement,” said Cannon. “We expect things like cost of sales, cost of goods sold, SG&A [selling, general and administrative expenses], research and development to be broken out in tabular format on a quarterly basis with these key key components. The reason this is so important to investors is to be able to put this into their urban models, and have better sense and better ability to forecast future cash flows with the trends they see in these disparate items that are currently aggregated. We have heard consistently from investors how critical this information is.”

The extra reporting may be hard work for financial statement preparers as well. “We’ve also heard, to be honest, from preparers, that it can be difficult to prepare, and so we really spent a long period of time making sure that this is operational to preparers, as well as providing critical information to users,” said Cannon.

The degree of difficulty will probably differ, depending on the company, but it may be hardest for manufacturing companies that do business around the world. 

“We heard throughout this process that this first it will vary significantly across different preparers,” said Cannon. “Some preparers told us this is relatively straightforward. Others, on the other hand, especially manufacturers of global operations that perhaps have been acquiring companies throughout the globe, this could be very difficult and costly. The board went into this with our eyes wide open that this wasn’t going to be a cost-free exercise for preparers. But the decision we came up with was that this information is so critical to users that we would move ahead with the standard. At the same time, since the exposure draft, we underwent a number of changes in order to address the cost concerns from preparers.”

One of the biggest changes involved the cost of goods sold. “Perhaps the most significant was on the inventory issue,: said Cannon. “Cost of goods sold would have had a two-step disaggregation in the exposure draft, and we simplified that to one step that would just break out purchases of inventory as well as compensation, depreciation and amortization. We heard from preparers that that would be much more straightforward than our initial proposal, especially manufacturers. And we heard from users that in some ways, it would be more intuitive information that they would be getting.”

FASB also decided to give more time for implementing the new standard and didn’t require a retrospective approach to look back for information.

The amendments in the ASU are effective for annual reporting periods starting after Dec. 15, 2026, and interim reporting periods beginning after Dec. 15, 2027, although early adoption is permitted. It will  be effective for the 2027 annual 10-K for calendar year reporters and then it will be required for each interim period following going forward. 

For users of financial statements such as investors and financial analysts, the adjustment shouldn’t be difficult for forecasting future cash flow. “I think the way we structured this for users, it’s going to be fairly straightforward,” said Cannon, who was formerly a sell-side analyst and research director. Many analysts already have a model in Excel for items like cost of goods sold. “They’re going to have to insert three or four more lines into their Excel spreadsheet, and these breakouts will aggregate to that number,” said Cannon. “It’s something that investors have been saying for a significant amount of time that would be useful”

Eventually their forecasting abilities may improve as a result of the standard. “Their accuracy in terms of improving their forecasts of, say, cost of sales will take time to improve, because they won’t initially see the trends in compensation and in these other line items,” said Cannon. “But over time, as those trends develop, they’ll improve their ability to better forecast those line items on the income statement.”

In addition to the ASU, FASB is issuing a FASB in Focus summary of the new standard and two videos, one short and the other more in depth that walks through some of the illustrative examples in the ASU about how the new standard works in practice. The ASU and other educational materials are available at www.fasb.org. Cannon does not believe it will require a great deal of training to implement the new standard, but accounting technology systems will need to be updated.

While FASB is no longer trying to converge its U.S. GAAP standards with the International Accounting Standards Board’s International Financial Reporting Standards, the two boards are following some similar aspects in terms of disaggregation and the update to IAS 18 (which has been superseded by IFRS 15) is scheduled for implementation in the same timeframe that FASB’s new standard is implemented. 

“Theirs is a little bit different,” said Cannon. “It does not include purchase of inventory, so that doesn’t have to be broken out. In addition, they have a different kind of format for the information to be disclosed, but it does include breakouts in compensation, amortization and depreciation, so there are some similarities and the timeframe is similar.”

The IASB standard also goes a bit further by changing the income statement presentation, while FASB’s is a disclosure-only project.

The new standard may help investors analyze the impact of inflation and other factors, such as increased tariffs, by disaggregating items like purchases of inventory. 

“Inflation is tricky to forecast, but it certainly will give investors a better ability to deal with inflationary aspects of the income statement and how they impact the overall earnings of the company,” said Cannon.

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Accounting

Sotheby’s pays $6M to settle NY sales tax evasion probe

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Sotheby’s Inc. agreed to pay $6.25 million to settle a New York state lawsuit that accused it of advising wealthy clients they could avoid sales taxes by falsely claiming they were buying art for resale purposes.

New York Attorney General Letitia James announced the deal in a statement Thursday. She said Sotheby’s employees from 2010 to 2020 encouraged clients to make the false claims even though they knew the purchases were actually for private collections or intended as gifts.

“Sotheby’s intentionally broke the law to help its clients dodge millions of dollars in taxes, and now they are going to pay for it,” James said. “Every person and company in New York knows they are required to pay taxes, and when people break the rules, we all lose out.”

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Sotheby’s Auction House in New York

Robert Caplin/Bloomberg

James sued Sotheby’s in 2020, accusing the auction house of helping a shipping executive use a false resale certificate to dodge taxes. The state later expanded the case by including allegations involving seven additional collectors and numerous Sotheby’s employees from across the organization, including its tax department.

In a statement, Sotheby’s said that it admitted no wrongdoing in connection with the settlement and was committed to full compliance with the law.

“These allegations relate to activity from many years ago — in some cases over a decade — and Sotheby’s provided much of the evidence which the AG used to obtain a settlement with the taxpayer referenced in the complaint six years ago,” the auction house said in its statement.

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Discover delays filing over accounting disagreement with SEC

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Discover Financial Services said it will miss a deadline to file its quarterly report with regulators, citing disagreements with the Securities and Exchange Commission over its accounting treatment of a credit-card misclassification blunder. 

The company said in a filing Wednesday that it was unable to file the 10-Q form for the three months through Sept. 30 by the required date after SEC staff disagreed with “certain aspects of the company’s accounting approach for the card product misclassification matter.”

Discover disclosed last year that it overcharged merchants after misclassifying certain credit-card accounts into its highest pricing tier, and the Chief Executive Officer stepped down as compliance woes mounted. The credit-card company said in July that it had reached an agreement to settle class-action litigation with the affected retailers, and that it expected the $1.2 billion it already set aside for related liabilities to be enough to resolve the issue. 

Discover credit card
Discover credit card

Angus Mordant/Bloomberg

Discover expects that when it files its 10-Q form, it will likely reflect re-allocations to prior periods of about $600 million of the charge to other expenses recorded in its quarterly report for the period ended March 31, it said. The firm said that because the reallocations would reverse a charge to other expenses recorded for the first quarter, “this would result in an increase in pre-tax income by the same amount in the three months ended March 31, 2024 and the nine months ended September 30.”

Capital One Financial Corp. is expected to buy Discover in one of the biggest mergers announced this year. The SEC was reviewing Discover’s financial statements in connection with the pending merger, according to the filing. 

A representative for Discover declined to comment beyond the filing. A representative for Capital One didn’t immediately respond to a request for comment.

A late financial statement can be considered a financial reporting red flag and large companies go to great lengths to avoid missing SEC deadlines. In the filing Wednesday, Riverwoods, Illinois-based Discover said it likely won’t file under the allotted extension period of five calendar days because it needs more time to address the issues. The company also hasn’t determined if it will have to redo, or restate, its prior financial statements to address any potential accounting errors, it said.

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PCAOB releases CAMs guidance for auditors of small firms

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The Public Company Accounting Oversight Board is rolling out a new series of staff publications targeted at auditors of small public companies, starting with one on critical audit matters, as board members face the likelihood of a deregulatory emphasis under the incoming Trump administration and probable changes in board composition.

The PCAOB released the first of the new series of staff publications, “Audit Focus: Critical Audit Matters,” which aims to provide easy-to-digest information to auditors, especially those who audit smaller public companies. With an eye toward protecting investors and improving audit quality, each edition of Audit Focus reiterates applicable auditing standards and staff guidance and offers reminders and good practices tailored to PCAOB-registered auditors of smaller public companies. 

The PCAOB staff is continuing to identify a great many deficiencies related to critical audit matters. CAMs are a relatively new requirement from the PCAOB. A CAM is defined as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that relates to accounts or disclosures that are material to the financial statements; and involved especially challenging, subjective or complex auditor judgment.  

This edition of Audit Focus highlights key reminders on determination, communication and documentation of CAMs, along with the PCAOB staff’s perspectives on some of the common deficiencies, such as not accurately describing how a CAM was addressed in the audit, plus good practices that the staff has observed related to CAMs, such as use of practice aids.

PCAOB board members George Botic and Christina Ho discussed the recent inspection findings during a panel discussion Wednesday during Financial Executives International’s Current Financial Reporting Insights conference.

“When you think about where our inspectors see repeated observations, deficiencies, if you will, particularly in Part I.A, which are for the firms not obtaining sufficient appropriate audit evidence, things like revenue recognition, inventory, allowance for credit losses in the financial sector, areas around business combinations, allowance for allocation of purchase price, things such as that, as well as long-lived assets, goodwill, intangibles, evaluation, those are some of the more frequent areas,” said Botic. “ICFR certainly is one as well in the internal control space. But those areas, those themes, really haven’t changed. Sometimes we’ll see more of one versus another.”

During its inspections last year, the PCAOB saw some improvements at the largest firms, even though audit deficiency rates still appear to be high, with 46% of the engagements reviewed in 2023 having at least one deficiency significant enough to be included in Part I.A of the inspection report, excluding broker-dealer audit inspections, according to a staff spotlight publication that was released in August.

“There appears to be some improvement in terms of the deficiency rate trend for the largest firms,” said Ho. “It’s probably too soon to tell whether that is going to be the ongoing trend. Also for triennial firms, the spotlight also highlighted the fact that the deficiency rates are not improving.”

She pointed out that financial restatements are another way to look at the situation. “Obviously, the deficiency rate is not the only measurement of audit quality,” said Ho. “We also look at restatements, which I think for many of the preparers and audit committees that I talk to, and even investors, they focus on that metric a lot. The multiple metrics paint a picture.”

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PCAOB board member Christina Ho speaking at the FEI CFRI virtual conference

Botic sees advantages in having several such metrics. “The audit process is one of the most complex processes, probably in business,” said Botic. “When you think about all the judgments that you all go through for your financial statements and preparing them, then the auditor makes his or her own risk assessment judgments, it’s an incredibly complex process. So I agree, not one metric necessarily is the only metric for sure. We’re inspecting the audit, so our inspectors are looking at what the auditor did or didn’t do, as the case may be, and as part of that, we may identify the accounting was wrong. That is one possibility, as Christina mentioned, the categorization of the reports. But in my view and from my prior life as well, and spending a lot of time in inspections, I actually think that the spread from the inspection deficiency rates for the filers that we looked at compared to the restatement number, I think that’s actually … reflective of the success of our inspection program.”

Ho recently found herself singled out in a letter from a pair of Senate Democrats, Elizabeth Warren of Massachusetts and Sheldon Whitehouse of Rhode Island, for painting an overly rosy picture of the problems plaguing auditing firms, and she complained in a LinkedIn post that they were “persecuting” her and trying to “stifle” her from  “expressing views inconsistent with their false narrative.”

Accounting Today asked Ho during a press conference after the FEI CFRI session about the political pressure she faced, especially with President-elect Trump’s administration coming in and perhaps replacing PCAOB board members as happened during his first administration as well as the Biden administration.

“Like I said in my LinkedIn post, I’m not a political person,” Ho responded. “When I was at Treasury, I worked under two different administrations as a career person, and I always feel like accounting shouldn’t be political. But obviously, elections have consequences, and I’m not living in a cocoon that I’m not aware of what’s going on. I really do think that it’s in the best interest of the capital markets for political influence to be minimized to technical areas that require expertise, and that’s how I operate, whether I was in Treasury or even at the board here. I often feel like the areas we work in, auditing and accounting, are specialized and require expertise and I hope that the experts can always be allowed to voice their views and also do their job well.”

The PCAOB has been facing pushback on some of its proposed standards, such as the so-called NOCLAR standard on the auditor’s responsibility to detect noncompliance with laws and regulations, as well as proposed standards on firm and engagement metrics. The Securities and Exchange Commission has already approved and adopted one of the PCAOB’s more far-reaching standards, on a firm’s quality control system, Ho pointed out. However, she recognizes the criticisms that the PCAOB has been hearing about some of the other proposed standards, even though NOCLAR and the other standards are still scheduled on the agenda this year.

“One of the really important things that regulators should do is to listen,” said Ho. “We should take comments very seriously and we should not rush into adopting standards or rules when we don’t have enough evidence to support the benefits and also the effectiveness of those proposals.” 

She acknowledged that the increased risks and responsibilities of auditors, as well as the potential penalties, may be one factor that’s making it harder to attract young people to the accounting and auditing profession.

“I have certainly heard many anecdotal comments about the regulatory environment making the profession less attractive,” said Ho. “I’ve heard from people who talk about how they don’t want to do public company audits because of the inspections, and also our posture on enforcement. If you are not allowed to get indemnified, you know, as an individual, if something happened and there’s in your sanction, certainly people consider that as an increased risk for what they do. I think these things have an impact on the attractiveness of the profession and certainly impact talent. That is some of the anecdotal information I’ve heard. I’ve also heard from smaller firms that they are trying to stay under the 100 number because that will move them into annually, inspected so that they can stay under 100 so they don’t have to be inspected every year. Those kind of comments certainly concern me, because I don’t think this audit marketplace can afford less competition and also less talent. These are things that I think about and I’m concerned about.”

The PCAOB typically inspects each firm either annually or triennially (i.e., once every three years). If a firm provides audit opinions for more than 100 issuers, the PCAOB inspects them annually. If a firm provides audit opinions for 100 or fewer issuers, the PCAOB, in general, inspects them at least every three years. 

Ho was also asked about the PCAOB’s relationship with the Institute of Internal Auditors after the two organizations clashed over the PCAOB’s exposure draft for its audit confirmation standard initially seemed to blame internal auditors before it was revised following a protest by the IIA. Ho met with the IIA and established a better understanding.

“I have a good relationship with the IIA organization, and I actually have been an internal auditor before,” said Ho. “I understand what they do and their values and why it’s important. I certainly think that they play a key role in fostering the trust of the capital markets, because they are in the company. Different data that have been published that the external auditor, they come in and focus on the financial statements and the internal control over financial reporting. Their scope is limited to that, whereas the internal auditors are covering the entire company and the operations and and they have access to much more information and people than external auditors, so they play a key role in facilitating the trust. It looks like they are also focusing a lot on modernizing their standards. They have done that, and then they have been really focusing on AI as well. So I think that it’s important to make sure that all the key players in the financial report ecosystem are working together so that we can collectively ensure the quality of the financial reporting and the audit.”

Accounting Today also asked about the role of artificial intelligence and data analytics programs in auditing and if they could be degrading audit quality without the human element being present.

Ho pointed out that the PCAOB has published a staff spotlight report on generative AI. “What the staff is seeing from the firms and the issuers in terms of their use of AI, based on that, it’s pretty clear, and based on my understanding, too, that the use of AI in the audit and financial reporting is still very much focused on repetitive tasks and very low-level areas that do not involve human judgment,” she added. “And everything they were doing using AI still requires human supervision. At this point, I don’t see right now that AI is off doing its own thing. I know that the firms are making significant investments, and AI is evolving, and more and more companies are using them. There will be more maturity. And I think that there is an opportunity, which is why it’s very important for regulators to stay on top of that, to make sure that we’re proactive in thinking and to ensure that we put guardrails if needed to make sure that there is a responsible use of AI, but at the same time, not keep people from using technology to make audits more effective and efficient.”

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