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A Continued Focus on High-Quality Financial Reporting

An organization’s board of directors is responsible for the operational, strategic, and financial performance of that entity.  Boards are responsible for setting policy guidelines for how management should operate, short- and long-term goals for the organization and systems to ensure that management is acting according to these directives.  They are also responsible for putting procedures in place to measure the progress of corporate objectives.  This is especially true when it comes to the quality of the company’s financial reporting.

Not only must a company ensure that it has the systems in place to generate and compile the appropriate information for financial reporting, but it must also confirm that the processes for accurate analysis and presentation to the board of directors are done so that they can make the most meaningful decision for what is best for the organization at that current time.   Focusing on these details will link objectives, principals, and actions to the board of directors and organizations needs.

What are some of the key items that boards should be focusing on for this reporting period? Sagar Teotia, U.S. Securities and Exchange Commission’s Chief Accountant, highlights them in a recent release^[1] as follows:

1. Significant Estimates and Judgments; Reasonable Judgments – Companies should ensure that significant judgments and estimates are disclosed in a manner that is understandable and useful to investors, and that the resulting financial reporting reflects and is consistent with the company’s specific facts and circumstances.

Centri’s Take – Significant estimates and judgements continue to be an area of focus as they impact various aspects of a company’s financial statements from the way revenue is recognized to whether a company will continue on as a going concern. So, there is no surprise that in a review of SEC comment letter trends for the period of April 1, 2019 through March 31, 2020, significant management estimates and judgements continue to be an area of focus. One of the hardest hit areas noted through SEC comment letter trends specifically surrounds the quality of disclosures associated with goodwill and intangible assets, including impairment assessments.

To assess whether a triggering event has occurred, entities must consider events or circumstances such as macroeconomic conditions, industry and market conditions, cost factors that have a negative effect on earnings and cash flows, and overall financial performance. Because the COVID-19 situation continues to evolve, it is possible that triggering events could occur throughout the year, necessitating more frequent impairment assessments. Boards should give special attention to identify such events in the changing business landscape to ensure impairment assessments are considered proactively and properly reflected within the Company’s quarterly financial statements.

2. The Importance of Disclosure Controls and Procedures (DCP) and Internal Control over Financial Reporting (ICFR) – The Office of the Chief Accountant continues to emphasize the importance of robust internal accounting controls to high-quality, reliable financial reporting.  Public companies are required to maintain DCP and ICFR.  In addition, Management is required to evaluate the effectiveness of a public company’s DCP as of the end of each fiscal quarter, and the effectiveness of its ICFR at the end of each fiscal year.

Centri’s Take – Management is responsible for maintaining a system of internal control over financial reporting (ICFR) that provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. While Management is required to evaluate the effectiveness of ICFR on an annual basis, Boards should be meeting with their internal/outsourced internal audit teams on at least a quarterly basis to properly identify what impacts recent changes in process as a result of COVID and remote working conditions may have had on the effectiveness of a company’s internal controls to ensure proper disclosure within the impacted quarterly financial statements. [For more details, read Centri’s insight]

3. Reminders about an Entity’s Ability to Continue as a Going Concern – Financial reporting pursuant to U.S. generally accepted accounting principles (GAAP) presumes a reporting entity has the ability to continue as a going concern. OCA reminds preparers that in each reporting period, including interim periods, Management should consider whether relevant conditions and events, taken as a whole, raise substantial doubt about the entity’s ability to meet its obligations as they become due within one year after the issuance of the financial statements.  In instances where substantial doubt about an entity’s ability to continue as a going concern exists, Management should consider whether its plans alleviate such substantial doubt and make appropriate disclosures to inform investors.

Such disclosures should include information about the principal conditions giving rise to the substantial doubt, Management’s evaluation of the significance of those conditions relative to the entity’s ability to meet its obligations, and Management’s plans that alleviated substantial doubt.  If after considering Management’s plans substantial doubt about an entity’s ability to continue as a going concern is not alleviated, additional disclosure is required.  The COA notes that GAAP requires such disclosure in the notes of the financial statements, and this may be incremental to other disclosure requirements in filings with the Commission.

Centri’s Take – Management’s evaluation is based only on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued and should be approved by those with proper authority. For most public companies, this authority would lie with the Board of Directors, or a special committee of the Board of Directors. The term “reasonably knowable” is intended to emphasize that an entity may not readily know all conditions and events, but Management should make a reasonable effort to identify conditions and events that can be identified without undue cost and effort. With the ever evolving COVID-19 crisis comes new known and unknown factors for Management to consider when making this evaluation, so special attention should be given to this topic to ensure that quarterly disclosures are complete and accurate. [For more details, read Centri’s insight here]

4. Addressing Complex or Emerging Issues in Financial Reporting – There were several complex financial reporting issues that arose during the first quarter 2020 reporting cycle which were presented to OCA for consultation.  These issues included the financial reporting ramifications of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), debt modifications, hedging, consolidation, business combinations, lease concessions, revenue recognition, and income taxes.

Centri’s Take – Boards should continue to evaluate how business decisions made over the course of the past few months may potentially impact judgements that had been applied pre-pandemic. Key debt covenants should be evaluated on a quarterly basis in light of new and evolving circumstances, lease contracts should be evaluated to determine if concessions have been granted/received and if prior judgements surrounding termination and renewal clauses still hold true. Revenue contracts should be re-evaluated to determine if estimates made surrounding variable consideration, such as returns and allowances, as well as contract volume estimates are still accurate. [For more details, read Centri’s insight here]

[1] SEC Chief Accountant Sagar Teotia, Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19