Financial reporting enters a new age

Inspectors this year at the Public Company Accounting Oversight Board will probably report flaws in 40% of the 2022 audits they review, PCAOB Chair Erica Williams said Thursday, noting that many auditors fail to back up their opinions with solid evidence.

“We are seeing audit quality for both domestic and international firms trend in the wrong direction for the second year in a row,” Williams said in a speech. Inspection reports this year will probably show that the proportion of flawed audits surged 6 percentage points in 2022 after rising 5 percentage points in 2021.

“Audit opinions were signed without completing the audit work required to verify the accuracy of financial statements,” Williams said. “That is a serious problem at any rate, and 40% is completely unacceptable.”

Backed by Securities and Exchange Commission Chair Gary Gensler, Williams has led a push for expanded inspections, tougher enforcement and stricter standards since January 2022, when she took the top post at the agency that oversees the accounting firms auditing publicly listed companies.

“The PCAOB has not hesitated to bring enforcement cases against auditors when appropriate,” Williams said. Last year it doubled the number of enforcement orders compared with 2021 and imposed a record total in penalties, she said.

Board inspectors annually vet 800 audits in more than 30 jurisdictions worldwide. Last year the PCAOB for the first time secured access for inspections in China.

Audits by units of KPMG and PwC in China showed “high rates of deficiencies,” the PCAOB said in May after an inspection of audits focused on China-based companies listed on U.S. stock exchanges.

The board identified weaknesses in all four audits it reviewed last year by KPMG Huazhen, which is headquartered in Beijing, and three of four audits performed by PwC in Hong Kong. The flaws encompassed controls testing, goodwill, revenue, journal entries and independence.

The PCAOB findings were the culmination of a successful multi-year effort by the U.S. to overcome obstacles posed by regulators in Beijing.

Under a U.S. law enacted in 2020, more than 200 companies headquartered in China faced the prospect of delisting from U.S. stock exchanges if the PCAOB was barred from reviewing their audits for three straight years.

“We are continuing to demand complete access with no loopholes and no exceptions,” Williams said.

Indeed, the PCAOB is on track by the end of this year to audit 99% of the total market share of the U.S.-listed companies audited by Hong Kong and mainland China firms, according to Williams.

“Should the People’s Republic of China authorities obstruct or otherwise fail to facilitate the PCAOB’s access — in any way and at any time — the board will act immediately,” she said.

Meanwhile, the board has “laid out the most ambitious standard-setting and rulemaking agendas in PCAOB history,” focusing on more than half of its rules, Williams said. Nearly all of the standards under review were set on an interim basis in 2003 soon after creation of the PCAOB.

For example, the PCAOB on Sept. 28 unanimously approved the replacement of a 20-year-old interim rule with a standard tightening the requirements for auditors when verifying with a third party assertions made by a client in a financial statement.

The new standard requires an auditor to confirm with a client’s lenders, customers or other third parties the amounts of cash and cash equivalents reported by the client.

An auditor will no longer be able to assume accuracy of the numbers based on “negative confirmation,” or the lack of a response or objection from third parties.

Subject to SEC approval, the standard will take effect for audits of financial statements for fiscal years ending on or after June 15, 2025.

“To keep investors protected, our standards must keep up,” Williams said. “Capital markets don’t stand still. They evolve constantly. Practices change. Technology advances relentlessly, and new risks emerge.”

With the final deadline for employee benefit plan audits approaching, CFOs should play a front-and-center role in ensuring that third-party auditors are furnished with plan data, ideally with access to trustee technology platforms, Stacy Farber, a partner at Farmington Hills, Michigan-based accounting firm UHY LLP, told CFO Dive.

The Employee Retirement Income Security Act (ERISA) of 1974 generally requires plans with more than 100 participants to obtain an audit of the plan's financial statements annually and file form 5500 containing the financial details with the Internal Revenue Service. Under ERISA, an employee benefit plan includes pensions, 401(k) and A 403(b) plans.  

The objective of benefit plan audits is to report information on the qualification of the plan, its financial condition, investments and the operations of the plan. The Department of Labor typically is involved in post-audit inquiries and enforcement actions, Farber said.

Benefit plan audits are due the last day of the seventh month after the plan year ends — July 31 for a calendar year plan — which can be extended to Oct. 15. Plans that have fewer than 100 plan participants will file Form 5500-SF, a simplified annual reporting form.

“The CFO is often the plan administrator, so they have the fiduciary responsibility to ensure that all of this is done correctly,” said Farber. “If DOL comes in, they can go into much more detail than we can as the auditors,” resulting in fines, penalties, interest, and the potential loss of tax-exempt status.

While an HR staff member may be coordinating the transmission of information to third-party auditors, it’s imperative for the CFO to be constantly engaged, said Farber.

Audits “tend to move a little bit faster because the CFO wants it done, so they'll tend to drive those people to get us what we need faster than when the CFO is not involved,” she said.

Auditors also should ideally have access to technology systems run by plan trustees, she added. Most of the time auditors are given read-only access to technology systems, and delays result in a small number of situations where auditors don’t have access and have to ask company staff to retrieve information. 

The biggest problems typically include inconsistent remittances, the lack of timely payroll system updates when employees change their deferral percent or amount, and incorrect matching contributions, Farber said.

ERISA missteps can have serious financial consequences, with EBSA pursuing both civil and criminal actions. According to ERISA enforcement results data from the Employee Benefits Security Administration (EBSA) — part of the Department of Labor — for fiscal year 2022, total monetary recoveries were more than $1.4 billion. 

Of that number, $931 million was recovered in civil investigations, including $542 million owed to terminated vested participants in plans that EBSA helped collect. Separately, EBSA investigations also led to the indictment of 103 people — including corporate officers, plan officials and service providers — for crimes related to employee benefit plans. While third-party auditors usually assess compliance through a sampling of transactions, EBSA can review all transactions, significantly magnifying the scope of the review.

CFOs should regularly review plan transaction reports to proactively address issues, said Farber.

“It is helpful to review the transactions occasionally,” as part of monthly or quarterly reports from plan trustees, she said. “It's a good idea, just to even look over them and make sure that somebody's maintaining a remittance schedule and reconciling that periodically, because that's going to help identify issues before the audit.”

The Financial Accounting Standards Board is revisiting a project that could lead to a minor cleanup of U.S. generally accepted accounting principles that are contained in the Accounting Standards Codification, a 14-year-old document maintained by FASB that is considered the authoritative home for GAAP, which sets the standards for corporate financial reporting.

The FASB proposed in 2019 removing some detailed information such as definitions, dubbed “concept statements,” from the codification which are not part of GAAP, but which can help explain how they are applied according to documents provided before a FASB meeting Wednesday, when the board is scheduled to decide whether to proceed with the plan. 

While the project is not expected to change how GAAP is used in practice or to be particularly controversial, the proposed changes have sparked some debate about the project’s potential “unintended consequences,” with accounting firms writing seven of the 10 comment letters received, according to the meeting material.

The codification update is one of the lower key changes that the FASB has taken up in recent months. It has surfaced on the board’s agenda after years on the back-burner and as the board has recently approved such hot-button issues as a controversial requirement under which companies will have to report vastly more information about the taxes they pay and new standards for crypto assets. 

Among the details of the new plan that have stirred concern is the board’s plan to remove the definition of the term transfer from the codification. “Two respondents suggested that deleting the first definition of the term transfer could result in confusion. The other respondent stated that using the term transferring in paragraph 230-10-50-4 in the consequential amendments but linking to the Master Glossary term transfer is confusing,” the material from the staff stated. 

The plan to remove the definition of expected losses and expected residual returns drew responses from four commentators. While three respondents supported the removal and the amendments to Topic 810, Consolidation, those respondents also recommended clarifying amendments to the standalone definitions of the terms expected losses and expected residual returns. “Those respondents recommended that the aforementioned language be incorporated in those standalone definitions by providing a glossary link to the term expected cash flow,” the material states.

The codification update could be implemented sometime early next year. 

Real estate valuations are part of the typically routine financial reporting practices at the heart of a New York judge's bombshell ruling Tuesday in the civil-fraud case against former President Donald Trump and other defendants including his two oldest sons, The Trump Organization and its former CFO Allen Weisselberg. 

But the day-to-day approach of Trump and some of his officers to financial reporting was far from routine, as described in the ruling from New York Supreme Court Judge Arthur F. Engoron. In his 35-page decision, Engoron found that New York Attorney General Letitia James had satisfied her burden of establishing liability on the part of the defendants related to their use of fraudulent documents that inflated the value of many of Trump’s signature real estate assets. 

“In defendants’ world: rent regulated apartments are worth the same as unregulated apartments; restricted land is worth the same as unrestricted land; restrictions can evaporate into thin air...and square footage subjective,” Engoron wrote. “That is a fantasy world, not the real world.”  

On Wednesday morning Trump took to his own social media platform to attack the ruling, the AG and the judge, reiterating that the suit was politically motivated. He also asserted that there are disclaimers in the financial statements that leave him off the hook. “There is a POWERFUL Disclaimer Clause (some call it a ‘non-reliance clause,’...),” Trump wrote. Trump’s lawyer, Christopher Kise, said they would appeal, the Associated Press reported. The ruling could have serious consequences for Trump’s business: Engoron authorized James to cancel certificates for Trump companies, jeopardizing his control over the properties, according to a Bloomberg report. 

The Trump Organization isn’t the first or only company to run into legal problems with real estate valuation practices. Last year Wells Fargo beat a proposed class-action lawsuit that accused the bank of using improperly inflated underwriting metrics and deceiving investors about its commercial loans over a three-year span. But the judge’s decision in the Trump case is a cautionary tale for CFOs and financial executives seeking appraisals they can vouch for in today’s volatile commercial real estate markets. Here are three key valuation takeaways from the ruling: 

1. Accountants’ disclaimers aren’t a defense: Trump lawyers again argued that the AG’s complaint should be dismissed because the Statements of Financial Condition contained disclaimers made by then Trump accountants, Mazars, which indicated they had not audited or reviewed the statements and couldn’t give an opinion as to whether they complied with Generally Accepted Accounting Principles. But Engoron stated that these “non-party disclaimers do not insulate defendants from liability…In sum, the Mazars disclaimers put the onus for accuracy squarely on the defendants’ shoulders.” 
2. “Worthless” clauses are worthless: Donald Trump cited a clause in his company’s financial statements which he effectively viewed as another disclaimer. In part, it noted that the estimated current value of assets require judgment and might not be the value that the assets would fetch if sold. “They call it ‘worthless clause’ too, because it makes the statement ‘worthless,’” Trump stated in a sworn deposition, according to the judge’s ruling. Engoron rejected Trump’s assertion. “The clause does not use the words ‘worthless’ or ‘useless’ or ‘ignore’ or ‘disregard’ or any similar words…Additionally, as discussed supra, a defendant may not rely on a disclaimer for misrepresentation of facts peculiarly within the defendant’s knowledge.”
3. Discrepancies matter: One of the valuations that the ruling took issue with was for the 10,966-square-foot Trump Tower apartment triplex where Trump lived for decades. Between 2012 and 2016, the ruling said Trump submitted statements falsely claiming the triplex was 30,000 square feet, which resulted in an overvaluation of between $114 million and $207 million dollars. Engoron wrote that the defendants suggested the square footage calculation was subjective. “Well yes, perhaps, if the area is rounded or oddly shaped, it is possible measurements of square footage could come to slightly differing results due to user error,” he wrote. However, the judge continued, a “discrepancy of this order of magnitude, by a real estate developer sizing up his own living space of decades, can only be considered fraud.”

Three out of four companies worldwide are unprepared for regulations coming into force next year requiring outside audits of environmental, social and governance policies, KPMG said.

Although roughly half of companies (52%) subject their ESG disclosures to an audit, only 30% of those respondents say that they attain “limited” or “reasonable” compliance with coming audit standards, KPMG found in a survey of 750 companies across regions, industries and revenue sizes.

“While most companies have been doing some voluntary reporting on sustainability issues, they typically didn’t subject that reporting to the same rigor, controls and oversight that will be needed to meet the new regulatory requirements to be assured,” Mike Shannon, KPMG’s global head of ESG audit, said Monday in a statement.

Regulators in the U.S., EU, U.K., Japan and other jurisdictions are either ramping up or considering mandatory ESG reporting rules with the aim of providing investors with consistent and comparable company disclosures.

Currently, CFOs at multinational companies must navigate a maze of more than 600 different — and sometimes conflicting — ESG rules worldwide, according to Wolters Kluwer.

As regulators in the U.S. and several other countries seek to reduce confusion by better aligning regulations, they are also starting to mandate much more detailed, far-reaching and costly ESG disclosure.

“For the first time in history, businesses are being required to report on both financial and non-financial data,” Karen Abramson, Wolters Kluwer’s CEO for corporate performance and ESG, said Monday in a statement. “This shift is creating a true sea change in the complexity of corporate reporting.”

A rule proposed by the Securities and Exchange Commission in March 2022 would require publicly traded companies to disclose in detail their carbon emissions and those by their energy providers. Companies would also need to report on Form 10-K their risks from climate change and strategy for curbing such risks.

The SEC has repeatedly delayed release of a final rule as it pores over a record 16,000 public comment letters. A requirement that some companies gauge and report the carbon emissions across their supply chains — including by suppliers and customers — has triggered opposition by Republican lawmakers and industry organizations including the U.S. Chamber of Commerce.

The concern has prompted extensive deliberation over a final rule by agency staff, SEC Chair Gary Gensler said during testimony to a Senate committee on Sept. 12.

Under the proposed rule, companies would also need to subject their data and findings on carbon emissions and climate risk to an independent audit.

“Only 25% of companies feel they have the ESG policies, skills and systems in place to be ready for” an external audit, KPMG said.

Companies better prepared for an ESG audit tend to have boards engaged on ESG issues, conduct regular ESG training and institute controls for ESG data, KPMG said.

In addition to meeting compliance rules, ESG audits help a company burnish its reputation, expand market share, spark innovation and cut costs, according to about half of the KPMG survey respondents.

Larger companies tend to be better prepared for ESG audits than smaller ones, KPMG said.

Companies based in France, Japan and the U.S. are more ready for audits than their counterparts elsewhere, KPMG said. Companies in Brazil and China report the lowest level of readiness.

Fifty-eight percent of companies unprepared for an ESG audit report difficulty balancing the goals of ESG audits with the profit expectations of shareholders, KPMG said.

The Financial Accounting Standards Board voted 7-0 Wednesday to effectively finalize new accounting standards for certain crypto assets such as Bitcoin, keeping the guidelines narrowly focused by excluding nonfungible tokens (NFTs). At the same time, the board recognized the need to adapt to fast-changing financial technology by including assets that are “created or reside on a distributed ledger based on blockchain or similar technology,” according to documents prepared for the meeting.  

Under the accounting standards update — which will go into effect for the fiscal years beginning after Dec. 15, 2024 — the rules that underpin generally accepted accounting practices will call for companies to report qualifying crypto assets using the fair value accounting method, which is a change from current practice under which most companies report it as an intangible asset that is impaired to the lowest observable value within a given reporting period. 

The accounting change is one of the most consequential in a very busy year for FASB decisions, according to Jack Castonguay, assistant professor of accounting at Hofstra University in New York. “This is much bigger than the three previously issued ASUs,” Castonguay wrote in an emailed response to questions from CFO Dive. “It provides guidance where there wasn’t much, if any, to begin with. It fundamentally changes the accounting structure — going from impairment accounting to fair value accounting is a huge shift as it changes both balance sheet presentation and income statement recognition.”

While many companies in the crypto industry have long clamored for fair value accounting, the FASB decision comes at a tricky time for crypto. The sector is just beginning to regain its footing after the collapse of FTX and other crypto companies last year.The fall in valuations prompted sharp criticism of regulatory oversight of the new asset class.

On Wednesday, FASB Chair Richard Jones noted that in his brief time at the FASB no other issue has “excited such passion” as crypto assets. But he made clear at the meeting that, in spite of that increased attention, the FASB has sought to remain focused on its mission of making sure accounting reflects economic reality. 

“Our mission is to best reflect the economics of the transaction, [and ] provide investors and allocators of capital with the information they need,” Jones said. “I think this moves the needle there, I think we’ve heard overwhelmingly from investors that allocate capital that this will provide them better information to make their decisions.”

In addition to investors, financial executives and preparers of financial reports may also benefit from the new rule, experts have said, because it resolves a reporting issue that may have discouraged CFOs from putting digital assets on their balance sheets. 

The new standard is expected to be simpler for firms that hold crypto assets, because a company will report the value of the asset based on its level on a given exchange at the end of the reporting period, rather than having to follow the ups and downs of an asset’s value through a reporting period to report the lowest level, CFO Dive previously reported. 

“The big difference is now their change in value, both gains and losses, will be reflected on the income statement if this is adopted,” Castonguay wrote. “Currently, only impairment losses are recognized. Essentially they have to immediately book any losses and can’t recognize gains or impairment reversals. This will add more variability to earnings but also more accurately reflect the economics of holding crypto assets.” 

Grayscale Investments CFO Ed McGee was one of the executives who has supported the fair value change. Last year he told CFO Dive that he supported FASB proceeding quickly to provide relief that would allow digital assets to be held at fair value while also working toward creating a stand-alone section of the U.S. GAAP accounting standards. 

McGee would need more time to review the FASB decision before commenting, but a spokesperson for Grayscale, one of the world’s largest digital asset managers, expressed general support for the FASB’s new initiative.

“At Grayscale, we are supportive of all progress that provides clearer crypto accounting guidance. Ultimately, these are important milestones that further cement the role of digital assets in the global financial system,” the company statement emailed to CFO Dive said. 

The number of companies restating results or revealing accounting flaws surged more than 150% during the 2023 proxy season, demanding extra scrutiny from company directors overseeing audits, Glass Lewis said in a report.  

“Problematic accounting and poor internal control over financial reporting at companies has put a strain on audit committees,” Glass Lewis said in the “2023 Proxy Season Briefing” based on analysis of 4,680 reports from companies that held an annual meeting from January through June.

The number of accounting errors rose after a record number of businesses went public early this decade either as a special purpose acquisition company or as a conventional initial public offering, Glass Lewis said. Many of the companies are “in the early stages of developing strong internal controls.”

The number of IPOs in the U.S. soared to a record 1,035 in 2021 from just 232 in 2019, according to Statista, as hundreds of SPACS, or “blank-check companies,” secured financing.

A SPAC has been perceived to be a faster, cheaper way to raise money than through a conventional IPO. It sells shares listed on a stock exchange and then merges with a private company, usually within two years, in a so-called de-SPAC transaction.

The number of U.S. IPOs plummeted last year to just 181 because of regulatory scrutiny, compliance challenges, a downturn in the global economy and challenges securing adequate valuation.

During the first half of this year, U.S. IPOs raised $8.8 billion, an 87% jump compared with the same period in 2022 but only about one-tenth the $84.2 billion surge in IPO proceeds during the first six months of 2021, EY said. During the first half of last year, U.S. IPOs raised a paltry $4.7 billion.

The SPAC market collapsed during the first six months of this year, EY said, with the total number of transactions falling to 32, a 70% decline compared with the first half of last year, EY said. Proceeds during the same period fell to $2.7 billion from $14.7 billion, an 82% slump.

Accounting flaws at SPACS have sapped investor enthusiasm. Restatements by all categories of companies soared to 1,470 in 2021 compared with the prior year, a 289% increase, according to Audit Analytics. Excluding SPACs, though, restatements would have fallen 10%.

Newer companies, whether funded via a SPAC or conventional IPO, are more prone to the mistakes and oversights that lead to restatements, according to Deloitte.

“While internal control issues can affect any company, newly public companies tend to be more susceptible to internal control weaknesses,” according to Deloitte.

“These organizations are often still refining their internal controls, putting additional controls in place, establishing accounting policies, assembling their teams and considering or implementing technology solutions,” Deloitte said in a report on restatements.

Deloitte analyzed SEC filings since 2020 and found that newly public companies tended to restate because of errors in five areas: revenue recognition, deferred tax assets and liabilities, leases, equity awards and earnings per share.