Conclusiones de los auditores a partir de las directrices sobre el virus de los reguladores financieros

The precipitating events causing the current economic instability are unlike any we have seen in recent history. Nonetheless, the guidance and statements of regulators regarding the possible impact of the COVID-19 pandemic on financial reporting, and regulators’ reaction to past market disruptions, can provide important clues for auditors regarding the possible focus of inspection and enforcement efforts in the upcoming months.

In recent weeks, the staffs of the U.S. Securities and Exchange Commission and Public Company Accounting Oversight Board issued guidance and statements regarding the importance of accurate financial reporting in response to the COVID-19 pandemic. In doing so, both implicitly acknowledged that periods of economic instability may increase the risk of financial fraud and financial statement error.

In fact, in a recent speech, Steven Peikin, co-director of the SEC’s Division of Enforcement, stated that past downturns have shown that stresses on an issuer’s financial condition may raise the risk to investors by exposing an issuer’s preexisting improper conduct or enticing the issuer to engage in such conduct.[1]

While much of the focus has been on an issuer’s obligations, auditors, given their role as gatekeepers, can also benefit from keeping such regulatory guidance in mind as they prepare for future interim reviews and audits.

Recent Regulatory Guidance and Lessons From Past Market Disruptions

On March 25, the staff of the SEC’s Division of Corporation Finance issued guidance regarding disclosure and securities law obligations for public companies in light of the COVID-19 pandemic.[2]

In the guidance, the staff warned that they are monitoring companies’ disclosures regarding the effects and risks of the pandemic on their businesses, financial condition and results of operations.

Subsequently, on April 2, the staff of the PCAOB issued its own guidance for public issuer audits nearing completion.[3] The spotlight document cautioned that auditors still have an obligation to comply with audit standards and rules, as well as applicable regulatory and professional requirements, despite the challenges presented by the pandemic.

It also noted that changing incentives and pressures on management may result in new risks of material misstatement, while mounting stress on internal controls resulting from remote working arrangements and travel restrictions may increase the risk of financial statement errors.

Finally, the staff identified several financial statement areas that may need to be revisited due to the pandemic, including subsequent events, going concern and estimates.

Shortly thereafter, on April 3, Sagar Teotia, the SEC’s chief accountant, issued a statement about the need for high-quality financial reporting as a result of the significant impact of the COVID-19 pandemic.[4] Teotia highlighted many of the same accounting areas requiring significant judgment and estimates identified by the PCAOB staff.[5]

He also stated that the Office of the Chief Accountant “remains actively focused on independence matters in these unprecedented times.” He remarked, however, that the office “has consistently not objected to well-reasoned judgments” with respect to financial statement items and “will continue to apply this perspective.”

On April 8 , SEC Chairman Jay Clayton and SEC Director of the Division of Corporation Finance William Hinman issued a joint statement providing their observations and requests to public companies relating to disclosure issues surrounding the COVID-19 pandemic with a focus on upcoming earning releases and analyst calls.[6]

The joint statement again called for high-quality disclosures and echoed much of the content of the guidance previously issued by the SEC staff in recent weeks.

Finally, as mentioned above, on May 12, the Division of Enforcement’s Peikin delivered a speech at the Securities Enforcement Forum West 2020 discussing, among other topics, how the Division of Enforcement is functioning in light of the COVID-19 pandemic and its efforts to detect and address misconduct related to COVID-19.[7]

In his remarks, Peikin stated that the experience and lessons learned from past market disruptions, including the 2008 global financial crisis, has informed the staff’s ongoing response to the pandemic.

While the triggering events and market conditions preceding the 2008 crisis were significantly different from the economic disruption caused by the COVID-19 pandemic, the regulatory reaction to the crisis can provide insight into possible future inspection and enforcement efforts in the wake of the pandemic.

Indeed, both events share characteristics including a high degree of uncertainty in terms of scope and duration, sharp declines and unpredictable fluctuations in the stock market, and substantial economic response by the federal government. And while the similarities between these events should not be overstated, they also should not be overlooked.

Following the 2008 crisis, the PCAOB issued a report examining the impact of the crisis on issuer audits, providing a resource to help assess upcoming regulatory scrutiny.[8]

The PCAOB described the report as an attempt to inform the public about the audit risks and challenges identified through its inspection program. Although some of its observations related exclusively to financial services issuers, given that their operations largely contributed to the 2008 crisis, the report also highlighted significant deficiencies that were common across all issuer types, including fair value measurements, impairment of goodwill, indefinite-lived intangible assets and other long-lived assets, revenue recognition, valuation of inventory and income taxes.

The PCAOB’s report acknowledged that, in response to the increased risks resulting from the 2008 financial crisis, audit firms issued technical guidance, required additional training, developed new audit tools, required additional audit procedures and increased monitoring of audit engagement personnel.

Despite these efforts, however, there were still “a number of deficiencies in audit areas significantly affected by the economic crisis.”[9] And, not surprisingly, these deficiencies resulted in increased referrals to the enforcement program.

Accounting and Audit Areas of Possible Interest

By reviewing the SEC and PCAOB staffs’ recent guidance and taking stock of past inspection and enforcement activity, an informed opinion can be made as to the accounting and audit areas that likely will be at the center of some of the COVID-19 pandemic-related enforcement efforts.

These areas may help auditors as they plan their interim reviews and audits, given that regulators often seek audit information during the course of investigations into potential financial misstatements by an issuer or other SEC registrant. Such areas of future regulatory scrutiny may include:

Subsequent Events

With no immediate end in sight to the COVID-19 pandemic, auditors should continue to scrutinize management’s subsequent event[10] disclosures to ensure that all material events occurring after the balance sheet date through the financial statement’s issuance date were properly disclosed.

Going Concern

Auditors also may need to spend more time and resources examining management’s going concern[11] assessments, given the far reaching, negative impact of the COVID-19 pandemic on some business sectors.

Even where an auditor concludes that no substantial doubt exists that the client can continue as a going concern, the auditor may still want to document in detail why that is the case and consider if disclosure is nonetheless required.

Critical Audit Matters

Audit firms’ continued implementation of the PCAOB’s critical audit matter,[12] or CAM, requirements will undoubtedly be impacted by the COVID-19 pandemic.[13] While audit firms are still trying to determine what qualifies as a CAM in normal circumstances, the pandemic will force the issue.

Under the PCAOB’s AS 3101, an auditor is required to identify within its audit report those audit matters relating to material accounts or disclosures involving “especially challenging, subjective, or complex auditor judgment.”

The auditor also must explain why it considers the matter to be a CAM and describe how it was addressed in the audit. One can envision lengthy audit reports containing multiple CAMs in light of the pandemic.

Nevertheless, it is likely that both regulators and plaintiffs’ counsel will scrutinize CAM disclosures to determine if matters later found to relate to material misstatements were properly disclosed and adequately addressed. As a result, overdisclosure may be preferable to underdisclosure.

Remote Audit Procedures

Under the new normal of remote working and concerns about the spread of COVID-19, clients may be reluctant to open their offices to auditors. As a result, auditors may be forced to replace procedures typically performed on-site — such as physical observation of inventory and in-person interviews of management — with new virtual procedures.[14]

While one would hope that regulators would acknowledge the unusual circumstances presented by the pandemic in reviewing such alternative procedures, the fact remains that auditors must design procedures of appropriate nature, timing and extent to adequately address any risks of material misstatements.

Moreover, those procedures must be performed with professional skepticism, without overly relying on management representations. As such, alternative procedures, even in this unique environment, will need to be designed with care.

Controls Assessment

Remote working may also be impacting an issuer’s internal controls[15] over financial reporting, such that segregation of duties, delegation of authority and access to certain financial reporting systems may be changing on the fly. To ensure that any modified controls are not being exploited by individuals to misstate financial results, auditors will need to stay informed of any changes and, as needed, alter any planned procedures.

Asset Valuations and Impairments

Asset valuations and impairment[16] may be especially difficult in the current environment and susceptible to management overstatement. Because valuation determinations rely on significant judgment and estimates, the SEC and PCAOB may focus more on the reasonableness of management’s approach to valuations of such assets as property, plant and equipment, long-lived assets, goodwill, financial instruments and investments.

As a result, it may be even more important for auditors to ensure that management’s model, assumptions and inputs are consistent with the industry and reflect observable market inputs.

Market disruptions, however, can make assumptions regarding market multiples, discount rates and future cash flows that much more uncertain, such that auditors should fully document why certain models, assumptions and inputs were used.

Additionally, because regulators may scrutinize both the timing and amount of any asset impairments taken in light of the COVID-19 pandemic, auditors will want to test the sufficiency of management’s assessments, whether performed annually or based on triggering events specified by generally accepted accounting principles.

Revenue Recognition

Management under economic stress may feel pressure to meet or maintain revenue targets and analyst expectations which, in turn, may cause them to be aggressive in recognizing revenue, especially with respect to amount and timing. This risk of material misstatements continues to exist even under the newly implemented revenue recognition[17] standard set forth in ASC 606.

Thus, auditors should pay special attention to changes in business practices and sales contracts to ensure revenue continues to be recognized properly. Auditors will also want to consider whether possible side agreements or other arrangements exist that may be indicative of earnings management or channel stuffing.

Allowances/Reserves

Like asset valuations and impairments, allowances and reserves[18] relating to areas such as inventory, account receivables, loan losses and contingent liabilities are heavily reliant on judgment and may be significantly impacted by the COVID-19 pandemic.

The SEC and PCAOB, therefore, may scrutinize these accounts, as management may be motivated to understate them to minimize their impact on the financial results. Accordingly, auditors will want to examine whether such amounts truly reflect the current economic realities.

Income Taxes

Income tax accounting[19] will continue to be a complex accounting area that may require heightened auditor scrutiny in light of the COVID-19 pandemic, especially with respect to the ability to fully realize deferred tax assets.

Conclusión

While the above provides an overview of possible regulatory focus, it is not exhaustive. The SEC and PCAOB staffs’ guidance also highlighted hedging, debt restructuring, leases, audit committee communications and other accounting and audit areas.[20]

Given the continued uncertainties surrounding the economic impact of COVID-19’s market disruption, audit firms and their lawyers should consider proactively assessing the sufficiency of their audit programs, documentation requirements and training, concentrating on those areas in that the SEC, PCAOB and other regulators may likely focus their future enforcement efforts.

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[1] See Keynote Address: Securities Enforcement Forum West 2020, Speech by Steven Peikin, SEC Co-Director, Division of Enforcement (May 12, 2020) (https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020).

[2] See CF Disclosure Guidance: Topic 9 (SEC Mar. 25, 2020) (https://www.sec.gov/corpfin/coronavirus-covid-19).

[3] See COVID-19: Reminders for Audits Nearing Completion Spotlight, at 2-3 (PCAOB Apr. 2, 2020) (https://pcaobus.org/Documents/COVID-19-Spotlight.pdf).

[4] See Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19, Public Statement by Sagar Teotia, SEC Chief Accountant (Apr. 3, 2020) (https://www.sec.gov/news/public-statement/statement-teotia-financial-reporting-covid-19-2020-04-03).

[5] These areas include but are not limited to: fair value and impairment considerations, leases, debt modifications or restructurings, hedging, revenue recognition, income taxes, going concern, subsequent events, and adoption of new accounting standards (e.g., the new credit losses standard). Id.

[6] See The Importance of Disclosures – For Investors, Markets and Our Fight Against COVID-19, Public Statement by Jay Clayton, SEC Chairman, and William Hinman, SEC Director, Division of Corporation Finance (Apr. 8, 2020) (https://www.sec.gov/news/public-statement/statement-clayton-hinman).

[7] See Peikin Speech at https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020.

[8] Report on Observations of PCAOB Inspectors Related to Audit Risk Areas Affected by the Economic Crisis; PCAOB Release No. 2010-006 (Sept. 29, 2010) (https://pcaobus.org/Inspections/Documents/4010_Report_Economic_Crisis.pdf).

[9] Id. at 26.

[10] See PCAOB COVID-19 Spotlight; see also SEC Chief Accountant Teotia Public Statement.

[11] See id.

[12] See PCAOB COVID-19 Spotlight.

[13] The CAM requirements are already effective for large accelerated filers with fiscal years ending on or after June 30, 2019. These requirements apply to all other filers for audits of fiscal years ending on or after December 15, 2020.

[14] See PCAOB COVID-19 Spotlight.

[15] See id.

[16] See id.

[17] See id.

[18] See id.

[19] See id.; see also SEC Chief Accountant Teotia Public Statement.

[20] See id.

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Note this was originally published in Law360.