Several important changes to accounting and auditing standards will have a significant impact on corporate counsel during the next several years. One such change will directly affect how and when companies report certain types of revenue; another will make significant changes to lease reporting in companies’ financial statements; and a third is expected to significantly increase the level of information and disclosures that appear in public companies’ audit reports.
In-house counsel should familiarize themselves with these impending changes, since their roles and responsibilities are likely to expand. These changes will likely cause corporate counsel to play a more central role in deciding how to structure certain transactions. In-house counsel should also revisit certain commonly accepted contract provisions and language.
In-house counsel will need to understand accounting principles and practices to have more effective conversations with executive leadership, identify potential issues that may require legal attention, and better support their companies’ overall business strategies. In this article, the authors will provide an overview of the impending changes and outline what lawyers can do now to prepare.
New Revenue Recognition Standards
In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued converged guidance on how companies should recognize and report revenue from contracts with customers under U.S. generally accepted accounting principles (GAAP). The new guidance was the result of many years of effort by the boards, including multiple rounds of exposure drafts and public comments.
The final version of the guidance, Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606), represents a major accounting change for U.S. companies, and is part of an ongoing effort by the FASB and IASB to converge accounting standards on a global basis.
The overarching objective of these standards-setting organizations is to improve disclosure and transparency for readers of financial statements. By removing inconsistencies in the way revenue is treated across various industries, the new standard intends to make comparisons among different types of companies more accurate and meaningful. It also simplifies financial statement consolidation for companies with domestic and international operations.
ASU 2014-09 reflects a shift from “rules-based” accounting to a “principles-based” system. The new standard still has rules, of course, but its broad objectives designed to ensure good reporting have replaced much of the detailed, industry-specific revenue recognition guidance upon which companies traditionally relied. Because the new standard applies general principles rather than industry-specific rules, companies will likely apply subjective judgment more often than in the past.
ASU 2014-09 spells out a five-step process for determining how entities should recognize revenue:
Although these steps might seem relatively straightforward, they create numerous situations that require considerable judgment and interpretation by management. For example, in identifying the contract and its specific performance obligations, many companies must determine how to evaluate long-term obligations such as warranties or future product updates. These variables could greatly affect businesses in aerospace, construction, oil and gas, software, and various other industries that have traditionally had their own unique standards and conventions.
In the same way, determining the transaction price is not always as simple as it sounds. In many cases the price might cover multiple performance obligations. To record revenue properly, the entity must determine whether to bundle or unbundle these performance obligations, assign revenue to each obligation, and recognize revenue as it satisfies each one.
Because each step of the process could involve subjective interpretation, corporate counsel must be alert to potential manipulation or error. In addition to ensuring the entity has justified all estimates and interpretations, corporate counsel also must confirm company representatives properly document all such decisions.
Corporate counsel need to review standard contract language to ensure it accurately reflects the new arrangements, and nonstandard contracts will require scrutiny to avoid inadvertent misstatement. The corporate counsel’s office should expect to devote considerable resources to support this intensive review effort, since many companies are already operating under the new standard.
For publicly traded companies, the new revenue standard applies to the first annual reporting period beginning after Dec. 15, 2017, and must be reflected in the first interim period of the year of adoption, i.e., the 10-Q. In most cases, public companies will first adopt the revenue standard in either calendar year 2018 or the fiscal year ending in 2019. Moreover, since the Securities and Exchange Commission (SEC) requires public companies to present three-year historical earnings comparisons in their annual reports, these entities will need to review and adjust financial statements going back to 2016 (or the fiscal year ending in 2017) as well.
For privately held companies, the standard goes into effect for the first annual reporting period beginning after Dec. 15, 2018, and must be reflected beginning with the annual report in the year of adoption. In most cases, private companies will first adopt the revenue standard in calendar year 2019 or fiscal year 2020. The entity will need to review and adjust any other reporting periods presented in the financial statements as well. Early adoption of the revenue standard is permitted for both publicly traded and privately held companies.
New Lease Accounting Standard
A second sweeping change in accounting standards is following on the heels of ASU 2014-09. And, like the revenue recognition standard, this new guidance — Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) — will also require effort and understanding on the part of in-house counsel.
The FASB adopted its new lease accounting standard in February 2016 with the stated objective of providing the users of financial statements with improved visibility and transparency regarding companies’ long-term lease obligations. It accomplishes this goal by requiring that entities now show all long-term leases on the balance sheet, rather than merely in footnotes. This change is much more than merely a revision to reporting conventions — it could have significant effects on a company’s financial position.
Under the existing GAAP rules, companies categorize leases as either operating leases or capital leases, and only capital leases appear on the balance sheet. For operating leases — which encompass a large portion of all leases — entities do not report either the value of the leased assets or the liability of future lease payments on the balance sheet. Rather, they only disclose operating leases and the related future obligations in the footnotes to the financial statements.
ASU 2016-02 requires all leases over 12 months in duration to appear on the balance sheet. It also changes the term “capital lease” to “finance lease,” and does away with the previous bright-line thresholds used to distinguish between the two classes. The new standard prescribes five indicators of a finance lease, and a lease is classified as such if it meets any of the following five indicators:
Under the new standard, companies will record the “right-of-use” value of the property or equipment as an asset on the balance sheet. The offsetting entry is a liability for the present value of scheduled lease payments. The specific income and balance sheet entries used to accomplish this accounting will vary, depending on whether the lease is a finance lease or an operating lease, but the underlying principle is the same for all leases over 12 months’ duration.
The new standard is likely to cause significant balance sheet changes for any company that leases property, vehicles, or equipment, including both production equipment and everyday office equipment or computers. It also will affect other financial statements, particularly the income and cash flow statements.
Moreover, similar to the revenue recognition standard, entities will feel the effects of ASU 2016-02 far beyond the accounting function. In most companies, the legal team is likely to take the lead in reviewing the contracts affected by these changes, and to develop proposed contract modifications for future contracts. The general counsel’s office is also likely to be involved in other negotiations related to debt arrangements and covenants that could be affected by the balance sheet changes.
For publicly traded companies, the new lease accounting standard applies to the first annual reporting period beginning after Dec. 15, 2018. In most cases, this means either calendar year 2019 or the fiscal year ending in 2020. For privately held companies, the new standard goes into effect for the first annual reporting period beginning after Dec. 15, 2019 — that is, calendar year 2020 or fiscal year 2021. Although these dates are one year later than the comparable dates for the revenue recognition standard, because the FASB also permits early adoption of the new lease accounting standard, some companies may choose to implement the new revenue and lease standards simultaneously to complete the transitions quickly and to avoid having to make retrospective adjustments to their financial statements for two years in a row.
New PCAOB Auditing Standards
A third group of changes in accounting procedures that could affect the corporate general counsel’s office involves new information required to appear in a standard auditor’s report. In June 2017, the Public Company Accounting Oversight Board (PCAOB) adopted changes to auditing standards, known as AS3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion. The SEC approved the new rules in October 2017. As was the case with the two new FASB standards just discussed, the PCAOB auditing standard changes could have a significant impact beyond the accounting function, so in-house counsel should become familiar with the changes.
Under the new rules, the audit report must now include a statement disclosing how long the auditor has served in that capacity for the company. While seemingly routine, this disclosure could become complicated by mergers and acquisitions, and the general counsel’s office could be called upon for input in this area. The PCAOB also made some revisions to the standard language in auditors’ reports regarding auditor independence and specific auditor responsibilities.
An area of greater potential concern, from in-house counsel’s perspective, involves new guidance on communication and disclosure of critical audit matters (CAMs). The new standard defines CAMs as those that:
The new standard requires auditors take the following steps for each CAM: 1) identify the matter; 2) describe the principal considerations in determining that the matter is a CAM; 3) describe how the auditor addressed the matter in the audit; and 4) refer to the relevant financial statement accounts or disclosures.
Auditors and those involved in preparing financial statements have expressed several concerns with these new CAM disclosure standards that could affect the corporate counsel’s office. These concerns relate to the CAM information disclosed, and the potential for increased litigation. For example, potential plaintiffs could misinterpret the new statements required of the auditor as acts of negligence by the company, or could use them to map out future litigation. Additionally, plaintiffs could obtain auditor workpapers related to CAM analyses and determinations through discovery. These work papers could increase litigation exposure for both the auditor and the company. Likewise, investors who suffer a loss could assert legal claims against the company or its auditors, and corporate counsel would be involved in such matters.
Moreover, while the SEC endorsed the new requirements as being helpful in providing investors with more meaningful information about the audit and various areas of risk, another concern is that these extensive disclosures add significantly to the size and complexity of the audit report. Readers of financial statements may view any deviations from the historical audit report language unfavorably.
The new standard applies to any audits conducted under PCAOB standards. The new report format, tenure disclosure, and other new language requirements apply to all such audits for fiscal years ending on or after Dec. 15, 2017. The requirement for communication and disclosure of CAMs is being phased in over several years.
For large accelerated filers, the new CAM communication and disclosure requirements will apply to audits for fiscal years ending on or after June 30, 2019. For all other companies to which the requirements apply, the CAM disclosure requirements will apply to audits for fiscal years ending on or after Dec. 15, 2020. Certain types of organizations such as brokers/dealers and some investment companies could be exempt from some of the CAM disclosure requirements.
Corporate Counsel’s Expanding Role
The imminent changes in accounting and auditing standards will have effects that extend far beyond the accounting and financial reporting functions. They will affect how investors, lenders, and other interested parties evaluate companies, and in some instances, could also change how companies interact with customers, subcontractors, suppliers, and other third parties. In all cases, the corporate counsel’s office can expect to be asked for considerable input into the questions raised by these new standards.
To carry out their responsibilities, corporate general counsel should familiarize themselves with these pending changes as well as the fundamental accounting principles upon which they are built. Armed with this knowledge, and supported by a solid working relationship with the other professions involved, in-house counsel can begin to identify how these provisions will affect the advice they provide to their companies regarding contract language and other critical matters.