Audit Committee Insights | January/February 2023

We’re past New Year’s and spring is not quite in sight. It’s a busy and important time of year for audit committee members, especially with 10-K and proxy deadlines looming. We scour available resources and keep up with regulatory developments to help keep you up to date. Read on to stay informed on these relevant developments for audit committee members.

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Audit Committee Practices Report. Size and skillset matter.

Many boards are taking a fresh look at their audit committee structures and practices in light of emerging corporate reporting areas and increased risks, according to a new report from the CAQ and Deloitte’s Center for Board Effectiveness. In addition, cybersecurity; Enterprise Risk Management; and environmental, social, and governance reporting top many audit committee agendas. The Audit Committee Practices Report: Priorities and Committee Composition provides insight into shifting oversight priorities and practices related to audit committee composition. Key insights include:

• 28% of respondents anticipate replacing the current audit committee chair in the next 12 months. A portion of those expecting to change the chair (19%) plan to do so with a current audit committee member and 3% with a current director who is not an audit committee member.
• Beyond the chair, an even greater percentage of respondents (42%) anticipate replacing one or more members of the audit committee in the next 12 months. Of these, about 24% expect to do so with current board members, while 18% plan to do so with new directors who are not presently on the board.
• 74% of respondents do not have a policy (formal or informal) to rotate the chair and/or members of their audit committees, and only 4% require new directors to serve on their audit committees (17% recommend it).
• Outside of financial reporting and internal controls, respondents anticipate Cybersecurity (63%), ERM (45%), and environmental, social, and governance disclosure and reporting (39%) as being among their top three areas of focus in the next 12 months.

Mind the Non-GAAP. The SEC updates its guidance.

It’s not new, but it’s here to stay. Non-GAAP is OK, but mind the SEC’s rules (Regulation G). Two words: Prominent and misleading. Non-GAAP should be neither. In December 2022, the SEC updated its Compliance & Disclosure Interpretations (C&DIs) related to non-GAAP. The CAQ issued an Alert providing an overview of the updates as well as a detailed comparison of the previous and new C&DIs.

For example, here are some excerpts:

Question 100.01 (Updated): Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes… Presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business is one example of a measure that could be misleading. When evaluating what is a normal, operating expense, the staff considers the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment. The staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring.

Question 100.05 (New): Can a non-GAAP measure be misleading if it, and/or any adjustment made to the GAAP measure, is not appropriately labeled and clearly described?

Answer: Yes. Non-GAAP measures are not always consistent across, or comparable with, non-GAAP measures disclosed by other companies. Without an appropriate label and clear description, a non-GAAP measure and/or any adjustment made to arrive at that measure could be misleading to investors.

Question 102.10(b) (New): Are there examples of disclosures that would cause the non-GAAP reconciliation required by Item 10(e)(1)(i)(B) of Regulation S-K to give undue prominence to a non-GAAP measure?

Answer: Yes. The staff would consider the following examples of disclosure of non-GAAP measures as more prominent than the comparable GAAP measures:

• Starting the reconciliation with a non-GAAP measure.
• Presenting a non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures. See Question 102.10(c).
• When presenting a forward-looking non-GAAP measure, a registrant may exclude the quantitative reconciliation if it is relying on the exception provided by Item 10(e)(1)(i)(B) of Regulation S-K.  A measure would be considered more prominent than the comparable GAAP measure if it is presented without disclosing reliance upon the exception, identifying the information that is unavailable, and its probable significance in a location of equal or greater prominence.

Audit Committee Considerations – Questions to ask

The audit committee has a role to play in assessing management’s reasons for presenting non-GAAP financial measures and KPIs, as well as the transparency, comparability, and consistency of the disclosures. The audit committee also oversees whether the measures present a fair and balanced view of the company’s performance. Read more from the CAQ on non-GAAP here.

In executing this oversight, audit committees may want to consider asking management the following questions:

1. Does the company have an internal policy for determining how non-GAAP financial measures and KPIs are generated, calculated, and presented?
2. How are these non-GAAP financial measures or KPIs being used (e.g., determining compensation of executives, as an input to debt covenant calculations, measuring company progress)?
3. Are the non-GAAP financial measures and KPIs transparently disclosed in such a way that the users can understand the basis for their calculations?
4. Are the disclosed non-GAAP financial measures and KPIs consistent with what is used by management to evaluate and make decisions about the company’s overall strategy and performance?
5. Do the disclosed non-GAAP financial measures and KPIs provide meaningful insight into factors affecting and the company’s performance?
6. Does the company have internal controls and DCPs over non-GAAP financial measures and KPIs, and are they precise enough to detect a material misstatement?
7. Are the controls and processes over non-GAAP financial measures and KPIs in scope for internal audit?
8. Do the non-GAAP financial measures or KPIs represent a balanced picture (i.e., is the company including both negative and positive adjustments)?
9. How do the company’s non-GAAP financial measures and KPIs compare to those of other companies in the industry?
10. What is the external auditor’s involvement in these non-GAAP financial measures or KPIs, if any?
11. What impact do economic volatility and other uncertainties have on the non-GAAP financial measure, and are the related adjustments, if any, appropriate and expected to be nonrecurring?

Do you know where your digital assets are? What they are? Jumpstart your digital assets journey.

From crypto assets to NFTs (non-fungible tokens), companies are engaging with digital assets in a variety of ways – some through more straightforward applications, like investing, and others by exploring new opportunities to engage with customers and improve business processes. Digital assets and the underlying technology, blockchain, present new risks that public companies should bear in mind and that audit committees should consider as part of their oversight duties.

If you are looking for a primer, this new CAQ publication will help set the stage for why and how companies may be engaging with digital assets.

Here is a sample of questions audit committees can consider:

Questions for management

1. What are the company’s objectives for engaging with digital assets?
2. Does the company have the requisite expertise to use, monitor, and report on digital assets?
3. Has management considered the tax, legal, regulatory, or financial reporting requirements that apply to the company related to its engagement with digital assets? Do these requirements call for external advice?
4. Has management considered the risks associated with the use of digital assets?
5. Has management considered what internal controls it will need to design and implement for reporting and safeguarding digital assets?
6. Will third-party involvement be required for management to engage in digital asset transactions?
7. Has management considered all potential impacts to the financial statements arising from the company’s involvement with digital assets?

Questions for auditors

1. What is the experience of the engagement partner and other senior engagement team members with digital assets? Would the firm be able to supplement the engagement team’s expertise if necessary (e.g., by engaging qualified specialists)?
2. Does the audit firm have other similarly situated clients in the digital asset ecosystem?
3. Do the engagement partner and other senior engagement team members understand the company’s objectives for engaging with digital assets?
4. Do the engagement partner and other senior engagement team members understand the applicable regulatory environment, and whether there is a risk an entity may not comply with laws and regulations?
5. What policies and procedures does the audit firm have regarding conducting and monitoring audit engagements involving digital assets, including considering the risks associated with performing such audits? Does the audit firm require some type of monitoring of these types of audits by other professionals in the firm?
6. What is the auditor’s understanding of the financial reporting implications of the company’s planned activities related to digital assets?
7. Does the auditor have access to specialized technology-based audit tools needed to identify, assess, and respond to risks of material misstatement?
8. Can the auditor obtain sufficient appropriate audit evidence related to the company’s financial reporting and internal controls over financial reporting related to the company’s digital assets?
9. How does the audit firm monitor auditor independence considerations associated with audit engagements involving digital assets (e.g., monitoring whether its staff invests in digital assets, holds an account on an exchange or with a third-party custodian, or engages in crypto asset mining activity)?

Sample letter to companies regarding crypto from the SEC

Meanwhile, the SEC’s Division of Corporate Finance “believes that companies should evaluate their disclosures with a view towards providing investors with specific, tailored disclosure about market events and conditions, the company’s situation in relation to those events and conditions, and the potential impact on investors. Companies with ongoing reporting obligations should consider whether their existing disclosures should be updated.” The Staff published a Sample Letter in December 2022 to assist companies in meeting their obligations. The sample comments focus on the need for clear disclosure about the material impacts of crypto asset market developments, which may include a company’s exposure to counterparties and other market participants; risks related to a company’s liquidity and ability to obtain financing; and risks related to legal proceedings, investigations, or regulatory impacts in the crypto asset markets.

Looking to enhance your audit committee report in the proxy? Check out our illustrative report.

Over the past nine years, the CAQ and Ideagen’s Audit Analytics have tracked disclosure of several key areas of audit committee oversight within the proxy statements of companies in the S&P Composite 1500 (S&P 1500). The 2022 Audit Committee Transparency Barometer continues to reflect positive long-term disclosure trends.

New in the 2022 Barometer

• We pulled together the various example disclosures where audit committees provided robust disclosure into a new sample report (see Appendix III).
• In another new appendix, Questions to Consider When Preparing Audit Committee Disclosures, we include questions for audit committees to consider when thinking about how to enhance existing disclosures (see Appendix IV).
• We highlight 4 steps to enhancing disclosures as excerpted from a new report, Audit Committee: The Kitchen Sink of the Board, How Audit Committees Can Manage Their Evolving Responsibilities and Polish Their Proxy Disclosures. These steps are:
  • Step 1: Define your goals
  • Step 2: Actively seek out disclosure examples
  • Step 3: Advocate for your disclosures
  • Step 4: Regularly revisit disclosures

“Many audit committees do not want to be at the front of the pack with their disclosures but failing to stay in line with peers could be a red flag to investors, forcing them to make assumptions to fill in the blanks of information not disclosed.”

– Excerpt from Audit Committee: The Kitchen Sink of the Board report

ICYMI: CAQ Public Policy and Technical Alerts (PPTA), December 2022 and January 2023

Each month, the PPTA highlights and examines the regulatory, standard-setting, legislative, and broader financial reporting developments impacting the public company audit profession. The CAQ’s December 2022 and January 2023 Alerts included these featured articles.

SEC Updates Regulatory Flexibility Agenda
The SEC updated its Regulatory Flexibility Agenda. The SEC’s final Climate and Cybersecurity Risk Governance rules are targeted for April 2023

Paul Munter Named SEC Chief Accountant
The SEC announced that Paul Munter has been appointed Chief Accountant. He has served as Acting Chief Accountant since January 2021.

SEC issues sample letter to companies regarding recent developments in crypto asset markets
The SEC issued an illustrative letter with sample comments that the Division of Corporation Finance may issue to companies depending on their particular facts and circumstances with regard to crypto asset market developments. In meeting their disclosure obligations, companies should consider the need to address crypto asset market developments in their filings generally, including in their business descriptions, risk factors, and management’s discussion and analysis.

FASB defers sunset date of reference rate reform guidance
The FASB issued an Accounting Standards Update (ASU) that extends the period of time preparers can utilize the reference rate reform relief guidance. The Board included a sunset provision within Accounting Standards Update No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, based on expectations of when the London Interbank Offered Rate (LIBOR) would cease being published. To ensure the relief in Topic 848 covers the period of time during which a significant number of modifications may take place, the ASU defers the sunset date of Topic 848 from December 31, 2022, to December 31, 2024, after which entities will no longer be permitted to apply the relief in Topic 848.

Not just a Hallmark holiday. Valentine’s Day Trivia

Valentine’s Day started with the Romans
There is a theory that while the Roman Emperor Claudius II was trying to bolster his army, he forbade young men to marry. In the spirit of love, St. Valentine defied the ban and performed secret marriages, and for his disobedience, Valentine was executed on February 14 around the year 270 A.D. Yikes!

Official holiday until 1969
In 496 A.D., Pope Gelasius I made the feast of St. Valentine an official holiday, apparently hoping to expel the pagan rituals of Lupercalia by combining it with St. Valentine’s Day. After the Second Vatican Council in 1969, Pope Paul VI decided to remove St. Valentine’s Day from the calendar of major holidays, mostly because very little about the actual St. Valentine could be verified. So…it is actually a Hallmark holiday.

Americans spend a lot on love
According to a survey by the National Retail Federation, Americans spent $23.9 billion on Valentine’s Day in 2022, the second-highest year on record. The record for spending was set in 2020, with $27.4 billion spent on the holiday.

Men and women prefer candy to flowers
Both men and women prefer to receive chocolate over flowers, according to the National Confectioners Association. The survey also found that chocolate sales represent 75% or more of Valentine’s Day candy purchases.

Valentine’s Day is a popular holiday to get engaged
A 2017 study by diamond retailer James Allen found that 43% of millennials chose Valentine’s Day as their ideal day to propose or to accept a proposal.

Spotify revealed the most-added song to love-themed playlists
According to the music streaming platform, “All of Me” by John Legend is the most-added song in love-themed playlists. It’s also the top song choice on Spotify playlists called “Valentine’s Day,” for both men and women. Streams of the track, which was released in 2013, have spiked by at least 50% on Valentine’s Day every year since.

Happy Valentine’s (or Galentine’s) Day!

Questions and comments about Audit Committee Insights can be addressed to Vanessa Teitelbaum, Senior Director, Professional Practice (vteitelbaum@thecaq.org). This newsletter is intended as general information and should not be relied upon as being definitive or all-inclusive. The CAQ encourages readers to refer to applicable rules, standards, guidance, and other resources in their entirety. All entities should carefully evaluate which requirements apply to their respective organizations.

Check out the CAQ’s Audit Committee Resource Collection for more information.