5 Critical Areas of Concern in Financial Reporting Today
- November 10, 2022
- Posted by: Hood & Strong
- Category: Tax
In recent years, companies have been experiencing the effects of inflation, increases in interest rates and continued supply chain issues because of the COVID-19 pandemic and the Russian invasion of Ukraine. In light of ongoing economic uncertainty, Securities and Exchange Commission (SEC) Acting Chief Accountant Paul Munter recently identified the following five areas to monitor when preparing your company’s 2022 financial statements:
- Accounting estimates
Certain judgments and estimates are particularly susceptible to the potential for change in the near term. Examples include:
- Fair value measurements,
- Useful lives of assets,
- Going concern assessments,
- Subsequent events, and
- Discontinued operations.
These issues may affect amounts reported on your company’s balance sheet and/or income statement. In addition, some situations may warrant some additional disclosure beyond what has historically been provided when entities were operating in a more steady-state economic environment.
- Credit losses
Accounting Standards Update 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, applies to any business that extends credit, but it largely affects banks. Currently, only larger entities are applying the current expected credit loss (CECL) accounting model. But about 4,000 smaller ones, including community banks and credit unions, will have to start applying the CECL model in 2023.
This model requires lenders to look to the future, make reasonable and supportable estimates that take macroeconomic factors into account, and set aside loss reserves based on these estimates. In contrast, under the previous incurred loss model, losses were written off after borrowers defaulted on their payments. Certain assumptions underlying the CECL model — including cash flow projections and discount rates — may be susceptible to revisions in an uncertain environment.
- Changing prices
Munter also flagged another FASB topic that most accountants haven’t looked at recently: Accounting Standards Codification Topic 255, Changing Prices. It provides guidance on reporting the effects of inflation in a company’s financial statements, including the effects on profits.
The United States has been experiencing a historically high rate of inflation over the past year. Munter warned that Topic 255 is still in effect, and it’s “something to think about in terms of reporting the effects of inflation.”
- New audit procedures
In the coming audit season, the nature of audit inquiries, testing procedures and document requests may differ from what’s been done in the past. For instance, auditors of public companies may identify new or additional critical audit matters (CAMs). CAMs are defined as matters that:
- Have been communicated to the audit committee,
- Are related to accounts or disclosures that are material to the financial statements, and
- Require an auditor to make a subjective decision or use complex judgment.
Examples of common CAMs include goodwill and other intangible assets, revenue recognition, taxes, and business combinations. CAMs are specific to the engagement and the year of the audit. As a result, they’re expected to change from year to year.
Compared to prior fiscal years, auditors in 2022 also may need to perform “a much more robust risk assessment as they think through the key risk elements with respect to issuers and a heightened sense of due care and professional skepticism,” said Munter. When assessing risk, auditors must consider the effects of external forces on the organization. These forces are constantly changing, causing auditors to modify their procedures for every audit.
For example, auditors may ask what your company is doing to fortify its balance sheet against a possible downturn, as well as discussing possible strategies to reduce risk in today’s uncertain environment. They also might be increasingly cautious when setting materiality levels and skeptical when reviewing accounting estimates and going concern assessments.
- Special disclosures
The SEC periodically issues guidance on special-purpose disclosures to keep investors and lenders informed about the effects of a particular event or unprecedented market conditions. For example, in 2020, the SEC’s Division of Corporation Finance (CorpFin) issued guidance to help companies better disclose the effects of the COVID-19 pandemic.
As companies begin preparing their 2022 financials, Stephanie Sullivan, a CorpFin associate chief accountant, advised them to be transparent about any lingering impacts of the pandemic, related changes that have become permanent and other factors that aren’t directly related to the pandemic. For example, companies may need to disclose:
- Increased costs associated with employees returning to office,
- Wage increases,
- Continued supply shortages,
- Liquidity responses to increases in interest rates and oil prices, and
- New supply chain financial arrangements that could impact cash flows.
“We certainly recognize that a lot of disclosures that were made in 2020 and 2021 no longer continue to be relevant, and they should be removed from the filing. We expect disclosures to be evolving: Things removed and things added,” said Sullivan.
For more information
As audit season approaches, it’s important to focus on these five reporting issues. But there may be others that aren’t on the SEC’s radar that are relevant to your current situation. Contact your CPA to help you provide transparency to stakeholders during these uncertain times.
Sidebar: Auditing with an eye on fraud
In a public statement issued on October 11, Securities and Exchange Commission (SEC) Acting Chief Accountant Paul Munter urged auditors to give special attention to their fraud risk assessments this year. He’s worried that the current volatile economic and geopolitical environment may result in new pressures, opportunities or rationalizations for fraud.
Auditors must apply due professional care and skepticism when designing audit procedures — such as inquiries and tests — to identify potential fraud risks. Specifically, Munter said auditors should be skeptical of what management provides when the timing or manner in which audit evidence is produced is questionable. Examples of red flags include:
- Invoices for large amounts with vague descriptions,
- Invoices with related parties that have descriptions outside the normal course of business, and
- “New” evidence provided by management in the late stages of the audit process that may involve a difficult or contentious audit matter.
“Auditors should avoid any assumptions of honesty, be mindful of potential unconscious biases, and apply the appropriate level of professional skepticism,” said Munter.