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Financial Reporting and Regulatory Update

Second Quarter 2019

SEC Exploring Potential Changes to Earnings Releases and Quarterly Reports

A Q&A with Mark Shannon of Crowe

The Financial Education and Research Foundation spoke with Mark Shannon, partner in the Crowe assurance professional practice, about the timing of earnings releases and quarterly reports.

The SEC recently issued a request for comment on potential changes to earnings releases and quarterly reports. Under current rules, registrants must file quarterly reports on Form 10-Q, which SEC rules require auditors to review prior to filing. One of the questions posed in the request is whether the current interim reporting regime should move to a semiannual model. How would changing the cadence of financial reporting affect the relationship between the auditor and the preparer?

MARK SHANNON: As an auditor, I hope it wouldn’t. Whether or not the cadence changes under today’s regime, auditors still would function as independent professional service providers to their clients. Rather than affecting the actual relationship between the auditor and the client, the biggest impact might be later identification and resolution of issues. That was an argument that the SEC noted in 1999 when it instituted the requirement of quarterly reviews by auditors.

I think that argument probably still holds true. Auditors might identify errors with material or unusual transactions when they perform a review, but the longer the period of time between auditor reviews, the longer any issues will go unchecked.

Do you think that any changes should be made to the current role of auditors in the quarterly reporting process?

Shannon: Under today’s rules, auditors provide limited assurance as to the reliability of the data that feeds into the Form 10-Q and from there feeds into investor decision-making. Investors are the best group to weigh in on this particular question, because the costs and benefits of any changes would flow down most directly to financial statement users. For example, under the current reporting structure, auditors are required to perform a review of the registrant’s financial statements that are in the Form 10-Q. While an auditor’s review under professional standards is less in scope than an audit, the review enhances the reliability of financial reporting because it’s an independent check. The review includes looking at what conclusions management reached and determining whether or not any modifications need to be made.

Auditor involvement in the quarterly financial reporting process also adds rigor to how preparers go about producing their financial statements. They have to work with the knowledge that there will be an independent check that comes in behind them. They need to operate their internal controls every quarter to prepare disclosures that will stand up to that independent check. The relationship between preparers and auditors enhances the reliability of the financial statement data. I think we can all agree more reliable data leads to better decision-making. But you can probably see the trade-off: Less auditor involvement leads to less reliable data, less useful information, and potentially less efficient capital markets.

One other data point is particularly telling in the context of useful information and reliable data. Back in late 2018, the SEC’s Division of Enforcement announced it had identified five companies whose interim financial statements in their Form 10-Qs had not been reviewed by their auditors prior to filing. Each of those five companies filed between one and three Form 10-Qs that did not get an auditor review. When the auditor came in and did the review of four out of the five companies, the auditor found a material error in the financial statements, and those four companies restated at least one Form 10-Q. As for the fifth company, we will never know whether or not its original deficient filing had any material errors because it never filed any amended filings, and it subsequently terminated its registration. This tells me that auditor involvement is important to the reliability of the data people are using to make their investment decisions.

What impacts would streamlining the information in the Form 10-Q have on the reporting process?

SHANNON: To me streamlining is more about the footnotes to the Form 10-Q than it is about the basic financial statements themselves. The basic financial statements already are condensed as compared to annual financial statements. Current SEC rules, at least with respect to the face of the financial statements, allow companies to collapse a lot of the captions from their annual financial statements for interim reporting, to the extent they meet certain quantitative thresholds.

SEC rules with respect to interim reporting indicate a footnote can be omitted from interim financial statements to the extent the footnote substantially duplicates the disclosure in the annual financial statements. So, if an interim financial statement footnote doesn’t have any new or material information, that footnote disclosure can be omitted from the interim financial statement under SEC rules because SEC rules presume that an investor has access to annual financial statements.

Some tension can exist between SEC rules and Financial Accounting Standards Board (FASB) rules for interim disclosures, which can add to the volume of information in Form 10-Q. One of the things that Crowe pointed out in a comment letter to the SEC on this request for comment was our understanding that a lot of the disclosures that people have anxiety about in terms of irrelevant or immaterial information in interim financial statements appear to be driven by FASB standards rather than SEC rules.

In our comment letter, Crowe asked the SEC to work with the FASB to determine how they can incorporate the spirit of the SEC rules around interim disclosures in future standards, and the FASB actually has an ongoing disclosure framework project on interim reporting. So I think the two could mesh nicely, but a bit of work is required to reduce what some view as unnecessary or immaterial disclosures.

Examples of areas where some have anxiety about unnecessary or immaterial interim disclosures include fair value, derivative, and pension disclosures. I think people look at specific interim disclosure requirements in those FASB standards and say, “Things really haven’t changed since my annual financial statements. Do I really have to put this in my quarterly disclosure document?”

How would streamlining the information in the Form 10-Q impact financial statement users?

SHANNON: From the user perspective, we hear often about disclosure overload with questions like, “How can I make informed decisions when there’s all this noise in disclosure documents?”

To the extent possible, preparers should focus the 10-Q disclosures on those items that are material, provide new information, or discuss new transactions. That will go a long way toward focusing users on the relevant information that should be affecting an investment decision today versus a bunch of information that probably doesn’t affect the investment decision but must be provided anyway. It’s about focus and about providing the most relevant data for the user.

What are your thoughts on the Form 10-Q filing feeding short-termism in U.S. capital markets?

SHANNON: I’ll point back to the actual request for comment, which highlighted a couple of different views about whether current quarterly reporting practices really result in what the request defines as “short-termism.” Short-termism often refers to an undue focus on quarterly earnings guidance rather than long-term goals.

In my view, short-termism is a corporate governance issue. Whether reports are done on a quarterly basis or a semiannual basis or an annual basis, there’s always going to be a paradigm where, if a company is going to produce earnings guidance, it’s going to look to the period over which it is attempting to meet that earnings guidance, and management might make certain decisions that affect whether the company meets or exceeds those goals.

The corporate governance aspect comes into play when thinking about long-term goals. Companies should ask how they are structuring management decisions to meet those long-term goals and whether they can make those management decisions without undue focus on meeting shorter-term goals such as earnings guidance. That to me is the essence of the governance aspect of avoiding short-termism. It falls to the audit committee to exercise its governance mandate to say, “I don’t want you making decisions on a short-term basis that affect exceeding or falling short of earnings guidance; I want you to make decisions that meet these long-term goals,” whatever the long-term goals happen to be. It should not matter whether a company does daily reporting, monthly reporting, quarterly reporting, semiannual reporting, or annual reporting – governance should be in place to avoid short-termism.

Another question is whether earnings guidance should be prohibited altogether. It is difficult to know whether all users and all stakeholders really have the same views with respect to quarterly earnings guidance and whether or not the guidance is useful or detrimental to their investment decisions. Some users might value earnings guidance in their investment strategies for various reasons. Other investors might have a different view, which I think is probably part of the dichotomy you see described in the SEC’s request for comment. I don’t know that earnings guidance in and of itself feeds short-termism, and I think earnings guidance can be useful, to the extent corporate governance demonstrates that a company is invested in making long-term strategic decisions rather than short-term decisions that might impede its ability to meet long-term goals.

What are the ramifications (positive and negative) of moving away from quarterly reporting?

SHANNON: You hear a lot in the marketplace about investors wanting more data more quickly. A lot of the comment letters to the SEC on this topic, particularly from the user community, show that commenters feel anxiety with moving away from the quarterly reporting process because they make their decisions based on quarterly data; the less data they have, the harder it is for them to make their decisions. I can certainly understand that perspective, and I think that is a pretty large negative. We live in a data-driven society, and taking data away makes it more difficult for users to make investment decisions. It potentially makes the capital markets less efficient.

On the other hand, from a positive perspective, moving away from quarterly reporting reduces administrative burden. Companies would not have to prepare disclosure documents as frequently, and auditors would not perform reviews as often. Companies would save the time and effort of preparing disclosure documents, operating internal controls, and readying the documents to file with the SEC. 

However, I think it is relevant to weigh the reduced administrative burden versus our data-driven society and how much we rely on data today. Stakeholders in the financial reporting process, including users, preparers, and auditors, have to decide whether the positives outweigh the negatives. It’s a difficult decision, although I will say that, solely in the context of efficient capital markets, the negatives might actually outweigh the positives.

What is the relationship between the 10-Q SEC filing and the earnings release? Do you think there is any information that investors are getting from the 10-Q that they’re not getting from the earnings release?

SHANNON: It might be helpful to point out why people file Form 10-Qs versus earnings releases. Every company that is subject to the reporting requirements of the Securities Exchange Act of 1934, other than foreign private issuers, has to file a quarterly report on Form 10-Q, and that particular quarterly report includes all the basic financial statements and footnotes. It also includes other disclosure items – for example, management’s discussion and analysis (MD&A) – and it includes management certifications on the information included in the 10-Q. Management certifications basically say, “We reviewed this and it has all the material information that needs to be disclosed.” On the other hand, the federal securities laws do not require companies to publish an earnings release or conduct an earnings call. If a company chooses to have an earnings release, conduct an earnings call, or provide earnings guidance as previously noted in the short-termism discussion, no rules say what the company should disclose or how the disclosure should be formatted. Certain rules apply to certain measures, like non-GAAP measures. And there is a general prohibition against materially misleading information, but other than that, not a lot of rules cover what is disclosed in an earnings release.

So, on the one hand, 10-Qs are required filings and have required formats that must be followed to enhance comparability between companies. On the other hand, earnings releases are not required and do not have any guidance with respect to what is included or how the information is formatted.

The timing of Form 10-Q in relation to an earnings release can vary as well. Some companies provide their earnings release in advance of their Form 10-Q. Other companies issue their earnings release at the same time as their Form 10-Q filing. The relationship varies from company to company.

The incremental information investors get in a Form 10-Q versus an earnings release differs as well. Whether a lot of overlap exists between a Form 10-Q filing and an earnings release depends on the information that the issuer might choose to put in the earnings release.

Some companies will include summarized financial information in their earnings release. Others might include a full set of basic financial statements that look exactly like the financial statements that they’ll subsequently file in their Form 10-Q. Companies also use various methods of explaining the data included in an earnings release. Some companies issue a press release to highlight a few key areas, while others might not do much at all in the way of providing context around the earnings release.

Going back to incremental information in the Form 10-Q, I don’t know that I’ve ever seen anyone put all the information required in a Form 10-Q in the earnings release. For example, I mentioned MD&A earlier. MD&A is based on various SEC rules and interpretations, and it’s often comparable across companies. Earnings releases or press releases companies provide are not as comparable across companies because companies are permitted wide latitude in the information provided.

Other information in the 10-Q is usually incremental to the earnings release, including detailed footnote disclosures. More information might be included in those footnote disclosures than some believe is material as mentioned earlier, but the main point is the Form 10-Q is rules-based and provides comparability.

Another thing important to highlight given our discussion about data reliability is that a company is not required to involve its auditor prior to filing its earnings release, and no requirement exists for an auditor to do any procedures on an earnings release prior to its filing. That’s not to say that some companies don’t ask auditors to do certain things like read the earnings release and provide comments. But auditors are not required to perform any procedures on earnings releases under professional standards.

When a company files its 10-Q, however, SEC rules require auditors to perform, under professional standards, review procedures on the financial statements and related footnotes in the 10-Q. So the 10-Q has a data reliability element that is not in the earnings release, which, as I mentioned earlier, forms the foundation of our capital markets.

What are your thoughts on the “Supplemental Approach”?

SHANNON: The Supplemental Approach is a potential change in interim reporting the SEC put forth in its request for comment. Companies would use their earnings release filed on Form 8-K as the basis for their quarterly required disclosures. To the extent additional material information exists but is not included in the Form 8-K, companies would later file that information in a Form 10-Q. Or, alternatively, companies could incorporate by reference the disclosure from the 8-K earnings release into the Form 10-Q.

The Supplemental Approach has a number of broad-based challenges that would affect preparers, users, and auditors. For example, if a company filed an earnings release under the Supplemental Approach without any changes to the way the current reporting regime works, users will be confused as to whether or not the data had actually been subject to auditor review at that time, which is that reliability of data factor. Preparers themselves or the audit committees as part of their corporate governance mandate might raise questions such as whether the auditor has weighed in on the earnings release when the company files it.

For auditors, current professional standards for reviews really are not compatible with the Supplemental Approach. If the Supplemental Approach were to be adopted, I think a lot of additional steps would have to happen outside of SEC action. The professional standards for how auditors execute their work would have to change. Users would require a lot of education about whether the information they have at any given point in time is reliable because it has been previously subjected to auditor review.

To the extent users or preparers want auditors to provide data-reliability-type services on earnings releases as part of the Supplemental Approach or otherwise, I think it really behooves both users and preparers to weigh in on that particular point, either through this request for comment or if there is a proposed rule in the future.

The Supplemental Approach has some positives – for example, reduction of administrative burden – but at the same time a lot of challenges are inherent in that approach that I think would have to be resolved before heading down that path.


Mark Shannon
Partner in the Crowe Assurance Professional Practice (APP)
Mark Shannon is a partner in the Crowe assurance professional practice. His responsibilities include supporting the audit practice on technical accounting issues related to Securities and Exchange Commission (SEC) rules. Shannon devotes significant effort to the firm’s SEC audit practice – consulting on SEC rules and filing requirements, securities offerings, comfort letters, and comment letters. He serves as a designated liaison to the SEC on practice matters related to accounting, financial reporting, and regulatory issues. Beginning his career at PricewaterhouseCoopers, Mark served as an audit manager focused on the financial services industry, including property casualty insurance clients and broker-dealers. He spent seven years at the SEC in roles including associate chief accountant in the Division of Corporation Finance’s Office of the Chief Accountant. He was an expert resource on Regulations S-X and S-K, primarily in the financial services, oil and gas, and retail industries. He also served as an accounting branch chief overseeing the staff review of filings in the oil and gas, mining, and food industries and as a staff accountant reviewing the filings of technology companies. Prior to joining Crowe, Shannon was the corporate controller of a privately held engineering, design, and construction company. His experience has led him to develop deep technical knowledge in complex accounting and unusual reporting issues across a broad range of topics.