Summary
- The first part of the Survey examines the Holding Foreign Companies Accountable Act.
- The second part of the Survey provides accounting standards updates.
The year 2022 saw significant developments in the years-long effort to secure access for the Public Company Accounting Oversight Board (the “PCAOB” or the “Board”) to carry out its regulatory responsibilities with respect to registered public accounting firms based in China and Hong Kong that audit the financial statements of Chinese companies whose securities are traded or offered in the U.S. public markets. The catalyst was actions taken by the PCAOB and the SEC pursuant to the Holding Foreign Companies Accountable Act (the “HFCA Act”). This law, which was enacted in late 2020, threatened to impose U.S. trading prohibitions on the securities of Chinese issuers whose auditors could not be fully inspected or investigated by the PCAOB for three consecutive years as a result of restrictions imposed by Chinese authorities. During 2022, however, the PCAOB entered into an agreement with Chinese regulators to secure access to the Chinese accounting firms, and, in December 2002, the PCAOB announced that its inspectors had obtained the full access contemplated by the agreement. As a result, the looming trading prohibition threat has been lifted, at least for now.
The Sarbanes-Oxley Act of 2002 created the PCAOB to regulate audits of financial statements of companies whose securities are traded in the United States or who are publicly offering securities in the United States. The PCAOB’s regulatory authority has four major components: (a) mandatory registration of public accounting firms that audit, or substantially participate in auditing, U.S. public companies; (b) establishment of auditing and other professional standards applicable to U.S. public company audits; (c) periodic inspections of registered public accounting firms to assess the firms’ and their associated persons’ compliance with the Sarbanes-Oxley Act, PCAOB and SEC rules, and professional standards; and (d) investigations and disciplinary proceedings arising from potential violations of applicable laws, rules, and professional standards. Importantly, the Sarbanes-Oxley Act provides that a foreign public accounting firm that audits an issuer of securities traded or publicly offered in the United States is subject to the Act in the same manner and to the same extent as a U.S.-based accounting firm.
Application of PCAOB regulation to non-U.S. accounting firms raised issues of extraterritorial enforcement of U.S. laws almost from the outset. With the cooperation of foreign regulators, the PCAOB has succeeded over the years in conducting inspections of firms in many non-U.S. jurisdictions. However, some countries, most notably the People’s Republic of China (“PRC”), refused to permit the PCAOB access to their countries to conduct inspections or investigations of accounting firms headquartered in those countries or of their associated persons. This was problematic due to the large number of Chinese companies whose securities were traded in the United States, but whose financial statements were audited by accounting firms that were headquartered in mainland China or Hong Kong.
The HFCA Act was enacted in 2020 to address, among other things, the failure of the PRC to permit PCAOB access to carry out its regulatory responsibilities with respect to China-based accounting firms. Among other provisions, the HFCA Act requires the SEC to identify issuers whose financial statements were audited by a firm that had a branch or office located in a foreign jurisdiction and that “the Board is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction …, as determined by the Board.” The HFCA Act also required the SEC to prohibit trading in the securities of any issuer that the SEC has identified as not being subject to inspection or investigation for three consecutive “non-inspection years.”
Pursuant to the HFCA Act and PCAOB Rule 6100, which the PCAOB adopted to implement its obligations under the HFCA Act, on December 16, 2021, the PCAOB issued a report (“2021 Determination Report”) setting forth its determinations that it was unable to inspect or investigate completely PCAOB-registered public accounting firms headquartered in mainland China or Hong Kong because of a position taken by one or more authorities in those jurisdictions. The 2021 Determination Report identified the registered firms that were subject to the PCAOB determinations. The Report started the clock ticking on the three-year non-inspection period that would trigger the trading prohibition.
Based on the PCAOB’s 2021 Determination Report, beginning in March 2022, the SEC identified Chinese issuers whose annual reports for 2021 indicated that their financial statements had been audited by a registered public accounting firm that had been identified by the PCAOB in its 2021 Determination Report. Ultimately, the SEC conclusively identified over 170 such issuers. Under the HFCA Act, each company’s fiscal year that ended prior to the date of identification was deemed a “non-inspection year,” and 2021 was the first of the three consecutive years that would trigger the trading prohibition. The identification of specific companies that were subject to the trading ban, and the market impact on these companies, increased the pressure to reach a resolution of the United States–China regulatory dispute.
On August 26, 2022, the PCAOB announced that it had signed a Statement of Protocol (“Protocol”) with the China Securities Regulatory Authority and the Ministry of Finance of the People’s Republic of China (“PRC Authorities”) to permit the PCAOB to inspect and investigate registered public accounting firms based in China or Hong Kong that audit U.S. issuers. According to the PCAOB, the Protocol, the text of which was not made public, included “comprehensive, explicit, and detailed” provisions to enable the PCAOB to carry out its regulatory functions with respect to China-based firms:
The Protocol represented a substantial achievement in addressing the PCAOB’s longstanding inability to inspect or investigate China-based firms. The PCAOB emphasized, however, that the Protocol was a “first step” and that “the real test will be whether the words agreed to on paper translate into complete access in practice.” The PCAOB indicated that the PCAOB inspection team would be on the ground in China by mid-September 2022.
On December 15, 2022, the PCAOB announced that it had “secured complete access to inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong.” Accordingly, the PCAOB voted to vacate its determinations in the 2021 Determination Report.
The Board issued a formal report (“2022 Determination Report”) describing in detail the terms of the Protocol, the PCAOB’s inspection and investigation activities with respect to mainland China and Hong Kong–headquartered audit firms, and the PRC Authorities’ actions to facilitate PCAOB access in accordance with the Protocol. The 2022 Determination Report noted that by executing the Protocol, the PRC Authorities reversed positions they had previously taken that impaired the PCAOB’s ability to conduct inspections and investigations, subject to the PRC Authorities in fact providing the PCAOB with complete access to inspect and investigate. Based on its inspection and investigation activities, the Board found that “the [Protocol’s] prescriptive framework has worked as intended.” The PCAOB “was able to complete field work on two audit firm inspections, obtain all requested documents and other information in both inspections and multiple investigations, and take testimony of all witnesses sought by the PCAOB in two investigations.” Accordingly, the Board “concluded that, consistent with the [HFCA Act], the Board is able to inspect and investigate completely firms headquartered in mainland China and Hong Kong” and vacated the 2021 determinations pursuant to PCAOB Rule 6100(h). The Board emphasized that it would reconsider its determination if, in the future, it encountered impediments to inspections or investigations in China or Hong Kong as a result of positions taken by an authority in either jurisdiction.
The Protocol and its apparently successful implementation represent a substantial achievement for the PCAOB. It also demonstrated the efficacy of Congress’ strong-arm approach in the HFCA Act. Hopefully, removing the trading prohibition threat (assuming continuing Chinese cooperation) will encourage Chinese companies to continue to avail themselves of the U.S. capital markets, while providing to U.S. investors previously unavailable protections under the Sarbanes-Oxley Act regarding the audits of these companies’ financial statements.
On December 29, 2022, President Joseph R. Biden, Jr., signed the Consolidated Appropriations Act, 2023. Although primarily an “omnibus” appropriations bill, this act also includes a provision amending the HFCA Act. The amendment changes section 104(i)(3)(A) of the Sarbanes-Oxley Act to reduce from three to two the number of consecutive non-inspection years that will trigger a trading prohibition of a covered issuer. This amendment has no immediate effect, in light of the PCAOB’s determinations that, in 2022, it was able to conduct inspections and investigations completely of registered public accounting firms headquartered in mainland China and Hong Kong, and that the PRC Authorities had not taken a position to restrict PCAOB access or otherwise impair its ability to conduct its planned inspections and investigations. However, the shortened timeframe for triggering a trading prohibition should maintain pressure on the PRC Authorities to continue to permit full PCAOB inspections and investigations in 2023 and subsequent years.
In 2022, the Financial Accounting Standards Board (the “FASB” or the “Board”) issued six Accounting Standards Updates (“ASUs”) to its Accounting Standards Codification (“ASC” or the “Codification”), compared to ten ASUs in 2021. The ASUs make improvements to fair value hedging methodologies, eliminate certain accounting guidance for troubled debt restructurings and enhance related disclosures, resolve a divergence in practice regarding fair value measurements of equity securities that are subject to contractual sale restrictions, mandate new disclosures related to supplier finance programs, allow certain exceptions for insurance providers when applying retrospective disclosure requirements for long-duration contracts, and further defer the sunset date for reference rate reform. The following discussion summarizes the ASUs issued by the FASB in 2022.
On March 28, 2022, the FASB issued ASU 2022-01 to allow multiple hedged layers to be designated for a single closed portfolio of financial assets or one or more beneficial interests secured by a portfolio of financial instruments. This amendment enables entities to achieve hedge accounting for a greater proportion of the interest rate risk that is inherent in the assets included in the closed portfolio.
FASB last made targeted improvements to the optional hedge accounting model under Topic 815 in August 2017. ASU 2017-12 included the addition of the last-of-layer method to make portfolio fair value hedge accounting more accessible to interest rate risk hedges of portfolios of prepayable financial assets. Prior to ASU 2022-01, GAAP permitted only prepayable financial assets and one or more beneficial interests secured by a portfolio of prepayable financial instruments to be included in a last-of-layer closed portfolio. With ASU 2022-01, entities are now able to include non-prepayable financial assets in a closed portfolio hedged using the portfolio layer method. As a result, entities can apply the same portfolio hedging method to both prepayable and non-prepayable financial assets, meaning that the accounting will be consistent for similar hedges.
These amendments apply to all entities that elect to apply the portfolio layer method of hedge accounting under ASC Topic 815. The amendments apply to public business entities for fiscal years beginning after December 15, 2022, and for interim periods within those fiscal years. For all other entities, the amendments apply for fiscal years beginning after December 15, 2023, and for interim periods within those fiscal years. Early adoption is permitted. Upon adoption, entities have the option to apply the amendments related to disclosures on a prospective basis from the initial application date or on a retrospective basis to each prior period presented after the date of adoption of ASU 2017-12.
On March 31, 2022, the FASB issued ASU 2022-02 to respond to feedback gathered during its post-implementation review of its updated credit losses standard, specifically to (a) eliminate the accounting guidance for troubled debt restructuring (“TDRs”) by creditors and enhance disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty and (b) require that public business entities disclose current-period gross write-offs by year of origination for financing receivables and net investments in leases.
Prior to the amendments, GAAP included an exception that permitted creditors to record modifications that constitute TDRs in allowance for credit losses upon the modification. This separate guidance has been eliminated. The amendments now require that entities evaluate whether the modification represents a new loan or a continuation of an existing loan, consistent with the accounting for other loan modifications that do not involve TDRs. For public business entities, the amendments also require disclosure of current-period gross write-offs by year of origination for financing receivables and net investment in leases. This disclosure shall be provided in accordance with amended ASC 326-20-50-6, which provides for disclosure of the amortized cost basis of financing receivables by credit quality indicator and class of financing receivable by year of origination.
The amendments go effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, for entities that have adopted the amendments in ASU 2016-13. Early adoption is permitted. For entities that have not yet adopted the amendments in ASU 2016-13, the amendments go effective at the same time as the entity adopts the amendments in ASU 2016-13.
On June 30, 2022, the FASB issued ASU 2022-03 to update Topic 820, Fair Value Measurement. The update addresses a divergence in practice that resulted from conflicting guidance in ASC Topic 820 with regard to whether a contractual restriction that prohibits the sale of an equity security should be taken into account when measuring the fair value of that equity security. The update primarily reconciles this conflict, while also introducing new disclosure requirements for equity securities that are subject to contractual sale restrictions that are measured at fair value in accordance with ASC Topic 820. The amendments included in the update affect every entity with investments in equity securities measured at fair value that carry restrictions on sale.
The update clarifies that a contractual restriction on the sale of an equity security is not to be considered as part of the unit of account when measuring the fair value of an equity security. The updated standard states, “A contractual sale restriction is a characteristic of the reporting entity holding the security rather than a characteristic of the asset and, therefore, is not considered in measuring the fair value of an equity security … .” Furthermore, entities may not recognize and/or measure contractual sale restrictions as a separate unit of account. Where securities are subject to contractual sale restrictions, entities are now required to provide the following disclosures: (a) fair value of such securities reflected in the balance sheet, (b) the nature and remaining duration of restriction(s), and (c) any circumstances that could cause a lapse in such restrictions.
As an illustration, a contractual restriction could be reflected in a lock-up agreement or a market standoff agreement and would not be taken into account in measuring the fair value of an equity security. By contrast, entities would include in the unit of account of an equity security restrictions on resale, such as an inability to resell on a national securities exchange or over-the-counter market equity securities that were originally sold in a private placement, and thus subject to securities law restrictions on resale.
For public business entities, the amendments go effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2024, including interim periods within those fiscal years. For any entity that is not an investment company under ASC Topic 946, the amendments contained in this update should be applied prospectively and adjustments should be made from the date of the adoption of the amendments. For investment companies under ASC Topic 946, the amendments should be applied to investments that are executed on or after the date of adoption.
On September 29, 2022, the FASB issued ASU 2022-04 to address concerns regarding a lack of transparency and inconsistent presentation of “supplier finance programs,” which are also referred to as reverse factoring, payables finance, or structured payables arrangements. These are programs that allow a buyer to offer its suppliers the option to receive payment on invoices ahead of an invoice due date, with such early payments made by a third-party finance provider or other intermediary once the buyer has confirmed the supplier’s invoice as valid.
The update adds new ASC Subtopic 405-50, Liabilities—Supplier Finance Programs, which requires disclosure of quantitative and qualitative information to allow the user of financial statements to better ascertain the nature and magnitude of any supplier finance program. The new standard employs both prescriptive and principles-based disclosure requirements. For each annual reporting period, the buyer party to a supplier finance program must disclose: (a) key terms of the program, including payment terms, timing, the basis for its determination, and the assets pledged as security or other forms of guarantees provided and (b) the amount of outstanding obligations of the buyer at the end of the reporting period that the buyer has confirmed as valid to the finance provider or intermediary and that remain unpaid by the buyer, along with a rollforward of such obligations since the previous reporting period. During interim periods, the buyer should disclose the confirmed amount of its obligations to the finance provider or intermediary that remains unpaid by the buyer. Such other information shall also be provided, as necessary, to disclose “sufficient information to enable users of financial statements to understand the nature, activity during the period, changes from period to period, and potential magnitude of the entity’s supplier finance programs.”
The amendments are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, excluding the rollforward information, which is effective for fiscal years beginning after December 15, 2023. Early adoption is permitted. During the fiscal year of adoption, information on the terms of supplier finance programs is to be included in each interim period, notwithstanding the fact that they are annual disclosure requirements. The amendments should be applied retroactively wherever a balance sheet is presented, with the exclusion of the rollforward information.
On December 15, 2022, the FASB issued ASU 2022-05 to respond to stakeholder feedback regarding ASU No. 2018-12, Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts (LDTI). Among other things, ASU 2018-12 required a retroactive transition method to its improvements to the accounting for LDTIs, but did not provide an exception for contracts that had been derecognized due to a sale of one or more such contracts or entities prior to the LDTI effective date.
The update provides that an insurance entity may make an accounting policy election to exclude from the requirements of ASU 2018-12 certain contracts (a) that have been derecognized because of a sale or disposal and (b) for which the insurance entity has no significant continuing involvement. The effect is to reduce implementation costs on the basis that such implementation would not provide useful information to investors or other allocators of capital. Without updated guidance to 2018-12, an insurance entity would be required to reclassify a portion of previously recognized gains or losses due to the adoption of a new accounting standard.
The amendments under this update are effective consistent with the effective dates of the amendments in ASU 2020-11, which, for public business entities that meet the definition of an SEC filer and are not SRCs, are effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years. For all other entities, the updated standard is effective for fiscal years beginning after December 15, 2024, and interim periods within fiscal years beginning after December 15, 2025. Early adoption is permitted.
On December 21, 2022, the FASB issued ASU 2022-06 to extend the sunset provision contained within ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. ASU 2020-04 provided transition relief for adopting the updated reference rate reform standard, which transition relief included a sunset provision that was established with the expectation that the London Interbank Offered Rate (“LIBOR”) would cease being published after December 31, 2021. With the announcement that the intended cessation date of USD LIBOR is now June 30, 2023, ASU 2022-06 defers the sunset date under 2020-04 to December 31, 2024, effective immediately upon issuance of ASU 2022-06.