2019 update for instructors and students

2019 UPDATE FOR INSTRUCTORSAND STUDENTS

ACCOUNTING

FOR LAWYERSFIFTH AND CONCISE FIFTH EDITIONS

by

MATTHEW J. BARRETT

Professor of LawNotre Dame Law School

FOUNDATION PRESS

The publisher is not engaged in rendering legal or other professional advice,and this publication is not a substitute for the advice of an attorney. If yourequire legal or other expert advice, you should seek the services of acompetent attorney or other professional.

© 2019 LEG, Inc. d/b/a West Academic444 Cedar Street, Suite 700St. Paul, MN 551011-877-888-1330

PREFACE TO THE 2019 UPDATE

Thank you for using our materials. In an effort to provide the mosttimely, accurate, and helpful materials possible, I want to highlightimportant developments occurring since the fifth editions went to press andto call to your attention a few typos and other glitches that appear in eitherthe fifth or concise fifth editions. Double asterisks (**) note materials addedor substantially revised since the 2018 Update.

** This 2019 Update highlights the most significant developments affectingour materials that have occurred between December 31, 2013, the cutoff datefor the fifth editions, and June 30, 2019, along with a few “subsequentevents,” namely the Financial Accounting Standard Board’s tentativedecisions to delay certain effective dates for new rules regarding long-duration insurance contracts, hedging activities, credit losses, and leaseaccounting, as well as agreements to resolve investigations and litigationagainst Equifax Inc. and Facebook, Inc. In particular, this update describesnew generally accepted accounting principles (“GAAP”) in three importantareas: revenue recognition (effective for most public companies no later thanthe start of fiscal years beginning after December 15, 2017 and for emerginggrowth companies and non-public enterprises in annual reporting periodsbeginning December 15, 2018 and interim periods within fiscal yearscommencing after December 15, 2019); leases (with effective dates currentlyone year later than those for revenue recognition); and credit losses (witheffective dates currently two years later than those for revenue recognition).Collectively, these changes, which affect the balance sheet and the incomestatement, mark the most significant accounting changes in generations.Given the magnitude of these areas, especially revenue recognition, to mostenterprises, knowledgeable accountants and lawyers often refer to theserules collectively as the “New GAAP.” Although transactional lawyers mustincreasingly focus on these new rules and their implementation, litigatorsmay well encounter the previous rules for the next decade or so.

The updates that follow provide cross references to the fifth edition,including chapter and section headings and page numbers, and whereapplicable, the concise fifth edition.

** I gratefully acknowledge the helpful research, drafting, and editingassistance of Andrew M. Meerwarth , a Notre Dame law student in the Classof 2018, Elizabeth Lombard from the Class of 2020, John Michael Neubertfrom the Class of 2021, and the efforts of my administrative assistants,Sharon Loftus and Alicia Cummins.

If you find any glitches, inaccuracies, or other significant developmentsthat do not appear below, please let me know. You can reach me via e-mailat <[email protected]>, phone at (574) 631-8121, or fax at (574) 631-8078.You will not offend me in any way because I want our materials to be as

iii

iv PREFACE TO THE 2019 UPDATE

accurate and helpful as possible. I also welcome any other comments orsuggestions that you might be willing to share. Thanks again.

Matthew J. BarrettJuly 31, 2019

TABLE OF CONTENTS

PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iiiTABLE OF ACRONYMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi

Page references set forth the first item in this Update for that section.

2019 Fifth ConciseUpdate Edition Edition

Page No. Page No. Page No.

CHAPTER I Introduction to Financial Statements,Bookkeeping, and Accrual Accounting . . . . . . . . . . . . . . 1 1 1

D. The Income Statement2. The Closing Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 40 40

E. The Statement of Changes in Owner’s Equity3. The Corporation

a. Contributed Capital(1) Shares with Par Value . . . . . . . . . . . . . . . . . . . . . . 1 58 57

F. Accrual Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 694. Practice Problem. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 102 94

H. The Statement of Cash Flows3. Cash and Cash Equivalents . . . . . . . . . . . . . . . . . . . . . . . . 5 128 1204. Classification of the Statement of Cash Flows . . . . . . . . . 6 129 1217. Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 135 126

CHAPTER II The Development of Accounting Principlesand Auditing Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 155 139

C. Generally Accepted Accounting Principles1. The Establishment of Accounting Principles

a. The Securities and Exchange Commission . . . . . . . . . 9 167 155(3) Regulations, Releases, and Informal Guidance

on Periodic Reporting . . . . . . . . . . . . . . . . . . . . . . 11 174 159(6) International Accounting Principles . . . . . . . . . . 11 178

b. The Private Sector(3) Stock Exchanges, Listing Standards, and Quasi-

Private Ordering . . . . . . . . . . . . . . . . . . . . . . . . . . 13 196 158c. Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 199 161d. International Accounting Standards . . . . . . . . . . . . . . 14 203 163

3. Who Selects Among Generally Accepted AccountingPrinciples? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 210 171

4. Critique . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 223

v

vi TABLE OF CONTENTS



D. Sound Accounting Practices Necessary for Registrants Under the Federal Securities Laws

2. Sarbanes-Oxley, Dodd-Frank, and the JOBS Act b. Internal Control over Financial Reporting

(1) Management’s Report on Internal Control overFinancial Reporting . . . . . . . . . . . . . . . . . . . . . 17 233

c. Whistleblower Incentives and Protections . . . . . . . 18 2373. Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 259

E. Audits and Generally Accepted Auditing Standards1. The Establishment of Generally Accepted Auditing

Standardsa. Issuers

(2) Public Company Accounting Oversight Board . 27 275b) Registration and Inspection . . . . . . . . . . . . . 27 277 194d) International Issues . . . . . . . . . . . . . . . . . . . 28 281 196

4. Independence and The Audit Processa. Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 296 177b. The Audit Process

(3) Reporting the Audit Results . . . . . . . . . . . . . . . 32 314 1885. The Expectation Gap. . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 328 200

F. Alternatives to Audits1. Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 339

G. Published Sources of GAAP, GAAS, & Other FinancialInformation1. GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 346

H. Accountants’ Legal Liability . . . . . . . . . . . . . . . . . . . . . . . . . 41 355 210

CHAPTER III The Time Value of Money . . . . . . . . . . . . . . 45 383 215

A. Importance to Lawyers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 384 216B. Interest

1. Factors Determining Interest Rates. . . . . . . . . . . . . . . . 46 388 219C. Future Value

1. Single Amountsc. Practical Advice Part I: Why You Should Start

Saving for Your Retirement as Soon as Possible . . 51 401D. Present Value

2. Annuitiesc. Calculating the Amount of the Annuity Payment . . 52 423 242

TABLE OF CONTENTS vii



CHAPTER IV Introduction to Financial StatementAnalysis and Financial Ratios . . . . . . . . . . . . . . . . . . . . 53 439 255

C. The Balance Sheet2. Analytical Terms and Ratios

a. Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 453 265c. Net Book Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 457 268

D. The Measurement of Income1. Results of Operations

a. The Income Statement(1) Unusual or Nonrecurring Operating Items . . . 54 468 276(4) Discontinued Operations . . . . . . . . . . . . . . . . . . 55 472 280(5) Extraordinary Items . . . . . . . . . . . . . . . . . . . . . 57 474 281

b. Pro Forma Metrics(2) The Pitfalls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 481 286(3) Regulation G . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 484 287

2. Ratio Analysisa. Coverage Ratios

(3) Dividend Coverage, Dividend-Payout, and Dividend Yield . . . . . . . . . . . . . . . . . . . . . . . . . 63 494 296

b. Profitability Ratios (1) Earnings Per Share . . . . . . . . . . . . . . . . . . . . . . 64 495 297(2) Price-Earnings Ratio . . . . . . . . . . . . . . . . . . . . . 65 498 299

c. Activity Ratios(3) Asset Turnover . . . . . . . . . . . . . . . . . . . . . . . . . . 65 507

F. Management’s Discussion and Analysis2. Compliance with GAAP Alone Does Not Satisfy MD&A

Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 532 3233. Enforcement Issues Arising From Liquidity Problems. 67 542 325

G. The Future of Financial and Non-Financial Reporting. . . . 68 543 326

CHAPTER V Legal Issues Involving Shareholders’Equity and the Balance Sheet . . . . . . . . . . . . . . . . . . . . 73 547 329

C. Distributions and Legal Restrictions1. Dividends and Redemptions . . . . . . . . . . . . . . . . . . . . . . 73 5552. Stock Dividends and Stock Splits . . . . . . . . . . . . . . . . . . 74 5583. Restrictions on Corporate Distributions

b. Contractual Restrictions . . . . . . . . . . . . . . . . . . . . . . 75 594D. Drafting and Negotiating Agreements and Other Legal Documents Containing Accounting Terminology and Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 618 354

viii TABLE OF CONTENTS



CHAPTER VI Revenue Recognition and IssuesInvolving the Income Statement . . . . . . . . . . . . . . . . . . 83 641 359

A. Importance to Lawyers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 643 361B. Essential Requirements for Revenue Recognition. . . . . . . . 84 653 367

1. A Bona Fide Exchange Transactionb. Exceptions to the Exchange Transaction Requirement

(1) Fair Value Accounting . . . . . . . . . . . . . . . . . . . . 104 736 410a) Investments in Securities . . . . . . . . . . . . . . 113 745 416

ii. Active Investments (b) Equity Method . . . . . . . . . . . . . . . . 114 759 429

(2) Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 7682. Earnings Process Substantially Complete

a. General Rules(1) Delivery, Passage of Title, or Performance . . . . 115 775 444

b. Exceptions to the Substantial Completion Requirement(2) Long-Term Contracts . . . . . . . . . . . . . . . . . . . . . 116 787 455

3, Customer Deposits and Prepayments . . . . . . . . . . . . . . 116 808 465C. The Matching Principle for Expenses

2. Accrual of Expenses and Lossesb. The Problem of Uncollectible Accounts . . . . . . . . . . 117 830 483

D. Drafting and Negotiating Agreements and Other LegalDocuments Containing Terminology Implicating theIncome Statement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 849 496

CHAPTER VII Contingencies . . . . . . . . . . . . . . . . . . . . . . . . 119 855 501

C. Securities Disclosure Issues . . . . . . . . . . . . . . . . . . . . . . . . . 119 897 544E. Discovery Issues

2. Work Product Protection. . . . . . . . . . . . . . . . . . . . . . . . . 125 956 566

CHAPTER VIII Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 985 581

B. Determining Ending Inventory1. Which Costs and Goods to Include in Inventory

a. Includable Costs(3) Other Illustrations of “Cost Accounting” . . . . . 127 1001 596

2. How to Price Inventory Itemsa. Flow Assumptions

(2) Critique and Basis for Selection(c) Last-In, First-Out

(ii) Disadvantages . . . . . . . . . . . . . . . . . . . . 128 1027 609b. Lower of Cost or Market . . . . . . . . . . . . . . . . . . . . . . 130 1042 616

TABLE OF CONTENTS ix



CHAPTER IX Long-Lived Assets and Intangibles. . . . . . 133 1059 627

A. Importance to Lawyers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 1062 630E. Intangibles Assets and Goodwill . . . . . . . . . . . . . . . . . . . . . 133 1106 660

2. Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 1113 667F. Lease Accounting

2. Treatmentc. New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 1142 677

*

TABLE OF ACRONYMS

BBA British Bankers’ AssociationCAM Critical audit matterCAO Chief accounting officerCECL Current expected credit lossCFPB Consumer Financial Protection BureauECB European Central BankEuribor Euro interbank offered rateFDIC Federal Deposit Insurance CorporationGCF General Collateralized Financing IBC Incentive-based compensationKAM Key audit matterOCC Office of the Comptroller of the CurrencyPCD Purchased financial assets with credit deteriorationSOFR Secured Overnight Financing RateSRT SEC Reporting TaxonomyTibor Tokyo interbank offered rateUGT [U.S.] GAAP Financial Reporting TaxonomyUSITC United States International Trade Commission

*

xi

C H A P T E R I

INTRODUCTION TO FINANCIAL

STATEMENTS, BOOKKEEPING, AND

ACCRUAL ACCOUNTING

D. THE INCOME STATEMENT

2. THE CLOSING PROCESS

At the very bottom of page 40 [below the balance sheet on page 40 ofthe concise], insert the following text:

Once again, most enterprises now use computers to close their books, but thefundamental concepts remain the same. Technology has enabled businessesto close their books more accurately and more quickly. In 2017, a leadingaccounting and consulting firm surveyed the practices of about 500 largecompanies globally. The survey found that the median amount of time thosefirms spent closing their books each quarter had dropped from six days in2009 down to 4.5 days. Tatyana Shumsky, Robotic Accountants Close BooksFaster, WALL ST. J., Aug. 15, 2017, at B4.

E. THE STATEMENT OF CHANGES IN OWNER’S EQUITY

3. THE CORPORATION

a. CONTRIBUTED CAPITAL

(1) Shares with Par Value

On the bottom of page 58, replace the carryover sentence with thefollowing [and note the development when reading the carryoverparagraph that starts on the bottom of page 57 of the concise]:

For example, as a result of a 2015 corporate reorganization, Google hasbecome a wholly owned subsidiary of Alphabet Inc. (“Alphabet”). TheAmended and Restated Certificate of Incorporation of Alphabet Inc., whichyou can access at https://abc.xyz/investor/other/certificate-of-incorporation.html, assigns a $0.001 par value to all of the company’s shares.

1

2 CHAPTER I FINANCIAL STATEMENTS, BOOKKEEPING, & ACCRUAL ACCOUNTING

Near the top of page 62 [at the bottom of page 57 of the concise],replace the next six full paragraphs with the following:

To illustrate a more complicated presentation of shareholders’ equityarising from a complex corporate charter, we can again turn to Alphabet. InOctober 2015, the company filed its Amended and Restated Certificate ofIncorporation with the Delaware Secretary of State. As you may recall, youcan access the document at https://abc.xyz/investor/other/certificate-of-incorporation.html. Article IV authorizes Alphabet to issuePreferred Stock, Class A Common Stock, Class B Common Stock, and ClassC Capital Stock and assigns a $0.001 par value to each and every share.

Although Alphabet had not issued any outstanding preferred shares asof December 31, 2018, the company’s certificate of incorporation authorizes100 million preferred shares. Subject to any limitations prescribed by law,the certificate of incorporation gives the board of directors the authority toissue shares of Preferred Stock in series, to establish from time to time thenumber of shares in each series, and to fix the preferences and rights of thepreferred shares in each series without separate shareholder approval. Eventhough Alphabet’s charter authorizes these so-called “blank check” preferredshares, the company has not issued any preferred shares, and the board hasnot established any such preferences.

Alphabet can issue up to twelve billion shares of common stock, includingnine billion shares of Class A Common Stock and three billion shares of ClassB Common Stock. The holders of the Class A and Class B common sharesenjoy identical rights, except as to voting. The Class B common shares enjoysuper-voting power. The company’s certificate of incorporation grants theholders of the outstanding Class A common shares one vote per share. Bycomparison, the holders of outstanding Class B common shares can cast tenvotes per share. As of April 22, 2019, Larry Page, Sergey Brin, and Eric E.Schmidt, Google’s co-founders and Alphabet’s former executive chairman andnow technical advisor, respectively, beneficially owned almost ninety-threepercent of the company’s outstanding Class B shares, which translated toalmost fifty-seven percent of the total voting power of all outstandingcommon shares. The holders of Class B shares can convert their shares intoClass A shares at any time. In addition, the Class B shares automaticallyconvert to Class A shares upon sale or transfer.

Finally, Alphabet can issue three billion shares of Class C Capital Stock.The Class C shares enjoy no voting rights, except as applicable law requires.Apart from the differences in voting rights and unless otherwise provided inthe certificate of incorporation, the Class C shares rank equally, shareratably, enjoy the same rights and privileges, and mirror in all other respectsthe Class A and Class B shares. In April 2014, Google distributed thepredecessors of the Class C capital shares to the then-holders of its Class Aand Class B shares on a share-for-share basis.

Alphabet’s balance sheet as of December 31, 2018, which appears onpage 46 of the Form 10-K for the year then ended (“Alphabet’s 2018 Form 10-

CHAPTER I FINANCIAL STATEMENTS, BOOKKEEPING, & ACCRUAL ACCOUNTING 3

K”) that Alphabet filed with the Securities and Exchange Commission(“SEC”) on February 6, 2019, describes this more complicated capitalstructure. You can access the Form 10-K via a link on Alphabet’s website athttps://abc.xyz/investor/index.html, which collects various documentspresenting the company’s quarterly and annual earnings and links to newsstories about the company. Alternatively, from Alphabet’s home page athttps://abc.xyz, select the “Investors” link in the top right-hand corner.Within the “Numbers” section on the “Investor Relations” page, click on the“PDF” option under the “10-K” heading for “2018” and the “Q4 & fiscal year”materials. As a third approach, you could use the SEC’s Electronic DataGathering and Retrieval (“EDGAR”) database to obtain the Form 10-K viawww.sec.gov. From the SEC’s homepage, click on the “Company Filings” linkunder the search box at the upper right of the page. Enter “Alphabet Inc.” inthe box for “Company Name.” Next insert “10-K” in the box for “Filing Type”and click on the “Search” option. Scroll down the search results until you findthe Form 10-K filed on February 5, 2019, and click on the link to thatdocument. Although Alphabet amended the Form 10-K the following day toinclude the signature of Ernst & Young LLP, the Company’s independentauditor, which was inadvertently omitted from the consent filed as part of theoriginal Form 10-K, the February 5 version contains all of the informationrelevant to our discussion.

In addition to Alphabet’s December 31, 2018 consolidated balance sheetand statement of stockholders’ equity, the text in Note 11, which begins near the bottom of page 74 of the company’s Form 10-K for the year endedDecember 31, 2018, provides additional information about Alphabet’sshareholders’ equity. From those portions of Alphabet’s 2018 Form 10-K, wecan determine that as of December 31, 2018, the company’s Amended andRestated Certificate of Incorporation authorized 100 million convertiblepreferred shares, nine billion Class A common shares, three billion Class Bcommon shares, and three billion Class C capital shares, and assigned a$0.001 par value to all 15.1 billion authorized shares. As of that date,Alphabet had issued at least approximately 299,242,000 shares of Class Acommon stock, 46,972,000 shares of Class B common stock, and 349,678,000of Class C capital stock. On December 31, 2018, approximately 299,242,000Class A common shares, 46,636,000 Class B common shares, and 349,678,000Class C capital shares remained outstanding.

F. ACCRUAL ACCOUNTING

On page 69 [omitted from the concise], replace the third paragraphwith the following text:

** The federal government’s annual financial reports often illustrate thedifferences between the cash and accrual methods. For its fiscal year endingSeptember 30, 2016, the federal government reported a $779 billion budgetdeficit, applying the cash method of accounting. When the federalgovernment used the accrual method and considered the increases in


amounts owed for estimated federal employee and veteran benefits liabilities,the deficit or net operating cost for the same fiscal year increased to $1,159billion. BUREAU OF THE FISCAL SERV., U.S. DEP’T OF THE TREASURY, 2016FINANCIAL REPORT OF THE UNITED STATES GOVERNMENT 2, 57, available viahttps: / /www.f iscal .treasury.gov/reports-statements/ f inancial-report/index.html. Historically, the federal deficit under the accrual methodhas received far less media attention than the widely publicized cashshortfall.

4. PRACTICE PROBLEM

On page 102 [page 94 of the concise], replace the introductorysentence after the T-accounts with the following text:

Using the T-accounts, we can prepare the following six-columnworksheet as of July 31, income statement for the month of July, and balancesheet as of July 31:

E. Tutt, EsquireSix-Column Worksheet, July 31

Trial Balance Income Statement Balance SheetAccount Debit Credit Debit Credit Debit Credit

CashAccounts Receivable: CooganAccounts Receivable: Estate of SmithAccounts Receivable: Georgina Hats, Inc.Accounts Receivable: PotterAccounts Receivable: Southacre Corp.Prepaid SalaryLandOffice EquipmentLibraryNote PayableAccounts Payable: P.M. RyanAccrued Telephone Costs PayableAccrued Interest PayableClient AdvancesProprietorshipProfessional IncomeInterest ExpenseMiscellaneous ExpenseRent ExpenseSecretarial ExpenseTelephone ExpenseFire Loss

SubtotalsNet Income

Totals

$ 43515

1,000

100225

100120

1,800775630

5100

75240

25 120

$5,765

$ 1,200100

255

2002,8601,375

$5,765

$ 5100

75240

25 120

$565 810$1,375

$1,375

$1,375 $1,375

$ 43515

1,000

100225

100120

1,800775630

$5,200 $5,200

$ 1,200100

255

2002,860

$4,390 810$5,200


H. THE STATEMENT OF CASH FLOWS

3. CASH AND CASH EQUIVALENTS

On pages 128 and 129 [pages 120 and 121 of the concise], replace thissection with the following text:

The statement of cash flows has historically explained the change duringthe period in cash and cash equivalents. Starting with financial statementsof public companies for fiscal years beginning after December 15, 2017, thestatement of cash flows explains the change during the period in the total ofcash, cash equivalents, and amounts generally described as restricted cash orrestricted cash equivalents (collectively referred to simply as “cash and cashequivalents”). All non-public enterprises could elect to wait until fiscal yearsbeginning after December 15, 2018 to implement this change.

Cash includes currency, undeposited checks on hand, and deposits atbanks and other financial institutions that the enterprise can withdraw “ondemand” without prior notice or penalty.

The term “cash equivalents” means “short-term, highly liquidinvestments.” To satisfy this definition, cash equivalents must meet tworequirements:

1. An enterprise must be able to convert the equivalents to cashreadily; and

2. The original maturity dates of these equivalents must not exceedthree months, so that changes in interest rates do not threaten toaffect adversely the equivalents’ value.

Examples of cash equivalents include United States Treasury bills,certificates of deposit, commercial paper, and money market funds. Theoriginal maturity date means the maturity date when an enterprise acquiresthe investment. For example, a five-year U.S. Treasury note purchased threemonths from maturity qualifies as a cash-equivalent because the note willmature in three months. A five-year U.S. Treasury note purchased two yearsbefore its maturity date does not become a cash equivalent three monthsbefore its maturity because the note’s maturity exceeded three months on theacquisition date. According to accounting standards, an enterprise mustdisclose its definition of cash equivalents, which typically appears in thenotes to the financial statements. As an example, Starbucks includes itsdefinition of cash equivalents on page 54 of its 2012 Form 10-K, whichappears in Appendix A of the Fifth Edition on page 1218 [page 750 of theconcise].

The credit crisis in the late 2000s uncovered certain ambiguities in therequirements necessary to qualify as a “cash equivalent” for financialaccounting purposes. After the relevant accounting rule’s promulgation, newfinancial instruments, such as auction-rate securities and variable-ratedemand notes, which typically offered higher returns than short-term


commercial paper and Treasury securities, became very popular. Althoughthese securities sometimes carried maturities up to thirty years, they alsocontained features, such as provisions allowing the holder to sell thesecurities back to the issuer every ninety days, designed to qualify thesecurities as “highly liquid.” As a result, numerous enterprises treated thesesecurities as cash equivalents for financial accounting purposes. As the creditcrisis worsened, some issuers defaulted, and most securities in the $330billion auction-rate securities market suddenly became illiquid.

Statutes, administrative rules, or contractual provisions may limit anenterprise’s ability to access or use its cash or cash equivalents to acquireother assets or to satisfy liabilities. For example, as a condition for a loan, afinancial institution may require the borrower to maintain a minimumbalance in a separate account or to pledge a cash equivalent. Such limitationsor requirements give rise to restricted cash or restricted cash equivalents.Once the new rules take effect, an enterprise must disclose, either on the faceof the financial statements or in the notes to those statements, amountsconsidered restricted cash or restricted cash equivalents and the nature ofany such restrictions or limitations.

Starting as early as fiscal years beginning after December 15, 2017 forpublic business entities, but with a one year delay for all other enterprises,when an entity presents cash and cash equivalents on more than one lineitem within a balance sheet, the entity must, for each period presented, showon the face of the financial statements or disclose in the notes to thosestatements, the line items and amounts of cash and cash equivalentsreported on the balance sheet. These amounts, disaggregated by the lineitem, such as cash and cash equivalents within current assets, investmentswithin long-term assets, or other assets, should sum to the total amount ofcash and cash equivalents at the end of the corresponding period shown onthe statement of cash flows.

4. CLASSIFICATION OF THE STATEMENT OF CASH FLOWS

On page 129 [page 121 of the concise], replace the last sentence inthe first paragraph in this section with the following text:

Along with separating these three sections, the statement of cash flows mustreconcile the changes in the beginning and ending totals of cash and cashequivalents for each period. Please note that the new rules specifically statethat enterprises may not treat transfers between cash and cash equivalents,including amounts generally described as restricted cash or restricted cashequivalents, as part of an enterprise’s operating, investing, or financingactivities. As a result, the statement of cash flows will not report details ofsuch transfers.


7. DISCLOSURES

On page 135 [page 126 of the concise], insert the following text at theend of this section:

For public business entities, no later than fiscal years beginning afterDecember 15, 2017, and interim periods within those fiscal years, when anenterprise presents cash and cash equivalents, including restricted cash andrestricted cash equivalents, on more than one line within the balance sheet,the entity must also set forth, either on the face of the statement of cashflows or in the notes to the financial statements, the specific line items andamounts of cash and cash equivalents reported within the balance sheet. Theseparate amounts should sum to the total amount of cash and cashequivalents at the end of each period shown on the statement of cash flows.The enterprise must also disclose the nature of any restrictions on cash orcash equivalents, thereby providing insight into the availability of suchamounts. For all other entities, these new rules apply to fiscal yearsbeginning after December 15, 2018, and to interim periods within fiscal yearsbeginning after December 15, 2019.

C H A P T E R II

THE DEVELOPMENT OF

ACCOUNTING PRINCIPLES AND

AUDITING STANDARDS

C. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

1. THE ESTABLISHMENT OF ACCOUNTING PRINCIPLES

a. THE SECURITIES AND EXCHANGE COMMISSION

On page 167 [page 155 of the concise], insert the following text afterthe second paragraph:

** In the last twenty-plus years, the number of public companies in theUnited States has declined steadily since peaking in the 1990s. In 1996, 7,322domestic companies listed their shares on U.S. stock exchanges. By 2017,that number had fallen to 3,671. The number of IPOs in the United Statesalso shrank from 845 in 1996 to 128 in 2016. By comparison, about six millionprivate companies of all sizes currently operate in the United States. In May2019, The Wall Street Journal reported that ninety-seven firms in this groupqualified as so-called “unicorns,” or privately held companies worth at least$1 billion. Venture capital firms and private equity from wealthy investors,investment funds, and sovereign-wealth funds have provided funding toenable companies to avoid public markets, while mergers and acquisitions,going private transactions, and bankruptcies have removed thousands offirms from stock-exchange listings in the United States. The accounting firmPwC estimates that companies can spend more than $2 million annually tomaintain a public listing, after incurring one-time costs between $10 millionand $34 million in the typical IPO. In an effort to boost the number of publiccompanies, regulations stemming from the JOBS Act now allow eligible firmswith less than $1 billion in annual revenue to float their contemplated IPOsby certain investors to assess demand before filing a registration statementwith the SEC. In addition, the SEC now allows all issuers to file preliminaryIPO documents confidentially. The SEC has also proposed to allow allcompanies to test-the-waters before filing a registration statement. Forwhatever reason, the IPO market took off during the spring of 2019, andnotwithstanding disappointing drops in share prices after IPOs at Lyft andUber, the IPO market appears ready to break a calendar year record for theamount raised in 2019. See Aaron Back, There is No Stopping IPO Boom,

9

10 CHAPTER II DEVELOPMENT OF ACCOUNTING PRINCIPLES & AUDITING STANDARDS

WALL ST. J., May 20, 2019, at B10; John Hartsel & Peter St. Onge, Opinion,Canada’s Free Market Example for the SEC, WALL ST. J., May 17, 2019, atA13; Andrew Ramonas, Nasdaq Backs SEC Plan to Help Big Companies PegIPO Interest, Sec. L. (Bloomberg Law), May 2, 2019; Gabriel T. Rubin, SECAims to Ease Firms’ Path to IPOs, WALL. ST. J., Feb. 20, 2019, at B7; JasonM. Thomas, Where Have All the Public Companies Gone?, WALL ST. J., Nov.17, 2017, at A15; see also Michael Greene, Encouraging Companies to GoPublic Won’t Be Easy, 49 Sec. Reg. & L. Rep. (Bloomberg BNA) 324 (Feb. 20,2017); Maureen Farrell, America’s Roster of Public Companies Is ShrinkingBefore Our Eyes, WALL ST. J., Jan. 5, 2017, at A1 (reporting that theUniversity of Chicago’s Center for Research in Security Prices had similarlyfound that the number of U.S.-listed companies–foreign anddomestic–peaked at 9,113 in 1997, and had fallen by more than 3,000 to 5,734in mid-2016, and to about the same number as in 1982).

On page 168 [page 156 of the concise], replace the first full paragraphwith the following text:

In June 2018, the SEC issued a final rule that has expanded the numberof registrants that can qualify as a smaller reporting company, once knownas a “small business issuer.” Such a classification recognizes that a one sizeregulatory structure for public companies does not fit all and allows eligibleenterprises to take advantage of scaled disclosure requirements that reflectthe characteristics and needs of smaller companies and their investors.Beginning September 10, 2018, the new definition enables a company withless than $250 million of public float to provide scaled disclosures. Bycomparison, the previous definition set a $75 million threshold. In addition,companies with less than $100 million in annual revenues qualify if they alsohave a public float that does not equal or exceed $700 million. The previousrevenue test allowed scaled disclosure only if the enterprise had less than $50million in annual revenues and no public float. The SEC’s rules, however,continue to preclude certain enterprises, such as majority-owned subsidiariesof an ineligible parent, investment companies, including businessdevelopment companies, and asset-based issuers, from qualifying as smallerreporting companies. See 17 C.F.R. § 240.12b-2 (2018); see also SmallerReporting Company Definition, 83 Fed. Reg. 31,992 (July 10, 2018).

On page 169 [page 157 of the concise], insert the following text afterthe first full paragraph:

** In an August 2018 tweet, President Donald Trump asked the SEC tostudy switching from quarterly reporting to a six-month system. In December2018, the SEC published a request for public comment on how the SEC couldenhance, or at least maintain, investor protection arising from periodicdisclosures while reducing companies’ compliance burdens arising fromquarterly reporting. About two months earlier, SEC Chairman Jay Claytonexpressed the opinions that it was “good” for President Trump to raise theissue, quarterly reporting was unlikely to change for the largest companies“anytime soon,” but it might make sense to ease the reporting requirements

CHAPTER II DEVELOPMENT OF ACCOUNTING PRINCIPLES & AUDITING STANDARDS 11

for smaller companies. Critics contend that quarterly reporting increasescosts and causes companies to focus on short-term results rather than long-term growth. The SEC has required quarterly reporting since 1970, when theCommission formalized practices at stock exchanges that preceded theagency's creation in 1934. See Request for Comment on Earnings Releasesand Quarterly Reports, 83 Fed. Reg. 65,601 (Dec. 21, 2018); see also GabrielT. Rubin, SEC to Review Quarterly Reporting, WALL ST. J., Nov. 30, 2018, atB10; Andrew Ramonas, SEC Puts Quarterly Earnings Reports on RegulatoryAgenda, Fin. Accounting News (Bloomberg Law), Oct. 17, 2018; Ben Bain,Trump Push for Fewer Company Profit Reports Tempered by SEC, Fin.Accounting News (Bloomberg Law), Oct. 11, 2018.

(3) Regulations, Releases, and Informal Guidance on Periodic Reporting

On pages 174 after the carryover paragraph at the top of the page[after the first full paragraph on page 159 of the concise], insert thefollowing discussion:

** After taking office, President Trump has signed various executive ordersand memoranda seeking to reduce regulatory burdens and to reformadministrative procedures. Pursuant to that initiative, former AttorneyGeneral Jeff Sessions issued a memorandum that set forth various principlesfor issuing appropriate regulatory guidance. These principles included aguideline that any prescription should avoid language that suggests that thepublic must go beyond any requirements set forth in the applicable statuteor regulation. Although these executive actions technically do not apply toindependent regulatory agencies like the SEC, we should expect thatpresidential appointees will follow policy objectives coming from the OvalOffice. In September 2018, SEC Chairman Jay Clayton reiterated the SEC’slongstanding position that “the Commission and only the Commission[adopts] rules and regulations that have the force and effect of law.”Accordingly, informal staff guidance, whether SABs, Staff Legal Bulletins,other manuals, compliance guides, outlines, statements, and oral responses,seemingly “create no enforceable legal rights or obligations of theCommission or other parties.” See Jay Clayton, Chair, Sec. & Exch. Comm’n,Public Statement, Statement Regarding SEC Staff Views (Sept. 13, 2018),https://www.sec.gov/news/public-statement/statement-clayton-091318; seealso David G. Tittsworth, INSIGHT: Putting SEC Staff Guidance in Its Place,Fin. Accounting News (Bloomberg Law), Oct. 17, 2018.

(6) International Accounting Principles

On pages 178 to 186 [omitted from the concise], replace this entiresection with the following discussion:

Although the SEC has long called for the development of globalaccounting standards and issued a statement in support of both convergenceand international financial reporting standards (“IFRS”) in 2010, the SECseems unlikely to require or allow domestic companies to use IFRS for


purposes of the federal securities laws anytime soon. Under the Administra-tive Procedure Act, the SEC must give formal notice and allow a period forpublic comment before adopting international accounting principles. In 2007,the SEC issued final rules that allow foreign private issuers to use IFRS toprepare the financial statements required under the federal securities lawswithout any reconciliation to U.S. GAAP. In 2008, the SEC published aproposed “roadmap” for public companies to transition to IFRS for publicfilings. Interested readers can find resources related to the SEC’s efforts topromote the development of a single set of high-quality, globally acceptedaccounting standards and the currently unlikely transition to IFRS at https://www.sec.gov/spotlight/globalaccountingstandards.shtml. See CommissionStatement in Support of Convergence and Global Accounting Standards, 75Fed. Reg. 9494 (Mar. 2, 2010), available at https://www.sec.gov/rules/other/2010/33-9109fr.pdf; Roadmap for the Potential Use of Financial StatementsPrepared in Accordance With International Financial Reporting Standardsby U.S. Issuers, 73 Fed. Reg. 70,816 (Nov. 21, 2008), available at https://www.sec.gov/rules/proposed/2008/33-8982fr.pdf; see also MATTHEW J. BARRETT &DAVID R. HERWITZ, ACCOUNTING FOR LAWYERS 178-86 (5th ed. 2015).

The credit crisis, the Madoff scandal, and Congressional mandates inDodd-Frank and the JOBS Act diverted the SEC’s attention away from globalaccounting principles, especially when combined first with an inadequatebudget, then sequestration, and, finally, vacancies on the Commission. As aresult, the movement to global accounting standards has stalled within theUnited States, while efforts to converge standards continue. In June 2016,the SEC seemingly archived its “spotlight” web page on global accountingstandards.

In December 2016, the SEC’s Chief Accountant opined that he did notexpect the agency to take any action anytime soon that would allow domesticissuers to use IFRS for financial reporting under the federal securities laws.He indicated, however, that the SEC would continue reviewing a proposalthat his predecessor had offered two years earlier that would permit domesticcompanies to supplement their financial results under U.S. GAAP withnumbers under IFRS without reconciliation to GAAP. In her last policystatement in January 2017, outgoing SEC chair Mary Jo White stronglyurged her successor Jay Clayton and the incoming commissioners to build onpast efforts to narrow the differences between U.S. GAAP and IFRS and topursue high-quality, globally accepted accounting standards. Then-chairWhite observed that U.S. investors could directly purchase the securities ofmore than 500 foreign private issuers with a worldwide market capitalizationthat exceeded $7 trillion. In addition, U.S. investors had invested $4 trillionin U.S. mutual funds that held debt and equity securities issued bycompanies based outside the United States, many of which operated injurisdictions that have adopted IFRS. So far, current SEC head Clayton hasnot shown much interest in any project that would require or allow domesticcompanies to use IFRS. See Steven Marcy, SEC’s White Urges Successor toPursue Global Accounting Rules, 49 Sec. Reg & L. Rep. (Bloomberg BNA) 127(Jan. 16, 2017); Steve Burkholder, No U.S. Action Soon on Global Accounting


Rules: SEC Staff, 48 Sec. Reg. & L. Rep. (Bloomberg BNA) 2267 (Dec. 12,2016); Steve Burkholder, SEC Official Suggests Allowing U.S. Filers to DoSupplemental IFRS-Based Reporting, 46 Sec. Reg. & L. Rep. (BloombergBNA) 2386 (Dec. 15, 2014).

On page 160 of the concise [omitted from the Fifth Edition], add thefollowing text at the end of the third paragraph:

In December 2016, the SEC’s Chief Accountant opined that he did not expectthe agency to take any action anytime soon that would allow domestic issuersto use IFRS for financial reporting under the federal securities laws. Heindicated, however, that the SEC would continue reviewing a proposal thathis predecessor had offered two years earlier that would permit domesticcompanies to supplement their financial results under U.S. GAAP withnumbers under IFRS without reconciliation to GAAP. In her last publicstatement in January 2017, outgoing SEC chair Mary Jo White stronglyurged her successor Jay Clayton and the incoming commissioners to build onpast efforts to narrow the differences between U.S. GAAP and IFRS and topursue high quality, globally accepted accounting standards. So far, currentSEC head Clayton has not shown much interest in any project that wouldrequire or allow domestic companies to use IFRS. See Steven Marcy, SEC’sWhite Urges Successor to Pursue Global Accounting Rules, 49 Sec. Reg & L.Rep. (Bloomberg BNA) 127 (Jan. 16, 2017); Steve Burkholder, No U.S. ActionSoon on Global Accounting Rules: SEC Staff, 48 Sec. Reg. & L. Rep.(Bloomberg BNA) 2267 (Dec. 12, 2016); Steve Burkholder, SEC OfficialSuggests Allowing U.S. Filers To Do Supplemental IFRS-Based Reporting,46 Sec. Reg. & L. Rep. (Bloomberg BNA) 2386 (Dec. 15, 2014).

b. THE PRIVATE SECTOR

(3) Stock Exchanges, Listing Standards, and Quasi-Private Ordering

On page 196, add the following discussion at the end of this section[after the carryover paragraph on page 158 of the concise]:

** In May 2019, the SEC approved a plan that could lead to the launch ofa new national securities exchange that seeks to respond to criticisms thatthe thirteen stock exchanges currently operating in the United Statesimproperly focus on short-term financial results. The proposed Long-TermStock Exchange (‘LTSE”) hopes to encourage listed companies to achievelong-term strategic goals rather than quarterly financial targets. LTSE hassuggested at least three potential listing standards with financial reportingand disclosure implications. In an effort to encourage long-term thinking, theexchange’s listing standards would prohibit companies from releasingquarterly earnings guidance. In addition, listed companies could not tieexecutive bonuses to financial targets over periods shorter than one year.Finally, if a listed company pays bonuses in stock, the shares could not fullyvest for at least five years. More controversially, LTSE has suggested a


system that would give investors more voting power the longer that they ownshares. See Alexander Osipovich, New Securities Exchange May Lure TechStartups, WALL ST. J., May 11, 2019, at B17; Alexander Osipovich & DennisK. Berman, New Stock Exchange to Take Long-Term View, WALL ST. J.,Oct. 17, 2017, at B1.

c. CONGRESS

On page 199 [page 161 of the concise], add the following discussionat the end of this section:

In 2019, we can again watch as members of Congress seek to influenceaccounting standards. In response to the 2008 financial crisis, in 2016 FASBissued new standards for credit losses that adopt the so-called “currentexpected credit losses” (“CECL”) model. The new rules, which start becomingeffective for public companies for fiscal years beginning after December 15,2019, change existing rules that do not recognize credit losses on loans andother lending transactions until such losses become “probable,” which inpractice means at least not until sometime after the borrower or customerhas missed at least one payment. Under the new standard, banks and otherbusinesses must look to the future, consider past experience, and recordexpected losses as soon as the lender extends credit. Most banks expect thattheir credit losses will increase under the new standards, which will reduceprofits and equity and could force the banks to boost the capital they musthold to satisfy regulatory requirements, which in turn could mean less moneyto lend. The American Bankers Association and many banks have critized thenew rules. In May 2019, twenty-five members of Congress wrote to the SEC,urging the Commission to postpone the new standards until the agency couldstudy them. Fifteen senators, eight Democrats and seven Republicans,likewise wrote to the Federal Reserve Board and the Federal DepositInsurance Corp, seeking a delay until the regulators could study how the newrules would affect lending. Later that same month, five senators co-sponsoredlegislation that would require the SEC and other federal agencies to studythe new rules and their effect on the economy before they go into effect. FiveRepublicans and five Democrats have co-sponsored similar legislation in theHouse of Representatives. See Nicola M. White, Bipartisan LawmakersIntroduce Bill to Block Loan-Loss Rule, Fin. Accounting News (BloombergLaw), June 10, 2019; Nicola M. White, Senator Introduces Bill to Halt CreditLosses Rule, Fin. Accounting News (Bloomberg Law), May 22, 2019; NicolaM. White, Senators Press to Delay Loan Loss Accounting Rules, Fin.Accounting News (Bloomberg Law), May 10, 2019.

d. INTERNATIONAL ACCOUNTING STANDARDS

On page 203 [page 163 of the concise], replace the third fullparagraph with the following text:

** In 2002, the European Union adopted rules that required 7,000 listedcompanies to use international accounting standards, effective January 1,


2005. The IFRS Foundation has compiled and published profiles about theuse of IFRS in 166 jurisdictions, including the G20 and 146 other countries. See IFRS Foundation, Analysis of Use of IFRS Standards Around the WorldApr. 25, 2018), http://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#analysis. As of April 25, 2018, 144 jurisdictions requiredIFRS for all or most domestic listed companies and financial institutions,subject to the caveat that some countries have approved local variations orspecial applications, such as carve-outs. In 2019, Russia adopted a plan toalign domestic financial reports with IFRS by 2022. In addition, the UnitedStates, China, and India have all sought to converge their national standardswith IFRS. As previously mentioned, more than 500 foreign private issuers,including forty percent of banks, representing market capitalizations in thetrillions of dollars, file financial statements using IFRS with the SEC withoutreconciliation to U.S. GAAP. See Mary Jo White, Chair, Sec. Exch. Comm’n,Remarks at the Financial Accounting Foundation Trustees Dinner (May 20,2014), https:// www.sec.gov/News/Speech/Detail/Speech/1370541872065#.VAW6_bkg8iQ.

3. WHO SELECTS AMONG GENERALLY ACCEPTED ACCOUNTING

PRINCIPLES?

With regard to the chart on page 210 [page 171 of the concise], as aresult of the JOBS Act, please add the following Note A to the twocolumns on the left for SEC registrants:

**Note A: Emerging growth companies can elect not to comply with new orrevised financial accounting standards that apply to public companies untilthe standards become mandatory for private companies.

On page 213 [omitted from the concise], in the first paragraph of thissection, digital currency and its underlying blockchain technologyoffer another contemporary example of a situation where businesstransactions have evolved more rapidly than U.S. GAAP. In thissituation, the lack of specific rules also hurts investor confidence.See generally Denise Lugo, Lack of Accounting Guidance StiflesBlockchain Growth in U.S., Corp. L. & Accountability Rep.(Bloomberg BNA), July 28, 2017.

4. CRITIQUE

On page 223 [omitted from the concise edition], insert the followingnew note after note 7:

7A. Beginning with audit reports issued on or after January 31, 2017, a newPCAOB rule requires audit firms of issuers to file a report with the Board onForm AP that includes, among other disclosures, the name and identificationnumber of the engagement partner. Audit firms must submit these reportswithin ten days after the date the issuer includes the audit report in a


registration statement or thirty-five days after the date the issuer firstincludes the audit report in a document filed with the SEC. Advisors to auditcommittees and investors can use the AuditorSearch link on the PCAOB’swebsite, enter a company’s name, and the name of the engagement partnerwill appear. Knowing a partner’s name, an advisor can also find all auditsthat the partner has led since the rule’s effective date, which could help anaudit committee or investor assess the auditor’s qualifications andperformance. See Public Company Accounting Oversight Board; OrderGranting Approval of Proposed Rules to Require Disclosure of Certain AuditParticipants on a New PCAOB Form and Related Amendments to AuditingStandards, 81 Fed. Reg. 29,925 (May 9, 2016); Improving the Transparencyof Audits: Rules to Require Disclosure of Certain Audit Participants on a NewPCAOB Form and Related Amendments to Auditing Standards, PCAOBRelease No. 2015-008 (Dec. 15, 2015), https://pcaobus.org/Rulemaking/Docket029/Release-2015-008.pdf; see also Michael Rapoport, We All Know the OscarAccountant–But Who Does Your Company’s Audit?, WALL ST. J., Mar. 4, 2017,at B1. On page 224[omitted from the concise edition], insert the followingcitation at the end of note 10:

See also Sec. & Exch. Comm’n v. AgFeed Indus., Inc., No. 3:14-CV-00663(M.D. Tenn. Mar. 24, 2017) (imposing a $75,000 fine on an audit committeechair for ignoring red flags and delaying disclosure of an accounting fraudwhile engaged in efforts to raise capital for expansion and acquisitions),available at https://www.sec.gov/files/Judg14-cv-00663Gothner.pdf; PressRelease, Sec. & Exch. Comm’n, SEC Charges Animal Feed Company and TopExecutives in China and U.S. with Accounting Fraud; U.S.-Based AuditCommittee Chair Charged for Complicity in Scheme (Mar. 11, 2014), https://www.sec.gov/news/press-release/2014-47.

On page 225[omitted from the concise edition], insert the followingnew problems after Problem 2.2C:

**Problem 2.2AA. What was the name of the engagement partner for themost recent Amazon.com audit? During the last year, did that individualserve as the engagement partner on any other audit for a public company?Explain briefly where you found your answers.

**Problem 2.2BB. What was the name of the engagement partner for themost recent Alphabet audit? During the last year, did that individual serveas the engagement partner on any other audit for a public company? Explainbriefly where you found your answers.

**Problem 2.2CC. What was the name of the engagement partner for themost recent UPS audit? During the last year, did that individual serve as theengagement partner on any other audit for a public company? Explain brieflywhere you found your answers.


D. SOUND ACCOUNTING PRACTICES NECESSARY FOR

REGISTRANTS UNDER THE FEDERAL SECURITIES LAWS

2. SARBANES-OXLEY, DODD-FRANK, AND THE JOBS ACT

b. INTERNAL CONTROL OVER FINANCIAL REPORTING

(1) Management’s Report on Internal Control Over Financial Reporting

On page 233 [omitted from the concise], insert the following text atthe end of the first paragraph:

**If management fails to implement, maintain, and evaluate properly andreport annually on the effectiveness of internal control over financialreporting (“ICFR”), including disclosing any identified material weaknesses,the SEC can bring an enforcement action against the company and itsmanagement, consultants, and auditor. If a material weakness exists, no onecan conclude ICFR was effective. Moreover, disclosure alone will not sufficewithout meaningful remediation when material weaknesses continue forsignificant periods of time. In early 2019, the SEC announced settledadministrative charges against four public companies that failed to maintainICFR for seven to ten consecutive annual reporting periods. Two of thecompanies also failed to complete the required evaluation of the effectivenessof ICFR for two consecutive annual reporting periods. See Press Release, Sec.& Exch. Comm’n, SEC Charges Four Public Companies With LongstandingICFR Failures (Jan. 29, 2019), https://www.sec.gov/news/press-release/2019-6; In re Magnum Hunter Resources Corp., Accounting and AuditingEnforcement Release No. 3756 (Mar. 10, 2016), available at https://www.sec.gov/litigation/admin/2016/34-77345.pdf (rapid revenue growth and significantacquisitions strained the company’s accounting resources and left thecompany with inadequate and inappropriately aligned staffing unable tocomplete the standard monthly closing process in a timely manner, whichgave rise to an undisclosed material weakness and led to sanctions againstthe company, two senior officers, a consultant, and the audit engagementpartner).

** In addition, weak internal controls continue to lead to class actionlawsuits and large settlements. In 2018, five companies agreed to class actionsettlements that exceeded $100 million. All five lawsuits alleged weakinternal controls over financial reporting. In addition, three-quarters ofaccounting-related class actions that settled during the year includedinternal control allegations. See Amanda Iacone, Accounting Class ActionSettlements Hit Near-Record High in 2018, Fin. Accounting News (BloombergLaw), Apr. 17, 2019.


c. WHISTLEBLOWER INCENTIVES AND PROTECTIONS

On the top of page 237 [omitted from the concise], replace the lastsentence of text in the carryover paragraph with the following:

**By early June 2019, the whistleblower program had awarded more than$384 million, including $83 million to three Merrill Lynch insiders in 2018,the largest payout to date. As of the conclusion of the fiscal year endedSeptember 30, 2018, the SEC had obtained $1.7 billion in penalties in casesinvolving whistleblowers during the program’s history. During the fiscal yearended September 30, 2018, the SEC received more than 5,200 tips, up fromabout 3,000 in 2012. In May 2019, the SEC issued the first award pursuantto a provision in the whistleblower rules designed to incentivize internalreporting to a claimant who also submitted the same information to the SECwithin 120 days. As a result, the SEC also gave the tipster credit for theinformation undercovered in the company's internal investigation. See PressRelease, Sec. & Exch. Comm'n, SEC Awards $3 Million to Joint Whistle-blowers (June 3, 2019), https://www.sec.gov/news/press-release/ 2019-81;Press Release, Sec. & Exch. Comm'n, SEC Awards $4.5 Million toWhistleblower Whose Internal Reporting Led to Successful SEC Case andRelated Action (May 24, 2019), https://www.sec.gov/news/press-release/2019-76; Gregory Zuckerman, Whistleblower Inc., Wall St. J., Dec. 8, 2018,at B1;Matt Robinson, Merrill Insiders Get $83 Million in SEC Whistle-BlowerAwards, 50 Sec. Reg. & L. Rep. (Bloomberg BNA) 443 (Mar. 26, 2018).

On page 237 [omitted from the concise], after the citation to 18 U.S.C.§ 1514A (2012) in the carryover paragraph at the bottom of the page,replace the remainder of that paragraph with the following text:

The whistleblower protections apply to individuals who report accounting-related violations of the federal securities laws, including accounting fraud,false or misleading disclosures in public filings, and violations of the FCPAbooks and records or internal controls provisions. Dodd-Frank section922(c)(2) further mandated that no “agreement, policy form, or condition ofemployment” could waive any such right or remedy. See 18 U.S.C. § 1514(e)(2012). Accordingly, SEC Rule 21F-17 prohibits any person from taking anyaction to impede a whistleblower from communicating with the SEC abouta possible securities law violation. 17 C.F.R. 240.21F-17(a) (2018). After theSEC’s Office of the Whistleblower warned against using confidentiality,severance, or other agreements to discourage employees or other individualsfrom reporting perceived wrongdoing, the SEC has continued to bringenforcement actions that protect the rights of whistleblowers, especiallywhen companies ask departing employees to waive any monetary recoveryfor reporting misconduct as a condition for severance payments or other post-employment benefits. See, e.g., In re Anheuser-Busch InBev SA/NV,Accounting and Auditing Enforcement Release No. 3808 (Sept. 28, 2016)(requiring the payment of more than $2.7 million in disgorgement, almost$300,000 in interest, and a penalty exceeding $3 million to resolve chargesthat the company violated the FCPA’s books and records and internal control


provisions and imposed a substantial penalty in a separation agreement forviolating strict non-disclosure terms, thereby chilling the former employee’scommunications with the SEC), https://www.sec.gov/litigation/admin/2016/34-78957.pdf; see also Andrew Ramonas, SEC Official Sees Drop in Anti-Whistleblower Severance Deals, Corp. L. & Accountability Rep. (BloombergBNA), Oct. 17, 2017; Yin Wilczek, SEC Settles First-Ever Action for Whistle-Blower Retaliation, 12 Corp. L. & Accountability Rep. (Bloomberg BNA) 673(June 20, 2014); William McLucas et al., Dispatches from the WhistleblowerFront: Five Common Pitfalls for Companies to Avoid, 45 Sec. Reg. & L. Rep.(Bloomberg BNA) 1345 (July 22, 2013).

In February 2018, the Supreme Court resolved a circuit split as towhether the anti-retaliation provision for “whistleblowers” in Dodd-Frankextends to individuals who have not reported alleged misconduct to the SEC.Unlike the anti-retaliation provisions in Sarbanes-Oxley, an aggrievedwhistleblower under Dodd-Frank need not exhaust administrative remediesby filing a complaint with the Labor Department, can sue directly in federalcourt within a six-year statute of limitations, and can recover double backpay with interest. By comparison, Sarbanes-Oxley imposes a 180-daydeadline on administrative complaints and limits recovery to actual back paywith interest. Notwithstanding support for the whistleblower from theSolicitor General, the SEC, and Senator Charles Grassley, the Republicanchair of the Senate Judiciary Committee, in Digital Realty Trust, Inc. v.Somers, 138 S. Ct. 767 (2018), the Supreme Court unanimously limited theDodd-Frank anti-retaliation remedies to individuals who report misconductto the SEC. Congress, of course, can change this result by amending thestatute. See, e.g., Dave Michaels, Supreme Court Questions Whether Dodd-Frank Protects All Whistleblowers, WALL ST. J., Nov. 29, 2017, at B14; PhyllisDiamond, Senate Judiciary Chair Backs Whistleblower in High CourtDispute, Corp. L. & Accountability Rep. (Bloomberg BNA), Oct. 23, 2017.

3. ENFORCEMENT

On the top of page 259 [omitted from the concise], insert thefollowing notes after Note 5:

**5A. After lengthy investigations, federal prosecutors and regulatorsdropped the criminal and civil charges against two ex-J.P. Morgan traders fortheir alleged roles in hiding the losses. In 2013, prosecutors reached a dealnot to charge the head trader in exchange for his willingness to testifyagainst his two former colleagues, but the head trader’s more recent publicstatements and deposition testimony concluded that the ex-traders actedwith senior management’s assent. In June 2019, the Federal Reserveannounced the termination of its enforcement action against J.P. Morganbased upon substantial improvements in the firm’s internal audit functionsand risk-management program. Another key regulator, the Office of theComptroller of the Currency, closed its case the previous month. See JesseHamilton, JPMorgan’s London Whale Saga Ends Quietly as Fed ClosesOrder, Sec. L. News (Bloomberg Law), June 6, 2019; Rebecca Davis O’Brien,


‘London Whale’ Civil Case Dropped, WALL. ST. J., Aug. 19, 2017, at B9; LucyMcNulty et al., J.P. Morgan ‘Whale’ Blames Brass, WALL ST. J., Aug. 4, 2017,at B1.

5B. Following the financial crisis, the SEC has brought enforcement actionsagainst other large, public companies for deficient internal accountingcontrols, sometimes accompanied by charges alleging inadequate books andrecords. (As described below in Note 10, infra, the SEC has brought evenmore enforcement actions that combine anti-bribery charges with assertedviolations of the internal accounting controls provisions, sometimes alongwith alleged infractions of the books and records provisions.)

About a month after Bank of America Corp.’s $16.65 billion globalsettlement with the U.S. Department of Justice in 2014 to resolve variousinvestigations arising from the financial crisis, the bank also consented to anorder in public cease-and-desist proceedings and agreed to pay a $7.65million penalty to the SEC for violating the FCPA’s books and records andinternal controls provisions. The infractions occurred when Bank of Americaincreasingly overstated its regulatory capital by amounts that reached $3.714billion on December 31, 2013 after the bank acquired Merrill Lynch in 2009and failed to recognize losses on certain notes as they matured. See In reBank of Am. Corp., Accounting and Auditing Enforcement Release No. 3588(Sept. 29, 2014), https://www.sec.gov/litigation/admin/2014/34-73243.pdf.

Without admitting or denying liability, General Motors Co. agreed in2017 to pay a $1 million penalty to settle charges that inadequate internalcontrols prevented the company from assessing the potential financial effectsof faulty ignition switches. From spring 2012 to fall 2013, the company’saccountants did not know that the automaker was investigating faultyswitches which eventually led to the company recalling 2.6 million cars. SeeIn re General Motors Co., Accounting and Auditing Enforcement Release No.3850 (Jan. 18, 2017), https://www.sec.gov/litigation/admin/2017/34-79825.pdf.

On page 260 [omitted from the concise], insert the following text atthe end of Note 9:

** More recently, an investigative report from the SEC warns about cyber-related threats, including email scams and other cyber attacks, andhighlights the need for updated internal accounting controls to guard againstsuch threats. All enterprises need to protect their data, cash, and otherassets. The report details how nine publicly traded companies lost nearly acombined $100 million to cyber thieves who used spoofed or compromisedemails that appeared to come from corporate executives or legitimatevendors, sometimes along with phony purchase orders or fabricated invoices,to convince personnel in accounting departments to wire funds to foreignbank accounts that the thieves controlled. Although the SEC decided not topursue enforcement actions, the report and subsequent comments from theSEC Chair caution that public companies must periodically reassess andadjust their internal accounting controls based on current and emergingrisks. Accordingly, inadequate controls and defenses against cyber attacks


could lead to losses and enforcement actions in the future. See Report onInvestigation Regarding Certain Cyber-Related Frauds Perpetrated AgainstPublic Companies and Related Internal Accounting Controls Requirements,Exchange Act Release No. 84429 (Oct. 16, 2018), available at https://www.sec.gov/litigation/investreport/34-84429.pdf; see also Amanda Iacone, SEC’sClayton Wants Better Controls After Rash of Cyber Fraud, Fin. AccountingNews (Bloomberg Law), Nov. 12, 2018; Amanda Iacone, SEC: CyberattacksTargeted Accountants, Cost Companies $100M, Fin. Accounting News(Bloomberg Law), Oct. 16, 2018.

On pages 260-262 [omitted from the concise], replace the text ofNote 10 with the following:

**10. Since 2010, the SEC’s Enforcement Division has operated a specializedunit dedicated to investigating potential FCPA violations. Not surprisingly,the number of enforcement actions and the size of penalties or settlementsincreased significantly. The Wall Street Journal reported that the JusticeDepartment and the SEC reached settlements in FCPA cases with twenty-three companies in 2010. Those settlements imposed about $1.8 billion intotal fines, penalties, and disgorgement. In 2012, The Wall Street Journalreported that three companies, Avon Products Inc., WeatherfordInternational Ltd., and Walmart Inc., had collectively spent $456 million toinvestigate alleged FCPA violations for which those companies had not beencharged! That same article reported that compensation for top lawyersspecializing in FCPA matters had reached $2 million per year. See JoePalazzolo, From Watergate to Today, How FCPA Became So Feared, WALL ST.J., Oct. 2, 2012, at B1; Joe Palazzolo, FCPA Inc.: The Business of Bribery,WALL ST. J., Oct. 2, 2012, at B1.

** Although enforcement cases at both the Justice Department and the SEChave declined after record numbers in 2016, those agencies imposed morethan $1.1 billion in corporate penalties and disgorgement during the firstquarter of 2019, plus more than $282 million against Walmart in June 2019.As a result, 2019 could well break the record for total sanctions in a year. SeePress Release, Sec. & Exch. Comm’n, Walmart Charged With FCPAViolations (June 20, 2019), https://www.sec.gov/news/press-release/2019-102;Lucinda Low et al., INSIGHT: FCPA Penalties on Track for Potential Recordin 2019, Sec. Law (Bloomberg Law), Apr. 22, 2019; Victoria Graham, Anti-Bribery Enforcement Remains Steady Under Trump, Corp. L. &Accountability Rep. (Bloomberg BNA), June 21, 2018; Steven R. Peikin,Reflections on the Past, Present, and Future of the SEC’s Enforcement of theForeign Corrupt Practices Act (Nov. 9, 2017), https://www.sec.gov/news/speech/speech-peikin-2017-11-09.

In 2016, Brazilian-based petrochemical manufacturer Braskem S.A.agreed to pay a total of $957 million in a global settlement to resolve chargesthat the company created false books and records to conceal illicit bribes towin or retain business and did not maintain adequate internal controls.Braskem agreed to pay $325 million in disgorgement, including $65 millionto the SEC and $260 million to Brazilian authorities, and more than $632


million in criminal penalties and fines to the Department of Justice andauthorities in Brazil and Switzerland to settle the charges. In addition,Braskem must retain an independent corporate monitor for at least threeyears. The SEC’s complaint alleged that Braskem made approximately $325million in profits through bribes paid through intermediaries and off-bookaccounts managed by its largest shareholder and Latin America’s biggestconstruction company, Salvador-based Odebrecht SA, which in turn pledguilty to bribery and agreed to pay penalties totaling up to $4.5 billion in thelargest anti-corruption settlement to date. In April 2017, the United StatesDistrict Court for the Eastern District of New York agreed with prosecutorsthat the company could only afford $2.6 billion and ordered Odebrecht to pay$2.39 billion to Brazil, $93 million to the United States, and $116 million toSwitzerland. See Patricia Hurtado, Odebrecht to Pay $2.6 Billion Fine forU.S. Bribe Conviction, Corp. L. & Accountability Rep. (Bloomberg BNA), Apr.18, 2017; Patricia Hurtado, Braskem Ordered to Pay $632 Million inCorruption Probe, Corp. L. & Accountability Rep. (Bloomberg BNA), Jan. 27,2017; Press Release, Sec. & Exch. Comm’n, Petrochemical ManufacturerBraskem S.A. to Pay $957 Million to Settle FCPA Charges (Dec. 21, 2016),https://www.sec.gov/news/pressrelease/2016-271.html; Press Release, Sec. &Exch. Comm’n, SEC Announces Enforcement Results for FY 2016 (Oct. 16,2016), https://www.sec.gov/news/pressrelease/2016-212.html.

In what had previously been the largest bribery case, in late 2008 theSEC announced that Siemens Aktiengesellschaft (“Siemens”), a German-based manufacturer, had consented to an unprecedented enforcement actionin U.S. federal court to resolve charges that the company violated the anti-bribery, books and records, and internal controls provisions in the FCPA. Intotal, Siemens agreed to pay more than $1.6 billion in disgorgement andfines, including $350 million in disgorgement to the SEC. In addition to anapproximately $285 million fine that Siemens paid in 2007 to the Office ofthe Prosecutor General in Munich, Germany, Siemens agreed to pay a $450million criminal fine to the U.S. Department of Justice and an approximately$569 million fine to the Prosecutor General in Munich. Over more than a six-year period, Siemens made at least 4,283 payments to third parties in waysthat obscured the purpose for, and the ultimate recipients of, approximately$1.4 billion in expenditures to bribe government officials in return forsteering business to Siemens in Asia, Africa, Europe, the Middle East, andthe Americas. Elaborate payment schemes, including slush funds, off-bookaccounts, and the use of business consultants, intermediaries and largeamounts of cash in suitcases sought to conceal the corrupt payments, whichSiemens recorded on its books as “management fees, consulting fees, supplycontracts, room preparation fees, and commissions,” and the company’sinadequate internal controls allowed the illegal conduct to flourish. Theconduct involved employees at all levels, including former seniormanagement, which set a disappointing “tone at the top” that tolerated, andeven rewarded, bribery. A Siemens spokesman told The Wall Street Journalthat the cost of investigating and addressing the corruption allegations alsoapproached the total amount of the fines. See SEC v. Siemens


Aktiengesellschaft, Accounting and Auditing Enforcement Release No. 2911(Dec. 15, 2008), https://www.sec.gov/litigation/litreleases/2008/lr20829.htm;see also Dionne Searcey, U.S. Cracks Down on Corporate Bribes, WALL ST. J.,May 26, 2009, at A1.

** The SEC, along with the Department of Justice, continue to bring andresolve FCPA cases alleging deficient internal accounting controls, usuallyaccompanied by charges involving inaccurate books and records, albeit at aseemingly slower pace than the recent past. In June 2019, Walmart Inc.(“Walmart”) and its wholly owned Brazilian subsidiary, WMT Brasilia S.a.r.l.,agreed to pay more than $282 million to resolve charges that, from 2000through 2011, the global retail giant operated without a system of sufficientanti-corruption internal controls. The settlement followed a seven-yearinvestigation by the U.S. government into improper payments by Walmartsubsidiaries through third-party intermediaries to government officials inBrazil, Mexico, China, and India to secure permits and fast-track storeopenings. The SEC found that even after Walmart learned about certainanti-corruption risks as early as 2003, the retailer failed to investigatesufficiently the allegations or delayed implementing appropriate internalaccounting controls. According to the SEC’s cease-and-desist order, variousinternal audits warned about potentially corrupt practices and payments andsignaled a need for stronger internal accounting controls. Foreignsubsidiaries frequently employed third-party intermediaries, who madeimproper payments to government officials to obtain licenses, permits, orother approvals for new stores. Without sufficient internal accountingcontrols, the Mexican subsidiary donated cash or merchandise, including carsand computers that government officials could convert to personal use, tolocal governments, sometimes around the time that the subsidiary obtainedpermits, licenses, or other government approvals. The inadequate internalcontrols and these transfers enabled Walmart to open new stores at anaccelerated pace and to boost its profits. Books and records used vague termssuch as “miscellaneous,” “professional fees,” “incidental,” and “governmentfee” to describe the improper payments. To resolve the investigations,Walmart promised to remit more than $144 million in disgorgement andinterest to the SEC, to report to the SEC on the status of the company’sremediation efforts and the implementation of anti-corruption relatedcompliance measures for two years, and to pay almost $138 million inforfeiture and penalties to the Justice Department in exchange for a non-prosecution agreement. Finally, WMT Brasilia S.a.r.l, pled guilty to violating the FCPA’s books and records provision. In addition to the $282 million paidto the SEC and the Justice Department, The Wall Street Journal reportedthat Walmart spent more than $900 million on an internal investigation andrelated compliance improvements. Earlier, Walmart agreed to pay $160million to settle a class action lawsuit alleging that the company misleadinvestors about corruption at its Mexican subsidiary. See In re Walmart Inc., Accounting and Auditing Enforcement Release No. 4054 (June 20, 2019),https://www.sec.gov/litigation/admin/2019/34-86159.pdf; Press Release, Dep’tof Just., Walmart Inc. and Brazil-Based Subsidiary Agree to Pay $137 Millionto Resolve Foreign Corrupt Practices Act Case (June 20, 2019), https://www.


just ice .gov /opa/pr /walmart - inc -and-brazi l -based-subsid iary -agree-pay-137-million-resolve-foreign-corrupt; see also Dave Michaels &Sarah Nassauer, Walmart to Pay $282 Million in Settlement of BriberyProbe, WALL ST. J., June 20, 2019, at B3; Perry Cooper, Walmart $160MMexican Bribery Scheme Settlement Gets Final OK, Class Action (BloombergLaw), Apr. 9, 2019.

In other recent significant settlements involving FCPA matters:

•JPMorgan Chase & Co. promised to pay more than $264 million insanctions, including about $131 million in disgorgement and interest to theSEC, to resolve charges that the firm bypassed its normal hiring process toprovide valuable jobs and internships to the typically unqualified relativesand friends of client executives and influential government officials in theAsia-Pacific region to win business. Through these referrals, knowninternally as the “Sons and Daughters” program, the bank violated theFCPA’s anti-bribery, books and records, and internal controls provisions. SeeIn re JPMorgan Chase & Co., Accounting and Auditing Enforcement ReleaseNo. 3824 (Nov. 17, 2016), available at https://www.sec.gov/litigation/admin/2016/34-79335.pdf.

•Swedish telecommunications firm Telia Company AB agreed to pay$965 million to the SEC, the DOJ, and authorities in Sweden and theNetherlands, including $457 million in disgorgement, to resolve charges thatthe company paid more than $300 million in bribes to win business inUzbekistan and failed to devise and maintain a reasonable system of internalaccounting controls. As part of this same investigation, about eighteenmonths earlier, Dutch telecom VimpelCom Ltd. agreed to pay $795 millionto resolve FCPA charges when bribes in Uzbekistan, disguised as shamcontracts and charitable contributions, also led to books and records charges.See In re Telia Co. AB, Accounting and Auditing Enforcement Release No.3898 (Sept. 21, 2017), available at https://www.sec.gov/litigation/admin/2017/34-81669 .pdf; see also Press Release, Sec. & Exch. Comm’n, VimpelCom toPay $795 Million in Global Settlement for FCPA Violations (Feb. 18, 2016),https://www.sec.gov/news/pressrelease/2016-34.html; Samuel Rubenfeld,Telia to Pay Nearly $1 Billion to Settle Uzbek Bribery Claims, WALL ST. J.,Sept. 25, 2017, at B7.

•Teva Pharmaceutical Industries Ltd. agreed to pay more than $519million, including more than $236 million in disgorgement and interest to theSEC, to settle civil and criminal charges that the company violated the FCPAby paying bribes to foreign governmental officials in Russia, Ukraine, andMexico and failed to devise and maintain proper internal accounting controlsto prevent such bribes, which were concealed as legitimate payments todistributors. See Press Release, Sec. & Exch. Comm’n, Teva PharmaceuticalPaying $519 Million to Settle FCPA Charges (Dec. 22, 2016), https://www.sec.gov/news/pressrelease/2016-277.html.

Surges in international cooperation, investigations against entireindustries, criminal prosecutions against implicated individuals, and so-


called “carbon copy” prosecutions where multiple sovereigns bring successivelegal actions for conduct violating the laws of different nations but arisingfrom the same facts have accompanied the FCPA’s growing prominence.These high profile and global enforcement efforts have attracted increasedscrutiny from business groups, the press, the judiciary, and Congress. Criticscontend that the law needs clarification and discourages U.S. businesses fromentering into international transactions, including overseas contracts andforeign acquisitions.

In late 2017, the Justice Department permanently extended andexpanded a pilot program, launched in April 2016, that now allowscompanies to escape criminal charges and to receive as much as a fiftypercent reduction off the low-end fines for FCPA violations. The policypresumes declination of prosecution when an enterprise voluntarily disclosesthe misconduct, fully cooperates with prosecutors, and remediates any problems. This last condition requires the enterprise to help investigatorsidentify individuals responsible for the misconduct and to implementmeasures to address any internal problems or deficiencies. Even whenaggravating circumstances, such as executive management’s participation inthe misconduct, pervasive illegal activity, or criminal recidivism, preclude adeclination, the policy nevertheless offers incentives for meritorious actions.If the enterprise has voluntarily self-disclosed, fully cooperated, and timelyand appropriately remediated, the Justice Department will recommend afifty percent reduction off the lowest fine in the range under the applicableU.S. Sentencing Guidelines. In addition, the DOJ will not require theappointment of a monitor, assuming that the company has put an effectivecompliance program in place before resolution. In cases where the enterprisedoes not voluntarily disclose, but otherwise cooperates and remediates, theDepartment will recommend up to a twenty-five percent reduction off thelowest fine in the applicable Guidelines range. See Crim. Div., U.S. Dep’t ofJustice, FCPA Corporate Enforcement Policy, U.S. Attorneys’ Manual at 9-47.120, available via https://www.justice.gov/criminal-fraud/corporate-enforcement-policy.

Even if the Justice Department declines prosecution, however, theDepartment expects disgorgement, and the SEC does not view a declinationas a bar to an enforcement action. During the pilot program in 2017, forexample, the Justice Department advised Halliburton Company that it wouldnot take any action and would close its investigation arising from self-disclosed payments to a local company in Angola while winning lucrativeoilfield services contracts. The SEC brought an administration action allegingthe company violated the books and records and internal accounting controlsprovisions, which Halliburton settled. The settlement required the companyto pay $14 million in disgorgement, $1.2 million in prejudgment interest, anda $14 million civil penalty. See In re Halliburton Co., Accounting andAuditing Enforcement Release No. 3884 (July 27, 2017), available athttps://www.sec.gov/litigation/admin/2017/34-81222.pdf; see also NicholasBerg, et al., Difficult Choices: Self-Reporting in Light of New DOJ FCPAPolicy on Presumption of Declination, Corp. L. & Accountability Rep.


(Bloomberg BNA), Dec. 29, 2017. More recently, the Department of Justicedeclined to prosecute The Dun & Bradstreet Corporation under the FCPACorporate Enforcement Policy on the same day that the SEC announced thatthe company had agreed to pay more than $9 million, including almost $6.1million in disgorgement and a $2 million civil penalty, for falsely recordingimproper payments by two subsidiaries to Chinese government officials toobtain specific business as legitimate business expenses. Because thepayments continued after an executive had raised concerns, the failure tostop the improper payments or the false entries into the subsidiary’s recordsviolated the books and records and internal accounting controls provisions inthe FCPA. Compare Declination Letter from Crim. Div., U.S. Dep’t of Justice,to Dun & Bradstreet Corp. (Apr. 23, 2018), https://www.justice.gov/criminal-fraud/file/1055401/download, with In re Dun & Bradstreet Corp., Accountingand Auditing Enforcement Release No. 3936 (Apr. 23, 2018), https://www.sec.gov/litigation/admin/2018/34-83088.pdf.

On pages 264 and 265 [omitted from the concise], replace thecarryover paragraph with the following text:

** Second, corporate anti-corruption and legal compliance programs,prompt discovery and self-reporting, cooperation, and other appropriateresponses to illegal conduct may persuade a prosecutor to exerciseprosecutorial discretion and to decide not to file criminal charges against theenterprise. Alternatively, the prosecutor may reduce any penalties imposedor limit any compliance obligations, such as a monitor or complusoryreporting. Although now advisory, rather than mandatory, after the decisionof the Supreme Court in United States v. Booker, 543 U.S. 220 (2005), theUnited States Sentencing Commission’s Organizational SentencingGuidelines (the “Sentencing Guidelines”) also provide incentives forenterprises to establish and maintain effective internal controls to fosterlawful and ethical behavior. In particular, various amendments to theSentencing Guidelines address important areas such as organizationalculture, compliance program responsibilities of corporate directors, adequacyof program resources, authority of compliance personnel, training,evaluations of program effectiveness, and risk analysis. The SentencingGuidelines suggest leniency for organizations that can show that they haveestablished and maintained compliance programs that prevent, detect, andreport misconduct. U.S. SENTENCING GUIDELINES MANUAL § 8C2.5(f), (g)(2012). Strong internal controls, therefore, allow an enterprise an opportunityto avoid criminal liability, to propose reduced penalties, and to minimize anyongoing compliance obligations. See U.S. Dep’t of Justice, Crim. Div.,Evaluation of Corporate Compliance Programs (Apr. 2019) https://www.justice.gov/criminal-fraud/page/file/937501/download; see also MicheleEdwards & Stephen Martin, INSIGHT: Act Now, Document Your Work toSatisfy New DOJ Compliance Guidelines, Sec. Law (Bloomberg Law),May 31, 2019; Thomas Petzinger, Jr., This Auditing Team Wants You toCreate a Moral Organization, WALL ST. J., Jan. 19, 1996, at B1 (discussingthe efforts of one of the then Big Five accounting firms, KPMG Peat Marwick,


to respond to clients’ requests to certify that their compliance programswould satisfy the federal sentencing guidelines).

E. AUDITS AND GENERALLY ACCEPTED AUDITING STANDARDS

1. THE ESTABLISHMENT OF GENERALLY ACCEPTED AUDITING

STANDARDS

a. ISSUERS

(2) Public Company Accounting Oversight Board

On page 275 [omitted from the concise], replace the sentence directlyafter the citation to 15 U.S.C. § 7211 (2012) with the following:

In 2017, the Board paid its chairperson a $672,676 annual salary, whilemembers collected $546,891 each year for their services. See SteveBurkholder, New Leader Named in Complete SEC Overhaul of Audit Board,49 Sec. Reg. & L. Rep. (Bloomberg BNA) 1935 (Dec. 18, 2017).

b) Registration and Inspection

On page 277, insert the following text at the end of this section [onpage 194 of the concise, insert the text before the carryoverparagraph at the bottom of the page]:

** In 2016, the PCAOB found deficiencies in twenty-eight percent of the BigFour audits that the board inspected, which marked an improvement fromthirty-five percent in 2015. Among the Big Four, the PCAOB cited KPMG forthe highest number of deficient audits during this period, finding problemsin twenty audits in 2016, or thirty-eight percent of those inspected, animprovement from fifty-four percent and twenty-eight deficient audits in2015. Because the PCAOB’s inspections focus on audits most prone tomistakes or defects, those percentages likely exceed the numbers thatrandom selection would have produced. See Michael Rapoport, AuditRegulator Weighs Shift on Inspection Focus, WALL ST. J., May 6, 2016, at C2.

** In June 2019, KPMG LLP agreed to pay a $50 million penalty, thelargest fine that the SEC has ever imposed on an auditor, to settleadministrative charges arising from misconduct that violated the basicrequirement that auditors act with integrity. KPMG admitted that formerpartners and employees altered audit workpapers after receiving stoleninformation from a PCAOB employee about which audits the board plannedto inspect in 2017 to reduce the likelihood that inspectors would finddeficiencies in those audits, which the SEC previously described as “‘literallystealing the exam.’” In addition, auditors at the firm, including formerengagement partners, cheated on internal training exams related tocontinuing professional education and courses that a prior SEC order


mandated after an audit failure at a client, by sharing exam answers andusing a trick to select manually the scores necessary to pass the tests, oftenlowering that level to less than twenty-five percent correct answers. Afteruncovering the scheme related to the planned inspections in 2017, KPMGLLP fired six auditors, including five partners and the head of its auditpractice. About a year later, the SEC brought civil charges against threeformer PCAOB staffers and three former KPMG LLP partners. The U.S.Attorney’s Office for the Southern District of New York announced parallelcriminal charges to which three individuals pled guilty, a jury convicted twoothers, and the sixth awaits trial. See In re KPMG LLP, Accounting andAuditing Enforcement Release No. 4051 (June 17, 2019), https://www.sec.gov/litigation/admin/2019/34-86118.pdf; see also Micah Maidenberg & DaveMichaels, KPMG to Pay Penalty Over Cheating Scandal, WALL ST. J.,June 18, 2019, at B1; Amanda Iacone, KPMG Cheating Pervasive, SEC Saysin $50 Million Settlement, Bloomberg Law, June 17, 2019; Dave Michaels,KPMG to Pay Record SEC Fine for Auditor, WALL ST. J., June 14, 2019, atB1; Press Release, Sec. & Exch. Comm’n, Six Accountants Charged withUsing Leaked Confidential PCAOB Data in Quest to Improve InspectionResults for KPMG (Jan. 22, 2018), https://www.sec.gov/news/press-release/2018-6; Dave Michaels & Michael Rapoport, KPMG Fires Partners Over Leak,WALL ST. J., Apr. 12, 2017, at B1.

d) International Issues

On pages 281 and 282, replace the first full paragraph and thecarryover paragraph with the following text [on page 196 of theconcise, insert the following text after the carryover paragraph atthe top of the page]:

In 2016, the SEC ratified a new PCAOB rule that requires audit firmsto file a report with the Board for each audit report provided to an issuerthat, among other disclosures, names any other public accounting firm,including foreign affiliates, that either issued an audit report such thatresponsibility for the audit was divided, or contributed at least five percentof the total audit hours. Audit firms must submit such reports on Form APwithin thirty-five days after the date the issuer first includes the audit reportin a document filed with the SEC. A shorter, ten-day deadline applies if theissuer includes the audit report in a registration statement. Therequirements apply to auditors’ reports issued on or after June 30, 2017.Knowing the name of a disclosed accounting firm that participated in theaudit will enable readers to determine whether the firm had registered withthe Board and has been subject to at least one PCAOB inspection, or islocated in a country, such as and especially China and Hong Kong, but alsoBelgium, that does not allow PCAOB inspections. For example, Ernst &Young’s Chinese affiliate performed between ten and twenty percent of thework on the audit of Walmart’s financial statements for its fiscal year endedJanuary 31, 2018, according to the firm’s Form AP. Readers can now alsodetermine whether the PCAOB or other regulators have brought any publicdisciplinary proceedings against the other participants in the audit. See


Public Company Accounting Oversight Board; Order Granting Approval ofProposed Rules to Require Disclosure of Certain Audit Participants on a NewPCAOB Form and Related Amendments to Auditing Standards, 81 Fed. Reg.29,925 (May 9, 2016); Improving the Transparency of Audits: Rules toRequire Disclosure of Certain Audit Participants on a New PCAOB Form andRelated Amendments to Auditing Standards, PCAOB Release No. 2015-008(Dec. 15, 2015), https://pcaobus.org/Rulemaking/Docket029/Release-2015-008.pdf; see also Michael Rapoport, The Blind Spot in Financial Reports,WALL ST. J., July 23, 2018, at B8.

** As of September 10, 2018, the PCAOB had conducted inspections in fiftyforeign jurisdictions, but was prevented from inspecting the U.S.-relatedaudit work and practices in Hong Kong. As of that date, the PCAOB wasprevented from inspecting U.S.-related audit work in Belgium, China, andto the the extent their audit clients have operations in China, Hong Kong.These restrictions prevented the PCAOB from inspecting the principalauditor’s work on the financial statements of 224 U.S.-listed companies with$1.8 trillion in total market capitalization. In addition, the PCAOB couldinspect some, but not all, of the auditor’s work for another 207 U.S.-listedcompanies. Dating back to 2010, the PCAOB has published and regularlyupdated lists containing those foreign companies whose securities trade inU.S. markets and that have filed financial statements with the SEC, but forwhich asserted non-U.S. legal obstacles prevent the Board from inspectingthe companies’ PCAOB-registered auditors. The SEC typically requiresissuers that have operations in a jurisdiction where obstacles prevent PCAOBinspections to disclose that fact as a risk factor accompanying in investmentin that issuer. Once again, no one should assume that the PCAOB hasreviewed the quality control practices or audit procedures at these publiccompanies’ registered auditing firms. See William D. Duhnke, Chairman,Pub. Co. Accounting Oversight Bd., Statement on the Vital Role of AuditQuality and Regulatory Access to Audit and Other InformationInternationally–Discussion of Current Information Access Challenges withRespect to U.S.-listed Companies with Significant Operations in China (Dec.7, 2018).

4. INDEPENDENCE AND THE AUDIT PROCESS

a. INDEPENDENCE

After Note 1 on the bottom of page 296, insert the following new note[on page 177 of the concise, insert the text that follows after thesecond full paragraph]:

1A. In 2016, the SEC brought and settled its first enforcement actions forauditor independence failures arising from close personal relationships.Ernst & Young agreed to pay a total of $9.3 million after two audit partnersgot too close to their clients on a personal level, which compromised theauditing firm’s objectivity, impartiality, and independence. While theauditing firm asked individuals on engagement teams whether they had any


familial, employment, or financial relationships with audit clients that couldraise independence concerns, the firm did not specifically inquire about non-familial close personal relationships that could impair independence. In thefirst case, Ernst specifically tasked the senior partner on an engagementteam for the audit of a public company to improve the firm’s relationshipwith the client, which the firm considered a “troubled account.” The partnerproceeded to initiate and maintain an improperly close friendship with theclient’s CFO. The partner and the CFO stayed overnight at each other’shomes on multiple occasions, traveled together with family members onovernight trips with no legitimate business purpose, and exchangedhundreds of personal text messages, e-mails, and voicemails during the auditperiods. Certain Ernst partners learned about the engagement partner’sexcessive entertainment spending, but did not take any action to confirm thathe was complying with his obligations to remain independent. See In re Ernst& Young LLP, Accounting and Auditing Enforcement Release No. 3802 (Sept.19, 2016), https://www.sec.gov/litigation/admin/2016/34-78872.pdf. In thesecond case, a different partner serving on the engagement team for anotherpublic company maintained a romantic relationship with the client’s chiefaccounting officer. The partner supervising the audit became aware of factssuggesting an improper relationship, but failed to perform a reasonableinquiry or to raise concerns internally. See In re Ernst & Young LLP,Accounting and Auditing Enforcement Release No. 3803 (Sept. 19, 2016), https://www.sec.gov/litigation/admin/2016/34-78873.pdf.

1B. Of the fifty-four disciplinary cases that the PCAOB settled in 2017 withregistered public accounting firms, twelve cases, or approximately twenty-two percent, included independence violations. In seven matters, allinvolving broker-dealer clients, the firms provided impermissible book-keeping and financial statement preparation services to the audit clients.These services included using the client’s trial balance to prepare thefinancial statements filed with the SEC; entering client information into atemplate that created the financial statements; using client information todraft the notes to the financial statements; and making multiple changes toclient-prepared financial statements and footnotes and then sending themback to the client for approval. Such activities violate the SEC’s prohibitionson auditing one’s own work, performing management functions on the client’sbehalf, or both. Next, three cases involved prohibited business or familyrelationships with clients. In one case, the audit client employed thereviewing partner’s son in an accounting role. In two cases, the audit firm’sowners and directors were concurrently serving as directors and executivesat the audit client, including one audit where the reviewing partner failed toobserve the two-year cooling off period after having just served as theengagement partner. Finally, one case involved material, unpaid fees forpreviously performed services where the client had not entered into anyagreement to pay timely the past due fees. See Cathy Allen, PCAOBEnforcement of Auditor Independence Cases in 2017: What We Can Learnfrom Them?, Corp. L. & Accountability Rep. (Bloomberg BNA), Mar. 13, 2018.


**1C. With the Big Four’s extensive and growing consulting practices,independence considerations can prevent companies from changing auditors.After KPMG, which has audited General Electric Co. since 1909, failed tocatch GE’s recent accounting problems that have led to more than $25 billiondollars in writeoffs arising from GE’s insurance operations and acquisitionsin its power unit, thirty-five percent of GE’s shareholders voted in 2018against continuing to retain KPMG as the company’s auditor, up from aboutthree percent the previous year. In 2018, GE paid KPMG $133.3 million foraudit and other services, the highest amount that a U.S. traded companypaid to its auditor, but independence requirements and nonaudit servicesprevented Deloitte, Ernst & Young, and PwC from seeking the auditengagement for 2019. In December 2018, GE’s board announced plans tosolicit bids for a new auditor to handle the audit of the financial statementsfor 2020, which could end a relationship that has lasted 110 years. SeeRichard Clough, GE Urged to Drop KPMG as Auditor Following AccountingMissteps, Fin. Accounting News (Bloomberg Law), Apr. 16, 2019; MichaelRapoport, For GE, Dropping KPMG Won’t Be Easy, WALL ST. J., Mar. 28,2019, at B10.

At the end of Note 11 on page 303 [omitted from the concise], insertthe following text:

** Since June 2018, at least three U.S. law firms have established allianceswith Big Four global affiliates in an effort to form multidisciplinary teamsthat can provide business, consulting, legal, and technology advice under oneumbrella. These alliances have brought together an immigration law firmwith Deloitte’s British arm, another immigration firm and PwC, and a laborand employment law firm with Deloitte Legal. While state bar regulationsprevent the Big Four from offering traditional legal services in the UnitedStates, those accounting firms offer environmental, tax, and other servicesand employ an average of about 2,200 lawyers each. By comparison, anaverage of about 3,800 lawyers practice at the ten largest global law firms.Whether or not the Big Four poses a threat to Big Law, the accounting firmincreasingly offer attractive employment opportunities to lawyers. See StevenDiFiore et al., INSIGHT: The EBG, Deloitte Alliance–Client-Focused MindsetCalled for Global Workforce Mangement Model, Bloomberg Law, June 17,2019; Sam Skolnik, Big Four-Big Law Alliance Could Spur MorePartnerships, US Law Week (Bloomberg Law), May 10, 2019; Jason Tashea,Should Big Law Firms Worry About Increasing Competition from the BigFour Accounting Firms?, Am. Bar Ass’n J., Sept. 2018, at 48-53.

**At the end of the text in the second paragraph in Note 12 on pages303 and 304, please note that the concept release on auditorindependence and audit firm rotation no longer remains on thePCAOB’s docket of standard-setting activities.


On page 305[omitted from the concise edition], insert the followingnew problems after Problem 2.3C:

**Problem 2.3AA. Did any other public accounting firm, including anyforeign affiliate of the registered public accounting firm that signed the auditopinion, share responsibility for the most recent Amazon.com audit orcontribute at least five percent of the total audit hours? If so, summarize anydetails provided. Explain briefly where you found your answer(s).

**Problem 2.3BB. Did any other public accounting firm, including anyforeign affiliate of the registered public accounting firm that signed the auditopinion, share responsibility for the most recent Google audit or contributeat least five percent of the total audit hours? If so, summarize any detailsprovided. Explain briefly where you found your answer(s).

**Problem 2.3CC. Did any other public accounting firm, including anyforeign affiliate of the registered public accounting firm that signed the auditopinion, share responsibility for the most recent UPS audit or contribute atleast five percent of the total audit hours? If so, summarize any detailsprovided. Explain briefly where you found your answer(s).

b. THE AUDIT PROCESS

(3) Reporting the Audit Results

a. STANDARD REPORT

On page 314 [omitted from the concise], after the citation at the topof the page, insert the following text:

** Effective for audits of financial statements for periods ending on or afterDecember 15, 2020, the ASB has again revised its standard audit report ona complete set of financial statements. Among other changes, the revisedreport moves the auditor’s opinion to the beginning, sets forth management’sresponsibility to evaluate whether circumstances raise substantial doubtabout the enterprise’s ability to continue as a going concern, and expands thediscussion of the auditor’s responsibilities as follows:

Independent Auditor’s Report

[Appropriate Addressee]

Report on the Audit of the Financial Statements

Opinion

We have audited the financial statements of ABC Company, which comprisethe balance sheets as of December 31, 20X1 and 20X0, and the relatedstatements of income, changes in stockholders’ equity, and cash flows for theyears then ended, and the related notes to the financial statements.


In our opinion, the accompanying financial statements present fairly, in allmaterial respects, the financial position of ABC Company as of December 31,20X1 and 20X0, and the results of its operations and its cash flows for theyears then ended in accordance with accounting principles generally acceptedin the United States of America.

Basis for Opinion

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America (GAAS). Our responsibilities underthose standards are further described in the Auditor’s Responsibilities for theAudit of the Financial Statements section of our report. We are required tobe independent of ABC Company and to meet our other ethicalresponsibilities, in accordance with the relevant ethical requirementsrelating to our audits. We believe that the audit evidence we have obtainedis sufficient and appropriate to provide a basis for our audit opinion.

Responsibilities of Management for the Financial Statements

Management is responsible for the preparation and fair presentation of thefinancial statements in accordance with accounting principles generallyaccepted in the United States of America, and for the design,implementation, and maintenance of internal control relevant to thepreparation and fair presentation of financial statements that are free frommaterial misstatement, whether due to fraud or error.

In preparing the financial statements, management is required to evaluatewhether there are conditions or events, considered in the aggregate, thatraise substantial doubt about ABC Company’s ability to continue as a goingconcern for [insert the time period set by the applicable financial reportingframework].

Auditor’s Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether thefinancial statements as a whole are free from material misstatement,whether due to fraud or error, and to issue an auditor’s report that includesour opinion. Reasonable assurance is a high level of assurance but is notabsolute assurance and therefore is not a guarantee that an audit conductedin accordance with GAAS will always detect a material misstatement whenit exists. The risk of not detecting a material misstatement resulting fromfraud is higher than for one resulting from error, as fraud may involvecollusion, forgery, intentional omissions, misrepresentations, or the overrideof internal control. Misstatements are considered material if, individually orin the aggregate, they could reasonably be expected to influence the economicdecisions of users made on the basis of these financial statements.

In performing an audit in accordance with GAAS, we:

• Exercise professional judgment and maintain professionalskepticism throughout the audit.


• Identify and assess the risks of material misstatement of thefinancial statements, whether due to fraud or error, and design andperform audit procedures responsive to those risks. Such proceduresinclude examining, on a test basis, evidence regarding the amountsand disclosures in the financial statements.

• Obtain an understanding of internal control relevant to the audit inorder to design audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion onthe effectiveness of ABC Company’s internal control. Accordingly, nosuch opinion is expressed.

• Evaluate the appropriateness of accounting policies used and thereasonableness of significant accounting estimates made bymanagement, as well as evaluate the overall presentation of thefinancial statements.

• Conclude whether, in our judgment, there are conditions or events,considered in the aggregate, that raise substantial doubt about ABCCompany’s ability to continue as a going concern for a reasonableperiod of time.

We are required to communicate with those charged with governanceregarding, among other matters, the planned scope and timing of the audit,significant audit findings, and certain internal control–related matters thatwe identified during the audit.

Report on Other Legal and Regulatory Requirements

[The form and content of this section of the auditor’s report would varydepending on the nature of the auditor’s other reporting responsibilities.]

[Signature of the auditor’s firm][City and state where the auditor’s report is issued][Date of the auditor’s report]

AUDITOR REPORTING AND AMENDMENTS, INCLUDING AMENDMENTS ADDRESSING

DISCLOSURES IN THE AUDIT OF FINANCIAL STATEMENTS, Statement of AuditingStandards No. 134 (Am. Inst. of Certified Pub. Accountants May 2019)(footnotes omitted) (to be codified at AU-C¶700.A81, illus. 1), https://www.aicpa.org/content/dam/aicpa/research/standards/auditattest/downloadabledocuments/sas-134.pdf.

SAS No. 134 similarly provides sample reports when the auditor mustdeviate from the standard opinion. In particular, please note that SAS No.134 includes new requirements for situations in which the circumstancesraise doubts about the enterprise’s ability to continue as a going concern fora reasonable period. If the financial statements and related notes do notinclude adequate disclosure about such a situation, the auditor cannot givean unqualified opinion. In addition, the section describing the basis for eitherthe qualified or adverse opinion must state either that substantial doubtexists about the entity’s ability to continue as a going concern and that the


financial statements do not adequately address that matter, or thatmanagement’s plans have alleviated the substantial doubt that exists aboutthe entity’s ability to continue as a going concern, but the financialstatements do not adequately disclose the situation. See Ken Tysiac, ASBenhances communication in auditors’ reports, J. ACCT. (May 8, 2019),https://www.journalofaccountancy.com/new/2019/may/asb-enhancescommunication-in-auditors-reports-201921143.html.

On pages 318 and 319, replace the text that begins after thecarryover paragraph on the top of page 318 and continues until thenext section with the following text [in the concise, insert this textafter the carryover paragraph at the top of page 188]:

In October 2017, the SEC ratified a rule that the PCAOB had previouslyapproved, which contains the most significant changes to the audit reportsince the 1940s. Although the new rule retains the “pass-fail” model thatrequires the auditor to opine on whether or not the financial statementsfairly present the enterprise’s financial condition and operating results, therevisions to the audit reports for public companies will add information andimprove readability. Most significantly, excluding audits of emerging growthcompanies (“EGCs”) and private firms, the new rules will compel an auditorto disclose and discuss any “critical audit matters” (“CAMs”) that the auditoridentified during the current audit, or to state that no CAMs arose. ThePCAOB expects most audit reports to describe at least one CAM. See MichaelRapoport, More Insight on Audit Red Flags Is in Works, WALL ST, J., Mar. 20,2019, at B10.

The new PCAOB rule defines a CAM as any matter arising from theaudit of the financial statements that:

(1) the auditor communicated, or was required to communicate, to theaudit committee;(2) relates to accounts or disclosures material to the financial statements;and (3) involved especially challenging, subjective, or complex auditorjudgment.

Please note that CAMs relate to particular accounts or disclosures, and notto the financial statements considered as a whole, which marks asignificantly lower materiality threshold. When discussing each CAM withinthe audit report, the auditor must identify the CAM; set forth the principalconsiderations that led the auditor to determine that the matter qualified asa CAM; describe how the auditor addressed the CAM in the audit; and referto the relevant financial statement accounts or disclosures. The PCAOBexpects auditors to tailor the discussion to each audit, to avoid boilerplatelanguage, and to detail what transactions or accounts sparked each CAM.Not surprisingly, once a matter reaches a certain threshold, the auditor mustalso document the basis for determining whether or not the matter meritedtreatment as a CAM. Although auditors should discuss any CAM with theaudit committee, the audit report remains the audit firm’s responsibility.


Some commentators worry that the new rules provide incentives forauditors to report information beyond that necessary under the SEC’sdisclosure rules, specifically why the auditor considered the matter a CAMand how the auditor addressed the issue during the audit. In turn, draftaudit reports may force management preemptively to disclose informationbeyond what the securities laws require. These commentators also believethat the new requirements increase litigation risk for auditors. Prior to theeffective date, auditors have prepared “dress rehearsal” audit reports fortheir clients, which could offer important insights into an enterprise’sfinancial statements, and discovery opportunities in litigation. See MichaelRapoport, More Insight on Audit Red Flags Is in Works, WALL ST, J., Mar. 20,2019, at B10; Amanda Iacone, Wanted: Detailed Audit Reports Tailored toEach Company, Fin. Accounting News (Bloomberg Law), Mar. 18, 2019;Amanda Iacone, 2019 Outlook: Audit Reports to Undergo Biggest Update inDecades, Fin. Accounting News (Bloomberg Law), Dec. 24, 2018; AmandaIacone, Auditors, Clients to Test New, More Detailed Audit Report, 50 Sec.Reg. & L. Rep. (Bloomberg BNA) 778 (May 21, 2018); David M. Fine &Christina M. Conroy, New “Critical Audit Matter” Reporting RequirementPresents Challenges for Independent Auditors and Public Company AuditCommittees, Corp. L. & Accountability Rep. (Bloomberg BNA), Nov. 29, 2017.

To provide information about the auditor, clarify the auditor’s role andresponsibilities, and improve readability, the new rule also requires the auditreport to:

• Specify the year in which the auditor’s tenure began; • Address the report, at a minimum, to the company’s shareholders

and board of directors (or equivalent groups);• Add the phrase “whether due to error or fraud,” when describing the

auditor’s responsibility under PCAOB standards to obtainreasonable assurance as to whether the financial statements containmaterial misstatements or omissions;

• Express the opinion in the report’s first section; and • Insert section titles to guide the reader.

As a result of these enhancements, the standard audit report for a publiccompany, other than an EGC, will soon read as follows:

Report of Independent Registered Public Accounting Firm

To the shareholders and the board of directors of X Company

Opinion on the Financial Statements

We have audited the accompanying balance sheets of X Company(the “Company”) as of December 31, 20X2 and 20X1, the relatedstatements of [titles of the financial statements, e.g., income,comprehensive income, stockholders’ equity, and cash flows], for eachof the three years in the period ended December 31, 20X2, and therelated notes [and schedules] (collectively referred to as the“financial statements”). In our opinion, the financial statements


present fairly, in all material respects, the financial position of theCompany as of [at] December 31, 20X2 and 20X1, and the results ofits operations and its cash flows for each of the three years in theperiod ended December 31, 20X2, in conformity with [the applicablefinancial reporting framework].

Basis for Opinion

These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on theCompany’s financial statements based on our audits. We are apublic accounting firm registered with the Public CompanyAccounting Oversight Board (United States) (“PCAOB”) and arerequired to be independent with respect to the Company inaccordance with the U.S. federal securities laws and the applicablerules and regulations of the Securities and Exchange Commissionand the PCAOB.

We conducted our audits in accordance with the standards of thePCAOB. Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financialstatements are free of material misstatement, whether due to erroror fraud. Our audits included performing procedures to assess therisks of material misstatement of the financial statements, whetherdue to error or fraud, and performing procedures that respond tothose risks. Such procedures included examining, on a test basis,evidence regarding the amounts and disclosures in the financialstatements. Our audits also included evaluating the accountingprinciples used and significant estimates made by management, aswell as evaluating the overall presentation of the financialstatements. We believe that our audits provide a reasonable basisfor our opinion.

Critical Audit Matters

The critical audit matters communicated below are matters arisingfrom the current period audit of the financial statements that werecommunicated or required to be communicated to the auditcommittee and that: (1) relate to accounts or disclosures that arematerial to the financial statements and (2) involved our especiallychallenging, subjective, or complex judgments. The communicationof critical audit matters does not alter in any way our opinion on thefinancial statements, taken as a whole, and we are not, bycommunicating the critical audit matters below, providing separateopinions on the critical audit matters or on the accounts ordisclosures to which they relate.


[Include critical audit matters; if none, replace the previous sentencewith “We determined that there are no critical audit matters.”]

[Signature]We have served as the Company’s auditor since [year].[City and State or Country][Date]

The new rules similarly amend the illustrative reports whenever the auditordeparts from the standard unqualified opinion.

Except for the changes related to CAMs, the new rules apply to auditsof all public companies for fiscal years ending on or after December 15, 2017. As to CAMs, the new rules apply to audits of large accelerated filers for fiscalyears ending on or after June 30, 2019. For audits of all other non-EGCs, theCAM rules apply to audits of public companies for fiscal years ending on orafter December 15, 2020. To reiterate: the new rules do not require CAMs inaudit reports for EGCs. See Public Company Accounting Oversight Board;Order Granting Approval of Proposed Rules on the Auditor’s Report on anAudit of Financial Statements When the Auditor Expresses an UnqualifiedOpinion, and Departures from Unqualified Opinions and Other ReportingCircumstances, and Related Amendments to Auditing Standards, 82 Fed.Reg. 49,886 (Oct. 23, 2017); The Auditor’s Report on an Audit of FinancialStatements When the Auditor Expresses an Unqualified Opinion and RelatedAmendments to PCAOB Standards, PCAOB Release No. 2017-001 (June 1,2017), available at https://pcaobus.org/Rulemaking/Docket034/2017-001-auditors-report-final-rule.pdf.

** Following the nomenclature and requirements in international auditingstandards, the ASB uses the term “key audit matters” (“KAMs”), rather thanCAMs, to set forth the reporting guidance for such additional information inan audit report. Unless the client has specifically engaged the auditor toreport on any KAMs, the ASB’s standards do not require the auditor toinclude a discussion about such items in the audit report. In addition, thepass-fail model for audit reports seems likely to remain in place for privatefirms and EGCs for at least several more years. See Amanda Iacone, PrivateCompany Audits to Stick With Pass-Fail Model for Now, Fin. AccountingNews (Bloomberg Law), May 20, 2019; Ken Tysiac, ASB enhancescommunication in auditors’ reports, J. ACCT. (May 8, 2019), https://www.journalofaccountancy.com/news/2019/may/asb-enhances-communication -in-auditors-reports- 201921143.html.

In an effort to give investors more insight into an enterprise’ssupplemental information, including so-called “non-GAAP” financialmeasures, the PCAOB continues to work on a research project that arosefrom a proposed rule regarding the auditor’s responsibilities as to “otherinformation” contained in the annual report, but outside the financialstatements and accompanying notes. While the PCAOB’s current standardsrequire the auditor to “read and consider” that information, which includesthe selected financial information, Management’s Discussion and Analysis,


and any exhibits contained in the annual report, no current reportingobligation exists regarding that other information. The original proposalwould have required an auditor to apply specific procedures to evaluate thatother information based on relevant audit evidence obtained and to reportany material factual inconsistency or misstatement in the other information.The PCAOB continues to reevaluate whether the current standards needrevisions and, if so, how to change the existing performance and reportingresponsibilities related to this other information accompanying auditedfinancial statements.

5. THE EXPECTATION GAP

Replace the first sentence in carryover paragraph toward the bottomof page 328 [the second full paragraph on page 200 in the concise]with the following text:

** In August 2018, the FASB updated the chapter on qualitativecharacteristics of useful financial information in the Board’s conceptualframework for financial reporting to align the FASB’s definition ofmateriality with the interpretations of the Supreme Court, SECadministrative materials, and the auditing standards of the PCAOB andAICPA. Until that time, the legal and auditing standards for materialityseemingly differed from the accounting standard.

After the carryover paragraph at the top of page 329[the second fullparagraph on page 200 in the concise] insert the following text:

** The FASB’s conceptual framework now describes materiality as “entityspecific.” While recognizing that small amounts may not matter to aninvestor or other decision maker, the conceptual framework warns thatmagnitude by itself, without regard to the nature of the item and thesurrounding circumstances, generally will not suffice to justify disregardingthe amount or item as immaterial. As a result, only those individuals whounderstand the reporting entity’s pertinent facts and circumstances canreach proper materiality judgments. In its basis for conclusions, which FASBconsiders integral to the concept framework, FASB observed that itsdiscussion of materiality now differs from the definition in the IASB’sconceptual framework. See CONCEPTUAL FRAMEWORK FOR FINANCIAL

REPORTING: CHAPTER 3, QUALITATIVE CHARACTERISTICS FO USEFUL FINANCIAL

INFORMATION, AMENDMENTS TO STATEMENT OF FINANCIAL ACCOUNTING

CONCEPTS NO. 8, ¶¶ QC11-11B, BC3.18D (Fin. Accounting Standards Bd.2018).


On page 338, insert the following new problems after Problem 2.5C[in the concise edition, insert these problems as new Problem 2.3 onpage 208]:

**Problem 2.5AA. What kinds of audit reports did Amazon.com’s auditorissue for the year ended December 31, 2012? How long has that firm servedas Amazon.com’s auditor? Explain briefly where you found your answers.

**Problem 2.5BB. What kinds of audit reports did Google’s auditor issue forthe year ended December 31, 2012? How long has that firm served asAlphabet’s auditor? Explain briefly where you found your answers.

**Problem 2.5CC. What kinds of audit reports did UPS’s auditor issue forthe year ended December 31, 2012? How long has that firm served as UPS’sauditor? Explain briefly where you found your answers.

F. ALTERNATIVES TO AUDITS

1. REVIEW

At the end of the first paragraph on page 339 [omitted from theconcise], insert the following text:

**In September 2018, the SEC brought the first enforcement proceedingsagainst issuers that filed quarterly reports with interim financial statementswithout first having their independent external auditor review them. Thefive companies agreed to cease and desist orders and to pay various fines foreach occurrence. Press Release, Sec. & Exch. Comm’n, Public CompaniesCharged With Failing to Comply With Quarterly Reporting Obligations(Sept. 21, 2018), https://www.sec.gov/news/press-release/2018-207.

G. PUBLISHED SOURCES OF GAAP, GAAS, & OTHER

FINANCIAL INFORMATION

1. GAAP

On page 346 [omitted from the concise], in the fourth full paragraph,the “professional view” now normally costs $1034 per user, per year.

On page 348 [omitted from the concise], in the second full paragraph,the print edition, current through October 31, 2018, now costs $282and contains five volumes and more than 10,000 pages.


H. ACCOUNTANTS’ LEGAL LIABILITY

On page 355 [page 210 of the concise], replace the carryoverparagraph that begins on the page with the following:

In the mid-2000s, auditing firms began inserting clauses in engagementletters that require arbitration, mediation, or alternative dispute resolution;bar punitive damages in any dispute; and obligate the client to indemnify theauditor for any losses arising from the client’s misrepresentations, willfulmisconduct or fraudulent behavior. Until very recently, those clausesappeared to have reduced dramatically the amounts of judgments or publiclyreported settlements for failed audits. With a July 2018 decision ruling thatPricewaterhouseCoopers LLP (“PwC”) must pay more than $625 million indamages to the Federal Deposit Insurance Corporation (“FDIC”) after anaudit failure involving Colonial Bank (“Colonial”) in Alabama, that trend mayhave changed. See Colonial BancGroup, Inc. v. PricewaterhouseCoopers LLP,No. 2:11-cv-746-BJR (M.D. Ala. July 2, 2018).

Each of the Big Four issued unqualified audit opinions just monthsbefore various financial institutions failed during the credit crisis, Deloitteaudited Bear Stearns and Washington Mutual; Ernst & Young inspectedLehman Brothers; KPMG examined Countrywide, Fannie Mae, and NewCentury Financial Corp.; and PwC issued unqualified opinions for AIG andFreddie Mac. Although private lawsuits followed, compared to the muchlarger settlements and judgments in the late 1990s and early 2000s, theauditing firms seemingly escaped relatively unscathed. In 2010, KPMGagreed to pay a quite modest $24 million to settle a federal securities classaction arising from its Countrywide audits. About two years later, Deloitteagreed to pay a mere $19.9 million to certain Bear Stearns shareholders toresolve a class action lawsuit. The following year, KPMG reportedly agreedto pay $76.5 million to settle a class action lawsuit arising from its audits ofFannie Mae. Ernst & Young reached a $99 million settlement in 2013 toresolve class-action allegations arising from its Lehman audits. See MichaelRapoport, Ernst & Young Agrees to Pay $99 Million in Lehman Settlement,WSJ.com, Oct. 18, 2013, http://www.wsj.com/articles/SB10001424052702304384104579143811517891526; Court Issues Mixed Ruling in ShareholderLawsuit Over Lehman Debacle, 10 Corp. Accountability Rep. (BNA) 1101(Oct. 26, 2012); Fannie, KPMG to Pay $153M to Settle Class Action, 45 Sec.Reg. & L. Rep. (BNA) 912 (May 13, 2013); Court Clears $294.9M Accord inBear Securities Suit, 44 Sec. Reg. & L. Rep. (BNA) 2115 (Nov. 19, 2012);Stephen Joyce, Countrywide, KPMG Agree to $624 Million Settlement inPension-Led Class Action, 8 Corp. Accountability Rep. (BNA) 498 (May 14,2010).

Following the credit crisis, some state officials showed an increasedinterest in failed audits. The New York attorney general’s office filed a civilfraud lawsuit against Ernst & Young in 2010, alleging that the auditorcollected $125 million in fees in the seven years before Lehman Brotherscollapsed and watched while the investment bank misstated its financial


statements. During 2012, the U.S. District Court for the Southern District ofNew York remanded the New York attorney general’s lawsuit to state court.In early 2014, a New York appellate court reinstated the New York AttorneyGeneral’s civil fraud lawsuit against Ernst & Young seeking to disgorge the$125 million in fees that the auditing firm collected from Lehman. See ChrisDolmetsch, Ernst & Young to Face New York Claim Over Lehman-RelatedFees, Court Rules, 46 Sec. Reg. & L. Rep. (Bloomberg BNA) 367 (Feb. 20,2014); S.D.N.Y. Remands State AG’s Suit Against Ernst & Young OverLehman Audits, 44 Sec. Reg. & L. Rep. (BNA) 680 (Apr. 2, 2012); Steve Eder,Lehman Auditor May Bear the Brunt, WALL ST. J., Mar. 14, 2011, at C1.

In a developing trend, investors increasingly bring lawsuits alleging thatthe auditor improperly examined internal controls. In 2015, PwC agreed topay $65 million to settle such a lawsuit filed after brokerage firm MF GlobalHoldings Ltd.’s bankruptcy. About two years later, MF Global’s bankrupctyadministrator and PwC reached a settlement for an undisclosed amountduring the third week of an expected five week federal trial. Allegingaccounting malpractice, the administrator had sued PwC for $3 billion indamages and interest. See Michael Rapoport, MF Global, PwC SettleMalpractice Lawsuit, WALL ST. J., Mar. 24, 2017, at B10.

In early July 2018, a federal judge in Alabama ordered PwC to pay$625.3 million in damages to the FDIC, the receiver for Colonial fornegligence during the audits of Colonial’s parent, Colonial BancGroup, Inc.(PwC had asked the court to award no more than $306.7 million in damagesand plans to appeal the ruling. In April 2018, Crowe Horvath, LLP, whichserved as Colonial’s internal auditor, settled FDIC claims for $60 million. )Earlier, the judge ruled that PwC did not design its audits to detect fraudand did not gather sufficient evidence to render unqualified opinions. Asbackground, Colonial collapsed in 2009's largest bank failure amid a massivefraud that its biggest customer, Taylor Bean & Whitaker Mortgage Corp.(“TBW”), and certain Colonial employees perpetrated. In the fraud, TBW,once the nation’s twelfth largest mortgage lender, transferred mortgages toColonial that TBW had already sold to other investors. (In 2016, PwC settledlawsuits that TBW’s bankruptcy trustee and Ocala Funding, a TBWsubsidiary, had brought collectively seeking $5.5 billion in damages fromTBW’s collapse for undisclosed amounts. TBW’s trustee and Ocala alsobrought separate actions against Deloitte, TBW’s auditor, seeking at least$7.6 billion in damages. Those complaints alleged that grossly negligentaudits caused the mortgage lender’s collapse. In February 2018, Deloitteagreed to pay $149.5 million to settle Justice Department allegations arisingfrom the firm’s audit of TBW.) If upheld on appeal, the decision against PwCexposes auditors to greater legal liability, which seems likely to pressurethem to enhance their efforts to detect fraud, and could drive audit feeshigher. As already described, lawsuits alleging auditing malpractice caninvolve billions of dollars in potential damages. See Colonial BancGroup, Inc.v. PricewaterhouseCoopers LLP, supra; see also Amanda Iacone, PwCPenalty Presses Heavier Fraud-Detection Burden onto Auditors, Corp. L. &Accountability Rep. (Bloomberg BNA), July 10, 2018; Michael Rapoport,


Judge Hits PwC With Big Payout, WALL ST. J., July 3, 2018, at B10; PatrickFitzgerald, PricewaterhouseCoopers Settles $5.5 Billion Crisis Era Lawsuit,wsj.com (Aug. 26, 2016), http://wsj.com/articles/pricewaterhousecoopers-settles-5-5-billion-crisis-era-lawsuit-1472226383; Ruth Simon & MichaelRapoport, Deloitte & Touche Sued Over Taylor Bean Collapse, wsj.com (Sept.27, 2011), https://www.wsj.com/articles/SB10001424052970204010604576595133072373372.

C H A P T E R III

THE TIME VALUE OF MONEY

A. IMPORTANCE TO LAWYERS

On page 384 [page 216 of the concise], replace the first full paragraphwith the following:

** Lawyers encounter time value of money concepts in various contexts.When drafting, negotiating or interpreting legal agreements, lawyers mustunderstand the difference between simple interest and compound interest.In the years ahead, lawyers must pay particular attention to references toLibor, the London interbank offered rate, which the British Bankers’Association has called the “ ‘world’s most important number.’ ” Beginning inthe late 1980s, Libor has often served as a benchmark to fix the interest ratefor hundreds of trillions of dollars in financial contracts worldwide, includingadjustable rate student loans, credit cards, mortgages, and corporate debt.Although most commonly linked to U.S. dollars, financial contracts have alsotied Libors to the British pound, Japanese yen, Swiss franc, and euros. Otherinterbank offered rates, or Ibors, include the Euro interbank offered rate(“Euribor”) and the Tokyo interbank offered rate (“Tibor”). Following a seriesof scandals around the world that led to various financial institutions payingabout $10 billion in fines and penalties, job firings, resignations, guilty pleas,and criminal convictions, the United Kingdom’s Financial Conduct Authorityhas announced plans to phase out Libor after 2021. This development raisesmultiple transitional issues, including the need to select an alternative rateor to designate a replacement rate in any new agreement that will extendpast 2021. In addition, lawyers should at least consider, and potentiallyaddress, the rate’s demise in legacy contracts continuing past 2021 thatincorporate Libor but that do not name a successor. Finally, public companiesand their lawyers should evaluate the risks arising from the transition awayfrom the benchmark and to disclose any material exposures. To at least someextent, these same considerations apply to other Ibors. The European CentralBank wants to see a replacement for Euribor in place by 2020.

Lawyers also often need to help clients decide upon or negotiate aninterest rate in a contract, or to select either an expected rate of return bywhich an investment will grow over time or an appropriate discount rate toallow the client to compare a future amount to a current sum. Thesesituations usually require the lawyer to understand the factors that influenceinterest rates, to reference various market rates, and to exercise professionaljudgment.

45

46 CHAPTER III THE TIME VALUE OF MONEY

B. INTEREST

1. FACTORS DETERMINING INTEREST RATES

After the first full paragraph on page 388 [in the concise, after thesecond paragraph on page 219], insert the following text:

** In another aberration that has arisen after central bank intervention,several nations in Europe continue to see negative interest rates. Withnegative rates, rather than receive interest on deposited funds, customersmust pay regularly to keep their money at a bank. In an effort to stimulatestruggling economies, central banks, including the European Central Bank(“ECB”), began charging commercial banks, such as Barclays, Credit Suisse,or Deutsche Bank, interest on their deposits with the central banks. Thispolicy sought to create incentives for commercial banks to lend money at lowinterest to consumers and businesses, while enabling those banks to chargecustomers to deposit cash. The central banks hoped that this situation wouldboost the economy by encouraging consumers and businesses to borrow andspend more and to save less. So far, the European economy has not recoveredfully, and negative interest rates remain prevalent. In late May 2019, theECB’s deposit rate was minus 0.4 percent. See Daniel Kruger & SamGoldfarb, Growing Economic Worries Spark Slide in Bond Yields, WALL ST.J., May 29, 2019, at A1; Brian Blackstone, Negative Rates, Designed to JoltEurope, Become a Crutch, WALL ST. J., May 21, 2019, at A1.

At the end of the second full paragraph on page 388 [in the concise,at the third paragraph on page 219], insert the following text:

**In March 2019, the yield on 10-year U.S. Treasury bonds dropped belowthe yield on three-month obligations for the first time since 2007, which gaverise to an inverted yield curve. In an inverted yield curve, obligations withshorter maturities yield more than their peers with longer maturities. Suchcurves have often, but not always, predicted recessions in the United Statesand have produced a very unreliable record internationally. See JamesMackintosh, Yield Curve Isn’t a Recession Guarantee, WALL ST. J., March 25,2019, at B1.

After the graphic on page 389, replace all the text thru the bottom ofpage 391 [in the concise, the carryover paragraph on pages 220 and221] with the following:

In today’s global economy, large commercial lenders, including financialinstitutions, rely less frequently on their prime rate--the interest rate thatthey charge their best and most creditworthy borrowers. Historically, suchlenders would charge higher interest rates, such as prime plus an additionalpercentage, on loans that carried greater risk.

Beginning in the late 1980s, many lenders started using Libor to setinterest rates in credit card agreements, student loans, mortgages, business

CH APTER III THE TIME VALUE OF MONEY 47

loans, and other financial contracts. An estimated $370 trillion in financialagreements, including $10 trillion in loans, tie their underlying interest rateto Libor, which explains the frequent description of this benchmark in thefinancial press as “ ‘the world’s most important number.’ ” Contracts linkabout $200 trillion of the total to U.S. dollars. Originally, the BritishBankers’ Association (“BBA”) calculated Libor based on the interest ratesthat select London banks would pay to borrow overnight from each other. In2013, Intercontinental Exchange Inc. (“ICE”), which owns the New YorkStock Exchange and other exchanges around the world, acquired Libor fromthe BBA for one euro, then worth about $1.30, and took over the benchmark’sadministration in early 2014. As currently calculated, every business daypanels of between eleven and seventeen large, mostly European,international banks submit interest rates that they pay, or use their “expertjudgment” or “guesswork” to estimate what they theoretically would pay, toborrow dollars and four other currencies from each other on an unsecuredbasis for periods ranging from overnight to one year. After eliminating a setnumber of the highest and lowest rates, ICE computes and publishes theaverage of the remaining rates on a daily basis. See Alexandra Harris, Libor’sEnd Forces Global Banks to Juggle Multiple Replacements, Fin. AccountingNews (Bloomberg Law), June 3, 2019; Daniel Kruger, Exchange Seeks LiborFix, WALL ST. J., May 7, 2019, at B10; David Enrich, Libor: A Eulogy for theWorld’s Most Important Number, WALL ST. J., July 28, 2017, at B1; MaxColchester, Scandal-Hit Libor to Be Phased Out, WSJ.com, July 27, 2017,available at https://www.wsj.com/articles/u-k-calls-time-on-scandal-hit-libor-1501148216; Bob Van Voris, Banks Must Defend Libor Lawsuit After JudgesWarn of Impact, Corp. L. & Accountability Rep. (Bloomberg BNA) (May 24,2016).

Ever since 2008, evidence showing rate manipulation has severelytarnished Libor’s integrity. First, The Wall Street Journal raised questionsabout Libor’s accuracy by publishing a front-page story detailing an analysisthat suggested that several participating banks had understated theirborrowing rates in an effort to mask their own financial difficulties. Suchunderstatements would have translated to an estimated $45 billion reductionin interest payments by borrowers during the first four months in 2008 alone.Regulators opened probes. As then-administrator, the BBA adopted reformsand asked government officials to intervene in the rate-setting process.Nevertheless, rate-rigging continued.

Early in 2012, The Wall Street Journal reported that at least one bankhad told regulators that various traders successfully manipulated theJapanese yen Libor rate as recently as June 2010. Later in 2012, the Britishbank Barclays PLC agreed to pay $453 million in fines and admitted thattraders and executives had tried to manipulate Libor and Euribor.Authorities in the United States and elsewhere have imposed about $10billion in fines, penalties, and disgorgement against financial institutionsworldwide for colluding to influence various interest rates, including Liborand Euribor. In addition, prosecutors have filed criminal charges againstindividuals who allegedly orchestrated the schemes, secured guilty pleas, and


obtained criminal convictions against various individuals. See Erik Larson,Citigroup Agrees to Pay $100 Million to 42 States in Libor Probe, 50 Sec. Reg.& L. Rep. (Bloomberg BNA) 886 (June 25, 2018); Austen Hufford, BankersIndicted in Libor Scandal, WALL ST. J., Aug. 25, 2017, at B10; David Enrich,Libor: A Eulogy for the World’s Most Important Number, WALL ST. J., July 28,2017, at B1; Aruna Viswanatha, Barclays to Pay $100 Million to ResolveStates’ Libor Manipulation Claims, WALL ST. J., Aug. 9, 2016, at C1; EUFines Financial Institutions Over Fixing Key Benchmarks, WALL ST. J., Dec.5, 2014, at C1; Max Colchester & Jean Eaglesham, Libor Process UnderReview, WALL ST. J., June 29, 2012, at C1; Sara Schaefer Munoz et al.,Barclays CEO Is on the Hot Seat, WALL ST. J., June 29, 2012, at C2; JeanEaglesham et al., Traders Manipulated Key Rate, Bank Says, WALL ST. J.,Feb. 17, 2012, at C1; Carrick Mollenkamp & Mark Whitehouse, Study CastsDoubt on Key Rate, WALL ST. J., May 29, 2008, at A1.

At least sixteen of the world’s largest banks, including Bank of AmericaCorp., Citigroup Inc., and JPMorgan Chase & Co., find themselves defendingvarious civil suits, including antitrust and RICO claims seeking trebledamages, from various plaintiffs alleging massive damages frommanipulations involving Libor, Euribor, Tibor, and other rates. Variousborrowers maintain that the schemes caused inflated interest rate marginson adjustable-rate mortgages, lenders claim the fraud reduced profits onloans linked to these rates, and public entities assert that the manipulationscost governments billions of dollars in interest payments and inflated bondcosts. In an extremely significant case, the United States Court of Appeals forthe Second Circuit vacated a 2013 district court decision that dismissedconsolidated, multidistrict litigation on the ground that the plaintiffs hadfailed to plead antitrust injury. See Gelboim v. Bank of America Corp., 823F.3d 759 (2d Cir. 2016), cert. denied, 137 S. Ct. 814 (2017). After remand,another appeal, and an additional remand, the United States District Courtfor the Southern District of New York again narrowed the litigation byrejecting amended complaints and dismissing claims seeking to establish so-called “conspiracy jurisdiction,” ruling that only plaintiffs alleging a specificnexus between Libor-related transactions and a jurisdiction in the UnitedStates can proceed. See In re: LIBOR-Based Financial Instruments AnttrustLitigation, 2019 WL 1331830 (S.D.N.Y. Mar. 25, 2019). Even with this rulingand various settlements, the litigation leaves the banks facing the prospectof damages globally that could easily exceed tens of billions of dollars andseems likely to continue well into the 2020s. See Mike Leonard, LIBORPlatintiffs Fail to Make Out ‘Conspiracy Jurisdiction,’ Fin. Accounting News(Bloomberg Law), Mar. 26, 2019; Antoinette Gartrell, Charles Schwab,Investment Banks to Face Off in $665B Libor Suit, Corp. L. & AccountabilityRep. (Bloomberg BNA), Sept. 22, 2017; Suzanne Kapner, Banks Looking at$100 Billion Legal Tab, WALL ST. J., Mar. 27, 2013, at C1.

** Alternative benchmarks to Libor, Euribor, and other interbank ratesoriginally included the Federal Reserve’s federal funds target rate–the rateat which the Federal Reserve suggests that banks lend to each otherovernight–or its discount rate, the rate at which member banks may borrow


from the Federal Reserve. In an effort to spur the recovery from the financialcrisis, however, the Federal Reserve continues to hold these rates artificiallylow. As a result, some financial contracts have been using the GeneralCollateralized Financing (“GCF”) Repo index, which tracks short-termcollateralized loans between banks. In June 2017, the Alternative ReferenceRate Committee, the group that the Federal Reserve created to recommendan alternative or replacement for Libor in the United States, identifiedanother rate based on loans collateralized by Treasury securities, known asthe Secured Overnight Financing Rate (“SOFR”). Unlike Libor, whichrepresents an estimated, short-term unsecured interest rate based upon so-called “expert judgment” as to what banks would charge each other in“wholesale” transactions, SOFR tracks the rates actually charged forovernight secured loans where the borrower had pledged U.S. Treasuryobligations, commonly referred to as repurchase agreements . The New YorkFederal Reserve began publishing SOFR in April 2018, along with indicativehistorical data back to August 2014. Interested readers can find thisinformation at https://apps.newyorkfed.org/markets/autorates/Rates-Search-Page. The New York Fed plans to start tracking rates for various term loanswhere the borrower has pledged U.S. Treasury obligations as security.According to the New York Fed, daily trading volume on securities in therepo markets underlying SOFR has averaged $843 billion a day since thebenchmark’s launch. By comparison, the median daily volume of transactionsthat support the three-month Libor has remained below $1 billion. In May2019, however, The Wall Street Journal reported that since SOFR’s debut,borrowers had sold $105 billion in debt linked to SOFR, only a fraction of the$900 billion tied to Libor. SOFR has shown some volatility, especially at theend of months or any time demands for cash increase. At the end of 2018, forexample, the benchmark jumped from 2.46 percent on December 28 to 3.00percent on December 31 and then to 3.15 percent on January 2, 2019, beforefalling to 2.70 percent on January 3, and dropping back down to 2.45 percenton January 4. See Nicola M. White, Rulemaker Aims to Ease AccountingHeadaches From Libor’s Demise, Bloomberg Law (Bloomberg Law), June 19,2019; Daniel Kruger & Telis Demos, Firms Slow to Adopt Libor Replacement,WALL ST. J., May 21, 2019, at B10; Alexandra Harris, Putting Libor Out of ItsMisery Is Proving Easier Said Than Done, Fin. Accounting News (BloombergLaw), Apr. 3, 2019; Daniel Kruger & Telis Demos, Volatility Hits NewBenchmark Rate, WALL ST. J., Feb. 12, 2019, at B1.

After the financial crisis, interbank lending has slowed significantly.Given the lack of actual transactions, in July 2017 the United Kingdom’sFinancial Conduct Authority, which regulates Libor, effectively began thebenchmark’s phase out by announcing that after 2021 it would no longercompel banks to submit data underlying the rate. Nonetheless, ICE, whichyou may recall replaced the BBA as Libor’s administrator in 2014, almostcertainly wants to preserve the revenue arising from licensing Libor. In aneffort to strengthen Libor, ICE has adopted new procedures governing howglobal banks derive and submit quotes used to generate the benchmark andrevised the rate’s calculation to include actual transactions when possible. Inaddition, ICE has announced a revamped benchmark, the U.S. Dollar ICE


Bank Yield Index, based on market transactions that set yields for bonds thatbanks issue and which ICE argues better reflects credit risk. Anotherbenchmark, Ameribor, seeks to track rates when regional and communitybanks lend to each other through mutual lines of credit. The Bank forInternational Settlements, which serves as the bank for central banks, has reservations about a one-size-fits-all replacement. Going forward, expertspredict that SOFR will eventually dominate secured lending, while at leastone other index seems likely to prevail in unsecured transactions. SeeAlexandra Harris, Putting Libor Out of Its Misery Is Proving Easier SaidThan Done, Fin. Accounting News (Bloomberg Law), Apr. 3, 2019; DanielKruger, Exchange Seeks Libor Fix, WALL ST. J., May 7, 2019, at B10; DanielKruger, Pioneer Tackles Libor Alternative, WALL ST. J., Apr. 17, 2019, at B12;Alexandra Harris, Libor Refuses to Die, Setting Up $370 Trillion BenchmarkBattle, 50 Sec. Reg. & L. Rep. (Bloomberg BNA) 733 (May 14, 2018); MaxColchester, Scandal-Hit Libor to Be Phased Out, WSJ.com, July 27, 2017,available at https://www.wsj.com/ articles/u-k-calls-time-on-scandal-hit-libor-1501148216.

** Given these developments, transactional lawyers in particular will wantto help clients anticipate various transitional issues. For example, clients willcertainly want either to use an alternative rate for any Libor or to designatea replacement rate in any new agreement that extends past 2021. Inaddition, lawyers should ask their clients to at least consider, and potentiallyto raise with other parties, Libor’s demise in legacy contracts continuing past2021 that incorporate a Libor rate but do not name a successor. In particular,parties may want to address: (1) what trigger events would precipitate thetransition from an Ibor to a new rate; (2) what rate would replace the Ibor;and (3) exactly when would the substitution occur? Finally, public companiesand their lawyers should evaluate any risks arising from the transition awayfrom an Ibor and disclose any material exposures arising from changes in thecost of credit or the value of assets and liabilities. Holding all other thingsconstant, a switch from an unsecured rate to a secured rate would typciallywork to favor borrowers. See Adam Tempkin, Libor Fallback Language forCLOs Expected This Week: Overview, Fin. Accounting News (BloombergLaw), May 28, 2019; Amanda Iacone, Libor Advisory Group Urges Clarity toAid Rate’s Phaseout, Fin. Accounting News (Bloomberg Law), Apr. 15, 2018;Tortoise Investments, Replacing LIBOR: The Countdown Begins, FORBES,Aug. 16, 2017, available at https://www.forbes.com/sites/tortoiseinvest/2017/08/16/ replacing-libor-the-countdown-begins/#46f9e97e4e2b; Mark D. Younget al., LIBOR Replacement Plans Bring Regulatory Considerations forDerivatives (Aug. 17, 2017), available at https://www.skadden.com/insights/publications/ 2017/08/libor-replacement-plans.

As a practical point, anytime a legal agreement references an index, theparties and their lawyers should at least consider under what circumstancesthe parties might want or need to replace the index and, when appropriate,specify any triggering events and designate the process for selecting anyreplacement.


If a business modifies a loan or debt contract, U.S. GAAP currentlyrequires the enterprise to perform the so-called “ten percent test.” That testrequires the business to compare the cash flows from the existing agreementwith the cash flows from the new arrangement. If those cash flows do notcome within ten percent of each other, the accounting rules treat themodification as a new agreement. If a business needs to analyze hundredsor thousands of loan agreements individually, and any underlying assets andliabilities, that comparison becomes quite burdensome. FASB, however, hastentatively and unanimously agreed that if the parties to a loan, lease, debtcontract, or other arrangement change the terms to transition to a newreference rate, the parties can treat the modification as a continuation of theoriginal contract, rather than a new agreement. FASB plans to release theproposal for public comment before the end of 2019. Although beyond thescope of this text, Libor also affects hedging transactions. In 2018, FASBadded SOFR to the list of interest rates that enterprises can use to applyhedge accounting. See Tatyana Shumsky, Board to Ease Cost of Libor Shift,WALL ST. J., June 20, 2019, at B10; Nicola M. White, Rulemaker Aims to EaseAccounting Headaches from Libor’s Demise, Bloomberg Law (BloombergLaw), June 19, 2019; Nicola M. White, LIBOR’s Looming End LeavesHedgers, Lenders in a Bind, Fin. Accounting News (Bloomberg Law), Mar. 21,2019.

C. FUTURE VALUE

1. SINGLE AMOUNTS

c. PRACTICAL ADVICE PART I: WHY YOU SHOULD STARTSAVING FOR YOUR RETIREMENT AS SOON AS POSSIBLE

On page 401 in the last paragraph [omitted from the concise], updatethe annual returns on various investments as follows:

Based on data from Morningstar, Inc., investments in large company stocksfrom 1926 through 2018, as measured today by the S&P 500 (an indexpublished by the financial services company Standard & Poor’s that tracksthe stock market performance of 500 large companies), have produced acompound annual return of 10.0 percent. Stocks in smaller companies havegenerated even better returns, posting compound gains averaging 11.8percent per year. During that same period, long-term corporate bondsreturned an average of 5.9 percent annually, long-term government bondsposted a 5.5 percent average annual return, short-term U.S. Treasury billsearned a 3.3 percent average annual return, and inflation averaged 2.9percent per year. DUFF & PHELPS, 2019 SBBI®[STOCKS, BONDS, BILLS, AND

INFLATION®] YEARBOOK 2-4 to 2-6 (2019).


D. PRESENT VALUE

2. ANNUITIES

c. CALCULATING THE AMOUNT OF THE ANNUITY PAYMENT

After the first full paragraph on page 423 [in the concise, after thecarryover paragraph on page 242], insert the following text:

** In this example, notice that the amount that Brianna owed on her loanwent down with each payment. In this context, amortization refers topaying off a loan with regular payments, so that the amount owed at the endof each period drops during the loan’s lifetime. When the payment on a loandoes not cover the interest due for a period, the unpaid interest gets addedto the amount owed, and the loan balance increases from one period to thenext, a situation called negative amortization. The amount owed on theloan goes up because the borrower is not paying enough to cover the intereston the loan, let alone to repay any principal. For example, negativeamortization arises on most student loans until repayment begins becauseinterest typically accrues on each loan while the student remains enrolledin a qualified educational program or during the grace period before the firstrequired payment, but the borrower usually need not make any paymentsduring that period. In addition, when a recent graduate selects an income-based repayment option, the low, required minimum payments immediatelyafter graduation frequently do not offset the interest that accrues on the loaneach month, and the amount owed on the loan increases, often dramatically.Adjustable rate mortgages with low, introductory “teaser” rates can also leadto negative amortization when the minimum payment does not equal orexceed the interest charged during the period, which commonly occurs wheninterest rates jump suddenly, but the required monthly payment does notchange.

C H A P T E R IV

INTRODUCTION TO FINANCIAL

STATEMENT ANALYSIS AND

FINANCIAL RATIOS

C. THE BALANCE SHEET

2. ANALYTICAL TERMS AND RATIOS

a. WORKING CAPITAL

On page 453 [page 265 of the concise], after the second sentence inthe first paragraph under this heading, replace the rest of thatparagraph with the following:

**In 2018, The Wall Street Journal reported that publicly listed businessesaround the world held about $5.2 trillion in working capital. As interest ratesrise from near-zero levels globally, businesses increasingly are attempting toconvert excess working capital into cash so that they can repay loans andreduce interest expenses, fund expansion or acquisitions without the need toborrow additional funds, or distribute amounts to owners. To raise or toconserve cash, these businesses try to lower inventories by ordering andholding only needed materials and liquidating aged items, to collect accountsreceivable sooner by shortening extensions of credit and focusing on overduereceivables, or to work with suppliers to extend payment terms. According toa study that The Wall Street Journal referenced, companies that cut the timethat it took to convert working capital to cash by seven days increasedearnings by between one and two percent. External factors, such as therecent tariffs on imports, can hurt such strategies. See Nina Trentmann &Ezequiel Minaya, Firms Struggle to Free Cash Trapped on Balance Sheets,WALL. ST. J., Nov. 30, 2018, at B6; Tatyana Shumsky & Nina Trentmann,Putting the Squeeze on Working Capital, WALL ST. J., Aug. 22, 2017, at B5.As mentioned on page 134 of the Fifth Edition [page 125 of the concise], thesestrategies also boost operating cash flows on a one-time basis.

Importantly, a simple net figure for working capital does not tell theentire story. For example, if one company has $25,000,000 in current assetsand $20,000,000 in current liabilities, and another has $10,000,000 in currentassets and $5,000,000 in current liabilities, both have working capital of$5,000,000 but their financial conditions differ quite significantly. A ratiowould provide more instructive information. As we will see shortly,

53

54 CHAPTER IV INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS & FINANCIAL RATIOS

accountants and financial analysts have developed a ratio, the current ratio,which compares current liabilities to current assets.

c. NET BOOK VALUE

On page 457 [page 268 of the concise], after the second paragraphunder this heading, insert the following text:

** Book value typically does not reflect market value or fair value. Asshown at the bottom of Table 4-1 on page 458 [page 269 of the concise]Starbucks’ net book value on September 30, 2012 was $6.82 per share. OnSeptember 28, 2012, the last trading day in Starbucks’ 2012 fiscal year, ashare of Starbucks’ common stock closed at $50.71 per share, or more thanseven times its net book value. Because financial accounting does not treatall economic resources as assets or all obligations as liabilities, items likeinternally developed intellectual property, excellent management, customerloyalty, and potential litigation losses do not appear on the balance sheet. Incontrast, historical cost may overvalue assets that have dropped in value, butfor which an enterprise has not yet recognized such a decline, such as loansor accounts receivable that customers have stopped repaying. This situationarose frequently at financial institutions during the credit crisis in the late2000s and reoccurred at banks in Europe in early 2019 when investors feltthat the weakened economy and negative interest rates lowered the value ofloan portfolios and other assets. In addition, investors feared the banks hadomitted or understated their liabilities for money laundering scandals. As aresult, shares traded on stock exchanges at amounts below book value. See,e.g., Avantika Chilkoti, Europe’s Banks Face Triple Whammy, WALL ST. J.,Mar. 27, 2019, at A1.

D. THE MEASUREMENT OF INCOME

1. RESULTS OF OPERATIONS

a. THE INCOME STATEMENT

(1) Unusual or Nonrecurring Operating Items

On page 468, insert the following text after the carryover paragraphat the top of the page [after the first full paragraph on page 276 ofthe concise]:

** Two recent situations illustrate why lawyers must compare carefully anenterprise’s income statements for different years. First, legislation late in2017 cut the highest corporate tax rate in the United States from thirty-fivepercent to twenty-one percent starting in 2018, but also imposed a one-timetax on accumulated foreign profits that companies had not repatriated to theUnited States. As a result, some corporations recognized significant gains

CHAPTER IV INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS & FINANCIAL RATIOS 55

from the lowering of the tax rates on previously untaxed domestic income,while other corporations reported additional tax expense on unrepatriatedforeign profits. In addition, the thirty-five percent rate applied to incomeearned in 2017 and previous years, while the twenty-one percent rate appliesto 2018 and later years. As a result, some corporations saw increases in netincome in 2018 arising from the reduced tax rates and lower income taxexpense even though the company generated more income before taxes in2017. Similarly, some corporations reported significant period-to-periodgrowth in net income from 2017 to 2018 that they will have great difficultymatching in 2019. See, e.g., Michael Rapoport, Impact of Bank Tax-Cut BoostWill Wane, WALL ST. J., Jan. 14, 2019, at B10.

** Second, as described in detail on pages 106 to 107, infra, enterprisesmust now include changes in the market value of equity investments in netincome. In 2018, unrealized investment losses and a write-down at KraftHeinz Co. caused net profits at Warren Buffet’s Berkshire Hathaway Inc. todecline from $44.9 billion in 2017 to about $4 billion in 2018, while operatingincome rose from $14.5 billion in 2017 to a record $24.8 billion in 2018. SeeNicole Friedman, Big Kraft Investment Bites Berkshire, WALL ST. J., Feb. 25,2019, at B1.

(4) Discontinued Operations

On pages 472 to 474 [pages 280 to 281 of the concise], replace thisentire section with the following text:

The term “discontinued operations” refers to a distinct component of anenterprise that a reporting entity has designated as held for disposition; sold;otherwise transferred, such as by distribution to owners in a spinoff; orabandoned. A component comprises operations and cash flows that theenterprise can distinguish, both operationally and for financial reportingpurposes, from its other operations. A segment, reporting unit, subsidiary, orother asset group, such as a division, department, or consolidated jointventure or affiliate, can qualify as a component.

Under certain conditions, an enterprise must separately report theresults of any discontinued operations, net of any related income tax expenseor benefit, on the income statement, as well as in the operating section of thestatement of cash flows, once the enterprise has either designated thecomponent as held for sale, transferred it, or abandoned it. Before ASU No.2014-08, Presentation of Financial Statements (Topic 205) and Property,Plant, and Equipment (Topic 360): Reporting Discontinued Operations andDisclosures of Disposals of Components of an Entity, those rules appliedwhenever: (1) the disposition or sale eliminated, or would eliminate, thecomponent’s operations and cash flows from the entity’s ongoing operations,and (2) the enterprise would not have any significant continuing involvementin the component’s operations. As a result, the previous rules applied todisposals of small groups of assets that often recurred from year to year.


After the amendments in ASU No. 2014-08, which now apply to alldisposals or designations for sale during interim and annual periodsbeginning on or after December 31, 2015, enterprises must report suchevents in discontinued operations only if the disposal or designation for salerepresents a strategy shift that will have a major effect on theenterprise’s operations and financial results. Thus, the component’ssignificance, whether in financial magnitude or geographic scope, determinesif the disposal or designation for sale qualifies for presentation asdiscontinued operations. This new limitation enhances convergence with therules in IFRS 5, Non-current Assets Held for Sale and DiscontinuedOperations.

The separate listings for discontinued operations, which appear beforeany extraordinary items on the income statement and in the sections foroperating, investing and financial activities on the statement of cash flows,enable the reader to assess the results of continuing operations in the currentperiod and to compare those results to prior periods on a consistent basis. Asa practical matter, discontinued operations, if material, require an enterpriseto reclassify amounts previously included in income from continuingoperations and cash flows from the various activities in financial statementsfor prior years to the separate listing for discontinued operations in thosesame years for the purpose of presenting comparative financial statements.In the mid-2000s, more than 100 public companies incorrectly failed to reportcash flows from discontinued operations separately on their statements ofcash flows. See Steven Marcy, SEC Allows Cash Flow Correction WithoutFiling Formal Restatement, 38 Sec. Reg. & L. Rep. (BNA) 451 (Mar. 13, 2006).

Although an enterprise’s net income or loss and overall cash flows foreach year remain unchanged, the distinction between continuing operationsand discontinued operations, as well as any resulting reclassifications, canaffect contract drafting and interpretation. For example, and if material, ahypothetical Starbucks decision to discontinue a segment, such as itsChina/Asia Pacific operations, in fiscal 20X9 would require the company toreclassify the amounts shown in income from continuing operations, as wellas cash flows from operating, investing, and financing activities, during fiscalyears 20X7 and 20X8 to the categories for discontinued operations for 20X7and 20X8 in its 20X9 annual report.

This separate category for discontinued operations on the incomestatement will also contain any loss (or gain for a subsequent increase invalue) that the enterprise must recognize pursuant to the rules for theimpairment or disposal of long-lived assets, which we will discuss later inChapter IX, net of any applicable income tax effect. If the enterprise expectsa loss from a proposed sale, then pursuant to the doctrine of conservatism theenterprise must immediately include the estimated loss on the incomestatement under the heading for discontinued operations. By comparison, anenterprise cannot recognize future operating losses from these discontinuedoperations until they occur. If the enterprise expects a net gain on the sale,both the revenue recognition principle and conservatism require theenterprise to wait until it recognizes the income, which ordinarily occurs at


the actual disposal. Moreover, the enterprise must disclose the gain or lossrecognized on the disposal either on the face of the income statement or inthe notes to the financial statements.

Now that ASU No. 2014-08 applies, the Codification also requiresdisclosure of the pre-tax income attributable to the disposal of a significantpart of an enterprise that does not qualify for reporting as a discontinuedoperation. In addition, an enterprise now must present separately on thebalance sheet, for each comparative period when material, any assets andliabilities designated for sale or other disposal. Finally, the new rules requireadditional disclosures, including a reconciliation of the major classes of assetsand liabilities classified as held for sale, for the initial period in which theenterprise presents those items separately on the financial statements andfor all prior periods shown. See FASB ASC Subtopic 205-20 (codifyingACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS,Statement of Fin. Accounting Standards No. 144 (Fin. Accounting StandardsBd. 2001), as amended by PRESENTATION OF FINANCIAL STATEMENTS (TOPIC

205) AND PROPERTY, PLANT, AND EQUIPMENT (TOPIC 360): REPORTING

DISCONTINUED OPERATIONS AND DISPOSALS OF COMPONENTS OF AN ENTITY,Accounting Standards Update No. 2014-08).

(5) Extraordinary Items

On pages 474 to 477 [pages 281 to 283 of the concise], replace thiswhole section with the following text:

Until FASB issued ASU No. 2015-01, Income Statement–Extraordinaryand Unusual Items (Subtopic 225-20): Simplifying Income StatementPresentation by Eliminating the Concept of Extraordinary Items, GAAPrequired an entity to separately classify, present, and disclose extraordinaryevents and transactions. To meet the definition of extraordinary, an event ortransaction needed to qualify as both “unusual in nature” and “infrequent inoccurrence.” Effective no later than fiscal years beginning after December 15,2015, and interim periods within those years, but with an option for earlyadoption, ASU No. 2015-01 eliminated the concept of extraordinary itemsfrom GAAP. The new rules align the guidance in the Codification with IAS1, Presentation of Financial Statements, which previously prohibited thepresentation of extraordinary items in financial statements. Please keep inmind, however, that the previous rules can still apply in legal mattersinvolving accounting periods ending before the reporting enterprise adoptedthe new rules or their effective date. See generally MATTHEW J. BARRETT &DAVID R. HERWITZ, ACCOUNTING FOR LAWYERS (5th ed. 2015).

Even though events and conditions rarely qualified for treatment asextraordinary items under GAAP, preparers, auditors, and regulators oftenneeded to devote time and expend resources to decide whether thecircumstances satisfied the “unusual” and “infrequent” requirements.Ultimately, FASB decided to reduce the income statement’s complexity andcost while at least maintaining the usefulness of the information provided in


financial statements. In particular, the Codification retains the presentationand disclosure requirements summarized on pages 467 and 468 of the text[pages 275 and 276 of the concise] for any unusual or infrequent item thatmaterially affects the financial statements in a particular accounting period.When such an item or transaction occurs, (1) an enterprise can highlight theitem (a) as a separate line on the income statement, (b) in a parenthetical onthe income statement itself, or (c) in an explanatory note to the financialstatements, and (2) the federal securities laws may require a public companyto disclose information about a material unusual or nonrecurring item inMD&A.

b. PRO FORMA METRICS

(2) The Pitfalls

On page 481, insert the following text after the first full paragraph[on page 286 of the concise, insert the following text after thecarryover paragraph]:

Famed investor Warren Buffet has criticized the use of certain non-GAAP measures, especially when such metrics exclude amounts related tostock options, restricted shares, or other share-based compensation. In his2016 annual letter to Berkshire Hathaway shareholders, he wrote inpertinent part:

[I]t has become common for managers to tell their owners to ignorecertain expense items that are all too real. “Stock-basedcompensation” is the most egregious example. The very name saysit all: “compensation.” If compensation isn’t an expense, what is it?And, if real and recurring expenses don’t belong in the calculationof earnings, where in the world do they belong?

Letter from Warren E. Buffet to the Shareholders of Berkshire HathawayInc. at 16 (Feb. 27, 2016), available at www.berkshirehathaway.com/letters/2015ltr.pdf.

** In his 2019 annual letter to shareholders, Buffet specifically criticizedanother non-GAAP metric, adjusted EBITDA, as a measure that “redefines‘earnings’ to exclude a variety of all-too-real costs.” In addition to ignoringinterest expense, income taxes, depreciation, amortization, and share-basedcompensation, some companies also have excluded other big losses orexpenses, including write-downs and impairments, research anddevelopment expenses, marketing costs, corporate overhead, such as generaland administrative expenses, and restructuring costs, whether related toacquisitions or divestitures, from their non-GAAP operating results. Notably,Berkshire Hathaway owns about a twenty-seven percent interest in KraftHeinz Co., which reported more than $24.3 billion in adjusted EBITDAbeginning with its 2015 merger through the 2018 third quarter, but onlyabout $6 billion in cash flow from operations during that same period before


taking a $15.4 billion write-down on various assets, including goodwill andthe value of its Kraft and Oscar Mayer brands in the 2018 fourth quarter. See Letter from Warren E. Buffet to the Shareholders of Berkshire HathawayInc. at 4 (Feb. 23, 2019), available at https://www.berkshirehathaway.com/letters/2018ltr.pdf; see also Michael Rapoport, Kraft Heinz Tailored Resultsin Spotlight, WALL ST. J., Mar. 6, 2019, at B5; Annie Gasparro, Kraft Heinz’sPromise Turns Sour, WALL ST. J., Feb. 23, 2019, at B3.

** As other examples, both Uber Technologies Inc. and Lyft Inc. report non-GAAP metrics that ignore significant expenses and that the companiescontend better measure their financial performance. In addition to a $3billion operating loss during 2018, Uber reported $940 million in “coreplatform contribution profit, ” a measure that excludes unallocated costs suchas research for self-driving cars. Lyft recharacterized a $911 million lossduring 2018 as a $921 million “contribution” profit. See Rolfe Winkler, TechFirms’ Creativity Meets Investor Reality, WALL ST. J., May 15, 2019, at B1.

(3) Regulation G

On pages 484 and 485 [pages 287 and 288 of the concise, beginningwith the carryover paragraph on the bottom of page 287], replace theremainder of this section beginning with the first full paragraph onpage 484 with the following text:

After concerns about this two-tiered reporting system developed andcomplaints surfaced about different interpretations regarding non-GAAPmetrics in comment letters from the SEC staff to various registrants, theDivision of Corporation Finance published guidance in early 2010 to helppublic companies distinguish unlawful presentations from permissible non-GAAP disclosures. After updates in May 2016 and October 2017, theguidance in the Division’s Compliance and Disclosure Interpretations nowcautions against the following:

• Excluding normal, recurring, cash operating expenses;• Treating items inconsistently between periods;• Eliminating nonrecurring charges, while including nonrecurring

gains; • Substituting specially tailored revenue recognition rules; and• Giving “greater or equal prominence” to non-GAAP measures by:

• Providing a full income statement of non-GAAP measures;• Omitting comparable GAAP amounts from an earnings release

headline or caption that includes non-GAAP measures;• Presenting a non-GAAP measure before the most directly

comparable GAAP figure (including in an earnings releaseheadline or caption);

• Featuring a non-GAAP measure using a style of presentation(e.g., a bold or larger font) that emphasizes the non-GAAPmeasure over the comparable GAAP measure;


• Describing a non-GAAP measure as, for example, “recordperformance” or “exceptional” without at least an equallyprominent descriptive characterization of the comparable GAAPnumber; or

• Including discussion and analysis of a non-GAAP measurewithout a similar discussion and analysis of the comparableGAAP figure in a location with equal or greater prominence.

In addition, the guidance provides that the prohibition against designationsas “non-recurring, infrequent or unusual” arises from the description and notfrom the item’s nature. The staff’s interpretation continues: “The fact that aregistrant cannot describe a charge or gain as non-recurring, infrequent orunusual, however, does not mean that the registrant cannot adjust for thatcharge or gain. Registrants can make adjustments they believe areappropriate, subject to Regulation G and [Regulation S-K].” Staff of the Sec.& Exch. Comm’n, Non-GAAP Financial Measures (October 17, 2017),available at https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.

After the 2016 interpretation from the SEC’s staff updated the original2010 guidance, the use of non-GAAP measures by public companiesincreased; the gap between GAAP numbers and non-GAAP measures grewto the widest difference since 2008 and the financial crisis; and dozens ofcompanies enjoyed success in responding to comment letters from the SECstaff. The Wall Street Journal reported that for 2015 total GAAP earnings forcompanies in the S&P 500 fell twenty-five percent below their non-GAAPfigures, a level exceeded only in 2001, 2002, and 2008 in the aftermath of thedot-com and housing bubbles. The research firm Audit Analytics found thatninety-six percent of S&P 500 companies used a non-GAAP measure in theirfourth-quarter 2016 disclosures. Before the staff’s 2016 guidance, AuditAnalytics found that 202 companies, or forty percent of the S&P 500,displayed a non-GAAP measure before a comparable GAAP number in theirheadlines. Afterwards, only twenty-eight companies, or six percent of theS&P 500, used such a presentation. Another Audit Analytics study found thatsixty-nine percent of companies that responded to questions about non-GAAPmeasures in comment letters from the SEC staff in the year after the staff’s2016 guidance persuaded the staff that their adjusted numbers did notmislead investors. See Tatyana Shumsky, Firms Persuade SEC on ProfitMetric, WALL ST. J., May 23, 2017, at B6; Audit Analytics, A Look at Non-GAAP Reporting after New SEC Guidance (Jan.5, 2017), available atwww.auditanalytics.com/blog/a-look-at-non-gaap-reporting-after-new-sec-guidance/; Justin Lahart, S&P 500 Earnings: Far Worse Than Advertised,WALL ST. J., Feb. 25, 2016, at C1.

In October 2017, the SEC’s new chairperson publicly recognized thatnon-GAAP metrics can provide valuable insights and offer both backward-and forward-looking information, but the chair also warned that theCommission will remain vigilant in scrutinizing non-GAAP financialmeasures. See Steve Burkholder, SEC Still Probing Alternative Performance


Measures Use: Chairman, Corp. L. & Accountability Rep. (Bloomberg BNA),Oct. 30, 2017.

In a creative approach, companies in the video-game industry havesought to work around the SEC staff’s interpretations by providing “do-it-yourself” instructions and the numbers necessary to convert GAAP resultsto various metrics that the firms previously used to report revenues andearnings. Without calculating the non-GAAP numbers, these companies haveexplained how they compute them from the financial statements that theyfile with the SEC. At least so far, the approach appears to have enabledadjusted numbers to reach the public without drawing comment from theSEC staff. See Neil Weinberg, Want Take-Two Interactive’s AdjustedEarnings? You Do the Math, Corp. L. & Accountability Rep. (BloombergBNA), May 24, 2017.

So far, the SEC has largely limited efforts to encourage compliance withRegulation G to comment letters from the SEC staff and cautionary remarksat various conferences. The SEC, however, has brought a few enforcementactions. Late in 2009, the SEC brought the first enforcement action underRegulation G against SafeNet, Inc. (“SafeNet”). In a civil injunction actionagainst the company, its former CEO, its former CFO, and three formeraccountants, all of the defendants accepted the SEC’s allegations that at theCFO’s direction, SafeNet: (i) recorded improper accounting adjustments tovarious expenses, (ii) incorrectly classified ordinary operating expenses asnon-recurring expenses to integrate acquired businesses into currentoperations, and (iii) represented to investors that the company’s non-GAAPearnings excluded certain non-recurring expenses, when, in fact, thecompany had misclassified and excluded a significant amount of ordinaryoperating expenses from its non-GAAP earnings in an effort to meet orexceed quarterly targets. In addition to a permanent injunction, SafeNetagreed to pay a $1 million civil penalty. The former officers and accountantsconsented to disgorgement, civil penalties, officer and director bars, andadministrative orders suspending them from appearing or practicing beforethe SEC as accountants. See SEC v. SafeNet, Inc., Accounting and AuditingEnforcement Release No. 3068 (Nov. 12, 2009), https://www.sec.gov/litigation/ litreleases/2009/lr21290.htm.

** More recently, the SEC has brought at least three other enforcementactions involving the misuse of non-GAAP measures as follows:

• In 2016, the SEC charged the former CFO and the former chiefaccounting officer (“CAO”) of American Realty Capital Properties, areal estate investment trust, with overstating the company’sfinancial performance by fraudulently manipulating the calculationof adjusted funds from operations, a non-GAAP metric widely usedin the industry. The CAO later pled guilty to the charges. See In reMcAlister, Accounting and Auditing Enforcement Release No.3889(Aug. 15, 2017), https://www.sec.gov/litigation/admin/2017/34-81397.pdf; Press Release, Sec. & Exch. Comm’n, Executives Charged With


Inflating Performance of Real Estate Investment Trust (Sept. 8,2016), https://www.sec.gov/news/pressrelease/2016-180.html.

• In 2017, marketing company MDC Partners, Inc. agreed to pay a$1.5 million civil penalty to settle charges that the company failed todisclose personal benefits that the company paid on its CEO’s behalfand improperly used a non-GAAP metric called “organic revenuegrowth.” The number originally excluded the effects of acquisitionsand foreign currency rate changes, but the company incorporated athird item, which resulted in better “organic revenue growth”results, without disclosing the change. In addition, MDC Partnersfailed to give GAAP numbers equal or greater prominence to non-GAAP metrics in its earnings releases. See In re MDC Partners, Inc.,Accounting and Auditing Enforcement Release No. 3849 (Jan. 18,2017), https://www.sec.gov/litigation/admin/2017/33-10283.pdf.

• In 2018, home and business security company ADT Inc. agreed tosettle a cease-and-desist administrative proceeding and to pay a$1000,000 civil penalty to resolve charges that the companyimproperly disclosed non-GAAP financial information in twoearnings releases by failing to afford equal or greater prominence tocomparable GAAP measures. In the headlines of the underlying 2018earnings releases, ADT presented its adjusted EBITDA and the increase year-over-year without mentioning the company’s netincome or loss, the comparable GAAP financial measure. The secondrelease contained nine bullet points in the highlights section,including three that referenced improvements in adjusted EBITDA,adjusted net income, and adjusted net income per share, withoutmentioning the comparable GAAP measures in the highlightssection. Not until the second full paragraph did the company reportthat its net loss had increased from $141 million to $157 millionyear-over-year. See In re ADT Inc., Accounting and AuditingEnforcement Release No. 4009 (Dec. 26, 2018), https://www.sec.gov/litigation/admin/2018/34-84956.pdf.

In essence under Regulation G, non-GAAP metrics cannot mislead andmust supplement GAAP amounts, rather than supplant them by attainingequal or greater prominence. Moreover, registrants must label non-GAAPmeasures appropriately, explain why the presentation provides usefulinformation, and reconcile such metrics to the most directly comparableGAAP number. As mentioned during the discussion of the SEC andinternational accounting principles on page 12, supra, in December 2016 theSEC’s Chief Accountant indicated that the Commission had been reviewinga proposal from his predecessor that would allow domestic companies tosupplement their financial results with numbers under IFRS withoutreconciliation to GAAP. As a result, we should not be surprised if non-GAAPmetrics continue to grow in importance.

When a business combination, such as a merger or acquisition, occursduring a reporting period, both Regulation S-X and FASB ASC Topic 805,


Business Combinations, require a public entity to disclose certain pro formainformation to show what the entity’s financial statements would look like ifthe combination had occurred at the beginning of the first annual accountingperiod presented in the financial statements. See FASB ASC ¶ 805-10-50-2(h). After a recent update to the Codification, entities must now describe thenature and amount of any material, nonrecurring pro forma adjustmentsdirectly attributable to a business combination. Id. at -2(h)(4). Because theCodification requires such data and disclosures, any resulting pro formanumbers technically do not qualify as “non-GAAP.” As a consequence,Regulation G contains an important exception for such disclosures. Any suchdisclosures, however, remain subject to SEC regulations regarding mergersand business combinations that predate SOx.

2. RATIO ANALYSIS

a. COVERAGE RATIOS

(3) Dividend Coverage, Dividend-Payout, and Dividend Yield

On page 494 [page 296 of the concise edition], replace the secondsentence in the second paragraph and accompanying citation[citation omitted in the concise edition] with the following text andcitations:

The Wall Street Journal has reported that although the dividend-payout ratiosurged after the financial crisis in the late 2000s to a high of 38.19 percent,even that level remains significantly below the more than fifty percenthistorical payout since 1925. As interest rates dropped to historically lowlevels after the crisis, dividend-paying shares became attractive to investors,especially retirees. When interest rates return to more normal yields, mostobservers expect higher dividends will become a less attractive strategy forpublic companies, which seem likely to increase share buybacks, the typicallypreferred method for returning corporate earnings to shareholders. See MikeBird, Dividend Frenzy Weakens, Wall St. J., Nov. 3, 2016, at C4; MaxwellMurphy, Wal-Mart Joins February Dividend Boosters, Record Looms, CFOJ., Feb. 21, 2013, http://blogs.wsj.com/cfo/2013/02/21/wal-mart-joins-february-dividend-boosters-record-looms/.

On page 494 [page 296 of the concise edition], replace the secondsentence in the third paragraph with the following text:

As of early July 2018, companies in the S&P 500 index had paid dividendsover the previous twelve months that equaled a 1.89 percent yield, a figurethat approximated the index’s twenty-year median, but down from 2.01percent a year earlier.


b. PROFITABILITY RATIOS

(1) Earnings Per Share

On page 495[page 297 of the concise], replace the third paragraph inthis section with the following text:

When evaluating a corporation’s earnings per share, lawyers shouldconsider adding another step to their analysis by going beyond the standardper-share amounts reported to the nearest penny on the face of the incomestatement and computing the amount to the tenth of a cent. An academic study that examined more than 950,000 quarterly earnings reports for morethan 25,000 companies from 1980 to 2013 (and that the researchers lastupdated in 2014) found that when earnings per share figures were calculateddown to a tenth of a cent, the number “4” appeared less frequently in thetenths place than any other digit and only 8.6 percent of the time. Thenumbers “2” and “3” also appeared less frequently than expected. This effect,which the authors dubbed “quadrophobia,” suggests that companies nudgeearnings up until at least a “5” appears in the tenths place, which then letsthem round earnings per share up to the next highest cent. Such a practicecan enable the company to meet analyst and investor expectations. Investorsoften aggressively purchase shares in companies that beat earningsestimates, even by a penny, and dump shares of companies that fall short.See Dave Michaels, Missing “4” in Earnings Raises SEC’s Suspicions, WALL

ST. J., June 23, 2018, at B1.

During the trial of former Enron executives Jeffrey Skilling and KennethLay, the company’s head of investor-relations testified that Skilling managedEnron’s earnings per share to meet or exceed Wall Street expectations in aneffort to avoid a significant drop in Enron’s stock price and that Lay at leastacquiesced in the practice. In 2010, The Wall Street Journal reported thatcomputer maker Dell Inc. did not report earnings per share with a “4" in thetenths place between its IPO in 1988 and 2006, which could have happenedby chance only once in 2,500 occurrences. That same year, Dell paid $100million to settle SEC charges that the company manipulated quarterlyresults during fiscal years from 2002 to 2005. In 2018, The Wall StreetJournal reported that enforcement officials at the SEC were investigatingwhether the conspicuous absence of the number “4” in quarterly reportsmeant that companies had improperly rounded their earnings up to the nexthighest cent and had sent inquiries to at least ten companies. See SEC v. DellInc., Accounting and Auditing Enforcement Release No. 3156 (July 22, 2010),http://www.sec.gov/litigation/litreleases/2010/lr21599.htm; see also GaryMcWilliams & Kara Scannell, Profit Tweaking May Lose Favor After EnronTrial, WALL ST. J., Feb. 16, 2006, at C1; John R. Emshwiller & GaryMcWilliams, Enron Witness Faults Profit Reports, WALL ST. J., Feb. 2, 2006,at C6.


(2) Price-Earnings Ratio

On page 498 [page 299 of the concise], add the following text at theend of this section:

**When doing such comparisons, be sure to compare “apples to apples”because multiple P/E variations exist, including ratios based upon: the lastfiscal year’s net income, income from operations, or income from continuingoperations; the last twelve months’ earnings; the expected earnings for thecurrent fiscal year; the expected earnings for the next twelve months; theexpected earnings for a future fiscal year; and average earnings over somespecified period. In early 2019, The Wall Street Journal reported that theS&P 500 had traded at a five-year average of 16.4 times projected nexttwelve months’ earnings, more than ten percent above the ten-year averageof 14.6 times. See Akane Otani, Reduced Forecasts Fan Fears for Stocks,WALL ST. J., Jan. 14, 2019, at A1; Jason Zweig, When Lower P/E Ratios ofFunds Mean Nothing, WALL ST. J., Aug. 12, 2017, at B1.

c. ACTIVITY RATIOS

(3) Asset Turnover

On page 507 [omitted from the concise], replace the first fullsentence on the top of the page to correct the erroneous use of thefigure for the receivables turnover ratio rather the appropriatenumber for the inventory turnover ratio, which in turn led to anincorrect sales to inventory ratio, to read as follows:

If we divide Starbucks’ 5.3 times inventory turnover ratio by its .552 cost ofgoods, including occupancy costs, for each dollar of sales ratio, we canextrapolate a sales to inventory ratio of 9.6 times (5.3 times/.552).

F. MANAGEMENT’S DISCUSSION AND ANALYSIS

2. COMPLIANCE WITH GAAP ALONE DOES NOT SATISFY

MD&A REQUIREMENTS

On page 532, insert the following text at the end of Note 2 [omittedfrom the concise]:

Dating back to at least 2013, so-called “segment reporting” has attractedincreased attention from the SEC staff, which has repeatedly warned aboutinadequate disclosures regarding business segments, especially from one-segment reporting. In 2016, the SEC brought cease-and-desist proceedingsagainst PowerSecure International, Inc. for failing to follow U.S. GAAPregarding segment reporting. Without admitting or denying the civil charges,PowerSecure agreed to pay a $470,000 fine and consented to an order that


found that the company “failed to accurately identify and report its segments[and to] disclose segment level financial results at a sufficientlydisaggregated level” from 2012 to 2014. Before PowerSecure changed itssegment reporting disclosure to include three segments in the Form 10-Q forthe second quarter in 2014, the company previously reported only onesegment. The larger the business, the more skeptically the businesscommunity and the SEC view single-segment reporting. In fact, PowerSecureshould have identified seven operating segments. Although GAAP allowsenterprises to aggregate operating segments into reporting segments, evenPowerSecure’s 2015 Form 10-K disclosed four reportable segments withoutany substantive changes in the business or the information provided to theboard of directors. Given the inadequate disclosures, investors could notreview profitability metrics for the various reporting segments. In addition,PowerSecure tested for goodwill impairment at a higher level than GAAPrequired, which easily could have prevented the company from recognizingan impairment loss. See In re PowerSecure Int’l, Inc., Accounting andAuditing Enforcement Release No. 3822 (Nov. 7, 2016), https://www.sec.gov/litigation/admin/2016/34-79256.pdf; see also Steve Burkholder, InvestorsWelcome Effort for More Information on Company Segments, Corp. L. &Accountability Rep. (Bloomberg BNA), Sept. 22, 2017; Steve Burkholder,Company-Segment Reporting Is Top SEC Concern, Corp. L. & AccountabilityRep. (Bloomberg BNA), Nov. 20, 2015; Steven Marcy, SEC Staff CommentLetters Probably Will Continue to Focus on MD&A in 2014, 12 Corp. L. &Accountability Rep. (Bloomberg BNA) 94 (Jan. 24, 2014).

On page 534, insert the following text after the first full paragraph[after the carryover paragraph at the top of page 323 of the concise]:

As part of Bank of America Corp.’s $16.65 billion global settlement withthe U.S. Department of Justice in 2014 to resolve various investigationsarising from the financial crisis, the bank agreed to pay a $20 million civilpenalty to the SEC for inadequate MD&A disclosures in the company’s Form10-Qs for the second and third quarters of 2009. In the SEC’s cease-and-desist proceedings, the bank admitted wrongdoing in failing to discloseknown uncertainties regarding increased costs arising from the bank’sexposure to repurchase claims from Fannie Mae and certain insurersstemming from the sale of more than $2 trillion in residential mortgageloans. See In re Bank of Am. Corp., Exchange Act Release No. 72,888(Aug. 21, 2014), https://www.sec.gov/litigation/admin/2014/34-72888.pdf. Please also note the increase in the severity of sanctions for inadequateMD&A disclosures, which started with an agreement to establish internalMD&A procedures in the Caterpillar proceeding; progressed to a $1 millionpenalty, along with a commitment to retain an independent auditor toconduct an examination of such procedures in the Sony civil action; andjumped to a $20 million civil penalty and an admission of wrongdoing in theBank of America settlement.


3. ENFORCEMENT ISSUES ARISING FROM LIQUIDITY PROBLEMS

On page 542, add the following new note [on page 325 of the concise,insert the following discussion as new text before the Problems]:

6. Distinct from the MD&A requirements that apply only to publiccompanies, financial reporting under GAAP presumes that the reportingorganization will continue to operate as a going concern. Until ASU No. 2014-15, Presentation of Financial Statements–Going Concern (Subtopic 205-40):Disclosure of Uncertainties about an Entity’s Ability to Continue as a GoingConcern, the Codification did not offer any guidance about management’sresponsibility to assess or disclose in the notes to the financial statementsany adverse conditions or events that raise substantial doubt about anorganization’s ability to continue as a going concern. After the financial crisisin the late 2000s, users of financial statements expressed concerns about thelack of going concern opinions that would have warned about potentialbusiness failures and bankruptcies. Effective for annual periods ending afterDecember 15, 2016, as well as interim periods thereafter, Subtopic 205-40now requires an organization’s management to evaluate whether anyconditions or events, considered in the aggregate, raise substantial doubtabout the organization’s ability to continue as a going concern for a period ofone year after the organization issues the financial statements. If substantialdoubt exists, the Codification requires certain disclosures in the notes to thefinancial statements. See FASB ASC Subtopic 205-40. When anorganization’s liquidation becomes imminent, the Codification requires theorganization to use the liquidation basis of accounting under Subtopic 205-30,Presentation of Financial Statements–Liquidation Basis of Accounting.

In March 2017, Sears Holdings Corp. (“SHC”), the parent of Sears andKmart, became the first large, public company to disclose “substantial doubt”about its ability to continue as a going concern. Management furtherexpressed its belief that certain expected cost savings, potential asset sales,and additional borrowing or refinancing would probably mitigate thesubstantial doubt. Significantly, Deloitte & Touche LLP, the company’sindependent auditor, issued an unqualified opinion on SHC’s financialstatements for the most recent fiscal years thru January 28, 2017, and didnot add an explanatory paragraph expressing doubt about SHC’s ability tosatisfy its obligations. That omission presumably indicated that SHC’smanagement satisfied Deloitte that the planned responses alleviated thesubstantial doubt. See Steve Burkholder, Sears ‘Going Concern’ Warning IsNew Accounting Rules’ First Test, Corp. L. & Accountability Rep. (BloombergBNA), Mar. 28, 2017; Anne Steele, Sears Stock Stumbles After Going-ConcernWarning, WALL ST. J., Mar. 23, 2017, at B1.


G. THE FUTURE OF FINANCIAL AND NON-FINANCIAL

REPORTING

On page 543 [page 326 of the concise], at the end of the firstparagraph in this section, insert the following text:

FASB has also begun to consider whether the balance sheet should includemore intangible assets, including research and development. A recent studyfound that in 2015 intangibles accounted for an estimated eighty-four percentof the market value of Fortune 500 companies, compared to only seventeenpercent in 1975. See Denise Lugo, Financial Reporting Distorts Value ofIntangible Assets, Corp. L. & Accountability Rep. (Bloomberg BNA), Aug. 10,2016; see also Vipal Monga, The Big Mystery: What’s Big Data Really Worth,WALL ST. J., Oct. 13, 2014, at B1.

On pages 543-544 [omitted from the concise], starting with the thirdparagraph in the middle of page 543, replace the next threeparagraphs with the following text:

During the project’s second phase, FASB and IASB published twochapters of a revised conceptual framework on the objective of generalpurpose financial reporting and the qualitative characteristics for usefulfinancial information. These chapters now form part of FASB’s currentconceptual framework. Late in 2010, the Boards suspended work on the jointconceptual framework until they could complete four other, higher priorityconvergence projects.

** In early 2014 and after consultation with the other Board members,FASB’s Chairman restored the conceptual framework project to FASB’sresearch agenda, announcing that FASB would no longer conduct the projectwith IASB. The FASB project seeks to develop an improved conceptualframework for principles-based, internally consistent accounting standardsthat furnish capital providers the information they need for soundinvestment decisions. Within the overall project, FASB has completed workon a disclosure framework and has been redeliberating an exposure draft onpresentation. In addition, FASB has begun work on elements andmeasurement. Two other topics remain inactive: recognition and reportingentity. Interested readers can access updates on the overall project via https://www.fasb.org/jsp/FASB/Page/TechnicalAgendaPage&cid=1175805470156# tab_1175805471232, which contains links to the updates on thevarious topics currently on the Board’s technical agenda.

** To guide both the Board and reporting entities in an effort to producemore effective, better coordinated, and fewer redundant disclosures in thenotes to financial statements, FASB adopted changes to its conceptualframework in 2018. Investors had expressed concerns about disclosureineffectiveness and overload. Preparers had complained about cost. Thedisclosure framework project encompassed two components: the Board’sdecision process in establishing disclosure requirements and the reportingenterprise’s decision process in exercising appropriate discretion. The first


component sets forth principles to help the Board identify relevantinformation for both annual and interim reporting and establish limits onwhat information should appear in the notes to financial statements. Mostsignificantly, the conceptual framework concludes that the Board generallyshould not require enterprises to disclose forward looking information, suchas forecasts, predictions, and expectations in the notes. In addition, the Boardmust assess whether the potential benefits from requiring the specificinformation justify the associated costs, including whether the enterprisemust provide the same information in another context. The secondcomponent seeks to empower a reporting enterprise to exercise appropriatediscretion when preparing disclosures and clarifies that the enterprise andits auditor may consider materiality when evaluating disclosurerequirements. At the same time that FASB amended the conceptualframework, the Board issued two ASUs that added relevant disclosurerequirements regarding fair value measurements and defined benefit pensionor other post retirement plans, clarified others, and eliminated severalrelated to those topics that did not survive a cost versus benefit analysis.FASB hopes that a sharper focus on the most important information willresult in less volume and reduce costs. As part of the disclosure frameworkproject, the Board continues to review disclosures regarding income taxes,inventory, and interim reporting and plans to review disclosures related toother current or future projects, including several topics on its researchagenda. Interested readers can access updates on these projects via https://www.fasb.org/jsp/FASB/Page/TechnicalAgendaPage&cid=1175805470156.

In addition and perhaps of more fundamental concern, critics of thecurrent model increasingly object to excess focus on short-term performanceand call for enterprises to reveal indicators that management tracks on aregular basis to assess the business’s long-term performance andsustainability, including non-financial metrics such as environmentalstewardship and workforce traits. On the financial side, enterprises coulddisclose key trends in operating or performance data, information aboutmarket share, new products, revenue per transaction, revenue per employee,order backlogs, customer-cancellation rates, costs per unit, customeracquisition costs, customer satisfaction, customer loyalty-card membership,and intangible assets, especially those intangibles not currently included infinancial statements. From a non-financial standpoint, an enterprise mightdiscuss its governance, strategy, opportunities, risks, performance andprospects in the context of its external environment and provide forward-looking information about how those ingredients will lead to the value in theshort, medium, and long terms. See Steve Burkholder, ‘Integrated Reporting’Attracts More Companies World-Wide, Corp. L. & Accountability Rep.(Bloomberg BNA), Mar. 14, 2017. Ultimately, securities regulators, stockexchanges, or accounting rule-makers may develop a framework regardingthe types of supplemental and non-financial information that enterprisesshould provide to investors. In the meantime, however, leadership in thisarea will likely come from individual companies and industries that providevoluntary disclosures, potentially within MD&A.


** If public companies disclose key performance indicators, not surprisinglythe SEC expects the disclosures to present the information accurately,consistently, and without otherwise misleading investors. The SEC hasbrought enforcement actions against companies that inflate or manipulatesuch information. See, e.g., In re KBR, Inc., Accounting and AuditingEnforcement Release No. 3946 (July 2, 2018) (imposing a $2.5 million civilpenalty against a company that inflated work in backlog attributable to “firmorders”), https://www.sec.gov/litigation/ admin/2018/33-10516.pdf; In reConstant Contact, Inc., Securities Exchange Act Release No. 83,377 (June 5,2018) (levying an $8 million fine for including customers who received a freemonth of service after calling to cancel their subscription in the last monthin the quarter in the number of unique paying customers),https://www.sec.gov/ litigation/admin/2018/33-10504.pdf. On pages 545 and 546 [pages 327 and 328 of the concise], startingwith the carryover paragraph at the bottom of page 545 [the secondfull paragraph on page 327], replace the rest of this section with thefollowing text:

After a successful voluntary program that allowed public companies tofile financial reports using eXtensible Business Reporting Language(“XBRL”) that makes financial data interactive, the SEC issued a final rulein 2009 that obligates public companies to provide their financial statementsto the agency and on their corporate websites in interactive data formatusing XBRL. When preparers accurately “tag” various kinds of information,this computer language allows users to retrieve and efficiently analyze datafound in financial reports. The SEC announced grace and amnesty periods,which have now expired, for any tagging mistakes during the first twenty-four months that the XBRL requirements applied.

The SEC believed that XBRL would make financial data more useful toinvestors because the technology allows them to download the informationfrom the financial statements directly into spreadsheets, analyze it usingcommercial off-the-shelf software, and use the information within investmentmodels in other software formats. Using XBRL, for example, could enableusers to compare financial results under U.S. GAAP and IFRS. As anadditional benefit, XBRL reporting could help public companies automateregulatory filings and business information processing. Such automationmight increase the speed and accuracy of financial disclosures, reducecompliance costs, and provide new information to management to analyzeoperations. Finally, the data tags could assist the SEC in its enforcementefforts. The agency’s Division of Economic and Risk Analysis, through itsOffice of Research and Data Services, has developed a Corporate Issuer RiskAssessment program designed to detect unusual patterns in financialstatements and potential accounting fraud, which seeks to improve on anearlier Accounting Quality Model.

Critics, however, have complained that the actual benefits from XBRLreporting have not exceeded the costs necessary to tag the data in thefinancial statements and related notes. In late 2012, a Columbia Business


School study reported responses showing that less than ten percent of inves-tors and analysts surveyed actually used XBRL-tagged data. See Trevor S.Harris & Suzanne Morsfield, An Evaluation of the Current State and Futureof XBRL and Interactive Data for Investors and Analysts 21 (Dec. 2012),available via https://academiccommons.columbia.edu/catalog/ac:161038.

In June 2016, the SEC issued an order that allows public companies touse “Inline XBRL” to file required financial statement data with the agencythrough March 2020. That format embeds the XBRL data directly into aHyperText Markup Language (HTML) document, which eliminates the needfor a separate attachment for the data. As a result, public companies and theSEC staff can focus on a single document, which alleviates the need tocompare a text document to a data file. Consequently, the new format shouldreduce the costs to prepare filings and improve data quality, which in turnshould increase the use of XBRL data. In addition, the SEC has proposed torequire the use of the Inline XBRL format for all financial statementsincluded in periodic filings with the agency. Finally, the technology industryhas begun a lobbying campaign in support of pending legislation that wouldrequire all eight major financial regulatory agencies in the United States touse standardized data, specifically XBRL, to collect electronically allregulatory filings under existing securities, commodities, and banking laws. See Order Granting Limited and Conditional Exemption From ComplianceWith Interactive Data File Exhibit Requirement to Facilitate Inline Filing ofTagged Financial Data, Exchange Act Release No. 78,041, 81 Fed. Reg.39,741 (June 13, 2016); Inline XBRL Filing of Tagged Data, Securities ActRelease No. 10,323, Exchange Act Release No. 80,133, Investment CompanyAct Release No. 32,518, 82 Fed. Reg. 14,282 (Mar. 1, 2017); see also DeniseLugo, Push Underway to Require U.S. Regulatory Filings in XBRL, 48 Sec.Reg. & L. Rep. (Bloomberg BNA) 1799 (Sept. 5, 2016).

In 2010, FASB and FAF, its parent organization, assumed ongoingdevelopment and maintenance responsibilities for the [U.S.] GAAP FinancialReporting Taxonomy (“UGT”), a task that contemplates a new UGT eachyear. In March 2019, FASB announced that the SEC had accepted the 2019UGT, as well as the 2019 SEC Reporting Taxonomy (“SRT”), which markedthe SRT’s debut. The SRT contains elements necessary to meet SECrequirements for financial schedules and disclosures about oil- and gas-producing activities, as well as elements that filers commonly use, but thatGAAP does not require. Each UGT organizes and standardizes thousands ofelements that public companies can use to identify and tag pieces of data intheir financial reports. The number of elements changes each year as newversions adopt tags that users suggest, add tags to reflect new rules in theCodification, and remove elements redundant or no longer necessary undercurrent GAAP. Because the SEC’s website maintains only the current-yeartaxonomy and the immediately prior version, the agency’s staff stronglyencourages public companies to use the most recently approved UGT toaccess all the up-to-date tags relating to new accounting standards and otherimprovements. Please also note that the Codification itself now provides a listof all XBRL elements that contain an electronic link to each paragraph in the


Codification. For additional information regarding FASB’s efforts to improveUGT and SRT, interested readers can select a Quicklink for “TAXONOMY(XBRL)” on the right side or near the bottom of FASB’s home page, or godirectly to http://www.fasb.org/jsp/FASB/Page/LandingPage&cid=1176164131053.

On the international front, in March 2019 the IFRS Foundationpublished IFRS Taxonomy 2019, which translates both IFRS and IFRS forSMEs into XBRL. The 2019 taxonomy also contains XBRL tags for all IFRSdisclosure requirements. Interested readers can access IFRS Taxonomy 2019via http://www.ifrs.org/issued-standards/ifrs-taxonomy/ifrs-taxonomy-2019/.

The SEC has also published recent IFRS taxonomies on theCommission’s website. Beginning with a foreign private issuer’s first annualreport for a fiscal period ending on or after December 15, 2017, the SECrequires such issuers to submit their financial statements in XBRL format.It these issues fail to do so, they risk losing the ability to access the U.S.public capital markets quickly during the next year by using the shelfregistration process. See IFRS Taxonomy for Foreign Private Issuers ThatPrepare Their Financial Statements in Accordance with InternationalFinancial Reporting Standards as Issued by the International AccountingStandards Board, Securities Act Release No. 10,320, Exchange Act ReleaseNo. 80,128, 82 Fed. Reg. 12,641 (Mar. 1, 2017); see also Denise Lugo, SECElectronic Tagging Requirement for Foreign Companies Begins, Corp. L. &Accountability Rep. (Bloomberg BNA), Mar. 23, 2018.

C H A P T E R V

LEGAL ISSUES INVOLVING

SHAREHOLDERS’ EQUITY AND THE

BALANCE SHEET

C. DISTRIBUTIONS AND LEGAL RESTRICTIONS

1. DIVIDENDS AND REDEMPTIONS

On pages 555 and 556 [omitted from the concise], replace thecarryover paragraph that starts on page 555 and the first fullparagraph on page 556 with the following text:

** The 2003 Tax Act and subsequent legislation reduced the statutoryincome tax rates on individuals for both long-term capital gains andqualifying dividends to no more than fifteen percent during tax years 2003to 2012. The American Taxpayer Relief Act of 2012 increased the maximumstatutory income tax rates on long term capital gains and qualifyingdividends received after 2012 to twenty percent. After the so-called Tax Cutsand Jobs Act of 2017, a statutory thirty-seven percent income tax ratepotentially applies to ordinary income, including short-term capital gains, inthe highest tax brackets. In addition, a provision from the Affordable CareAct imposes an additional 3.8 percent tax on net investment income, whichincludes both dividends and all capital gains. This net investment income taxcan raise the highest statutory rates to 23.8 percent on qualifying dividendsand long-term capital gains and 40.8 percent on short-term capital gains.Although redemptions will still allow shareholders to decide when they wantto recognize income and enable them to use their cost to acquire theredeemed shares as an offset to the proceeds from the redemption, thesechanges to the Internal Revenue Code have eliminated the rate differentialbetween income from qualified dividends and long-term capital gains, whileretaining the preferential rate that distributions enjoy relative to ordinaryincome, including short-term capital gains.

** Public companies have responded to these changes in the tax laws byincreasing the amounts returned to shareholders via dividends and sharerepurchases. Between 2007 and 2016, companies in the S&P 500 indexdistributed $7 trillion to shareholders, which represented ninety-six percentof total net income, largely via repurchases. As interest rates have droppedto record lows, dividend-paying companies, especially those that increasedtheir dividends regularly, saw their stock prices soar. In 2018, every quarter

73

74 CHAPTER V LEGAL ISSUES INVOLVING SHAREHOLDERS’ EQUITY AND THE BALANCE SHEET

set a new record for buybacks by S&P 500 companies. During the year, thosefirms, fueled by the 2017 tax overhaul, repurchased a record $770 billion inshares, which smashed the previous $588 billion high set in 2015. The recordrepurchases unleased an intense debate over how they affect the broadereconomy with critics contending that the buybacks enriched shareholdersand executives rather than funding capital improvements or raises forworkers that would have boosted economic growth. See, e.g., Jessica Menton,Volatility Unlikely to Derail Buybacks, WALL ST. J., May 17, 2019, at A1;James Mackintosh, Buybacks Aren’t What is Ailing Capitalism, WALL ST. J.,Feb. 11, 2019, at B9; Gabriel T. Rubin & Michael Wursthorn, Democrats TakeAim at Stock Buybacks, WALL ST. J., Feb. 5, 2019, at A2; Jesse M. Fried &Charles C.Y. Wang, The Real Problem With Stock Buybacks, Wall St. J.,July 9, 2018, at R1.

** Starbucks, like numerous other public companies, has initiated regulardividends, raised its dividend, and increased its share buybacks. In March2010, Starbucks announced that its board of directors had approved an initial$0.05 per share quarterly cash dividend, as adjusted for the Company’s mostrecent stock split. About three years later and following several dividendincreases, Starbucks announced that its board of directors had raised thetarget dividend payout ratio to 35-45 percent. In June 2018, the boardboosted the quarterly cash dividend to $0.36 per share, a twenty percentincrease over the previous per share amount, and Starbucks announced acommitment to return $25 billion to shareholders through fiscal year 2020via dividends and share repurchases.

2. STOCK DIVIDENDS AND STOCK SPLITS

On page 558 [omitted from the concise], replace the carryoverparagraph at the bottom of the page with the following text:

Now that individual investors no longer dominate stock markets, publiccompanies increasingly aspire for their shares to trade at high prices,sometimes above $1,000 per share. Moreover, experts say a stock split costsa company at least a couple hundred thousand dollars. Thus, stock splitshave occurred much less frequently since about 2000. The Wall StreetJournal has reported that only six companies in the S&P 500 index splittheir shares in 2016, down from about ten times that number and sometimestriple digits during the bull markets in the 1980s and 1990s. Both Google Inc.and Apple Inc., however, essentially split their shares in 2014. As mentionedon page 2, supra, Google distributed a third class of nonvoting shares toexiting shareholders on a share-for-share basis prior to its reorganization.Apple, in turn, completed an unusually large seven-for-one stock split in asuccessful effort to enhance the company’s attractiveness for addition to theDow Jones Industrial Average. See Erik Holm & Ben Eisen, Letting StockPrices Soar, WALL ST. J., May 27, 2017; Daisuke Wakabayashi, Apple BoostsBuyback, Splits Stock to Reward Investors, Apr. 24, 2014, WALL ST. J., at A1;John Kell, S&P Indexes Change Plan on Handling Google’s Stock Split,WSJ.com, Mar. 11, 2014, http://online.wsj.com/articles/SB1000142405270230

CHAPTER V LEGAL ISSUES INVOLVING SHAREHOLDERS’ EQUITY AND THE BALANCE SHEET 75

4704504579433702574702342; Jason Zweig, Fewer Companies Make SplitDecisions, WALL ST. J., Dec. 7, 2013, at B1. As another example, in 2010Berkshire Hathaway split the new Class B shares described on page 558 ofthe Fifth Edition [omitted from the concise] fifty-to-one in connection withthe company’s plan to purchase the railroad company Burlington NorthernSanta Fe Corp. The stock split, which significantly reduced the market priceper share, also enabled Standard & Poor’s to include the shares in the S&P500, coincidentally replacing the railroad’s shares in the index and creatingincreased demand for the Class B shares. See Scott Patterson, BerkshireHathaway Shares Added to the S&P 500 Index, WALL ST. J., Jan. 26, 2010,at C4. (Berkshire’s Class A shares have never split and traded above$280,000 a share in late 2017.)

3. RESTRICTIONS ON CORPORATE DISTRIBUTIONS

b. CONTRACTUAL RESTRICTIONS

On page 594 [omitted from the concise edition], replace the first fullparagraph with the following text:

** As the Federal Reserve and other central banks around the world haveheld down interest rates, lenders have been more willing to extend covenant-lite loans in an effort to boost their investment returns. Citing informationfrom the Bank for International Settlements, in September 2017 The WallStreet Journal reported that companies in the United States have becomemore leveraged than at any time since 2000. In particular, the articlehighlighted the growth in covenant-lite loans from private-equity firmsoutside the oversight applicable to supervised financial institutions. Nearlyone-third of such loans to that point in 2017, including five of the six largest,went to companies with debt to EBITDA ratios that exceeded 6.0. In responseto complaints from members of Congress, the Government AccountabilityOffice reviewed the 2013 guidance from the Federal Reserve and otherregulators regarding leveraged lending to supervised financial institutionsand determined in 2018 that the regulators had exceeded their authority andneeded Congressional approval to enforce such a rule. One commentatorlikened the situation to a speed limit with no enforcement. In October 2018,a top Federal Reserve official warned that covenant-lite loans thenencompassed about eighty percent of the market, and the Office of theComptroller of the Currency cautioned that such risky loans could affectsafety-and-soundness ratings in a semiannual risk report released in May2019. See Jesse Hamilton, Leveraged Lending Hazards Push Regulators toLecture Bank Boards, Banking (Bloomberg Law), May 20, 2019; Lisa Lee etal., Fed Fires Warning Shot at Wall Street’s Riskier Loan Deals, Sec. LawNews (Bloomberg Law), Oct. 25, 2018; Christopher Whittall, Risky LoansSurge in U.S., Overseas, WALL ST. J., Sept. 25, 2017, at A1.


D. DRAFTING AND NEGOTIATING AGREEMENTS AND OTHER

LEGAL DOCUMENTS CONTAINING ACCOUNTING TERMINOLOGY

AND CONCEPTS

On page 618 [page 354 of the concise], add the following note afternote 3:

3A. Asset-based lending agreements or credit facilities rely on the quality ofthe assets, usually accounts receivable, inventory, or other collateral,supporting the loan. These agreements usually contain representations,warranties, and covenants that involve the intersection between legal andaccounting concepts and can easily lead to unintended defaults. For a briefarticle describing several best practices when negotiating such agreementson the borrower’s behalf, see Kimberly C. MacLeod et al., Asset-BasedLending Credit Facilities: The Borrower’s Perspective, BUS. L. TODAY, Feb.2017, at 1.

On page 619 [omitted from the concise], insert the following text atthe end of the second full paragraph near the bottom of the page:

**Although the funding status of corporate pensions generally improved in2018, The Wall Street Journal reported in mid-2019 that a leading consultingfirm estimated that among companies in the S&P 500 index, lower interestrates caused pension funding to drop from 93.7 percent on September 30,2018 to 85.6 percent on May 31, 2019. See Lauren Silva Laughlin, LowerInterest Rates Hold a Hidden Danger, WALL ST. J., July 16, 2019, at B12.

On page 622 in the carryover paragraph at the top of the page[omitted from the concise], replace the text after the end of thecitation in the eighth line with the following text:

**Later that year, the Boards removed the project from their joint agenda,concluding that they could not devote the resources necessary to complete theproject until after they had finished their priority convergence projects. In2017, the FASB added a project to its agenda on distinguishing liabilitiesfrom equity, specifically including convertible debt. Such obligations allowinvestors to swap their loans to the borrower for equity in the borrower if theborrower’s stock reaches a certain price. GAAP currently provides fivedifferent sets of rules to account for convertible debt, and misclassificationshave frequently required companies to restate their financial statements. Theproject seeks to improve understandability and to reduce complexity, whileretaining information important to users. The Board expects to issue aproposed accounting standard update during the third quarter of 2019.Interested readers can monitor developments via https://fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=1176170473714; see also Nicola M.White, Plan to Fix Debt, Equity Accounting Confusion Due This Summer,Bloomberg Law, June 19, 2019. Like the earlier joint project, this projectseems likely to cause enterprises to treat more financial instruments asliabilities than under the current rules. As a result, any required


reclassifications could affect the ratios commonly contained in loanagreements and other contracts. See, e.g., Michael Rapoport & JonathanWeil, More Truth-in-Labeling for Accounting Carries Liabilities, WALL ST. J.,Aug. 28, 2003, at C1.

On page 623 [omitted from the concise], replace the first twoparagraphs with the following text:

Although the SEC seems unlikely to require public companies in theUnited States to file financial statements using IFRS, the likelihood remainsthat the industrialized world will eventually embrace some system of globalaccounting standards. This likelihood deserves serious consideration,especially when drafting or negotiating agreements involving enterprisesinterested in cross-border securities listings. In this regard, note that theaudit report that appears on page 89 of Starbucks’ 2012 Form 10-K inAppendix A on page 1253 of the Fifth Edition [page 785 of the concise] refersto “accounting principles generally accepted in the United States of America.”As a result, GAAP in this country could potentially become APGAUS. Inaddition, please observe that the same audit report also refers to “thestandards of the Public Company Accounting Oversight Board (UnitedStates).” Id.

(d) Lease accounting. As described in more detail on pages 146 to 151,infra, starting in fiscal years beginning after December 15, 2018, the rules inthe Codification governing lease accounting will require public companies torecognize more assets and liabilities arising from leases on the balance sheet.The new rules apply to other organizations in fiscal years beginning afterDecember 15, 2019. By adding an estimated $2 trillion to balance sheetsglobally, the new guidance will significantly affect certain financial ratios,including the current, debt to equity, return on assets, and asset turnoverratios.

(e) Deferred income tax assets and liabilities. Until ASU No. 2015-17,Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes,GAAP required enterprises to separate deferred income tax assets andliabilities into current and noncurrent amounts in a classified balance sheet.For public companies, beginning for fiscal years starting after December 15,2016, and interim periods within those years, FASB amended Topic 740 torequire enterprises to classify all their deferred taxes as noncurrent. Fornonpublic enterprises, the amendments apply to financial statements forannual periods beginning after December 15, 2017, and interim periodswithin annual periods beginning after December 15, 2018. The Codificationretains the requirement that an enterprise offset deferred tax liabilities andassets and present a net amount on the balance sheet. These amendmentsalign the presentation of deferred taxes under GAAP with IAS 1,Presentation of Financial Statements. See INCOME TAXES (TOPIC 740):BALANCE SHEET CLASSIFICATION OF DEFERRED TAXES, ACCOUNTING

STANDARDS UPDATE NO. 2015-17 (Fin. Accounting Standards Bd.), available


at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176167636650.

The so-called Tax Cuts and Jobs Act of 2017, Pub, L. No. 115-97, 131Stat. 2054, which President Trump signed on December 22, 2017, reduced thecorporate income tax rate from a maximum thirty-five percent to a flattwenty-one percent. As a result, many companies abruptly needed toremeasure their deferred tax assets and deferred tax liabilities based on thenew rate. For companies using the calendar-year for financial accountingpurposes, this remeasurement occurred for the fourth quarter of 2017.

Companies record deferred tax assets when expected deductions and taxcredits will reduce future tax obligations. Citicorp, for example, accumulatedmore than $45 billion in deferred tax assets, largely from losses during thefinancial crisis. If a company had recorded a deferred tax asset using a thirty-five percent rate, then when the 2017 tax legislation reduced the expectedbenefit to twenty-one percent, the company must write down the deferred taxasset. This write-down translates to additional income tax expense and lessincome from continuing operations for the accounting period that includesthe enactment date. After the 2017 tax legislation, Citigroup Inc. recognizeda $22 billion charge against 2017 fourth-quarter earnings. In addition tolower earnings, such charges reduce shareholders’ equity, book value, and,for banks, regulatory capital, which can adversely affect a bank’s ability toextend loans, pay dividends, or buyback shares. See Christina Rexrode, CitiTakes $22 Billion Tax-Law Hit, WALL ST. J., Jan. 17, 2018, at B1.

As a related issue involving deferred tax assets, an enterprise mustrecord a valuation allowance and write down a deferred tax asset wheneverit becomes more likely than not that the firm will not realize the recorded taxbenefit. Such circumstances could arise when, for example, management doesnot expect the firm to return to profitability. Companies and their officers canface SEC enforcement actions when they fail to record a necessary valuationallowance as ASC 740-10-30 requires. See, e.g., In re Hampton RoadsBankshares, Inc., Accounting and Auditing Enforcement Release No. 3600(Dec. 5, 2014), available at https://www.sec.gov/litigation/admin/2014/34-73750.pdf.

In contrast, when tax rates drop, the remeasurement of a deferred taxliability reduces the liability and creates a tax benefit to the corporation thatreduces income tax expense and increases income from continuing operationsfor the period that includes the enactment date. For example, the reductionin the corporate income tax rate cut Verizon Communications Inc.’s morethan $48 billion in deferred tax liabilities by almost $17 billion, whichallowed the company to boost its 2017 fourth quarter earnings by thatamount. See Ryan Knutson, Telecom to Post Tax Gain, Lifting QuarterResults, WALL ST. J., Jan. 18, 2018, at B3.

The 2017 tax legislation also subjects multinational companies to a one-time repatriation tax on post-1986 accumulated earnings in their foreignsubsidiaries at two different tax rates: a 15.5 percent rate for cash and cash


equivalents and an eight percent rate for illiquid assets. If suchmultinationals indefinitely reinvested foreign profits outside the UnitedStates, previous law did not require the companies to pay any federal incometax until they brought the money back to the United States. As a result, mostcompanies kept those profits abroad and did not recognize a deferred taxliability for these potential taxes. (For example, page 41 of Starbucks’ 2012Form 10-K, which you can find at page 1205 of the Fifth Edition [page 737 ofthe concise] discloses that as of September 30, 2012, the Company’s foreignsubsidiaries held about $703 million of Starbucks’ $2.1 billion in cash andshort-term investments.) About $3 billion of Citigroup’s $22 billion chargearising from the 2017 tax legislation came from this repatriation tax. A fewcompanies, including Pfizer Inc. and Apple Inc., however, recorded deferredtaxes on the profits in their foreign subsidiaries in previous years, whichincreased the parent companies’ global tax rates and lowered their reportedearnings. See Christina Rexrode, Citi Takes $22 Billion Tax-Law Hit, WALL

ST. J., Jan. 17, 2018, at B1; Richard Rubin, Pfizer Piles Profits Abroad, WALL

ST. J., Nov. 9, 2015, at B1.

(f) Debt issuance costs. As part of FASB’s efforts to reduce complexity inaccounting standards and to simplify the presentation of costs thatenterprises incur when issuing debt or borrowing funds, ASU No. 2015-03now requires enterprises to present such costs on the balance sheet as adirect deduction from the debt’s carrying amount. Previously, such costsappeared as an asset, usually a deferred cost, on the balance sheet. Thistreatment differed from the guidance under IFRS. For public companies, thenew rules apply to financial statements for fiscal years beginning afterDecember 15, 2015, and interim periods within those fiscal years. For allother entities, the amendments apply to financial statements for those samefiscal years and interim periods within fiscal years beginning after December15, 2016. The new rules apply retrospectively, meaning that enterprisesshould adjust the balance sheet for each individual period presented to reflectthe amendments’ period-specific effects and disclose the effects on any lineitems affected. The amendments could affect any covenants based on thedebt-to-equity, debt-to-asset, return on asset, or asset turnover ratios. SeeINTEREST– IMPUTATION OF INTEREST (SUBTOPIC 835-30): SIMPLIFYING THE

PRESENTATION OF DEBT ISSUANCE COSTS, ACCOUNTING STANDARDS UPDATE

NO. 2015-03 (Fin. Accounting Standards Bd.), available at https://www.fasb.org/jsp/FASB/ Document_C/DocumentPage?cid=1176165915303.

** (g) Balance Sheet Classification of Debt. Transactional lawyers shouldpay attention to proposed new debt classification rules that could requireenterprises to treat more debt as a current liability. Current GAAP allows anenterprise to classify as a noncurrent liability any short-term debt on thebalance sheet date that the enterprise refinances on a long term basis afterthat date, but before the enterprise issues financial statements or theybecome available for issuance. In March 2019, FASB seemingly completedredeliberations on a proposed accounting standards update that wouldprohibit an enterprise from considering a subsequent refinancing whenclassifying debt as of the balance sheet date; require the enterprise to


disregard any unused long-term financing arrangement in place on thebalance sheet date when determining the classification of debt; and force theenterprise to disclose information when a borrower violates a provision in along-term debt agreement that would convert the loan to a current liability,the agreement provides a specified grace period, and the borrower has notcured the violation before issuing the financial statements. The Boarddirected the staff to draft a revised standards update with a forty-five daycomment period and expects to issue the revised proposal in the third quarterof 2019. The changes in the proposed rules would reduce working capital andaffect the current ratio, usually for the worse. See Denise Lugo, CompaniesMight Find Credit Crunched Under New Accounting Rule, Corp. L. &Accountability Rep. (Bloomberg BNA), Sept. 25, 2017. Interested readers canfollow developments, including tentative decisions to date, on the project viahttps://fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=1176172383619.

On page 629 [omitted from the concise], with regard to Problem 5.6,in 2013 Starbucks lost an arbitration with Kraft Foods Global, Inc.The arbitrator ordered Starbucks to pay Kraft $2,227.5 million indamages, plus prejudgment interest and attorneys’ fees, whichStarbucks estimated at $556.6 million. Accordingly, Starbucksrecorded a $2,784.1 litigation charge in fiscal 2013. Three days later,Starbucks and its various lenders amended the Credit Agreement toavoid a default by excluding the impact of the Kraft arbitration in anamount up to $2.9 billion for a total of six fiscal quarters. We canonly speculate, but we guess that the amendment cost Starbuckssomething beyond any attorneys’ fees incurred to negotiate theamendment. We note that the first page acknowledged “the receiptand sufficiency” of “further valuable consideration.” In mostpertinent part, the agreement revised the definition of ConsolidatedEBITDA to read as follows:

“Consolidated EBITDA” means, for any period, for the Companyand its Subsidiaries on a consolidated basis, an amount equal toConsolidated Net Income for such period plus (a) the following to theextent deducted in calculating such Consolidated Net Income: (i)Consolidated Interest Charges for such period, (ii) the provision forfederal, state, local and foreign income taxes payable by theCompany and its Subsidiaries excluding any tax credits for suchperiod, (iii) depreciation and amortization expense, (iv) fees,charges, reserves, costs or expenses related to litigation,restructuring, severance activities, discontinued operations, casualtyevents and financing, acquisition or divestiture activities; provided,that the total cash amount of such items shall not exceed$250,000,000 in the aggregate, (v) commencing with the fiscalquarter ending September 29, 2013 and through and including allfiscal quarters ending on or before December 31, 2014, fees, charges,reserves, costs or expenses related to the Kraft Matter; provided,that the total cash amount of such items shall not exceed


$2,900,000,000 in the aggregate, and (vi) other expenses of theCompany and its Subsidiaries reducing such Consolidated NetIncome that do not represent a cash item in such period or anyfuture period and minus (b) the following to the extent included incalculating such Consolidated Net Income: (i) federal, state, localand foreign income tax credits of the Company and its Subsidiariesfor such period and (ii) non-recurring gains increasing ConsolidatedNet Income (or reducing net loss) that do not represent cash itemsfor such period or any future period.

You can access the amended Credit Agreement at https://www.sec.gov/Archives/edgar/data/829224/000082922413000044/sbux-9292013xexhibit1023.htm.

C H A P T E R VI

REVENUE RECOGNITION AND

ISSUES INVOLVING THE INCOME

STATEMENT


On pages 643 and 644 [pages 361 and 362 of the concise], replace thetwo paragraphs that begin with the first full paragraph on page 643[the carryover paragraph at the bottom of page 361] with thefollowing text:

In 2014, FASB and IASB issued new and converged accounting rules onrevenue recognition for contracts with customers, completing a joint projectthat began in 2002 to: simplify the rules on revenue recognition; increasecomparability across companies, industries and capital markets; and improvedisclosures. Previously, different industries applied various methods andstandards for recognizing revenue, a situation that arose from disjointed andsometimes inconsistent accounting principles. Effective no later than forfiscal years beginning after December 15, 2017 for public entities and fiscalyears beginning after December 15, 2018 for non-public enterprises, the newstandards in FASB ASC Topic 606, Revenue from Contracts with Customers,supersede most of the guidance in Topic 605, Revenue Recognition, andvarious rules throughout industry topics in the Codification. In essence, thetransfer of control will drive revenue recognition under the new rules, ratherthan the culmination of an earnings process or the transfer of risks andrewards under the previous rules. See Denise Lugo, New Accounting RulesSpell Big Changes for Public Companies, Corp. L. & Accountability Rep.(Bloomberg BNA), Jan. 12, 2017; Analysis: New Revenue RecognitionStandard Brings Major Changes for Nonfinancial Assets, Sec. L. Daily(Bloomberg BNA), June 9, 2014.

On page 649, replace the second and third sentences in the first fullparagraph [the third sentence in the carryover paragraph at thebottom of page 364 in the concise edition] with the following:

The Second Circuit later affirmed the judgment sentencing Collins to oneyear and one day in prison and two years of supervised release after hisconvictions. See United States v. Collins, 581 Fed. Appx. 59 (2d Cir. 2014).

83

84 CHAPTER VI REVENUE RECOGNITION & ISSUES INVOLVING INCOME STATEMENT

On page 649 [omitted from the concise], replace the carryoverparagraph at the bottom of the page with the following text:

In May 2017 and about five years after the international law firm Dewey& LeBoeuf LLP filed for the largest law firm bankruptcy in U.S. history whileowing creditors almost $250 million, a New York jury convicted the firm’sformer CFO of defrauding investors and conspiracy. That same jury acquittedthe firm’s former executive director, an attorney, but not before seven formeremployees had pled guilty to a scheme that allegedly inflated profits for 2008and 2009 by about $36 million and $23 million, respectively. After a first trialin 2015 ended in a hung jury, the firm’s former chairman, also an attorney,reached a deferred prosecution agreement with prosecutors. That agreementenabled the former chairman to avoid a second trial without admittingwrongdoing, but barred him from practicing law in New York or acting as anofficer of a publicly traded company for five years. Shortly thereafter, theSEC issued an order barring him from appearing or practicing before theSEC as an attorney.

The case began in 2014 when the Manhattan District Attorney’s officefiled a 106-count grand jury indictment that charged the firm’s leaders withoverstating revenue, improperly hiding losses, and disguising cash flowshortfalls. The first jury acquitted the defendants on charges that theyfalsified business records, but deadlocked on fraud and larceny charges. Laterin 2014, the SEC filed civil charges alleging that the three leaders, plus twoother finance professionals, facilitated securities fraud when the firm issued$150 million in bonds in 2010. The note purchase agreement governing thebond offering required the firm to provide quarterly certifications to investorsand lenders. The civil suit, which remains pending against some of thedefendants, further alleges that every certification the firm provided beforeits collapse was fraudulent. See In re Davis, Exchange Act Release No. 77,325(Mar. 8, 2016), available at https://www.sec.gov/litigation/admin/2016/34-77325.pdf; see also Chris Dolmetsch, Ex-Dewey & LeBoeuf Exec SandersAvoids Prison in Fraud Case, Corp. L. & Accountability Rep. (BloombergBNA), Oct. 11, 2017; Matthew Goldstein, Judge in Dewey & LeBoeuf FraudCase Whittles Down Charges, N.Y. TIMES, Feb. 27, 2016, at B3; JenniferSmith & Ashby Jones, Fallen Law Firm’s Leaders Are Indicted, WALL ST. J.,Mar. 7, 2014, at B1; Press Release, Sec. & Exch. Comm’n, SEC Charges FiveExecutives and Finance Professionals Behind Fraudulent Bond Offering byInternational Law Firm (Mar. 6, 2014), https://www.sec.gov.new/press-release/2014-45.

B. ESSENTIAL REQUIREMENTS FOR REVENUE RECOGNITION

On page 653 [page 367 of the concise], replace the first paragraph inthis section with the following text:

In 2014, the FASB and IASB completed a joint project to convergeaccounting rules on revenue recognition for contracts with customers. In ASU

CHAPTER VI REVENUE RECOGNITION & ISSUES INVOLVING INCOME STATEMENT 85

No. 2014-09, FASB added ASC Topic 606, Revenue from Contracts withCustomers, as well as Subtopic 340-40, Other Assets and DeferredCosts—Contracts with Customers, to the Codification. In addition to the newtopic and subtopics, ASU No. 2014-09 included approximately 800 substan-tive amendments to the Codification. At the same time, the IASB issuedIFRS 15, Revenue from Contracts with Customers. When effective, the newstandards in Topic 606, which mark the biggest changes to GAAP in decades,supersede most of the guidance in Topic 605, Revenue Recognition, andnumerous rules throughout the industry topics in the Codification. SeeREVENUE FROM CONTRACTS WITH CUSTOMERS (TOPIC 606), ACCOUNTING

STANDARDS UPDATE NO. 2014-09 (Fin. Accounting Standards Bd.), availablevia http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176164076069.

To aid the transition to the new rules and their implementation, FASBdeferred the effective dates and issued various ASUs providing technicalcorrections, improvements, and additional guidance. In ASU No. 2015-14,Revenue from Contracts with Customers (Topic 606): Deferral of the EffectiveDate, FASB deferred the effective dates for the new standards by one year.As a result, Topic 606 became mandatory for public companies for fiscal yearsbeginning after December 15, 2017, including interim periods within thoseyears. For public companies using the calendar year, the changes took effecton January 1, 2018. Public companies could adopt the new rules early, but noearlier than annual reporting periods beginning after December 15, 2016,including interim periods within that annual period.

For non-public enterprises, the new rules become effective no later thanannual reporting periods beginning after December 15, 2018, and interimperiods within fiscal years commencing after December 15, 2019. For non-public companies using the calendar year, the changes take effect beginningJanuary 1, 2019 for annual periods and January 1, 2020 for interim periods.(Note that FASB increasingly gives private companies additional time toimplement new standards so that such firms can learn from publiccompanies. See, e.g., Lisa White, INSIGHT: ASC 606 Fundamental Tips forPrivate Companies, Fin. Accounting News (Bloomberg Law), Aug. 16, 2018.)For annual reporting periods beginning after December 15, 2016, plusinterim periods within such a reporting period or starting in the next annualreporting period, non-public enterprises could adopt the new guidance early.Early adoption possibilities for non-public companies using the calendar yearinclude the following: (1) January 1, 2017 for annual and interim reportingpurposes; (2) January 1, 2017 for annual reporting purposes, and January 1,2018 for interim reporting purposes; (3) January 1, 2018 for annual andinterim reporting purposes; (4) January 1, 2018 for annual reportingpurposes, and January 1, 2019 for interim reporting purposes.

With very limited exceptions for contracts that fall within the scope ofother standards, Topic 606 applies to all enterprises. In ASU No. 2016-20,FASB clarified, however, that Topic 606 does not apply to any contractsubject to the rules in Topic 944, Financial Services–Insurance. SeeTECHNICAL CORRECTIONS AND IMPROVEMENTS TO TOPIC 606, REVENUE FROM


CONTRACTS WITH CUSTOMERS, ACCOUNTING STANDARDS UPDATE NO. 2016-20(Fin. Accounting Standards Bd.), available via http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176168723765.

Ultimately, the guidance in Topic 606 seeks to implement the coreprinciple that “an entity should recognize revenue to depict the transfer ofpromised goods or services to customers in an amount that reflects theconsideration to which the entity expects to be entitled in exchange for thosegoods or services.” To achieve that core principle, Topic 606 directsenterprises to apply the following five steps: (i) identify the contract with thecustomer; (ii) determine the separate performance obligations in the contract;(iii) ascertain the transaction price; (iv) allocate the transaction price to theperformance obligations in the contract; and (v) recognize revenue when, oras, the enterprise satisfies a performance obligation. With regard to thoserequirements:

1. Identify the contract with the customer. As the first step in theprocess, the entity must identify the contract with the customer to providegoods or services in exchange for consideration. A contract createsenforceable rights and obligations. If no agreement exists between the entityand the customer, the analysis ends, but the Codification does not require awritten contract to establish an agreement. Oral and implied agreements,which can arise in an instant, also satisfy the requirement for a contract. Anycontract, however, must reflect a substantive transaction. In addition, thisstep requires the determination that it is probable, based upon the customer’sability and intention to pay, that the entity will collect the considerationpromised in exchange for the goods or services transferred to the customer.If not, Topic 606 allows an entity to recognize revenue in the amount of anynonrefundable consideration received once the entity has transferred controlof the promised goods or services and has no obligation under the contract totransfer additional goods or services. See REVENUE FROM CONTRACTS WITH

CUSTOMERS (TOPIC 606): NARROW-SCOPE IMPROVEMENTS AND PRACTICAL

EXPEDIENTS, ACCOUNTING STANDARDS UPDATE NO. 2016-12 (Fin. AccountingStandards Bd.), available at https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168130444.

2. Determine the performance obligations in the contract. Next,the entity must determine all the performance obligations, or promises, inthe contract, keeping in mind that the various components could be sointerrelated as to form a single performance obligation. Topic 606 defines theterm “performance obligation” as “a promise in a contract with a customer totransfer a good or service to the customer.” To identify performanceobligations in a contract, an entity must evaluate whether the promisedgoods and services are distinct. That classification requires the promised goodor service to meet both of the following criteria: (1) the customer can benefitfrom the promised good or service either on its own or together with otherresources that are readily available to the customer; and (2) the promise totransfer the good or service to the customer is separately identified fromother promises in the contract. With regard to the second factor, the entity


must determine whether the nature of its promise in the contract seeks totransfer each of the goods or services individually, or to transfer a combineditem to which the promised goods or services are inputs.

For example, a wireless phone company that sells cell phones atdiscounted prices when customers also sign up for two-year service contractswould identity two separate performance obligations: the sale of the cellphone and the promise to provide cell phone service during the two-yearservice period. As a second example, an automotive manufacturer that sellscars that come with a service agreement for regular maintenance for the firstthree years, including periodic oil changes and tire rotation, and a five-yearwarranty has agreed to provide a car, maintenance for three years, andwarranty protection for five years. Similarly, a software company that offerstechnical support for ninety days and free upgrades for a year after acustomer purchases software has agreed to provide the software, technicalsupport for ninety days, and any upgrades issued in the next twelve months.Please note, however, that in some circumstances, such as customizedsoftware, the separate goods and services in a contract may be so interrelatedas to form a single performance obligation. Topic 606 requires such combinedgoods and services to remain a single performance obligation until theenterprise identifies a distinct good or service.

After ASU No. 2016-10, Identifying Performance Obligations andLicensing, the Codification now provides that an enterprise need not assesswhether goods or services promised to a customer meet the definition of aperformance obligation if those goods or services are immaterial in thecontext of the contract with the customer. In addition, the rules allow anenterprise to treat shipping and handling activities that occur after controlhas passed to the customer as fulfillment costs rather than as an additionalpromised service. See REVENUE FROM CONTRACTS WITH CUSTOMERS (TOPIC

606): IDENTIFYING PERFORMANCE OBLIGATIONS AND LICENSING, ACCOUNTING

STANDARDS UPDATE NO. 2016-10 (Fin. Accounting Standards Bd.), availableat http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176168066253.

3. Ascertain the transaction price. Third, the entity must ascertainthe transaction price. In this determination, Topic 606 excludes amountscollected on behalf of third parties, such as some sales taxes, from thetransaction price. In ASU No. 2016-12, FASB amended the Codification topermit an enterprise, as an accounting policy election, to exclude amountscollected from all sales and other similar taxes from the transaction price.See REVENUE FROM CONTRACTS WITH CUSTOMERS (TOPIC 606): NARROW-SCOPE

IMPROVEMENTS AND PRACTICAL EXPEDIENTS, ACCOUNTING STANDARDS UPDATE

NO. 2016-12 (Fin. Accounting Standards Bd.), available at http:/www.fasb.http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_ C%2FDocumentPage&cid=1176168130444.

As under current rules, if any contemplated payment will occur morethan a year after the transfer of the goods or services so that the transactionincludes a financing component, the entity must consider the time value of


money when calculating the transaction price. Likewise, if a customerpromises noncash consideration, the entity should measure thatconsideration at fair value. If the entity cannot reasonably estimate the fairvalue of the noncash consideration, the entity should measure thatconsideration indirectly by using the normal selling price of the goods orservices provided. Unlike current rules which dictate that enterprises mustwait to recognize any variable consideration until certain, Topic 606 requiresthe entity to include an estimate for such contingent consideration in thetransaction price if it is probable that a significant reversal in the cumulativeamount of revenue recognized will not occur. If necessary, the entity mustupdate the estimated transaction price at the end of each reporting period.If the entity pays, or expects to pay, consideration to the customer, whethervia a cash rebate or in items through a coupon, voucher, loyalty program, orother discount, the entity should account for the payment or expectedpayment as a reduction in the transaction price, applying the guidance onestimates of variable consideration if necessary.

4. Allocate the transaction price to the performance obligationsin the contract. As the fourth step in the process, the entity must allocatethe transaction price to each performance obligation in the contract. Thisprocess may require an entity, first, to use market information, costestimates and expected margins, or a residual approach to determine thestandalone selling prices of the various goods and services specified in theagreement, and, then, to allocate the total transaction price to eachperformance obligation on the basis of relative standalone selling prices.

To illustrate, recall the wireless phone company example in the secondstep. If the company sells cell phones at discounted prices when bundled withtwo-year service contracts, the company should identify the phone and theservice plan as separate performance obligations. If the company offers thebundled deal for $500, while the prices for the cell phone and the service planwhen sold independently are $400 and $200, respectively, the companyshould allocate the $500 bundled sale price to the phone and service planaccording to their relative standalone selling prices. Thus, the companywould allocate two-thirds ($400/$600) of the $500 bundled price, or $333.33,to the phone, and the remaining one-third ($200/$600), or $166.67, to theservice plan.

If the transaction price includes variable consideration or a discount thatrelates entirely to one performance obligation, the entity should allocate thatamount to that performance obligation, rather than to all performanceobligations in the contract. In addition, the entity should allocate anysubsequent changes in the transaction price on the same basis as at contractinception. Finally, the entity should recognize as revenue, or as a reductionto revenue, any amounts allocated to a satisfied performance obligation inthe accounting period in which the transaction price changes.

5. Recognize revenue when, or as, the entity satisfies aperformance obligation. As the last step, an entity should recognizerevenue when the entity fulfills a performance obligation by transferring


control of a good or service to the customer. An entity can satisfy aperformance obligation over time or at a point in time. An entity transferscontrol over time if:

• The customer simultaneously receives and consumes the benefitsfrom the entity’s performance as the entity performs;

• The entity’s performance creates or enhances an asset that thecustomer controls during performance; or

• The entity’s performance does not create an asset with an alternativeuse to the entity, and the entity has an enforceable right to paymentfor performance completed to date.

When an entity satisfies a performance obligation over time, the entityshould recognize revenue over that period by consistently applying a methodto measure the progress in completely satisfying that performance obligation.Topic 606 approves input and output methods for this purpose.

If an entity does not satisfy the performance obligation over time, theentity must determine the point in time at which the customer obtainscontrol. Topic 606 states that indicators of the transfer of control include, butare not limited to, the following:

• The customer owns legal title to the asset;• The customer holds the significant risks and rewards from

ownership of the asset;• The customer has accepted the asset; • The entity enjoys a present right to payment for the asset; and• The entity has transferred physical possession of the asset.

If we continue the example involving the wireless phone company, thecompany would record $333.33 in revenue from the sale of the phoneimmediately upon its transfer to the customer. Given that the customer willreceive the benefits of the service contract over its two-year term, thecompany will recognize the $166.67 in revenue from that plan at the rate ofabout 22.8 cents per day ($166.67/730 days) during the two-year serviceperiod. As another example, please note that with the focus on control ratherthan the transfer of risks and rewards, Tesla Inc. can now immediatelyrecognize revenue from cars sold with guaranteed buy-backs as sales, ratherthan as leases under the previous rules, even though the electric-carmanufacturer has ended the incentive. See Amanda Iacone, Tesla: $520MReduction in Deficit Due to Accounting Rule, Corp. L. & Accountability Rep.(Bloomberg BNA), Mar. 16, 2018.

When more than one party is involved in providing goods or services toa customer, an enterprise must determine whether it has promised to providethe specified good or service itself, in which case the enterprise acts as aprincipal, or to arrange for another party to provide that good or service, suchthat the enterprise has agreed to act as an agent. When a principal satisfiesa performance obligation, the principal recognizes revenue in the grossamount of the expected consideration. When acting as an agent, however,


an enterprise can only recognize a net amount equal to the fee orcommission that the enterprise expects to earn in the transaction.

The Codification treats an enterprise as a principal if the enterprisecontrols the specified good or service before transferring it to a customer.Although not exclusive, the guidance provides the following indicators, whichmay be more or less relevant or may provide more persuasive evidence indifferent contracts, to assist in determining whether an enterprise controlsa specified good or service before transferring it to the customer:

• Primary responsibility for fulfilling the promise to provide thespecified good or service;

• Inventory risk, meaning the ability to direct the use of, and to obtainany remaining benefits from, the specified good or service; and

• Discretion to establish the price for the specified good or service.

Please note that if a contract with a customer includes more than onespecified good or service, the Codification may treat an enterprise as aprincipal for some specified goods and services and an agent for others. SeeASC ¶¶ 606-10-55-36 to -40; REVENUE FROM CONTRACTS WITH CUSTOMERS

(TOPIC 606): PRINCIPAL VERSUS AGENT CONSIDERATIONS (REPORTING REVENUE

GROSS VERSUS NET), ACCOUNTING STANDARDS UPDATE NO. 2016-08, available at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176167987739.

ASU No. 2016-10, Identifying Performance Obligations and Licensing,also clarified how enterprises should account for licenses of intellectualproperty, including music, television shows, brands, and franchise rights.Topic 606 now contains implementation guidance as to whether anenterprise’s promise to grant a license provides the customer with a right touse intellectual property, which the enterprise satisfies at a point in time, ora right to access the intellectual property, which is satisfied over time. In thatregard, the Codification distinguishes between:

• Functional intellectual property, such as software, drug formulas,and completed media content, including music, films, and televisionshows, that has a significant standalone functionality; and

• Symbolic intellectual property, such as brands, team or trade names,logos, and franchise rights.

The promise to grant a license to functional intellectual property typicallydoes not include supporting or maintaining the intellectual property duringthe license period. As a result, the enterprise usually satisfies the promise toprovide the intellectual property at the point in time when the customer canuse and benefit from the license, but not before the beginning of the licenseperiod. By comparison, the promise to grant a license to symbolic intellectualproperty includes supporting or maintaining that property during the licenseperiod. Consequently, the enterprise satisfies a license to symbolicintellectual property over time. See REVENUE FROM CONTRACTS WITH

CUSTOMERS (TOPIC 606): IDENTIFYING PERFORMANCE OBLIGATIONS AND


LICENSING, ACCOUNTING STANDARDS UPDATE NO. 2016-10 (Fin. AccountingStandards Bd.), available at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176168066253.

Under Topic 606, some businesses can book revenue sooner than thestandards in Topic 605 allowed, while other firms will need to wait longer torecord revenue. For example, a wireless phone company that sold cell phonesat discounted prices when customers also signed up for a two-year servicecontract previously recognized little or no revenue when the companydelivered the phone to the customer. Under the new rules, the wirelesscompany will recognize the allocated revenue attributable to the phone oncethe company delivers the phone to the customer. In contrast, Topic 606 willnot allow an automotive manufacturer that sells cars that come with aservice agreement and a warranty to recognize the full amount collected fromthe customer as revenue when the manufacturer delivers the automobile tothe customer. The manufacturer must wait to recognize the portion of thetransaction price allocable to the service agreement and the warranty,presumably recognizing those portions as the manufacturer performs theagreed services, or ratably over the length of the warranty period. Likewise,if a software company promises to provide technical support and freeupgrades to new versions of that software for a period of time after acustomer accepts the software, the company can only recognize the revenueattributable to the transfer of the software itself at the time of thetransaction. The software company must wait to recognize the portion of thetransaction price allocable to the technical support and the upgrades,presumably ratably over time during the technical support period and for theduration of the eligibility for free upgrades. Finally, airlines with frequentflyer programs will recognize less revenue for flights flown than they dounder current GAAP because the airlines will need to defer the value of milesearned on the flight until those miles are redeemed. This treatment willcause liabilities associated with those unredeemed miles to increase. SeeDenise Lugo, Airline Frequent Flyer Liability to Spike from New Accounting,Corp. L. & Accountability Rep. (Bloomberg BNA), Aug. 18, 2017; MichaelRapoport, New Rules to Alter How Companies Book Revenue, WALL ST. J.,May 29, 2014, at B1.

The Boards assert that the new rules will make revenue recognitionmore uniform, so that users of financial statements can compare results notjust across industries, but around the globe. Although the joint project soughtto achieve a global standard, different interpretations remain. For examplethe word “probable” means a seventy to eighty percent likelihood under U.S.GAAP, but more likely than not, or anything greater than fifty percent, underIFRS. See Denise Lugo, Converging Global Accounting Rules Will TakeGenerations, Corp. L. & Accountability Rep. (Bloomberg BNA), Oct. 13, 2017.

In addition to any industry-specific changes arising from more uniformrevenue recognition standards, the rules in Topic 606 will especially affectlawyers working on mergers and acquisitions. As previously described, thenew rules can significantly change when an enterprise recognizes revenue


and related costs. These changes, in turn, can lead to acceleration ordeceleration of earnings before interest, taxes, depreciation, and amortization(“EBITDA”). See Stephen M. Quinlivan et al., Impact of the New RevenueRecognition Standard on M&A, Law360, Sept. 21, 2017. Both acquirers andtargets often use EBITDA multiples, and similar or related metrics, to priceM&A transactions. If the new rules accelerate revenue recognition and atarget company’s valuation stays constant, the target’s EBITDA multiple willdecrease. This change may deter sellers who may not accept a transactionbased on a lower multiple. In contrast, whenever the new rules deceleraterevenue, the target’s EBITDA multiple will increase. This higher multiplemay discourage a potential acquirer who fears overpaying based on thatmultiple. When looking at pre- and post-Topic 606 revenue figures andEBITDA multiples, buyers, sellers, and their advisors all could easilystruggle psychologically with these incongruous comparisons and theinability to compare apples to apples.

Revenue recognition also typically affects accounts receivable and, thus,working capital. M&A teams also often use working capital to evaluatetargets and proposed transactions, typically over a twelve-month time period.When that period includes pre- and post-Topic 606 reporting periods, M&Alawyers should consider appropriate adjustments. Once again, attorneys willalso need to take into account any industry-specific accounting ramifications.

Costs to obtain or fulfill a contract with a customer. Topic 606 alsospecifies the accounting for certain costs to obtain or fulfill a contract. As astarting point, an entity should recognize as an asset those incremental coststhat the entity would not have incurred without the contract and that theentity expects to recover. As a practical expedient, however, the entity mayexpense such incremental costs when incurred if the amortization period doesnot exceed one year. With regard to costs to fulfill a contract, an entity shouldfirst apply any other applicable standards, including those in Topic 330,Inventory, discussed in Chapter VIII, and Topic 360, Property, Plant, andEquipment, discussed in Chapter IX. Otherwise, an entity should recognizean asset from the costs to fulfill a contract if the entity expects to recoverthose costs and they:

• Relate directly to a contract; and • Generate or enhance resources that the entity will use in satisfying

performance obligations in the future.

Additional disclosures. Topic 606 calls for disclosures about thenature, amount, and timing of, and any uncertainty about, the expectedrevenue and related cash flows arising from contracts with customers. Topic606 requires qualitative and quantitative information about disaggregatedrevenue, which might break out revenue from the sale of goods versus theprovision of services. Other disclosures might set forth relevant categories ofgoods or services or identify revenue from different segments or geographicregions. Required disclosures also include: (i) information about any losseson any receivables or contract assets arising from contracts with customers,variable revenue arising from performance obligations satisfied in whole or


in part in previous accounting periods, contract balances and performanceobligations; (ii) significant judgments and changes in judgments, such asthose determining the transaction price, amounts allocated to performanceobligations, and when the entity satisfies various performance obligations;and (iii) assets recognized from the costs to obtain or fulfill contracts.Although FASB has decided that enterprises need not disclose amounts forestimated performance obligations in certain situations where the enterpriseneed not estimate variable consideration to recognize revenue, the new rulesprescribe qualitative disclosures in such circumstances. See REVENUE FROM

CONTRACTS WITH CUSTOMERS (TOPIC 606): TECHNICAL CORRECTIONS AND

IMPROVEMENTS, ACCOUNTING STANDARDS UPDATE NO. 2016-20 (Fin.Accounting Standards Bd.), available via https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168723765; REVENUE FROM CONTRACTS

WITH CUSTOMERS (TOPIC 606), Accounting Standards Update No. 2014-09(Fin. Accounting Standards Bd.), available at http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid= 1176164076069.

While the new disclosure requirements aim to provide more usefulinformation to financial statement readers, commentators caution that thesignificant judgments and estimates underlying Topic 606 could produceinconsistent reporting among companies in the same industry and allowearnings manipulation. For example, management must often estimaterevenue in contracts calling for variable payments and decide when to recordrevenue as circumstances change on long-term contracts, which suggests theneed for enhanced focus on cash flows. See Steve Burkholder, Investors WorryRevenue Rules Will Allow Earnings Manipulation, Corp. L. & AccountabilityRep. (Bloomberg BNA), June 2, 2017.

Transition. An enterprise can use either the full retrospective methodor a modified retrospective method to adopt the new standards. Under thefull retrospective method, the enterprise would apply the new rules to eachprior accounting period presented in the financial statements. Thisalternative required a public company preparing financial statements basedon calendar years and adopting the new rules on January 1, 2018 to reportresults under the new rules for 2016, 2017, and 2018 when the companyreleased its financial statements for 2018 in early 2019. As a result, thecompany needed to update the figures for 2016 and 2017 to conform to thenew standard. In addition, the company would record an adjustment toretained earnings as of January 1, 2016, to reflect the cumulative effect of thenew standard on all periods prior to 2016.

Under the simpler modified retrospective method, the enterprise wouldnot update the amounts from the prior periods to reflect the new rules. Uponinitial adoption on January 1, 2018, the illustrative public company from theprevious paragraph electing this method would have reported only 2018revenues under the new standard, while continuing to report 2016 and 2017revenues under the previous rules. Under the modified retrospective method,the company also would have recorded an adjustment to retained earningsas of January 1, 2018 to reflect the cumulative effect of applying the newstandard to all periods prior to 2018. Although the company would not have


reported the figures for 2016, 2017, and 2018 consistently, it would not haveneeded to update amounts from 2016 and 2017. Because only the amounts for2018 reflect application of the new standard, the Codification requiresincremental disclosures to present the 2018 results under the previous rulesto provide consistent comparisons for all periods presented.

Alphabet, for example, adopted Topic 606 early on January 1, 2017;chose to use the modified retrospective method; recorded a net reduction of$15 million to opening retained earnings as of January 1, 2017; has continuedto report prior period amounts in accord with its historic accounting underTopic 605; and has reported that applying Topic 606 increased revenues by$34 million for the year ended December 31, 2017. Starbucks, by comparison,delayed adoption until its 2019 fiscal year, which began on October 1, 2018.See Alphabet Inc., Annual Report (Form 10-K) 58 (Feb. 6, 2018): DeniseLugo, Starbucks, Oracle, Apple Postpone Adoption of Revenue Rule, Corp. L.& Accountability Rep. (Bloomberg BNA), Sept. 5, 2017.

** As an actual example in the first batch of quarterly reports preparedunder the new rules, the changes in the timing and allocation of revenuerecognition boosted jet manufacturer Boeing Co.’s 2017 earnings by $1.3billion. By comparison, General Electric Co.’s 2017 earnings fell $1.56 billionunder the new standard. Observers have also noticed that companies haveadded length and detail about their revenue recognition policies in the notesto the financial statement with some disclosures as long as ten pages. Afterfeedback from the SEC, including comments offered to Alphabet and FordMotor Co., these disclosures may evolve in future years. The SEC hasspecifically asked public companies in comment letters to provide deeper,more granular information about revenue, such as which products,distribution channels, or geographic regions influence sales, but severalfirms, including Amazon, Alphabet, and Ford, have successfully rebuffed therequests. See Michael Rapoport, SEC Presses for Revenue Clarity, WALL ST.J., Dec. 24, 2018, at B6; Amanda Iacone, Investor Response Mixed asCompanies Adopt New Revenue Standard, Corp. L. & Accountability Rep.(Bloomberg BNA), May 25, 2018; Steve Burkholder, U.S. Companies StillStruggle to Get Ready for New Revenue Rules, Corp. L. & Accountability Rep.(Bloomberg BNA), Mar. 5, 2018.

Given Topic 606’s broad coverage, virtually every non-insuranceenterprise should carefully review its existing contracts (especially “one-off”or non-systematic, agreements), business systems and operations, andinternal controls to determine exactly what the enterprise will need to do toachieve optimal results under the new standards. Enterprises may want torevise their existing contracts to establish a more optimal system forrecognizing revenue. Because the new guidance focuses on contract termsand conditions in determining whether an entity has transferred control ofgoods or services to the customer, lawyers can draft or revise contracts tospecify exactly how and when the entity transfers control. Lawyers also haveoften been actively involved in the establishment, evaluation, revision, anddocumentation of internal controls related to revenue recognition, the relatedinternal control over financial reporting, and drafting updated disclosures.


This involvement will continue beyond the entity’s original adoption of thenew revenue recognition standards. See Lisa M. Starczewski, The NewRevenue Recognition Standard: Why, and How, Attorneys Should TakeNotice, 12 Corp. L. & Accountability Rep. (Bloomberg BNA) 701 (June 27,2014).

Staff Accounting Bulletin No. 74, now codified in SAB Topic 11.M,requires public companies to disclose both quantitative and qualitativeinformation about the expected effects of adopting a new accounting standardon the company’s financial statements. Dating back to 2016, the SEC staffhas repeatedly stressed the importance of such disclosures, not only as to thenew guidance on revenue recognition, but also as to other new rules,especially those on leases and credit losses. In addition, the staff has highlighted its expectation that these disclosures become more robust andquantitative as a new standard’s effective date approaches. See Disclosure ofthe Impact that Recently Issued Accounting Standards Will Have on theFinancial Statements of the Registrant When Adopted in a Future Period,Staff Accounting Bulletin Topic 11.M., available at https://www.sec.gov/interps/account/sabcodet11.htm#M; see also Steve Burkholder, SEC CloselyWatching Disclosures on Revenue Rule Expected Impact, 32 Corp. CounselWeekly (Bloomberg BNA) 157 (May 10, 2017); Denise Lugo, How CompaniesApply New Accounting a Top Issue at SEC, Corp. L. & Accountability Rep.(Bloomberg BNA), Apr. 6, 2017; Denise Lugo, SEC: Companies ShouldDisclose Effects of New Accounting Standards, Corp. L. & Accountability Rep.(Bloomberg BNA), Nov. 7, 2016.

Although most observers believe that most public companies haveadequately prepared themselves to adopt Topic 606, a mid-2017 survey thatDeloitte & Touche LLP conducted found that only eight percent of privatecompanies were ready to adopt the new standards. More than sixty percentof about 3,000 executives polled responded that their companies eitherremained early in the assessment phase as to how the new standards wouldaffect their financial results or had not started to implement the standards.This delay potentially disadvantages private companies considering IPOs.Although emerging growth companies with annual gross revenues less than$1 billion can elect to delay adoption of the new rules until the privatecompany deadline in 2019, such an election would hinder the transparencyand comparability of the firm’s financial statements. See Denise Lugo, IPOMarket Could Stall Next Yar from New Revenue Accounting, Corp. L. &Accountability Rep. (Bloomberg BNA), Sept. 20, 2017.

In 2017, the SEC’s Office of the Chief Accountant and Division ofCorporation Finance issued SAB No. 116 to bring existing SEC staff guidanceinto alignment with the standards in ASC Topic 606. Historically, Topic 13in the Staff Accounting Bulletin Series has presented the SEC staff’s viewsregarding the general revenue recognition guidance collected in ASC 605,including SAB No. 104. The guidance in SAB No. 116 applies once aregistrant adopts Topic 606. Until that time, registrants should continue tofollow prior staff guidance on revenue recognition, including SAB No. 104. InASU No. 2017-14, FASB updated the Codification to reflect the guidance in


SAB No. 116. See INCOME STATEMENT–REPORTING COMPREHENSIVE INCOME

(TOPIC 220), REVENUE RECOGNITION (TOPIC 605), AND REVENUE FROM

CONTRACTS WITH CUSTOMERS (TOPIC 606): AMENDMENTS TO SEC PARAGRAPHS

PURSUANT TO STAFF ACCOUNTING BULLETIN NO. 116 AND SEC RELEASE NO.33-10403, ACCOUNTING STANDARDS UPDATE NO. 2017-14 (Fin. AccountingStandards Bd.), available at http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176169471253; Staff Accounting Bulletin No. 116, 82Fed. Reg. 41,146 (Aug. 18, 2017), available at https://www.sec.gov/interps/account/sab116.pdf.

Although transactional lawyers must increasingly focus on the newconverged rules, litigators may need familiarity with the previous rules inTopic 605 for the next decade or so. Under Topic 605, an enterprise canrecognize revenue only when (1) realized or realizable, a threshold thatgenerally requires a bona fide exchange transaction with an outsider; and (2)earned, a standard that seeks to ensure that the enterprise has substantiallyaccomplished the earnings process. See FASB ASC ¶ 605-10-25-1 (acodification of RECOGNITION AND MEASUREMENT IN FINANCIAL STATEMENTS OF

BUSINESS ENTERPRISES, Statement of Fin. Accounting Concepts No. 5, § 83(Fin. Accounting Standards Bd. 1984). Not every case or administrativeauthority, however, identified the previous prerequisites for revenuerecognition in just that way. For example, the SEC staff listed four conditionsthat an enterprise must meet before recognizing revenue. In Staff AccountingBulletin No. 101, Revenue Recognition in Financial Statements, the SEC’sstaff attempted to put together, in a single document, all the then-authoritative literature found in various standards on revenue recognition.In addition, the staff expressed its belief that enterprises could recognizerevenue only upon satisfying the following four conditions: (1) the evidencemust persuasively demonstrate that an arrangement exists; (2) theenterprise must have delivered the product or performed the services; (3) thearrangement must contain a fixed or determinable sales price; and (4) thecircumstances must reasonably assure collectibility. Revenue Recognition inFinancial Statements, Staff Accounting Bulletin No. 101, 64 Fed. Reg. 68,936(Dec. 9, 1999), available at http://www.sec.gov/interps/account/sab101.htm.Subsequently, the SEC staff revised this interpretative guidance to rescindmaterial that private sector developments in U.S. GAAP had addressed andto incorporate portions of the frequently asked questions and answersdocument. Staff Accounting Bulletin No. 104, 68 Fed. Reg. 74,436 (Dec. 23,2003), available at http://www.sec.gov/interps/account/sab104rev.pdf.

On page 660 at the end of the first full paragraph[at the end of thefirst full paragraph in note 1 on page 370 of the concise], insert thefollowing update:

**In February 2019, Skilling was released from federal custody after servingmore than twelve years of his sentence. See Rebecca Elliott, Old Enron UnitsThrive as Skilling Is Free, WALL ST. J., Feb. 25, 2019, at B6,


On page 662 [page 372 of the concise], replace the discussion in note3 [note 2 in the concise], starting with the carryover paragraph atthe bottom of that page with the following:

The statute also does not clearly set forth what misconduct can triggera so-called “clawback.” Must the CEO or CFO engage in wrongdoing? In U.S.Securities & Exchange Commission v. Jensen, the Ninth Circuit became thefirst appellate court to rule on that question. Vacating a judgment for twocorporate officers after a bench trial and remanding the case to the districtcourt, the Ninth Circuit held that section 304 allows the SEC to pursuedisgorgement against CEOs and CFOs of public companies required toprepare an accounting restatement “as a result of misconduct,” even if theofficers did not engage in the underlying misconduct themselves. See UnitedStates Sec. & Exch. Comm’n v. Jensen, 835 F.3d 1100, 1117 (9th Cir. 2016).Thus, the Ninth Circuit agreed with the SEC and most district courts thathave addressed that issue. See, e.g., SEC v. McCarthy, Accounting andAuditing Enforcement Release No. 3250 (Mar. 4, 2011), available athttps://www.sec.gov/litigation/ litreleases/2011/lr21873.htm (CEO agreed toreimburse Beazer Homes USA Inc. for a $5.7 million incentive bonus, 40,103restricted stock units, $772,000 in stock sale profits, and 78,763 restrictedshares awarded in, or for, fiscal 2006; when approving the settlement, thecourt barred CEO from seeking indemnification for payments under thesettlement); see also Settlement Between SEC, Beazer CEO in Clawback CaseWins Court Approval, 9 Corp. Accountability Rep. (BNA) 371 (Apr. 1, 2011);SEC v. Jenkins, 718 F. Supp. 2d 1070 (D. Ariz. 2010); SEC v. Jenkins,Accounting and Auditing Enforcement Release No. 3025 (July 23, 2009),https://www.sec.gov/litigation/litreleases/2009/lr21149a.htm; see also PressRelease, U.S. Sec. & Exch. Comm’n, Former CEO [Jenkins] to Return $2.8Million in Bonuses and Stock Profits Received During CSK Auto AccountingFraud (Nov. 15, 2011), available at https://www.sec.gov/news/press/2011/2011-243.htm.

Any accounting restatement now creates worries for a CEO or CFO whoreceived incentive-based or equity-based compensation during the twelve-month period that begins when the issuer issued or filed the misstatedfinancial document. Nonetheless, another open question under the statute iswhether the misconduct that triggers a clawback requires scienter, which youmay recall refers to a mental state reflecting an intent to deceive,manipulate, or defraud. Alternatively, will negligence, dereliction of duty, orsome other improper behavior suffice as misconduct under the statute? Otherissues include whether the public company must actually file a restatementto invoke the statute and whether the statute applies to now-private firmsthat were public companies when the misconduct occurred. See Matthew J.O’Hara, New Ninth Circuit Case on SOX Clawback Leaves Unresolved Issues,Corp. L. & Accountability Rep. (Bloomberg BNA), Nov. 28, 2016.

Separate from SOx section 304, Dodd-Frank section 954 requires theSEC to issue rules directing the national securities exchanges to bar fromlisting any issuer that does not develop, disclose, and implement a clawbackpolicy. Such policies must apply to any current or former executive officer


who received incentive-based compensation, including stock options, basedon erroneous financial information required under any federal securities lawin the three-year period before an accounting restatement. These policiesmust also require the executive to repay the excess over what the issuerwould have paid under the restatement. See 15 U.S.C. § 78j-4 (2012). As apractical matter, however, this implementation can only occur after: (1) theSEC proposes and issues implementing regulations; (2) the securitiesexchanges draft listing standards that comply with the final regulations; (3)the SEC approves the listing standards; and (4) listed companies adoptpolicies that satisfy the listing standards.

The SEC has yet to issue final regulations pursuant to Dodd-Franksection 954, and the provision does not impose a deadline for any action onthe agency. Over the dissent of two commissioners, in July 2015 the SECproposed rules to implement the provisions in section 954. Although thecomment period closed on September 14, 2015, the SEC has not taken anyadditional action on the matter. The proposed rule would direct the nationalsecurities exchanges to establish listing standards that would require eachlisted company to adopt, disclose, and implement a policy compelling therecovery of incentive-based compensation (“IBC”) that exceeded what shouldhave been awarded. An obligation to prepare an accounting restatement tocorrect a material error would trigger the policy. The policy must: (1) applyto current and former executive officers; (2) require recovery without regardto fault; (3) cover any excess compensation received in the three fiscal yearspreceding the date of the need to restate; (4) limit discretion whenconsidering whether to pursue a clawback; and (5) forbid the company fromproviding indemnification for any clawbacks to any officer. In addition, eachcompany must disclose its policy and its actions to recover any excesscompensation. See Listing Standards for Recovery of Erroneously AwardedCompensation, Securities Act Release No. 9861, Exchange Act Release No.75,342, Investment Company Act Release No. 31,702, 80 Fed. Reg. 41,144(July 1, 2015); see also Rob Tricchinelli, Divided SEC Proposes ClawbackRule; Looks Back 3 Years, Defines Officer Broadly, 13 Corp. L. &Accountability Rep. (Bloomberg BNA) 1509 (July 3, 2015).

Banks and other financial institutions, in particular, have aggressivelyadopted and used clawbacks. In response to a trading scandal, in 2011 UBScancelled half of the share-based bonuses awarded to investment bankerswhose bonuses exceeded $2 million or two million Swiss francs. After the“London Whale” fiasco in 2012, JP Morgan Chase & Co. reportedly seizedabout two years of total annual compensation from three London-basedtraders responsible for the blunder by voiding restricted stock and stockoption grants. In 2016, Wells Fargo & Co. clawed backed about $60 millionin compensation from its CEO and the head of its retail banking divisionafter employees opened thousands of unauthorized accounts and fired otheremployees who objected to the misconduct. Credit Suisse Group AG,Goldman Sachs Group Inc., and Morgan Stanley also have reportedly usedclawbacks. See Michael Greene, Will Wells Fargo Scandal Lead to Changesin Pay Plans?, Corp. L. & Accountability Rep. (Bloomberg BNA), Oct. 6, 2016;


Dan Fitzpatrick, J.P. Morgan: ‘Whale’ Clawbacks About Two Years ofCompensation, WALL ST. J., July 13, 2012, http://wsj.com/article/SB10001424052702303740704577524730994899406.html; Suzanne Kapner& Aaron Lucchetti, Pay Clawbacks Raise Knotty Issues, WALL ST. J., May 17,2012, at C1; Deborah Ball, A First for UBS: Bonus Clawbacks, WALL ST. J.,Feb. 9, 2012, at C3; Richard Hill, Dimon Tells Senators Loss Was Part ofHedging Strategy, to Expect Clawbacks, 44 Sec. Reg. & L. Rep. (BNA) 1191(June 18, 2012); Robin Sidel, Wall Street Toughens Its Rules on Clawbacks,WALL ST. J., Jan. 27, 2010, at C1.

More recently, some corporations have adopted broad clawback policiesthat also apply to excessive risk-taking, misconduct that causes significantfinancial or reputational harm, or detrimental conduct, which can includefailing to “blow the whistle” when someone else violates a corporate policy.In addition to the clawbacks mentioned in the previous paragraph, WellsFargo reportedly stripped about $112 million in awards from eight otherexecutives after multiple scandals at the bank. See Anders Melin & JennySurane, Equifax Investors Push for Changes to Clawback, Bonus Policies,Corp. L. & Accountability Rep. (Bloomberg BNA), Nov. 29, 2017.

Recognizing the limitations in SOx section 304 and even before the waitbegan for the SEC rules mandated in Dodd-Frank section 954, variousinstitutional investors have encouraged public companies to adopt broader“clawback” or executive compensation recoupment policies than section 304authorizes and to disclose such policies. In particular, these investorsadvocate, first, for policies that apply to all senior executives, for longerperiods of time, and in situations beyond misconduct and, then, for actualenforcement of the policies. See Tina Chi, Companies Assessing Risk ShouldReview Pay Programs, Implement Clawback Policies, 8 Corp. AccountabilityRep. (BNA) 162 (Feb. 19, 2010).

Although companies globally continue to adopt, expand, and enforcebroad clawback policies, legal requirements vary from country to country,which creates challenges for multinational corporations. In the UnitedStates, these broad policies have become “best practices,” but smallercompanies have lagged behind the largest public companies inimplementation. Based on a study by ISS Corporate Solutions, BloombergBNA reported in late 2016 that 86.4 percent of companies in the S&P 500 hadclawback policies. By comparison, the study found such provisions at 70.5percent of S&P Midcap 400 companies, but at only 34.6 percent of smallercompanies in the Russell 3000. Explicitly including clawback provisions thatcomply with applicable legal requirements in employment agreements andamending those provisions as applicable law changes aids, but doesguarantee, their enforceability. See Brian Jebb & Sarah Henchoz, INSIGHT:Implementing Compensation Clawbacks in a Global Economy, Corp. Law(Bloomberg Law), May 3, 2019; Michael Greene, Will Wells Fargo ScandalLead to Changes in Pay Plans?, Corp. L. & Accountability Rep. (BloombergBNA), Oct. 6, 2016.


As we await the SEC’s final rule implementing Dodd-Frank section 954,lawyers designing clawback policies should take care to eliminate thepossibility of indemnification and consider the following questions whendesigning or administering a clawback policy:

• Who does the clawback policy cover? In addition to any current orformer CEO and CFO, should the policy apply to current and formerdirectors, any current or former officer, and any current or formeremployee?

• What conduct or event will trigger a clawback? Does a clawbackrequire a restatement, any misconduct, or personal responsibilityfor a defined event, including reputational or other harm?

• What compensation does the clawback cover? Bonuses, stock options,performance-based awards? How much? Note that some state wagelaws may not allow an employer to claw back any previously earnedcompensation, including certain bonuses.

• Who will administer the policy?• How much discretion, if any, should the policy give to the

administrator?• Can the administer exercise “self help” and hold back other

compensation that the individual has earned?

On page 671 [omitted from the concise], after the third full sentenceat the top of the page, replace the rest of Note 5 with the followingdiscussion:

After the former executives admitted that certain aspects of the General Retransaction were fraudulent, in 2012 federal prosecutors signed deferredprosecution agreements that dropped the charges. Earlier, General Reentered into a nonprosecution agreement with the federal government in2010. The company agreed to pay about $92 million and to implement certaincorporate-governance changes. See SEC v. Ferguson, Accounting andAuditing Enforcement Release No. 2369 (Feb. 2, 2006), https://www.sec.gov/litigation/litreleases/lr19552.htm; see also Chris Dolmetsch, Greenberg’s HardFeelings Endure After Settling Lawsuit, 49 Sec. Reg. & L. Rep. (BloombergBNA) 344 (Feb. 20, 2017); Former General Re, AIG Executives Get ReprieveOver Alleged Roles in AIG Accounting Fraud, 9 Corp. Accountability Rep.(BNA) 938 (Aug. 5, 2011); Karen Richardson et al., Jury Convicts Five ofFraud in Gen Re, AIG Case, WALL ST. J., Feb. 26, 2008, at A1; Kip Betz et al.,AIG to Pay $1.6B to Resolve NY, SEC, DOJ Charges Over Accounting, 38 Sec.Reg. & L. Rep. (BNA) 263 (Feb. 13, 2006); Karen Richardson et al., AIG LegalThicket Grows Thornier, WALL ST. J., Feb. 3, 2006, at A3; Second General ReOfficial Pleads Guilty in Stock Fraud Case Over AIG Financials, 37 Sec. Reg.& L. Rep. (BNA) 1081 (June 20, 2005).

In 2009, former AIG CEO Maurice “Hank” Greenberg, without admittingor denying wrongdoing, agreed to settle SEC charges that alleged hisinvolvement in material misstatements that enabled AIG to create the falseimpression that the company consistently met or exceeded key earnings andgrowth targets. In so doing, Greenberg consented to a judgment directing


him to pay $7.5 million in disgorgement and a $7.5 million penalty. Later, ina 2017 settlement agreement with the New York Attorney General,Greenberg admitted that he initiated, participated in, and approved twofraudulent transactions and agreed to repay about $9 million in bonuses thathe received from 2001 to 2004. In an interview shortly after that settlement,Greenberg estimated that he spent about $200 million fighting the chargesover almost a dozen years. See SEC v. Greenberg, Accounting and AuditingEnforcement Release No. 3032 (Aug. 6, 2009), https://www.sec.gov/litigation/litreleases/2009/lr21170.htm; see also Chris Dolmetsch, Greenberg’s HardFeelings Endure After Settling Lawsuit, 49 Sec. Reg. & L. Rep. (BloombergBNA) 344 (Feb. 20, 2017).

While working on the joint project that ultimately led to the largelyconverged revenue recognition standards described earlier on pages 84 to 96,supra, FASB decided in 2008 to join IASB’s project on accounting forinsurance contracts. That project sought to improve, simplify, and convergethe recognition, measurement, presentation, and disclosure requirements,not only for insurance companies, but also for other enterprises such asbanks, guarantors, and service providers that issue contracts with insurancerisk. After more than fifty meetings, the Boards reached agreements on manyareas, but came to different conclusions on other issues.

** Based upon feedback received after the Boards issued separate exposuredrafts in 2013, FASB decided to focus on making targeted improvements toexisting U.S. GAAP and to limit the scope of any new rules to insuranceentities as described in existing U.S. GAAP. For short-duration contracts,such as auto and homeowners’ insurance, FASB decided to limit the targetedimprovements to enhanced disclosures. In 2015, FASB issued ASU No. 2015-09, Financial Services–Insurance (Topic 944): Disclosures about Short-Duration Contracts.

** In August 2018, FASB issued ASU No. 2018-12, Financial Services––Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, that will apply to insurers that issue long-durationcontracts, such as life insurance policies, disability income insurance, long-term-care insurance, and annuities. FASB originally announced that the newrules would apply to public companies starting with fiscal years, and interimperiods within those fiscal years, beginning after December 15, 2020, whichmeant that the rules would take effect for such companies using the calendaryear on January 1, 2021. For all other insurers, the new rules would becomeeffective for fiscal years beginning after December 15, 2021, and interimperiods within fiscal years beginning after December 15, 2022. For thoseinsurers using the calendar year, the changes would have started to takeeffect beginning January 1, 2022. In July 2019, however, the FASBtentatively decided to defer the mandatory effective dates for all enterprisesby at least a full year and directed the staff to draft a proposed accountingstandards update opening a thirty-day comment period. See Project Update:Insurance–Effective Date (Fin. Accounting Standards Bd. July 23, 2019),https://fasb.org/jsp/FASB/FASBContent_C/ProjectUpdateExpandPage&cid=


1176173019542; see also Nicola M. White, Insurance Companies to GetBreathing Room on Accounting Overhaul, Bloomberg Law, July 17, 2019.

** When effective, the new rules will require insurers to review at leastannually the assumptions they use to measure the amount of their insuranceobligations and, if necessary, to update those assumptions. Insurers willinclude any changes in the amounts of their obligations in net income, whichseems likely to increase volatility in their earnings and to decrease theirpredictability, but to provide a more current view of expected future cashflows. Under current rules, the amount of an insurance obligation remainsconstant until and unless a policy becomes unprofitable, at which time theinsurer must recognize the entire loss all at once, which distorts past andcurrent earnings. Insurance companies will also need to use a standarddiscount rate tied to the yield from high-quality bonds to measure theirexpected liabilities. Typically, this standard rate will fall below the rate thatinsurers currently use: the rate they earn on their investments. The lowerinterest rate will, in turn, increase the amount of an insurance obligation onthe insurer’s balance sheet. The new rules also simplify the accounting forthe costs to acquire a new policy, so-called deferred acquisition costs. Underthe new rules, insurers will amortize or allocate these costs on a constant-level basis as long as the policy remains outstanding. Finally, new disclosureswill provide information about significant inputs, assumptions, andjudgments, See FINANCIAL SERVICES–INSURANCE (TOPIC 944): TARGETED

IMPROVEMENTS TO THE ACCOUNTING FOR LONG-DURATION CONTRACTS,Accounting Standards Update No. 2018-12 (Fin. Accounting Standards Bd.),available at https://fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176171066930&acceptedDisclaimer=true; see also Michael Rapoport, Rule Aimsto Increase Transparency for Insurance Investors, WALL ST. J., Aug. 16, 2018,at B10.

** By comparison, to replace an interim standard, IFRS 4, InsuranceContracts, in 2017 IASB issued IFRS 17, Insurance Contracts, originally tobecome effective January 1, 2021, with earlier adoption allowed undercertain conditions. In June 2019, the IASB sought comments on a proposalto grant a one-year delay in the changes’ effective date and to adopt otherchanges designed to ease implementation. IFRS 4 allowed insurers indifferent countries to use different models. In some countries, those modelsdiffered from the accounting used in other industries. Although beyond thescope of this text, IFRS 17 provides one accounting model for all insurancecontracts in all IFRS jurisdictions, which should enhance comparabilityamong companies across IFRS jurisdictions, insurance contracts, andindustries. See Michael Kapoor, Insurers Offered 1-Year Delay in GlobalAccounting Change, Bloomberg Law, June 26, 2019.

On page 682 [page 387 of the concise] in the carryover paragraph atthe bottom of the page [the first full paragraph in the concise], insertthe following text:

The term “post-closing adjustments” can also describe what the text calls“top-side adjustments” or “top-side journal entries.” In 2016, the SEC brought


an enforcement action against oil services company WeatherfordInternational Plc and two accounting executives in the tax department forfraudulently using post-closing adjustments to lower the company’s incometax expense by at least $100 million each year from 2007 to 2010, therebyinflating earnings, to align results with previously announced projections andanalysts’ expectations. Weatherford agreed to pay a $140 million penalty tosettle the charges. See In re Weatherford Int’l Plc, Accounting and AuditingEnforcement Release No. 3806 (Sept. 27, 2016), available at https://www.sec.gov/litigation/admin/2016/33-10221.pdf.

On page 683, insert the following text at the bottom of the page[before note 5 at the top of page 388 of the concise]:

** So-called “cookie jar” or “cushion” accounting can also lead to criminalsanctions. In March 2019, Baton Holdings LLC, the successor in interest tofinancial services and marketing company Bankrate Inc., signed anonprosecution agreement and agreed to pay $28 million in penalties andrestitution to resolve an investigation into a scheme to inflate the company’searnings artificially. Former executives, including the CFO and vicepresident of finance, deliberately left millions of dollars in unsupportedexpense accruals on the company’s books and then reversed those accrualsin later quarters to boost earnings to meet or exceed analyst expectations.Previously. a federal judge had sentenced the former CFO to ten years inprison and the former vice president of finance to thirty months in prisonafter their guilty pleas to criminal charges and ordered them each to paymore than $21 million in restitution. In 2015, Bankrate settledadministrative charges related to the scheme and agreed to pay a $15 millioncivil penalty to the SEC. See Press Release, Dep’t of Just., Bankrate Inc.’sSuccessor in Interest Agrees to Pay $28 Million to Resolve Securities andAccounting Fraud Charges (Mar. 6, 2019), https://www.justice.gov/opa/pr/bankrate-inc-s-successor-interest-agrees-pay-28-million-resolve-securities-and-accounting; In re Bankrate, Inc., Accounting and Auditing EnforcementRelease No. 3683 (Sept. 8, 2015), https://www.sec.gov/litigation/admin/2015/33-9901.pdf.

** The pressure to meet earnings expectations remains high. In mid-2019,The Wall Street Journal reported that the share prices of companies in theS&P 500 whose operating results for the first quarter had fallen short ofanalysts’ estimated earnings had declined 3.2 percent from two trading daysbefore the earnings announcement to two sessions after the release. Thatdrop exceeded the 2.5 percent average decline over the previous five years.See Corrie Driebusch, Earnings Misses Hurt More This Season, WALL ST. J.,Apr. 25, 2019, at B12.


1. A BONA FIDE EXCHANGE TRANSACTION

b. EXCEPTIONS TO THE EXCHANGE TRANSACTION REQUIREMENT

(1) Fair Value Accounting

On page 736, insert the following text at the end of the firstparagraph in this section [on page 410 of the concise at the end ofthe carryover paragraph at the top of the page]:

Even with this new definition, unified framework, and the expandeddisclosures, considerable subjectivity remains. For example, mutual fundcompanies have assigned different valuations to their investments in UberTechnologies Inc., a company whose shares are not publicly traded. In 2017,The Wall Street Journal reported that four companies valued theirinvestments at $41.46 a share as of June 30, 2017, down from their original$48.77 per share purchase price in late 2015, while a fifth group set the valueat $42.70 per share, a sixth company maintained the $48.77 purchase price,and a seventh firm had written the value up to $53.88 per share. See RolfeWinkler & Greg Bensinger, Mutual Funds Mark Down Uber Investments byUp to 15%, WALL ST. J., Aug. 23, 2017, at B1.

On pages 742 and 743 [omitted from the concise], replace the twoparagraphs beginning with the carryover paragraph at the bottomof the page 742 and the first full paragraph on page 743 with thefollowing discussion:

** In response to continued calls from investors for additional informationregarding fair value measurements and complaints from enterprises aboutthe costs to provide such information, the FASB has attempted to strike anappropriate balance. After mandating additional information and clarifyingexisting disclosure requirements following the credit crisis, the FASBrevisited the disclosure requirements for fair value measurement whileworking on its disclosure framework project in ASU No. 2018-13, Fair ValueMeasurement (Topic 820): Disclosure Framework–Changes to the DisclosureRequirements for Fair Value Measurement. Perhaps most significantly, toempower an enterprise to omit immaterial disclosures regarding fair valuemeasurements, FASB decided to eliminate “at a minimum” from the phrase“an entity shall disclose at a minimum” in those disclosure requirements. Inaddition, the Board revised the disclosure requirements to remove some,modify others, and, for public enterprises only, to add two more. Inparticular, enterprises no longer need to disclose:

• The amount of, and reasons for, transfers between Level 1 and Level2 of the fair value hierarchy;

• The policy for timing of transfers between levels; and• The valuation processes for Level 3 fair value measurements.


Although nonpublic entities now need not disclose the changes in unrealizedgains and losses for the period included in earnings for recurring Level 3measurements held at period end, they must disclose transfers into and outof Level 3, as well as purchases and issues of Level 3 assets and liabilities.

** Next, ASU No. 2018-13 clarifies that a measurement uncertaintydisclosure communicates information about the uncertainty in measurementas of the reporting date. When effective, the amendments will require publicenterprises to disclose changes in unrealized gains and losses for the periodincluded in other comprehensive income for recurring Level 3 measurementsheld at period end. Finally, public companies will need to disclose the rangeand weighted average of significant unobservable inputs used to developLevel 3 measurements. The amendments apply to all entities for fiscal years,and interim periods within those years, beginning after December 15, 2019,but entities can adopt any removed or modified disclosures immediately anddelay providing the additional disclosures until their effective date. See FAIR

VALUE MEASUREMENT (TOPIC 820): DISCLOSURE FRAMEWORK–CHANGES TO THE

DISCLOSURE REQUIREMENTS FOR FAIR VALUE MEASUREMENT, AccountingStandards Update No. 2018-13 (Fin. Accounting Standards Bd.).

** About eight years earlier, FASB issued ASU No. 2010-6, ImprovingDisclosures About Fair Value Measurements, to amend Subtopic 820-10 in aneffort to increase transparency in financial reporting. Those amendmentsrequired enterprises to make disclosures about significant transfers in andout of Level 1 and Level 2 categories and activity in Level 3 fair valuemeasurements. In the reconciliation for changes in amounts for Level 3, thenew rules required enterprise to present information about purchases, sales,issuances, and settlements on a gross basis. The amendments clarified thelevel of disaggregation required and addressed disclosures about inputs andvaluation techniques. An enterprise should provide disclosures about fairvalue measurements for each class of assets and liabilities. A class refers toa subset of assets or liabilities within a line item on the balance sheet. Forfair value measurements that fall within Level 2 or Level 3, an enterpriseshould describe the inputs and techniques used to determine both recurringor nonrecurring measurements.

** In 2011, FASB and IASB completed a joint project to develop commonrequirements for measuring fair value and for disclosing information aboutfair value measurements. The converged standards gave fair value the samemeaning in U.S. GAAP and IFRS and, except for minor differences inwording and style, imposed the same fair value measurement and disclosurerequirements. While the amendments did not require additional fair valuemeasurements, the guidance changed the wording used to describe numerousrules in Topic 820 and clarified that an enterprise should disclosequantitative information about the unobservable inputs used in a fair valuemeasurement categorized as Level 3 within the fair value hierarchy in aneffort to improve comparability. In addition, the new rules requiredadditional disclosures about fair value measurements. For fair valuemeasurements categorized within Level 3, the converged standardsmandated the no longer required disclosures under U.S. GAAP about the


valuation processes and the fair value measurement’s sensitivity to changesin unobservable inputs and any interrelationships between those inputs.Finally, the amendments, and a related clarification, exempted nonpublicenterprises from certain disclosure requirements. For example, as eliminatedin ASU No. 2018-13, nonpublic enterprises no longer needed to disclosetransfers between Level 1 and Level 2 or to explain the reasons for suchtransfers. In addition, the converged standard eliminated the need fornonpublic enterprises to provide a narrative description as to how changesin unobservable inputs affect Level 3 measurements and to show thehierarchy levels for items disclosed, but not measured at fair value for thebalance sheet. See FAIR VALUE MEASUREMENTS (TOPIC 820): AMENDMENTS TO

ACHIEVE COMMON FAIR VALUE MEASUREMENT AND DISCLOSURE

REQUIREMENTS IN U.S. GAAP AND IFRSS, Accounting Standards Update No.2011-04 (Fin. Accounting Standards Bd.); FINANCIAL INSTRUMENTS (TOPIC

825): CLARIFYING THE SCOPE AND APPLICABILITY OF A PARTICULAR DISCLOSURE

TO NONPUBLIC ENTITIES, Accounting Standards Update No. 2013-03 (Fin.Accounting Standards Bd.) (exempting nonpublic companies from the needto provide hierarchy levels for fair value amounts disclosed, but not includedon the balance sheet).

On pages 744 and 745 [omitted from the concise], replace the textstarting with the first full paragraph and continuing to the end ofthis section with the following discussion:

In 2005, the FASB and IASB began a comprehensive joint project toimprove and simplify the financial accounting for financial instruments, suchas investments, derivatives, loans, and long-term receivables. This efforteventually morphed into separate components on classification andmeasurement, credit impairment, and hedge accounting. As a long-term goal,both Boards aspired to require enterprises to measure all financialinstruments at fair value, with realized and unrealized gains and lossesreflected in net income in the period in which they occur. The Boards havenow issued guidance on all three topics in the financial instruments project,but they could not agree upon converged standards, and banks and otherfinancial institutions continue to express concerns about the compliance costsnecessary to reach the Boards’ ultimate objective.

Classification and Measurement

In 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assetsand Financial Liabilities. ASU No. 2016-01 amends various aspects of therecognition, measurement, presentation, and disclosure of financialinstruments. For public companies, ASU No. 2016-01 applies to fiscal yearsbeginning after December 15, 2017, including interim periods within thoseyears. For all other organizations, the new rules apply to fiscal yearsbeginning after December 15, 2018, and interim periods within fiscal yearsbeginning after December 15, 2019, with special provisions governing earlyadoption, which cannot occur before a fiscal year beginning after


December 15, 2017, including interim periods within that fiscal year. Thefour significant changes announced in ASU No. 2016-01 relate to therecognition and measurement of equity investments that the entity does notconsolidate or account for under the equity method, impairment assessments,debit value adjustments, and enhanced disclosures.

** First, the new rules supersede the previous guidance described on pages750 to 754 of the Fifth Edition [pages 421 to 426 of the concise] that requiredenterprises owning equity securities with readily determinable fair values toclassify those securities as either “trading” or “available-for-sale.” Under thenew rules, enterprises will measure these securities at fair value, withchanges in the fair value recognized in net income. Under the previousguidance, enterprises included changes in the fair value of equity securitiesclassified as “trading” in net income, while reporting changes in the fair valueof “available-for-sale” securities in other comprehensive income, whichreflects a change in geography for the latter. In addition, the amendmentsallow enterprises owning securities without readily determinable fair valuesto remeasure those securities at cost minus impairment, if any, plus or minusadjustments for any observable price changes in orderly transactions for theidentical or a similar investment in the same issuer. The new rules, which donot apply to holdings large enough to convey control or significant influencethat require accounting under the equity method, will likely increase thevolatility of earnings, while reducing the number of items that enterpriseswill recognize in other comprehensive income. In that regard, famed investorWarren Buffet warned Berkshire Hathaway Inc. shareholders, which at thetime owned some $170 billion in equity securities, that the new rules would“‘produce some truly wild and capricious swings’ in the company’s [netincome].” In fact, the rules forced a $1.14 billion loss at Berkshire Hathawayin the first quarter of 2018, the company’s first net loss since 2009,notwithstanding a forty-nine percent increase in operating profit to $5.29billion. After reporting about $6.2 billion in losses on equity securities in thefirst quarter of 2018, Berkshire posted $4.5 billion and $11.4 billion in gainson such securities in the second and third quarters, respectively. For the full2018 calendar year, a $20.6 billion loss from a reduction in the amount ofunrealized gains existing in Berkshire’s investments caused net income todecline from $44.9 billion in 2017 (an amount that included about $29.1billion from a one-time net benefit following the enactment of the so-calledTax Cuts and Jobs Act of 2017) to about $4 billion in 2018, while operatingincome rose from $14.5 billion in 2017 to a record $24.8 billion in 2018. Thisexample again illustrates the importance of separately analyzing the variouscomponents of net income, here the company’s operating results, theunrealized gains or losses from equity securities during the period, and anyone-time items. See Nicole Friedman, Big Kraft Investment Bites Berkshire,WALL ST. J., Feb. 25, 2019, at B1; Michael Rapoport, Selloff Could HitEarnings, WALL ST. J., Jan. 7, 2019, at B9; Denise Lugo, SEC: AlternativeMetrics OK to Convey Effects of New Equity Rule, 50 Sec. Reg. & L. Rep.(Bloomberg BNA) 741 (May 14, 2018); Katherine Chiglinsky, Buffet’sAccounting ‘Nightmare’ Fuels First Loss Since 2009, Corp. L. &Accountability Rep. (Bloomberg BNA), May 8, 2018; Steve Burkholder,


Buffet: Accounting Rule on Stock Holdings Will Distort Earnings, Corp. L. &Accountability Rep. (Bloomberg BNA), Feb. 27, 2018.

As to equity securities without readily determinable fair values, the newrules simplify impairment assessments. Enterprises will use a processsimilar to the qualitative assessment for long-lived assets, including goodwill,described on page 138, infra. If an impairment exists, the enterprise shouldcalculate the investment’s fair value and recognize a loss, which will reducenet income, for the amount by which the investment’s carrying value exceedsits fair value. This new approach reduces the complexity of past “other-than-temporary” impairment determinations.

Third, the amendments require that when an entity has elected toremeasure a liability at fair value under the so-called fair value optiondescribed on pages 764 to 766 of the Fifth Edition [pages 434 to 436 of theconcise], the entity must present separately in other comprehensive incomethe portion of the total change in the liability’s fair value resulting from achange in the instrument-specific credit risk. Under previous rules,enterprises reported this change in net income, which produced thecounterintuitive result that net income increased when the enterprise’sdefault risk rose, but net income fell when the default risk decreased. Thischange excludes from net income gains or losses that an enterprise typicallywould not realize because enterprises usually do not transfer or settle thesefinancial liabilities at their fair values before maturity.

Finally, the new rules require enterprises to present separately financialassets and financial liabilities on the balance sheet or in the accompanyingnotes to the financial statements by measurement category and type offinancial asset or financial liability, such as receivables, loans, or securities.

Credit Impairment

The financial crisis that exploded in 2008 spurred increased attention tocredit impairment and loan losses. Banks and other organizations mustrecognize losses when customers cannot repay loans or make paymentsrequired under other contracts. These enterprises typically used a so-calledwrite-down to recognize an expense or loss for the nonpayment and set up anallowance or contra-asset account. Current GAAP follows an “incurred loss”approach that defers such credit losses until they are “probable,” which inpractice usually means after the debtor has already missed payments. Whenmeasuring credit losses under this approach, an enterprise only consideredpast events and current conditions. Critics have long expressed concerns thatcurrent GAAP restricts an organization’s ability to record credit losses thatthe organization expects, but that do not yet meet the “probable” threshold.The global financial crisis in the late 2000s highlighted these “too little, toolate” concerns. The Federal Reserve Board has observed that the incurredloss model delays the recognition of credit losses and overstates assets. SeeNicola M. White, Credit Card Giants Like Chase Facing Boost in Loan LossReserves, Bloomberg Law, June 19, 2019; Steve Burkholder, Banks Face


Landmark Credit-Loss Accounting Changes, Corp. L. & Accountability Rep.(Bloomberg BNA), Dec. 14, 2016.

In responding to such concerns, in 2014 IASB revised IRFS 9, FinancialInstruments, and adopted a so-called dual measurement approach to creditlosses. Under this approach, which applies to calendar year companiesbeginning in 2018, enterprises, including banks, immediately recognize onlythose losses arising from probable defaults during the next twelve months.Once a significant increase in credit risk occurs, however, the entity mustrecognize lifetime expected losses.

** By comparison, in ASU No. 2016-13, Financial Instruments–CreditLosses (Topic 326): Measurement of Credit Losses on Financial Instruments,FASB adopted the so-called current expected credit loss (“CECL”) model thatwill require not only banks, but all organizations, to record immediately alllosses expected over the lifetime of a financial instrument or othercommitment to extend credit. In addition, the CECL model expands therange of information used to estimate credit losses. When effective, Topic 326will require enterprises to measure all expected credit losses at the reportingdate on loans, debt securities, trade receivables, net investments in leases,off-balance-sheet credit exposures, reinsurance receivables, and otherfinancial assets that convey a contractual right to receive cash. Organizationswill estimate expected losses based on historical experience, currentconditions, and supportable forecasts, which will involve discretion andrequire judgment. Accordingly, the guidance also requires new disclosuresabout credit quality indicators and the year of origination. These changes willrequire organizations to review their systems, internal controls anddisclosures, often with assistance from lawyers. See FINANCIAL INSTRUMENTS

–CREDIT LOSSES (TOPIC 326): MEASUREMENT OF CREDIT LOSSES ON FINANCIAL

INSTRUMENTS, ACCOUNTING STANDARDS UPDATE No. 2016-13 (Fin. AccountingStandards Bd.), available at https://fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168232528&acceptedDisclaimer=true; see alsoNicola M. White, Not Affected By New Loan Loss Rules? Think Again,Bloomberg Law, July 2, 2019; Peter Rasmussen, ANALYSIS: FASB’s NewCredit Loss Standard May Apply to You, Bloomberg Law Analysis(Bloomberg Law), May 15, 2019.

** FASB’s new standards on credit losses currently become mandatory forpublic companies other than emerging growth companies for fiscal yearsbeginning after December 15, 2019, including interim periods within thoseyears. For public companies using the calendar year, the changes take effecton January 1, 2020. For emerging growth companies and private entities,including not-for-profit organizations, the new rules currently becomeeffective no later than annual reporting periods beginning after December 15,2021, again including interim periods within those years. For those entitiesusing the calendar year, the changes currently take effect beginning January1, 2022. In July 2019, however, the FASB tentatively decided to defer themandatory effective date for smaller reporting companies, emerging growthcompanies, and all other entities, including private companies and not-for-profit organizations, until fiscal years beginning after December 15, 2022,


including interim periods within those years. FASB also directed the staff todraft a proposed accounting standards update providing a thirty-daycomment period. If finalized, the new credit loss rules would apply to thosesmaller reporting companies, emerging growth companies, and privatecompanies using the calendar year, starting January 1, 2023. Allorganizations can adopt the new rules early, but no earlier than annualreporting periods beginning after December 15, 2018, including interimperiods within that annual period. See Project Update, Credit Losses,Hedging, and Leases–Effective Dates for Private Companies, Not-for-ProfitOrganizations and Small Public Companies (Fin. Accounting Standards Bd.July 22,2019), https://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdateExpandPage&cid=1176173010144; CODIFICATION IMPROVEMENTS TO TOPIC

326, FINANCIAL INSTRUMENTS–CREDIT LOSSES, ACCOUNTING STANDARDS

UPDATE No. 2018-19 (Fin. Accounting Standards Bd.), available at https://fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176171644373&acceptedDisclaimer=true; see also Nicola M. White, Small Banks to Get MoreTime on Loan Loss Accounting Changes, Bloomberg Law, July 17, 2019.

** In the current economic environment with burgeoning student loan debtnow exceeding $1.5 trillion and increasing default rates, the new rules seemmost likely to affect enterprises that extend student loans or issue creditcards with no set payoff date, which gives customers more time to run upbalances and miss payments. JP Morgan Chase & Co., for example, expectsto record thirty-five percent more losses under CECL, while DiscoverFinancial Corp., which extends fewer commercial loans, has predicted a fifty-five to sixty-five percent increase. By comparison, American Express Co.,which caters to customers with higher credit scores and who typically pay offtheir balances in full every month, forecasts that loan loss reserves willincrease only modestly. Unlike other banks, Wells Fargo & Co. anticipatesthat its loan loss reserves will decrease by as much as $1 billion under thenew rules. See Nicola M. White, Credit Card Giants Like Chase Facing Boostin Loan Loss Reserves, Bloomberg Law, June 19, 2019; Felice Maranz,Financial Firms May Gain from Big Accounting Change, KBW Says, Fin.Accounting News (Bloomberg Law), June 17, 2019; Nicola M. White, WellsFargo Surprisingly Predicts Loan Loss Drop Under New Rules, Fin.Accounting News (Bloomberg Law), Apr. 12, 2019.

As described in more detail on pages 748 to 750 of the Fifth Edition[pages 418 to 421 of the concise], organizations report some financial assets,most notably held-to-maturity debt securities, loans and trade receivables,at amortized cost. This amount reflects the original cost to acquire the debtsecurity or the amount the organization disbursed in the loan or extended ascredit, adjusted to reflect the amortization of any discount or premium. If anorganization measures any financial asset at amortized cost, the newguidance will require the organization to report such assets on the balancesheet at the net amount the organization expects to collect. To determine thiscarrying value of a financial asset or group of financial assets, theorganization would subtract the allowance for credit losses, which serves asa contra-account to the underlying assets, from the relevant cost basis. The


income statement would reflect the increase or decrease in expected creditlosses that occurred during the accounting period. If an organization believedthat it would only collect $9,000 on a $10,000 trade receivable, it mightrecord the following journal entry:

Credit Loss Expense $1,000Allowance for Credit Losses $1,000

The trade receivable would then appear on the balance sheet at $9,000,reflecting the $10,000 cost less the $1,000 allowance for credit losses. Theincome statement would report a $1,000 expense, which would more timelyreflect the expected loss.

If an organization purchases a financial asset with credit deterioration,a so-called “PCD asset,” such as a bond originally issued by a company nowin bankruptcy, the new rules will require the organization to include theinitial allowance for credit losses in the “cost” to acquire the bond, ratherthan creating that allowance through credit loss expense. For example, if anenterprise purchases a $10,000 bond for $6,000, expecting to collect $7,500when the issuer emergences from bankruptcy, the enterprise would recordthe following journal entry:

Investment in Bonds $7,500Allowance for Credit Losses $1,500Cash 6,000

Immediately after the acquisition, the bond would appear on theorganization’s balance sheet at its $6,000 actual cost, reflecting the $7,500amount that the organization expects to collect, less the $1,500 allowance,which the organization has added to the bond’s deemed purchase price. Thistreatment enhances comparability between PCD assets and originated andnon-PCD assets.

The organization would calculate expected credit losses based onrelevant information about past events, including historical experience,current conditions, and reasonable and supportable forecasts that affect thereported amount’s collectibility. The guidance does not require a specificmethod to determine expected losses, so organizations must use judgment todetermine the relevant information and estimation methods mostappropriate in the circumstances. Once again, organizations should describethe judgments and methods in the notes to the financial statements.

By presenting credit losses as an allowance, rather than as a write-downas under current GAAP, an enterprise can include reversals of credit lossesin current period net income when the estimate of credit losses declines. Thistreatment will align the recognition of expected credit losses and anysubsequent recoveries with the reporting period in which they occur. CurrentGAAP prohibits reflecting any reversals in current-period earnings.

ASU No. 2016-13 added paragraph 326-30-35-12 to the Codification torequire that enterprises record credit losses for available-for-sale debt


securities through an allowance for credit losses. When effective, thistreatment also will allow enterprises to recognize subsequent reversals insuch anticipated credit losses in current income. As a result, the newguidance aligns the income statement recognition of credit losses and anysubsequent reversals with the reporting period in which the changes occur.In addition, the amendments will limit the allowance on available-for-saledebt securities to the amount by which the amortized cost exceeds the fairvalue.

Observers expect that the CECL model will reduce volatility in earningsduring a credit cycle. The new model, however, will require banks to recordlosses based on their future projections about which loans will go bad andwill likely require banks to increase their allowances for loan lossessignificantly. Critics have complained that “ ‘[t]oo little, too late has becomeall up front.’ ” Concerns that the CECL model would force enterprises torecognize loan losses prematurely and excessively caused the IASB to rejectthe FASB’s approach. See FINANCIAL INSTRUMENTS–CREDIT LOSSES (TOPIC

326): MEASUREMENT OF CREDIT LOSSES ON FINANCIAL INSTRUMENTS,ACCOUNTING STANDARDS UPDATE NO. 2016-13 (Fin. Accounting StandardsBd.), available at http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168232528; see also Steve Burkholder, Banks Face LandmarkCredit-Loss Accounting Changes, Corp. L. & Accountability Rep. (BloombergBNA), Dec. 14, 2016; Steve Burkholder, New Accounting Rules to AccelerateLoan-Loss Recognition, Corp. L. & Accountability Rep. (Bloomberg BNA),June 17, 2016; Michael Rapoport, Proposed Accounting Change Could CatchLenders Unprepared, WALL ST. J., Aug. 13, 2014, at C3; Michael Rapoport,Banks Outside U.S. Get New Rules on Accounting for Bad Loans, WALL ST.J., July 25, 2014, at C3.

Hedge Accounting

In the third project, FASB recently simplified the accounting rules forhedging activities. Enterprises often use hedging instruments, includingfutures, options, and other derivatives, to reduce risks arising from changesin foreign currency exchange rates, commodity prices, and interest rates.Futures are nothing more than financial contracts that obligate the buyer topurchase an asset or the seller to sell an asset, such as a physical commodityor a financial instrument, at a predetermined future date and price. Bycomparison, an option gives the holder the right, but not the obligation, tobuy or sell the underlying asset at a predetermined price on or before afuture date.

Although extremely complex and generally beyond the scope of this text,current GAAP allows an enterprise to delay recording the economic effect ofa hedge on its income statement until the fiscal period in which theenterprise completes the underlying transaction. This treatment, whichrequires compliance with strict documentation rules, enables firms to reportless volatile earnings from quarter to quarter. The new rules permit moreflexibility in hedging interest rate risk for both variable rate and fixed ratefinancial instruments, expand eligibility for hedge accounting to nonfinancial


risks, simplify the documentation process, and offer relief for enterprises thatmight have minimally erred in applying the rules.

For public companies, the new rules apply to fiscal years beginning afterDecember 15, 2018, and interim periods within those fiscal years. For suchcompanies using the calendar year, the changes take effect on January 1,2019. For all other entities, the new rules currently become effective for fiscalyears beginning after December 15, 2019, and interim periods within fiscalyears beginning after December 15, 2020. For these entities using thecalendar year, the changes currently start to take effect beginning January1, 2020. In July 2019, however, the FASB tentatively decided to defer themandatory effective date for private companies and emerging growthcompanies for an additional year and directed the staff to draft a proposedaccounting standards update providing a thirty-day comment period. Iffinalized, the new hedging rules would apply to private companies and EGCsin fiscal years beginning after December 15, 2020, meaning effective January1, 2021 for companies using the calendar year, and interim periods withinfiscal years beginning after December 15, 2021, which means January 1,2022 for calendar-year-end companies. All organizations can adopt the newrules early in any interim period and record the effect of adoption as of thebeginning of the fiscal year of adoption. See DERIVATIVES AND HEDGING

(TOPIC 815): TARGETED IMPROVEMENTS TO ACCOUNTING FOR HEDGING

ACTIVITIES, ACCOUNTING STANDARDS UPDATE NO. 2017-12 (Fin. AccountingStandards Bd.), available at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176169282347; see also Project Update, Credit Losses, Hedging, andLeases–Effective Dates for Private Companies, Not-for-Profit Organizationsand Small Public Companies (Fin. Accounting Standards Bd. July 22, 2019),h t t p s : / / w w w . f a s b . o r g / j s p / F A S B / F A S B C o n t e n t _ C / P r o j e c tUpdateExpandPage&cid=1176173010144; Tatyana Shumsky, FASB ProposalLooks to Trim ‘Hedge Accounting’ Requirements, WALL ST. J., Mar. 28, 2017,at B5.

a) INVESTMENTS IN SECURITIES

On pages 745 to 755 [pages 416 to 426 of the concise], please note thatASU No. 2016-01, which was discussed on pages 106 to 108, supra,significantly changes the accounting for passive (in contrast toactive), equity investments starting no earlier than fiscal yearsbeginning after December 15, 2017, potentially including interimperiods within that fiscal year. When effective, the new guidanceprovides separate guidance for debt securities and equity securities.Under Topic 320, Investments–Debt Securities, enterprises willcontinue to classify debt securities into one of three categories atacquisition: (1) held-to-maturity securities; (2) trading securities; or(3) available-for-sale securities. As a result, the discussion on pages747 to 755 of the Fifth Edition [pages 418 to 426 of the concise]continues to apply to debt securities. New Topic 321,Investments–Equity Securities, however, requires enterprises to


measure all equity securities deemed passive investments at fairvalue, with changes in the fair value recognized in net income. Thenew rules, however, do allow enterprises owning equity securitieswithout readily determinable fair values to remeasure thosesecurities at cost minus impairment, if any, plus or minusadjustments for any observable price changes in orderlytransactions for the identical or a similar investment in the sameissuer. As discussed earlier, the new rules do not apply to “active”investments in equity securities, including those in which theinvestor enjoys control or significant influence over the investee,and which thus require accounting under the equity method. Whenapplicable, the new rules will likely increase the volatility ofearnings, while reducing the number of items that enterprises willrecognize in other comprehensive income.

(ii) Active Investments

(b) Equity Method

On page 759 [page 429 of the concise], insert the following text afterthe carryover paragraph [after the second full paragraph in theconcise]:

When an enterprise receives a distribution from an investee, ASU No.2016-15, Statement of Cash Flows (Topic 230): Classification of Certain CashReceipts and Cash Payments, adopted guidance requiring the enterprise toelect to classify such distributions under either the cumulative earningsapproach or the nature of the distribution approach. The cumulative earningsapproach generally views distributions as returns on investment and treatsthem as cash inflows from operating activities. An exception applies if theinvestor’s cumulative distributions exceed the cumulative earnings that theinvestor has recognized in income. In that event, this approach treats thatexcess as a return of investment that produces a cash inflow from investingactivities. In contrast, and as the name suggests, the nature of thedistribution approach classifies distributions on the basis of the nature of theinvestee’s activity or activities that generated the distribution. Thus, theenterprise would classify returns on investment as cash inflows fromoperating activities and treat returns of investment as cash inflows frominvesting activities. This later approach requires the enterprise to obtainaccess to the necessary information. See ASC ¶ 230-10-45-21D.

(2) Losses

On page 768 [omitted from the concise], replace the last fullparagraph with the following text:

As part of the FASB’s recent projects on financial instruments, ASU No,2016-13, which was described on pages 109 to 112, supra, added Topic 326,Financial Instruments–Credit Losses. Once effective, Topic 326 allows an


enterprise to recover, through the income statement, a previously recognizedcredit loss on available-for-sale debt securities when evidence emerges thatthe impairment has reversed, as allowed under IFRS. The previous inabilityto recognize recoveries of credit losses through the income statement arosefrom a bias toward conservatism in financial reporting.

2. EARNINGS PROCESS SUBSTANTIALLY COMPLETE

a. GENERAL RULES

(1) Delivery, Passage of Title, or Performance

On page 775 [page 444 of the concise] and immediately after theprincipal case, insert the following new note:

0. Pacific Grape involved a so-called “bill-and-hold arrangement.” In AAERNo. 108, the SEC set forth the following seven conditions as the criteria thata registrant should use to determine whether to recognize revenue from atransaction when delivery has not occurred:

(1) Have the risks of ownership passed to the buyer?(2) Has the buyer made a fixed commitment to purchase the goods,preferably in a written document?(3) Has the buyer requested the arrangement for a substantial businesspurpose?(4) Is there a fixed and reasonable schedule for delivery of the goods,which aligns with the buyer’s substantial business purpose and observescustomary practice in the industry?(5) Has the seller retained any specific performance obligations thatleave the earnings process incomplete?(6) Has the seller segregated the ordered goods from its inventory suchthat the seller cannot use the goods to fill other orders?(7) Are the goods finished and ready for shipment?

See In re Parness, Accounting and Auditing Enforcement Release No. 108,[1982-1987 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 73,508 (Aug. 5, 1986).The SEC staff later reiterated these conditions in SAB Topic 13.

To bring existing guidance into conformity with ASC Topic 606, inAugust 2017 the SEC issued an interpretive release to update its guidanceon bill-and-hold arrangements. Topic 606 acknowledges that in somecontracts the customer may obtain control over a product even though itremains in the seller’s physical possession. Topic 606 specifically addressesbill-and-hold arrangements. In addition to setting forth factors that indicatewhen the customer has obtained control, the guidance specifies the followingfour criteria that the arrangement must meet before the seller can recognizerevenue by transferring control and lists additional criteria that the sellermust meet to recognize revenue in a bill-and-hold arrangement:


• A substantive reason must exist for the arrangement, such as thecustomer requested the arrangement;

• The seller must identify the product separately as belonging to thecustomer;

• The product must exist in a condition ready for physical transfer to thecustomer; and

• The seller cannot have the ability to use the product or to direct it toanother customer.

See ASC ¶ 606-10-55-83. If the seller recognizes revenue from the sale of aproduct on a bill-and-hold basis, the seller should consider whether aremaining performance obligation, perhaps to provide custodial services,requires the seller to allocate a portion of the transaction price to thatperformance obligation. See ASC ¶ 606-10-55-84.

Once a registrant adopts Topic 606, the interpretive release states thatthe guidance in In re Parness no longer applies. Until that time, registrantsshould continue to follow the guidance in In re Parness and SAB Topic 13. SeeCommission Guidance Regarding Revenue Recognition for Bill-and-HoldArrangements, Securities Act Release No. 10,402, Exchange Act Release No.81,428, 82 Fed. Reg. 41,147 (Aug. 18, 2017).

b. EXCEPTIONS TO THE SUBSTANTIAL COMPLETIONREQUIREMENT

(2) Long-Term Contracts

On pages 787 to 797 [pages 455 to 457 in the concise], please note thatTopic 606 eliminates the percentage-of-completion and completedcontract methods. In addition, since Topic 606 supersedes previousSEC guidance on revenue recognition, the new revenue recognitionstandards supersede the program method as well. Although Topic606 does not recognize the percentage-of-completion method as such,the conceptual justification for that method aligns with the core“control” principle underlying the new standards. In effect, thepercentage-of-completion method recognizes that in long-termconstruction contracts the parties have agreed that the customercontrols the work in process, which means that a continuous saleoccurs as the work progresses. Once an entity adopts Topic 606, theentity can no longer apply the percentage-of-completion, completedcontract, or program methods.

3. CUSTOMER DEPOSITS AND PREPAYMENTS

**In note 1 on page 808 [page 465 in the concise], please keep in mindthat the Treasury Department has removed Treasury Regulationsection 1.451-5 for tax years ending on or after July 15, 2019. The so-called Tax Cuts and Jobs Act of 2017 added sections 451(b) and (c) to


the Internal Revenue Code. Section 451(b) generally requires anaccrual method taxpayer to include an advanced payment in incomewhen the taxpayer treats the item as revenue for financialaccounting purposes. Under section 451(c), an accrual methodtaxpayer who receives an advance payment must either: (1) includethe entire advance payment in income in the tax year received, or (2)elect to defer any remaining portion of the advance payment untilthe following taxable year. Because section 451(c) applies uniformlyand consistently to all accrual taxpayers, that election overrides thedeferral method that Treasury Regulation section 1.451-5 offered,which sometimes allowed a multiyear deferral. See RegulationsRegarding Advance Payments for Goods and Long-Term Contracts,84 Fed. Reg. 33,691 (July 15, 2019), available at https://www.govinfo.gov/content/pkg/FR-2019-07-15/pdf/2019-14947.pdf.

C. THE MATCHING PRINCIPLE FOR EXPENSES

2. ACCRUAL OF EXPENSES AND LOSSES

b. THE PROBLEM OF UNCOLLECTIBLE ACCOUNTS

On page 830 [page 483 in the concise] before the Problem, insert thefollowing text:

As discussed on pages 108 to 112, supra, ASU No. 2016-13 requires aswitch from an “incurred loss” approach to a “current expected credit loss”(CECL) model for bad debts and many other financial instruments. Wheneffective, we can expect the new rules to force enterprises to recognize baddebts sooner, but with less volatility during an economic cycle.

D. DRAFTING AND NEGOTIATING AGREEMENTS AND OTHER

LEGAL DOCUMENTS CONTAINING TERMINOLOGY IMPLICATING

THE INCOME STATEMENT

On pages 849 and 850 [page 496 of the concise], delete the carryoverparagraph [first paragraph in the concise].

On page 851 [page 498 of the concise], insert the following text:

(g) “New GAAP.” As already discussed in this chapter, when effective the newor pending guidance on revenue recognition, equity investments that anenterprise does not consolidate or account for under the equity method,impairment assessments, debit value adjustments, and credit lossespotentially affects every enterprise’s income statement and related financialratios. In Chapter IX, this Update also discusses new standards governingaccounting for leases. Lawyers must consider all of these new rules and their


effects when drafting and negotiating legal documents containing amountsfound on the income statement or financial ratios involving measures ofrevenues or earnings.

(h) Current projects. Among other topics, FASB’s technical agenda includesprojects on identifiable intangible assets and subsequent accounting forgoodwill, business combinations, income taxes, financial performancereporting, segment reporting, and various research projects. Interestedreaders can monitor FASB’s technical agenda and obtain updates on allcurrent projects via https://www.fasb.org/jsp/FASB/Page/TechnicalAgendaPage&cid=1175805470156.

C H A P T E R VII

CONTINGENCIES

C. SECURITIES DISCLOSURE ISSUES

On page 897 [omitted from the concise], add the following text to theend of the first paragraph of this section:

More recently, the Rand Institute has estimated that asbestos settlementscould ultimately cost businesses and their insurers more than $265 billion.See Jef Feeley & David Voreacos, Huge Potential Liability Emerges for BASF,13 Corp. L. & Accountability Rep. (Bloomberg BNA) 1929 (Sept. 11, 2015).

On page 909 [page 544 of the concise], add the following text at theend of note 5 [note 4 of the concise]:

The failure to assess potential loss contingencies can give rise to anenforcement action for deficient internal accounting controls. As brieflydescribed on page 20, supra, without admitting or denying liability, GeneralMotors Co. agreed in early 2017 to pay a $1 million penalty to settle chargesthat inadequate internal controls prevented the company from assessing thepotential financial effects of faulty ignition switches. When losscontingencies, including potential vehicle recalls arise, public companiesmust assess the likelihood that a loss will occur. When a reasonablepossibility exists that the company will incur a material loss, the companymust provide an estimate of the loss or range of loss or state that no estimatecan be made. Although General Motors began investigating ignition switchesin the spring of 2012, accountants did not learn about the safety issue untilNovember 2013. As a result, during at least an eighteen-month period, theaccountants did not, and could not, properly evaluate the likelihood of arecall arising from 2.6 million defective switches or the potential lossesarising from such a recall. See In re General Motors Co., Accounting andAuditing Enforcement Release No. 3850 (Jan. 18, 2017), https://www.sec.gov/litigation/admin/2017/34-79825.pdf.

On page 910 [page 545 of the concise], replace the first example ofpress reports and securities filings documenting that publiccompanies continue to record accruals for estimated amountsnecessary to resolve pending or expected litigation with thefollowing text and more recent examples:

** In addition to accruals or disclosures related to potential liabilities thatcould reach billions of dollars at Bayer AG (Roundup weedkiller litigation),

119

120 CHAPTER VII CONTINGENCIES

Boeing (737 MAX plane crashes and groundings), Johnson & Johnson (talcproduct litigation), and PG&E Corp. (California wild fires), other moreisolated situations where public companies recorded estimated expenses ordisclosed amounts of reasonably possible losses prior to resolving aninvestigation or litigation include:

•As described in more detail on page 23, supra, in June 2019 WalmartInc. agreed to pay $282 million to resolve Foreign Corrupt Practices Actinvestigations. More than eighteen months earlier, the company recorded a$283 million loss related to those investigations. See Wal-Mart Stores, Inc.,Form 8-K (Nov. 16, 2017), available at https://www.sec.gov/Archives/edgar/data/104169/000010416917000075/form8-kx10312017.htm; see also DaveMichaels & Sarah Nassauer, Walmart to Pay $282 Million in Settlement ofBribery Probe, WALL ST. J., June 21, 2019, at B3.

•In May 2019, Equifax Inc. announced that its financial results for thequarter ended March 31, 2019 included a $690 million pre-tax legal accrual for estimated costs to resolve federal and state investigations and consumerclass actions arising from the 2017 data breach that exposed the personalinformation, including Social Security numbers, birth dates, and addresses,of about 148 million customers. Slightly more than two months later, theFederal Trade Commission issued a press release announcing that Equifaxhad agreed to pay at least $575 million, and potentially up to $700 million,in a global settlement to resolve those investigations and related litigation.See Press Release, Fed. Trade Comm’n, Equifax to Pay $575 Million as Partof Settlement with FTC, CFPB, and States Related to 2017 Data Breach(July 22, 2019), https://www.ftc.gov/news-events/press-releases/2019/07/equifax-pay-575-million-part-settlement-ftc-cfpb-states-related; PressRelease, Equifax Inc., Equifax Releases First Quarter Results (May 10, 2019),https://investor.equifax.com/tools/viewpdf.aspx?page={CCBD6343-78A1-406F-9A12-51EC489C73F2}; see also Dave Sebastian & AnnamariaAndriotis, Equifax Reaches Data-Breach Pact, WALL ST. J., July 23, 2019, atB1; David Solomon, INSIGHT: Minimizing Litigation, Reputational Risk inthe Data Breach Age, Bloomberg Law, June 20, 2019.

•In April 2019, Facebook, Inc. announced that it had recorded a $3billion estimated and probable loss for the first quarter of 2019 in connectionwith the Federal Trade Commission’s inquiry into the company’s platformand user data practices. The company further estimated that the eventualloss in the matter would range between $3 billion and $5 billion. Almostexactly three months later, the FTC imposed a record-breaking $5 billionpenalty and new restrictions on Facebook’s business operations, includingvarious compliance requirements. That same day, Facebook announcedsecond quarter earnings that included a one-time $2 billion charge, reflectingthe difference between the $5 billion penalty and the $3 billion losspreviously accrued. See Press Release, Fed. Trade Comm’n, FTC Imposes $5Billion Penalty and Sweeping New Privacy Restrictions on Facebook (July 24,2019), https://www.ftc.gov/news-events/press-releases/2019/07/ftc-imposes-5-billion-penalty-sweeping-new-privacy-restrictions; Press Release, Facebook,Inc., Facebook Reports First Quarter 2019 Results (Apr. 24, 2019), https://

CHAPTER VII CONTINGENCIES 121

s21.q4cdn.com/399680738/files/doc_news/Facebook-Reports-First-Quarter-2019-Results.pdf; see also Jeff Horwitz & Deepa Seetharaman, FacebookPosts Big Earnings, Brushing Off Fine, WALL ST. J., July 25, 2019, at A1; JeffHorwitz, Facebook Prepares to Pay Big Fine, WALL ST. J., Apr. 25, 2019, atA1.

•Wells Fargo & Co. has announced a series of charges related to variouslegal matters, including mortgage-related regulatory investigations, salespractices, and other consumer-related matters, and probable liability forstate income taxes in states where the bank does business, but does notmaintain a physical presence, after the Supreme Court’s 2018 decision in asales tax case involving South Dakota and retailer Wayfair Inc.

** •In August 2018, Wells Fargo agreed to pay more than $2 billion toresolve a U.S. Department of Justice investigation into the bank’s saleof mortgage-backed securities between 2005 and 2007. The company’spress release stated that: “The amount of the settlement was fullyaccrued as of June 30, 2018.” See Press Release, Wells Fargo & Co., WellsFargo Reaches Agreement with DOJ to Resolve Legacy RMBS Claims(Aug. 1, 2018), https://newsroom.wf.com/press-release/consumer-lending/wells-fargo-reaches-agreement-doj-resolve-legacy-rmbs-claims; see alsoEmily Glazer, Wells Settles Mortgage Case for $2 Billion, WALL. ST. J.,Aug. 2, 2018, at B1.

•In July 2018, the bank announced that its $5.2 billion in secondquarter 2018 net income included “net discrete income tax expense of$481 million mostly related to state income taxes driven by the recentU.S. Supreme Court decision in South Dakota v. Wayfair” and “$619million of operating losses primarily related to non-litigation expense forpreviously disclosed matters.” Press Release, Wells Fargo & Co., WellsFargo Reports $5.2 Billion in Quarterly Net Income (July 13, 2018),https://newsroom.wf.com/press-release/wells-fargo-reports-52-billion-quarterly-net-income; see also Peter Rudegeair, Settlements Crimp WellsFargo’s Profit, WALL ST. J., July 14, 2018, at B12.

•In May 2018, Wells Fargo announced its preliminary agreement topay $480 million to settle a consolidated securities fraud class actionarising from alleged misstatements and omissions in disclosures relatedto the bank’s sales practices. The press release stated: “The amount wasfully accrued as of March 31, 2018.” Press Release, Wells Fargo & Co.,Wells Fargo Reaches Agreement in Principle to Resolve ConsolidatedSecurities Fraud Class Action (May 4, 2018), https://newsroom.wf.com/press-release/corporate-and-financial/wells-fargo-reaches-agreement-principle-resolve-consolidated; see also Emily Glazer, Wells Fargo SettlesSecurities Fraud Class Action for $480 Million, WALL ST. J., May 5, 2018,at B10.

•In April 2018, Wells Fargo entered into consent orders with theOffice of the Comptroller of the Currency (“OCC”) and the ConsumerFinancial Protection Bureau (“CFPB”) to resolve issues regarding


interest rate-lock extensions on home mortgages and collateralprotection insurance on auto loans. The orders required the bank to pay$1 billion in total civil money penalties. As a result, the companyannounced that it would adjust its first quarter 2018 preliminaryfinancial results to add an additional non-deductible $800 millionexpense accrual. The accrual reduced first quarter 2018 net income andnet income applicable to common stock to $5.1 billion and $4.7 billion,respectively. See Press Release, Wells Fargo & Co., Wells Fargo Entersinto Consent Orders with OCC and CFPB (Apr. 20, 2018), https://newsroom.wf.com/press-release/corporate-and-financial/wells-fargo-enters-consent-orders-occ-and-cfpb; see also Wells Fargo & Co., Form 8-K/A(Apr. 23, 2018), available at https://www.sec.gov/Archives/edgar/data/72971/000007297118000307/wfc-04202018xform8ka.htm; Michael Rapo- port, New Settlement for $1 Billion Makes Dent in Wells Profit, WALL ST.J., Apr. 23, 2018, at B6.

•Earlier in April 2018, the bank announced $5.9 billion inpreliminary first quarter 2018 net income, but cautioned that thecompany may need to revise its results to reflect additional accruals forthe OCC and CFPB matters. The earnings release stated that OCC andCFPB had offered to resolve the matters for $1 billion. See Press Release,Wells Fargo & Co., Wells Fargo Reports Preliminary First Quarter 2018Net Income of $5.9 Billion; Diluted EPS of $1.12 (Apr. 13, 2018),https://newsroom.wf.com/press-release/wells-fargo-reports-preliminary-first-quarter-2018-net-income-59-billion-diluted-eps-1; see also EmilyGlazer, Wells Gets Another Blow, WALL ST. J., Apr. 14, 2018, at B11.

•In January 2018, Wells Fargo announced its fourth quarter 2017and full year 2017 financial results. The fourth quarter results included$3.25 billion in pre-tax expense from mostly non-deductible “litigationaccruals for a variety of matters, including mortgage-related regulatoryinvestigations, sales practices, and other consumer-related matters.”Press Release, Wells Fargo & Co., Wells Fargo Reports Fourth Quarter2017 Net Income of $6.2 Billion; Diluted EPS of $1.16, https://newsroom.wf.com/press-release/corporate-and-financial/wells-fargo-reports-fourth-quarter-2017-net-income-62-billion; see also Laura J. Keller, WellsFargo’s Earnings Take Yet Another Big Litigation Hit, Corp. L. &Accountability Rep. (Bloomberg BNA), Jan. 16, 2018; Emily Glazer,Banks Upbeat As Taxes Muddy Earnings, WALL ST. J., Jan. 13, 2018, atA1.

•In October 2017, the bank announced that its third quarter 2017results included a non-tax-deductible $1 billion litigation accrual forpreviously disclosed mortgage-related regulatory investigations. SeePress Release, Wells Fargo & Co., Wells Fargo Reports Third Quarter2017 Net Income of $4.6 Billion; Diluted EPS of $0.84 included theimpact of a discreet litigation accrual of $(0.20) per share for previouslydisclosed mortgage-related regulatory investigations 1-3, 7 (Oct. 13,2017), https://www08.wellsfargomedia.com/assets/pdf/about/investor-


relations/earnings/third-quarter-2017-earnings.pdf; see also EmilyGlazer & Rachel Louise Ensign, Wells Fargo Trips as BofA Cruises,WALL ST. J., Oct. 14, 2017, at B1.

•In June 2018, Societe Generale SA announced that it had agreed to payabout $1.3 billion to U.S. and French regulators to resolve investigations intoLibor and Euribor manipulation and bribery in Libya. In the press releaseannouncing the settlement, the bank stated in relevant part:

The payment of these penalties is fully covered by the provisionallocated to the IBOR and Libyan matters and booked in SocieteGenerale’s accounts. As a result, they will have no impact on SocieteGenerale’s results. Following these payments, the provision forlitigation will amount to approximately 1.2 billion euro equivalent.

Press Release, Societe Generale, Societe Generale reaches agreement withthe DOJ, the CFTC and the PNF to resolve their pending IBOR and Libya-related investigations (June 4, 2018), https://www.societegenerale.com/sites/default/files/pr-societe-generale-reaches-agreements-with-the-doj-the-cftc-and-the-pnf-04062018.pdf; see also Fabio Benedetti-Valentini & GaspardSebag, Soc-Gen Agrees to Pay $1.3 Billion to Settle Libya, Libor Probes, 50Sec. Reg. & L. Rep. (Bloomberg BNA) 851 (June 11, 2018).

•In September 2017, Volkswagen AG announced an expected €2.5 billionincrease in provisions related to the buyback or retrofit program for dieselvehicles related to the company’s emission scandal. As of September 30, 2017,Volkswagen AG had recognized more than €23 billion, or about $25 billion(by early 2019, the amounts had grown to about €29 billion, or approximately$33 billion), in provisions related to legal fees, fines and penalties, recallcosts, and compensation to customers arising from its diesel emissionsscandal, including €14.6 billion in 2015, €6.0 billion in 2016, and €2.6 billionin the 2017 third quarter. The Wall Street Journal also reported that by theend of the 2017 third quarter, Volkswagen had paid out €14.5 billion in costsrelated to the emissions scandal, expected to pay out another €2.5 billionbefore the end of the year, and determined that the diesel issue was nowherenear coming to an end. See Press Release, Volkswagen AG, Ad hoc:Volkswagen Group increases Provision for Recall Actions in North America(Sept. 29, 2017), http://www.volkswagenag.com/en/news/2017/09/Ad_hoc_29_Sep.html; Volkswagen AG, Interim Report 2017 (January-September) 6, 38,http://www.volkswagenag.com/presence/investorrelation/publications/interim-reports/2017/volkswagen/en/Q3_2017_e.pdf; Volkswagen AG, AnnualFinancial Statements of Volkswagen AG (as of December 31, 2016) 4-5,http://www.volkswagenag.com/presence/investorrelation/publications/annual-media-conference/2017/jahresabschluss/Jahresabschluss_VWAG_2016_e.pdf;see also Karin Matussek, Ex-VW CEO Winterkorn Charged in Germany OverDiesel Rigging, Sec. Law (Bloomberg Law), Apr. 15, 2019; William Boston,VW Profit Drops on Diesel Charge, WALL ST. J., Oct. 28, 2017, at B4.

•As of June 30, 2017, BP p.l.c. reported on its consolidated balance sheetmore than $15 billion in accrued liabilities related to the 2010 Deepwater


Horizon oil spill in the Gulf of Mexico, including about $2.2 billion in currenttrade and other payables, $955 million for current provisions, and more than$12.1 billion in non-current other payables. During the 2017 second quarter,BP recorded a $347 million pre-tax charge to reflect the latest estimate forclaims, including business economic loss claims and associatedadministrative costs. Through June 30, 2017, BP had recognized more than$63.2 billion in pre-tax charges related to the spill, an amount that has growneven since BP announced in July 2016 that it could reliably estimate all of itsremaining material liabilities arising from the accident. After recording anexpected $5.2 billion pre-tax charge for the 2016 second quarter, BP projectedthat total pre-tax charges would reach $61.6 billion. During 2010, the yearthe accident occurred, BP recorded $40.9 billion in pre-tax charges related tothe spill. BP has recognized additional net charges during accounting periodsfrom 2011 to the present. See Press Release, BP p.l.c., BP p.l.c. Groupresults[:] Second quarter and half year 2017, at 19-21 (Aug. 1, 2017),available at https://www.bp.com/content/dam/bp/en/corporate/pdf/investors/bp-second-quarter-2017-results.pdf; see also Press Release, BP p.l.c., BPestimates all remaining material Deepwater Horizon liabilities (July 14,2016), https://www.bp.com/en/global/corporate/media/press-releases/bpestimates-all-remaining-material-deepwater-horizon-liabilitie.html; PressRelease, BP p.l.c., Group results First quarter 2011, at 21, 24 (Apr. 27, 2011),available at https://www.bp.com/content/dam/bp/pdf/investors/bp-first-quarter-2011-results.pdf.

•On June 27, 2017, the European Commission announced a €2.42 billionantitrust fine, or $2.74 billion based upon that day’s exchange rate, againstGoogle. That same day, Kent Walker, Google’s general counsel, announcedthe Company’s disagreement with the decision and advised that Googlewould consider an appeal. Three days later, Google’s parent, Alphabet Inc.,announced plans to accrue the fine in its 2017 second quarter results.Alphabet’s 2017 second quarter earnings release stated that the Companyhad accrued the fine in the second quarter and that the $2.74 billion amountappeared in “Accrued expenses and other current liabilities” on thecompany’s balance sheet. Google later appealed the fine. See Press Release,Alphabet Inc., Alphabet Announces Second Quarter 2017 Results (July 24,2017), https://abc.xyz/investor/pdf/2017Q2_alphabet_earnings_release.pdf; seealso Sam Schechner & Natalia Drozdiak, Google Appeals EU AntitrustPenalty, WALL ST. J., Sept. 12, 2017, at B4; Press Release, Alphabet Inc., Howwe will account for the EC fine in our Q2 results (June 30, 2017),https://abc.xyz/investor/news/releases/2017/0630.html; The EuropeanCommission decision on online shopping: the other side of the story, GOOGLE

INC. (June 27, 2017), https://www.blog.google/topics/google-europe/european-commission-decision-shopping-google-story/.

•In August 2014, Bank of America Corp. reached a $16.65 billionsettlement with the U.S. Department of Justice, the SEC and other federalagencies, and six states to resolve charges and investigations related toresidential mortgage-backed securities, collateralized debt obligations, andthe 2008 financial crisis. The bank and its affiliates agreed to pay $9.65


billion in cash and to provide approximately $7.0 billion in consumer reliefin the then-largest settlement between the United States and a singlecompany. The company announced that the settlement would reduce 2014third-quarter pre-tax earnings by $5.3 billion, which suggested that the bankhad previously accrued more than $11.0 billion related to the underlyingmatters. See Press Release, Bank of America Corp., Bank of America ReachesComprehensive Settlement with U.S. Department of Justice and StateAttorneys General to Resolve Mortgage-related Litigations andInvestigations (Aug. 21, 2014), http://newsroom.bankofamerica.com/press-releases/corporate-and-financial-news/bank-america-reaches-comprehensive-settlement-us-departm; see also Christina Rexrode & Andrew Grossman,BofA Accord Ends a Long Legal Drama, WALL ST. J., Aug. 22, 2014, at C1.

On page 917 [page 550 of the concise], insert the following text at theend of note 9 [note 8 in the concise]:

As an example of an investment analyst report that could potentially lead tohelpful information about an accrual for ongoing litigation, consider:“Moody’s believes that potential additional litigation charges, which couldarise from legacy cases, are unlikely to meaningfully negatively affect UBS’ssolid capitalization level and metrics, considering the improving groupprofitability and significant provisions that UBS has established during theprior years.” Moody’s Investors Service, Rating Action: Moody’s upgradesUBS AG’s long-term senior unsecured debt ratings to Aa3, outlook stable(June 18, 2018), https://www.moodys.com/research/Moodys-upgrades-UBS-AGs-long-term-senior-unsecured-debt-ratings--PR_385013. If you representa client in significant litigation adverse to UBS, how might you pursue thisopportunity?

E. DISCOVERY ISSUES

2. WORK PRODUCT PROTECTION

On page 956, insert the following at the end of the first paragraph innote 3 [at the end of the carryover paragraph on page 566 of theconcise]:

In Schaeffler v. United States, 806 F.3d 34 (2d Cir. 2015), the Second Circuitliberally interpreted Adlman, vacated a district court decision that denied amotion to quash an IRS administrative summons, and held that the work-product doctrine protected a memorandum that Ernst & Young prepared toadvise on the federal income tax implications of a large and complexrefinancing and restructuring when the taxpayers believed litigation washighly probable. The court of appeals also held that the taxpayers did notwaive the attorney-client privilege by sharing documents with a consortiumof lenders with a common legal interest with the taxpayers.

C H A P T E R VIII

INVENTORY

B. DETERMINING ENDING INVENTORY

1. WHICH COSTS AND GOODS TO INCLUDE IN INVENTORY

a. INCLUDABLE COSTS

(3) Other Illustrations of “Cost Accounting”

On page 1001 [page 596 the concise], insert the following citations atthe end of the first paragraph in this section:

**Elizabeth A. Eccher et al., Analysis of Cost Behavior When CalculatingDamages Part 1: Understanding Costs, BUS. L. TODAY (Nov. 15, 2018), https://businesslawtoday.org/2018/11/analysis-cost-behavior-calculating-damages-part-1-understanding-costs/; Elizabeth A. Eccher et al., Analysis of CostBehavior When Calculating Damages Part 2: Analyzing Avoided Costs, BUS.LAW TODAY (Nov. 15, 2018), https://businesslawtoday.org/2018/11/analysis-cost-behavior-calculating-damages-part-2-analyzing-avoided-costs/.

On page 1007 [omitted from the concise], insert the following text atthe end of Note 4:

Following the inauguration of President Trump, the United StatesDepartment of Commerce has focused more attention on U.S. trade law,including the antidumping laws. From January 20, 2017 to November 1,2017, the Commerce Department initiated seventy-seven antidumping andcountervailing duty investigations, reporting a sixty-one percent increaseover the forty-eight investigations in the previous year. On November 1,2017, the Department maintained 412 antidumping and countervailing dutyorders that offer relief to American companies and industries. During 2017,the Department announced affirmative final determinations that exportersfrom Canada had sold softwood lumber at less than fair value and thatexporters from Japan and Turkey have dumped steel reinforcement bar inthe United States. After the Department determines that the allegeddumping has occurred, and if so, the margin of dumping, the United StatesInternational Trade Commission (“USITC”) must determine whether theimports in question have materially injured, or threatened with materialinjury, the industry in the United States. If both the Department and theUSITC reach affirmative final determinations on their individual questions,

127

128 CHAPTER VIII INVENTORY

then the Department will issue an antidumping duty order to offset thedumping. Even a preliminary decision, however, brings immediateconsequences by discouraging importers from purchasing the products inquestion. See Press Release, U.S. Department of Commerce Finds Dumpingand Subsidization of Imports of Softwood Lumber from Canada (Nov. 2,2017), https://www.commerce.gov/news/press-releases/2017/11/us-department-commerce-finds-dumping-and-subsidization-imports-softwood; PressRelease, U.S. Department of Commerce Issues Final Determination ofDumping and Foreign Subsidy Duty Rates on Steel Rebar from Japan andTurkey (May 16, 2017), https://www.commerce.gov/news/press-releases/2017/05/us-department-commerce-issues-final-determination-dumping-and-foreign; see also Peter Nicholas & Paul Vieira, U.S. Readies Canada LumberTariff, WALL ST. J., Apr. 25, 2017, at A1.

2. HOW TO PRICE INVENTORY

a. FLOW ASSUMPTIONS

(2) Critique and Basis for Selection

c) LAST-IN, FIRST-OUT

(ii) Disadvantages

On page 1027 [page 609 of the concise], replace the carryoverparagraph at the bottom of the page with the following new text:

To further illustrate LIFO’s effects, consider Exxon Mobil Corporation’sfinancial results for 2007 through 2015. When oil prices increased rapidlyduring 2007, LIFO increased Exxon Mobil’s costs, and therefore, reduced itsincome before taxes, by about $9.5 billion. If Exxon Mobil had used FIFO,rather than LIFO, to value its ending inventory, its income before taxeswould have increased from a then-record $70.5 billion to about $80 billion.The notes to Exxon Mobil’s 2007 financial statements quantified thecompany’s LIFO reserve, or the cumulative difference between theinventory’s current replacement cost and its carrying amount on the balancesheet, at $25.4 billion. Exxon Mobil Corp., Annual Report (Form 10-K) 50, 56(Feb. 28, 2008); see also David Reilly, Big Oil’s Accounting Methods FuelCriticism, WALL ST. J., Aug. 8, 2006, at C1 (providing the LIFO reserve andan estimated net profit for 2005). By comparison, when oil prices fell duringthe second half of 2008, Exxon Mobil’s LIFO reserve fell to $10.0 billion atDecember 31, 2008, which means that LIFO actually added $15.4 billion tothe company’s reported $81.75 billion in income before taxes during 2008.Exxon Mobil Corp., 2008 Annual Report (Form 10-K) 58, 64 (Feb. 27, 2009).Then, as oil prices generally rose during the period from 2009 to 2012, whenaverage worldwide realizations increased from $57.86 per barrel during 2009to $100.29 per barrel in 2012, Exxon Mobil’s LIFO reserve increased to $21.3billion on December 31, 2012. Over that four-year period, therefore, LIFO

CHAPTER VIII INVENTORY 129

reduced the company’s income before taxes by more than $11 billion. ExxonMobil Corp., Annual Report (Form 10-K) 53, 68 (Feb. 27, 2013); Exxon MobilCorp., Annual Report (Form 10-K) 62, 69 (Feb. 26, 2010). When averageworldwide realizations dropped from $100.29 per barrel in 2012 to $97.48 perbarrel in 2013, Exxon Mobil’s LIFO reserve dropped to $21.2 billion onDecember 31, 2013. Exxon Mobil Corp., Annual Report (Form 10-K) 54, 69(Feb. 26, 2014). Finally, after oil prices started falling in 2014, plummetingto less than $27 per barrel in early 2016, such that the worldwide averagerealization fell to $44.77 per barrel in 2015, Exxon Mobil’s LIFO reservedwindled to $4.5 billion on December 31, 2015. See Exxon Mobil Corp.,Annual Report (Form 10-K) 55, 74 (Feb. 24, 2016).

On page 1028 [page 610 of the concise], replace the last fullparagraph with the following:

LIFO’s long-term future in the United States has brightenedconsiderably since 2016, but nevertheless remains partly cloudy. The SECnow appears highly unlikely to require registrants to adopt IFRS anytimesoon. Because IFRS prohibits LIFO, the conformity requirement, in turn,would have precluded any registrant forced to adopt IFRS from using LIFOfor federal income tax purposes, thereby eliminating LIFO’s most significantadvantage. All eight of President Obama’s budget proposals containedrecommendations that would have repealed the LIFO inventory accountingmethod for tax purposes, most recently for taxable years beginning afterDecember 31, 2016. After that date, the last proposal would have requiredtaxpayers to write up their beginning LIFO inventory to its FIFO value, andtaxed the income resulting from the change ratably over the ten-year periodstarting with the first taxable year beginning after December 31, 2016. Thatproposal would have generated more than an estimated $80 billion inadditional federal income taxes over that period. See DEP’T OF TREASURY,GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2017REVENUE PROPOSALS 105, 267 (2016), available at http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2017.pdf.Although none of President Trump’s three budget proposals for fiscal years2018, 2019, and 2020, respectively, have contained such a recommendation,for almost twenty years influential members of Congress from both majorpolitical parties have sponsored legislation to repeal LIFO. In 2005, the billswould have applied only to oil and gas companies, but the more recentversions would have expanded their reach to all businesses. In addition, theCongressional Budget Office periodically issues options for reducing thefederal deficit and estimated that repealing LIFO and the lower of cost ormarket method would have increased federal revenues by more than $100billion between fiscal years 2017 and 2026. See Congressional Budget Office,Repeal the “LIFO” and “Lower of Cost or Market” Inventory AccountingMethods, https://www.cbo.gov/budget-options/ 2016/52276 (Dec. 8, 2016); seealso Brian W. Carpenter, et al., The Impending Demise of LIFO: History,Threats, Implications and Potential Remedies, 28 J. APPLIED BUS. RESEARCH

645 (July/Aug. 2012), available at https://www.researchgate.net/publication/


268365773_The_Impending_Demise_Of_LIFO_History_Threats_Implications_And_Potential_Remedies.

b. LOWER OF COST OR MARKET

On page 1042 [page 616 of the concise], replace the first paragraph[second paragraph in the concise] with the following text:

Until recently, the Codification followed a rather complex formula fordetermining the “market” value of inventory. The formula incorporated allthree bases discussed above. FASB ASC Topic 330, Inventory, which, as youwill recall, codified ARB No. 43, defines market value as “currentreplacement cost.” Until a recent simplification effort, the formula providedthat market value lay somewhere between a maximum of net realizable valueand a minimum of net realizable value less expected or normal profit, asdepicted:

net realizable value

market value

net realizable value less normal profit

In other words, net realizable value served as a ceiling which market valuecould not exceed and net realizable value less normal profit functioned as afloor below which market value could not drop. Whenever replacement costfell somewhere between the ceiling and the floor, these rules treatedreplacement cost as the proper test of market value. If replacement costexceeded net realizable value, then the formula set net realizable value asthe appropriate figure for market value. If replacement cost fell below netrealizable value less normal profit, then the Codification established thelatter as the figure for market value. We must emphasize that the principleof lower of cost or market only applied when cost exceeded the market valueas so determined.

In an effort to reduce complexity and accounting costs, ASU No. 2015-11,Inventory (Topic 330): Simplifying the Measurement of Inventory, amendedthe Codification to require enterprises to measure certain inventories at thelower of cost or net realizable value, thus eliminating the need to determinea normal profit. The new rules, however, do not apply to any inventories thatan enterprise measures under LIFO or the retail inventory method. Theamendments apply to all other inventories, including any items that anenterprise uses FIFO or average cost to measure. The changes apply to publicbusiness entities for fiscal years beginning after December 31, 2016,including interim periods within those fiscal years. For all other entities, thenew rules apply to those same fiscal years and to interim periods beginningafter December 31, 2017. Any enterprise can adopt the new rules early, aslong as it does so as of the beginning of an interim or annual reportingperiod. See FASB ASC 330-10-35-1B.

CHAPTER VIII INVENTORY 131

No matter which set of rules applies, if an entity writes down goodsbelow cost at the end of a fiscal period, the Codification treats the reducedamount as “cost” for subsequent accounting purposes, which means that theenterprise cannot “write-up” the inventory if the market rises, not even to thegoods’ original cost. See FASB ASC 330-10-35-14.

On page 1047 [omitted from the concise], beginning with thesentence in note 1 that begins on the eighth line from the bottom ofthe page, replace the remainder of the first paragraph in note 1 withthe following:

Moreover, the SEC has brought enforcement actions not only against publiccompanies and their executives for failures to write-down inventoriesappropriately, but also against auditors for deficient audit procedures orneglecting apparent problems regarding inventory obsolescence See, e.g.,In re Logitech Int’l, S.A., Accounting and Auditing Enforcement Release No.3765 (Apr. 19, 2016), available at https://www.sec.gov/litigation/admin/2016/34-77644.pdf (actions against company and officers arising from the failureto write down inventory, including millions of dollars of excess componentparts, for a failed product in an effort to meet earnings guidance); In re SteinMart, Inc., Accounting and Auditing Enforcement Release No. 3704 (Sept. 22,2015), available at https://www.sec.gov/litigation/admin/2015/34-75958.pdf(action against company for delaying write-downs of permanently markeddown inventory until actual sale); In re Childers, Accounting and AuditingEnforcement Release No. 455, [1991–1995 Transfer Binder] Fed. Sec. L. Rep.(CCH) ¶ 73,914 (June 24, 1993) (action against auditor arising from auditsand interim reviews of Star Technologies, Inc.); In re Arthur Andersen & Co.,Accounting Series Release No. 292, [1937–1982 Transfer Binder] Fed. Sec. L.Rep. (CCH) ¶ 72,314 (June 22, 1981) (related to deficiencies in connectionwith audits of Mattel, Inc. and Geon Industries, Inc.).

C H A P T E R IX

LONG-LIVED ASSETS AND

INTANGIBLES


On page 1062, insert the following text before the carryoverparagraph at the bottom of the page [on page 630 of the concise,before the last paragraph in the introductory section]:

In 2016, FASB completed a project on lease accounting that began as ajoint effort with IASB and that will require organizations to recognize moreassets and liabilities arising from leases on the balance sheet. By adding anestimated $2 trillion to balance sheets globally, the new guidance willsignificantly affect certain financial ratios, including the current, debt toequity, return on assets, and asset turnover ratios. When these new leaseaccounting rules become effective, no later than in fiscal years beginningafter December 15, 2018 for public entities, and fiscal years beginning afterDecember 15, 2019 for all other organizations, the new standards in FASBASC Topic 842, Leases, will replace the guidance currently in Topic 840.

E. INTANGIBLE ASSETS AND GOODWILL

On page 1106, insert the statistics before the penultimate sentencein the third paragraph near the bottom of the page [before thepenultimate sentence in the carryover paragraph on page 660 of theconcise]:

Nevertheless, The Wall Street Journal reported in 2013 that companies inthe S&P 500 index were carrying $2 trillion in goodwill on their books,including more than $50 billion at AT&T Inc., Bank of America Corp.,Berkshire Hathaway Inc., General Electric Co., and Procter & Gamble Co.See Emily Chasan & Maxwell Murphy, Companies Get More Wiggle Room onSoured Deals, WALL ST. J., Nov. 12, 2013, at B1.

On page 1107, insert the following text after the second fullparagraph [in the concise edition, after the carryover paragraph atthe top of page 661]:

In ASU No. 2017-01, FASB amended the Codification to clarify when anenterprise should treat a transaction as a “business combination,” which

133

134 CHAPTER IX LONG-LIVED ASSETS AND INTANGIBLES

requires the acquisition (or disposal) of a business, as opposed to thepurchase (or sale) of assets. In response to concerns that enterprises werereporting many transactions resembling asset purchases as businesscombinations, the new guidance imposes a screen intended to reduce thenumber of transactions in the combinations category. When a singleidentifiable asset or a group of similar identifiable assets providessubstantially all of the fair value of the gross assets transferred, thetransaction does not satisfy the screen. Even when a transaction meets thescreen to qualify as eligible for treatment as a business combination, theintegrated set of assets and activities involved must include, at a minimum,an input and a substantive process that together significantly contribute tothe ability to create output. Otherwise, the transaction more closelyresembles the purchase of one or more assets and does not qualify as abusiness combination. The new rules apply prospectively to public companiesfor annual periods beginning after December 15, 2017, including interimperiods within those fiscal years. Private companies must apply theamendments to annual periods beginning after December 15, 2018, andinterim periods within annual periods beginning after December 15, 2019.Under certain circumstances, enterprises can adopt the new rules early. SeeBUSINESS COMBINATIONS (TOPIC 805): CLARIFYING THE DEFINITION OF A

BUSINESS, ACCOUNTING STANDARDS UPDATE NO. 2017-01 (Fin. AccountingStandards Bd.), available via https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168739996; see also Steve Burkholder, NewGuidance May Ease Process of Combinations Accounting, Corp. L. &Accountability Rep. (Bloomberg BNA), Jan. 6, 2017.

On page 1108, at the top of the page replace the text in the carryoverparagraph after the first full sentence [after the second sentence inthe second paragraph on page 661 of the concise edition] with thefollowing discussion:

This goodwill appears on the balance sheet as a non-current asset, typicallywith and just below other intangible assets.

When a business combination includes contingent consideration, such asthe earn-outs described in the section of drafting and negotiating contractsand legal agreements involving accounting terminology and concepts inChapter VI, the acquirer may make a cash payment to satisfy such acontractual provision. ASU No. 2016-15, Statement of Cash Flows (Topic230): Classification of Certain Cash Receipts and Cash Payments, adoptedguidance requiring acquirers to separate and classify such payments. Whenan enterprise makes a cash payment soon after the acquisition date to settlea liability arising from contingent consideration, the enterprise shouldclassify the payment as a cash outflow for investing activities. Although theCodification does not explicitly state a time period, some members of theEmerging Issues Task Force, which proposed the new rule, believe that “arelatively short period of time . . . (for example, three months or less) wouldqualify as “soon after.” When such a payment does not occur soon after theacquisition date, the acquirer should classify any payment up to the amount

CHAPTER IX LONG-LIVED ASSETS AND INTANGIBLES 135

of the contingent liability recognized on the acquisition date, including anymeasurement-period adjustments as a cash outflow from a financing activity.The acquirer should classify any excess as a cash outflow from operatingactivities. See ASC ¶ 230-10-45-13(d), -15(f), -17(ee); see also STATEMENT OF

CASH FLOWS (TOPIC 230): CLASSIFICATION OF CERTAIN CASH RECEIPTS AND

CASH PAYMENTS (A CONSENSUS OF THE FASB EMERGING ISSUES TASK FORCE),ACCOUNTING STANDARDS UPDATE NO. 2016-15 ¶ BC16 (Fin. AccountingStandards Bd.), available via https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168389912.

As briefly described in Note 5 on page 892 of the text [Note 10 on pages533 and 534 of the concise], the measurement period for a businesscombination typically ends no later than one-year after the transaction’sclosing. During this period, new information about the facts andcircumstances that existed on the acquisition date frequently becomesavailable. If known at the time of the acquisition, this new information oftenwould have affected the amounts initially recognized or would have resultedin the recognition of additional assets or liabilities.

Until ASU No. 2015-16, GAAP required the acquirer to adjustretrospectively the provisional amounts recorded, usually with acorresponding adjustment to goodwill. To simplify the accounting for suchadjustments, the amendments in that ASU eliminated that requirement.Today, the Codification requires an acquirer to recognize such adjustmentsin the reporting period in which the acquirer determines the adjustmentamounts. In addition, the acquirer must record, in the same period’s financialstatements, the effect on earnings arising from any changes in depreciation,amortization, or other items, such as inventories, that the adjustments to theprovisional amounts caused, calculated as if the acquirer had completed theaccounting at the acquisition date. Finally, the acquirer must presentseparately on the face of the income statement or disclose in the notes to thefinancial statements the portion of the amount recorded in current-periodearnings by line item that the acquirer would have recorded in previousreporting periods if it had recognized any adjustments to provisional amountsas of the acquisition date.

The new guidance applies to public business entities for fiscal yearsbeginning after December 15, 2015, including interim periods within thosefiscal years. For all other enterprises, the amendments became effective forfiscal years beginning after December 15, 2016, and interim periods withinfiscal years beginning after December 15, 2017. Enterprises could adopt thenew rules early for any financial statements that had not yet been issued ormade available for issuance. See BUSINESS COMBINATIONS (TOPIC 805):SIMPLIFYING THE ACCOUNTING FOR MEASUREMENT-PERIOD ADJUSTMENTS,ACCOUNTING STANDARDS UPDATE NO. 2015-16 (Fin. Accounting StandardsBd.), available via https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176166411212.

To reduce the cost and complexity associated with measuring certainidentifiable intangible assets, new guidance announced in ASU No. 2014-18,


Business Combinations (Topic 805): Accounting for Identifiable IntangibleAssets in a Business Combination, now gives private companies anaccounting alternative for measuring certain intangibles in a businesscombination. As described in more detail below, the Codification no longerrequires electing private companies to recognize separately from goodwill (1)noncompetition agreements, often referred to as “covenants not-to-compete,”and (2) customer-related intangible assets that cannot be sold or licensedindependently from the other assets of a business. As a result, privatecompanies that elect this alternative will recognize fewer intangible assetsin a business combination when compared to enterprises that do not elect, ordo not qualify for, the alternative.

As a disclosure requirement, an enterprise must provide informationabout goodwill and other intangible assets in the years subsequent to theiracquisition. Required disclosures include material changes in the carryingamount of goodwill and intangible assets, the current carrying amounts offinite-lived and indefinite-lived intangibles by asset classes, and theestimated intangible amortization expense for the next five years.

2. GOODWILL

Starting on page 1113, replace this entire section with the followingdiscussion [in the concise, insert the following discussion after thecarryover paragraph at the top of page 667]:

With regard to the subsequent accounting for goodwill arising from abusiness combination, FASB ASC Topic 350 currently prohibits publiccompanies from amortizing goodwill, but they must test goodwill forimpairment at least annually or whenever a triggering event occurs thatsuggests a substantial loss in the value of the goodwill. If the goodwill hassuffered an impairment, the enterprise must write-down the goodwill to itsimplied fair value and charge current income for the difference between thegoodwill’s carrying value and its implied fair value. Lawyers should keep inmind that any such write-downs reduce equity and could cause an enterpriseto violate a covenant in a loan agreement.

By comparison, the Codification permits private companies to adopt anaccounting alternative that allows them to dispense with annual impairmenttesting if they amortize goodwill on a straight-line basis over ten years. If aprivate company can demonstrate a shorter, and more appropriate, usefullife, the company can amortize goodwill over that period. In addition, anyprivate company that elects the accounting alternative that essentially allowsthe company to combine noncompetition agreements and certain customer-related intangibles with goodwill must also adopt the alternative to amortizegoodwill.

To understand these rules, some recent history may help. Beginning inthe early 2000s, GAAP required all enterprises to use a two-step quantitativeprocess to test goodwill for impairment. Under the first step, an enterprisescreened for impairment by comparing the fair value of each reporting unit


with its carrying value, including goodwill. The second step measured theamount of the impairment, if any. If a reporting unit’s carrying amountexceeded its fair value, the enterprise pretended that an acquisition hadoccurred and calculated the goodwill’s implied fair value by measuring theunit’s identifiable assets and liabilities as of the date of the impairment testin accordance with the rules now codified in ASC Topic 805, BusinessCombinations. If the goodwill had become impaired, the enterprise wrote-down the goodwill to its implied fair value and charged current income forthe difference between the goodwill’s carrying value and its implied fairvalue.

Readers of financial statements might view goodwill as a report card foracquisitions and for the executives who did the buying. When an enterprisewrites down goodwill, management acknowledges that the enterpriseoverpaid in a business combination, whether because executivesoverestimated the financial benefits that would arise from the transaction,the costs to integrate the operations and cultures exceeded expected benefits,or economic or market conditions simply changed. As no surprise, write-downs surged during the 2008 financial crisis. More recently, a 2016 Duff &Phelps study found that companies in the United States added a record $458billion in goodwill to their balance sheets in 2015. During the same year,goodwill impairments at public companies in the United States more thandoubled from 2014 to $57 billion, with companies in the energy andinformation technology sectors showing the biggest spikes. More recently,public companies in the United States recorded goodwill impairmentstotaling $35.1 billion in 2017 and more than $40 billion during the first threequarters in 2018. See Tatyana Shumsky, Goodwill Impairments Continue toClimb Despite Strong Economy, CFO JOURNAL (Dec. 20, 2018),https://www.wsj.com/articles/goodwill-impairments-continue-to-climb-despite-strong-economy-11545301801; Denise Lugo, Energy Companies to BenefitFrom New Goodwill Impairment Test, Corp. L. & Accountability Rep.(Bloomberg BNA), Jan. 30, 2017; Emily Chasan & Maxwell Murphy,Companies Get More Wiggle Room on Soured Deals, WALL ST. J., Nov. 12,2013, at B1; Scott Thurm, Buyers Beware: The Goodwill Games, WALL ST. J.,Aug. 15, 2012, at B1.

The development of GAAP continued after private companies complainedabout the quantitative procedure that required enterprises to calculate thefair value of each reporting unit at least annually. In response, FASB issuednew rules in 2011 that simplified how both private and public firms testgoodwill for impairment. Like the recent amendments for indefinite-livedassets, the new rules added an optional qualitative starting point thatallowed an enterprise to assess the likelihood that a reporting unit’s carryingamount exceeded its fair value. The qualitative factors typically consideredinclude the enterprise’s financial performance, industry and economicchanges, cost factors, legal and regulatory matters, and other company-specific issues. The enterprise need not perform the two-step, quantitativecomparison unless, after considering all relevant events and circumstances,the enterprise determines that it is more likely than not that a reporting


unit’s carrying value exceeds its fair value. As with indefinite-livedintangibles, an enterprise may choose to skip the qualitative assessment forany reporting unit in any period and proceed directly to a quantitativecomparison. Practically speaking, these rules eliminated the need for manyenterprises to calculate the fair values of various reporting units at leastannually. See INTANGIBLES—GOODWILL AND OTHER (TOPIC 350), TESTING

GOODWILL FOR IMPAIRMENT, ACCOUNTING STANDARDS UPDATE No. 2011-08(Fin. Accounting Standards Bd.).

Next, preparers and auditors of private company financial statementsexpressed further concerns to the then-newly created Private CompanyCouncil (PCC) about the cost and complexity underlying the process forassessing goodwill impairment. In PCC’s outreach to users of privatecompany financial statements, the council learned that users often disregardgoodwill and goodwill impairment losses in the analysis of a privatecompany’s financial condition and operating performance. Ultimately, PCCconcluded that the benefits of the current accounting for goodwill after initialrecognition by private companies did not justify the related costs.

Based on this PCC consensus, early in 2014 FASB issued an accountingstandards update on accounting for goodwill that gives private companies anoption to amortize goodwill, generally on a straight-line basis over ten years.(As mentioned earlier, if a private company can demonstrate a shorter, andmore appropriate, useful life, the company can amortize goodwill over thatperiod.) Any private company that elects this alternative, however, mustadopt an accounting policy to test goodwill for impairment at either theentity level or the reporting unit level. Rather than test goodwill forimpairment annually as non-electing enterprises must do, this election allowsa private company to conduct such an evaluation only when a triggeringevent occurs that indicates that the fair value of the applicable entity or thereporting unit may have dropped below its carrying amount. If a triggeringevent has occurred, the entity can elect either to perform the qualitativeassessment or to proceed directly to a quantitative test to determine whethergoodwill has been impaired. If any qualitative assessment concludes that itis more likely that goodwill has not been impaired, the evaluation ends.Otherwise, the entity will apply the quantitative test and record animpairment only if the carrying amount of the entity or reporting unitexceeds its corresponding fair value. In that event, the goodwill impairmentloss, which represents the difference between the applicable carrying amountand fair value, cannot exceed the goodwill’s carrying amount. If elected, aprivate company could apply the accounting alternative prospectively to anygoodwill that existed at the beginning of the period of adoption and to newgoodwill recognized in annual periods beginning after December 15, 2014,and in interim periods within annual periods beginning after December 15,2015. The guidance, however, also allowed early application to any period forwhich a private company’s annual or interim financial statements had notyet been made available for issuance. See INTANGIBLES—GOODWILL AND

OTHER (TOPIC 350): ACCOUNTING FOR GOODWILL (A CONSENSUS OF THE PRIVATE


COMPANY COUNCIL), ACCOUNTING STANDARDS UPDATE No. 2014-02 (Fin.Accounting Standards Bd. Jan. 2014).

As mentioned in the introduction to this section on intangible assets andgoodwill, after ASU No. 2014-18, the Codification no longer requires electingprivate companies to recognize separately from goodwill (1) covenants not-to-compete and (2) customer-related intangible assets that cannot be sold orlicensed independently from the other assets of a business after certaintransactions, including business combinations. (Private companies mustcontinue to recognize customer-related intangibles that the firm can sell orlicense independently from the other assets in the business, such as mortgageservicing rights, commodity supply contracts, core deposits, and customerinformation.) This accounting alternative reduces the cost and complexityassociated with measuring and estimating the fair value of eligibleidentifiable intangible assets, but electing companies cannot subsumeexisting non-compete covenants and customer-related intangibles intogoodwill. If a private company elects the alternative, the company must alsoadopt the alternative announced in ASU No. 2014-02 to amortize goodwill.A private company that decides to amortize goodwill, however, need notadopt the alternative in ASU No. 2014-18.

If the first transaction within the scope of ASU No. 2014-18 occurs in theprivate company’s first fiscal year beginning after December 15, 2015, theelective adoption applies to that fiscal year’s annual reporting and all interimand annual periods thereafter. If the first transaction within the scope ofASU No. 2014-18 occurs in a fiscal year beginning after December 31, 2016,the election becomes effective in the interim period that includes the date ofthat transaction and all subsequent interim and annual periods. In addition,ASU No. 2014-18 allowed early adoption for any interim and annual financialstatements that had not yet been made available for issuance. See BUSINESS

COMBINATIONS (TOPIC 805): ACCOUNTING FOR IDENTIFIABLE INTANGIBLE

ASSETS IN A BUSINESS COMBINATION, ACCOUNTING STANDARDS UPDATE NO.2014-18 (Fin. Accounting Standards Bd.).

Until ASU No. 2016-03, when an enterprise elected to adopt anaccounting alternative after its effective date, the alternative needed toqualify as preferable, as set forth in Topic 250, Accounting Changes andError Corrections. When concerns arose that private companies that electedthe accounting alternatives in ASU No. 2014-02 and ASU No. 2014-18 aftertheir effective dates would not benefit from the favorable provisions in thosenew rules, ASU No. 2016-03 removed the effective dates from those ASUswithin its scope and allowed private companies that voluntarily elect thegoodwill accounting alternative in ASU No. 2014-02 to apply the alternativeprospectively. In addition, the amendments included transitional provisionsthat allow private companies to forgo a preferability assessment the firsttime that they elect one of the specified accounting alternatives. Anysubsequent change to an accounting policy election, however, must qualifyas preferable. See INTANGIBLES–GOODWILL AND OTHER (TOPIC 350), BUSINESS

COMBINATIONS (TOPIC 805), CONSOLIDATION (TOPIC 810) & DERIVATIVES AND

HEDGING (TOPIC 815): EFFECTIVE DATE AND TRANSITION GUIDANCE,


ACCOUNTING STANDARDS UPDATE NO. 2016-03 (Fin. Accounting StandardsBd.).

Seemingly without jeopardizing relevant information for users of privatecompany financial statements, the alternative to combine certain intangibleswith goodwill, the election to amortize goodwill, and the relief from therequirement to test goodwill for impairment at least annually have resultedin significant cost savings for many private companies that carry goodwill ontheir balance sheets. These savings arise for at least three reasons. First,private companies no longer need to expend resources to value certainintangibles separately. Second, amortization reduces the likelihood thatgoodwill would suffer an impairment. Consequently, private companies havenot needed to test goodwill for impairment as frequently. Third, the abilityto test for impairment at the entity-level and the elimination of the secondstep of the quantitative test (that would otherwise require the hypotheticalapplication of the acquisition method to measure the reporting unit’sidentifiable assets and liabilities as of the date of the impairment test inaccordance with ASC Topic 805, Business Combinations, to calculate thegoodwill’s implied fair value) has reduced the cost of any impairment test.

Based upon feedback that many public companies shared similarconcerns about the cost and complexity of the annual goodwill impairmenttest, FASB again simplified the subsequent accounting for goodwill for publiccompanies in ASU No. 2017-04, Intangibles–Goodwill and Other (Topic 350):Simplifying the Test for Goodwill Impairment. The new goodwill impairmentstandards eliminate the second step of the current two-step impairment test,which would otherwise require enterprises to determine the fair value ofindividual assets and liabilities for each reporting unit to calculate an impliedfair value of goodwill. Under the new standard, enterprises recognize animpairment of goodwill based on the calculation in the first step, whichcompares a reporting unit’s carrying amount to its fair value.

For interim or annual goodwill impairment tests performed on testingdates after January 1, 2017, the Codification now allows most organizations,but most significantly, public companies, to elect to apply new guidance thateliminates the second step of the current two-step impairment test on aprospective basis. ASU No. 2017-04 permits, but does not require, privatecompanies that (1) have elected the accounting alternative to amortizegoodwill, but (2) have not elected the private company alternative to subsumecertain intangible assets into goodwill, to adopt the amendments on or beforethe effective date without the need to justify preferability. You may recallthat any private company that has elected to subsume certain intangibleassets into goodwill must also amortize goodwill. If a private company hasmade such an election, the company must justify the new guidance aspreferable before switching to that guidance.

Under the new guidance, an enterprise should perform its annual orinterim goodwill impairment test by comparing a reporting unit’s fair valueto its carrying amount. During this process, the enterprise should considerthe income tax effects from any tax deductible goodwill on the reporting


unit’s carrying amount. If the unit’s carrying amount exceeds its fair value,the enterprise should recognize an impairment charge for the difference, butthe loss recognized cannot exceed the total amount of goodwill allocated tothat reporting unit.

These new rules become mandatory for public business entities that filewith the SEC for fiscal years beginning after December 15, 2019, whichmeans enterprises using the calendar year must apply the new rules startingJanuary 1, 2020. Public business entities that do not file with the SEC get anadditional year to adopt the new rules, which will apply to any interim orannual impairment tests in fiscal years beginning after December 15, 2020.Finally, all other organizations, including not-for-profit entities, must adoptthe amendments for impairment tests in fiscal years beginning afterDecember 15, 2021. All organizations, however, can elect to adopt the newrules for impairment tests performed after January 1, 2017. SeeINTANGIBLES–GOODWILL AND OTHER (TOPIC 350): SIMPLIFYING THE TEST FOR

GOODWILL IMPAIRMENT, ACCOUNTING STANDARDS UPDATE NO. 2017-04 (Fin.Accounting Standards Bd.), available at http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168778106.

Because the Codification requires judgments and projections,particularly after the amendments that allow enterprises to start with aqualitative assessment, management enjoys considerable leeway whendeciding whether to write down goodwill and by how much. Readers shouldkeep in mind that management might use pessimistic projections to write-offassets, including goodwill, acquired in a transaction that predecessorsarranged, while adopting optimistic forecasts to avoid or minimize a potentialimpairment arising from their own acquisitions. When goodwill exceeds acompany’s market value, the market believes that the company should write-down goodwill, but no accounting rule requires an impairment loss in thatsituation. See Emily Chasan & Maxwell Murphy, Companies Get More WiggleRoom on Soured Deals, WALL ST. J., Nov. 12, 2013, at B1; Scott Thurm,Buyers Beware: The Goodwill Games, WALL ST. J., Aug. 14, 2012, at B1.

** In the second phase of the project that led to ASU No. 2017-04, the FASBhad planned to reconsider the subsequent accounting for goodwill for publicbusiness entities and not-for-profit entities, which follows an impairment-only approach. Initially, the FASB planned to monitor the IASB’s projects ongoodwill and impairment before considering whether to amend GAAP topermit or require direct write-off, goodwill amortization, or other changes toimpairment testing and moved that second phase to the research agenda.Even before the IASB voted in June 2019 to keep the impairment approachto goodwill set forth in IFRS 3, Business Combinations, the FASB decidedlate in 2018 to add a broad project on the subsequent accounting for goodwilland the accounting for certain identifiable intangible assets to its technicalagenda. Interested readers can monitor developments regarding the projectvia the page for FASB's technical agenda at https://www.fasb.org/jsp/FASB/Page/TechnicalAgendaPage&cid=1175805470156. See Project Update, Identi-fiable Intangible Assets and Subsequent Accounting for Goodwill (Fin.Accounting Standards Bd. Mar. 12, 2019), https://www.fasb.org/jsp/FASB/


FASBContent_C/ProjectUpdateExpandPage&cid=1176171566054B ; see alsoNicola M. White, Accounting for Goodwill Writedowns Under RenewedScrutiny, Bloomberg Law, July 9, 2019; Michael Kapoor, InternationalRulemaker Rejects Changing Goodwill Accounting, Bloomberg Law, June 18,2019; Denise Lugo, Possible New Intangibles Rules May Affect M&AReporting, Corp. L. & Accountability Rep. (Bloomberg BNA), Sept. 29, 2017.

On page 1132, replace the last sentence in the first paragraph in note10 [note 3 on page 670 of the concise] with the following text:

Although this definition encompasses a wide variety of transactions, pleasekeep in mind that ASU No. 2017-01 now disqualifies transactions moreclosely resembling asset acquisitions, as briefly described on page 134, supra.

On page 1133, replace the second and third sentences in the first fullparagraph [the third paragraph in note 3 on page 670 of the concise],with the following:

When the acquirer and the seller cannot agree on a price, an earn-out mayenable them to bridge the gap. In a typical earn out, the acquirer agrees topay additional consideration after the closing if the acquiree satisfies one ormore specified milestones, such as a target level of sales or earnings, withina set time frame.

On page 1133, insert the following new discussion after the lastparagraph in note 10 [at the end of note 3 on page 671 of the concise]:

As hopefully no surprise, lawyers risk disappointed clients, if notmalpractice, if they do not understand the accounting terms and conceptsthat typically appear in merger and acquisitions agreements enough to draftand negotiate agreements that reflect the client’s expectations. See generallyMARK L. STONEMAN, UNDERSTANDING THE USE OF FINANCIAL ACCOUNTING

PROVISIONS IN PRIVATE ACQUISITION AGREEMENTS (2d ed. 2014). Importantissues include:

Financial statement representations. As mentioned in the earlier discussionsabout drafting and negotiating legal agreements involving accounting termsand concepts at the end of Chapters V and VI, merger and acquisitionagreements usually contain representations, warranties, and covenants thatinvolve the intersection between legal and accounting concepts. For recentarticles discussing these provisions, see Daniel Avery & Michael Hickey,Trends in M&A Provisions: Financial Statement Representations, 18 Mergers& Acquisitions L. Rep. (Bloomberg BNA) 535 (Apr. 6, 2015); Daniel Avery &Linh Lingenfelter, Trends in M&A Provisions: No Undisclosed LiabilitiesRepresentations, 17 Mergers & Acquisitions L. Rep. (Bloomberg BNA) 1376(Sept. 22, 2014).

Working capital adjustments. Businesses typically operate with a certainamount of cash, accounts receivable, inventories, and prepaid assets thatenable the firm to meet payroll and other operating expenses and to pay


accounts payable and accrued expenses as they come due. Accordingly, atarget needs sufficient working capital to maintain ordinary businessoperations after an acquisition. Given general business conditions,seasonality, large and infrequent transactions, and unusual events orcircumstances, working capital can vary from the normal level at anyparticular point in time. When the transaction values a target based on amultiple of income, EBITDA or another measure, that valuation dependsupon the seller delivering the target to the buyer with sufficient workingcapital to continue the business as usual and to deliver the financial resultsthat provided the basis for the purchase price. Without adequate workingcapital, the buyer would need to fund any shortfall, which effectivelyincreases the purchase price. Alternatively, a target could hold excessworking capital, which adds value to the business. In either event, comparingworking capital at closing to historic levels may provide a simple approachfor determining a working capital adjustment. For example, if a business hasmaintained average working capital levels equal to ten percent of revenuesover the past three fiscal years, the acquirer and target may adjust thepurchase price downward if working capital falls below its historic level atclosing or upward for any excess working capital.

To address this issue, merger and acquisition agreements typicallyinclude a purchase price adjustment based on the difference between workingcapital at closing and an agreed amount. Drafting and negotiating a mergeror acquisition agreement requires counsel to understand, at a minimum, thepurpose for such a working capital adjustment; the precise definition ofworking capital for purposes of the agreement, which may exclude certaincurrent assets and current liabilities; the accounting methods, policies,practices, and estimates that the target has used in the past, as well as anyalternative approaches that the parties will use in the agreement, todetermine “working capital” as contemplated in the agreement; anycircumstances unique to the business or industry; one or more materialitythresholds; and the need for a dispute resolution process. For a discussion ofvarious issues that can arise, see Barry T. Mehlman et al., Net WorkingCapital Adjustments in M&A Deals: The Buyer’s Perspective, 19 Mergers &Acquisitions L. Rep. (Bloomberg BNA) 30 (Jan. 4, 2016).

Earn-outs. As suggested earlier in this note, drafting and negotiating anearn-out provision requires counsel to understand, at a minimum, thepurpose for such a provision; the precise definition of the milestone; theaccounting methods, policies, practices, and estimates that the parties willuse to determine the milestone as contemplated in the agreement; and theneed for a dispute resolution process.

On page 1134, after the first paragraph in note 11 [after thecarryover paragraph in note 4 on the top of page 672 of the concise],replace the rest of the note with the following text:

Until ASU No. 2014-17, Business Combinations (Topic 805): PushdownAccounting, GAAP offered only sparse guidance for determining whether andwhen an acquired enterprise could apply pushdown accounting in its


separate financial statements after an acquirer obtained control. Inparticular, section 805-50-S99 of the Codification contained some directionfrom the SEC staff, which technically did not apply to non-SEC registrants.In addition, considerable diversity in practice existed among non-registrants,and the limited guidance did not address various issues involving all entitiesthat had arisen in practice.

The amendments to the Codification in ASU No. 2014-17 now give anacquired entity the option to apply pushdown accounting in its separatefinancial statements whenever an acquirer obtains control of the entity. If theacquired entity elects pushdown accounting, the firm would follow theguidance in ASC Topic 805, Business Combinations, to recognize andmeasure the firm’s assets, including goodwill, and liabilities.

The new guidance also contains disclosure requirements. To comply withthese provisions, an entity must assess at each reporting date whether anacquirer has obtained control of the entity since its last reporting date. If achange-in-control event occurred during the reporting period, and theacquired entity elected to use pushdown accounting in its separate financialstatements, the acquired entity must disclose information that would enablereaders of the financial statements to evaluate the effect of pushdownaccounting on those statements. If the acquired entity decides not to applypushdown accounting, the entity must disclose a change-in-control event andstate the firm’s election to continue to prepare its financial statements usingthe historical basis that existed before the acquirer obtained control.

The amendments became effective on November 18, 2014. After thatdate, an acquired entity can make an election to apply the guidance to futurechange-in-control events or to its most recent change-in-control event. If theenterprise has already issued, or made available for issue, the financialstatements for the period in which the most recent change-in-control eventoccurred, the enterprise must justify a subsequent change to pushdownaccounting as preferable in accordance with Topic 250, Accounting Changesand Error Corrections. See BUSINESS COMBINATIONS (TOPIC 805): PUSHDOWN

ACCOUNTING, A CONSENSUS OF THE FASB EMERGING ISSUES TASK FORCE,ACCOUNTING STANDARDS UPDATE No. 2014-17 (Fin. Accounting StandardsBd.), available via https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176164564812.

In response to ASU No. 2014-17, the SEC staff issued Staff AccountingBulletin No. 115, which rescinded the staff’s earlier guidance on pushdownaccounting. In ASU No. 2015-08, FASB amended the Codification to removethat earlier guidance. See Staff Accounting Bulletin No. 115, 79 Fed. Reg.69,373 (Nov. 18, 2014), available at https://www.sec.gov/interps/account/sab115.pdf; BUSINESS COMBINATIONS (TOPIC 805): PUSHDOWN ACCOUNTING,AMENDMENTS TO SEC PARAGRAPHS PURSUANT TO STAFF ACCOUNTING

BULLETIN NO. 115, ACCOUNTING STANDARDS UPDATE NO. 2015-08 (Fin.Accounting Standards Bd.).


F. LEASE ACCOUNTING

2. TREATMENT

On pages 1142 to 1145, replace the entire section “c. PROPOSEDREVISIONS” with the following text (on page 677 of the concise,insert the following new text directly above the Problems):

c. NEW RULES

In the post-Enron effort to improve accounting standards, observersincreasingly criticized the accounting principles that govern leases, notingthat the ninety percent and seventy-five percent tests for capital leasesillustrate arbitrary accounting rules that obscure financial statements,sometimes describing those tests as the “poster children” for rules-basedaccounting standards. If a lessee classifies an agreement as an operatinglease under current accounting rules, neither an asset for the right to use theleased asset nor a related liability for the future lease payments (includinga current liability for payments due in the next year) appear on the lessee’sbalance sheet. In 2004, The Wall Street Journal reported that “off-balancesheet” commitments for operating leases totaled $482 billion for companiesin the Standard & Poor’s 500 stock index alone, an amount equal to eightpercent of the $6.25 trillion that those same companies reported as debt ontheir balance sheets. Using an even broader sample, the SEC staff estimatedthat under the current “all-or-nothing” approach to lease classification andaccounting, public companies did not recognize on their balance sheets“approximately $1.25 trillion in non-cancelable future cash obligationscommitted under operating leases,” instead disclosing such commitments inthe notes to their financial statements. STAFF OF U.S. SEC. & EXCH. COMM’N,REPORT AND RECOMMENDATIONS PURSUANT TO SECTION 401(C) OF THE

SARBANES-OXLEY ACT OF 2002 ON ARRANGEMENTS WITH OFF-BALANCE SHEET

IMPLICATIONS, SPECIAL PURPOSES ENTITIES, AND TRANSPARENCY OF FILINGS

BY ISSUERS 4 (June 15, 2005), available at https://www.sec.gov/news/studies/soxoffbalancerpt.pdf. In addition to keeping these obligations off balancesheets, operating leases have historically boosted liquidity, increased returnson assets, and enhanced earnings by lowering depreciation expenses, whilereducing leverage. See Jonathan Weil, How Leases Play a Shadowy Role inAccounting, WALL ST. J., Sept. 22, 2004, at A1.

Almost ten years after beginning a comprehensive reconsideration oflease accounting as a joint project with the IASB, in February 2016 the FASBissued ASU No. 2016-02, Leases (Topic 842). Topic 842 will supersede theaccounting rules governing leases in Topic 840. The new rules in Topic 842will require lessees to recognize assets and liabilities from most leasecontracts, thus bringing as much as an estimated $4 trillion in leaseobligations onto balance sheets worldwide. In essence, Topic 842 movesoperating lease obligations from the notes to the balance sheet itself. Therules in Topic 842 will also require enhanced disclosures to supplement theamounts recorded in the financial statements. The new rules apply to all


organizations that lease assets, whether real estate, airplanes, railroad cars,construction and manufacturing equipment, or furniture and fixtures.Although now rather dated, respondents to a 2011 survey by PwC predictedthat the then-joint project on leasing would most significantly affectenterprises’ accounting practices, relative to any other project as the FASBand IASB worked toward converging international accounting standards,including the revenue recognition project. See Amanda Iacone, WhatInvestors Need to Know About U.S. Lease Accounting Changes, Fin.Accounting News (Bloomberg Law), May 17, 2019; Michael Rapoport, NewRule to Shift Leases Onto Corporate Balance Sheets, WALL ST. J., Feb. 26,2016, at C3; PwC Survey Finds Leasing Expected to be Biggest ConvergenceChallenge, 9 Corp. Accountability Rep. (BNA) 476 (Apr. 22, 2011).

** Topic 842 became mandatory for public companies for fiscal years, andinterim periods in those years, beginning after December 15, 2018. For publiccompanies using the calendar year, the changes took effect on January 1,2019. Once again, the FASB has given non-public organizations additionaltime to implement the new standards, hoping that such organizations canlearn from public companies. For all other organizations, the new rulescurrently become effective no later than annual reporting periods beginningafter December 15, 2019, and for interim periods within fiscal yearscommencing after December 15, 2020. For non-public organizations using thecalendar year, the changes currently take effect beginning January 1, 2020for annual periods and January 1, 2021 for interim periods. In July 2019,however, the FASB tentatively and unanimously decided to give non-publiccompanies and emerging growth companies an additional year to begin usingthe new lease accounting rules and directed the staff to draft a proposedaccounting standards update opening a thirty-day comment period. Allorganizations can still elect to adopt the new standards early. To simplifytransition to the new rules, the FASB earlier decided to permit enterprisesto apply the new standard at its adoption date, rather than retroactively atthe beginning of the earliest comparative period presented in the financialstatements. This election potentially allows an enteprise to avoid recognizinglease assets and lease liabilities on leases that expired before the effectivedate. See LEASES (TOPIC 842): TARGETED IMPROVEMENTS, ACCOUNTING

STANDARDS UPDATE No. 2018-11 (Fin. Accounting Standards Bd.), availableat https://fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176170977888&acceptedDisclaimer=true; LEASES (TOPIC 842), ACCOUNTING STANDARDS

UPDATE NO. 2016-02 (Fin. Accounting Standards Bd.), available via https://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498; see alsoProject Update, Credit Losses, Hedging, and Leases–Effective Dates forPrivate Companies, Not-for-Profit Organizations and Small PublicCompanies (Fin. Accounting Standards Bd. July 22,2019), https://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdateExpandPage&cid=1176173010144; see also Nicola M. White, Private Companies Win Reprieve for LeaseAccounting Changes, Bloomberg Law, July 17, 2019.

Under Topic 842, an enterprise must determine whether a contract is alease or contains a lease. Topic 842 defines a lease as “[a] contract, or part of


a contract, that conveys the right to control the use of identified property,plant, or equipment (an identified asset) for a period of time in exchange forconsideration.” Control over an asset requires that the customer has both: (1)the right to obtain substantially all of the economic benefits from the asset’suse, and (2) the right to direct the asset’s use. A so-called “embedded lease”occurs when a contract explicitly or implicitly identifies an asset, and thecustomer controls the asset’s use. Once a contract contains an embeddedlease, the parties need to divide the contract into its lease and nonleasecomponents and to account for those components separately. For example, anenterprise might sign a contract that outsources information technology (IT)functions under a multiyear contract. As a result, the “provider” buys thecomputers and servers and hires the people who fulfill the IT services for theenterprise. Such scenarios can give rise to embedded leases of the computersand servers unless the provider can swap out equipment or use the sameequipment for different clients. Other examples include soft drink supplyagreements that provide beverage dispensing machines or coolers, credit cardprocessing agreements that supply point of sale equipment, and musicstreaming services that furnish satellite receivers or speakers. As a result,at least some experts believe that determining the total number of leases thatmight be embedded in a contract likely presents the biggest challenge in thetransition to the new rules. In any event, lawyers will likely help clientsreview their leases and other contracts in preparation for the transition tothe new rules. See Kevin D. Oles & Jim Balthaser, INSIGHT: LeaseAccounting Changes Present More Than Accounting Problems, Fin.Accounting News (Bloomberg Law), June 3, 2019; Denise Lugo, RestaurantsMight Find Lease Accounting Changes Unappetizing, Corp. L. &Accountability Rep. (Bloomberg BNA), Apr. 27, 2018; Denise Lugo,Identifying a Lease Will Be Hardest Part of Lease Accounting, Corp. L. &Accountability Rep. (Bloomberg BNA), June 13, 2017.

The new rules in Topic 842 will require lessees to recognize “right-of-use”assets and related lease liabilities, each initially measured at the presentvalue of the required lease payments, for all leases with terms exceeding oneyear, including land easements. Such easements, or so-called “rights of way,”convey the right to use, access, or cross another party’s land for a specifiedpurpose. As a practical expedient to the new rules, an enterprise need notreconsider its accounting for existing land easements if it does not use the oldleases standard to account for them. Many such easements would not meetthe definition of a lease under the new rules, or even if they did, enterprisesoften prepay for these easements, which means that they would otherwiseappear as assets on balance sheets. Once an enterprise has adopted the newrules in Topic 842, however, the enterprise must evaluate any new ormodified land easements under the new standard. See LEASES (TOPIC 842):LAND EASEMENT PRACTICAL EXPEDIENT FOR TRANSITION TO TOPIC 842,ACCOUNTING STANDARDS UPDATE NO. 2018-01 (Fin. Accounting StandardsBd.), available at https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176169927843.


If a lease contains a provision that gives the lessee the option to extendthe lease or to purchase the underlying asset, the lessee must include anyrelated payments only if the lessee is reasonably certain to exercise theoption. For leases with a term that does not exceed twelve months, a lesseecan elect by class of underlying asset not to recognize lease assets and leaseliabilities. In that event, the lessee will recognize lease expense for suchleases on a straight-line basis over the lease term.

As under previous guidance, the lessee’s financial reporting of theexpenses and cash flows arising from a lease will depend on its classification,but as either a finance or operating lease under the new guidance, ratherthan as either a capital or operating lease under Topic 840. Unlike Topic 840,which only requires lessees to recognize capital leases on the balance sheet,Topic 842 will require enterprises to recognize both finance and operatingleases on the balance sheet. Thus, the main difference between old GAAP inTopic 840 and the new rules in Topic 842 is that lessees must recognize leaseassets and lease liabilities for most leases classified as operating leases underTopic 840.

Topic 842 requires a lessee to classify each lease at its commencementdate. As under previous GAAP, the classification between a finance lease andan operating lease depends upon whether the lessee essentially purchasedthe underlying asset on an installment basis. Accordingly, a lessee shallclassify a lease as a finance lease if the lease meets any of the followingcriteria at the time of lease commencement:

• The lease transfers ownership of the underlying asset to the lesseeby the end of the lease term.

• The lease grants the lessee an option to purchase the underlyingasset that the lessee is reasonably certain to exercise.

• The lease term covers the major part of the underlying asset’sremaining economic life. If the commencement date falls at or nearthe end of the underlying asset’s economic life, however, thiscriterion shall not apply.

• The present value of the sum of the lease payments by the lessee andany residual value that the lessee has guaranteed by the lesseeequals or exceeds substantially all of the underlying asset’s fairvalue.

• Given the specialized nature of the underlying asset, the parties donot expect it to have any alternative use to the lessor at the end ofthe lease term.

When a lease does not meet any of these criteria, the lessee shall classify thelease as an operating lease. The original classification shall continue until theparties modify the lease or alter its term, or the lessee changes itsassessment as to whether it is reasonably certain to exercise an option topurchase the underlying asset.


For a finance lease, the lessee must:

1. Recognize a right-of-use asset and a lease liability, initiallymeasured at the present value of the lease payments, on thebalance sheet;

2. Report interest on the lease liability separate from amortizationof the right-of-use asset on the income statement; and

3. Classify repayments of the principal portion of the lease liabilityas financing outflows and interest payments on the lease liabilityas operating outflows on the statement of cash flows.

For an operating lease, by comparison, the lessee must:

1. Recognize a right-of-use asset and a lease liability, initiallymeasured at the present value of the lease payments, on thebalance sheet;

2. Report a single lease cost on the income statement, calculated soas to allocate the cost of the lease over the lease term on astraight-line basis; and

3. Classify all cash payments as operating outflows on thestatement of cash flows.

The new rules for lessees will most significantly affect the balance sheet,where assets and liabilities related to operating leases, including currentliabilities for lease payments due within the next year, will appear for thefirst time. As a result, organizations with operating leases will report largeramounts for total assets and current and total liabilities, relative to previousstandards. By adding these amounts to balance sheets, the new rules willdecrease liquidity and increase leverage at many organizations. Collectively,this new reporting could adversely affect financial covenants based uponcertain financial ratios, including the current ratio, acid test, return onassets, and asset turnover. In addition, organizations must present right-of-use assets and lease liabilities for finance leases and operating leases asseparate line items or disclose the information in the notes to the financialstatements.

The new rules will significantly affect lease negotiations, loanagreements, compensation arrangements, and other legal contracts. Pleaserecall or observe that Starbucks’ Credit Agreement in Problem 5.6 on pages629 to 639 of the Fifth Edition [omitted from the concise] anticipated the newlease accounting rules. Specifically, for purposes of that agreement, the lastsentence in Section 1.03(b) on page 632 retains GAAP as it existed at thetime the parties signed the Credit Agreement, unless the parties “enter intoa mutually acceptable amendment addressing such changes.” As with otherimportant changes in GAAP, enterprises also will need to review any existingrestrictive covenants that incorporate financial ratios to evaluate anyconsequences and appropriate actions.

As with the new revenue recognition rules, enterprises will need toreview their internal controls to determine exactly what the enterprise willneed to do to achieve optimal results under the new standards. As mentioned


earlier, lawyers are often actively involved in the establishment, evaluation,revision, and documentation of internal controls, the related internal controlover financial reporting, and drafting updated disclosures.

The FASB and IASB could not agree upon a convergent treatment andadopted different approaches for lease accounting by lessees. In January2016, IASB issued IFRS 16, Leases, which adopts a single approach for lesseeaccounting. Lessees will treat all leases as financing leases, again meaningthat the lessee will recognize amortization of the right-to-use asset separatelyfrom the interest expense on the underlying lease liability.

** Although the FASB and the IASB proposed changes in lessor accounting,investors and analysts generally agreed that the current rules for lessorshave worked well. Consequently, both Boards have largely chosen to retainthose rules. With the new revenue recognition rules in Topic 606, however,a lessor will need to determine whether the lease transfers control of theunderlying asset, rather than the risks and rewards incidental to ownership,once Topic 606 applies to the lessor. A lessor cannot recognize selling profitor sales revenue at lease commencement if the lease does not transfer controlof the underlying asset to the lessee. In addition, the FASB has adoptedseveral narrow-scope improvements for lessors. For example, these improve-ments provide an accounting policy election, similar to the option in the rulesin Topic 606, that allows lessors to exclude amounts collected from customersfor sales and other similar taxes from the transaction price. Anotherimprovement requires lessors to exclude from revenue any lessor costs thata lessee pays directly to a third party. In contrast, a lessor must record asrevenue any reimbursements from the lessee for costs that the lessor paiddirectly to a third party. See LEASES (TOPIC 842): NARROW-SCOPE

IMPROVEMENTS FOR LESSORS, ACCOUNTING STANDARDS UPDATE NO. 2018-20(Fin. Accounting Standards Bd.), available via https://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498.