What must be stated in the audit committee report required for the company’s proxy statement?
This memorandum outlines key considerations from White & Case's Public Company Advisory Practice for US public companies in preparation for the 2020 annual reporting and proxy season. Show
Section I of this memo describes our key considerations for Annual Reports on Form 10-Ks in two parts: (1) Housekeeping Items for Form 10-Ks in 2020; and (2) Top Seven Disclosure Considerations for the Form 10-K in 2020. Section II of this memo describes our key considerations for Annual Meeting Proxy Statements in two parts: (1) Housekeeping and Deep Cleaning Items to Prepare for 2020 Annual Meeting Proxy Statements; and (2) Top Seven Considerations for 2020 Annual Meeting Proxy Statements. Section I: Considerations for Annual Reports on Form 10-K in 2020Recent SEC rulemaking and other developments in 2019, including rules adopted in 2019 pursuant to the FAST Act,1 have resulted in a number of changes to SEC filings, including your upcoming 10-K, as described below. (1) Housekeeping Items for Form 10-Ks in 2020As a result of the FAST Act rule changes, the following housekeeping items should be addressed for upcoming Form 10-Ks: Update 10-K Cover Page:First, make sure your Form 10-K cover page is updated to reflect the most recent changes to the form adopted pursuant to the recent FAST Act rule changes, as follows:
Note that two additional changes were made to the Form 10-K cover page in 2018 pursuant to additional rule amendments.2 Given all of these recent changes, it is important to confirm that your Form 10-K cover page reflects all recent updates (see also XBRL changes to the cover page, described in "XBRL Changes" below).3 Update Executive Officer Heading: Second, for companies that include executive officer biographies in the Form 10-K, the heading should be changed to "Information about our Executive Officers," instead of "Executive officers of the registrant."4 (2) Top Seven Disclosure Considerations for the Form 10-K in 2020Below is our list of the top seven items to consider when preparing your upcoming Form 10-K in 2020. (1) MD&A: Revised Item 303 of Regulation S-K requires only a two year discussion of financial results. Specifically, companies are permitted to eliminate discussion of the earliest of the three-year period presented in their financial statements if: (i) such discussion is already included in any of its prior SEC filings and (ii) the company identifies the location in the prior filing where the omitted discussion may be found. While we expect most companies to take advantage of this rule change, it is important to first confirm whether any of the discussion of the third earliest year remains material and should therefore still be included in the MD&A.5 (2) Description of Property: Item 102 of Regulation S-K was revised to emphasize materiality and now requires disclosure of physical properties to the extent such properties are material to the company. Accordingly, for this year's Form 10-K, it is important to assess which, if any, of a company's properties warrant discussion based on what is material in light of the company's particular circumstances. In some cases, application of this analysis may result in a description of property on an individual basis or on a collective basis, or may result in no disclosure at all.6 (3) Exhibits: The following items should be considered when preparing your upcoming Form 10-K exhibit list:
(4) Risk Factors: As a result of the FAST Act rule changes, the SEC relocated the risk factor disclosure rule from Item 503(c) to Item 105 of Regulation S-K. More importantly, the SEC also eliminated the generic risk factor examples from the rule in order to encourage companies to focus on their particular businesses when identifying and disclosing risks. For upcoming Form 10-Ks, a number of recent trends and events may impact risk factor disclosures, as well as disclosures in other sections of the annual report. Although each company will need to assess its own material risks and tailor risk factors to its unique circumstances, below is a list highlighting certain areas of SEC focus and key trends that a company should also consider when assessing its risk factors.
(5) Critical Audit Matters ("CAMs")21: Under the Public Company Accounting Oversight Board's ("PCAOB") new auditing standard, AS 3101, subject to transition periods, an auditor's report in a Form 10-K must disclose any CAMs arising from the current period's audit, or state that the auditor determined there were no CAMs for that period.22 Large accelerated filers are now subject to the CAM requirements (large accelerated filers with June 30, 2019 fiscal year ends were the first companies required to disclose CAMs). Accelerated filers and non-accelerated filers will be subject to the CAM requirements for audits of fiscal years ending on or after December 15, 2020. For any CAM, the auditor must disclose the principal considerations that led the auditor to determine that the matter is a CAM and how the CAM was addressed in the audit, among other items. A CAM is any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements and (ii) involved especially challenging, subjective or complex auditor judgment. The PCAOB's standard also provides a non-exclusive list of factors to be considered by an auditor to determine whether a matter is a CAM, including risks of material misstatement, the extent of audit effort and subjectivity required, and the degree of judgment involving estimates with significant measurement uncertainty. It is important for a company to engage with its auditor early and on a regular basis regarding potential CAM disclosure. The PCAOB recently noted that some audit teams began the process to determine CAMs as early as the second or third quarter of the fiscal year and that starting early provided ample time to identify CAMs and draft disclosure.23 The most frequently communicated CAMs have so far related to goodwill and other intangible assets; revenue recognition; taxes; and business combinations.24 For companies reporting CAMs in their upcoming Form 10-Ks, it will be important to ensure that disclosure is consistent throughout an annual report with respect to any matter disclosed as a CAM. (6) Non-GAAP Financial Measures: The SEC continues to focus on non-GAAP measures, so it is important to pay careful attention to the use and disclosure of such measures each fiscal quarter, including:
Moreover, the Staff's Compliance & Disclosure Interpretation ("C&DI") 100.01 reminds companies that some adjustments may be prohibited because they result in a non-GAAP presentation that is misleading. The example provided in the C&DI—that a performance measure excluding normal, recurring, cash operating expenses necessary to operate a registrants business could be misleading—is the basis for a number of recent Staff comments. Accordingly, a company should not only assess its compliance with non-GAAP disclosure requirements, but should also assess whether a non-GAAP measure itself may be misleading. (7) XBRL Changes and Hyperlinking
Section II: Considerations for 2020 Annual Meeting Proxy StatementsRecent SEC rulemaking and developments in corporate governance have resulted in a number of changes to consider for 2020 proxy statements. Due to heightened focus by investors and litigants on proxy statement disclosure, it is crucial for companies to carefully draft and review their proxy disclosure in light of all applicable rules and policies, including SEC rules and proxy advisory firm and investor policies, among others. The following are key considerations from White & Case's Public Company Advisory Practice for your upcoming annual meeting proxy statement. (1) Housekeeping and Deep Cleaning Items to Prepare for 2020 Proxy StatementsWhen preparing for proxy season and the drafting of your proxy statement, the following initial items should be addressed:
(2) Top Seven Considerations for 2020 Annual Meeting Proxy StatementsBelow are our top seven items to consider when drafting your annual meeting proxy statements. (1) New Hedging Disclosure Requirement in Effect: New Item 407(i) of Regulation S-K requires that a company describe any practices or policies it has adopted (whether written or not) regarding the ability of its employees, officers or directors (or any of their designees) to purchase financial instruments or to engage in transactions that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation to, or held directly or indirectly by, the employee or director.35 For the upcoming proxy season, it is important to review existing hedging policies and practices, and confirm that proxy disclosure is drafted to align with these. Although there is no requirement under the SEC rule to revise existing hedging policies (which companies commonly include in insider trading policies), there are several to-do items as a result of the new disclosure rule, including the following: First, Describe Your Existing Hedging Policy. The new hedging disclosure must accurately describe a company's existing hedging policy (such as its coverage of directors and executive officers, and categories of transactions that are specifically permitted or disallowed by the policy). A company is not required to describe what its hedging policy does not include (such as that its policy does not cover employees other than executive officers), but if a company does not have any hedging policy or practice, it must disclose that fact (or state that hedging is generally permitted).36 Second, Consider Placement in Proxy Statement. Placement of the Item 407(i) hedging disclosure can be in the CD&A or outside of the CD&A. To the extent existing CD&A disclosure already describes a company's hedging policy, the new SEC rule does not require companies to move or duplicate this disclosure elsewhere. The SEC's adopting release notes that including the disclosure outside of the CD&A would avoid subjecting it to say-on-pay votes.37 However, due to the nature of this disclosure and the fact that it is already commonly disclosed in the CD&A pursuant to Item 402(b)(2)(xiii), we do not typically expect there to be benefits to moving it outside the CD&A. Third, Consider ISS, Glass Lewis and Your Investor Policies. Although the new SEC rule does not require a company to adopt a hedging policy, there will likely be increasing pressure on companies without any hedging policy to adopt one. Proxy advisory firms and institutional investors generally favor robust hedging policies. For example, ISS notes in its reports whether a company has a "robust" hedging policy, which it defines as one that prohibits all types of hedging transactions by a broad group of participants.38 To the extent pressure from proxy advisory firms and investors increases on this issue, it may be prudent to reassess and consider expanding existing hedging policies (for example, to cover employees, rather than only executive officers). (2) Director Elections—Focus on Key Disclosure Items for Director Support: A crucial aspect of annual proxy statement preparation is ensuring that disclosure is drafted in order to obtain shareholder support for your directors. Understanding where your disclosure can raise red flags and reduce shareholder support for your directors is key. Below is a sample list of some items to consider: Director Elections: Director Independence Disclosure. Proxy advisory firms each have their own director independence criteria, and these criteria generally should be assessed alongside NYSE or Nasdaq requirements, as applicable, to ensure shareholder support for a company's directors. For a proxy statement's director independence section, under Item 407(a), a company must identify each director who is independent under NYSE or Nasdaq standards (as applicable). In addition, under Item 407(a)(3), a company's proxy statement must describe, by specific category or type, any transaction, relationship or arrangement that was considered by the board of directors under the applicable independence standard in determining that a director is independent.39 For this disclosure, there is a range of practices, but in any event, companies should consult with counsel to, among other things: (i) determine which transactions, relationships and arrangements warrant consideration by a board in an independence determination and therefore require proxy disclosure, and (ii) draft disclosure clearly so as not to raise issues under the proxy advisory firm independence criteria. Director Elections: Director Attendance Disclosure. A director's poor attendance at board and/or committee meetings, which typically means attendance at less than 75 percent of such meetings, can result in reduced shareholder support for that director. During the 2019 proxy season, more than 60 directors at Russell 3000 companies received negative ISS recommendations for this reason, with four such directors receiving less than 50 percent of the votes cast as a result. In the proxy statement, companies should make sure that their disclosure under Item 407(b) clearly notes whether their directors attended at least 75 percent of the meetings of the board and committees on which they served. If a director did not attend this threshold percentage of meetings, the SEC rule requires a company to name such director, and in this situation, a company should carefully consider the best approach to drafting this disclosure.40 Director Elections: Overboarding/Outside Directorship Disclosure. Given the increasingly strict overboarding policies of institutional investors, it is crucial to monitor the number of outside directorships your company's directors hold. During the 2019 proxy season, opposition to directors of Russell 3000 companies increased to its highest level since 2011, due in part to new or stricter overboarding policies of some institutional investors. Public company executives who sat on more than two outside public company boards were particularly hard hit, and a number of directors saw their support drop 25 percent or more on a year-over-year basis. Two key tips on this: First, Know Your Key Investors' Policies. A company should be aware of what its investors' policies are with respect to overboarding and educate its board of directors on these policies. If a director serves on more than the number of public company boards permitted by a particular policy, consider and weigh the range of options before filing your proxy statement (for example, by considering the percentage of votes which could potentially be lost if a director is overboarded, and if necessary, by requesting that the director step down from an outside board). In any event, controls should be in place to avert overboarding issues in the future. An overview of the overboarding policies of ISS and Glass Lewis, as well as key institutional investors, is provided below for your reference.41 Second, Carefully Draft Your Director Biographies in the Proxy Statement.In proxy statements, information on outside directorships is provided in the directors' biographical section pursuant to Item 401(e)(2) of Regulation S-K. Based on this disclosure, investors can find information on the number of outside directorships which a company's directors hold. One key point on this outside directorship disclosure is that, to the extent a director at your company is serving on an outside private company's board of directors, there should be no need to disclose this information under the SEC rule.42 Moreover, if a private company directorship is voluntarily disclosed, your proxy statement should clarify that the outside directorship is at a private company in order to avoid having that directorship inadvertently counted against the director under an overboarding policy. A second key point is to consider disclosing any extenuating or additional circumstances. For some investors, this additional explanation may be helpful if a director is overboarded. For example, Vanguard's policy states that a fund might vote for an overboarded director if the director has publicly committed to stepping down from a directorship in order to fall within the thresholds.43 Director Elections: Disclosure to Prepare for Special Cases.A number of other situations necessitate additional and often significant proxy disclosure to address investor concerns and maintain support for a company's directors, such as: (i) support below 70 percent for a say-on-pay proposal and (ii) significant support for a shareholder proposal. Even if your company is not facing these issues, it is important to plan in advance and strategize on your proxy statement disclosure to maintain investor support and help avert these types of situations.44 (3) Perquisites—Prioritize Your Company's Perquisite Processes: Perquisites continue to be a hot-button disclosure issue and a focus for the SEC in its reviews of proxy statement disclosure.45 In 2018, two SEC enforcement actions put the spotlight on perquisite disclosure. The key take-away for companies is to be organized and have processes in place to ensure that all benefits provided to executive officers are tracked, evaluated under the appropriate disclosure standard and properly disclosed if required. SEC Perquisite Disclosure Standard. As a reminder, under the SEC's perquisite disclosure standard, an item is not a perquisite if it is integrally and directly related to the performance of the executive's duties. However, an item is a perquisite if it confers a direct or indirect benefit that has a personal aspect, even if it may be provided for some business reason or for the company's convenience, unless it is generally available on a non-discriminatory basis to all employees. As the SEC reiterated in a recent enforcement action, the concept of a benefit that meets the first exception and is therefore integrally and directly related to job performance is "a narrow one" and only applies to items that an executive "needs [to] do the job."46 (4) Pay Ratio—Year Three: The 2020 proxy season will be the third year for mandatory pay ratio disclosure.47 The pay ratio rule, which requires disclosure of the ratio of the annual total compensation of a company's median employee to that of its chief executive officer, permits a company to identify its median employee once every three years, as long as the company reasonably believes there has not been a change in its employee population or compensation arrangements that would significantly alter the pay ratio disclosure. Whether or not a company used the same median employee for the first two years, it should confirm based on its own facts and circumstances if it is appropriate to do so for this year's proxy disclosure.48 (5) Clawback Policies on the SEC Agenda Again: The SEC's proposed clawback rules from 2015 pursuant to Section 954 of the Dodd-Frank Act, which would have required a company to recover compensation from current and former Section 16 officers if a company were required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement,49 have not been adopted, but the SEC recently put clawbacks back on the agenda by listing a new clawback rule proposal as an item that the SEC intends to complete within the next year.50 Increased Investor Scrutiny of Clawback Policies. A large number of companies have adopted clawback policies,51 which often meet ISS "best practice" and, for example, trigger a clawback of compensation from an executive officer when there is a financial restatement and misconduct by the executive. Moreover, high-profile scandals have led to scrutiny of clawback policies by investors as well as a push to expand clawback policies,52 while shareholder proposals on clawback policies appear to be gaining some traction. During the 2019 proxy season, two shareholder proposals on clawback policies passed, and there was significant average support of 45 percent for the three clawback proposals that went to a vote.53 Expanding Clawback Policies. Meanwhile, some companies have been expanding their clawback policies to trigger a clawback of compensation not only in the case of a financial restatement, but also if there is a significant violation of a code of conduct or reputational harm to a company. With clawback policy drafting, the devil, of course, is in the details, and when drafting a clawback policy, it is crucial to, among other things, weigh state law considerations, determine appropriate triggering events, and provide the board with sufficient discretion to act appropriately in times of crisis to address investor concerns. Next Steps on Clawbacks. Given the recent SEC agenda, it may be appropriate to take a wait-and-see approach before modifying an existing policy, but knowing what your clawback policy says, and making sure it is accurately described in your proxy statement, is a crucial first step. In addition, some companies may consider assessing the feasibility of a more expanded clawback policy and weigh the benefits of adopting such a policy. (6) Don't Forget Non-GAAP: Given the SEC scrutiny of non-GAAP disclosures (see Section I of this memo), a company should also make sure it is appropriately disclosing any non-GAAP financial measures in its proxy statement. When compensation target levels disclosed in a CD&A are non-GAAP financial measures, the disclosure is not subject to the SEC's non-GAAP requirements in Regulation G and Item 10(e), but a company must still provide disclosure as to how the numbers are calculated from the company's financial statements.54 For other pay-related circumstances, non-GAAP financial measures disclosed in a proxy statement are subject to the SEC's non-GAAP rules, but a company may be able to provide the required GAAP reconciliation in an annex to the proxy statement, provided that there is a prominent cross-reference to such annex.55 (7) Last (but not least)—Board Role in Risk Oversight: One of the evolving sections of the proxy statement in recent years has been the board risk oversight section. Item 407(h) of Regulation S-K requires companies to disclose the board's role in the risk oversight of a company, such as how the board administers its oversight function. In recent guidance, the SEC has emphasized that companies should also discuss how their boards oversee the management of material risks. For example, with respect to cybersecurity, SEC guidance notes that, "[t]o the extent cybersecurity risks are material to a company's business, we believe this discussion [under Item 407(h)] should include the nature of the board's role in overseeing the management of that risk."56 Similarly, Corp Fin Director Bill Hinman noted in a 2019 speech that companies may find the SEC's cybersecurity guidance useful when preparing disclosures about sustainability matters and other risks.57 Accordingly, companies should assess their disclosure for this section and consider providing additional information on the key risks that their boards oversee, as well as which committees oversee such risks.58 1 Referred to herein as the FAST Act rule changes. For more information, see our prior alert, "SEC Adopts Amendments to
Modernize and Simplify Disclosure Requirements." This publication
is provided for your convenience and does not constitute legal advice. This publication is protected by copyright. What does an audit committee report to?The audit committee is responsible for the appointment, compensation and oversight of the work of the auditor. As such, CPAs report directly to the audit committee, not management.
What are the main documents covered by an audit report?Audit Report Contents are the basic structure of the audit report which needs to be clear, providing sufficient evidence providing the justification about the opinion of the auditors and includes Title of Report, Addressee details, Opening Paragraph, scope Paragraph, Opinion Paragraph, Signature, Place of Signature, ...
What is the new requirement for audit committees in terms of King IV?King IV requires that the audit committee should, as a collective, have the necessary skill and experience to meet its obligations. This should be considered by the nominations committee prior to the AGM when they nominate members for appointment to the audit committee.
What are the obligations of the audit committees established by Sarbanes Oxley?The audit committee plays a critical role in auditors' compliance with the auditor independence rules, in part because the Sarbanes-Oxley Act mandates that audit committees be directly responsible for the oversight of the engagement of the company's independent auditor.
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