10 minute read 29 Jun 2023
Two parallel bridges over foggy river with stones in the water

How audit committees can prepare for 2023 Q2 reporting

Authors
Jennifer Lee

EY Americas Center for Board Matters Audit and Risk Specialist

Provider of board and audit committee insights. Conversent on financial reporting, risk and regulatory issues. Dedicated to family, team and client.

Pat Niemann

EY Americas Audit Committee Forum Leader

Community champion. Family man. USC Trojan alum.

10 minute read 29 Jun 2023

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  • How audit committees can prepare for 2023 Q2 reporting

We offer considerations for audit committees as they proactively address recent and upcoming developments impacting Q2 reporting.

In brief

  • Artificial Intelligence and related applications are increasingly a growing focus of risk discussions for audit committees.
  • Audit committees remain focused on understanding the impacts of the continued uncertain economic environment on financial reporting.
  • It is important to track expected SEC rulemaking and prepare for potential changes to reporting requirements and disclosures.

Presented by the EY Audit Committee Forum

This report is intended to help audit committees as they proactively address recent and upcoming developments that may affect quarterly reporting.

Risk management

Enterprise risk management (ERM), geopolitics, macroeconomic conditions, talent, and cybersecurity continue to be ongoing focus areas for audit committees. Artificial intelligence (AI) and generative AI applications, such as ChatGPT, are also becoming emerging priorities and areas of greater board discussions. As the use of AI and machine learning proliferates, AI technologies are rapidly outpacing the organizational governance and controls that guide their use. 

  • What audit committee chairs are saying about AI

    Tapestry Networks recently convened audit committee chairs of global Fortune 100 public companies to exchange views on how AI technology has progressed and its implications to companies. Tapestry Networks summarized the key points arising from this discussion in its recently released report. We’ve highlighted some notable themes included in this report, along with other key takeaways and considerations:

    • Generative AI capabilities are outpacing its developers’ goals. Generative AI is a subset of the technology that uses machine learning methods to create new, original content (such as languages or images), increasingly mimicking what have long been considered human behaviors. While the underlying research and development have been going on for years, the capabilities of new generative AI applications are vastly exceeding expectations while also creating some unintended consequences and impacts for organizations.
    • What lies ahead remains uncertain, because even the experts don’t fully grasp some aspects of the technology (including its implications and unintended consequences). There appears to be a fundamental uncertainty about what is being created, with many unsure of all that is at stake. The European Parliament’s Internal Market and Civil Liberties committees recently approved a draft proposal of the AI Act with the aim of promoting AI systems that are ethical, safe, transparent, traceable, not discriminatory, environmentally friendly, and overseen by humans. It also provides a risk classification framework that determines the level of risk an AI technology could pose, with four risk tiers: unacceptable, high, limited, and minimal. The proposal also calls for steep fines for noncompliance, with fines up to 30 million euros or 6% of global profits, whichever is higher. This potential landmark act could be a signal of more regulatory actions in the near future. Accordingly, it will be important that boards plan for multiple scenarios at different magnitudes of disruption and time horizons.
    • Be aware of risks, including early-stage commercialization risk. The more people use AI technologies, the faster those technologies develop and improve, which sets up a powerful first-mover advantage. However, there may be a host of risks, including those relating to premature commercialization. Audit committees should inquire with management and internal audit regarding risk assessments around AI and related AI governance, including how risks around ethical use of AI, accuracy of outputs, plagiarism, copyright, trademark violations, and protections of company IP were considered. Additionally, audit committees should ask management whether and how AI is used within the financial reporting processes, including any related internal control impacts. The potential societal impact of the AI system should also be carefully considered, including its impact on the financial, physical and mental well-being of humans and our natural environment. For example, potential impacts might include workforce disruption, skills retraining, discrimination, and environmental effects. Further, as employees adopt generative AI tools such as ChatGPT for use in the workplace, companies should consider implementing a corporate policy governing usage of such tools in the workplace to mitigate risks associated with data privacy laws, confidentiality, and other potential legal risks (e.g., intellectual property ownership issues) associated with the misuse of AI tools.
    • Prepare for generative AI’s involvement in geopolitical issues. There is significant risk of Al models becoming tools of political actors and potentially amplifying geopolitical risks. The use of the technology for rapid, large-scale communication, including disinformation risk, may become more prevalent in future campaigns and election cycles.
    • Consider adopting a zero-trust approach. Many leaders are asking how to build more trust in Al technologies as companies begin experimenting and implementing more advanced forms. Companies should consider a “zero trust attitude” whereby the burden is placed on the machine to prove accuracy of outputs. Audit committees should inquire regarding how controls and processes can evolve as quickly as the technology does.
    • Consider the opportunities. Boards should explore opportunities for deploying generative AI (including ways to leverage AI to enhance risk sensing capabilities and bolster risk management efforts within the organization), especially given a tight market for knowledge workers.

Accounting and disclosures

We anticipate audit committees will continue to evaluate evolving impacts stemming from the uncertain economic environment and ongoing changes in the business environment on their financial reporting processes. We’ve highlighted below some key accounting and reporting-related considerations that audit committees may want to consider with respect to the current economic environment:

For the full report and complete list of questions for audit committees, download the PDF.

Download the report

  • Verify that companies have the processes and controls in place to make sure management can appropriately consider how changes in the economic environment affect their accounting and financial reporting.
  • Continue to assess changes in the business, trends or uncertainties and the implications for financial reporting. Known trends or uncertainties may include inflation, rising interest rates, the war in Ukraine, and supply chain disruptions that affect the relationship of costs to revenue.
  • Revisit other disclosures included in SEC filings, such as risk factors, critical accounting estimates, liquidity, and capital resources to address certain risk concentrations (e.g., customer, supplier, geographic) and other known trends, events, and risks and uncertainties that have had or are reasonably expected to have a material effect on the business.
  • When a company is considering selling or transferring debt securities to meet its liquidity needs, it may have to change the classification of those securities. To classify debt securities as held to maturity, a company has to assess for each reporting period whether it has both the positive intent and the ability to hold them to maturity.
  • Companies that assert their intent and ability to indefinitely reinvest foreign earnings should challenge whether they can continue doing so in their operations that have been affected by rising interest rates and inflation. This assertion should be supported by projected working capital and an assessment of long-term capital needs in the locations in which those earnings are generated (or other foreign locations) and by an analysis of why those funds are not needed upstream. The analysis should also consider the increasing cost of capital in today’s high interest rate environment.
  • Companies that have reported significant increases in year‑over‑year inventory balances may need to consider whether to record a charge for any decline in value of inventory they cannot sell in the short term. In today’s environment, it is also important to determine which costs can be included in inventory. For example, higher-than-expected inflation in the cost of materials can be included in inventory and capitalized, because cost inflation is an element of actual inventory cost. In contrast, if a variance is driven by excess capacity, rework or other costs that cannot be included in inventory, those costs are accounted for as an expense.
  • In addition, companies may need to revise their estimates of how much variable consideration they will be entitled to under a contract with a customer if they change their expectations about returns of goods, contract volume and whether they will meet contractual conditions for performance bonuses or penalties. Companies that accept partial payment or extend payment terms need to consider the implications, such as whether the contract has been modified or includes a significant financing component.

SEC rulemaking and other reporting considerations

While the timing has continued to slip, several rule-related actions are expected in 2023 from the SEC, including a proposed rule on human capital management disclosure and final rules on climate and cybersecurity risk governance and disclosure. Although SEC Chair Gary Gensler faced skeptical questions about the extent of the SEC’s rulemaking agenda by some members of the House Financial Services Committee in an April hearing, he gave no indication that he plans to pull back.

In May, the SEC adopted a final rule on share repurchase disclosures, which requires most issuers to disclose daily quantitative share repurchase information on a quarterly basis. It also requires narrative disclosure to discuss share repurchase objectives, criteria used to determine the amount of the repurchase, and policies and procedures related to trading of securities during a repurchase program by its officers and directors. According to the rule, issuers also must disclose information about their adoption and termination of Rule 10b5-1 trading arrangements.

The SEC remains focused on companies’ use of non-GAAP financial measures in earnings releases and SEC filings and whether such metrics could potentially mislead investors. While no new guidance has been released, the SEC staff updated their Compliance and Disclosure Interpretations on this topic in December 2022 to reflect views the staff had previously communicated. Audit committees should understand the use and purpose of non-GAAP financial measures disclosed in filings with the SEC and review related disclosures in order to confirm that clear explanations of these measures are provided.

Audit committees should also understand management’s plans to update, as necessary, existing policies and compensation plans as a result of the SEC’s final rule on erroneously awarded compensation (also known as clawbacks) issued in October 2022. The final rule requires exchanges to establish listing requirements to mandate that issuers develop, implement and disclose their policies on recovering incentive-based compensation received by current or former executive officers when there is an accounting restatement of the financial statements due to an error. Both the NYSE and Nasdaq have finalized rules to implement the clawback rule which are expected to be approved by the SEC before the end of Q2. Companies are required to adopt a compliant policy no more than 60 days after the applicable listing standards are effective and begin to provide required disclosures. Audit committees should consider how their companies are preparing for potential regulatory changes, which could impact reporting requirements, disclosures, and enforcement trends. Download the full report to find out what actions audit committees may need to take.

Questions for the audit committee to consider

  • How strong are the organization’s capabilities to be highly informed about the internal and external environment, and risks, events and opportunities that may influence or compromise enterprise resilience?
  • How effective is the board’s oversight of emerging risks and other evolving external risks such as geopolitical developments, uncertain economic conditions, and climate risk? Does it have the information, expertise, and professional skepticism it needs to challenge management in these areas?
  • Does the organization perform stress tests to confirm that the financial reserves of the company can absorb distress in the economy? Does the organization have confidence in the financial strength of its counterparties?
  • What are the nonrecurring events and circumstances that have transpired, and what are the related financial reporting and disclosure implications?
  • In light of the current environment (including the macro market conditions), has the company evaluated how current market developments may change the value of assets and whether there are impairment indicators for assets such as property, plant and equipment; definite and indefinite-lived intangibles; inventory; receivables; debt; and equity investments? Have the valuation technique(s), inputs and assumptions been appropriately revisited and updated?
  • Are the company’s nonfinancial disclosures fit for purpose given current investor stewardship priorities, investing trends and related investor data needs?
For the full report and complete list of questions for audit committees, download the PDF.

Download the report

Summary

As the second quarter of 2023 closes, audit committees are keeping a close eye on the critical drivers of risk and evolving economic conditions to better assess both near- and long-term implications. They are also considering how the current business environment and new regulatory developments could impact financial reporting. 

About this article

Authors
Jennifer Lee

EY Americas Center for Board Matters Audit and Risk Specialist

Provider of board and audit committee insights. Conversent on financial reporting, risk and regulatory issues. Dedicated to family, team and client.

Pat Niemann

EY Americas Audit Committee Forum Leader

Community champion. Family man. USC Trojan alum.