Who Sets the Rules: FASB, SEC, IASB and Auditors

Introduction

Behind every number in a 10-K stand three separate institutions. One wrote the rule that decided how the number is measured, one requires the company to follow that rule and can punish it for failing, and one checked the company's work before the number was published. In the United States those roles belong to the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC) and the company's independent auditor, itself supervised by a regulator. Outside the United States, most jurisdictions require their listed companies to follow standards written by a fourth body, the International Accounting Standards Board (IASB), author of International Financial Reporting Standards (IFRS).

Knowing who does what is more practical than it sounds. It tells a banker where to look up a rule, which documents carry authority, what an audit opinion does and does not guarantee, and why a new standard can change a company's reported numbers without any change in its business. The division of labor is summarized below:

The FASB is a private-sector body, not a government agency, and its authority comes from the SEC's recognition. Following the Sarbanes-Oxley Act of 2002, the SEC reaffirmed in April 2003 that it would continue to recognize the FASB's pronouncements as generally accepted for the purposes of the federal securities laws. In practice, US generally accepted accounting principles (GAAP) means what the FASB has written, plus the SEC's own rules for registrants.

Everything the FASB has issued lives in one place. The FASB launched its Accounting Standards Codification on July 1, 2009 as the single source of authoritative nongovernmental US GAAP, reorganizing thousands of earlier pronouncements into roughly 90 topics and including relevant SEC guidance in separate sections. That structure is why accountants and bankers refer to rules by topic number: ASC 606 for revenue, ASC 842 for leases, ASC 740 for income taxes, ASC 805 for business combinations.

Accounting Standards Codification (ASC)

The FASB's organized collection of all authoritative US GAAP, arranged by numbered topics such as ASC 606 (revenue) and ASC 842 (leases). It became the single source of authoritative nongovernmental US GAAP in 2009, and new standards are added to it through Accounting Standards Updates.

The Codification changes through Accounting Standards Updates (ASUs), numbered by year, such as ASU 2016-02, which introduced the current lease standard. Each update follows a due process: the FASB publishes a proposal, takes public comments and only then issues the final standard with an effective date, often a year or more away. That lead time gives bankers advance warning of standards that will change reported figures, the subject of new accounting standards bankers should know.

The SEC's authority over financial reporting comes from the securities laws, which require public companies to file periodic reports. The FASB writes the accounting; the SEC writes the rules for what the filings must contain. Regulation S-X sets the form and content of the financial statements, including how many years must be presented. Regulation S-K governs the rest of the document, such as the business description, risk factors and management's discussion and analysis (MD&A). Regulation G and related rules govern non-GAAP measures, requiring a reconciliation to the most comparable GAAP figure, as covered in non-GAAP measures.

The SEC also checks the filings. Its Division of Corporation Finance reviews companies' reports, and as PwC's summary of the SEC filing review process notes, Section 408 of the Sarbanes-Oxley Act requires the SEC to review companies that file Exchange Act reports at least once every three years. When the staff has questions, it sends a comment letter, the company responds, and once the review is complete the correspondence is posted publicly on the SEC's website.

When a review or another investigation finds a violation, the SEC's Division of Enforcement can bring charges against companies and individual executives. In the Under Armour revenue disclosure case discussed in recognition and matching, it charged the company, which paid $9 million to settle. The SEC's Office of the Chief Accountant, meanwhile, advises the Commission on accounting questions and issues staff interpretations that registrants follow in practice.

The third layer is the independent auditor, an accounting firm the company hires to examine its financial statements. The auditor's report states whether, in its opinion, the statements are presented fairly in all material respects in accordance with US GAAP. For larger public companies, the auditor also reports on the company's internal control over financial reporting. Since the Sarbanes-Oxley Act of 2002, auditors of public companies are themselves overseen by the Public Company Accounting Oversight Board (PCAOB), which sets auditing standards, registers and inspects audit firms, and can discipline them.

Audit opinion

An independent auditor's conclusion on whether a company's financial statements are presented fairly, in all material respects, in accordance with the applicable accounting framework. An unqualified, or clean, opinion is based on reasonable assurance, not absolute assurance, that the statements are free of material misstatement.

The wording of the opinion defines its limits. Reasonable assurance is a high level of confidence, not a guarantee; material means large enough to influence a reasonable investor, so smaller errors can survive an audit; and the opinion covers the financial statements, not the earnings release, the adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) in an investor presentation or management's projections.

Auditor changes, disagreements and restatements are therefore significant events, disclosed in their own filings, and the way a company corrects past errors is covered in restatements, accounting changes and estimates.

Outside the United States, the leading standard setter is the International Accounting Standards Board (IASB), which operates under the IFRS Foundation and issues IFRS Accounting Standards. National and regional authorities decide whether to require them; the European Union, the United Kingdom, Canada, Australia and many other markets require IFRS for their listed companies' consolidated accounts, sometimes with local endorsement procedures. Enforcement remains national: there is no global equivalent of the SEC, so the strength of oversight varies by country.

The FASB and the IASB worked together for years on convergence, reducing the differences between their standards, which is why revenue recognition now follows essentially the same model under both frameworks. Differences remain in leases, development costs, inventory, impairments and several other areas, mapped in US GAAP vs IFRS differences.

For a banker, the institutions matter mostly through their effects on comparability. A new FASB standard can change how a company reports the same business: when the current lease standard took effect, operating lease liabilities appeared on balance sheets across corporate America, and when the revenue standard took effect, some companies recognized revenue earlier or later than before. Comparing a company's figures across years that straddle such a change requires reading the transition disclosures in the notes, which show how prior periods were or were not restated.

The authority behind each document also tells a banker how much weight to give it. Audited annual statements prepared under the Codification and subject to SEC review carry the most assurance. Quarterly statements are reviewed rather than audited. Earnings releases, investor presentations and management projections sit outside the audit entirely. Knowing where a figure sits in that hierarchy, as described in how to read a 10-K and 10-Q, is the first step in deciding how much diligence it needs before it goes into a model or a pitch book.