Approved by the Knesset: Public Companies are required to report on internal auditor's activities, critical accounting estimates and acquisition of assets
Last week, the Financial Committee of the Knesset had approved ISA's guidelines in three important areas: internal auditor's activities, critical accounting estimates and acquisition of assets. All of the aforesaid guidelines were binding for the last two years and lately it was decided to set them under regulations.
A. Report on activities of internal auditor
About three years ago, as part of the policy initiated by the chairman of the ISA Mr. Tery, the ISA had decided to reexamine the activities of "gatekeepers" and to amend reporting standards pertaining to them. The decision was made following several fraud and profit management affairs that occurred in the US and had significantly affected both the American and world financial markets.
The internal auditor of a public company is bounded by the Companies Law. His professional duty is to review the company's compliance with the law and the appropriateness of its business management. However, the Companies Law does not state the extent of auditing required from the internal auditor and does not formulate clear-cut obligations applicable to him, except for the requirement to submit an annual or periodic working plan proposal and a report on the internal auditor's findings.
The internal auditor's duty is to assist such organs as: the board of directors, the company's CEO and the auditing committee; but he is not obligated to report to investors. However, it is clear, that disclosure pertaining to the working methodology of the internal auditor and the treatment procedure of his findings will supply investors with valuable information regarding company's auditing practices and as a byproduct - will motivate both the company and the internal auditor to act more energetically in the area of internal auditing.
Until disclosure guidelines, which are the basis of present day regulations, were published the reporting requirements, related to internal auditors of reporting corporations, had been rather limited. Under the Securities Law Regulations an internal auditor is defined as a senior corporate officer: "hence, the company is required to publish, in its periodic report: the name of the internal auditor, his age, the date his tenure commenced, his position within the company, his family association with senior corporate officers or principal shareholders, as well as his education and professional experience in the last five years. In case the internal auditor is one of five highest paid employees of the corporation – all payments made to him by the company, have to be detailed.
Until the publication of ISA's guidelines no other disclosure, pertaining to internal auditors' activities, was required.
After a two year period, during which the guidelines were obligatory and the companies made comprehensive reports regarding the activities of their internal auditors, it was decided to set the aforesaid guidelines under regulations. Some additional disclosure requirements, such as: the way of deciding on remuneration received by the internal auditor, whether the auditing includes company's activities abroad, did the internal auditor reviewed special transactions carried out during the reporting period (including transactions with a controlling shareholder) were added to new regulations.
Regulations approved by the Knesset stipulate that the board of directors' report should include the following details regarding the internal auditor:
• Name of the internal editor, the date his tenure commenced, reference to his compliance with requirements stipulated under the law, auditor's holdings in the company he audits or in its affiliate and whether they might adversely affect his auditing responsibilities, disclosure pertaining to significant
business connections or other significant connections within the audited company or its affiliate and whether they might create a conflict of interest with respect to his position as an auditor;
• Whether the internal auditor is a company's employee or an outsider, disclosure pertaining to other positions held by him in the company and outside it;
• The way of appointment, date of appointment and reasons for appointment
• The scope of internal auditor's position, his plan of recompense and its characteristics;
• Definition process of the auditing plan, persons involved in its definition and disclosure regarding whether the internal auditor had examined material transactions carried out during a reporting period(including transactions with controlling shareholders);
• Reference to significant companies held by the main company and their activities abroad, within the auditing plan;
• According to what professional standards was the internal audit prepared by the internal auditor;
• Identity of the auditor's superior, in the organization;
• Dates on which the findings of the internal auditor were presented to the chairman of the board, the general manager and the chairman of the auditing committee; dates on which discussions were held by the board of directors on the findings presented by the internal editor, and if not held – why;
• Why, under given circumstances, the scope, nature and character of the internal auditor's working plan are, in the board's opinion, both sufficient and coherent with the internal audit's objectives; and whether the internal auditor was given continuous, unimpeded access to the company's information systems, including its financial data.
• Reasons for terminating the internal auditor's tenure.
B. Reporting on critical accounting estimates
Companies' business circumstances and the nature of their activities create conditions whereby they need to prepare accounting evaluations and estimates, as part of financial statements preparation, in order to exercise acceptable accounting rules.
Although estimates are an integral part of financial statements, the preparation of some requires the application of common sense under uncertain circumstances, circumstances that might significantly affect the financial presentation of a company. The aforesaid estimates relate to such issues as: income recognition, reduction of assets, assets' devaluation, standing claims, etc. Since some of the estimates are particularly uncertain, there is a possibility that reported results might be radically different from said estimates, despite the fact that there was no drastic change in the business environment; they are usually presented as "reporting and presentation risks".
This disclosure is aimed at allowing investors to acquire information pertaining to accounting rules and standards used as the basis for evaluating and presenting financial information; however, at present the disclosure does not provide information regarding significant reporting and presentation risks as part of company's financial statements, since this information is characterized as sensitive analytical data.
The amendment to regulations increases transparency, in regard to accounting policy implemented in financial statements, in two ways. First – it increases investor' awareness of the existence of critical accounting estimates related to significant uncertainty and requiring common sense evaluation; second – it imparts investors with insight, regarding implications the aforesaid estimates have on financial presentations of companies, as well as with the indication that changes in the aforesaid estimates might affect presentations of companies' financial results.
According to the approved amendment, every company must include in its directors' report information identifying and describing the aforesaid financial estimates, as well as to describe both qualitative and
quantitative effects, the use of said critical accounting estimates might have on financial statements of a company, along with variables that might change these estimates.
A critical accounting estimate is defined as such, when the following conditions transpire:
- At the time of choosing to make use of it, a company makes assumptions regarding circumstances/events
related to significant uncertainty
- A realistic change, including the use of a reasonable alternative estimate, might significantly affect financial presentation of a company.
According to the regulations, a company will be required to include in its directors' report description of critical accounting estimates, the methodology used to define regulations used as basis for their decision. A company will also be required to include a substantial discussion pertaining to the importance of said estimates for company's financial reports, sensitivity analysis that were done to these estimates, parameters whose change will affect the estimates, as well the discussion of changes done to the estimates during the
last three years.
C. Acquisition of assets
The amendment to regulations defines the scope of disclosure, required in the immediate report, regarding an asset acquisition or acquisition of a number of assets by a public company; starting from a stage when negotiations began regarding asset acquisition. Acquisition is defined as "gaining of control" (including indirect control) of the asset: purchase, barter transaction, amalgamation or any other way.
The scope of disclosure is related to the stage in which the transaction is found (negotiating, signing of a preliminary document, signing a purchase agreement and closing) and who significant it is to the company's business. The more progressive the stage of transaction is and the more significant to the company's business it is, the broader the required disclosure is going to be (since the company also possesses more information at a later stage).
The amendment stipulates that at the negotiating stage, when a company is obligated to report on negotiations pertaining to the asset, it has to submit an immediate report that includes a general description of the asset and the estimate of the required investment. The report has to feature an estimated time table for completion of the negotiations, and where the parties had signed a preliminary agreement, a memorandum of understanding, a basic agreement, etc., the main points of the aforesaid agreements have to be detailed in the immediate report.
At the stage of signing a purchase agreement the company is obligated to provide full disclosure regarding the purchase, relative to its significance for the acquiring company, including the following:
date of purchase; means of purchase (acquisition, barter, amalgamation, consolidation of assets, purchase by means of leasing, etc.) brief description of the acquired asset; consideration paid for the asset, dates of payments, financing of the purchase (including details of the loan, if taken), the nature of affiliation between the seller and the purchasing company, if there is one, taxes or levies on the purchase; laws and regulations applicable to the asset and limiting its usage (such as: business limitations ordinance, supervision of banks ordinance, etc.), purpose of the asset and its planned usage, details of suspending conditions pertaining to the implementation of the agreement and personal interest of company's principal shareholders pertaining to said acquisition and its significance.
Regarding the closing stage – the regulations stipulate that when the transaction is implemented later then the signing date and/or where its implementation is dependent on suspending conditions, the immediate report shall be submitted after all the conditions had been fulfilled. It should contain all updated facts regarding significant details integrated into the purchase agreement, as far as they were integrated, from the date of signing until the transaction took effect.
Alternatively – where not all of the conditions, stipulated by the agreement, had transpired – the immediate report, when submitted, should detail conditions which weren't fulfilled and the sate of the agreement in light of the noncompliance with the aforesaid conditions.
The regulations also stipulate details that have to be provided, relative to the type of asset: real estate, securities or company's activities, non-tangible asset, a machine or a production line.