of the Federal Audit Oversight Authority
Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the consolidated financial state-ments of the current period. These matters were addressed in the context of our audit of the consolidated financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. For each matter below, our description of how our audit addressed the matter is provided in that context.
We have fulfilled the responsibilities described in the Auditor’s responsibility section of our report, including in relation to these matters. Accordingly, our audit included the performance of procedures designed to respond to our assessment of the risks of material misstatement of the consolidated financial statements. The results of our audit procedures, including the procedures performed to address the matters below, provide the basis for our audit opinion on the accompanying consolidated financial statements.
Revenue recognition on long-term projects Risk
The Company derives a significant portion of its revenues from long-term and fixed price projects.
Such contracts involve key project milestones and financial milestones including the bid price, risk con-tingencies, the execution, post-completion warranty obligations and ongoing uncertainties around expected costs to complete. Therefore, the revenue, cost and gross profit realization can vary substantial-ly during the execution and reassessment of these projects against the contracted financial milestones.
The principal risks include:
• the potential manipulation of results to achieve performance targets through management’s use of estimates and judgments in relation to such projects;
• inappropriate or incorrect accounting for percentage of completion, variation orders, expected costs to complete, estimated project margin and risk contingencies; and
• unrecorded liabilities for warranties, contractual disputes or claims for liquidated damages.
We consider these the key judgmental areas impacting the recognition of revenue and margins in respect of long-term contracts.
See note 2 to these consolidated financial state-ments for ABB’s description of the accounting policy for Revenue Recognition.
Our audit response
We obtained an understanding of the process for how manage ment determines the percentage of completion, evaluated the design of, and per-formed tests of controls in this area. We evaluated the judgments made by management regarding the expected costs to complete estimate, the timing and recognition of variation orders, and the assumptions made in calculating warranty provi-sions with underlying data.
We evaluated management’s assessments around the potential for liquidated damages for projects behind contracted schedule and the contingency provisions to mitigate contract-specific financial risks. For those balances subject to claims, we made inquiries of external and internal legal counsel.
We also assessed whether management’s policies and processes for making these estimates continue to be applied consistently to all contracts of a similar nature.
Legal and Compliance Risk
The illegal behavior by any employee or agent that has and may in the future violate the US Foreign
Corrupt Practices Act of 1977, OECD (Organisation for Economic Co-operation and Development) legislation, anti-trust laws and other applicable laws and regulations may significantly impact the Company’s reputation, its ability to do business in certain jurisdictions and/or with certain counterparties or may result in significant fines or civil claims.
Determining the impact and likely outcome of any litigation matter requires significant judgment.
Therefore, estimating litigation reserves and contingent liabilities can involve highly judgmental estimates.
The principal risks include:
• the judgments involved in determining the likely outcome of legal cases, disputes or investiga-tions results in a risk that those legal provisions may be incorrect; and
• failure to provide on a timely basis for claims due to lack of understanding or awareness of the claim.
See note 15 to these consolidated financial statements for ABB’s descrition of Contingencies – Regulatory, Compliance and Legal.
Our audit response
We assessed judgments and accounting conclusions made by management arising from violation of legislation, anti-trust laws and other regulatory risks.
Our procedures included an evaluation of manage-ment’s calculations and the related underlying assumptions to verify that the relevant risks are reflected in the provisions.
Our procedures included discussions with internal legal counsel, and we also obtained and considered legal letters from external legal counsel and other supporting documentation.
Tax contingency reserves Risk
The Company operates in multiple jurisdictions and is therefore exposed to numerous tax laws around the world. Risk provisions are held where it is probable that a liability will materialize either in relation to previous planning strategies or a tax position taken in relation to submitted returns subject to tax audit. The amount of such a provision and whether it is probable that it will materialize are both considered to be significant judgmental areas.
Given the volume and complexity of intracompany transactions, including management fee recharges, transfer pricing is an area of complexity and judgment that is closely managed by ABB and
certain provisions are recorded to reflect areas of uncertainty. These matters have come under renewed focus with the current Base Erosion and Profit Shifting project of the OECD.
The principal risks include:
• significant judgments involved in determining the provision for tax liabilities that can result in misstatement of provisions; and
• there are ranges of possible transfer prices, therefore there is a risk of challenge by the tax authorities, particularly with the increased focus on tax and multinational businesses.
See note 16 to these consolidated financial statements for ABB’s description of Taxes.
Our audit response
We assessed tax exposures estimated by manage-ment and the risk analysis associated with these exposures along with claims or assessments made by tax authorities to date. We verified the compo-nents of the tax risk provision to ensure they reflect the tax risks in the business and evaluated the provisions.
We also reviewed documentation in relation to tax audits to ensure that any exposures the tax authorities are raising have been considered and provided for where necessary.
We reviewed, with the involvement of transfer pricing specialists, the significant transfer pricing policies applied by ABB including the related supporting documentation, and ensured that the tax risk provision included such risks.
Goodwill impairment Risk
The Company reviews the carrying amount of its reporting units annually or more frequent-ly if impairment indicators are present. The impairment assessment involves a comparison of the estimated fair value of each reporting unit to its carrying amount. This annual impairment test was significant to our audit because the balance of USD 9,501 million as of December 31, 2016 is significant to the financial statements representing 24% of the total assets. In addition, we note that management’s assessment process is assumption based, complex and subject to highly judgmental estimates.
The principal risks include:
• the incorrect determination of the reporting units and subsequent allocation of goodwill used for impairment assessments;
• inaccurate models are used to calculate the fair value of the reporting units; and
• the assumptions to support goodwill values (e.g. discount rates and growth rates) are inappropriate such as projected financial information, which are affected by expected future market or economic conditions.
See note 11 to these consolidated financial state-ments for ABB’s description of Goodwill and other intangible assets.
Our audit response
Our procedures included a review of the valuations prepared by management and related supporting third-party evidence for the fair values of each goodwill reporting unit. We performed audit procedures on the integrity of the models and the definition of the goodwill reporting units.
We involved valuation specialists to support our evaluation of the assumptions used in respect of the forecast growth rates and discount rates.
Our evaluation included a comparison to economic and industry forecasts.
We compared the forecasts used in generating the fair value to current business environment, and evaluated management’s assumptions underpinning the forecasts.
We reviewed the forecasts by stress testing key assumptions, assessing the impact on the sensitiv-ity analysis, and understanding the degree to which assumptions would need to move before impair-ment would be triggered.
Warranty provision Risk
During 2016, the Company determined that the provision for warranties in its solar business, acquired in 2013 as part of the purchase of Power-One, was no longer sufficient to cover expected warranty costs over the remaining warranty period.
Due to higher than originally expected product failure rates for certain solar inverters designed and manufactured by Power-One, the Company reassessed its model to determine the expected costs to cover future warranty claims.
The principal risks include:
• significant judgments involved in determining the amount of the warranty provision; and
• precision of the inputs and model used to calculate warranty provisions.
See note 15 to these consolidated financial statements for ABB’s description of Product and order-related contingencies.
Our audit response
We obtained an understanding of the process to determine the amount of solar inverter warranty provisions. Our audit procedures included evaluat-ing management’s methodology by understandevaluat-ing the basis for the assumptions developed and used in the calculation of the warranty provisions.
We also evaluated the validity of the data used for the calculations within the model.
Our procedures further included discussions with internal and external experts in regards to the reasonableness of the assumptions used.
White Collar Productivity restructuring provision Risk
On September 9, 2015, the Company publically announced a significant restructuring program, in an effort to reduce costs under the White Collar Productivity (“WCP”) 1,000-day program. As part of the WCP program, ABB committed to reduce headcount globally across all divisions and in most countries where ABB operates and will provide postemployment benefits to the impacted employees. At December 31, 2016 the Company has an outstanding provision of USD 334 million related to this program. The restructuring provi-sions are material to the financial statements and the recognition criteria and measurement depends upon local country facts and circumstances.
The principal risks include:
• the judgments involved in the determination of the assumptions used, such as the number of individuals affected and the related severance costs, to determining the required WCP related restructuring provision; and
• failure to recognize WCP restructuring provision and reversals timely.
See note 22 to these consolidated financial state-ments for ABB’s description on Restructuring and related expenses.
Our audit response
We assessed the process, controls and the result-ing WCP provisions estimated by management as part of our year-end audit.
For the locations with material WCP expenses and accruals, we obtained related supporting docu-mentation to evaluate the criteria to record the WCP provision pursuant to ASC 712 or ASC 420, which ever applicable, were met.
We reviewed the documentation related to the provision expenses recorded in 2016 and the completeness and the valuation of the provision balance as of December 31, 2016. This included an
evaluation of the estimated future severance payments that will be paid to employees terminat-ed under the WCP program and the change in estimate recorded.
We evaluated the presentation of the WCP expenses and accruals, ensuring these were recorded within the appropriate balance sheet and income statement line items, respectively.
We reviewed the restructuring disclosures, which includes the WCP provision, and ensured all required disclosures were made.
Illegal act in South Korea Risk
In February 2017, ABB uncovered criminal activity in its South Korean subsidiary that is an adjusting subsequent event for the financial statements as of December 31, 2016. The Company disclosed these irregularities and the initial results on February 22, 2017. The Company immediately launched an investigation in South Korea led by ABB and involving independent forensic and legal specialists. These criminal activities impacted the Company’s net income by USD 64 million, net of probable insurance recoveries and income taxes as of December 31, 2016.
See section “Other income (expense), net” in the Company’s analysis of results of operations within the Financial Review of ABB Group in the
Company’s annual report.
Our audit response
Once we become aware of this, we revisited our audit approach. Our audit procedures included, amongst others, understanding the nature of the criminal act, the circumstances in which the acts occurred, and understanding of other relevant information to evaluate the impact on the financial statements. We shadowed the ABB investigation with the support of EY forensic specialists and discussed on a number of occasions the investiga-tion with management and the Finance, Audit and Compliance Committee (FACC) to evaluate the approach and the corresponding findings, financial and disclosure consequences and impact on internal controls.
We further assessed the impact of these criminal acts to our overall audit strategy and the
appropriateness of the planned and executed audit procedures. Based on this re-assessment, we performed additional control testing around cash and the treasury function and expanded our cash confirmation audit procedures, as well as the procedures for outstanding loans and account receivables factoring arrangements in South Korea.
We finally assessed the Company’s financial statement presentation and disclosures.