By Christopher L. Garcia and Paul Ferrillo of Weil Gotshal & Manges LLP, and Matthew Jacques of AlixPartners
Christopher Garcia is a partner and Paul Ferrillo is of counsel in the Securities Litigation practice at Weil Gotshal & Manges LLP in New York, where they focus on complex securities litigation and investigation matters. Matthew Jacques is a Director in the Corporate Investigations practice at AlixPartners in Boston. Versions or excerpts of this article have appeared elsewhere.
The United States Securities and Exchange Commission on July 2, 2013, announced new initiatives aimed at preventing and detecting improper or fraudulent financial reporting. As we noted in the February 2014 issue of Dimensions, one of these initiatives - a computer-based tool called the Accounting Quality Model (the AQM; often known as “Robocop”) - is designed to enable real-time analytical review of financial reports filed with the SEC, intended to help identify questionable accounting practices. Mandatory financial reporting using XBRL is what allows the AQM to be possible, making high-quality XBRL filings more important than ever and not a secondary consideration when preparing SEC disclosures.
What is really driving the SEC renewed focus on accounting irregularities?
The SEC also announced the creation of the Financial Reporting and Audit Task Force, comprising 12 selected lawyers and both forensic and GAAP accountants from the SEC Division of Enforcement. Its mission is “[to] concentrate on expanding and strengthening the Division [of Enforcement's] efforts to identify securities-law violations relating to the preparation of financial statements, issues of reporting and disclosure, and audit failures.” To fulfill its mission, the Task Force will be responsible for “closely monitoring high-risk companies to identify potential misconduct, analyzing performance trends by industry, reviewing class action and other filings related to alleged fraudulent financial reporting, tapping into academic work on accounting and auditing fraud, and conducting street sweeps in particular industries and accounting areas,” as Andrew Ceresney, then Co-Director of the Enforcement Division, has explained. In carrying out these tasks, the Task Force will be aided by other critical offices and divisions within the SEC, including the Office of the Chief Accountant and the Division of Corporation Finance. Together, the Task Force and those assisting it constitute a veritable A-Team focused on rooting out accounting improprieties and fraud.
Why Directors And CFOs Must Take Note Of The Task Force
There is little question that corporate directors, CFOs, and financial reporting staff should take note of this substantial deployment of SEC resources. In 2010, the SEC created five specialized units in areas of market abuse, structured and new products, asset management, foreign corrupt practices, and municipal securities and public pensions. In the succeeding years, each of the units has utilized the very strategies that the Task Force has now been asked to exploit, including monitoring high-risk companies, analyzing performance trends by industry, and conducting street sweeps in particular industries. The result was an increase in inquiries made by the SEC, not to mention several significant enforcement actions, including a withering assault on insider trading; settled actions against banks, including most notably Goldman Sachs, relating to complex structured products; and a high-water mark in FCPA-related enforcement actions.
We anticipate a similar result in the area of financial reporting and disclosures, as a consequence of the Task Force's creation. Indeed, in a speech in September 2013, Director Ceresney explicitly noted that the goal of the Task Force will be to “focus on case generation” and “generat[ing] new accounting fraud investigations for staff in the Division to pursue.” In the same speech, he went so far as to describe the Task Force as the SEC's “Apollo 13 moment”: “Often, when you get a group of smart people in a room focused on a problem, you can find the answer. Kind of reminds me of that scene in Apollo 13 where they bring all of the disparate tools available on the space capsule into a room, dump it on to a table in front of a bunch of smart people, and say find a way to fix the problem. And so we created the Financial Reporting and Audit Task Force.” The problem the Task Force solves for the Enforcement Division is how the SEC can better marshal resources to identify accounting issues; the result, if past is prologue, will be increased engagement by the Commission with public companies concerning such issues.
Potential Areas Of Emphasis For The Task Force
While it may be prudent for directors and CFOs to attempt to ensure that their organizations steer clear of financial reporting deficiencies, it may also be important to pay particular attention to the areas of the Task Force's focus in order to stay out of its crosshairs. Based on our study of comments made by various SEC officials, we believe that the Task Force will be focused on a few key areas:
- Not just fraud. It is easy to look back at certain headline-grabbing frauds of the past (Adelphia, Worldcom, Enron, etc.) and think “Well, that's not our company.” However, recent SEC actions demonstrate that the SEC is not interested solely in pursuing cases that rise to the level of fraud; the Enforcement Division has brought a number of non-fraud actions against companies and individuals. For example, in June 2013 the Commission brought a settled action against PACCAR Inc. for having ineffective internal controls over the financial reporting process - without any allegations of fraud or intentional wrongdoing.
- Getting caught with a hand in the cookie jar. Accounting guidance requires companies to record expenses when they are probable and estimable through the establishment of an accrual (or reserve) on the books. Setting these reserves, and reversing them, requires professional judgment. The SEC has indicated that the AQM will be used to detect potentially problematic accrual and reserving practices. The Task Force will similarly be focused on identifying such practices.
- Valuation questions. Management judgment plays an important role in determining the value of assets or securities on a company's balance sheet. As Director Ceresney noted in his 2013 speech with respect to losses and reserves: “We recognize that accounting requires that management (and auditors) use their professional judgment but we will not tolerate decisions that are reached in bad faith, recklessly or without proper consideration of the facts and circumstances.” He also indicated that the SEC's focus on such accounting errors extends beyond management to audit committees: “We have brought actions against audit committees in the past for failing to recognize red flags and we intend to continue holding committees and their members accountable when they shirk their responsibilities.”
- Revenue recognition issues. Reserve issues and valuation issues play into the broader question of whether a company is taking measures to “smooth earnings.” As Task Force Chair David Woodcock has observed, “revenue recognition is always an issue.” With the recent growth of social media companies and cloud-based computing services, many companies are faced with difficult questions about how to account properly for these new technologies.
- Material weaknesses and internal controls. Material weaknesses and internal controls present another area of renewed emphasis for the SEC. In remarks before the AICPA National Conference in December 2013, Brian Croteau, Deputy Chief Accountant of the SEC, indicated: “I continue to question whether all material weaknesses are being properly identified. It is surprisingly rare to see management identify a material weakness in the absence of a material misstatement. This could be either because the deficiencies are not being identified in the first instance or otherwise because the severity of deficiencies is not being evaluated appropriately.”
- Multiple revisions of financial statements over a short period of time. Though sometimes multiple revisions of financial statements happen with good reason, the SEC considers this area to be a “warning sign” that the company involved might not be maintaining appropriate books and records; thus this will likely draw the scrutiny of the Task Force.
- Watching the gatekeepers. The SEC has stated several times over the past nine months that it was renewing its focus on the “gatekeepers” of financial reporting: the auditors and public company audit committees. Though they likely were not Task Force cases because of their age, the SEC has been true to its word, filing cases against the gatekeepers. The SEC announced charges against Big Four accounting firm KPMG, alleging it violated certain auditor-independence rules by performing prohibited services for some audit clients. More recently, the SEC charged Agfeed Industries Inc., a Chinese animal-feed company, and four of its top executives with participating in a massive accounting fraud involving faking revenues from its Chinese operations. Among those charged was the US-based chair of Agfeed's audit committee, who, after allegedly learning that the company was keeping two sets of books, “failed to conduct or prompt the company to conduct any further meaningful investigation into the misconduct.”
In the release announcing the charges against the executives, Enforcement Division Director Andrew Ceresney stated: “Agfeed's accounting misdeeds started in China, and US executives failed to properly investigate and disclose them to investors…. This is a cautionary tale of what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags.” Though the facts of Agfeed seem pretty egregious, this case is still an example of the SEC 'talking the talk, and walking the walk.'
Making Good Use Of Peacetime
What does all of this mean for corporate directors and CFOs? It means that there is no better time than the present - during peacetime, before any inbound inquiries from the SEC are received - to have tough discussions with management around the areas of focus we identified above, as well as the areas with which directors normally concern themselves. Audit committee members should have detailed discussions with management and the company's auditors regarding these issues, not only to make sure that practices are appropriate but also to identify “red flags” or “warning signs” in their financial statements that might attract SEC attention, whether by the Division of Corporation Finance, the Office of the Chief Accountant, or the Division of Enforcement.
Similarly, companies should take proactive measures to ensure and encourage full, candid internal reporting and communications up the ladder, so potential issues are not overlooked, ignored, or missed; and should also revisit their whistleblower practices to make sure internal reports of potential wrongdoing are dealt with efficiently and effectively (and without fear of retaliation). Indeed, dealing effectively and appropriately with whistleblowers alleging accounting irregularities is more important now than ever before. More of the whistleblower complaints the SEC received in fiscal year 2013 were in the area of financial reporting and disclosures (557 complaints, which equates to 17.2% of the total complaints) than in any other area.
In sum, renewed attention to accounting issues on the part of directors, CFOs, and financial reporting staff - to match the renewed attention being paid by the SEC - will undoubtedly pay dividends if the SEC ever comes knocking, which seems increasingly likely in the current environment.