Corporate
Aug. 13, 2002
Companies Should Be Candid SEC About Accounting Irregularities
Focus Column - By William E. Simpson - The epidemic of accounting abuses by corporations has shaken investors' confidence in the accuracy of corporate financial reporting. Notable recent examples include Xerox Corp.'s restatement of more than $6 billion in revenues, WorldCom Inc.'s mischaracterization of $3.85 billion in expenses and the collapse of Enron Corp.
By William E. Simpson
The epidemic of accounting abuses by corporations has shaken investors' confidence in the accuracy of corporate financial reporting. Notable recent examples include Xerox Corp.'s restatement of more than $6 billion in revenues, WorldCom Inc.'s mischaracterization of $3.85 billion in expenses and the collapse of Enron Corp. amid allegations of off-the-books partnerships used to hide debt and inflate profits.
Responding to the current crisis, the Securities and Exchange Commission has greatly increased the number of investigations of companies over accounting irregularities.
So what should a company do once it discovers potential misconduct? What steps should it take to mitigate the potential consequences from the SEC in instances of accounting and reporting irregularities? Many answers can be found in a recent SEC release.
Last October, the SEC issued a "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions," Exchange Act Release No. 44969.
Although the report deals with a matter in which a former controller made entries that resulted in the company's financial statements being misstated, the SEC points to the company's response as a model for others to follow. The SEC took the extraordinary step of taking no action against the company, even though the SEC found the books and records to be inaccurate and the reports misstated.
From 1995 through the first quarter of 2000, a controller for a subsidiary of Seaboard Corp. booked improper entries that overstated deferred farm assets and understated farming expenses on the subsidiary's financial statements. The misstatements came to light as a result of questions raised by Seaboard's internal auditing department.
After the initial investigation, Seaboard dismissed the controller and notified the SEC and the public that its financial statements would be restated. The company's cooperation with SEC staff included providing all information relevant to the underlying violations and the details of its investigation.
In their report, the SEC stated, "When businesses seek out, self-report and rectify illegal conduct, and otherwise cooperate with Commission staff, large expenditures of government and shareholder resources can be avoided and investors can benefit more promptly."
Toward this goal, the SEC set forth criteria that they would consider in determining the extent to which they would credit a company's efforts, including self-policing, self-reporting, remediation and cooperation. While there is no hard-and-fast rule with regard to measuring the credit to be given, a company's efforts can influence whether the SEC takes no enforcement action, brings reduced charges or seeks lighter sanctions.
Self-policing primarily relates to the system of controls that existed before the discovery of the misconduct or the receipt of an SEC subpoena. Did the company have effective compliance procedures in place to prevent financial reporting problems and uncover irregularities? Did it have policies to encourage the reporting of illegal acts and address the consequences when such acts occur? What tone did senior management set with regard to ethical standards?
The company and its advisors should gain an understanding of what compliance procedures were in place at the time of the misconduct. It should document these procedures so that it can demonstrate a track record of discouraging misconduct and setting an appropriate corporate tone. The company should point out to the SEC any role that compliance procedures played in bringing the misconduct to light.
Self-reporting entails those steps that a company takes in investigating the nature, extent, origins and consequences of the misconduct. Did the misconduct result from inadvertence, honest mistakes, negligence or deliberate wrongful conduct? At what levels in the chain of command was there knowledge of, or participation in, the misconduct? Over what period did the irregularities occur?
The company should be explicit in its request that all employees cooperate with the investigation and that no one in the company destroy any relevant records. In addition, the company should retain notes and documents resulting from the company's investigation.
The SEC also will consider the attorneys and accountants who conducted the investigation and whether they had previously done work with the company, which may compromise their independence. For example, the external auditors, who had previously opined on what may now be misstated financials, should probably not assist in the investigation. A company should consider retaining an outside accounting firm with no previous ties to the company to provide an independent and unbiased investigation.
Other issues include the nature and timing of communications regarding the accounting irregularities and potential misconduct within the company, as well as with outsiders. When were the audit committee and the board of directors informed? Did the company promptly, completely and effectively disclose the accounting irregularities and potential misconduct to the SEC and the public? These disclosures would ordinarily include the time periods affected and an estimate of the potential impact on previously reported financial statements.
In assessing remediation, the SEC will consider what disciplinary steps the company has taken against those who were involved in the misconduct. The company should demonstrate that it has improved internal controls to prevent a recurrence of the misconduct. Management also should consider instituting an ethical code of conduct or conducting a campaign to re-familiarize employees with an existing code.
Finally, the SEC will evaluate the company's cooperation, both with the staff of the SEC and with other law-enforcement authorities. In all communications with law-enforcement authorities, the guiding principles are to be sincere and forthcoming. The company should make available information gathered from its internal investigation, including interview notes, company documents and other information sufficient to reflect the company's effective response to the situation.
In addition, the company should identify, through consultation with its outside counsel, the possible securities laws violated and the evidence, if any, to facilitate enforcement actions against those responsible.
Stephen M. Cutler, the SEC's director of enforcement, stated in a press conference concurrent with the report, "Crediting those who seek out, self-report and rectify illegal conduct is critical to achieving the commission's goal of 'real-time enforcement.'" The SEC hopes that the lure of less punitive treatment will result in more efficient and effective enforcement of federal securities laws.
William E. Simpson, an attorney and certified public accountant, is managing director of FTI Simpson, a group of forensic accountants. He has assisted several companies in connection with investigations by the SEC.
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