At the first panel of the 15th Annual Financial Reporting Conference, the panelists discussed the SEC’s recent activities and plans for the future. Topics included the proliferation of non-GAAP measures, recent enforcement cases, and the activities of the OCA.
Guidance on Non-GAAP Measures
Kronforst began the panel by discussing the prevalence of non-GAAP measures. After summarizing the SEC’s revision of non-GAAP guidance in 2010, he expressed concern about usefulness disclosures: “I think usefulness disclosures over the years have become somewhat boilerplate, and the Commission, when they adopted the rules, was very clear that boilerplate is not acceptable.” The DCF is also looking out for cherry-picking of data, he noted: “If you have a change in your calculation that you need to disclose that’s not explicit in the rules, we will issue a comment.”
Kronforst also discussed the metrics companies include in financial statements that are not covered by GAAP or SEC rules, saying, “We comment on them all the time. Particularly in the tech industry, some of the metrics that we see are difficult to relate to results. We will often comment to make sure that investors understand what those are intended to convey, and also understand how they relate to results.”
Giving specific examples of “troubling” practices the division has seen, Kronforst cited “per-share measures on things that look like liquidity measures,” which the SEC expressly prohibits. “What we have observed, and what you’re going to start seeing comments on, are companies that are taking measures that look a lot like liquidity measures and are calling them performance measures. I think we’re going to start challenging those things, because, let’s be honest, it’s not a performance measure.” He also mentioned “adjusted EBITDA [earnings before interest, taxes, depreciation, and amortization], which apparently means anything.”
Another practice that has caught the DCF’s attention was the reporting of taxes on non-GAAP measures. “When we look at companies,” Kronforst said, “they do this reporting by quarter, and it’ll be, ‘Here’s our non-GAAP, and we adjust a little bit for the taxes on this non-GAAP. Our tax bills are really low, so we’re going to use this 8% tax rate.’ Stepping back, ‘It makes sense on a quarter-by-quarter basis, but what if we look at this over the long term?’” In the future, he said, “[Our] comments will say, ‘Are you sure that if you made that much money that you indeed would still have all of these deductions?’”
“I really hope,” he continued, “that companies take the opportunity to take a hard look at what they’re doing for their non-GAAP measures. I think there are some abuses out there, and we are going to crack down.”
Michael Maloney of the Division of Enforcement then addressed the panel. In discussing trends in enforcement activity, Maloney noted that the number of enforcement actions in issuer disclosure and reporting has doubled in the last two years. He emphasized that the majority of their leads come form “traditional” sources, including restatements, self-reporting, and tips. “The whistle-blower program in particular has really driven a lot of activity, and I think it’s working very well.”
While Maloney said that he has seen “signs of improvement,” certain issues with corporate reporting persist, as several cases illustrate. Areas of concern included revenue and expense recognition, impairment in valuation, insufficient disclosures, internal control failures (fraudulent and otherwise), and independence impairment.
Maloney noting that a key factor in many cases was “management pressure to hit targets,” as in the Enron scandal of a decade ago. “Unfortunately, we’re still seeing that today,” he said. In one case, a contract project lead at the Computer Sciences Corporation “directed the team to prepare contrived revenue assumptions to restore the reported contract profitability on that major contract. Top managers understood that those assumptions did not reflect reality, yet took no action, and also failed to disclose important details about that contract.” In another case, Marrone Bio Innovations’ COO/head of sales “was giving sales concessions on the side to customers in order to hit targets, was concealing that information both from their internal accounting department and the auditors, and was directing subordinates in some cases to ship products that weren’t even ordered in order to hit growth targets.”
“I really hope that companies take the opportunity to take a hard look at what they’re doing for their non-GAAP measures. I think there are some abuses out there, and we are going to crack down.”
Regarding unsupported transactions, Maloney cited the case of Saba Software, where revenues were both accelerated and falsified, and time charges were falsified to increase the profitability of certain contracts. Cases of faulty valuations included Miller Energy, where oil and gas rights purchased for approximately $2 million were suddenly revalued at approximately $480 million based on the report of an engineer, a non-accountant who did not use fair value measures.
To illustrate internal control failures, Maloney cited Magnum Hunter, which failed to identify several deficiencies as material weaknesses. Maloney stressed that “material weakness does not depend on a material misstatement actually having occurred, but whether there’s a reasonable possibility that the ICFR will fail to prevent or detect a material misstatement.”
Auditor independence was strongly impaired in the case of Berman and Company, which was paid approximately $272,000 in indemnification by a client. “If you think about an auditor getting paid by its audit client while that same client’s accounting is being questioned by the SEC, as well as the audit work, I think any logical person can see that there’s a real conflict there,” Maloney said.
Concerns of the OCA
Wesley Bricker returned to the issue of revenue recognition, noting that the standard was originally issued in 2014: “There’s been a real robust period of implementation, a real robust period of dialogue. But there’s still concern about the status of implementation efforts.” He anticipated that there would be no further deferral of the new standard’s effective date.
Internal controls will be particularly important as the new standard is implemented, Bricker said. “Implementation plans should focus on the sufficiency of internal accounting controls, but also the ability of management and the auditor to evaluate and test the effectiveness of those controls.” Auditors should not, however, be involved in the design of those controls, as “that would be inconsistent with the independence rules.”
Continuing, Bricker said that internal controls are also prominent in the OCA’s professional practice activities. “Credibility of financial reporting depends so much on thorough and objective assessments of internal controls,” he said.
As to auditor independence, Bricker stressed the role of audit committees and management “to have appropriate policies and procedures in place that promote a thorough evaluation of independence and the threats to independence around non-audit services.” Committees and management must also monitor non-audit services to avoid “scope creep,” he said.
Moderator Norman Strauss asked Bricker about the success rate of getting issuers to voluntarily seek consultation with the SEC. “Optimism prevails.” Bricker said. “We very much focus on having a rich and constructive dialogue with companies as they do that.”
Strauss then opened the floor to questions. The first question continued the thread on consultation, asking Kronforst and Maloney how their divisions handled the process. Kronforst said that the DCF has a similar process, and the most frequent cause of roadblocks is lawyers and auditors butting heads on what the company should report. “We get this bizarre back-and-forth, and we ultimately find out about it,” he said. “When I speak to lawyers, I always say, ‘Get the auditors involved up front.’” Maloney noted that, while enforcement actions are of course not voluntary, “we certainly never would dismiss the opportunity for the company to come in very early on in the investigation. We have had situations where we have ultimately wrapped up an investigation without bringing charges, because it was helpful to come in.”
Another question concerned the “trigger point” for enforcement involvement. Maloney replied that “it’s a subjective analysis. We have very limited resources. It’s hard to say what the trigger points are in any specific case. Sometimes that comes down to just the judgments and what we’ve seen in the past, and whether we think it’s resource-worthy to continue an investigation.”