Maloney began the panel by discussing recent enforcement cases, focusing on areas where there are, as he put it, “repeat problems.” These included revenue recognition, income taxes, balance sheet issues, and disclosures, among others, on the accounting side. On the audit side, he cited “a variety of different flavors of problems,” as well as independence issues. Of particular concern, he noted, were revenue recognition, income taxes, and disclosures.
On revenue recognition, Maloney highlighted cases involving recording revenue for jobs that did not exist, accelerating recognition to meet internal sales targets, and splitting documentation and purchase orders to get around deferral of revenue. Less “standard” cases included Homex, a Mexican home builder that reported $3.3 billion of revenue on sites that either had not been completed or, in some cases, not even begun. The Enforcement Division used time-stamped satellite imagery to compare the status of the sites to what was claimed.
Regarding income taxes, Maloney cited the case of oil services company Weatherford International, “one of the largest cases we’ve brought during my time in the Division.” The Enforcement Division alleged that income tax expenses were understated due to post-closing entries made in the ledger, and Weatherford ended up paying a $140 million penalty. During the investigation, Maloney said, the Enforcement Division uncovered that the company “cut and pasted” complex explanations for what were essentially “plug entries to lower income tax expense and debit receivables.” He noted that the Enforcement Division brought a case against the auditors, and that a tax partner who was a member of the engagement team was among the charged parties.
As for disclosure, Maloney said that cases over the past 12 to 18 months have come from all parts of filings, and not just financial statements, as well as statements outside of filings, such as press releases and earnings calls. Companies have allegedly made misleading disclosures regarding regulatory approvals for emissions standards (Navistar) and FDA approval of drugs (Aveo Pharmaceuticals).
In the realm of non-GAAP disclosures, Maloney cited the case of American Realty Capital Properties, which allegedly manipulated its adjusted funds from operations, as well as MDC Partners, which allegedly failed to disclose prerequisites, did not disclose information affecting the value of a key revenue metric, and did not give equal prominence to relevant GAAP measures. Other disclosure cases, he said, have involved false inventory capacity disclosures, false reasons given for why board members had resigned, and mischaracterization of evaluation methodology used in a proxy statement.
Strauss asked Maloney about whether enforcement actions focus on senior management or younger employees. Maloney replied that “there are not hard and fast rules about who we will or won’t charge. We go where the evidence leads us.” That said, he admitted that charged individuals most likely carry senior titles, such as CEO, CFO, or engagement partner. Bricker added that the SEC’s preference is to prevent financial reporting failure rather than prosecute it. “A strong internal control environment with good tone at the top not only enhances the quality of financial reporting, but also protects the individuals who play important parts in preparing information, and certainly facilitates a good audit,” he said. Maloney agreed, saying that internal control failures often underlie more serious violations.
Corporate Reporting of Non-GAAP Measures
Kronforst then discussed non-GAAP measures, a big initiative designed “to address some non-GAAP issues that we found troubling.” which the Division of Corporate Finance issued guidance on in 2016. “Almost a year ago, we issued guidance, and I have to say I think it was a success,” said Kronforst. “One of the big parts of that success was that companies took the initiative to make changes on their own.” With direction from the Division’s comment letters, which gave companies a quarter to adjust their practices, registrants were able to improve their reporting, putting themselves “in a much better place,” in Kronforst’s opinion.
He then laid out some of the guidance, which is tethered to Regulation G, such as inclusion of normal recurring cash operating expenses, rules for accelerating revenue, cherry-picking of disclosures, calculation of income tax, earnings per share, and per-share liquidity. Bricker added that disclosures on per share liquidity can be critical to shareholders and should be carefully vetted by management and audit committees.
Kronforst then discussed the provision of GAAP guidance alongside non-GAAP guidance. In general, he said, companies are expected to provide equivalent GAAP measures as a guidepost for users, but there is an “unreasonable efforts” exception. Kronforst also debunked rumors that the SEC was challenging the use of this exception, and noted that some companies have reevaluated and changed their approach.
At Kronforst’s invitation, Bricker discussed controls and oversight of non-GAAP measures, which Kronforst called “the most important” aspect of such reporting. Bricker noted that inconsistency in these measures over time makes them less useful for investors, and that controls and procedures make the information more robust and less prone to error; “where the numbers are best prepared is when there’s a good system that protects their integrity,” he said. He suggested that control structures for GAAP measures can provide a good model for reporting on supplemental metrics, be they non-GAAP or in an alternative framework.
Finally, Kronforst addressed the prominence of non-GAAP measures. Previously, “GAAP in some cases was nowhere to be found.” The SEC issued guidance to try to swing the pendulum back toward GAAP, and while there was some “handwringing” about the SEC’s “GAAP has to come first” mantra, Kronforst felt the SEC had largely accomplished its goal. While non-GAAP measures continue to be used, they no longer overshadow GAAP measures; Kronforst attributed this to the cumulative effect of various items in the SEC’s guidance and subsequent comments. “I think this is a good model,” he said of the process.
Transitioning to New GAAP Standards
Taking the floor, Bricker discussed companies’ transition to the new GAAP standards. He stressed planning as key for navigating the upcoming changes to the reporting framework, saying that allowing enough time for proper implementation will be critical. “It’s important for investors that the numbers have integrity the first time that they’re reported,” he said, adding that companies will also need to communicate the extent of the coming changes to investors (i.e., make transition disclosures).
A particular focus, Bricker said, has been compliance with the SEC’s existing guidance regarding disclosures in Staff Accounting Bulletin (SAB) 74. The language in the bulletin has been updated to improve consistency and allow for more nuance in disclosures. The SEC is working on emphasizing the benefits of companies disclosing the effect that upcoming reporting changes will have on their financial statements. “If there has been work done to quantify the effect,” Bricker said, “it’s important to lay that out, even if the implementation planning has been done.”
Bricker also stressed some technical matters of interpretation regarding transition disclosures. One such matter involved some companies’ overstressing of the quantification of a standards’ effect on the financial statements, reducing their transition disclosures to a simple statement of materiality (or nonmateriality). “For many companies, the impact of the disclosure requirements will be materially new information,” he said, which is the proper framework for companies to view their disclosures. In addition, when companies describe the effect of the transition to a new standard, they need to not only produce a number, but also describe the context for how they reached that number. “It’s important to take a fresh look at the full package,” he said.
Returning to the subject of internal controls, Bricker stressed that the same level of rigor in setting and testing controls is expected for material inside and outside the financial statements. Kronforst added that the Corporate Finance Division is paying attention to transition disclosures and issuing comment letters where appropriate.
Bricker also discussed important points about internal controls raised by a 2016 comment letter from the U.S. Chamber of Commerce. First, he said, material weaknesses in disclosure lead to higher capital costs. Second, companies and auditors need to communicate with each other, especially regarding risk assessments of internal control design. Finally, communication should occur throughout the year, not just at year-end evaluations. He also stressed that the SEC is ready to consult with companies about their controls at any time. To this, Kronforst added that the Division of Corporate Finance consults with companies on internal controls “fairly routinely.”
As final points, Bricker touched on the importance of the audit committee and tone at the top. Audit committees, he said, can play an important role in setting that tone and should take it into account when assessing their own effectiveness. He also said that tone at the top is an important part of the COSO 2013 framework, and that measurement techniques for tone are available. Quoting management consultant Peter Drucker, he said that “what gets measured gets improved.” Finally, he discussed additions at the Office of the Chief Accountant (OCA), particularly regarding the office’s research agenda.
Strauss then opened up the floor to the audience for questions. The first question was about SAB 74 disclosures, asking for more clarification about the SEC’s expectations beyond noting that new material will be included in the statements. Bricker reiterated that simply stating the materiality or immateriality of the standard’s impact would not be sufficient, largely due to the scope of the standard. He said that judgment will need to be backed up by analysis and a “comprehensive evaluation,” and that such an evaluation would likely reveal significant material effects. More concretely, he said that a description of the effect of decisions made to date would be the kind of content the SEC is looking for.
Another audience member asked whether the SEC has given any attention to issues surrounding accounting for income taxes, particularly regarding definitions of jurisdiction and transfer pricing. Bricker said that both FASB and the SEC have considered such guidance and are monitoring potential changes in the tax system to assess their effects. Kronforst added that regardless of any changes, rules on management’s discussion and analysis require income tax disclosures, and the Division of Corporate Finance has encouraged companies to examine and clarify such disclosures for several years. More generally, Bricker said that, as with other areas of disclosure, strong controls are essential.
The next question concerned the SEC’s own controls for ensuring that valid cases are not neglected by the SEC; the questioner specifically cited the case of Tony Menendez, who blew the whistle on a bill-and-hold scheme at Halliburton without support from the SEC. Maloney replied that the Office of Market Intelligence handles all tips that come into the SEC—which number over 10,000 annually—and evaluates them to determine which to follow up on. “The whistleblower program has been terrific in terms of helping us identify situations that really merit investigation,” he said.
For a final question, Strauss asked Bricker about the SEC’s policy of encouraging companies to come to them with difficult accounting questions. Bricker noted that the SEC also encourages companies to submit questions about new standards to the Transition Resource Group (TRG) operated by the IASB and FASB. For specific questions companies have for the SEC, he referred the audience to the OCA’s website.