Would SOX 404(b) Have Protected Koss?
Last week Koss, the manufacturer of high quality head phones, disclosed that their principal accounting officer had embezzled between $4.5 million and $31 million between 2005 and December, 2009. The advocates of requiring small issuers to annually file integrated audit reports on their respective internal control systems immediatley pointed at Koss as justification for requiring the implementation of 404(b) beginning in June, 2010. Is this adequate justification? For several reasons, I don’t believe it is.
This was an intentional fraud. Neither financial statement nor internal control audits are designed to guarantee the detection of fraud. Yes, an internal control audit would have disclosed the existence of significant deficiencies and material weaknesses. An expanded internal control review might have even stumbled across the defalcation. More likely it would have only resulted in an adverse opinion on the internal control systems by the company’s auditor. This could have been an alert to investors, but more likely it would have been ignored as the SEC’s own studies have indicated. Integrated audits have not resulted in a higher level of confidence by investors. Fraud audits for all issuers require a lower level of materiality that can not be justified economically.
If in this particular case the amount embezzled was material for any of the five years effected it would seem that it should have been detected under normal financial statement audit procedures in at least one year. A failure by the audit firm to properly complete an audit is not justification for adding another layer of regulation on small issuers under SOX.
The company had retained the same national audit firm for the past five years. Based on the professional fees disclosed in the proxy statement it is possible that Koss was a small fish in the big pond of this national firm and may or may not have gotten the service it needed and deserved. Some large national firms have been known to ‘rank’ their clients. If you are not the big dog on the porch you are not likely to get the same level of expertise, experience and service as the bigger clients.
Cost. Certainly for Koss the cost of an ICFR program – including both the external audit fees and the internal program costs - would have been less expensive than the amount embezzled, but requiring all firms to bear a cost to ‘potentially’ prevent an occasional fraud loss of this type is ridiculous. Theoretically, 404(b) would cost a firm similar in size to Koss, $250,000 annually (ballpark WAG). One-third to one-half of that being for the external auditors. So the investors in Koss would have been out something in excess of a million dollars. The cost/benefit equation for requiring this universally just wouldn’t seem to balance, unless you subscribe to the premise that something graeter than 10% of all statements are fraudulent.
There are already criminal and civil penalties in place to protect the investor from this type of malfeasance as we’ve discussed in our prior posts. Another in the form of 404(b) is not needed. The responsibility to the shareholders rightfully lies with the Audit Committe of the Board, the Board of Directors and management. If more company oversight is needed and beneficial those charged with governance are ostensibly sophisticated enough and in the best analytical position to know and provide it.
I still view the cost of 404(b) as an ineffective unsupportable dissipation of investors equity. We’ve had some great dialog on this topic in the past. Did I change anyone’s mind?
IFRS – Time to Panic?
In recent months the focus of discussions related to adoption of the International Financial Reporting Standards have centered on differences with US GAAP (such as LIFO inventory), timing and implementation. I don’t want to debate the necessity of adopting a world standard given our weakening influence over the world economy, or the esoteric benefits or detriments. My concerns are much more basic. Without tort reform in the United States, IFRS is a time bomb with a very short fuse resulting in a cataclysmic disaster waiting to happen.
Currently, US GAAP is a rules based set of standards. While the end result of their application frequently results in worthless unsupportable financial reporting, the issuer and their auditor have but to point to the ‘rules’ in defense. On the other hand, IFRS is principles based, and simpler to apply. But it can and frequently does require the issuer and his auditor to exercise judgment. Judgment that can be questioned, criticized and litigated.
Please don’t misunderstand. Professionally in my opinion the quality of financial reporting will be significantly improved by the application of sound principles. IFRS is long overdue. Without liability reform, however, I fear financial reporting and assurance services will quickly follow the health care industry in terms of cost to the providers.
Maybe I’m just paranoid in my advancing years.
S Corporation Pitfalls – Part 1
By Julia Kingston · 1 Comment
S Corporations are a popular business entity - they allow for limitation of liability, may reduce self-employment taxes, and income is passed through to the owners, resulting in only one level of taxation, while providing a “corporate veil” for liability protection. There are a number of possible pitfalls for the unwary, particularly if the company operated as a C Corporation prior to electing S Corporation status. This series on S Corporation pitfalls will discuss some of the more common issues, and some of the more serious… pitfalls that can have costly results without proper planning…
First, as a rule of thumb, do not hold appreciable assets, such as real estate or passive investments in an S Corporation. Why not? You probably know that there is generally no resulting tax when cash is distributed from S Corporation earnings. What many people fail to realize is that the distribution of appreciated property will result in a taxable transaction. When property is distributed from any type of Corporation (S Corporation or C Corporation) the distribution is made at the property’s Fair Market Value. This means that there is a realized taxable gain on the difference between the Fair Market Value at the date of distribution and the tax basis. You will pay tax on the transaction, and your resulting tax basis in the asset after distribution will be its Fair Market Value at the date of distribution.
This problem is most commonly avoided by distributing cash from the S Corporation to the owners, who then use the funds to purchase real estate, or other passive investments. These assets are frequently purchased through a limited liability company (LLC) to preserve pass through treatment of the income. If the real property is used by the S Corporation in its business, the property is then rented back to the S Corporation. The difference is that distributions from LLC’s (and partnerships) are made at the asset’s tax basis, with no gain or loss recognized on the distribution (resulting in a deferral of tax until the property is actually disposed of). Your basis in the distributed asset will be the same as it was in the hands of the LLC.
Placing appreciable assets into LLC’s instead of S Corporations will provide greater flexibility for future tax planning, and possibly defer the payment of income tax.
Oil and Gas Accounting – SEC Issues SAB 113
The Office of the Chief Accountant through Corp Fin recently published Staff Accounting Bulletin 113. There are four main areas of focus within this SAB which will likely affect everyone to some degree: valuation methodology of oil and gas reserves; clarification of methodology related to write-offs of excess capitalized costs under the full cost method; extending appliability of guidance to include unconventional methods of extracting oil and gas from sand and shale; and removing information from the guidance which is no longer necessary.
For the most part SAB 113 is pretty straight forward, however, as is the case with many of the SABs, hidden in the minutiae are land mines for the unwary or uninformed. Correspondingly you would be well served to skim through it for any matters that might affect your company, and then discuss them with your audit firm.
Additionally, on October 26, 2009 additional Oil and Gas Rules were released. These compliance and disclosure interpretations (C & DIs) relate to Regs S-X and S-K. There is some important information here which is very relevant and brief!
Hip Hip Hooray! Permanent exemption from 404(b) for Small Business is Possible!
Recently, the House Financial Services Committee passed H.R. 3817, the Investor Protection Act. The bill includes an amendment, which would permanently exempt small public companies from complying with Section 404(b) of the Sarbanes-Oxley Act of 2002. The bill must still be voted on by the entire House of Representatives, but it is nice to know that there is hope.
As noted in the October 19th blog post by Mark Bailey, the 404(b) requirement for small business issuers is not beneficial in most cases and thus the passing of this act by the House Financial Services Committee is welcome news.
Critical Accounting Policies and How They Differ From Significant Accounting Policies
In an effort to help improve my client’s filings, and of course avoid SEC Comment Letters, I am constantly reminding them that the disclosures required by SEC Rules Release 33-8098, contained in the MD&A, are considerably different than the significant accounting policies disclosed in the footnotes. Too frequently issuers simply cut and paste their summary of significant accounting policies into this section, which I believe will result in comments from the SEC if selected for a full review by Corp Fin.
I believe the intent of the critical accounting policies disclosures is for issuers to identify and disclose only those accounting policies that require significant judgment and estimation with a degree of uncertainty. Further, simply narrating the assumptions used in a Black-Scholes model for valuing stock options does not provide the appropriate information contained in the rules release. Disclosures related an issuers critical accounting policies (estimates) should include the methodology used in developing assumptions and the corresponding estimates, how the estimates impact the financial statements, and the effect of a change in the estimates and / or underlying assumptions.
The SEC provides two questions issuers need ask in making the “critical” determination:
- Did the estimate require making assumptions about matters that are highly uncertain?
- Would reasonably developed, different estimates / assumptions, at the time or in future periods, have a material impact on our financial statements?
When both questions are answered yes, it should be included in this section of the MD&A.
The included disclosures should not simply be boilerplate (like significant accounting policies tend to be) or be overly accounting technical (as “plain English” as possible). Further, the SEC expects varying numbers of critical accounting policies amongst issuers, but they have indicated three to five as a reasonable range.
The rules release provides several examples of disclosures that can help issuers develop the approach and content for appropriate inclusion in future filings.
Oil and Gas Accounting and Disclosure Rules Revised under SEC Release 33-8995
Last Friday, the AICPA released a discussion draft of the audit and accounting guide for Entities with Oil and Gas Producing Activities. While not authoritative it is anticipated to reflect the current standards being revised by both the Financial Accounting Standards Board which sets US GAAP, and the International Accounting Standards Board, all of which is being done in response to SEC Release 33-8995.
While the changes are too voluminous and complex to even summarize here, I’ve included links and welcome questions,comments to this post or phone calls to discuss the implications.
The definitions in Rule 4-10 have been significantly changed. The pricing mechanism for reserves has been defined as a twelve month average. The definition of what is and is not considered ‘oil and gas’ has been clarified to include bitumen and other saleable hydrocarbon resources (geothermal has been excluded); the definitions of ‘proved’ ‘unproved’, ‘developed’ and ‘undeveloped’ reserves has been amended and clarified; and the disclosure requirements under Regulation S-K has been expanded.
Additionally, the disclosure requirements within the financials and for the K’s and Q’s have been expanded and clarified including the disclosure requirements for MD & A. The SEC continues to coordinate with the FASB and the IASB who continue to develop their standards for the oil and gas entities. Given the SEC has come to the party first, it’s hard to imagine the other standard setting bodies will do anything but comply.
Foreign filers using Form 20-F will be subject to the same disclosure as opposed to the previous disclosure requirements summarized under Appendix A. Canadian filers, however, will not be subject to the new disclosure rules given that the requirements under the Multi-Jurisdictional Disclosure System (MJDS) using form 40-F are already consistent.
Now some good news. The implementation date for registrations filed and for annual reports on Forms 10-K and 20-F is for fiscal years ending on or after January 1, 2010. While the implementation is mandatory, “a company may not apply the new rules to disclosures in quarterly reports prior to the first annual report in which the revised disclosures are required”. Implementation may be deferred as discussions between the SEC, FASB and IASB go forward.
SEC Extends ICFR for Small Issuers to 2010
Today, October 2, 2009, the SEC announced that independent audits of internal control over financial reporting has been extended for smaller reporting companies. The press release indicates small companies will now need to be compliant beginning with annual reports for fiscal years ending on or after June 15, 2010.
Fair Value – Inactive Markets and Orderly Transactions
Recently issued “guidance” provides that when determining the fair value of certain assets (liabilities) it is only appropriate to use comparable transactions that were not fire (liquidation) sales where an active market exists. The recent guidance (pre codification FSP FAS 157-4, codification 820-10-65-65-4), effective for interim and annual periods ending after June 15, 2009, simply provides additional items to consider for adding additional premiums or discounts when developing fair value estimates.
Further, the new guidance continues to reiterate the fair value definition that has been around for several decades, “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Remember, the Company’s intent or ability to hold an asset should not be used in determining fair value as the estimate is market based and not entity specific.
In developing estimates, several factors provide an indication that significant adjustments to fair value (in this case quoted market prices – Level 1 inputs) may be necessary when market activity does not appear to be normal. Some of those factors include:
- Declines in recent transactions
- Price quotations are stale or vary substantially, including significant bid-ask spreads
- Indexes no longer correlate to values of individual assets or liabilities
After analyzing the market activity in general, the next step is to perform additional analysis to determine the transactions were not forced liquidations or distressed sales. Factors to consider when a transaction may constitute a distressed sale include:
- A recent transaction that appears to be an outlier compared to other recent transactions
- Signs indicate the seller is experiencing significant financial difficulty, e.g. at or near bankruptcy
- The asset (liability) was not marketed for an appropriate period or to multiple buyers
Three outcomes exist when analyzing transactions to determine if they fall within the fair value definition and require inclusion in estimates. First, if the transaction is not orderly, it would likely hold little weight in estimating fair value. Second, if the transaction is orderly, see above market activity analysis when determining how to include in fair value estimates including risk premiums. Finally, there may not be enough information available to conclude whether the transaction is orderly, in which case, it should still be considered, but not the sole indicator of fair value.
The guidance recognizes that issuers need not undertake undue cost and effort in making these market determinations, but should not ignore information that may be readily available in the public domain. Further, the degree of difficulty and subjectivity in developing risk premiums does not provide a sufficient basis to exclude risk adjustments to fair value.
At this point, you may be asking yourself – where does one obtain all of this information? That is a very good question and I am out of time…anyone, anyone, anyone?.!
Codification Has Officially Arrived
For those of you calendar year end issuers the time to eliminate references to the pre-codification GAAP standards is here. Your 3rd quarter interim financial information will no longer contain references to the various layers of GAAP. Instead of taking the time to use the cross-reference tool to the old standards and inserting long paragraph number references in place of the SFASs, EITFs, SOPS, and SABs, a better approach would be to transform your footnote disclosures to what the SEC continually refers to as “plain English”.
The benefit of using this approach is actually providing your investors with a meaningful description as to how your company actually applies the appropriate accounting guidance, instead of simply regurgitating accounting standards that few, and a lessening number of people, honestly understand.
A good starting point is to review your internal accounting policies and procedures, which in my experience, do not generally reference or contain any language from the accounting standards. Further, remember the following keys when drafting financial statement footnotes and compliance documents in general:
- Know your audience – remember these compliance documents are designed to provide useful information to investors and prospective investors, so be aware of the general level of sophistication and educational backgrounds of these groups.
- Focus on the significant and material items – Don’t spend a lot of time writing about things that ultimately are not going to be material to the financial statements or operations of the Company.
- Write concisely and avoid redundancy – Run-on sentences are the best way to lose the interest of your reader in addition to confusing them. Redundancy leads to inconsistency leads to SEC Comment Letters.
For more tips you can find a “plain English” handbook on the SEC’s website.
Don’t fear codification, overcome the learning curve as quickly as possible; it should ultimately make complying with the accounting standards easier and provide more understandable disclosure to keep your investors interested.
No Extension for Small Issuers ICFR Audit
Another month has passed and all signs continue to point to SOX Section 404(b) compliance for smaller-reporting companies for fiscal years ending on or after December 15, 2009. In effect, this means that calendar year non-accelerated filers will need to obtain an opinion on the effectiveness of internal control over financial reporting from their independent auditor as of December 31, 2009.
On June 22, 2009 the SEC released No. 33-8934A as a technical amendment and specifically stated that the technical amendment does affect the current effective date for compliance as noted above.
Stay tuned, but the reality of compliance should be setting in. It might be a good time to look through the SEC Guidance on ICFR.
Audit of ICFR for Small Reporting Companies
It appears the time has come for non-accelerated filers to obtain an audit of internal controls over financial reporting from their external auditor, likely in the form on an integrated audit with the filer’s financial statements.
To date, the SEC has not updated its most recent rules release on the requirement for non-accelerated filers to include an attestation report of their independent auditor on internal controls over financial reporting for fiscal years ending on or after December 15, 2009 (with certain exceptions for new registrants).
Recent remarks by both SEC Commissioner Luis Aguilar and SEC Chairman Mary Schapiro seem to indicate no additional extension will be granted, absent the SEC’s on-going cost-benefit study of SOX Section 404 indicating costs significantly out of line with the benefits.
In preparing for obtaining an audit report, which is as of the annual balance sheet date, it is a good idea to be familiar with a couple of different pieces of guidance. The first of which is the COSO ICFR guidance for smaller reporting companies to ensure appropriately designed and implemented controls to detect and prevent material misstatement of financial information. Secondly, to get an idea of the auditor’s approach, review the PCAOB’s Auditing Standard No. 5 and further the PCAOB’s staff views issued January 23, 2009.
IFRS – No Big Deal!
Judging by the material that is coming out from the Big 4 accounting firms, it seems that accounting as we know it is about to disappear and a new behemoth called IFRSs are about to invade the US accounting scene. Recently the office managing partner of one of those firms admitted to me that they viewed the issue as a consulting opportunity rather than a threat. I agree. Fear mongering is a great way to generate revenue for the consultants. Just look at the millennium bug.
IFRS are already here and have been for quite some time. Most of the standards that have been issued since in the past four years have been designed to bring US GAAP standards and international GAAP standards (IFRS) closer and closer together. This is commonly referred to as ‘convergence’. FASB 141 (R) for business combination’s and FASB 160 on minority interests are typical examples. FASB has issued standards that are consistent with the international standards. The International Accounting Standards Board (IASB) is doing the same thing as the FASB. They are issuing standards to bring them closer to US GAAP alternative over time where US GAAP is deemed preferable to IFRS. This convergence process has been going on for years and is nothing new.
What is new is the “road map” that has been put in place by the SEC, and it changed again recently. Foreign listers on the US exchanges are already allowed by the SEC to use IFRS. A limited group of about 100 US companies will experiment with early adoption of IFRS in the US in 2009. Most of these companies are already using IFRS for significant parts of their international operations anyway so they don’t need much outside help. For the rest of us, the SEC will make a decision in 2011 on whether to move to require all US listed companies to follow IFRS by 2014. Unless we get some xenophobic idiots appointed to the SEC this is a done deal. Although the new SEC Chairperson, Mary Shapiro, has announced that she is considering slowing down the process, it probably won’t change the FASBs agenda.
Is this a major issue? I don’t think so. By 2014, all of the major differences between US GAAP and IFRS will almost certainly have been eliminated. There are some problem issues to be resolved. Some are straightforward like the use of LIFO for inventory accounting. The problem here is that tax accounting in the US is impinging on real accounting. We will have to find some tax solution to unbundle the inbuilt tax problem that LIFO has created for many companies.
Other issues are more difficult and highly technical. The ugly issue of derivatives is always at the forefront here. Almost nobody understands the US standard FASB 133 and the same is true that almost nobody understands its international equivalent. All we know is that they have some differences and the financial institutions don’t like either of the standards anyway.
Some issues appear more frightening. For example, with IFRS we will lose those “bright line” guidelines that US accountants love so much. For example, the four tests for a capital lease that lawyers love to circumvent will be no more. Greater judgment will be required. This is an issue because you may have to get up in a court of law to defend your judgment. Looking on the bright side, at least you wont get tripped up by some smart trial lawyer because you did not follow some little known paragraph of one of the 14 FASs, 6 INTs, 10TBs, 2FASBSPs and about 25 EITFs that currently relate to leases in US GAAP. They will be gone as authoritative documents.
For non-listed companies, there are some proposals on the table on how to apply IFRS to smaller entities. Personally I don’t like the proposals because I don’t like having two-tier GAAP for large and small enterprises. Again, whatever changes occur will drift in over time largely unnoticed by most. If you have any experience with IFRS please comment.
SFAS 157 – How ‘Fair is Fair’ Value?
No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged. What is a supportable fair market value that reflects an orderly transaction between two or more willing market participants?
The SEC’s recently issued “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting” concludes, amongst other things, that “..additional measures should be taken to improve the application and practice related to existing fair value requirements – particularly as they relate to both Level 2 and Level 3 estimates”. In the report, the SEC’s Committee on Improvements to Financial Reporting (CIFiR) further recommended the SEC issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments and include factors that it considers when making this evaluation, as well as that the PCAOB should also adopt a similar approach with respect to auditing judgments.
In light of these conclusions, and unlikely forthcoming judgment “guidance” for valuing financial instruments with primarily Level 2 and 3 inputs, it is important to gather all pertinent information and variables potentially used in building a valuation model. There are several keys to doing this including:
- Monitor your investments and those similar throughout the reporting period, not just at the reporting date.
- Stay in touch with general economic indicators.
- Consider your true plans of instrument liquidation and whether the Company has the ability to wait out the market.
- Get your non-accounting finance and analyst types involved as they are generally more comfortable with assumptions and judgment than most accounting types.
- Provide your assumption documentation to your auditor as soon as possible – it is generally not difficult to audit the fair value model itself, however, getting reasonable documentation related to assumptions is where the time is spent, particularly when there is a difference in opinion as to what constitutes reasonable.
- Try to keep it simple concise and as straightforward as possible. Tying certain assumptions to the lining up of the planets will likely not pass your auditor’s smell test.
By the way, the SEC’s Report concluded that the fair value accounting standards did not cause the bank failures of 2008.
Proactively Controlling Your Audit Fee
For many firms it is that time of year. The annual invasion of that group of mind numbing, routine interrupting, standards spouting unwelcome invaders – your independent auditors! And they are expensive! Reflectively they can make you want to trade their presence for an unannounced three month visit from your cantankerous incontinent father-in-law who never speaks directly to you and who for fifteen years has referred to you only as “him / her”. An article published in cfo.com, Auditor Angst, has some great points to not only help you survive, but to reduce the expense at the same time. While the article primarily focuses on what the company can/should do there is obviously a lot the auditors can do as well. [Read more]