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?
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.
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.
Risky Business for Directors – How’s your ERM?
Not so many years ago, being elected to the Board of Directors of some companies essentially required you to act as a figurehead. Lunch in an expensive restaurant once a month, an annual retreat to a vacation resort to discuss corporate ’strategy’ and a small stipend were all that was required in trade for the collective experience and informal leadership. That’s all changed with the increased exposure to liability now faced by corporate governance. With the current state of our business environment, that exposure is greater this year than ever.
In an on-line article Executives Anticipate Rise in Fraud nearly two thirds of the executives polled anticipate an increase in fraud and misappropriation this year. In conjunction with auditors anticipating that nearly 25% of all firms may not be going concerns; the myriad of new regulatory requirements related to governance; and the corporate challenges fomented by a floundering economy this may not be a desirable year to be a Director. The current hot topic seems to be enterprise risk management.
While a long time focus of management, ERM has often been given little attention by the board. Recently, COSO published a document highlighting four critical areas that contribute to effective board oversight. It can be downloaded at www.coso.org.
As public company auditors and consultants we have observed the importance of an integrated approach to governance between the board and management. We regularly participate in joint meetings as frequently as allowed (we don’t charge for meetings with management and the board), for our own self-interest. Our best clients have the strongest most engaged boards. Boards of Directors are invaluable resources. Take full advantage.
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.