The Commissioners and staff at the Securities and Exchange Commission are great people: smart, talented, personable. Nonetheless, I would guess that most Compliance Week readers would like to interact with them as little as possible. I’m here to help.
No, I don’t know how to get your company off the list to get an SEC comment letter. But I can give some simple advice that will make your dealings with the SEC on accounting matters easier, and greatly reduce the chance that you’ll end up with a restatement or an enforcement action.
My advice won’t help with problems caused by accounting systems that break down, and I don’t have a magic bullet to make sure you find all the potential accounting issues right away instead of two years later. But you can do a few things with respect to accounting issues that are difficult because of uncertainty in how the accounting literature should be applied.
And there is uncertainty a-plenty to go around. This year, no less than 12 new accounting pronouncements become effective. Questions will arise (and already have arisen) about every one of those standards, and it’ll take some time to wrestle those questions to the ground. Add to that all the questions about how the recent market activity (or lack thereof) should affect valuation, impairment testing, and so forth, and you have plenty of accounting questions whose answers are subject to a great deal of judgment.
The SEC’s Advisory Committee on Improvements to Financial Reporting (CIFR) made some recommendations to the SEC on how to make companies that face uncertainty in accounting interpretation feel more comfortable applying their best judgment, rather than ask for more guidance or choose the “safest” answer instead of the best one. Many of CIFR’s ideas are still being debated. But whether the SEC makes any changes or not, companies can take a few relatively painless actions to reduce the risk of restatement significantly and the risk of SEC enforcement action almost entirely.
Discuss
When confronting an accounting issue with no clear answer, you absolutely must discuss the issue with as many resources as are available: internal accounting policy experts, senior financial management, auditors, external professionals (valuation specialists, for example), audit committee members, and whoever else might have relevant knowledge. Auditors—and in particular their national offices—are more likely than others to have encountered the issue in the past. Audit committee members may have seen similar issues in other venues, and their experiences may make them sensitive to things that management is not. Accounting personnel at other companies in the same industry might also have relevant experiences.
The point of discussing the issue broadly is to increase the chance that any relevant information will be brought to the discussion. Even if nobody has any additional relevant information, you’re better off because you can use your best judgment on how to handle things without worrying that another view has already become the accepted or expected treatment.
One thing to remember when discussing issues, however, is to make sure you aren’t just looking for arguments to support a pre-selected treatment. The SEC staff is unlikely to believe that a judgment was made in good faith if you simply wanted to find the best arguments to support the accounting you had already decided upon before doing any research. On the other hand, if you honestly attempt to understand the pros and cons of all the potential interpretations, and can explain why the chosen answer results in the best accounting, the staff is far more likely to accept your judgment.
Document
Convincing the SEC that you discussed the issue with all the right people and considered all of the potential ways to handle it will be much easier if the discussions and considerations are well documented. Without good documentation, forgetting the factors that were weighed in resolving the issue is easy. And several years later, when the SEC brings up the issue in a comment letter, the thinking in the accounting community about the issue may have changed. Without documentation to remind everybody of the level of knowledge that existed when the issue arose, the risk is greater that you will be asked to change things to conform to the new thinking.
Good documentation should lay out the facts and business purpose of the transaction, explain the accounting issue, identify relevant accounting standards, explore the potential alternative interpretations, describe consultations with experts, auditors, the audit committee, and others, and support the selected accounting. For a “cheat sheet” of what should be included in the documentation you might refer to the “Guidance for Consulting with the Office of the Chief Accountant” on the SEC’s Website. This document is intended for those making a pre-clearance submission to the SEC staff on an accounting matter, but is also a great starting point for internal documentation.
Comprehensive, timely documentation will ensure that if the SEC staff ever does ask about the accounting, there will be no question that the issue was addressed at the right time rather than in hindsight; this will carry great weight. The preparation of this documentation will also help to ensure that nothing is missed in dealing with the issue. Furthermore, with complete documentation in your files, responding to a future SEC comment letter should be quite easy.
Disclose
At the end of just about any conversation I have with a client about a difficult accounting issue, I ask: “What disclosures are you planning to make?” This question often comes as a surprise, and that is unfortunate— because the right answer, in addition to helping investors understand the company’s financial reporting better, can go a long way toward avoiding restatements and regulatory actions.
Consider the company that runs a goodwill impairment test, and then doesn’t record an impairment, despite the fact that its market value is below book value. While the accounting standard requires no incremental disclosures, not discussing issues like this is shortsighted. The company should take the opportunity to highlight that it considered the issue; describe how close the test came to requiring an impairment; discuss the likelihood of an impairment in the near future; explain what information was used to determine the fair values of its reporting units; and so forth. Other issues, of course, present their own list of things that would help investors understand the company’s conclusions and considerations. For just about any issue, a few sentences could mean the difference between confused and informed investors.
Convincing the SEC that you discussed the issue with all the right people and considered all of the potential ways to handle it will be much easier if the discussions and considerations are well documented.
Even if the SEC isn’t sure whether your accounting is correct, the fact that good disclosures are available to investors might make the staff more amendable to accepting the accounting, because the chance of investors being deceived will be greatly reduced, and it will be clear that the company was not attempting to hide anything. Further, complete disclosures about what happened, how it was accounted for, and why, all greatly reduce the chances of enforcement actions. As several lawyers have reminded me recently, “There is no such thing as a fully disclosed fraud.”
Making disclosures about important accounting judgments and decisions isn’t exactly a new idea; the SEC issued “Cautionary Advice” on the topic in late 2001, and proposed rules shortly thereafter. The rules were never finalized, but the proposal explains the kinds of disclosures that would help inform investors.
As an added bonus, good disclosures make it far easier for the markets to understand and accept diversity in interpretation. Diversity without disclosure is more troubling, because the diversity might not be known or understood. This leads to efforts to get uniform treatment.
Some might believe that making these disclosures will just underscore an issue that investors and regulators might otherwise ignore. That might be correct, but if so, leaving the disclosures out means that investors will miss useful information about the company’s financial position, which thwarts the purpose of financial reporting. And the SEC staff is particularly adept at identifying the key accounting issues even if they aren’t discussed in filings. So you’ll probably wind up discussing it with the staff anyways. It’s best to disclose voluntarily and show that you’re interested in transparency.
And for those who might resist disclosure because 10-Ks and 10-Qs are already too long, I might point out that the amount of unnecessary detail in most SEC filings is far larger than the few paragraphs it would take to discuss the handful of key accounting issues that warrant more discussion. For example, look at the legal disclosures in just about any 10-K, and you’ll find a long history that details exactly when certain motions were filed, when decisions were handed down, when cases were appealed, remanded, and resubmitted, and many other details that are not important. And look at how much of a typical management Discussion & Analysis is boilerplate language that provides little or no insight. There is no reason to include that kind of information at the expense of discussion of critical accounting decisions, particularly when a paragraph or two of narrative can significantly reduce the chances of restatements or SEC enforcement action.
So that’s it: Discuss, Document, Disclose. Sure, taking these steps in dealing with troublesome accounting issues will consume more time, but the reduced chances of SEC problems should make it well worth the effort. And as an added bonus, you’re likely to end up with better accounting and more informed investors as well.
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