by  Arthur Greenspan, James Walker, and David Massey, and Jakob Sebrow 

As a result of the COVID-19 pandemic, U.S. public companies face significantly increased challenges, and legal risks, relating to their accounting and financial reporting.[1] This is especially so when company management must make difficult accounting judgments and estimates in the face of great uncertainty. For most enterprises, the economic disruption and downturn caused by the pandemic have created unprecedented levels of uncertainty around their future business and financial prospects. This has led numerous listed companies, including General Electric, FedEx, IBM and Starbucks, to withdraw previously-announced financial guidance for 2020.

Public companies can choose not to provide forward-looking financial forecasts because of the pandemic. They cannot, however, avoid the sort of accounting judgments and estimates –including those related to valuation of assets and liabilities, recognition of revenue, recognition of losses, and setting of reserves for future losses and expenses – that are an inherent part of required financial reporting. Although the current environment of uncertainty will render many of these judgments and estimates much more difficult to make, they will still be subject to heightened scrutiny by investors and analysts, by the U.S. Securities and Exchange Commission and, in some cases, by the U.S. Department of Justice.

Sagar Teotia, the SEC’s Chief Accountant, has acknowledged the difficulties in navigating complex accounting issues during the current economic crisis, including those relating to judgments and estimates, but has also made clear that “[during] these challenging times, investors and other stakeholders need high-quality financial information more than ever.”[2] Steven Peikin, the Co-Director of the SEC’s Division of Enforcement, recently stated the issue more pointedly: “Previous economic downturns proved that stresses on the financial conditions of issuers may raise the risk to investors from financial statement and issuer disclosure frauds.”[3] The Co-Director also explained that the Enforcement Division has developed a “systematic process to review public filings from issuers in highly-impacted industries” during the pandemic, with a focus on, among other things, “disclosures, impairments, or valuations” that are potentially false or misleading.[4]

More concretely, the SEC has made clear – both in its public statements and through its enforcement actions over the past decade – that management’s exercise of judgment in an environment of uncertainty is no defense to charges if a judgment or an estimate is based on insufficient evidence or clearly unreasonable assumptions or methodologies.[5] Moreover, the DOJ has been aggressively targeting accounting fraud in recent years and has shown that it will bring criminal charges in egregious cases of fraudulent judgments or estimates.

Given the government’s sustained and aggressive enforcement record in this area, management of public companies and recognized “gatekeepers” – particularly audit committees and independent auditors[6] — need to pay particular attention to accounting judgments and estimates during these difficult times and take steps to avoid the issues that have led to SEC and criminal charges in the recent past. We highlight below the relevant enforcement background and some practical steps that can help mitigate risk in this area.

The SEC’s Focus on Accounting Judgments and Estimates

As noted, the SEC has reinforced the importance of rendering appropriate accounting judgments and estimates in light of the COVID-19 pandemic.[7] Judgments and estimates are used in a wide variety of accounting areas, including valuation of tangible and intangible assets, recognition of revenue, recognition of losses, and setting of reserves for losses and expenses. Estimates require the use of significant judgment by management, a process which, as the SEC’s Chief Accountant acknowledged, can be “challenging in an environment of uncertainty.”[8]

Notwithstanding such challenges, the SEC has brought numerous cases against public companies, their executives and their external auditors based on allegedly deficient judgments and estimates. While judgments and estimates are typically based on facts and circumstances unique to a particular company, the Commission’s prior cases in this area provide guidance to management and auditors, and to audit committees, as to the types of facts and issues that deserve heightened attention during the current downturn. While the Commission’s prior cases against audit committee members have not involved management’s use of judgments or estimates, they demonstrate that the SEC takes seriously audit committees’ oversight responsibility for financial reporting and will pursue charges against committee members if they ignore red flags signaling accounting fraud by management.[9]

Ultimately, heightened attention to judgments and estimates by management, auditors and audit committees serves the dual purposes of (i) discharging their legal and professional obligations to provide investors with “high-quality financial information,” and (ii) minimizing risk of liability, both for themselves and for the company, down the road.

SEC and DOJ Cases Based on Accounting Judgments or Estimates

The following cases are representative of the recent enforcement actions in the area of management judgments and estimates:

• As General Electric has disclosed, the SEC is currently conducting a wide-ranging investigation into various accounting and financial reporting issues at the company, including issues relating to the timing of both a large increase in reserves for its run-off insurance operations and a very large goodwill impairment charge relating to its power business.[10]
• Last year, the SEC charged a brand management company with maintaining inflated values of trademarks, including by improperly relying on unreasonable sales projections and excessive growth assumptions, and failing to record an impairment of the marks in a timely manner.[11]
• In 2018, the SEC charged an agricultural company with maintaining inflated values of land use rights, notwithstanding management’s awareness of severe legal and practical limitations on the company’s ability to generate revenue from the land, and failing to record an impairment of the rights’ value in a timely manner. The Commission subsequently charged the senior audit partners with failing to appropriately audit potential impairment and, after the company recorded an impairment, failing to address evidence signaling impairment in earlier periods.[12]
• In 2017, the DOJ charged a former executive at a failed oil-services company with scheming to fraudulently inflate reported revenue by, among other things, falsely assuring other members of management that revenue under certain contracts was collectible.[13]
• In 2015, the SEC charged an energy company and its former CFO with inflating the fair value of oil and gas assets, including by improperly relying on a petroleum reserve report, and charged the company’s former lead audit partner with failing to adequately test the company’s valuation estimates of those assets.[14]
• In the wake of the 2008-09 financial crisis, the SEC charged former executives of a failed bank with underestimating the bank’s loan losses and overvaluing its collateral and real estate portfolio, including by relying on stale appraisals; the Commission also charged two senior auditors with failing to appropriately scrutinize management’s estimates of the bank’s allowance for loan losses.[15]
• Notably, the DOJ brought criminal charges against the former bank executives based on the same conduct, highlighting that the executives relied on outdated property appraisals and delayed or rejected new appraisals that would have required the bank to mark down the value of its collateral and real estate holdings.[16]

Practical Lessons for Management, Auditors and Audit Committees

These cases provide important reminders for management, auditors and audit committees of steps they can take to avoid problems with judgments and estimates in the first instance and withstand subsequent scrutiny by the government and other parties.

Management

As a general principle, whether for purposes of valuing assets, recognizing revenue, setting reserves, or otherwise, management should take proactive and diligent steps to ensure – and to document – that its judgments and estimates are based on reasonable methodologies, data and assumptions. These steps should be incorporated into wider internal controls over financial reporting (ICFR) that management is obliged to maintain (and on which auditors are often obliged to opine). For example, management should:

• employ methodologies and criteria that are widely accepted by financial and accounting professionals for the financial metric in question and utilized by other companies in the same industry under similar circumstances;
• ensure that historical business data (such as sales or cash receipts) are accurate and as current as possible;
• ensure that projections of future business results are based on the best available current business and economic information and reasonable (and typically conservative) future-looking assumptions;
• when relying on an appraisal or other outside report, ensure that the report is current and meets the company’s internal criteria for reliability;
• maintain clear and accessible documentation reflecting these steps and all other pertinent information supporting the judgment or estimate; and
• ensure that the judgment or estimate is generated through the company’s normal-course accounting and financial reporting processes and that multiple business and financial executives are apprised of all pertinent information and concur with the result.

Ultimately, management should let the data and reasonable, conservative assumptions produce the judgment or estimate, and not let a negative impact on reported financial results affect the number. Most of the recommended controls reflect common sense. For companies with a good culture of compliance, including a “tone at the top” that instills respect for appropriate accounting and financial reporting throughout the enterprise, these controls should provide a solid basis to deflect second-guessing by the SEC and others.

Auditors

The SEC’s cases in the area of judgments and estimates also provide important reminders for outside auditors. The overarching lesson is that auditors must provide appropriate and independent scrutiny, and a healthy dose of skepticism, to management judgments and estimates. For example (and perhaps to state the obvious), auditors should independently review and test the appropriateness of methodologies, the reasonableness of assumptions, and the quality of historical data, and should not unquestioningly accept management representations in this regard. It is also good practice for auditors to communicate with multiple members of management, audit committee members, and other company personnel as needed, on these issues.

While the vast majority of auditors understand and follow these principles, the number and regularity of SEC cases against auditors is an important reminder that auditors “function as critical gatekeepers” in the financial reporting process [17] and that the Commission will not hesitate to charge auditors when it believes they have failed to properly fulfill that function.[18]

Audit Committees

Finally, the SEC’s focus on judgments and estimates is also an important reminder to audit committees that they, too, play a crucial role in the financial reporting process and can thereby play a meaningful part in helping ensure that management judgments and estimates are appropriate. Audit committees have responsibility for oversight of various aspects of financial reporting, including ICFR and the independent audit process,[19] and both of these areas are critical to the reporting of appropriate judgments and estimates. Accordingly, to help ensure appropriate reporting and as part of their broader oversight function, audit committees should:

• ensure that management sets an appropriate “tone at the top” which, in the words of the SEC, “creat[es] and maintain[s] an environment that supports the integrity of the financial reporting process and the independence of the audit”[20]; 
• ensure that management maintains robust internal controls over financial reporting, including controls around judgments and estimates such as those recommended above;
• work with management and the outside auditors to ensure compliance with the auditor independence rules;
• ensure that the auditors are provided with all of the information and records they seek and are given access to all management and other company personnel with whom they wish to communicate;
• ensure that the auditors are free to fully test and scrutinize management judgments and estimates, including the underlying methodology, data and assumptions; and
• maintain open lines of communication, and full and frank discussion, between the auditors and the audit committee.

With these basic steps, audit committees can help ensure the appropriateness of critical management judgments and estimates and, at the same time, bolster the company’s legal and factual position if the SEC, the DOJ or a third party questions the reported numbers.

Footnotes

[1] For the authors’ recent post on a related topic of interest, see Arthur Greenspan, Jakob Sebrow, James Walker & David Massey, “Accounting Fraud 2.0: Increased Enforcement Activity Based on Non-GAAP Metrics,” Compliance & Enforcement (Apr. 3, 2020), available at https://wp.nyu.edu/compliance_enforcement/2020/04/03/accounting-fraud-2-0-increased-enforcement-activity-based-on-non-gaap-metrics/.

[2] See Sagar Teotia, SEC Chief Accountant, “Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19” (Apr. 3, 2020) (“Teotia Statement”), available at https://www.sec.gov /news/public-statement/statement-teotia-financial-reporting-covid-19-2020-04-03, at 1-2; see also Sue Reisinger, “They’re Watching: Regulator Wants Accurate Financial Reporting Amid COVID-19 Losses,” Corporate Counsel (Apr. 3, 2020), available at https://www.law.com/corpcounsel/2020/04/03/theyre-watching-regulator-wants-accurate-financial-reporting-amid-covid-19-losses/.

[3] Steven Peikin, Co-Director, SEC Division of Enforcement, “Keynote Address: Securities Enforcement Forum West 2020” (May 12, 2020), available at https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020, at 3.

[4] Id. 

[5] See, e,g., Andrew Ceresney, Director, SEC Division of Enforcement, “The SEC Enforcement Division’s Focus on Auditors and Auditing” (Sept. 22, 2016) (“Ceresney Speech”), available at https://www.sec.gov/ news/ speech/ ceresney-enforcement-focus-on-auditors-and-auditing.html, at 7-9.

[6] See Teotia Statement, at 2; SEC Chairman Jay Clayton, SEC Chief Accountant Sagar Teotia & Director of SEC Division of Corporation Finance William Hinman, “Statement on Role of Audit Committees in Financial Reporting and Key Reminders Regarding Oversight Responsibilities” (Dec. 30, 2019) (“Statement Regarding Audit Committees”), available at https://www.sec.gov/news/public-statement/statement-role-audit-committees-financial-reporting; SEC Division of Enforcement, 2019 Annual Report (Nov. 6, 2019) (“2019 Enforcement Report”), available at https://www.sec.gov/files/enforcement-annual-report-2019.pdf (PDF: 1.67 MB), at 4-5; Ceresney Speech.

[7] See Teotia Statement, at 2-3.

[8] Id. at 2. 

[9] See Statement Regarding Audit Committees; Donald W. Prosser, CPA, Exch. Act Rel. No. 75855 (Sept. 8, 2015); Complaint, SEC v. AgFeed Industries, Inc., et al., No. 14 Civ. 663 (M.D. Tenn. Mar. 11, 2014); Complaint, SEC v. Krantz, et al., No. 11 Civ. 60432 (S.D. Fla. Feb. 28, 2011); Complaint, SEC v. Raval, No. 10 Civ. 101 (D. Neb. Mar. 15, 2010).

[10] See General Electric Company 2019 Form 10-K, filed Feb. 24, 2020, at 108.

[11] See Complaint, SEC v. Iconix Brand Group, Inc., No. 19 Civ. 11150 (S.D.N.Y. Dec. 5, 2019), at 28-39.

[12] See Agria Corp., Exch. Act. Rel. No. 84763 (Dec. 10, 2018); Michael Filkoski, CPA, et al., Exch. Act. Rel. No. 86720 (Aug. 21, 2019).

[13] See Indictment, United States v. Kostelecky, No. 17 Cr. 15 (D. N. Dak. Jan. 5, 2017).

[14] See Miller Energy Resources, Inc., et al., Exch. Act Rel. No. 75622 (Aug. 6, 2015).

[15] See, e.g., Complaint, SEC v. Lundstrom et al., No. 12 Civ. 343 (D. Neb. Sept. 25, 2012); John J. Aesoph, CPA, et al., Exch. Act. Rel. No. 68605 (Jan. 9, 2013).

[16] See, e.g., Indictment, United States v. Lundstrom, No. 14 Cr. 3136 (D. Neb. Dec. 9, 2014).

[17] Ceresney Speech, at 1.

[18] See 2019 Enforcement Report, at 4-5, 25, 41-43; Ceresney Speech.

[19] Id. at 11.

[20] Id.

Arthur Greenspan, James Walker, and David Massey are partners at Perkins Coie. Jakob Sebrow is an associate, at Richards Kibbe & Orbe LLP.

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