In 2013, the Securities and Exchange Commission (SEC) formed the Financial Reporting and Audit Task Force to detect fraudulent or improper financial reporting, and since then has brought more than 300 issuer reporting and disclosure cases. One area of focus is a company’s restatement of financial statements and company actions connected with the restatement.
The audit committee plays an important role in navigating a restatement—from investigating errors and their origins to overseeing the restatement process. A mishandled restatement can lead to a prolonged SEC investigation, increased exposure to liability in civil litigation, loss of confidence by lenders, and potential delisting by an exchange.
To survive a restatement, audit committees should avoid the following pitfalls.
- Engaging inexperienced counsel and advisors for investigation. A restatement is commonly precipitated or accompanied by an independent investigation overseen by the audit committee. Proper investigation of accounting errors is critically important, and inexperienced counsel could fumble the investigation—and restatement—from the beginning by incorrectly scoping the investigation, failing to obtain the relevant information, or losing credibility with regulators.Four qualities are essential for counsel tasked with conducting independent investigations into accounting errors.
- First and foremost, counsel must be independent from management. Counsel must not have done prior work for the company or have any significant ties to the management.
- Second, counsel should be experienced with conducting independent investigations for boards and board committees.
- Third, counsel should understand accounting and disclosure issues, and have experience with the nuances of accounting investigations. Nonetheless, counsel should also be expected to engage experienced, outside forensic accountants to aid in the investigation.
- Finally, counsel and their team must be respected by regulators and have a reputation of conducting appropriately thorough and complete investigations.
- Forming a special committee when the audit committee might suffice. While a special committee might be necessary in certain rare investigative circumstances, the board should avoid forming one if its audit committee is composed of independent and disinterested directors who are suited for the task. A special committee must be disbanded at some point (usually once the investigation is completed and before the restatement process begins), and the disbanding could become a complicated news item.In contrast, if the audit committee oversees the investigation, then, once the investigation is complete, the audit committee can pivot back to its normal role, which would include overseeing the actual restatement process. Investigations overseen by the audit committee also benefit from the positive relationship that the chair usually has with the company’s outside accounting firm.
- The run-away or open-ended investigation. Incorrectly scoped investigations can lead to burdensome legal fees, continued business disruptions, and inadequate investigatory results. Importantly, an independent investigation does not mean that counsel is independent of the client. The “client”—i.e., the audit committee—should discuss the scope and budget of the investigation with outside counsel and together tailor the investigation to the circumstances.
- Failing to keep auditors apprised of the investigation and errors found. Keeping auditors in the dark regarding the progress and results of the investigation could delay the restatement and result in the resignation of the auditor. The audit committee’s counsel should maintain a good relationship with the company’s auditors and keep them appropriately apprised of the investigation through periodic calls or meetings. If the auditor is conducting a shadow investigation, this dialogue will aid it in confirming that appropriate remedial measures occur (e.g., a restatement) and that the company’s professional practice group, risk, or forensic functions are informed.
- Indecisiveness and inability to reach conclusions. Indecisiveness can delay the investigative process, allow misconduct to persist unchecked, and create the damaging perception among investors, regulators, and the plaintiffs’ bar that the company’s problems extend beyond financial reporting. To minimize these effects and maximize potential cooperation credit, the audit committee, in conjunction with counsel, should reach conclusions concerning accounting errors as promptly as possible.
- Waiting too long to deal with wrongdoers. Once an investigation has made conclusions about individual conduct, any wrongdoers should be disciplined and, when necessary, removed from their position—either by terminating their employment or forcing their resignation. When determining cooperation credit, the SEC and Department of Justice (DOJ) will focus on whether the responsible individuals are still with the company, and, if so, whether they are still in the same positions. Removing wrongdoers clears the path for the audit committee to share investigation results with management so it can correct errors and implement remedial actions.
- Not self-reporting findings to the SEC. Whenever a restatement is made, the SEC will inquire whether the underlying accounting error was intentional. It also may inquire about the root cause of the error; how, when, and by whom it was discovered; the reporting periods impacted; how the error is being corrected; and the impact on the company’s financial control environment.The SEC expects a registrant to voluntarily share the results of its investigation. If the SEC learns of misconduct from a source other than the company, or if the company fails to make its investigative findings available to the SEC, the company could become ineligible for cooperation credit associated with self-reporting. The incentives in the SEC’s whistleblower bounty program provide additional motivation for companies to be proactive in promptly and thoroughly self-reporting.
- Audit committee micromanagement of the restatement. Management is ultimately responsible for financial reporting, and the audit committee must maintain its supervisory role and refrain from stepping into the role of management to correct errors. Once an accounting error has been identified, it must be assessed to determine whether the affected financial statements are materially misstated. Quantifying the errors is a critical step in determining materiality, and Staff Accounting Bulletin (SAB) 108 contains guidance.The audit committee counsel should assist management, as appropriate, in understanding the nature of the errors and how to correct them. This is also a good time for the audit committee to request that management re-evaluate the enterprise-wide risk assessment process and the design and effectiveness of internal controls over financial reporting.
- Failing to remediate. If accounting errors lead to a restatement, then the company may have deficiencies in internal controls. In addition, inadequate or ineffective internal controls often raise issues that should be investigated by the audit committee relating to the certifications by the CEO, CFO, and outside auditor. Failure to remediate gaps in internal controls and to address certification issues provides the opportunity for additional misconduct and could damage the company’s credibility with regulators. The SEC in particular will focus on what steps the company took upon learning of the misconduct or control weaknesses, whether the company took immediate corrective action, and what new and more effective internal controls or procedures the company plans to adopt to prevent a recurrence. When documenting remedial actions, the company should avoid characterizing them as other than what they are—improvements in internal control procedures. This neutral approach might help to mitigate potentially harmful collateral impacts in civil litigation.
- Creating an unnecessarily detailed SAB-99 materiality analysis. Shareholder class actions inevitably follow restatements. The audit committee should resist the impulse to create an unnecessarily detailed SAB-99 materiality analysis that will be discoverable in litigation against the company and could provide a roadmap for private plaintiffs. To the extent additional details regarding the materiality analysis are necessary, oral discussions with auditors are often sufficient.
Bradley J. Bondi is a partner with Cahill Gordon & Reindel LLP. He advises financial institutions and global corporations, boards of directors, audit committees, and officers and directors of publicly-held companies in significant corporate and securities matters, with particular emphasis on internal investigations and enforcement challenges, including those related to restatements. Michael D. Wheatley, a litigation associate at Cahill, assisted with this article.
Jonathan T. Marks, CPA, CFE, a managing director with Navigant Consulting, Inc. in its global disputes and investigations practice, and Michael Pesce, an associate director with Navigant, contributed to this article.