As reported in prior Updates (see, e.g., December 2014 and October-November 2014), during the past year, the SEC has shown renewed zeal for financial reporting enforcement, particularly matters involving erroneous valuations and estimates and inadequate internal controls. Two cases filed in January illustrate the types of financial reporting matters that are attracting the Commission’s attention.
In the Matter of First National Community Bancorp Inc., Securities Act Release No. 9714 (Jan. 28, 2015) (FNCB), deals with the reasonableness of the assumptions underlying determinations regarding the valuation of illiquid securities. The Commission charged a bank holding company with violations of the requirements to file accurate reports with the SEC, to maintain accurate books and records, and to maintain effective internal controls. The SEC’s charges were based on the alleged improper computation of the amount of other-than-temporary-impairment (OTTI) of certain investment securities reported on the bank’s financial statements as available for sale. The SEC also charged the bank’s Principal Financial Officer (PFO) with causing these violations by failing to establish and maintain the necessary policies and procedures for determining OTTI.
The Commission alleged that OTTI was materially understated in the financial statements in two 2010 quarterly reports filed on Form 10-Q and in the 2009 annual report on Form 10-K. Since the 10-K and one of the 10-Qs were incorporated into the subscription agreement for a private placement, the Commission also charged the bank holding company with a violation Section 17(a)(2) of the Securities Act, which makes unlawful, in the offer or sale of securities, to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made not misleading.
GAAP requires that an OTTI loss be recognized in earnings when the present value of the cash flows expected to be collected from a security is below its amortized cost – that is, when part of the loss in value is a credit loss, rather than a loss resulting from market factors. In this case, the investments as to which OTTI was an issue were a type of collateralized debt obligation created by pooling and securitizing securities issued by community and regional banks. In order to determine whether declines in the fair value of these securities were
“other than temporary,” the bank had to make assumptions about the likelihood of defaults on the underlying securitized instruments. Since those securities were issued by banks, the expected default rate was in part a function of the rate of bank failures, which was elevated in 2009 as a result of the financial crisis.
According to the SEC’s order, the PFO chose the default scenario that yielded the least amount of impairment of the securities on the bank’s balance sheet. Specifically, the OTTI determinations were “based on an expectation that bank failures and, therefore, default and deferral rates would not continue at the then-current levels for an extended period of time,” although the PFO “did not document his rationale or why he believed such assumptions were reasonable and supportable.” In addition, the PFO applied the same projected default rate to all of the investment securities in the portfolio, without regard to differences in the collateral or in other individual characteristics of each security. The Commission found that the resulting valuations were not in accordance with GAAP because the OTTI calculations were not based on reasonable and supportable assumptions.
Both the company and the PFO agreed to settle without admitting or denying the Commission’s charges. Both also agreed to the entry of an order requiring them to cease and desist from future violations of the reporting, recordkeeping and internal control requirements and to pay monetary penalties.
The second case, In the Matter of AirTouch Communications, Inc., Securities Act Release No. 9719 (Jan. 30, 2015), is a more traditional example of an alleged material revenue misstatement. In this case, the SEC did not charge violations of the reporting, books and records, or internal control requirements, but rather charged securities fraud in violation of the Section 17(a) of the Securities Act and Securities Exchange Act Rule 10b-5.
The gist of the Commission’s allegations are that the company entered into an agreement with a Florida-based fulfillment and warehousing service, under which the Florida entity would “purchase” products from the company. The Florida entity was not, however, required to pay the company for those products until they were re-sold to one of the company’s customers and the customer had paid the Florida entity. The company issued a purchase order to the Florida entity, and shipped $1.24 million in products to it. On the basis of the purchase order and shipment, the company recorded sales revenue (even though the Florida entity was not at that time required to pay for its “purchase”) and included that revenue in 2012 third quarter operating results. (This was the company’s only revenue for that quarter.) A Form 10-Q reflecting the revenue was filed with the SEC and used in soliciting additional capital from an investor.
The SEC alleges that neither GAAP nor the company’s revenue recognition policy permitted revenue to be recognized in these circumstances. The order states: “Because AirTouch did not sell any product to the Florida Entity—the Purchase Order and the Agreement merely documented, for tracking purposes, the transfer of AirTouch inventory to the Florida Entity in contemplation of future sales—the revenue associated with shipments to the Florida Entity was not realized, realizable or earned.”
According to the order, the CEO and CFO “each knew about the Agreement but did not provide it to others involved in AirTouch’s financial reporting process, including the controller, the chairman of the audit committee, and the company’s outside independent accountant.” In January 2013, the board of directors commenced an internal investigation concerning the revenues reported in the Form 10-Q. When the board and its outside auditor finally received the agreement, they ordered a restatement.
The company and the CEO, without admitting or denying the Commission’s allegations, agreed to the entry of an order finding that they had committed securities fraud and requiring each to pay a civil monetary penalty. The CEO was also barred from serving as an officer or director of a public company for five years. The case against the CFO is continuing.
Comment: First National Community Bank, like several other recent cases, demonstrates the Commission’s willingness to use its enforcement machinery to address accounting matters that previously would likely have been dealt with less formally, if at all. This is especially true in the area of valuation determinations relating to illiquid securities, intangibles, and other assets as to which valuation is dependent on assumptions and models. It also shows the Commission’s continuing focus on controls and its propensity to characterize accounting errors as internal control breakdowns. Audit committees should ask management to explain key assumptions that underlie the company’s financial reporting and how management selected those assumptions and determined their reasonableness.
In contrast, AirTouch is the latest in a long line of cases involving allegations of improper revenue recognition. The PCAOB’s Staff Practice Alert on Auditing Revenue (see September 2014 Update) highlights fraud risks associated with revenue, including the impact of side agreements on revenue recognition. Audit committees should ask the auditor what it views as the principal risks of financial reporting fraud, particularly with respect to revenue, and how it addressed those risks in the audit.