Every year the Securities and Exchange Commission releases a number of “Dear CFO” letters — guidance written to the finance chiefs of individual companies, but made public (with the names of the CFOs and companies redacted) because they focus on issues of broad interest. The agency has released five such letters so far in 2010, all focused on banking issues. The most recent letter, in March, concerned accounting for repurchase agreements, an issue raised by the now-infamous “Repo 105” transactions Lehman Brothers used to buff up its balance sheet.
But it’s likely the next Dear CFO letter will focus on nonbanking issues, according to Wayne Carnall, chief accountant for the SEC’s Division of Corporation Finance. Carnall made his prediction on Monday during a speech at an accounting-industry conference sponsored by the New York State Society of Certified Public Accountants. He didn’t indicate the specific issues that are being teed up for Dear CFO letters, but he did name several areas the SEC is paying close attention to, and therefore likely to issue individual comment letters on.
For one, Carnall noted that of late, companies (both financial and nonfinancial) have not been reporting enough detailed information about their short-term liquidity positions. To illustrate, he presented a hypothetical situation in which a retailer significantly increases its borrowing to finance inventory in anticipation of a big holiday season. A robust selling season will help the retailer repay most of its borrowing — but until it does, the SEC would like to see quarterly or periodic reports that reflect the retailer’s short-term liquidity constraints, said Carnall.
Carnall also pointed to an increasing number of U.S. issuers that have virtually all of their operations in developing countries. The SEC has little information about the parties preparing their financial statements, and as a result, the agency is now asking questions about the preparers’ credentials and whether they have experience with American companies and U.S. generally accepted accounting principles. So far, several of these issuers have self-reported to the SEC material weaknesses in internal controls over financial statements, said Carnell, who predicted the agency will be issuing individual comment letters on the subject.
Another area that will likely be the subject of SEC comment letters is disclosures related to contingent liabilities. The concern with such disclosures, said Carnell, is that some companies tend to issue “pages of disclosures” but “say little.” In addition, the agency is keeping watch on companies that claim they cannot report contingent liabilities because they are unable to calculate the cost with “precision or confidence.” Carnall pointed out that there is nothing in SEC rules or GAAP that precludes companies from reporting potential liabilities because the calculation lacks precision or confidence. The key criteria, he said, are that contingent liabilities be reasonably possible and estimable.
The SEC will also likely be looking more closely at noncash charges involving impairment of goodwill and deferred tax assets, said Carnall. Although such charges do not directly affect cash flow, they do indicate “that the business is under stress” and therefore should be properly disclosed to investors, he said.
Non-GAAP disclosures are on the SEC’s radar as well. Carnall said his team will be spending “a significant amount of time” looking for consistency in practice and accuracy of data with regard to non-GAAP information. That includes making sure such information is not misleading or given more play than GAAP data because it presents a more favorable picture. Carnall said some companies have been caught reporting profitable non-GAAP numbers in press releases or the Management’s Discussion and Analysis, while the income statement shows a loss.
Non-GAAP metrics were named as a “fraud risk factor” by Howard Scheck, chief accountant at the SEC’s Division of Enforcement, who also spoke at the conference. Other fraud factors that attract the agency’s attention include aggressive accounting policies and earnings forecasts, undue emphasis on achieving quarterly results or on increasing stock price, murky disclosures, and transactions that lack substance.
The fraud schemes that are most commonly uncovered by the SEC: improper revenue and expense recognition, manipulation of reserves, improper valuation, and changing estimates “to make the numbers,” said Scheck.