Category: Accounting

Do Law Firms Need Compliance Programs?

Dewey-LeBoeuf compliance

Do as I say; Not as I do.

The bankruptcy of Dewey & LeBoeuf sent shivers throughout big law firms. The firm could trace its history back 100 years and employed over 1000 lawyers when it exploded. Last week, key leaders of the firm were charged with securities law violations and criminal theft charges related to the law firm’s bond issuance.

When Dewey went under, the first thing that caught my eye  was its bond issuance. That seemed an unusual way for a law firm to finance its cash flow and capital needs. Unfortunately for the Dewey leaders, its one thing to lie to the firm’s partners and lenders about the firm’s financial health. But the lying to the bond purchasers is securities fraud.

According to the indictment and SEC complaint, the firm was behind on its lender covenants and started reclassifying items to make its financial statements meet the targets. In reading through the charges, some of those accounting adjustments sound bad and some sound questionable. An accountant would probably not approve, but that Dewey managers may have some arguments to justify the changes.

“I assume you new [sic] this but just in case. Can you find another clueless auditor for next year?”

Oh my… What would a lawyer say to his client who put something like this in an email?

What ever argument the Dewey managers may have had about the accounting treatment is going to be questioned when there are emails discussing the decisions with phrases like: “fake income”, “accounting tricks” and my favorite: “cooking the books”. At this point, we only have the government’s side of the story and the Dewey managers have not had a chance to tell their side of the story.

There is an email asking for back-dated checks so the firm can book revenue to the prior year in an effort to make 2009 year-end numbers. That is followed by a response from another manager asking the email to be re-worded so it does not sound like it’s engaging in accounting fraud.

The firm is not meeting its financial goals. That’s disappointing and the its lenders are going to reel the firm in. The solution was a bond offering. According the SEC and district attorney, the firm’s financial statements were fraudulent.

This seems like a classic “company gone bad” fraud scheme. The firm insists on making its numbers and pushes its accounting treatment to make the numbers in that quarter, but ends up robbing income from the following quarter. It hopes it can catch up, but never does.

The firm managers had been fraudulently claiming revenue that Dewey did not have and kept pushing expenses and financial obligations off into the future. Dewey had to cut partner compensation and that was not enough to prevent them from leaving. With the loss of partners, there was a loss of revenue. At some point the rubber band is stretched too far (not that law firms are that flexible) and snaps. The firm managers could no longer fool Dewey’s lenders and bond holder. It had no choice but to file bankruptcy, sending thousands onto the unemployment line.

But this was a law firm who, on a regular basis, dispensed advice about compliance and SEC enforcement and accounting fraud. As Donna Boehme and Joseph Murphy point out in 10 Inconvenient Truths About Law Firm Compliance (.pdf):

Fact 1: People create risks. Fact 2: Law firms have people.

It seems like Dewey had a case of not following the advice it dispensed to its clients.

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Borrowings and Form PF

Form PF

A question popped up during a meeting of some real estate compliance folks talking about Form PF. How do you treat subsidiary mortgage borrowings? Question 12(a) asks for the dollar amount of borrowings for the fund. Two main issues came into play: write-downs and recourse.

As many real estate funds are still recovering from the 2008 financial crisis they may have some properties that are underwater. They could have debt in excess of the value of the property. If the loan obligation is isolated at a property and the recourse is limited to the subsidiary then the investment would have a negative valuation. For accounting treatment, the loan value is likely written down to the fair value of the property. That results in a zero valuation rather than a negative valuation.

When Form PF asks for the value of the borrowing should you include the full value or the written down value? Italics means there is a definition and it refers to Instruction 15.

15. May I rely on my own methodologies in responding to Form PF? How should I enter requested information? …

for … borrowings where the reporting fund is the debtor, “value” means the value you report internally and to current and prospective investors;

So the value of a mortgage borrowing should be reported based on the value you report internally and to current and prospective investors. If you write down the mortgage in your annual report, then you can write down the value of the mortgage on Form PF.

That leads to the next question, which is whether to include the debt at all. Without recourse the borrowing is not a direct obligation of the fund. You could argue that the mortgage debt is not part of the “reporting fund’s borrowings.”

A private equity fund would likely not report the value of debt owed by portfolio companies unless the debt were recourse to the fund. I’m not sure that the position changes when the investment is a single real estate instead of an operating portfolio company.

There is the fallback in question 4 which allows you to explain any assumptions you made in responding to questions. You could include all of the debt and state that it includes non-recourse debt. Or take the opposite approach and exclude the non-recourse debt but explain that you excluded non-recourse debt from the answer.

A third question was how to treat debt on joint venture properties. Most seem to agree that you would only include your proportionate share of the debt. Again, you could make arguments either way.

Goodbye SAS 70; Hello SSAE 16

Apparently I missed this big change. Statement on Auditing Standards No. 70 (SAS 70) was a widely used reporting tool for service organizations all throughout the globe. However, the migration towards more globally accepted accounting principles has put SAS 70 in the rearview mirror. Statement on Standards for Attestation Engagements (SSAE) No. 16, Reporting on Controls at a Service Organization completely replaces SAS 70, effective for reports with periods ending on or after June 15, 2011.

SOC 1: SSAE 16 Type 1 Examination
A SSAE 16 Type 1 examination is a report on management’s description of a service organization’s system and the suitability of the design of controls.

SOC 1: SSAE 16 Type 2 Examination
A SSAE 16 Type 2 examination is a report on management’s description of a service organization’s system and the suitability of the design and operating effectiveness of controls.

One of the biggest differences introduced by SSAE 16 is that the service auditor is required to obtain a written assertion from management of the organization about the matters the CPA is reporting on. The organization’s management provides the auditor with a written assertion to be included in the SSAE 16 examination report. The written assertion states the following:

  • Management’s description of the service organization’s system fairly presents the service organization’s system that was designed and implemented as of a specified date (or for a Type 2 – throughout the specified period);
  • The controls related to the control objectives stated in management’s description of the service organization’s system were suitably designed to achieve those control objectives as of the specified date (or for a Type 2 – throughout the specified period);
  • The controls related to the control objectives stated in management’s description of the service organization’s system operated effectively throughout the specified period to achieve those control objectives (Type 2 only).

I’ll need to dive deeper into the changes. For now, I need to make sure I say “SSAE 16” instead of “SAS 70”.

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PCAOB is Ruled Unconstitutional

This morning, the United States Supreme Court issued its opinion in the case of Free Enterprise Fund v. PCAOB. For me in the compliance world, the case was about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gave the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

The Supreme Court ruled that the limitations on the power to remove the members of the board is unconstitutional under the separation of powers doctrine. The board members are inferior officers, and the method of appointment under the Sarbanes-Oxley Act violates the Appointments Clause.

The ruling does not seem to shut down PCAOB immediately since the Court declined to allow a broad injunction against PCAOB’s continued operation. The challengers to the method of PCAOB board-member appointment are entitled to a declaratory order “sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive.”

The Court also found the PCAOB provisions severable from the rest of Sarbanes-Oxley, so they did not invalidate the entire law.

There will have to be some quick tinkering by the SEC and Congress on how to deal with the ruling.

Administrative law professors will need to tinker with their classroom teaching and casebooks to address this case and its implications.

Update – Some key quotes from the Opinion:

We hold that the dual for-cause limitations on the removal of Board members contravene the Constitution’s separation of powers.

The Act before us does something quite different. It not only protects Board members from removal except for good cause, but withdraws from the President any decision on whether that good cause exists. That decision is vested instead in other tenured officers—the Commissioners— none of whom is subject to the President’s direct control.The result is a Board that is not accountable to the President, and a President who is not responsible for the Board.

Second Update

[T]he existence of the Board does not violate the separation of powers, but the substantive removal restrictions imposed by §§7211(e)(6) and 7217(d)(3) do. Under the traditional default rule, removal is incident to the power of appointment. … Concluding that the removal restrictions are invalid leaves the Board removable by the Commission at will, and leaves the President separated from Board members by only a single level of good-cause tenure. The Commission is then fully responsible for the Board’s actions, which are no less subject than the Commission’s own functions to Presidential oversight.

That leaves the 15 U.S.C. §7211(e)(6) and 15 U.S.C. §7217(d)(3) out in the cold, but saves PCAOB and Sarbanes-Oxley from destruction in a very narrow ruling. It seems that Congress will not need to take any action since the decision merely grants the SEC the right to remove any Board member for any reason. No longer is removal limited to a firing “for cause.”

There may be some argument that the past rulings and standards set by PCAOB were made by an unconstitutional. That’s heading down a path way beyond my expertise (or interest).

So life will continue on, but the PCAOB board members have  less job security.

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SEC Decides to Think Further About IFRS

The Securities and Exchange Commission voted to issue a statement that lays out its position regarding global accounting standards. They want to make it clear that “the Commission continues to believe that a single set of high-quality globally accepted accounting standards would benefit U.S investors.”

By 2011, the SEC will decide whether to incorporate IFRS into the U.S. financial reporting system, and if so, when and how. In trying to reach a decision, the SEC has published a Work Plan. It has six key areas:

  • Sufficient Development and Application of IFRS for the U.S. Domestic Reporting System
    • Comprehensiveness
    • Auditabilitity and Enforceability
    • Consistent and High-Quality Application
  • The Independence of Standard Setting for the Benefit of Investors
  • Investor Understanding and Education Regarding IFRS
  • Examination of the U.S. Regulatory Environment that Would Be Affected by a Change in Accounting Standards
  • The Impact on Issuers, Both Large and Small, Including Changes to Accounting Systems, Changes to Contractual Arrangements, Corporate Governance Considerations, and Litigation Contingencies
  • Human Capital Readiness

Certainly it would be better to have a single universal accounting standard. But is IFRS better than GAAP, worse than GAAP, or just different?

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Tuesday Morning Quarterback of Free Enterprise v. PCAOB

pcaob logo

On Monday, the Supreme Court listened to the oral arguments in Free Enterprise Fund v. Public Company Accounting Oversight Board (08-861). For me in the compliance world, the case is about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gives the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

If the Supreme Court agrees that PCAOB isn’t constitutional, it could force a revisit of Sarbanes-Oxley, or at least the portion of it that creates PCAOB. In a broader view for constitutional scholarship, the case could also call into question other independent agencies and how they appoint members of those agencies.

David Zaring in The Conglomerate thinks that the Supreme Court is unlikely to get in the way of an important government agencey. After all eliminating an agency is a sever sanction.

Orin Kerr in The Volokh Conspiracy> got the impression that the arguments did not go well for the challengers to the constitutionality of the Public Company Accounting Oversight Board.

Fawn John Johnson and Jess Bravin in The Wall Street Journal look to Justice Kennedy as the key to which way the Supreme Court will decide. The liberal justices are less likely to find fault with the independent agencies. For conservative legal scholars, the case is less about the accounting board itself than about the “unitary executive” theory, which holds that because the president is accountable to the electorate, he must be able to remove federal officials at will.

The transcript and reports seem to focus on how much control the SEC has over PCAOB. Hans Bader points out that the SEC had previously expressed its frustration about how little control it had over PCAOB, seemingly contrary to the arguments made in front of the Supreme Court.

David Zaring in The Conglomerate points out that the number of law review articles referring to “PCAOB”: 1021.  Number referring to “PCOAB”: 29. So much for the higher scholarship and editing of law review articles over blogs.

UPDATE:

Broc Romanek, of The Corporate Counsel.net provides a great first-hand account of the hearing and his experience at the Supreme Court the day of the hearing: My SCOTUS Experience: The Full Monty.

References:

Is PCAOB Constitutional?

vanderbilt law review

Now that Jones v. Harris has been argued, we have to sit and wait for the decision. But there is another compliance case coming up for argument in front of the Supreme Court: Free Enterprise Fund v. PCAOB.

The PCAOB case is much sexier than the Jones case since it involves the president’s constitutional powers of appointment and the separation of powers under the Constitution. (At least as far as compliance is sexy.)

The November 2009 edition of the Vanderbilt Law Review has a quartet of articles that focus on the PCAOB case and the underlying constitutional issues:

Congress created the Public Company Accounting Oversight Board PCAOB under the umbrella of the Securities and Exchange Commission. If PCAOB is a government agency and its members are officers, then the appointment of the PCAOB is very odd. The President can appoint the SEC Commissioners, but only remove them “for cause.” Then in turn the SEC Commissioners appoint the PCAOB members.

The issues arises from the Appointments Clause of the U.S. Constitution U.S. CONST. Art. I, § 2, cl. 2;:

[The President] shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

Are the PCAOB‟s Members “principal officers” of the United States, whose appointment must, be made by presidential nomination and Senate approval? Even if they are “inferior officers” of the United States, does PCAOB violate the Constitution‟s arrangement for the appointment and removal of such officers because they are put entirely in the hands of the SEC, an independent regulatory commission, beyond the effective reach of presidential oversight?

There are lots of interesting issues discussed in these articles and lots of interesting things the Supreme Court could do in its opinion for the PCAOB case. It could have broader implications to other government commissions, accountants and compliance professionals.

Fair Value Accounting: What Lawyers Need to Know

securitiesdocket

Bruce Carton of Securities Docket put together a great panel of securities and accounting experts to discuss the evolution of fair value accounting regulations and the impact of the guidelines in accounting and legal contexts.

Presenters

These are my notes from the webcast.

Fair value accounting records the estimated market value of many assets and liabilities on balance sheets. Although sometimes called “mark-to-market” but that is a misnomer. You need to estimate the value if there is no market for the asset. Fair value estimation methods were standardized by SFAS 157 (ASC Topic 820 –Fair Value Measurements and Disclosures) issued by FASB in 2007.

The standard came out just in time for the financial meltdown.

There are three types of measurement:

Level 1: Based on quoted prices in active markets for identical instruments.

  • Listed stocks, actively traded bonds.

Level 2: Based on observable (auditable) inputs used to estimate an exit value.

  • Two similarly situated buildings in a downtown real estate market.
  • OTC interest-rate swap, fair valued based on observable data such as the contract terms and the current LIBOR forward rate curve.
  • Contracts with option-like features, fair valued based on contract terms, observed volatility, interest rates.

Level 3: Based only on unobservable inputs and assumptions used by the company to estimate an exit value (i.e., where markets don’t exist or are illiquid).

  • CDOs, many financial derivatives, stock in unlisted companies.
  • Level 3 fair value estimates usually employ the company’s own models, notably variants of Discounted Cash Flow (Present Value) models.

Huge losses reported by financial firms on subprime assets led to a debate over the implementation of SFAS 157 when markets become illiquid and price inputs aren’t readily available. During the crisis, banks and investment banks were required to reduce the book value of mortgage-backed securities to reflect their current prices.Those prices declined severely with the collapse of credit markets as mortgage defaults escalated. Banks were forced to raise capital and quickly jettison some of thee securities to raise capital, further providing downward pressure on the values. So, banks and politicians have blamed fair value accounting for contributing to the crisis.

On the other side, fair value accounting gave a more realistic view of the financial health of an institution. One of the factors in the financial crisis was that parties did not trust the credit-worthiness of their counterparties. Fair value provides important information about the values of financial assets and liabilities, as compared to their historical costs (original price). There should be greater transparency allowed for better informed decisions. It also limits the ability to manipulate earnings by timing the sale of assets.

But there are downsides to fair value accounting. When markets are illiquid, fair value is a hypothetical transaction price that cannot be measured reliably. When fair values are provided by sources other than liquid markets, they are unverifiable and allow firms to engage in discretionary income management. By recognizing unrealized gains and losses, fair value accounting creates volatility in a company’s equity. This is particularly important for financial institutions because it affects their regulatory capital.

There is also the quirk of the fair value accounting for one’s own liabilities. Some banks reported gains because of a decline in quality of their debt. They recorded an income gain because they were more likely to default on their debt.

One of the issues in the financial crisis is that mortgage-back securities moved from Level 1 valuations to Level 3 valuations very quickly. Models were not established for valuations of these assets when they went toxic and cash flows dried up.

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New Rules Ease the Restructuring of CMBS Loans

real-estate-roundtable

The Treasury Department released new tax rules that make it easier for property owners to restructure loans that were packaged and sold as Commercial Mortgage Backed Securities. The IRS passed relief for residential mortgage packed securities in May, 2008.

Until now, tax rules have made it impossible for borrowers who are not in default to hold restructuring talks. Altering the terms of a mortgage that is part of a CMBS has a nuclear tax result. Only those loans that are actually delinquent could be modified. The loan servicers were unable to modify terms to prevent a default.

The new guidance from the Treasury makes it clear discussions involving lowering the interest rate or stretching out the loan term “may occur at any time” without triggering tax consequences. In addition, the guidance allows servicers to modify loans regardless of when they mature. The servicer only has to believe there is “a significant risk of default” upon maturity of the loan or at an earlier date and that  “the modified loan presents a substantially reduced risk of default”.

The IRS also issued final regulations that expand the list of permitted loan modifications to include certain modifications that are often made to commercial mortgages. The regulations expand this list of permitted exceptions to include changes in collateral, guarantees, and credit enhancement of an obligation and changes to the recourse nature of an obligation.

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When Work Papers are not Subject to the Attorney-Client Privilege

textron

The recent Textron decision is causing quite a kerfuffle. The court permitted Internal Revenue Service to gain access to documents created by the defense-contracting firm to determine whether the company’s calculation of its tax liabilities would pass muster during a possible IRS audit. Textron was trying to shield the documents under the Work-Product Doctrine.

Work-Product Doctrine

The Work-Product Doctrine shields an individual or business from having to turn over documents created in anticipation of litigation. The Doctrine traces its roots to a 1947 Supreme Court decision, Hickman v. Taylor, 329 U.S. 495. It protects material prepared in anticipation of litigation from being revealed to opposing lawyers in a court case. Seeing those materials gives an opponent the edge by sharing the other side’s legal strategy.

Tax Work Papers

Tax accrual work papers for public companies may never deserve work product immunity. Corporate taxpayers create work papers to comply with federal securities law. They exist exclusively because of financial accounting and disclosure requirements. Their creation occurs regardless of any prospect for future litigation.

Attorney-Client Privilege

One of the concerns of this case is that this may be an attack by the IRS on the Attorney-Client Privilege.  That privilege is broader and protects communications between clients and their lawyers. That privilege is not solely for communications that deals with anticipated litigation.

However, Textron, like most other public companies, showed the tax accrual papers to outside accountants. Once you send documents to someone other than the lawyers you have effectively removed attorney-client privilege over these documents.

Dangers of Email

One of the points to take away from this case is the danger of sending out blast emails to your lawyers, copying third parties who are not lawyers. If you do so, you have probably waived the attorney-client privilege for the contents of that email. It is all too easy to add others to the email distribution. Independent auditors do not enjoy confidential relationships with their clients for purposes of the attorney-client privilege.

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