Compliance & Financial Reporting Digest-January 2012
Editorial Comments:
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In this news digest, we have included some controversial or important financial reporting, tax, compliance and
SEC issues that we come across in our practice. The readers should perform their own research regarding the
applicability of these issues to their particular situations in consultation with their public accountants.
If you would like this publication to be emailed to your business associates or friends, please reply to this email
and include their names and email addresses.
A copy of this release has also been posted to our website http://www.internalcompliance.com under News
Digest.
SEC Enforcement Actions-Foreign Corrupt Practices Act (FCPA)
Background:
Washington, D.C., Feb. 6, 2012 — The Securities and Exchange Commission today charged London-based medical device
company Smith & Nephew PLC with violating the Foreign Corrupt Practices Act (FCPA) when its U.S. and German subsidiaries
bribed public doctors in Greece for more than a decade to win business.
Summary
Smith & Nephew PLC and its U.S. subsidiary Smith & Nephew Inc. agreed to pay more than $22 million in agreements with
the SEC and U.S. Department of Justice. The charges stem from the SEC’s and DOJ’s ongoing proactive global investigation of
bribery of publicly-employed physicians by medical device companies.
The SEC’s complaint against Smith & Nephew PLC alleges that its subsidiaries used a distributor to create a slush fund to
make illicit payments to public doctors employed by government hospitals or agencies in Greece. On paper, it appeared as
though Smith & Nephew’s subsidiaries were paying for marketing services, but no services were actually performed. The
scheme basically created off-shore funds that were not subject to Greek taxes to pay bribes to public doctors to purchase
Smith & Nephew products.
“Smith & Nephew’s subsidiaries chose a path of corruption rather than fair and honest competition,” said Kara Novaco
Brockmeyer, Chief of the SEC Enforcement Division’s Foreign Corrupt Practices Act Unit. “The SEC will continue to hold
companies liable as we investigate the medical device industry for this type of illegal behavior.”
The SEC alleges that the misconduct began in 1997, when Smith & Nephew’s subsidiaries developed a scheme to make
payments to three shell entities in the United Kingdom controlled by the distributor. Those funds were used by the
distributor to pay bribes to the Greek doctors on behalf of the Smith & Nephew subsidiaries. Smith & Nephew failed to act on
numerous red flags of bribery as employees at the company and its subsidiaries became aware of the payments. In one email exchange between employees at the U.S. subsidiary and the distributor concerning whether to reduce the distributor’s
commissions, the distributor stated, “… In case it is not clear to you, please understand that I am paying cash incentives right
after each surgery…” Smith & Nephew Inc. determined not to reduce the commissions.
For more information, please refer to: http://www.sec.gov/news/press/2012/2012-25.htm
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PCAOB Disciplinary Action for Sales Return Reserve Audit
Background:
In the audits of Pharmaceutical Corporation Medicis' Dec. 31, 2005, 2006 and 2007 financial statements, PCAOB found that
the external auditors (the “Auditors”) of Medicis failed to properly evaluate a material component of the company's financial
statements — its sales returns reserve.
Summary
PCAOB’s Order of February 8, 2012 against the Auditors of Medicis indicated that they failed to properly evaluate a material
component of Medicis's financial statements – its sales returns reserve. Specifically, the Auditors failed to comply with
PCAOB auditing standards in evaluating Medicis's sales returns reserve estimate, including evaluating Medicis's practice of
reserving for most of its estimated product returns at the cost of replacing the product ("replacement cost"). The audit
evidence available to the Auditors indicated that, at all relevant times, Statement of Financial Accounting Standards No. 48,
Revenue Recognition When a Right of Return Exists ("SFAS 48") applied to Medicis's product sales subject to a right of return
due to expiration and required Medicis to reserve for all of those estimated returns at gross sales price. Reserving for most of
its estimated returns at replacement cost, rather than gross sales price, resulted in Medicis's reported sales returns reserve
being materially understated and its reported revenue being misstated. Overall, the Auditors' approach to evaluating
Medicis's sales returns reserve methodology and estimate was inconsistent with their obligations to exercise professional
skepticism as the Company's independent auditors.
At all relevant times, SFAS 48 applied to Medicis's revenue recognition for its product sales because Medicis gave its
customers the right to return expired product. Under SFAS 48, a company, which sells product subject to a right to return,
may recognize revenue from those sales transactions at the time of sale only if certain conditions, including the ability to
estimate the amount of future returns, are met. If those conditions are not met, revenue recognition must be postponed. If
they are met sales revenue and cost of sales reported in the income statement must be reduced to reflect estimated returns.
The audit evidence obtained by the Auditors indicated that reserving at replacement cost and not at gross sales price had a
material impact on Medicis's returns reserve estimate.
For more information, please refer to: http://pcaobus.org/News/Releases/Pages/02082012_DisciplinaryOrderEY.aspx
FASB Publishes Proposal for Impairment of Indefinite-Lived Intangible Assets
Background:
The Financial Accounting Standards Board (FASB) on January 25, 2012 issued for public comment a proposed Accounting
Standards Update on indefinite-lived intangible asset impairment testing that is intended to simplify impairment assessment
and reduce the recurring costs to comply with existing guidance while improving the consistency of testing methods among
long-lived asset categories for preparers. Examples of intangible assets subject to the proposal would include indefinite-lived
trademarks, licenses, and distribution rights. The standard would apply to all public, private, and not-for-profit organizations.
Summary:
The amendments would allow an organization the option to first assess qualitative factors to determine whether it is
necessary to perform the quantitative impairment test. An organization electing to perform a qualitative assessment no
longer would be required to calculate the fair value of an indefinite-lived intangible asset unless the organization determines,
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based on a qualitative assessment, that it is “more likely than not” that the asset’s fair value is less than its carrying amount.
Under the current guidance (FASB Accounting Standards Codification® Subtopic 350-30, Intangibles—Goodwill and Other—
General Intangibles Other than Goodwill), an organization is required to test an indefinite-lived intangible asset for
impairment, on at least an annual basis, by comparing the fair value of the asset with its carrying amount. If the carrying
amount of an indefinite-lived intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to
the difference.
“This proposed amendment is intended to reduce the cost of evaluating indefinite-lived intangible assets for impairment
without changing the information provided to investors,” said Leslie F. Seidman, chairman of the FASB. “The proposed
amendment is similar to the simplification that the Board issued last year relating to the impairment testing of goodwill.”
Comparison of the Proposal with IFRS:
IAS 36, Impairment of Assets, requires an entity to test an indefinite-lived intangible asset for impairment by
comparing its carrying amount with its recoverable amount. The impairment test must be performed annually
irrespective of whether there is any indication of impairment and in between annual tests whenever there is an
indication of impairment. IAS 36 allows an entity to carry forward the most recent detailed calculation of an asset’s
recoverable amount when performing its current period impairment test, provided that certain criteria are met.
The Board recognizes that the guidance in Topic 350 and IAS 36 will not converge as a result of these proposed
amendments. The Board concluded that such an effort is beyond the scope of this proposed Update and can only be
approached by more broadly addressing these and other differences in impairment guidance between U.S. GAAP and
IFRS.
The amendments in this proposed Update would be effective for annual and interim impairment tests performed for
fiscal years beginning after June 15, 2012. Early adoption would be permitted. The exposure draft is open for
comment until April 24, 2012 and can be accessed at http://www.www.fasb.org.
SEC Staff Accounting Bulletin: Effects of Prior Year Misstatements in Current Year
Financial Statements
Background:
SEC Staff Accounting Bulletins reflect the Commission staff's views regarding accounting-related disclosure practices. They
represent interpretations and policies followed by the Division of Corporation Finance and the Office of the Chief Accountant
in administering the disclosure requirements of the federal securities laws. SEC has codified these interpretations under
various topics. For the benefits of filers of the financial statements with SEC, we have decided to include some of these
interpretations in our Monthly News Digest in summary form. If you are interested in reviewing the full text of the
interpretation, we recommend that you refer to the SEC website using the URL provided at the end of this section.
Prior Year Misstatements
Facts: During the course of preparing annual financial statements, a registrant is evaluating the materiality of an improper
expense accrual (e.g., overstated liability) in the amount of $100, which has built up over 5 years, at $20 per year. The
registrant previously evaluated the misstatement as being immaterial to each of the prior year financial statements (i.e.,
years 1-4). For the purpose of evaluating materiality in the current year (i.e., year 5), the registrant quantifies the error as a
$20 overstatement of expenses.
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Question 1: Has the registrant appropriately quantified the amount of this error for the purpose of evaluating materiality for
the current year?
Interpretive Response: No. In this example, the registrant has only quantified the effects of the identified unadjusted error
that arose in the current year income statement. The staff believes a registrant’s materiality evaluation of an identified
unadjusted error should quantify the effects of the identified unadjusted error on each financial statement and related
financial statement disclosure.
Topic 1M notes that a materiality evaluation must be based on all relevant quantitative and qualitative factors. This analysis
generally begins with quantifying potential misstatements to be evaluated. There has been diversity in practice with respect
to this initial step of a materiality analysis.
The diversity in approaches for quantifying the amount of misstatements primarily stems from the effects of misstatements
that were not corrected at the end of the prior year (“prior year misstatements”). These prior year misstatements should be
considered in quantifying misstatements in current year financial statements.
The techniques most commonly used in practice to accumulate and quantify misstatements are generally referred to as the
“Rollover” and “Iron Curtain” approaches.
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The Rollover Approach, which is the approach used by the registrant in this example, quantifies a misstatement
based on the amount of the error originating in the current year income statement. Thus, this approach ignores the
effects of correcting the portion of the current year balance sheet misstatement that originated in prior years (i.e., it
ignores the “carryover effects” of prior year misstatements).
The Iron Curtain approach, which quantifies a misstatement based on the effects of correcting the misstatement
existing in the balance sheet at the end of the current year, irrespective of the misstatement’s year(s) of origination.
Had the registrant in this fact pattern applied the Iron Curtain approach, the misstatement would have been
quantified as a $100 misstatement based on the end of year balance sheet misstatement. Thus, the adjustment
needed to correct the financial statements for the end of year error would be to reduce the liability by $100 with a
corresponding decrease in current year expense.
Weakness of the Rollover Approach
As demonstrated in this example, the primary weakness of the Rollover Approach is that it can result in the accumulation of
significant misstatements on the balance sheet that are deemed immaterial in part because the amount that originates in
each year is quantitatively small. The staff is aware of situations in which a registrant, relying on the Rollover Approach, has
allowed an erroneous item to accumulate on the balance sheet to the point where eliminating the improper asset or liability
would itself result in a material error in the income statement if adjusted in the current year. Such registrants have
sometimes concluded that the improper asset or liability should remain on the balance sheet into perpetuity.
Weakness of the Iron Curtain Approach
In contrast, the primary weakness of the Iron Curtain approach is that it does not consider the correction of prior year
misstatements in the current year (i.e., the reversal of the carryover effects) to be errors. Therefore, in this example, if the
misstatement was corrected during the current year such that no error existed in the balance sheet at the end of the current
year, the reversal of the $80 prior year misstatement would not be considered an error in the current year financial
statements under the Iron Curtain approach. Implicitly, the Iron Curtain approach assumes that because the prior year
financial statements were not materially misstated, correcting any immaterial errors that existed in those statements in the
current year is the “correct” accounting, and is therefore not considered an error in the current year. Thus, utilization of the
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Iron Curtain approach can result in a misstatement in the current year income statement not being evaluated as an error at
all.
Staff Position
The staff does not believe the exclusive reliance on either the rollover or iron curtain approach appropriately quantifies all
misstatements that could be material to users of financial statements. In describing the concept of materiality, Concepts
Statement 2, Qualitative Characteristics of Accounting Information, indicates that materiality determinations are based on
whether “it is probable that the judgment of a reasonable person relying upon the report would have been changed or
influenced by the inclusion or correction of the item” (emphasis added). The staff believes registrants must quantify the
impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the
current year financial statements. The staff believes that this can be accomplished by quantifying an error under both the
Rollover and Iron Curtain approaches as described above and by evaluating the error measured under each approach. Thus, a
registrant’s financial statements would require adjustment when either approach results in quantifying a misstatement that
is material, after considering all relevant quantitative and qualitative factors. As a reminder, a change from an accounting
principle that is not generally accepted to one that is generally accepted is a correction of an error.
The staff believes that the registrant should quantify the current year misstatement in this example using both the Iron
Curtain approach (i.e., $100) and the Rollover approach (i.e., $20). Therefore, if the $100 misstatement is considered material
to the financial statements, after all of the relevant quantitative and qualitative factors are considered, the registrant’s
financial statements would need to be adjusted. Correcting prior year financial statements for immaterial errors would not
require previously filed reports to be amended. Such correction may be made the next time the registrant files the prior year
financial statements.
For more information, please refer to: http://www.sec.gov/interps/account/sabcodet1.htm#N
Fraud Analysis and Preventions
Background:
It will come as no surprise to anyone that confidence in corporate America has been shaken by a series of accounting
scandals. The scandals of Enron and Parmalat and others have heightened sensitivities over the role structured financing has
played in questionable accounting practices. As business combinations have become more complicated and reports of
accounting scandal and fraud become more prevalent, other authorities have intervened
Because of the significance of fraud prevention program and controls, in our monthly edition of News Digest, we will focus on
basic elements of fraud, evaluating the risks of fraud and discussing ways to implement the processes, procedures, and
controls needed to mitigate such risks. This program identifies a number of different fraud schemes and concentrates on the
types of fraud committed against small businesses by those outside the organization, as well as examining the relevance and
importance of §404 of the Sarbanes-Oxley Act for public companies.
In this edition, we have focused on Consideration of Fraud in a Financial Statement Audit. In our future News Digests, we will
discuss other aspects of fraud such as evaluation risk of fraud and controls mitigating the risk of fraud.
Summary
SAS No. 99, Consideration of Fraud in a Financial Statement Audit (AU §316.06), defines fraudulent financial reporting as:
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“Intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive
financial statement users where the effect causes the financial statements not to be presented, in all material
respects, in conformity with generally accepted accounting principles (GAAP).”
Fraudulent Financial Reporting
Fraudulent financial reporting may be accomplished by the following:
1. Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements
are prepared
2. Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant
information
3. Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or
disclosure
Rationalizing Material Misstatements
Fraudulent financial reporting need not be the result of a grand plan or conspiracy. It may be that management
representatives rationalize the appropriateness of a material misstatement, for example, as an aggressive rather than
indefensible interpretation of complex accounting rules, or as a temporary misstatement of financial statements, including
interim statements, expected to be corrected later when operational results improve.
Informational Infrastructure
Financial reporting serves as the informational infrastructure of financial information. That is to say, financial reporting
provides decision makers, both inside and outside the organization, with reliable financial data they need to make informed
decisions. Financial reporting objectives address the preparation of reliable published financial statements, including interim
and condensed financial statements and selected financial data derived from such statements, such as earnings releases,
reported publicly. Entities need to achieve financial reporting objectives to meet external obligations. Reliable financial
statements are a prerequisite to obtaining investor or creditor capital, and may be critical to the award of certain contracts or
to dealing with certain suppliers. Investors, creditors, customers, and suppliers often rely on financial statements to assess
management's performance and to compare it with peers and alternative investments.
Reliable Information
The term "reliability," as used with financial reporting objectives, involves the preparation of financial statements that are
fairly presented in conformity with generally accepted or other relevant and appropriate accounting principles and regulatory
requirements for external purposes. Fair presentation is defined as:
1. The accounting principles selected and applied have general acceptance.
2. The accounting principles are appropriate in the circumstances.
3. The financial statements are informative of matters that may affect their use, understanding, and interpretation.
4. The information presented is classified and summarized in a reasonable manner, that is, it is neither too detailed nor
too condensed.
5. The financial statements reflect the underlying transactions and events in a manner that presents the financial
position, results of operations and cash flows within a range of acceptable limits, that is, limits that are reasonable
and practical to attain in financial statements.
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Corporate Ethical Climate
Corporate ethical climate can be defined as follows:
1. Financial statements are the responsibility of an organization's management. Therefore, it is usually management
who commits financial statement fraud, although it can be perpetrated by anyone with the opportunity and the
motive to omit or misstate information in the financial statements. Financial statement fraud is generally
instigated by members of management, or by persons under the direction and control of management.
2. An organization's board of directors and senior management generally set the code of conduct for the
organization. This code of conduct is often referred to as the company's "ethic." This ethic is the standard by
which all other employees tend to conduct themselves.
3. Judgments and management styles.
4. Because an entity's good reputation is so valuable, the standards of behavior must go beyond mere compliance
with law. In awarding reputation to the best companies, society expects more than that.
5. Integrity is a prerequisite for ethical behavior in all aspects of an entity's activities.
6. A strong corporate ethical climate at all levels is vital to the well-being of the corporation
7. Establishing ethical values is often difficult because of the need to consider the concerns of several parties. Top
management's values must balance the concerns of the enterprise, its employees, suppliers, customers,
competitors, and the public.
8. Managers of well-run enterprises have increasingly accepted the view that "ethics pays"—that ethical behavior is
good business.
9. Focusing solely on short-term results can hurt even in the short term. Concentration on the bottom line—sales or
profit at any cost—often evokes unsought actions and reactions. High-pressure sales tactics, ruthlessness in
negotiations or implicit offers of kickbacks, for instance, may evoke reactions that can have immediate (as well as
lasting) effects.
10. Ethical behavior and management integrity are a product of the "corporate culture." Corporate culture includes
ethical and behavioral standards, how they are communicated and how they are reinforced in practice. The CEO
usually is the dominant personality in the organization, and individually often sets its ethical tone.
Incentives and Temptations
1. A study by the Financial Executives Research Foundation suggested that certain organizational factors can influence
the likelihood of fraudulent and questionable financial reporting practices. Those same factors also are likely to
influence ethical behavior.
2. Individuals may engage in dishonest, illegal, or unethical acts simply because their organizations give them strong
incentives or temptations to do so. Emphasis on "results," particularly in the short term, fosters an environment in
which the price of failure becomes very high.
3. Incentives cited for engaging in fraudulent or questionable financial reporting practices and, by extension, other
forms of unethical behavior are:
a. Pressure to meet unrealistic performance targets, particularly for short-term results
b. High performance-dependent rewards
c. Upper and lower cutoffs on bonus plans
4. The study also cites "temptations" for employees to engage in improper acts:
a. Nonexistent or ineffective controls, such as poor segregation of duties in sensitive areas, that offer
temptations to steal or to conceal poor performance
b. High decentralization that leaves top management unaware of actions taken at lower organizational
levels and thereby reduces the chances of getting caught
c. A weak internal audit function that does not have the ability to detect and report improper behavior
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d. An ineffective board of directors that does not provide objective oversight of top management
e. Penalties for improper behavior that are insignificant or unpublicized and, thus, lose their value as
deterrents
5. Removing or reducing these incentives and temptations can go a long way toward diminishing undesirable behavior.
As suggested, this can be achieved following sound and profitable business practices. For example, performance
incentives—accompanied by appropriate controls—can be a useful management technique as long as the
performance targets are realistic. Setting realistic performance targets is a sound motivational practice; it reduces
counterproductive stress as well as the incentive for fraudulent financial reporting that unrealistic targets create.
Similarly, a well-controlled reporting system can serve as a safeguard against temptation to misstate performance.
Materials included in this News Digest extracted from Montgomery Auditing and Fraud 101: “A Basic Guide for Auditors”
published by Bisk Education, Inc.
Please direct any comments or questions regarding this digest to Saiid Shahabi, CEO of Internal Compliance
Corporation (“ICC”) via the following contact information:
Phone: (408)379-1100, Email: Shahabi@internalcompliance.com
For information about ICC services, please refer to ICC website http://www.internalcompliance.com/
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