Navigating The Minefield In The Economic Downturn: Financial And Legal Lessons From The Trenches

Thursday, January 1, 2009 - 00:00

Editor: Please describe your practice areas.

Palmer Winig: Ernst & Young's Fraud Investigation & Dispute Services practice helps companies find ways to manage risk, investigate alleged misconduct and measure the financial implications of disputes. My practice focuses on investigating alleged accounting errors and irregularities in financial statements on issues such as revenue recognition, reserves and estimates and other matters.

Kolovos: My practice focuses on securities litigation and enforcement matters. I represent public companies and their officers and directors in federal and state securities fraud class actions, derivative litigation, and SEC, DOJ, and other regulatory investigations. I also have conducted internal investigations on issues such as revenue recognition, options backdating, and earnings management.

Editor: What impact has the current economic downturn had on corporations?

Palmer Winig: All companies are being affected by the current economic recession and credit crisis. Spending by corporations and individuals has rapidly declined resulting in decreases in operating cash flows. Companies are revisiting their current strategies, focusing on operating cash flows and considering expense control measures. Many observers anticipate that workforce reductions, corporate restructuring and other cost reductions will continue in the near term.

Kolovos: Many companies have been accustomed to ready access to cash, through lines of credit or public or private financing. In the current environment, companies' access to financing may be significantly constrained. Even when financing is available, companies have less flexibility in modifying or replacing it when needed. Their customers and vendors are experiencing the same credit crunch, which means that there is strain in all phases of the operation.

Editor: What challenges does this present to corporations?

Kolovos: Most businesses are still highly focused on delivering results. Most are also dealing with liquidity issues and the impact of the erosion in their market capitalization. In the past, there was little risk that a company would fail to meet its debt covenants, or if it did, that it would be unable to obtain a waiver from its lenders. Not so now.

This renewed focus on issues that, in the recent past, were essentially taken for granted is also being seen at the regulatory level. The SEC made it clear years ago that it wants well-developed disclosure about the challenges that issuers face. But now, more than ever, companies face risks that originate outside of the company's own "four walls." Companies need to assess not only their own challenges, but also those of their customers, vendors, lenders and other sources of capital. So perhaps not surprisingly, we've been seeing more comments from the SEC on issuer disclosures, particularly in the areas of liquidity and known trends and uncertainties. Palmer Winig: But even against the difficult economic backdrop, companies are still focused on delivering strong financial results. The pressures on management and boards of directors are significant and coupled with the expectation for companies to do more with fewer resources.

Many companies built their internal controls, compliance systems and processes in the years of economic expansion after the adoption of the Sarbanes-Oxley regulations. Now, reductions in workforce, corporate reorganizations and other cost-cutting measures will place new stresses on the effectiveness of those systems. In particular, we have seen reductions in internal audit and other corporate compliance areas.

At the same time, regulation and scrutiny over financial reporting remains intense. Just this month, Lori Richards, the director of the SEC's Office of Compliance, Inspections and Examinations, told chief executives of financial services firms they must keep up their compliance programs despite undertaking cost-cutting measures.

The bottom line is that this financial reporting and compliance season will be more challenging. Subjective, judgmental and non-standard transactions will need to be closely evaluated, which is even more challenging when the institutional knowledge may no longer be with the organization.

Editor: Are there particular financial reporting or fraud risks that companies should look for during these times?

Palmer Winig: Forensic professionals have long said that fraud risk is greatest when three conditions are present: Pressure, Opportunity, and Rationalization.

There may be intense pressure on organizations to meet earnings expectations and maintain compliance with debt covenants. It's do or die time for some businesses. At the same time, many individuals are under intense personal pressures as a result of their own personal circumstances.

Workforce reductions, reorganizations and other cost-cutting measures may create opportunities to circumvent controls if existing compliance programs have been reduced or are not focused on the appropriate risks. Rationalization of questionable behavior may become easier in more difficult economic times as some individuals may view it as necessary to operate in the "gray areas" in these difficult times.

Kolovos: Put another way, a "perfect storm" may be forming. There's a common theme in most of the revenue recognition investigations I have done - the pressure to make a quarterly goal.

For example, when companies see a decline in revenue, they may be more inclined to offer incentives, such as future discounts and extended payment terms, or to bundle products and services in new ways that may call for the application of more complex revenue recognition models.

This pressure is also felt at the individual employee level. The need to achieve a sales quota can lead employees to agree to a non-standard deal term in order to get that sale done by quarter-end. If these terms are not identified and accounted for by controllership, that leads to the accounting error.

Given the current economic environment, these pressures are only exacerbated. And as employees see their 401K balances cut in half, it's only human nature to look for any opportunity to close a sale, even if a little "creativity" is required, whether they do so to increase compensation or to enhance their job security.

Palmer Winig: And it's a perfect storm because, at the same time these financial pressures are on the rise, companies are forced to undertake cost-cutting measures that may include the very functions intended to mitigate these risks - such as identify these "red flag" deal terms. What does all this mean? We can expect more financial reporting errors. Other than revenue recognition, one can also expect financial reporting errors related to earnings management through judgmental reserves or the inappropriate capitalizations of certain costs. It is important to remember, the underlying cause of these errors is not just meeting earnings expectations; it may also be the need to comply with debt covenants.

And if I could just briefly touch on two other risk areas: Bribery and corruption continue to be areas of regulatory enforcement. The global nature of business and the economic downturn, coupled with the increased pressure for revenue transactions, creates an increased risk of bribery, kickbacks, conflicts of interest and other kinds of corruption.

Asset misappropriation can occur when employees or outsiders use deception to steal corporate cash or physical assets. As more individuals are under intense personal financial pressure, we can reasonably expect to see more theft among the rank-and-file employees, management embezzlement, and abuse of trust at the highest levels.

Editor: What can companies do to mitigate these risks?

Palmer Winig: At first blush, it may seem hopeless. After all, fraud risks have been present since the dawn of time, and given the many other pressures businesses are facing, this might not be the first on the list. Nonetheless, maintaining skepticism and an awareness of fraud is a critical element of prevention.

As we discussed earlier, many companies have robust internal controls, compliance systems and processes. These systems were not meant to be static but flexible to adjust to the risk and changes within the organization.

Now is the time to revisit your internal controls to confirm they are adequately addressing the most significant risks. The first step is to triage the immediate challenges by assessing whether market changes have created new risks and/or exacerbated existing ones. Focus on whether a structural change has rendered an existing control ineffective and how to adjust the control to properly mitigate the risk. I would start with the most significant financial reporting risks the company must address in the next reporting cycle. While revenue recognition is generally a high-risk area, corporations should closely evaluate their debt covenants and consider if their significant judgments and estimates are free of management bias and if there is a need for any changes in reserve methodologies. For example, in the current environment, is it reasonable to assume there will not be an increase in bad debt expense in future periods?

Kolovos: Now is the time to really scrutinize your public disclosures and update your risk factors. Don't just use a "form." Too many things have changed to simply use your prior disclosures as a template.

Make sure you have the documentation needed to support your public disclosures, particularly on current "hot button" topics such as liquidity and access to credit markets. For example, if Lehman was your source for capital in the past, where does it come from now? Because of the need to re-evaluate all of these items, it is taking longer to prepare public disclosures. So here is a very practical suggestion: companies should revise their announcement calendars and work backwards to provide adequate time to prepare and review their filings.

Palmer Winig: When it comes to making judgments about specific transactions, remember that financial reporting judgments often are second-guessed long after the fact and can often be challenging to defend as the documentation for the basis of these judgments is generally sparse. The quality of the documentation impacts how outsiders view these difficult judgments. While two reasonable people may not always come to the same conclusion, the best defense is robust documentation that describes the basis and any related evidential matter for any significant judgment, such as a revenue transaction or a reserve, which is well worth the amount of time - and the investment - spent drafting this documentation.

As I mentioned earlier, now is the time to update your fraud and compliance risk assessment, as it will prove invaluable in providing the best and highest use of potentially limited resources. This also provides a means to build consensus with the various stakeholders such as employees, audit committees and boards of directors,

Kolovos: And one last point from the legal perspective. If you do find a financial reporting error, deal with it, and do so in the right way. Work with your auditors and legal counsel to determine whether the error is material, whether you need to make a corrective public disclosure, whether employee discipline is warranted, and whether other remedial steps should be taken to address the error, and make sure it does not happen again. Make sure you preserve the relevant documents. And consider whether to affirmatively alert the SEC to the error, including offering background about why the error occurred and detailing your remedial actions. Based on my recent dealings with the SEC staff, the strength of a company's compliance programs and the depth of its remedial actions continue to be important factors in how the SEC looks at cases of financial fraud and reporting errors.

Palmer Winig: Without doubt, it is going to be a difficult cycle. While financial reporting and fraud risks may be greater, companies have the tools in place to navigate the minefield. But remember a heightened awareness; triaging the most critical risks and acting upon them will make all the difference.

The views expressed are those of the authors, and not those of Ernst & Young LLP.

Please email the interviewees at carol.palmer@ey.com or peter.kolovos@wilmerhale.com with questions about this interview.