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The possibility of material inaccuracies in a company’s reported financial statements may prompt an investigation that will have important ramifications for the company and its senior management. Counsel for the corporation will often play a significant role in the investigation, either conducting it or providing representation to the company throughout the inquiry. An investigation into a company’s accounting practices may be triggered by a variety of events. An anonymous letter from a former, or possibly disgruntled, employee may allege that the company has engaged in improper accounting practices. A new outside auditor may question aggressive or controversial accounting practices that prior auditors appear to have approved. Exercising its heightened responsibilities under the Sarbanes-Oxley Act, an audit committee may require further investigation of accounting issues that are brought to its attention. Such investigations often involve complex and evolving accounting rules that don’t make readily apparent whether the accounting practices under scrutiny are permitted or prohibited. The alleged impropriety may be based on estimates made by management over which reasonable executives may legitimately disagree. It is often unclear at the outset of such an investigation whether the outside auditors had approved of the practice in question, or whether management fully disclosed to the auditors all material facts relating to the accounting practice. The recent accounting scandals giving rise to Sarbanes-Oxley demonstrate the difficult issues that are typically encountered in such investigations. Enron, for example, involved allegations that the company misused complex accounting rules by failing to include in its consolidated financial statements debts owed by special-purpose entities. However, the Generally Accepted Accounting Principles (GAAP) in effect at the time permitted the exclusion of such debt under certain circumstances, provided there was the requisite independence between the company and the special-purpose entity. In the ensuing investigation, it has yet to be finally determined the extent to which Enron violated these accounting rules or the extent to which the real scandal is that GAAP permitted the use of special-purpose entities at all. Although Enron’s auditor, Arthur Andersen, was successfully prosecuted for the destruction of documents, it has not been clearly established whether Enron provided complete and accurate disclosure to its auditor regarding Enron’s use of special-purpose entities and whether the auditor fully approved of the practice. Accounting fraud still open issue The Global Crossing scandal likewise involved accounting rules-in that case, rules for recognizing revenue from contracts under which Global Crossing sold telecommunications-carrier bandwidth capacity for a designated period of time. These accounting rules changed substantially in 1999. The ongoing litigation will determine to what extent Global Crossing’s financial disclosure complied with those rules, and the extent to which its auditor approved the disputed accounting practices. Although Enron and Global Crossing both filed for bankruptcy amid charges that accounting fraud was used to disguise the companies’ insolvency, one cannot assume that accounting fraud exists each time allegations arise. Such allegations require a thorough investigation that does not assume the existence of fraud, but also is not blind to the possibility that fraud may exist. The company, and the interests of the shareholders, must be vigorously represented throughout the investigation. Errors and irregularities The initial focus of such an investigation is whether there are any errors or irregularities in the company’s previously issued financial statements. Generally speaking, the accounting literature defines an error as a mathematical mistake, a mistake in the application of accounting principles or an oversight or misuse of facts that existed at the time the financial statements were prepared. An error is the result of an unintentional mistake. When management intends to mislead investors, however, the accounting literature characterizes the misstatement as an irregularity; lawyers would call it fraud. Management’s efforts to conceal facts from the auditor, or to subvert the audit process, may be strong evidence of irregularities. When a company determines that there were errors or irregularities in previously issued financial statements, such statements must be corrected, or restated, if the inaccuracies are material. The determination of materiality is not based on magnitude alone. An intentional irregularity may be considered material, even though an unintentional error of the same magnitude might be immaterial, because it is important to advise investors of the intentional nature of management’s misconduct. The restatement of previously issued financial statements is a significant and unpleasant event for any public company. It constitutes an admission by the company that its financial statements were materially inaccurate and makes it difficult to defend against the shareholder litigation that is certain to arise. Under Sarbanes-Oxley, management may be required to repay any compensation that was based on the erroneous financial results, and managers may find themselves personally the target of Securities and Exchange Commission (SEC) and criminal investigations. When the investigation involves aggressive accounting practices under principles of GAAP that are controversial or evolving, it may be useful to obtain the opinion of independent accounting experts, in addition to the company’s outside auditor. For example, when an outside auditor questions a particular accounting practice that had been approved by previous auditors, an independent accounting expert may offer an additional perspective on the correct application of GAAP. In some circumstances, the company may determine to adopt a more conservative accounting practice going forward, but determine that there was sufficient support under GAAP for the prior practice and that it is not required to restate financial statements for prior periods. Of course, full disclosure with respect to change in accounting practice is required, and the audit committee and the auditor ultimately must agree with this approach. Changes in estimates Errors and irregularities also must be distinguished from changes in accounting estimates. A change in an estimate is generally the result of new information, or new circumstances, causing a change in the perception of an item previously accounted for. Accounts receivable, for example, are generally reported net of a reserve for bad debts based on management’s best estimate of uncollectible accounts. The sudden bankruptcy of a large customer, or other new circumstances causing management to increase the reserve for bad debt, would be considered a change in estimate. Changes in estimate result in accounting adjustments in the year in which new information causes the estimate to be changed. Financial statements for prior periods are not restated. However, if the information giving rise to the change was actually known by the company in prior years, and the information is not new, the prior financial statements may be erroneous and require restatement. An investigation into allegations concerning a company’s accounting often requires a determination as to whether a change is properly characterized as a change in estimate, on the one hand, or an error or irregularity, on the other. While this determination ultimately must be approved by the audit committee and the auditor, company counsel can play a significant role in ensuring that all pertinent facts are brought to bear on the issue. Example of a change in estimate For example, construction companies often record revenue earned on fixed-priced contracts under the percentage- completion method. Under this method, the company will estimate the proportion of the total project that has been completed in each reporting period and recognize as revenue that proportion of the total revenue to be earned from the project. Thus, when a company has completed 50% of the project, it will report 50% of the revenue. As with any long-term project, reality is not always consistent with management’s best estimates. Management may have assumed that it would take 10,000 labor hours to complete the job and record 50% of the revenue after 5,000 labor hours had been expended. Unforeseen developments, however, may cause management to realize that it will take additional labor hours to complete the project, and the project is no longer 50% completed. The current-period financial statements would then be adjusted to compensate for the fact that the company previously recorded more revenue than is now appropriate. As a change in estimate, however, prior financial statements would not be restated. A change in estimate, particularly if it is large, may call into question the bona fide use of the estimates in a prior reporting period. If the change in estimate resulted from facts actually known by the company during the prior period, the accounting rules may require a restatement of the prior-period reporting as an error. If management knew that the estimates were inaccurate and deliberately used erroneous estimates to deceive investors, there is fraud. A proper investigation, therefore, must make a determination as to whether the facts demonstrate a true change in estimate or whether there was an error in prior financial statements that must be restated. Counsel conducting such an investigation needs to review the manner in which the estimates were prepared and documented. Counsel should also determine whether sufficient controls were in place to ensure that the estimates were based on accurate information, and that the estimating process was not overridden by the desire to obtain particular financial results. Further, counsel should document that the new information on which the change is based was not known by management in the prior reporting periods. Independent experts Counsel should also consider retaining additional experts to assist such an investigation. Independent experts in the construction industry, for example, may assist in the determination of whether percentage-of-completion estimates were reasonably based on information available at the time they were made. Corporate counsel, and in some cases the audit committee, must also determine who will conduct an investigation into the company’s accounting practices. In many circumstances, it may be appropriate for the chief legal officer, or general counsel, to perform the investigation. In more significant matters, however, the audit committee may appoint independent counsel to report directly to the audit committee. General counsel nevertheless may play an important role in representing the company in such an investigation and ensuring the cooperation of management. In those instances in which in-house counsel may have been involved in the practices under inquiry, counsel should not play a role in the investigation. It is also important that all parties to the investigation have competent legal representation. It is often a useful precaution to retain separate counsel for certain managers, particularly those involved in financial reporting. Separate representation can ensure exchange of necessary information while preserving the attorney-client privilege and avoiding potential conflicts of interest. What must be disclosed? Corporate counsel must also consider what must be publicly disclosed about the investigation, and when such disclosure should be made. It may take several months, if not longer, to ascertain fully the extent of any errors or irregularities in a company’s financial statements. If it appears reasonably likely that a restatement will be made, it may be necessary to disclose the nature of the allegations, the fact that an investigation is under way and the approximate magnitude of the amount well before the investigation is concluded. Counsel likewise should consider opening informal dialogue with the SEC staff at an early opportunity. Finally, counsel should take care to notify the appropriate insurance carriers of facts that may give rise to a claim under the directors’ and officers’ liability insurance policies. In many jurisdictions, late notice to the carrier results in the loss of coverage, and the facts that give rise to the investigation may also give rise to an obligation to provide notice to the carrier. Sarbanes-Oxley certainly has minimized the likelihood of accounting fraud in a number of significant respects. However, there will always be gray areas under the accounting rules, accounting estimates about which reasonable people may disagree and allegations of accounting fraud. Sadly, accounting fraud itself will never disappear. The need for thorough investigations and vigorous representation by counsel will always be part of the financial landscape. Harry Frischer is a partner at New York’s Proskauer Rose. His practice focuses on litigating securities and accounting fraud cases. He can be reached at [email protected].

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