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News < Back Compliance : Sarbanes Oxley : Auditing : Management The Financial Restatement Process A Road Map For The Audit Committee
Thus, thoughtful management of the restatement process is critical for the financial and operational health and stability of the company. This will be the responsibility of the company?s audit committee, which is all but mandated by the Sarbanes-Oxley Act of 2002 to conduct its own internal investigation. The ability of the committee and its external advisers to conduct this internal investigation in an organized, efficient and comprehensive manner, while bringing the highest level of integrity to the process, is crucial to minimizing the harm to the company and maintaining credibility with the SEC and capital markets. The Rise of the Restatement Since the passage of Sarbanes-Oxley, the incidence of restatements has steadily increased. Huron Consulting Group reported that there were 414 public company restatements in 2004, representing a 28% increase over the 323 in 2003 and a 78% increase over the 233 in 2000. This increase is directly attributed to the passage of Sarbanes-Oxley and the implementation of its mandates, including the review of a public company?s internal controls over financial reporting required by Section 404; the certifications by the company?s CEO and CFO required by Sections 302 and 906; and the increased staffing of, and scrutiny by, the SEC required by Sections 408 and 601. The regulatory enhancements and increased scrutiny have made both internal financial personnel and external auditors more closely examine past positions. Particularly when these people are new to the company, they may object to past aggressive accounting positions to which Sarbanes-Oxley now makes them certify, occasionally resulting in the reversal of previous judgment calls and a restatement. The Discovery of an Accounting Issue Various provisions of Sarbanes-Oxley provide new and more specific ways for accounting issues to surface. Section 404 of Sarbanes-Oxley, requiring that the external auditor attest to management?s report on the company?s internal controls over financial reporting, has increased the level of the external auditor?s scrutiny of a company?s internal controls while decreasing the ?materiality? threshold for raising concerns. Issues may also be brought to light through the channels established by the audit committee for the receipt of complaints regarding accounting, internal accounting controls and auditing matters. This is required by Section 301 of Sarbanes-Oxley or by the enhanced whistleblower protection provided by Section 806. In most cases, the accounting issue spawning the need for a restatement is discovered in the course of a year-end audit by a new audit team of the company?s external auditors, a new external auditor or a new CFO. Since Section 203 of Sarbanes-Oxley requires that lead and concurring audit partners rotate off a client engagement every five years, companies are faced with a ?fresh look? at their financial statements at least every five years, with every public company facing at least some new members of its external auditing team by 2007. The certification requirements imposed by Sections 302 and 906 of Sarbanes-Oxley may cause a new CFO to scrutinize closely the company?s prior financial statements. These new participants in the audit process may find errors in, or disagree with, past accounting judgments, even those blessed by their predecessors, thereby creating the need for a restatement. Once a restatement is indicated, other prior judgment calls may be revisited and a more conservative treatment required. Persons with some responsibility for the initial error may try to find other problems that are not attributable to them to reduce their share of blame. Accordingly, additional issues will almost certainly arise after the initial one. Material accounting issues should be immediately reported to the company?s audit committee, which, since the passage of Sarbanes-Oxley, has assumed new responsibilities and prominence. It will be responsible for leading the company through any restatement process, internal investigation, SEC investigation and stockholder lawsuits, and it must immediately take a proactive role in controlling these matters. The Internal Investigation The audit committee?s first step will be to evaluate the need for, and scope of, an internal investigation. Such an investigation is often necessary to determine whether there has been any misconduct by a company employee, and is essentially required by Section 304 of Sarbanes-Oxley, which requires the forfeiture of certain incentive compensation and profits by the CEO and CFO if the restatement was the result of their misconduct. The committee?s decision to conduct an internal investigation will invariably lead to its hiring of outside counsel. Whether the audit committee engages the company?s current outside counsel or a completely independent law firm is its first major decision with far-reaching consequences. The committee must first try to determine whether it is dealing with a good-faith error or some kind of misconduct. If the audit committee believes that the restatement is stemming from a good-faith error, it should consider retaining the company?s current outside counsel to conduct the investigation since it already possesses a detailed understanding of the company?s business and SEC reporting and is familiar with members of the company?s board and senior management. Accordingly, regular outside counsel will be able to hit the ground running without needing time to familiarize itself with the company and, due to its familiarity with senior management, will be able to conduct the investigation in a more discreet manner that is viewed as less adversarial. If the committee takes this route, it needs to be comfortable that regular outside counsel is experienced in internal investigations; is not beholden to management; and clearly understands that its duty is to the company. While this route provides many efficiencies, it may open the audit committee to criticism that it has not conducted a truly independent investigation. In the case of an accounting error, regular outside counsel can take a number of steps to bolster its independence, including bringing different lawyers onto the investigation team and prohibiting communication with management regarding the results of the investigation. However, if the committee has a sense that the restatement is the result of some kind of misconduct, it should engage completely independent counsel to conduct the investigation to avoid any hint of a lack of independence. The committee must then take proactive steps to reduce possible inefficiencies from this route, including controlling the size of the investigation team and the number of lawyers who descend on the company at any one time, and serving as a source of information regarding both the company?s business and the personalities of management. Whether the audit committee chooses to engage regular outside or completely independent counsel, a separate engagement letter pertaining to the investigation should be executed with the chosen law firm. This engagement letter should specify that the company is the client and that this counsel will report to the committee. In cases where the committee has hired independent counsel, this formulation will help preserve the attorney-client privilege with respect to discussions between the independent and regular outside counsel. The audit committee and its counsel will then determine whether forensic accountants are necessary to ascertain the origin and extent, and to assist in discussions of, the accounting issues. If retained, forensic accountants should be hired by the committee?s counsel, and the engagement letter should be between this counsel and the accountants. This approach will help preserve the work product protection with respect to the work done by the accountants at the behest of counsel, and counsel will report to the committee on the accountants? findings. Note that the company?s outside auditor is not permitted to perform these services because of the prohibition on the provision of non-audit services in Section 201 of Sarbanes-Oxley, not to mention the inherent independence issues. The scope of the investigation and the form of the deliverables should be established in writing at the outset. Opinions vary on the amount of documentation that should accompany an internal investigation. While the audit committee wants to demonstrate that the investigation has been thorough and comprehensive, the compilation of a mass of documents may well not be in the best interest of the company since an SEC investigation will raise the privilege issues discussed below, and stockholder plaintiffs will seek all discoverable documents detailing the issues. Accordingly, the committee will want to instruct counsel carefully as to the appropriateness of oral or written reports with respect to particular issues. That said, the decision making of the board and the audit committee throughout the process should be clearly documented in board and committee minutes drafted by counsel. The Process Immediately upon learning that there is an issue, the audit committee must take appropriate steps to ensure that all relevant documents, e-mails and other potential evidence are retained. This includes the suspension of regular periodic ?clean-ups? of files and e-mails. As seen in recent prosecutions, the destruction of evidence, even if inadvertent, can often be more harmful than the accounting issue itself because of public allegations of ?cover-ups? and possible criminal liability. If there is any uncertainty as to the culpability of certain members of management, the audit committee should err on the side of excluding such persons from the investigative process until they have been cleared of any wrongdoing. All employees should be instructed to maintain the confidentiality of the investigation and not to discuss it among themselves. When it is clear that a restatement is necessary, the company is required by Item 4.02 of Form 8-K to disclose that any previously issued financial statements should no longer be relied upon. The company should also issue a press release in connection with the filing of the Form 8-K. Especially since the full extent of the issues may not be known at this time, the audit committee should take care to monitor the disclosure in these documents as management may be tempted to provide too much information in an attempt to explain the situation and downplay any wrongdoing, leading to required embarrassing updates in the future if these statements prove to be erroneous. Before public disclosure, the audit committee should instruct senior management to contact both the SEC and the company?s listing exchange. As discussed below, the SEC puts a premium on self-reporting and cooperation, so it should be contacted as soon as the company has a handle on the issue. Since the delisting process may move faster than the restatement process, discussions with the listing exchange should also be initiated at this time. It may also be prudent to inform the company?s primary creditor and rating agencies. By corralling the various players that are pivotal to the health of the company and informing them of the situation and the fact that it is being dealt with swiftly and thoroughly, it may be possible to coordinate their processes, stave off punitive actions and alleviate unnecessary future pressure on the company. Finally, since the restatement process can drag on for months and even years, during which the company will be unable to release the usual financial statements to investors, the scope and content of what can be disclosed concerning the company?s operations should be determined so that capital markets may be reassured about the ongoing viability of the company?s business. The SEC Investigation The SEC has made it clear that it puts a premium on cooperation, and that this cooperation includes reporting the issue to the SEC immediately after its discovery; conducting an internal investigation; sharing the results of such investigation with the SEC; and taking appropriate remedial actions. Informing the SEC of the issues and the commencement of an internal investigation will often stave off a formal investigation by the SEC and may mitigate any potential penalties or sanctions. The SEC will often be willing to wait to review the results of the internal investigation before taking any action. Part of the SEC?s idea of ?cooperation? includes the waiver of the attorney-client privilege in connection with the internal investigation. Since the SEC will want to review any documents or reports prepared as part of the internal investigation, the audit committee should clearly specify when it wants counsel to prepare a written report or deliver an oral report. Upon completing its investigation, counsel may choose to make an oral presentation, possibly accompanied by power point slides, to the audit committee and the board. Counsel may then make this presentation to the SEC and avoid the production of a detailed written report. Counsel will generally also provide the SEC with a chronology of the relevant documents, many of which will already have been publicly filed. The SEC may also request disclosure of the external auditor?s work papers with respect to the company?s audit. While the SEC views the refusal to waive the attorney-client privilege as a failure to cooperate, the audit committee should be aware of the potential pitfalls of such a waiver. By far the most significant implication is that the waiver of the privilege makes the documents and information provided to the SEC discoverable by plaintiffs in any stockholder lawsuits. In addition, depending on the issues, the company runs the risk of having otherwise privileged information used by others to extract harsher settlements or to have criminal charges initiated by the Department of Justice. An accounting error that is quickly remedied may not lead to stockholder suits or criminal penalties, making the waiver of the attorney-client privilege appropriate. Evidence of fraud or misconduct at the company, which may subject it to numerous stockholder suits and criminal prosecutions, may well give the audit committee pause before waiving the privilege. Obviously, the advice of counsel experienced in this area is a necessity. The SEC has endorsed the practice of entering into confidentiality agreements covering reports of internal investigations provided to the SEC in an attempt to preserve the attorney-client privilege with respect to third party litigants. While the company should enter into such a confidentiality agreement, there is a split among federal courts as to whether such a confidentiality agreement can preserve privileges with respect to disclosed materials. A safer course of action may be to have counsel deliver an oral report to the board and the SEC because, if the privilege is deemed to have been waived, there will be no written documents to discover. Conclusion By properly organizing and leading the inquiry from the beginning, the audit committee can ensure that an internal investigation will be comprehensive and constructive. When an effective internal investigation is timely disclosed to the appropriate governmental authorities, it will mitigate the risk of penalties and sanctions. Through its awareness of the potential issues and its organization and control of the process, the audit committee has the ability to prevent a financial restatement from causing the company?s downfall. 
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