Two Restatements Results in Settled SEC Financial Fraud Charges

The Commission filed a settled financial fraud action centered on three restatements against a company and two of its officers last fall. It charged violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). The cooperating company settled, consenting to the entry of a cease and desist order based on each Section cited in the Order and agreed to pay a penalty of $140 million. In the Matter of Weatherford International PLC, Adm. Proc. File No. 3-17582 (Sept. 27, 2016). The cooperation by the company was not specified.

Now a firm and its former CFO have settled financial fraud actions based on two restatements rather than three. The administrative Order as to the company, and the complaint as to the individual, each allege violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The cooperating firm consented to the entry of a cease and desist order based on each Section cited in the Order and paid a penalty of $500,000. The cooperation by the company was not specified. The former CFO consented to the entry of an injunction based on each Section cited in the complaint as well as a five year officer and director bar and agreed to pay disgorgement, prejudgment interest and a penalty totaling $238,692. In the Matter of Advanced Emissions Solutions, Inc., Adm. Proc. File No. 3-17892 (March 29, 2017); SEC v. McKinnies, Civil Action No. 17-cv-00566 (D.D.C. Filed March 29, 2017); See Lit. Rel. No. 23793 (March 29, 2017).

Advanced Emissions provides environmental solutions to customers primarily in the power generation industry. Its shares were de-listed from NASDAQ Capital Market at the end of March 2015 and later re-listed on NASDAQ Global Market. Defendant Mark McKinnies served as CFO, senior vice president, secretary and as a member of the board of directors during the period here.

Historically the firm’s internal controls suffered from material weaknesses. Those traced to as early as 2006 when the company reported a number of material weaknesses. In 2012 the firm reported similar material weaknesses in internal controls. The financial statements for 2010 and 2011 were restated.

Two years later Advanced Emissions announced that its financial statements for 2013 and 2011- 2012 should not be relied on. The firm then failed to file any periodic reports with the Commission for almost two years. Ultimately Advanced Emissions restated its financial statements for 2011 through 2013, as well as some line items dating to earlier periods, in its 2014 annual report on Form 10-K, filed in February 2016. In that report the company identified five material errors:

Failure to record loss contingency: In 2013 the firm failed to record the long-term liability associated with a portion of an adverse arbitration ruling. The arbitration arose from a dispute with a manufacturer. In 2011 an arbitration panel issued an interim adverse ruling against the company, holding it liable for $37.9 million in damages and jointly and severally labile for an amount calculated as a percentage of the gross revenues generated by a joint venture through 2018. Under an indemnity Advanced Emissions was required to pay the full amount of the joint and several award. GAAP requires that a loss contingency be recorded if the loss is probable and reasonably estimable. The CFO and board of directors expressed concern that the company not be put in a difficult competitive position because of its financials. While spreadsheets were created internally showing the obligations under the indemnification after the award, and again later after a settlement of the issue, the amount was not record until the 2014 restatement. At that time a long term liability of $25.9 million was recorded which materially increased long term liabilities.

Premature revenue recognition: The firm routinely entered into long term contracts. It accounted for those agreements using a percentage of completion method based on the labor hours. GAAP permits this methodology but only if the contractor can make reasonably dependable estimates of its hours as well as those of subcontractors. Here the firm could estimate its hours which typically were at the front end of the contract. It failed to include those for another manufacturer used in the process. The hours for that manufacturer were the most significant part of the contract and typically came later in the process. That resulted in the premature recognition of revenue on the contract. The error was corrected in the second restatement resulting in a reduction of previously reported revenues of over $24 million.

Warranty accruals: Advanced Emissions instituted a policy that resulted in systematic over-accrual of warranty liabilities. When the error was discovered the firm failed to make the necessary correction. Generally, the firm reserved 1-2% of expected revenues on each project for the equipment warranty and 2% – 5% of expected revenues for the performance warranty. An analysis undertaken in 2013 demonstrated that a significant portion of the warranties had expired. Under GAAP the reserves should have been reduced. The CFO instructed that the amount be reversed over a 10 month period rather than corrected. As part of the second restatement the appropriate reversals were made.

Consolidation: In 2007 Advanced Emissions had a 50% stake in Clean Coal Solutions. The firm consolidated the results of Clean Coal under existing guidance. FAS 167 was amended, however, in June 2009, to provide that an enterprise such as Advanced Emissions identify which activities most significantly impact an entity’s economic performance and determine if it had the power to direct those activities. The firm failed to conduct this analysis. In 2011 it sold a portion of the joint venture, reducing its stake to 42.5%. The FAS 167 analysis was not conducted. The firm continued to consolidate Clean Coal until the 2014 restatement. De-consolidating Clean Coal had a material impact on the financial statements.

Overstatement of revenues: Advanced Emissions also overstated revenue by failing to eliminate intercompany revenues in consolidation and because of inadequate accounting systems in a subsidiary. In August 2012 the firm’s wholly owned subsidiary acquired two related privately held entities. Following the purchase the CFO was informed that the subsidiary staff did not have any members with professional accounting training. Nevertheless, the firm reported the subsidiary’s revenues using a percentage of completion approach based on costs. That method requires the use of accurate data regarding costs and project status. Because that type of data was no available the reported revenue was inaccurate. The difficulty was compounded by the fact that the subsidiary failed to properly eliminate inter-company revenues.

Finally, in the second restatement the firm again concluded that its internal controls were ineffective. The restatement listed 15 material weaknesses grouped into three categories. Those categories included ineffective risk assessment, insufficient technical accounting expertise and ineffective information technology. Following the second restatement the firm had a significant change in leadership. Those changes included a new CFO, a new senior management team and a new director who became Audit Committee Chair.

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