SEC Enforcement Action Highlights Importance of Internal Controls

The Commission’s action against PACCAR Inc, a commercial truck manufacturer, emphasizes the importance of good internal accounting controls. SEC v. PACCAR Inc., Civil Action No. 2;13-cv-00953 (W.D. Wash. Filed June 3, 2013). The case centers on three separate errors in the financial reporting of the company. Each traces to deficiencies in the internal accounting controls of the company.

The errors occurred in the period 2008 through the third quarter of 2012. During that period the Fortune 200 manufacturer and distributor of trucks and related aftermarket parts sold under the nameplates Kenworth, Peterbilt and DAF, reported two segments in its Commision filings. One was for trucks and aftermarket part sales and the other for financial services. Errors occurred in each segment.

Reportable segment: In its Form 10-K for the period ended December 31, 2009 PACCAR did not separately report income before taxes from truck sales and aftermarket part sales. GAAP, and the applicable Commission rules, require an issuer to report select information about reportable segments. A reportable segment is one which engages in business activities from which it may earn revenues and incur expenses, has operating results regularly reviewed by the chief operating decision maker and has discrete financial information available. The point is to permit investors to view the entity through the eyes of management.

Here PACCAR parts maintained separate internal financial statements which were regularly reviewed by its chief operating decision maker. Company executives viewed the business as a segment, a point reflected by internal strategic planning materials which divided the overall business into three segments — trucks, parts and financial services. By failing to include segment information in the Form 10-K, the company violated GAAP — investors could not see the results available to company executives. Those showed that the reported pre-tax income of $68 million resulted from the combination, before certain shares expenses, of a $474 million loss from the truck segment and a $542 million profit from the part sales.

Impaired receivables: PACCAR and its related finance company, defendant PACCAR Financial Corporation, understated impaired receivables and the associated specific reserve in the financial statement notes to the 2009 Form10-K, according to the complaint. In that filing the company failed to disclose that all of its non-accrual receivable as of year end were impaired. This resulted in a 24% understatement. It also failed to include all troubled debt restructurings in its impaired receivables disclosure. This resulted in a 39% understatement of impaired receivables. Likewise, the company failed to disclose the impairment of leases to its two largest past due customers, despite concerns of executives who were monitoring them. This resulted in a 64% understatement from what was actually reported for impaired receivables.

Retail loans and direct financing leases: The company overstated the amount of (a) retail loans and direct financing leases originated and (b) collections on retail loans and direct financing leases in its consolidated Statement of Cash Flows for the quarters ended June 30, 2009 and September 30, 2009. The amounts were equal and offsetting so there was no change to the amount of net cash provided by investing activities reported. The company identified these errors during the first quarter of 2010 and acknowledged them, along with the others, in comment letters in responses to the Commission staff.

While the complaint states that the errors resulted from inadequate internal controls and policies and procedures, it also acknowledges that the company has implemented remedial measures. It alleges violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B).

The company resolved the action, consenting to the entry of a permanent injunction prohibiting future violations of the Sections cited in the complaint. It also agreed to pay a civil monetary penalty of $225,000. The settlement takes into account the remedial actions of the company.

ABA Seminar: Fifth Annual FCPA Update: Protecting Your Business in the Future: Lessons from the New DOJ-SEC FCPA Guide, June 19, 2013 from 1:00 -2:30 p.m. EST. The discussion will focus on building effective compliance systems and conducting M&A due diligence. Co-moderators: Thomas Gorman and Frank Razzano. Panel: John Buretta, Principal Deputy to the Assistant AG, DOJ; Charles Cain, Assistant Director, FCPA Unit, SEC Division of Enforcement; Catherine Razzano, Assistant General Counsel, General Dynamics Corporation; Steve Siegal, Senior Counsel, Northrop Grumman Corporation; Ryan Ong, President, U.S. China Business Counsel. Live in Washington, D.C at 600 14^th St. N.W., Penthouse (no charge for ASECA members attending live in Washington who pre-register by sending an e-mail to cvitko.diane@dorsey.com). Webcast nationally by the ABA and available in other Dorsey & Whitney offices. For further information please click here.

The SEC Should Make Financial Fraud an Enforcement Priority Now

At the Financial Reporting Institute Conference last week SEC Commissioner Walter and Chief Accountant Paul Beswick addressed the necessity for high quality financial reporting, the application of international accounting standards or IFRS and the work of the Public Company Accounting Oversight Board. Commissioner or PCAOB. Elisse B. Walter, Keynote Luncheon Speech, 32^nd Annual SEC and Financial Reporting Institute Conference, Pasadena CA. (May 30, 2013)(here); Paul Beswick, Chief Accountant, Remarks at the 32^nd Annual SEC and Financial Reporting Institute Conference, Pasadena, CA. (May 30, 2013)(here). What was not addressed is the significant decline in Commission enforcement actions involving issuer financial fraud.

Commissioner Walter and Mr. Beswick stressed in their remarks the importance of the international accounting standards. As Commissioner Walter stated: “We are seeing this dynamic play out in the FASB and IASB priority Convergence projects . . . This progress is a positive development, with both the FASB and the IASB showing great skill in working together to create common standards that will effectively serve investors the world over . . . I continue to look forward to a day when there is one set of global accounting standards, and we are taking a number of steps in that direction at the SEC . . . “

Chief Accountant Beswick echoed the Commissioner’s statements, emphasizing the point that international standards are critical to U.S. investors: “[T]he reason that IFRS matters to the U.S. is that the U.S. is heavily invested in companies that prepare their financial statements using IFRS.” There are currently 450 foreign private issuers who file reports with the Commission using IFRS without reconciliation to U.S. GAAP.” Similarly, about 40% of the financial institutions reviewed by the large financial institutions group in the Division of Corporation Finance use IFRS. Overall there are untold amounts of capital invested through mutual funds and direct financial investments in jurisdictions that require or permit use of IFRS. Accordingly, the Commission staff closely monitors and participated in the development of these standards.

The Commissioner and the Chief Accountant also stressed the important work of the PCAOB in this area. Since the creation of the Board in 2002 in the Sarbanes-Oxley Act, over 2,300 audit firms have registered with it. Mr. Beswick noted its success in establishing cooperative arrangements with its foreign counter-parts: “So I’ll start by acknowledging the significant progress the PCAOB has made in reaching new cooperative agreements and developing stronger relationships with a growing number of non-U.S. regulators.” Although the recent MOU establishing a framework for making audit work papers available with the Chinese counter parts of the Board was not mentioned, it clearly represents a significant development (here).

Commissioner Walter emphasized two points she would like to see the Board focus on in the future. The first centers on “updating and maintaining their performance standards and quality control which have the most direct effect on how audits are performed. High quality audit standards that set clear expectations for auditor performance are absolutely critical to our financial system.”

A second priority for the Board, according to Commissioner Walter, should be inspections: “[E]xpanding the PCAOB’s ability to perform inspections in certain jurisdictions outside the U.S. . . “ should be a key focus. In this regard the recent MOU with PRC officials may be most significant since it holds the promise of continued talks which might result in cross-boarder inspections.

What was not mentioned is enforcement. While standard setting is clearly important, effective implementation requires consistent enforcement. Over the years financial fraud has been a critical focus for the SEC. In recent years, however, the number of actions brought in this area has significantly declined, according to a report issued earlier this year by Cornerstone Research (here).

The decline in financial fraud cases could be based on the success of the Sarbanes Oxley and the Board. At the same time, that point seems difficult to fully harmonize with the findings in the same Cornerstone Report that about 60% of the securities class actions being brought center on financial and related disclosure issues. Concerns raised by that finding are bolstered by the fact that a significant number of CFO’s who responded to a recent E&Y survey stated that they would be willing to engage in improper conduct to win business for the firm (here). These factors suggest that if accounting principles are going to accurately reflect the substance of transactions, enforcement by the SEC continues to be important.

Recent reports that the agency may again be focusing on financial fraud and is developing a computer program to read the tags on Edgar filings, seems to recognize this point. While searches on a computer are a good start, they are not enough. Someone has to analyze the financial data and conduct what are often difficult investigations. That takes expertise and dedication which requires time to develop. Now is that time. Before the next scandal emerges – and history tells us there will be one – the SEC has the opportunity to get ahead of the curve. Now is the time to form a specialty group focused on financial fraud, develop the expertise and make rooting out financial fraud a priority.

ABA Seminar: Fifth Annual FCPA Update: Protecting Your Business in the Future: Lessons from the New DOJ-SEC FCPA Guide, June 19, 2013 from 1:00 -2:30 p.m. EST. The discussion will focus on building effective compliance systems and conducting M&A due diligence. Co-moderators: Thomas Gorman and Frank Razzano. Panel: John Buretta, Principal Deputy to the Assistant AG, DOJ; Charles Cain, Assistant Director, FCPA Unit, SEC Division of Enforcement; Catherine Razzano, Assistant General Counsel, General Dynamics Corporation; Steve Siegal, Senior Counsel, Northrop Grumman Corporation; Ryan Ong, President, U.S. China Business Counsel. Live in Washington, D.C at 600 14^th St. N.W., Penthouse (no charge for ASECA members attending live in Washington who pre-register by sending an e-mail to cvitko.diane@dorsey.com). Webcast nationally by the ABA and available in other Dorsey & Whitney offices. For further information please click here.