The recent enforcement action against General Motors contains a not-so-subtle reminder to public companies that regulators are still taking a skeptical look at legal settlements that blindside investors.
GM has taken plenty of heat over defective ignition switches, recalling more than 600,000 vehicles in 2014 because the faulty switches could cause problems with power steering, power brakes, and airbag deployment. The Securities and Exchange Commission piled on recently with charges of its own that the company failed to have in place internal controls that would assure investors would be properly warned of losses that would be incurred as the enormity of the issue unfolded.
In response to the SEC action, GM said in the months immediately following the ignition switch recall, the company reorganized its vehicle engineering teams to produce greater transparency, urgency, and accountability. That included creating a new global vehicle safety organization focused on executing zero-defect safety systems for vehicles and customers.
Under Accounting Standards Codification Topic 450, companies are required to disclose information about contingencies, or matters such as litigation, warranty or product liability claims, environmental or regulatory issues, health and safety issues, or other claims that could lead to losses. If a loss is considered remote, companies are not required to make any kind of disclosure but, as certainty rises, so does the expectation of warning to investors.
If a loss is determined possible, for example, the rules require companies to give investors at least some preliminary information about any claim that is brewing. If a loss is considered probable, then companies are required to book an accrual for whatever amount they think they might lose.
Of course, few issues in accounting are as straightforward or as black-and-white as that. Foretelling a loss is tricky, says Cynthia Scheuer, managing director at accounting firm UHY Advisors, and determining when it’s not just possible but probable is even trickier. “It’s almost an art form to take in all those inputs and make a judgment,” she says.
“The SEC said it seems like you’re going from remote to probable in the blink of an eye. You disclose nothing, and then you disclose a large settlement. We don’t think negotiations really go that way in the real world.”
Bert Fox, Partner in Charge of Professional Practice, Grant Thornton
Although disclosure is a requirement under accounting standards, it relies on legal determinations and judgment, making it difficult sometimes for companies to determine when disclosures and accruals are in order. In 2007, the Financial Accounting Standards Board opened a project to update the loss contingency disclosure requirements adopted in 1975. After two exposure drafts and a host of public input, the board determined the issue would be better addressed by the SEC as an enforcement matter. That inspired SEC staff to begin looking more carefully at financial statement disclosures that came before corporate announcements of big settlements.
“The SEC said it seems like you’re going from remote to probable in the blink of an eye,” says Bert Fox, a partner in charge of professional practice at Grant Thornton. “You disclose nothing, and then you disclose a large settlement. We don’t think negotiations really go that way in the real world.”
The legal community put up some heavy resistance, both when FASB proposed tweaking the rules and then when the SEC started calling for better compliance. “Attorneys by their nature don’t like sharing information and providing roadmaps to litigation settlements,” says Fox. “It’s against their training. They don’t want to disclose until they absolutely have to.”
Around 2011 and 2012, the SEC wrung some new disclosures out of companies through public speeches and its routine review and comment process, and the matter seemed to quiet down. Now more recently, the SEC has sent some reminders that it’s still taking a skeptical look at unforetold settlements.
GM’s ACCOUNTING MISTEPS
Below is an excerpt from the SEC order, outlining GM’s internal accounting control failures to timely identify and evaluate loss contingencies related to the defective switch.
Under GM’s system of internal accounting controls in place in 2012 through the second quarter of 2014, GM’s processes were focused on recall accruals and thus generally only provided Warranty Group with information about vehicle issues at the point at which a recall was considered probable and the costs of such a recall were estimable, and did not provide information about potential vehicle issues to the Warranty Group prior to this point. The Warranty Group was therefore unable to make a timely evaluation of whether certain potential recall campaigns were reasonably possible and should be considered for disclosure, as required by ASC 450. In the case of the Defective Switch in the Cobalt, certain GM personnel understood that the Defective Switch presented a potential safety issue by approximately the Spring of 2012.Yet, GM’s Warranty Group did not learn of the issue until the FPE Director informed them of the likely recall in November 2013, and, as a result, prior to this time the Warranty Group were unable to evaluate the likelihood of a loss related to the potential recall of the Defective Switch to determine if disclosure of the nature of the potential recall or an estimate of the possible loss or range of loss was required.
GM made fundamental organizational changes in 2014 in its processes for investigating and deciding on potential recall campaigns. As part of those organizational changes, information is required to be provided to the Warranty Group earlier in the process and separate from an Emerging Issues List, such that a timely reasonably possible disclosure determination can be made.
As a result of the conduct described above, for large recall campaigns for the period 2012 through the second quarter of 2014 GM violated Section 13(b)(2)(B) of the Exchange Act by not devising and maintaining a system of internal accounting controls sufficient to provide reasonable assurances that transactions were recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles.
In the recent GM case, for example, the SEC charged the company $1 million for failing to have internal accounting controls that would assure proper assessment of the possible loss around defective ignition switches. The SEC says it learned through its investigation that the company understood the safety issue in the spring of 2012, but accountants did not learn of it until November 2013.
Only a few months earlier, the SEC also brought charges against another public company, RPM International, for failing to disclose a possible loss or record an accrual related to an investigation by the U.S. Department of Justice into an allegation that the company overcharged the federal government on certain contracts. The SEC said for more than a year the company “submitted multiple materially false and misleading filings to the SEC,” and the company ultimately restated.
The cases are focused on loss contingency requirements, but implications extend to other areas of accounting as well, says Fox, such as impairments, revenue recognition, and many others. “There has to be some sort of systematic process to make sure you regularly inquire of all stakeholders about events,” he says. “If you’re not talking to each other, problems could occur.”
Loss contingency disclosure represents an enforcement area that’s simple for the SEC to pursue, says Neri Bukspan, financial reporting and disclosure leader at EY. “It’s quite easy for the SEC to go back and look at the last quarter,” he says. “If you have a settlement that rises to the level of a material contingency and it’s not in there, it’s an easy question to ask.”
The lesson for public companies is to take a closer look at their risk assessments and tune in to where there could be losses occurring, experts say. Companies establish various types of controls to identify loss contingencies, says Fox. “Some do it by checklists, some do sub-certifications, and some do it by regular meetings or periodic interviews,” he says. “Somehow you have to make sure you put in some sort of method that assures communications will occur without just trusting that it will happen.”
Scheuer says it’s critical for the finance team to have a direct line of contact to the legal team, both inside the company and with outside counsel. “You have to be part of that team that is routinely updated on what’s going on,” she says.