Valuation practices under SEC scrutiny

Over the last several years, valuation and impairment issues have figured prominently in many of the Securities and Exchange Commission’s financial reporting enforcement actions. That effort shows no sign of waning.

“Valuation has been, and continues to be, one of the top areas that the SEC does focus on both from an overall regulatory standpoint, as well as from an examination standpoint,” says Paul Kraft, lead partner of Deloitte’s U.S. mutual fund practice, who was formerly with the Division of Investment Management. “The Office of Compliance Inspections and Examinations often looks at valuations as part of exams.”

Increasingly, U.S. regulators are going after corporate filers for potential material financial reporting errors and fair-value measurements that cannot be supported. Traditionally, the rule of thumb in determining whether a misstatement or omission was material and subject to SEC enforcement would be if there was a 5 percent or more deviation from actual reported earnings, explains Beth Boland, chair of the securities enforcement and litigation practice at law firm Foley & Lardner.

Today, although it’s still important to get the valuation “right,” it’s not enough. “Now what you see is more of a shift toward some of the more qualitative issues,” Boland says. Those qualitative issues include the robustness of systems and controls for ensuring that the financial statements accurately reflect the company’s financial status, or the ability to ensure that, even if there are no material errors in the financial statements, the processes to catch those errors are robust, she says.

From a compliance and enforcement standpoint, in particular, U.S. regulators have made it clear that the process for producing numbers is just as important—if not more so—than the numbers themselves. Management and auditors should heed the warning and take a closer look at what’s behind their numbers and better understand how they account for and audit fair-value measurements.

“Valuation has been, and continues to be, one of the top areas that the SEC does focus on both from an overall regulatory standpoint, as well as from an examination standpoint.”
Paul Kraft, Lead Partner, U.S. Mutual Fund Practice, Deloitte

During SEC examinations concerning valuation practices, “the Commission has concerned itself increasingly with the process of how companies value their investments, value their intangible assets, as a backdrop to understanding whether the registrant has followed a uniform process, and that they’ve done so consistently and thoughtfully,” says Chris Wright, Protiviti’s regional managing director for the Eastern United States.

Oil and gas pains

Although many valuation-related enforcement actions brought by the SEC this year have been the result of post-financial crisis deterioration in values of assets—such as loans and real estate—recent SEC activity suggests that the Commission currently has its sights on valuation-related accounting issues in the oil and gas industry, in particular.

The latest indication of that made headlines this month, when the Wall Street Journal reported that the SEC is investigating Exxon for how it values its assets, including its “longstanding practice of not writing down the value of its oil and gas reserves when prices fall. Exxon is the only major U.S. producer that hasn’t taken a writedown or impairment since oil prices plunged two years ago,” the Journal reported.

Alan Jeffers, Exxon’s media relations manager, has confirmed the SEC’s investigation. “We are fully complying with the SEC request for information and are confident our financial reporting meets all legal and accounting requirements,” he says.

Exxon is not the only oil and gas company that’s received the attention of the SEC for its valuation-related practices. Last year, the Commission brought charges against the former chief financial officer and current chief operating officer of Miller Energy Resources, an oil and natural gas production company, for inflating values of oil and gas properties that resulting in fraudulent financial reports.

PUBLIC COMPANY VALUATION ISSUES

Below is an excerpt from NERA Economic Consulting’s paper: Will SEC Quants Jump from Funds to Public Companies on Valuation Issues?
To help protect themselves from being targeted, issuers can learn from the SEC’s much more active presence in the investment advisor asset valuation area.
In the fund advisor space, two valuation issues stand out as receiving particular attention from the SEC. First, the SEC strongly disfavors stated valuation policies that differ from actual valuation practices. This divergence between policy and practice can occur either because the valuation policies are simply verbatim recitations of accounting standards without any specific applicability to the assets held or because asset classes held by the company have changed over time, making the once accurate policy out of date.
Second, the SEC has repeatedly found fault with valuations that fail to adequately adjust in the face of changed market conditions. Such valuations may reflect the use of stale market data, abuse of discretion in making valuation judgment calls, or an absence of procedures for correcting or adjusting values.
Public companies can best avoid the valuation problems faced by many in the investment adviser space by employing best practices in accounting and valuation.
Source: NERA Economic Consulting

“Financial statement information is the cornerstone of investment decisions,” William Hicks, associate regional director of the SEC’s Atlanta office, said in a statement. “We’ve charged that Miller Energy falsified financial statement information and grossly overstated the value of its Alaska assets and that the company’s independent auditor failed to conduct an audit that complied with professional standards. The SEC will aggressively prosecute such conduct.”

In that case, the SEC alleged that after acquiring oil and gas properties in Alaska in late 2009, Miller Energy overstated its value by more than $400 million. Although accounting standards require the company to record the properties at “fair value,” then-CFO Paul Boyd allegedly relied on a reserve report that did not reflect fair value for the assets.

Best practices

Other public companies can mitigate such SEC enforcement activity by employing best practices in accounting and valuation, which will effectively help management and auditors proactively prepare for any potential SEC examination. “The first thing you want make sure you have are robust valuation policies and procedures,” Kraft says.

Beyond policies and procedures, there are two different controls management and auditors should have a firm grip on, Boland says. One is the adequacy of their controls over financial results: “Did I get my financials right?’” The other is the adequacy of their controls over the disclosure of material issues like their financial results: “Did I get the disclosures about my financials right, and do we have a system by which we ensure that disclosures regarding our financials is an adequate one?” she says.

Kraft advises that management and auditors should also consider “doing a dry run of what an SEC inspection might entail and then make sure that, if there are any gaps or things you can enhance in your own process and policies, you do that in advance of the SEC coming out,” he says.

During an SEC examination, after asking whether the company has documented policies and procedures in place, an SEC examiner “almost always will lead with, ‘Tell us how,’ ” Wright says. “Tell us how you value your investments, your assets, your intangibles. How do you use third-party valuation firms to help you?” Once an SEC examiner has answers to those questions, the follow-up question often is, “tell us more,” he says.

Companies that use third parties should be prepared for even more questions from the SEC. “Merely using a third party to do valuations doesn’t absolve the registrant of ownership of the outcome,” Wright says. “A best practice would be to have a documented and controlled process around the information you provide the third-party valuation firm. Do you understand the assumptions they used? Do you agree with the assumptions they used?”

“Understand the questions that are asked ordinarily,” Wright adds. “Learn from the experience of others who have had to go through that, and build that process into the front-end.”

The overall idea is that companies should be able to clearly communicate how they approach valuations theoretically, as well as how they perform valuations mechanically, Wright says. “If they do so,” he says, “they are in a much better position relative to others who maybe have not enjoyed the same fate, because they are building in the quality at the front-end rather than having it inspected into their process by regulators on the back-end.”