Earlier this year the SEC announced that it had brought charges against a publicly traded company, Magnum Hunter Resources Corporation (MHR), a diversified natural gas, natural gas liquids and crude oil exploration and production company based in Texas.
The SEC’s charges are not based on material misstatements in MHR’s 2011 financial statements on Form 10-K. Rather, because of high growth arising from multiple business acquisitions, the company’s accounting staff could not keep up with the ever-increasing demands to maintain effective internal controls over financial reporting (ICFR). As a result, the SEC claims there existed a material weakness in MHR’s ICFR and that MHR did not adequately disclose this in its 2011 SEC filing.
The SEC imposed a Cease-and-Desist Order on MHR in March 2016, which states in part:
This proceeding concerns failures by MHR and its management to properly implement, maintain, and evaluate [ICFR] for the fiscal year-ended December 31, 2011 and to maintain ICFR sufficient to keep pace with MHR’s growth from at least the fiscal year-ended December 31, 2011 through the quarter-ended September 30, 2013.
The SEC Order also states that this failure was, in part due to improper evaluations of the severity of internal control deficiencies by both MHR’s SOX consultant and external auditor.
Material Weakness
To put all of this into context, SEC Regulation S-X defines a material weakness as:
…a deficiency, or a combination of deficiencies, in [ICFR] such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis. [Rule 1-02(a)(4)]
This is consistent with the definition of a material weakness in U.S. auditing standards, which is:
a deficiency, or a combination of deficiencies, in [ICFR], such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. [PCAOB AU 325, par 3]
Note these definitions use the term “reasonable possibility” to describe the likelihood of a material misstatement occurring. This term carries the same meaning as in ASC 450 (formerly SFAS No. 5), which I discussed in a previous post.
Charges by the SEC
In essence, the SEC’s charges hinge on the premise that, even though it did not find any material misstatement in MHR’s financial statements, because a material misstatement could have occurred, MHR should have made appropriate disclosures in its 2011 financial statements. Of interest is that MHR’s assessment of the effectiveness of ICFR concluded that a significant deficiency existed, not a material weakness.
In its audit work papers MHR’s external auditor documented that the control weaknesses arising from inadequate accounting staff did not rise to the level of a material weakness for the following key reasons: (1) the audit work did not identify material errors for the reporting period and (2) the auditor understood that MHR had recently hired additional accounting staff and that the existing staff, while overworked, was competent.
Despite the auditor’s documentation for its conclusion, the guidance in PCAOB AS No. 5 states that “[t]he severity of a deficiency does not depend on whether a misstatement actually has occurred but rather on whether there is a reasonable possibility that the company’s controls will fail to prevent or detect a misstatement.” (see par. 64)
Take-aways
Companies required to comply with SEC regulations should take note of these charges brought by the SEC. Further, companies should take seriously the requirements to maintain effective ICFR and disclose information that is pertinent to users of their financial statements.
In the end, it is the responsibility of the company’s management to not only prepare its financial statements, but to also maintain a system of ICFR sufficient to provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP (see SEC Exchange Rule 13(b)(2)(B) at 124).
