Internal financial investigations can lead to the identification of accounting transactions that, quantitatively material or not, may prompt a correction, restatement, or reclassification. In the context of corrupt payments, for example, recording a bribe payment to win business as something other than a bribe violates the basic accounting concept of faithful representation and, more specifically, likely violates the Foreign Corrupt Practices Act (FCPA) accounting provisions, which require that an issuer “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer.” While these scenarios are rarely quantitatively material enough to result in the correction of prior period accounting entries, there are reasons to consider correcting such accounting entries within a current period. Here, we discuss practical recommendations for tracking, recording, and documenting the remediation of current transactions under investigation as well as tips for handling other potentially sensitive transactions such as health and safety payments.
Underlying Accounting Concepts
The accounting concept of “faithful representation” requires that transactions and events be accounted for in a manner that represents their true economic substance rather than the mere legal form. While the term is often used in the context of a company’s financial statements, it also applies to the way transactions are recorded in the underlying detailed books and records, including its general ledger.
Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 2 defines the essence of the concept of materiality as “the omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” Statement of Financial Accounting Concepts No. 8 further clarifies the definition to stress that materiality should be viewed in the context of individual reporting entities. The U.S. Securities and Exchange Commission (SEC) 1999 Staff Accounting Bulletin No. 99 (SAB 99) clarifies the commission’s interpretation of materiality, making it clear that materiality judgments should not be based exclusively on quantitative considerations – i.e., based on dollars alone – but require management to undertake qualitative assessments as well. As stated in that bulletin: “As a result of the interaction of quantitative and qualitative considerations in materiality judgments, misstatements of relatively small amounts that come to the auditor’s attention could have a material effect on the financial statements.”
SAB 99 also addresses the commission’s view of what constitutes a registrant’s obligation to keep books and records that are accurate “in reasonable detail.” In addition to a materiality assessment, companies should consider:
- “The significance of the misstatement. Though the staff does not believe that registrants need to make finely calibrated determinations of significance with respect to immaterial items, plainly, it is “reasonable” to treat misstatements whose effects are clearly inconsequential differently than more significant ones.
- How the misstatement arose. It is unlikely that it is ever “reasonable” for registrants to record misstatements or not correct known misstatements – even immaterial ones – as part of an ongoing effort directed by or known to senior management for the purposes of “managing” earnings. On the other hand, insignificant misstatements that arise from the operation of systems or recurring processes in the normal course of business generally will not cause a registrant’s books to be inaccurate “in reasonable detail.”38
- The cost of correcting the misstatement. The books and records provisions of the Exchange Act do not require registrants to make major expenditures to correct small misstatements.39 Conversely, where there is little cost or delay involved in correcting a misstatement, failing to do so is unlikely to be “reasonable.”
- The clarity of authoritative accounting guidance with respect to the misstatement. Where reasonable minds may differ about the appropriate accounting treatment of a financial statement item, a failure to correct it may not render the registrant’s financial statements inaccurate “in reasonable detail.” Where, however, there is little ground for reasonable disagreement, the case for leaving a misstatement uncorrected is correspondingly weaker.”
Transactions Under Investigation
In the context of most FCPA, civil enforcement actions brought by the SEC, a purely quantitative analysis would likely result in a conclusion that amounts in question are not material to the financial statements taken as a whole and consequently do not require correction or result in the need to restate past financial statements. Indeed, in our experience, companies that investigate historical transactions of this type and conclude wrongdoing typically do not reopen their books to make such corrections.
Questions could arise however around the way companies deal with current period transactions under investigation for which financial statements have yet to be issued. Many of the SEC’s FCPA actions highlight the SEC’s position that, whether quantitatively material or not, the existence of historical illicit transactions that were improperly recorded in general ledger accounts and that did not reflect the substance of the actual payment would cause an entity’s books and records to be incorrect. Examples include:
- In the case of SEC vs. Textron Inc., kickbacks paid to the Iraqi regime in the Oil for Food Programme were described in the company’s books as “consultation fees and recorded as commission payments;”
- In the case of SEC vs. Schering-Plough, bribes paid were inappropriately recorded as “donations;”
- In the recent case of SEC vs. Eni S.p.A, payments made through an intermediary were inappropriately recorded as “brokerage fees.”
Given the scrutiny with which the SEC looks at how companies record transactions such as those described above – regardless of their quantitative materiality or their ultimate presentation on the financial statements – companies in the midst of ongoing investigations should consider ringfencing questionable transactions within the general ledger to accurately reflect current uncertainty as well as ultimate disposition once established. Throughout the investigation, companies should also work to ensure that the accounting control environment is remediated to be able to detect and/or prevent similar transactions on a go-forward basis.
Temporary Accounts and Ultimate Disposition
Accountants are sometimes faced with limited information for how to record transactions and typically make use of temporary accounts – often known as suspense accounts – to park those transactions until clarifying information is received. In cases where a company has incurred an expense and subsequently questions the actual nature of the expense through an investigation, temporary expense accounts may be used for purposes of reclassifying questionable entries away from certain general ledger accounts that may not be reflective of the underlying substance of the transaction. Recording such expenses in specially designated temporary accounts serves two main benefits: (1) it better reflects management’s current uncertainty about the accounting treatment and (2) it allows for better tracking of the population of expenses in question until resolved.
For multinational companies that maintain local books and records in multiple locations, temporary accounts should be established within those local general ledgers. Management may also consider establishing temporary accounts in the consolidated chart of accounts into which local transactions are rolled up. To the extent temporary accounts are not created in the consolidated chart of accounts, companies should ensure that they roll-up consistently to the same account in the consolidated trial balance.
Temporary accounts should be monitored closely and reviewed monthly by local and HQ management. Once investigations are complete, and an ultimate disposition of transactions can be concluded, transactions should be timely reclassified from the temporary expense account to an appropriate general ledger account. To the extent that a general ledger account is not established to accurately reflect the nature of the transaction in question, one should be set up.
A Different Angle: Health and Safety Payments
Companies may not wish to overtly highlight the nature of certain transactions, as described above. Such reasons may include instances of sensitive payments made to ensure the health and safety of their employees. Certain fact patterns may exist, particularly in jurisdictions with higher risks of corruption, whereby companies are coerced into making payments to government officials or other third parties to ensure the health and safety of their employees. Companies may further be faced with the possibility that overtly describing such payments in their local books and records may lead to additional heightened risk both within the organization and from the very institutions that are demanding such payments.
The SEC and U.S. Department of Justice’s (DOJ) Resource Guide to the U.S. Foreign Corrupt Practices Act  (Resource Guide) makes clear the department’s position on the issue of extortion or duress. The Resource Guide states: ”situations involving extortion or duress will not give rise to FCPA liability because a payment made in response to true extortionate demands under imminent threat of physical harm cannot be said to have been made with corrupt intent or for the purpose of obtaining or retaining business.” The Resource Guide further makes clear through a footnote, that the while the payments themselves would not give rise to FCPA liability, the transactions “must be accurately reflected in the company’s books and records so that the company and its management are aware of the payments and can assure that the payments were properly made under the circumstances.” The example provided by the department in that same footnote explains that while the payments in question may, in fact, have been considered coercive and therefore potentially exempted from FCPA enforcement scrutiny, the inappropriate manner in which they were recorded in the underlying books and records, and the fact that the approvals did not extend to management at the parent company are what led to an FCPA charge. The important takeaway here is that while a company may feel justified in making such payment and may avoid liability for doing so, it must take care to record such payments properly in its books and records and ensure that proper visibility and management approvals are obtained.
The SEC’s Interpretation of Books and Records
The SEC has alleged books and records violations in respect to documents that many would argue are unrelated to the financial reporting process, including invoices to customers, proposal documentation, contracts, and records of meetings. In the case of BHP Billiton for example, the SEC brought a books and records violation based on incomplete and allegedly inaccurate “hospitality applications” used internally to document the company’s selection of guests to the Olympics.
While many FCPA practitioners have lamented the SEC’s broad view of what it believes constitutes a corporation’s “books and records,” this broad view may give issuers some flexibility in how they document payments such as those made through coercion for the health and safety of their employees. Taking the position that the general ledger and supporting accounting documents alone do not constitute the entirety of corporate books and records, a company may very well put in place sufficient processes, policies, documentation, and approval mechanisms outside of the general ledger to comply with relevant standards.
The Chiquita Banana Case
The case involving Chiquita Brands International is a good illustration. The company plead guilty in 2007 to making $1.7 million in payments to a specially designated terrorist organization in Columbia over a period of years. Chiquita stated that it made those payments as a result of threats to the safety of its personnel. Subsequent civil litigation against Chiquita from terror victims sheds some light on the company’s internal accounting and approval processes through which these payments were recorded. Documents in that civil case describe the fact that the payments made to terrorist groups were designated internally as “sensitive payments” and that the true purpose of the payments and identity of the recipients were not clearly recorded in the general ledger. Notwithstanding, an expert report filed in that case reflects the fact that Chiquita had put in place significant internal controls around the process of making such payments, including:
- A formal memorandum prepared by the VP of internal audit documenting the required process and specifically stating that it was meant to ensure adherence to books and records provisions;
- The requirement to complete a specifically designed form including the payment amount, details of the payment, and a codename to which only specific individuals had the key to enable identification of the payee;
- An approval matrix detailing the required approvals based on monetary thresholds;
- Required review and approval by the local General Manager and the head of security;
- Review at company headquarters by the VP of internal audit and the company’s general counsel;
- Ongoing monitoring by internal audit.
The expert report further suggests that the payments were known to the company’s CEO and its audit committee. The record reflects a repeatable process, controlled, approved, documented, and made visible up the corporate chain. Notably, the SEC did not bring a case against Chiquita in respect of these accounting practices. This can be interpreted as a tacit acknowledgement by the commission that while the general ledger alone may not have properly reflected the nature of the transactions or allowed for the proper identification of the payees, the full complement of the books and records likely did.
Transactions under investigation
Companies should strive for representational faithfulness by ensuring that their books and records, including the general ledger, accurately reflect the underlying substance of the transactions against the backdrop of the commission’s “reasonable detail” guidance in SAB 99. In the case of questionable transactions in the current period, companies may benefit from setting up a process to ringfence questionable transactions into a temporary general ledger account until such time that they can be properly accounted for. Using temporary accounts may best reflect management’s thinking at the time of the investigation in that the true disposition and related accounting treatment of the transactions is not clear. To the extent management can reasonably estimate the illicit portion of a transaction, that amount should be transferred to the temporary account. If management cannot reasonably estimate the illicit portion, the entire amount of the transaction should be reclassified to the temporary account.
Management should use its best judgment when transactions are to be moved from the temporary account to an appropriate permanent general ledger account. While no standard exists for how and when this is to be done, ensuring open communication between finance and investigations team should result in management’s ability to make the determination at the right time. To the extent that transactions are not fully investigated by period end and management is not able to fully conclude on the proper accounting treatment, it should try to ensure that temporary account is set to roll-up to the financial statements in a manner that is most reflective of the facts at the time.
The final disposition of the transactions should be fully documented (where/when/how), and if concluded upon, illicit transactions should be recorded as such in the general ledger. During its investigations, the company should also identify and remediate the internal control lapses that led to the problematic transactions in the first place.
For companies dealing with sensitive transactions – for example, ones that take into account the health and safety of their employees – key controls should be put in place to ensure that the underlying books and records, taken as a whole, adequately document the nature of the transactions and related approvals.
- Establish a formal policy and process for handling of such transactions;
- Ensure that visibility and approvals extend through the subsidiary structure all the way up to top-level management at headquarters;
- Balance the need to protect sensitive information with the need to ensure that approvals do not sit with only a select few. Granting visibility to a multi-functional group across audit, finance, legal, and compliance is advisable;
- Ensure that the accounting process does not result in a misstatement of the financial statements, whether quantitatively material or not;
- Create an auditable record, outside the general ledger if necessary, to fully account for all transactions. The record should be established in a manner to ensure completeness and accuracy and should ultimately form the basis of the books and records of the company;
- For auditable records maintained outside the accounting systems (including GL or expense systems), link documentation back to underlying source data through unique transaction identifiers,
- Ensure that transactions recorded across the company are accounted for in a manner that will ensure that they roll-up to one consistent account in the consolidated chart of accounts.
- Perform a qualitative assessment of materiality and communicate the assessment to the proper corporate oversight mechanisms.
 https://www.justice. gov/criminal-fraud/fcpa-resource-guide
 See expert of Jason S Flemmons filed in US District Court for the Southern District of FL; Case 08-01916-MD-Marra/Johnson
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