It has been beaten into our heads as accountants... document, document, document. This is easy to remember when you are dealing with an unfamiliar type of transaction or a new accounting standard because you have to figure out what you are doing at the front end and since the auditors will be testing your determination. However, documentation diligence can lapse for ongoing judgments for contingencies like bad debt and litigation. In the moment, company decision makers become comfortable with the facts and analyses behind critical judgments, and those involved become satisfied that the accounting determination is solid. In the flurry of the end-of-period activity and with the relief of the hard judgments made, there can be a tendency for the documentation of these critical judgments to wait. Unfortunately, the clarity of the support for the judgment fades with time, and the absence of contemporaneous supporting documentation provides leverage for regulators and others to question the prudence of past judgments. Although documentation will not completely shield you from regulators, it can provide powerful evidence of your deliberation and may head off allegations of bad intent.

Section 13 of the Securities Exchange Act of 1934 requires companies to maintain "books and records" and frequently is cited by the U.S. Securities and Exchange Commission in its enforcement actions. Section 13 (b)(2)(A) requires reporting companies to "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." The following case examples highlight the importance of documenting your judgments to steer clear of books and records violations.

LITIGATION RESERVES

In one matter, regulators made allegations that a company was inappropriately manipulating the litigation reserve to meet earnings targets. By its very nature, judgments about litigation reserves are complicated because the details of the litigation and related strategies are highly confidential. Although the company assessed the status of litigation for each case and made determinations about the amount of loss that was probable and estimable, there was no contemporaneous documentation of the support for the quarterly judgments. In the absence of that information, as part of the internal investigation, we examined the chronology of each case and the information available at each quarter-end. The facts were consistent with movements in the reserve when developments in the cases showed the potential for greater loss, the reserve was increased and vice versa. Despite these facts, the regulator took the position that the judgments were not made in good faith because the company was unable to provide documentation of its judgments contemporaneously. When companies choose to settle rather than move forward to trial, this becomes a point of negotiation rather than a question of the facts in evidence.

LOAN LOSS RESERVE

In another matter, regulators alleged that a company ignored information from its forecasting system that suggested greater losses were on the horizon. Companies necessarily utilize assumptions as part of their determination about the amount of reserves to record in connection with loans that will not be fully repaid. From historical write-off experience to changes in the economy, there are several factors for which companies essentially must attempt to predict the future, including:

  • How will recent loan portfolio changes affect losses as compared with historical experience?
  • Are recent changes in write-offs a short-term blip or emblematic of a longer-term issue?
  • What impact will the current environment have on losses?

Since crystal balls are not possible, companies must use the contemporaneous available facts and make their best reasonable judgment. Unfortunately, regulators can and do bring cases influenced by hindsight. It is a lot easier to say "you should have predicted the financial crisis was coming" when the crash already has happened. Accurately predicting the future is much more difficult. Even if a registrant has lots of evidence showing the various factors it considered, and made its accounting deliberations in good faith, it is critical that the final determinations are memorialized into a document with all the considerations outlined in one place. Failure to do so could put a registrant at risk of a books and records violation.

Knowing without a doubt that regulators will be your Monday morning quarterback, it is best to fully document the rationale for your judgments contemporaneously. Be sure to document all the major elements that were considered, even when they did not result in a change to your reserve amount.

ASSET WRITE-DOWNS AND IMPAIRMENTS

Other areas that get a lot of attention from regulators are judgments related to the write-down of tangible assets (like vehicles and equipment) and the impairment of intangible assets (like customer lists and goodwill). When a company discloses a significant write-down of assets, the chances of receiving an inquiry from regulators increases dramatically. We have helped several clients deal with questions from regulators who were interested in both the timing why it wasn't taken sooner or why it is being taken now and the amount of the write-down. Once again, contemporaneous documentation of ongoing judgments and the critical changes that triggered the impairment at the time will be important in defending the propriety and timing of your judgments.

Even the most reasonable, carefully considered judgments can be wrong and may result in a significantly different amount from what was recorded. If, when this happens, you have taken the time to document your considerations and ultimate conclusion, you will have placed your company in the best position to show the regulators that it was a reasonable judgment and that the inquiry can be put to rest.

The views expressed herein are those of the author and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals. (c)FTI Consulting, Inc., 2013. All rights reserved.