Historical Blind Spots
It was during the implosion of Enron and hundreds of dot-com and telecom bubble companies a decade ago that accountancy became the “in” profession on the dinner-party circuit. Formerly staid CPAs regaled guests, young and old alike, with their explanations of the nuances of income recognition and the problems with “hollow swaps” (the mutual granting of access to telecom firms’ networks to artificially boost revenue and earnings). It was a time when everyone’s 401(k), mutual fund, or hedge fund investments were sinking, and people wanted to know how and when it might end.
Since then, of course, a more normal state of affairs has returned. Dinner guests no longer seek understanding of the latest pronouncements from the Financial Accounting Standards Board (FASB) or even the International Accounting Standards Board (IASB). They might even have trouble remembering people like Enron whistleblower Sherron Watkins, let alone the roles they played in those debacles of yore.
Trivia aside, what is more troubling about the current state of affairs is that the U.S. Congress seems to have forgotten that period, too — particularly the expensive lessons learned. This is normal, of course, but it is a lesson that investors ignore at their peril.
To wit, the Dodd-Frank Wall Street Reform and Consumer Protection Act includes a provision exempting small issuers (with market caps of less than $75 million) from the requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002. It also calls on the SEC to study whether it should extend the exemption to companies with market caps of up to $250 million.
In response to that study, CFA Institute has expressed concern that the mandated exemptions, and those under study, could lead to a reprise of the accounting problems markets experienced during the dot-com and telecom bubbles. It was precisely the corporate demographic exempted in Dodd-Frank, after all, that was most responsible for the financial reporting shenanigans a decade ago. For every Enron and WorldCom, there were dozens of Pets.coms, Flooz.coms, and Global Crossings using hollow swaps and other creative mechanisms to pull the wool over investors’ eyes. Section 404(b) was adopted precisely to combat those kinds of shenanigans by requiring auditors to review the internal controls for financial reporting systems (“ICFRs”) for all listed companies. Large-cap companies had to implement such audits years ago, and implementation for small issuers was imminent. That was before Dodd-Frank stepped in to prevent it.
So now, the pending reality of Dodd-Frank (one of many) is that investors in the United States will now have to cope with companies that are both subject to and exempt from the 404(b) audits. CFA Institute responded to the SEC’s study by calling for increased transparency about these differences by requiring companies who opt for the exemption to check a box on the front pages of their Forms 10-K and 10-Q. Exempt companies also should have to include prominent disclosures about their ICFRs, including why they took advantage of the exemption, what kinds of ICFRs are in place, and why these ICFRs will prevent faulty or fraudulent financial reports in the future.
Historical blind spots are nothing new in Congress or the financial markets. But the SEC should be able to alert investors to the potential pitfalls from this latest bout from Dodd-Frank with a few tweaks and disclosures like those CFA Institute has suggested. In doing so, it can at least reduce the potential for the kind of serious damage investors endured 10 years ago.