Managing Legal Risk the Financial Reporting Process (Portfolio 5503)

Portfolio 5503-2nd, Managing Legal Risk in the Financial Reporting Process (Accounting Policy and Practice Series), discusses the legal risks public companies face in the financial reporting process and offers advice for how to manage such risk.

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Portfolio 5503-2nd, Managing Legal Risk in the Financial Reporting Process (Accounting Policy and Practice Series), discusses the legal risks public companies face in the financial reporting process and offers advice for how to manage such risk.
Financial reporting by public companies is one of the foundations of the free enterprise system. Modern capitalism is built upon the financing of large entities by investors. Investors demand accountability for the capital they provide. The financial reporting process is the means by which public companies provide that accountability. Having a reputation for sound financial reporting will likely instill investor confidence in a company and enhance its ability to raise capital and use its securities to make acquisitions. Conversely, improper financial reporting will likely diminish investor confidence and lead to government investigations, shareholder litigation, and the costly measures needed to resolve these problems.
Written primarily for the benefit of the executive management and directors of public companies, this Portfolio analyzes the financial reporting process. It identifies risk factors in the financial reporting process and explains how those risk factors can increase the likelihood of violations of law. These include certain high-risk areas in the financial reporting process, where companies should be especially careful in their accounting and disclosures. To illustrate the problems that can occur, the Portfolio presents actual cases. The Portfolio also discusses the importance of establishing a record of good faith effort to comply with the financial reporting rules in order to lessen the potential for fraud and criminal charges, the most serious charges that a company may confront. It provides insight into the perspectives of the SEC and its staff on the financial reporting process. Moreover, the Portfolio calls attention to the problem of one company assisting another company to violate financial reporting requirements, an area of intensified focus for regulators at the beginning of the 21st century. Finally, the Portfolio suggests various steps that a company may take to reduce its legal risks, strengthen its financial reporting processes, and build a record of a good faith effort to comply with the financial reporting rules.
Securities law attorneys will appreciate that this Portfolio covers an enormous range of topics within the body of the federal securities laws and should understand that the citations of cases and other authorities herein are illustrative, not comprehensive. This Portfolio is intended first and foremost to be a practical aide to the management and directors of public companies, and not a traditional legal treatise. In the interest of making the issues discussed herein accessible to nonlawyers, this Portfolio is written in the vernacular, and gives preference to comprehensibility for the layperson over technical legal precision. A reader seeking a more detailed and technical discussion of relevant issues should refer to BNA Accounting Policy and Practice Series Portfolios concerning particular bodies of law or accounting rules.
This Portfolio should be cited as BNA Tax and Accounting Portfolio 5503-2nd, Wang, Managing Legal Risk in the Financial Reporting Process (Accounting Policy and Practice Series). Within the Accounting Policy and Practice Series, however, references to the Portfolios will include only the Portfolio numbers and titles.


Leonard W. Wang, Esq.

Leonard W. Wang, B.A. (Economics and Political Science) and J.D., University of Wisconsin-Madison, elected to Phi Beta Kappa, Phi Kappa Phi, the Order of the Coif, and the editorial board of the Wisconsin Law Review; member, the District of Columbia Bar and the State Bar of Wisconsin.
Mr. Wang formerly served as Assistant Director, Division of Enforcement, U.S. Securities and Exchange Commission. During a 22-year career with the SEC, Mr. Wang received the Chairman's Award for Excellence, the Stanley Sporkin Award, the Capital Markets Award, and the Division of Enforcement Director's Award. Mr. Wang may be contacted at

Table of Contents

Detailed Analysis

I. The Value of Sound Financial Reporting

A. Headline Failures

B. Underlying Causes of Failures

C. Consequences of Risk Taking

D. Prescriptive Goals

II. The Regulatory Perspective

A. Relevance

B. SEC Structure and Hierarchy

C. Differing Perspectives

D. SEC Division of Enforcement

E. SEC Role Concerning Generally Accepted Accounting Principles

III. The Importance of Avoiding Fraud and Criminal Charges

A. Categories of Charges

B. Consequences of Criminal Charges

C. Relationship Between Fraud and Criminal Charges

IV. Understanding the Risk Factors

Introductory Material

A. Recognize Legal Risk

1. The Asymmetric Profile of Legal Risk

a. Enron Corp.

b. Fannie Mae

2. Law Enforcement: A Risk Unlike Others

B. Recognize That the Facts May Be as Clear as Mud

1. Conflicting Recollections

2. Examples

C. Remember That a Lawyer's Opinion Is Just an Opinion

1. Benefits and Limitations

2. Potential Effect of Attorney's Involvement

3. Lessons Learned

D. Auditing Is Not a Substitute for Management

1. Respective Roles

2. Examples

E. Risks of Third Party Involvement in the Financial Reporting Process

1. Manipulation of Vendor-Vendee Relationships

2. Financial Engineering

3. Summary

V. SEC Benchmarks for Financial Reporting

Introductory Material

A. Completeness of Disclosure

1. Complying With More Than GAAP

a. Do Not Omit Material Information

b. Specific Disclosure Obligations

2. Disclosures to Persons Other Than Shareholders

3. Be Careful With Pro Forma Numbers

4. Keep All Shareholders in the Loop

B. Materiality

1. The Concept

2. SEC Staff Accounting Bulletin No. 99

a. Genesis

b. Scope and Applicability

c. Principles

d. Judicial and Enforcement Interpretations

3. Summary

VI. High Risk Areas

Introductory Material

A. High Risks in the Company's Financial Reporting Process

1. The Multiple Roles of the Executive Suite

a. Multiple Roles Create Risk

b. Examples

c. Summary

2. Leverage in Compensation

a. Examples

b. Lessons Learned and Pressure Points

3. When Financial Performance Supersedes Operational Performance

a. The Risks of Overemphasizing Financial Performance

b. Examples

c. Lessons Learned

4. Finalizing Financial Reports

a. Risk Factors

b. Reserves

c. Non-Recurring Items

d. Topside Entries

e. Living a Double Life

5. Question Success: Is It Too Good to Be True?

a. Warning Signs

b. Illusory Profits

c. Revenue Recognition Schemes

d. "Round Trip" Transactions

e. Lessons Learned

B. Assisting Someone Else's Violations: Beware of Business Not as Usual

1. Patterns

2. Examples

VII. Planning Points: Improving the Financial Reporting Process

Introductory Material

A. Reprise: Reasons for and Results of Flawed Decisionmaking

B. Think Better

1. Recognize the Risks

2. Understand the Rules

3. Recognize That Facts Are Subject to Variable Interpretations

4. Examples

5. Avoid Underestimating Risks

6. Comply With the Letter as Well as the Spirit

C. Think for Yourself

D. Improve the Management of the Financial Reporting Process

1. Separate Financial Reporting and Operational Responsibilities

2. Increase Oversight of Top Management

3. Recommendations

a. Reduce the Number of Hats Company Personnel Wear

b. Increase Oversight

(1) The Need for Greater Oversight

(2) Ways to Increase Oversight

(3) Increase Personal Accountability

(4) Increase Audit Committee Involvement

(5) Realign Internal Audit

(6) Ensure Ready Access to the Audit Committee and Internal Audit

(7) Look Below the Radar

c. Use of Outside Accountants

d. Create an Atmosphere of Openness

e. Ensure Thorough Recordkeeping

f. Rethink the Incentives in Compensation Arrangements

(1) Spread Out the Impact

(2) Compensate Integrity

(3) Think Carefully Before Using Stock Options

(4) Consider Expensing Equity Compensation

(5) Consider Other Benchmarks for Compensation

4. Consider Whether Earnings Guidance Is Really a Good Idea

5. Beware of News That's Too Good To Be True

6. Consult Your Accountants and Attorneys

a. Building the Record of Good Faith

(1) Consulting Accountants

(a) Make Full Disclosure to the Accountants

(b) The Accountants' Obligation to Blow the Whistle

(2) Consulting Attorneys

(a) Choosing Between Reliance on or Confidentiality of Attorneys' Advice

(3) An Attorney's Obligation to Blow the Whistle

(4) Summary as to Professional Advice

7. Consider Limiting Non-Audit Work

8. Governance Questions

9. Safeguards Against Helping Another Company Violate the Law

a. Is It Grandmother or the Wolf?

b. Do All the Parts Fit?

c. Does the Transaction Have Economic Substance?

d. Are You Buying the Brooklyn Bridge?

VIII. Conclusion

Working Papers

Working Papers


Worksheet 1 17 C.F.R. § 229.303

Worksheet 2 SEC Staff Accounting Bulletin: No. 99 - Materiality, Exchange Act Release No. SAB 99, 17 C.F.R. Part 211

Worksheet 3 Office of the Chief Accountant Issues Statement on Fannie Mae Accounting

Worksheet 4 In the Matter of Arthur Andersen LLP

Worksheet 5 In the Matter of Kemps LLC, f/k/a Marigold Foods

Worksheet 6 In the Matter of Fleming Cos., Inc.

Worksheet 7 In the Matter of American International Group, Inc.

Worksheet 8 In the Matter of Brightpoint Inc.

Worksheet 9 SEC Charges American International Group and Others in Brightpoint Securities Fraud

Worksheet 10 In the Matter of PNC Financial Services Group, Inc.

Worksheet 11 American International Group, Inc. Enters into Agreements with the United States

Worksheet 12 SEC Charges Gen Re Executive for Aiding in AIG Securities Fraud

Worksheet 13 17 C.F.R. § 244.100

Worksheet 14 17 C.F.R. § § 243.100, .101, .102, and .103

Worksheet 15 In the Matter of Orlando Joseph Jett

Worksheet 16 In the Matter of Sunbeam Corp.

Worksheet 17 SEC Disclosure Required by Sections 406 and 407 of Sarbanes-Oxley Act

Worksheet 18 17 C.F.R. § 240.13b2-2

Worksheet 19 SEC Final Rule: Implementation of Standards of Professional Conduct

Worksheet 20 17 C.F.R. § § 231, 241, 251, and 271

Worksheet 21 In the Matter of Cendant Corp.

Worksheet 22 List of Significant Accounting Pronouncements Principally Discussed




Securities Act of 1933:

Securities Exchange Act of 1934:

Misc. Statutes:

Securities and Exchange Commission:

Administrative Proceedings:

Litigation Releases:


Press Releases:



Rule Releases:

Staff Bulletins and Statements:

Interpretive Release:

Office of Federal Housing Enterprise Oversight:

U.S. Department of Justice Pleadings, Press Releases, and Reports:

U.S. Government Accountability Office:

Court Cases:

Materials From Court Proceedings:


Professional Organizations:

American Institute of Certified Public Accountants

Emerging Issues Task Force

Financial Accounting Standards Board

New York Stock Exchange

Professional Rules:

American Bar Association

District of Columbia


New York



Corporate Materials:

News Media:



Dow Jones & Co.


The New York Times




The Wall Street Journal

The Washington Post