Manager's Guide to Compliance

Sarbanes-Oxley, COSO, ERM, COBIT, IFRS, BASEL II, OMB's A-123, ASX 10, OECD Principles, Turnbull Guidance, Best Practices and Case Studies

Anthony Tarantino

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9780471792574
• eBook ISBN: 9781118429464
• Edition: 1
• Topic: Business
• Subtopic: Managerial Accounting
• Index: Business

Compliance requirements are here to stay.

Prepare your company for the growing challenge.

A Wall Street Journal/Harris poll revealed that two thirds of investors express doubts in the ability of corporate boards of directors to provide effective oversight. In the shadow of recent global scandals involving businesses such as Parmalat and WorldCom, Manager's Guide to Compliance: Best Practices and Case Studies is essential reading for you, whether your organization is a major corporation or a small business.

This timely handbook places U.S. and global regulatory information, as well as critical compliance guidance, in an easy-to-access format and helps you make sense of all the complex issues connected with fraud and compliance.

"Wide perspectives and best practices combined deliver a punch that will knock your 'SOX' off! The author has blended together a critical mix necessary for effectively handling the requirements of SOX."
—Rob Nance, Publisher, AccountingWEB, Inc.

"Robust compliance and corporate governance is an absolute necessity in today's business environment. This new book by Anthony Tarantino is an authoritative guide to understanding and implementing compliance and regulatory requirements in the United States and around the world. From SOX to COSO to ERM, this book covers them all."
—Martin T. Biegelman, Certified Fraud Examiner, Fellow and Regent Emeritus of the Association of Certified Fraud Examiners, and coauthor of Executive Roadmap to Fraud Prevention and Internal Control: Creating a Culture of Compliance

"If compliance wasn't difficult enough, now companies are faced with a barrage of technology vendors claiming to automate compliance as if it were a project. In his new book, Dr. Tarantino paints the reality of the situation: companies need to embrace the broader tenets of governance and use technology to embed governance policies and controls into their daily business processes. Only then can they gain business value from their compliance investments."
—Chris Capdevila, CEO and cofounder, LogicalApps

Chapter 1

U.S. SOX Section 401: Off-Balance Sheet Arrangements

INTRODUCTION1

Christopher Cox replaced William Donaldson as SEC Chairman in 2005. Since assuming his chairmanship, Cox has advocated a rethinking of regulations, arguing that they are overly complex and this complexity is partly to blame for the accounting scandals of the 1990s. Maybe the best evidence of this is the convoluted and confusing regulations and guidance around off-balance sheet (OBS) arrangements. This chapter will detail the current state of the U.S. regulations. It appears that the current regulations invite abuse and misunderstanding, and do not assure investors that Enron-type abuses are a thing of the past.

Section 401 of the Sarbanes-Oxley Act of 2002 requires the listing of off-balance sheet (OBS) arrangements, transactions, and obligations (including contingent obligations) that may have a material effect, current or future, on financial conditions, changes in financial results in operations, liquidity capital expenditures, capital resources, or significant components or revenues or expenses. The SEC final ruling requires the disclosure of “the nature and business purpose of the OBS arrangements, why and how they are needed in running a business.” For those wondering why this is an area of concern, a one-word explanation should suffice—Enron. It was Enron’s horrible abuse, and Arthur Andersen’s blessing such OBS arrangements, that led to the most infamous and globally recognized scandal in a generation.

The problems stem from the complexity and resulting confusion in how to account for OBS arrangements. Unfortunately, the SEC has not simplified the process to the extent to preclude significant abuse. Even a process as seemingly straightforward as procurement is given alternative interpretations. With U.S. GAAP’s taking a rules-based approach (as opposed to principles-based as favored by the International Financial Reporting Standards (IFRS)), it is curious how rules and guidance can be issued which are not clear and straightforward. One cynical interpretation is that the complexity is by design serving those who make their living interpreting the regulations and those using the complexity of the regulations to minimize their tax exposure. A less cynical interpretation is that U.S. tax law continues to evolve to the point that even the brightest financial experts struggle in understanding it.

After reading this section, ask yourself if these regulations are straightforward enough to assure their consistent application by companies of all sizes and complexities and to avoid Enron-type abuses of the past.

The following are some simple examples of OBS obligations that may need to be accounted for:

• Long-Term Purchase Agreements: Common practice is to use long-term purchase agreements to assure a reliable source of supply for goods and services at the lowest price. Many companies are moving their direct material programs to Vendor/Supplier Managed Inventory (VMI) programs, which are controlled by long-term purchase agreements. Section 401 clearly requires a time-phased listing of obligations (Year 1, Years 2–3, etc.) in a tabular format specified by the SEC.
• Cancellation and Restocking Charges: Though the SEC is clear in defining the requirement to list time-phased obligations, restocking and cancellation charges are not mentioned specifically in Section 401 but are listed as new triggering events requiring an 8-K filing “any material early termination penalties” under Section 409. Most long-term agreements include such provisions. Though the SEC’s intent is unclear, a company suffering a major downturn and paying restocking and/or cancellation charges will have trouble defending not listing these as OBS obligations.
• Lease Agreements: In addition to the aforementioned items, Capital and Operating Lease obligations should be listed as OBS obligations. Fees incurred due to early termination of agreements will need to be accounted for as well.

Even more complex is the requirement to account for contingent OBS obligations. The SEC provides an instruction “that a company must provide the disclosure required regarding off-balance sheet arrangements, whether or not the company is also a party to the transaction or agreement creating the contingent obligation arising under the off-balance sheet arrangement. In the event that neither the company nor any affiliate of the company is a party to the transaction or agreement creating the contingent obligation arising under the off-balance arrangement in question, the four-business-day period for reporting the event under this item would begin on the earlier of

• The fourth business day after the contingent obligation is created or arises, and
• The day on which an executive officer of the company becomes aware of the contingent obligation.”

This has major ramifications for those enterprises that sell through channel partners with indirect channel sales agreements. OBS obligations may exist for consignment inventory, returns, rebate programs with volume incentives, warranty, special pricing agreements, and so on. Contingent OBS obligations may come into play for those who have outsourced manufacturing, distribution/logistics, and design.

Obviously stung by the terrible abuses of Enron, the SEC has laid out a comprehensive process for companies to explain OBS transactions and obligations.

The SEC’s definition of OBS arrangements addresses certain guarantees that may be a source of potential risk to a company’s future liquidity, capital resources, and results of operations, regardless of whether or not they are recorded as liabilities. The SEC has ruled that this may include “contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity’s failure to perform under an obligating agreement (e.g., a performance guarantee).”

Accounting for OBS arrangements is not enough. The SEC has ruled that companies will have to explain the nature and business purpose of such arrangements. “The disclosure should explain to investors why a company engages in off-balance sheet arrangements and should provide the information that investors need to understand the business activities advanced through a company’s off-balance sheet arrangements. For example, a company may indicate that the arrangements enable the company to lease certain facilities rather than acquire them, where the latter would require the company to recognize a liability for the financing. Other possible disclosures under this requirement may indicate the off-balance sheet arrangement enables the company to obtain cash through sales of groups of loans to a trust; to finance inventory, transportation, or research and development costs without recognizing a liability; or to lower borrowing costs of unconsolidated affiliates by extending guarantees to their creditors.”

The SEC requires companies to explain the impact on their “liquidity, capital resources, market risk support, credit risk support or other benefits. This disclosure should provide investors with an understanding of the importance of off-balance sheet arrangements to the company as a financial matter . . . . Together with the other disclosure requirements, companies should provide information sufficient for investors to assess the extent of the risks that have been transferred and retained as a result of the arrangements.”

The SEC goes further. “In addition, the disclosure should provide investors with insight into the overall magnitude of a company’s off-balance sheet activities, the specific material impact of the arrangements on a company, and the circumstances that could cause material contingent obligations or liabilities to come to fruition. Disclosure is required to the extent material and necessary to investors’ understanding of

• The amounts of revenues, expenses, and cash flows of the company arising from the arrangements,
• The nature and total amount of any interests retained, securities issued and other indebtedness incurred by the company in connection with such arrangements, and
• The nature and amount of any other obligations or liabilities (including contingent obligations or liabilities) of the company arising from the arrangements that is, or is reasonably likely to become, material and the triggering events or circumstances that could cause them to arise.”

DEFINITION OF OBS ARRANGEMENTS2

The SEC has defined the term OBS arrangement as “any transaction, agreement or other contractual arrangement to which an entity that is not consolidated with the company is a party, under which the company, whether or not a party to the arrangement, has, or in the future may have:

• Any obligation under a direct or indirect guarantee or similar arrangement,
• A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement,
• Derivatives, to the extent that the fair value thereof is not fully reflected as a liability or asset in the financial statements, and
• Any obligation or liability, including a contingent obligation or liability, to the extent that it is not fully reflected in the financial statements (excluding the footnotes thereto).”

In particular, the proposals require a disclosure where the likelihood of the occurrence of a future event implicating an OBS arrangement or its material effect was higher than remote. As mentioned above, the SEC noted, “the disclosure threshold departed from the existing MD&A threshold, under which a company must disclose information that is ‘reasonably likely’ to have a material effect on financial condition, changes in financial condition or results of operations.” While this is an improvement, there is still an ambiguity as to the dividing line between “reasonably likely” and “remote.”

The SEC requires disclosure of enumerated items only “to the extent necessary to an understanding of the company’s off-balance sheet arrangements and their effect on financial condition, changes in financial condition and results of operations.” Specifically, the SEC requires a company to disclose

• “The nature and business purpose of the company’s off-balance sheet arrangements;
• The significant terms and conditions of the arrangements;
• The nature and amount of the total assets and of the total obligations and liabilities of an unconsolidated entity that conducts off-balance sheet activities;
• The amounts of revenues, expenses and cash flows, the nature and amount of any retained interests, securities issued or other indebtedness incurred, or any other obligations or liabilities (including contingent obligations or liabilities) of the company arising from the arrangements that are, or may become, material and the circumstances under which they could arise;
• Management’s analysis of the material effects of the above items, including an analysis of the degree to which the company relies on off-balance sheet arrangements for its liquidity and capital resources or market risk or credit risk support or other benefits; and
• A reasonably likely termination or material reduction in the benefits of an off-balance sheet arrangement and any material effects.”

The SEC specifies the need to account for “amounts of a company’s known contractual obligations, aggregated by type of obligation and by time period in which payments are due.” The SEC rejects requests to exclude “purchase orders and contracts for goods and services in the ordinary course of business.” It requires “disclosure of the amounts of a company’s purchase obligations without regard to whether notes, drafts, acceptances, bills of exchange, or other commercial instruments will be used to satisfy such obligations because those instruments could have a significant effect on the company’s liquidity.”

The SEC specifies that the categories of contractual obligations partly include

• Long-term debt obligations,
• Capital lease obligations,
• Operating lease obligations,
• Purchase obligations, and
• Other long-term liabilities reflected on the company’s balance sheet under its Generally Accepted Accounting Principles (GAAP).

OBS ENTITIES3

In 2005, the SEC issued its “Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers,” which added much needed clarification and expanded examples for purchase orders, leases, derivatives, and contingent OBS obligations. The SEC’s introduction underscores the complexity around OBS: “Issuers are involved in any number of contractual obligations, including debt obligations, retirement obligations, compensation agreements, leases, guarantees, derivatives, and obligations to purchase goods and services. In many cases, liabilities are recognized on the balance sheet at the inception of the contract, because one party has performed. For example, if an issuer borrows money, it recognizes a liability upon receipt of the funds. In other cases, liabilities are recognized as time passes, as in the case of interest related to the borrowed funds. In still other cases, contractual obligations remain off the balance sheet. Examples of these obligations may include operating leases, portions of obligations related to retirement plans, certain guarantees, and certain derivatives.”

The 2005 SEC Report and Recommendations provide much needed additional background on OBS entities and obligations. The SEC’s initial ruling was weak in providing examples and scenarios. “Companies have used off-balance-sheet entities responsibly and irresponsibly for some time. These separate legal entities were permissible under Generally Accepted Accounting Principles (GAAP) and tax laws so that companies could finance business ventures by transferring the risk of these ventures from the parent to the off-balance-sheet subsidiary. This was also helpful to investors who did not want to invest in these other ventures.”

In a major understatement, the SEC noted in its 2005 Report that Enron and similar scandals have given OBS a bad reputation as something underhanded “or at least less than fully transparent. The insinuation is that something that should be on the balance sheet is not, and that the reporting issuer has designed the transaction or arrangement to produce that result. However, questions about whether items should be reflected on the balance sheet do not arise only when there is an attempt to deceive financial statement users.”

The SEC defends OBS by noting that “many legitimate transactions generate such questions, and there are, of course, bounds as to what should be included on a balance sheet. It is this broader, more-inclusive question of the proper bounds of what should be included on the balance sheet” that are addressed in its 2005 Report. According to the SEC, the common characteristic of OBS is their creation of a condition “in which there may be a legal or economic nexus between the issuer and risks, rewards, rights or obligations not reflected (or not fully-reflected) on the balance sheet.”

The SEC describes how OBS can refer to many things: including separate legal entities, i.e., separate companies of which the parent holds less than 100% ownership, or contingent liabilities such as letters of credit or loans to separate legal entities that are guaranteed by the parent. Under U.S. GAAP, these items can be excluded from the parent’s financial statements, but usually they must be described in footnotes. Ironically, Enron did list their OBS arrangements, but their implications were missed by Arthur Andersen and the SEC.

While U.S. GAAP and U.S. tax laws do allow off-balance-sheet entities for valid reasons, they can be abused by those wishing to hide obligations and thu...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Preface
• Acknowledgments
• Chapter 1: U.S. SOX Section 401: Off-Balance Sheet Arrangements
• Chapter 2: U.S. SOX Section 404: Internal Controls
• Chapter 3: U.S. SOX Section 406: Code of Ethics
• Chapter 4: U.S. SOX Section 409: Real-Time Reporting of Material Changes
• Chapter 5: U.S. SOX Impact on Privately Held Companies and Nonprofits
• Chapter 6: U.S. SOX Impact on Small U.S. Companies
• Chapter 7: U.S. SOX Impact on Foreign Companies
• Chapter 8: U.S. Government’s Version of U.S. SOX: OMB Circular A-123
• Chapter 9: U.S. Healthcare Efforts to Improve Internal Controls: U.S. HIPAA
• Chapter 10: Bankers’ and Insurers’ Efforts to Improve Internal Controls
• Chapter 11: Australia, Canada, and UK Efforts to Improve Internal Controls
• Chapter 12: EU Efforts to Improve Internal Controls: OECD Principles
• Chapter 13: Global GAAP (IFRS) and Global Reporting Language (XBRL)
• Chapter 14: Compliance and Internal Controls Impact on Outsourcing
• Chapter 15: Civil and Criminal Penalties for Noncompliance
• Chapter 16: Business Penalties for Noncompliance: A Material Weakness
• Chapter 17: Revenue Recognition Requirements: U.S. SAB 101 and 104
• Chapter 18: Data Retention Requirements
• Chapter 19: Compliance and Internal Control Software
• Chapter 20: Auditing Internal Controls
• Chapter 21: Best Practices in Internal Controls: Enterprise Risk Management
• Chapter 22: Best Practices in Internal Controls: IT Risk Management & SDLC (NIST 800-30)
• Chapter 23: Best Practices in Internal Controls: Mapping COBIT to COSO I, COSO II, & PCAOB
• Chapter 24: Best Practices in Internal Controls: COBIT IT Control Objectives
• Chapter 25: Best Practices in Compliance and Internal Controls: ASX 10 Principles
• Chapter 26: Best Practices in Internal Controls: Segregation of Duties (SOD)
• Chapter 27: Best Practices in Internal Controls: Case Studies
• Chapter 28: Best Practices in Compliance Project Management
• Chapter 29: Best Practices in Governance and Ethics
• Chapter 30: Costs versus Benefits and the Business Reaction
• Appendix A: Frequently Asked P2P Questions
• Appendix B: Links to Referenced Organizations and Documents
• Glossary
• Index