What Valeant's 'Tone At The Top' Language Might Mean

| About: Valeant Pharmaceuticals (VRX)

Summary

VRX accounting review ongoing.

"Tone at the top" material weaknesses are very rare.

Past "tone at the top" cases may provide insight.

By now you've probably heard of the ongoing saga at Valeant (NYSE:VRX). The beleaguered pharmaceutical company has seen its stock plummet, questions about its accounting practices, harsh criticisms about its business practices, and turmoil among management and the board.

A recent WSJ article by Michael Rapoport provided a good overview of the accounting challenges that Valeant is facing, and Francine McKenna at MarketWatch provided an in-depth analysis of the probability of a qualified opinion.

In this blog, we want to focus on a particular aspect of Valeant's troubles. In its earnings statement released last week on March 21, the company slashed revenue guidance, announced the resignation of CEO J. Michael Pearson, and changed the composition of its Board of Directors. Valeant's controller was also placed on administrative leave. At the same time, however, the company stated that "in addition to certain Philidor-related accounting matters, the Ad Hoc Committee determined that certain other accounting issues required review."

Valeant concluded that "one or more material weaknesses exist in the company's internal control over financial reporting" and that "the tone at the top of the organization and the performance-based environment at the company, where challenging targets were set and achieving those targets was a key performance expectation, may have been contributing factors resulting in the company's improper revenue recognition". "Tone at the top" is very strong language that implies, among other things, improper management conduct.

Using our Internal Controls database, we identified only five other NYSE or NASDAQ companies that had 'tone at the top' language in their ICFR opinions between 2010 and 2015. (Note: several other companies had "tone at the top" language used by their auditor in the firms' resignation letters.)

History may not always repeat itself, but we may still be able to learn from the past. Does "tone at the top" always trigger a material restatement? And if so, what is the likelihood that the investigation uncovers additional issues and problems? How long does it typically take to file restated financial statements?

Two of the five companies we found, namely Brixmor Properties (NYSE:BRX) and Petrobras (NYSE:PBR), did not identify any material GAAP violations. For Brixmor, however, the "tone at the top" material weakness was related to intentional manipulation of non-GAAP metrics. The issue also led to the resignation of the CEO and the CFO of Brixmor.

The Audit Committee of the Board of Directors conducted a review that led the Board of Directors to conclude that specific Company personnel, in certain instances, were directly involved and/or supervised persons directly involved in smoothing income items, both up and down, between reporting periods in an effort to achieve consistent quarterly same property net operating income growth, an industry non-GAAP financial measure. Based on these findings, we concluded that there was a deficiency in the control environment specifically because the foregoing actions failed to demonstrate commitment to integrity and ethical values and senior management did not set an appropriate tone at the top. Although the actual amount of financial statement misstatement resulting from these actions was not significant, because of the override of controls that occurred at senior levels of management, we have concluded that the potential for material misstatement of the financial statements was more than remote. Accordingly, we have determined that this control deficiency constitutes a material weakness.

According to MarketWatch, the manipulation could have influenced executive compensation, since a similar metric was used as a performance target. Top management has resigned as a result of the discovery of the manipulation.

For Petrobras, the "tone at the top" language was linked to a corruption scandal in Brazil, of which Petrobras' executives were allegedly aware.

Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because the following material weaknesses in internal control over financial reporting existed as of that date: • inadequate "tone at the top" regarding internal controls, failure to communicate the ethical values prescribed in the Company's Code of Conduct, and lack of an effective whistleblower program; • failure to identify the need to write down payments advanced to contractors and suppliers that will not result in future economic benefits and failure to identify the need to recognize expenses related to the termination of these contracts; • deficiencies related to monitoring the need to reclassify certain property, plant and equipment from assets under construction to completed property, plant and equipment; • failure to recognize impairment losses in five Exploration and Production projects that were in their initial planning phase, for which there were no estimated future cash flows; • failure to timely monitor possible changes in the control parameters of the enterprise resource planning ("ERP") environment, which are used to support the internal controls related to the review and approval of manual journal entries, and deficiencies in the design of the internal control over review and approval of manual journal entries; and • deficiencies in control operations related to granting access procedures and segregation of duties analysis at the business process level.

Three other companies, Hertz (NYSE:HTZ), General Cable (NYSE:BGC) and Ixia (NASDAQ:XXIA) all ended up restating their financial statements subsequent to the "tone at the top" disclosure. Let's take a further look at the details of these restatements.

Click to enlarge

In each case, additional errors unrelated to the original issue were uncovered during the course of internal investigations. For example, Ixia, in addition to revenue problems, also identified "$639,000 of out-of-period adjustments" related to income taxes; General Cable identified foreign currency mistakes that "understated retained earnings by $6.5 million"; and Hertz disclosed a number of issues, ranging from accounts receivable to leases. (We could not estimate the impact of the additional errors for Hertz since no magnitude was provided in the original Item 4.02.)

Now, how long did it take to file restated financial statements? The issue of late filing is extremely sensitive to Valeant at the moment since it may trigger non-compliance with a bond covenant. According to its Item 4.02, the company is expected to file restated financial statements by April 29, or 39 days after the non-reliance filing (dated March 21) and 67 days after the February 22 press release in which $58 million error was first identified.

Returning to our past examples, that would require Valeant to significantly improve on the time-frame needed for Ixia, General Cable, and Hertz. Ixia and General Cable filed after 111 and 123 days, respectively, and Hertz required a whopping 429 days to issue finalized restated financials.

Can we predict whether Valeant's timetable will be similar to those of Ixia and General Cable? Or would it be more comparable to Hertz? Some aspects, such as magnitude provided and relatively short time required to restate, would suggest that Ixia and General Cable scenarios are more likely.

One thing is clear: It would be in the best interest of everyone to leave accounting issues behind as soon as possible and focus on the challenging business environment that Valeant is currently facing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Audit Analytics is a team from Audit Analytics, an independent provider of audit, regulatory and disclosure intelligence. This article was written by Olga Usvyatsky, VP of Research. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.