The accounting department is often the last to be sufficiently staffed and one of the first to scale down in a layoff. Decision makers do not adequately consider the impact on the Company’s internal control over financial reporting (ICFR) when managing expenses by cutting costs in this department.
However, the SEC has only become more emphatic on the importance of ICFR. Recently, the SEC settled charges against Texas-based oil company Magnum Hunter Resources Corporation (MHR), several executives, and the company’s internal controls consultant, for deficient evaluation of the company’s internal controls over financial reporting. The SEC alleged that MHR and two senior officers failed to properly evaluate and apply applicable ICFR standards and improperly concluded that MHR had no material weaknesses.
According to the SEC’s orders:
- MHR’s rapid growth, which included multiples of revenue growth and acquisitions over two years, strained its accounting resources.
- Executives were aware of this strain and failed to apply appropriate standards when determining the severity of MHR’s internal control deficiency.
- The consultant providing consulting and internal auditing services to MHR identified “inadequate and inappropriately aligned [accounting] staffing,” which caused delays in the internal audit testing and presented a “substantial risk” of misstatement.
- Despite the consultant’s belief that “the potential for error in such a compressed work environment presents substantial risk,” the consultant concluded that the staffing deficiency in the accounting department did not rise to the level of a material weakness.
The SEC alleged that MHR management accepted the consultant’s findings and relied on the absence of an actual material error in MHR’s financial statements as evidence that a material weakness did not exist. The SEC emphasized that a material weakness only requires a reasonable possibility of an error, not an actual misstatement.
Without admitting or denying the findings, MHR agreed to pay a penalty of $250,000 subject to bankruptcy court approval. One executive and the consultant providing internal controls services paid $25,000 and $15,000, respectively.
The MHR case is the latest in a series of enforcement cases involving ICFR, and it emphasizes the point that the existence of a material weakness as of a particular date does not hinge upon on whether a material misstatement actually occurs.