Summary
Few other disclosures give as much visibility into the integrity of a company’s reported results like the SEC’s Schedule II – Valuation and Qualifying Accounts. Unfortunately, despite such schedule being required of most public companies, few companies seemingly fully comply. The absence of otherwise required data, or worse, the outright omission of the schedule in its entirety, should raise investor concerns that a company may be engaging in some degree of inappropriate earnings management.
Analysis
As a matter of background for those unfamiliar with Schedule II, the vast majority of U.S. listed companies are categorized by the SEC as “commercial and industrial companies” thus making them subject to the requirements of Article 5 of Regulation S-X and its underlying rules. Rule 5-04 of Regulation S-X requires that an audited Schedule II, as prescribed by Rule 12-09 of Regulation S-X, be filed in support of valuation and qualifying accounts included in each fiscal year-end balance sheet and that the schedule cover each fiscal period for which an audited statement of operations is required to be filed [typically the latest three fiscal years]. Rule 12-09 of Regulation S-X then sets forth the form and content of Schedule II as follows:
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Column A |
Column B |
Column C |
Column D |
Column E |
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Description 1 |
Balance at beginning of period |
(1) Charged to costs and expenses |
(2) Charged to other accounts -- describe |
Deductions -- describe |
Balance at end of period |
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1 List, by major classes, all valuation and qualifying accounts and reserves not included in specific schedules. Identify each such class of valuation and qualifying accounts and reserves by descriptive title. Group (a) those valuations and qualifying accounts which are deducted in the balance sheet from the assets to which they apply and (b) those reserves which support the balance sheet caption, Reserves. Valuation and qualifying accounts and reserves as to which the additions, deductions, and balances were not individually significant may be grouped in one total and in such case the information called for under columns C and D need not be given.
Simply put in today’s accounting terminology, Rules 5-04 and 12-09 of Regulation S-X, including the accompanying instructional footnote above, requires, to the extent not otherwise disclosed directly in the notes to the accompanying financial statements, that a company provide an itemized roll-forward of the activity in each of its contra-asset accounts and liability reserves. Given their inherent uncertainty, contra-asset accounts and liability reserves typically constitute the soft underbelly of any set of consolidated financial statements. Thus, contra-asset accounts and liability reserves routinely pose the greatest accounting challenges to ethical managements as they attempt to derive the best possible estimates. Unfortunately, ethically-challenged managements often exploit the softness of contra-asset accounts and liability reserves to engage in inappropriate earnings management, i.e., tucking away earnings for a rainy day.
Admittedly, Rule 4-02 of Regulation S-X permits the exclusion of otherwise required disclosures to the extent that the subject amounts are not material. However, it is often apparent that Schedule II omissions by a company are based exclusively on the quantitative immateriality of an ending contra-asset or liability reserve balance to applicable balance sheet measures. Unfortunately, upon further scrutiny and analytical deduction, it is often apparent that the associated provisions or charge-offs were material to a company’s results of operations for one or more reported fiscal years.
Consistent with the underlying premises of SEC Staff Accounting Bulletins Nos. 99 and 108, any materiality assessment must also consider, among possible qualitative aspects, the quantitative materiality of the associated provisions and charge-offs to the statements of operations. Thus, any immateriality assertion by a company’s management that has been predicated exclusively on balance sheet measures is, at best, inappropriate and, at worst, an attempt to conceal inappropriate earnings management practices.
Furthermore, even in those all too rare instances where a company furnishes what would appear to be a fully compliant Schedule II, significant variability and/or unusual activity or financial relationships in the contra-asset accounts or liability reserves are unexplained, thus again leading one to question the integrity of reported results. Where the underlying activity or financial relationships beg for explanation, a company should provide sufficiently detailed explanations in their accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations pursuant to Item 303 of Regulation S-K. Best practices would further suggest providing accompanying explanatory footnotes directly on the face of Schedule II as well.
With that said, I challenge Corporate America to pull back their blinds and let the sunshine in…all the way in!
