Section 409 of the Act requires that public companies disclose to the public on a rapid and current basis information concerning material changes in their financial condition or operations, including trend and qualitative information and graphic  presentations. Form 8-K was amended to require public companies to file with the SEC any releases or announcements disclosing material, non-public financial information about completed Annual or quarterly periods. 

When breaking down this requirement the key points, which need to be interpreted, are (1) what are material changes? and (2)what is meant by rapid disclosure? After interpreting these key points, an analysis needs to be performed of what processes needs to be established to ensure that these points are actually met.

One of the points which was not previously understood was that only material events which impact previously filed annual or quarterly periods would be reported as part of this amended 8-K filing. Therefore, losing a major account would not be a material event which would need to be reported.

Events which trigger requirements for filing an 8-K have not been clearly defined by the SEC. Standards need to be established within the organization which specifies the type of events which would need to be reported as material change. 

Many organizations think they can centrally monitor activities to identify material changes. These standards must be managed in a distributed manner and reliance must be placed on these entities that they will escalate material changes. Certain changes can be identified centrally such as adjustments to previously reported financial results.

One widely documented event trigger is the acceleration of an obligation which was taken from the lessons learned from the Enron crises in which Enron rating downgrade triggered the repayment of loans which they defaulted on.

Other types of event triggers which would impact past reported financial results include expenses that were amortized which should have been expensed and expenses which were amortized which should have been expensed. Standards need to be established to determine the amount which would represent a material change. A miscategorization of how an expense should be treated of $200,000 is insignificant for organization which has $700 million in expenses.

Another example of a material change to past financial results includes a change on how revenue is recognized which requires a restatement of past earnings. Overall, an organization should have a detailed list of business practices which have an accounting and operational impact.

The key design for reporting material changes is to establish the triggers within the business prior to the entry of the 
transaction into the system. If the trigger fails at this point, then triggers need to be established at the system 
transaction level to identify these events. Additional triggers would also need to be established as a "safety-net"
to mine the databases for these events after the transactions have been successfully processed. The fetching of
transactional and database data in most cases require the use of the organization's data warehouse. An analysis needs to be performed of the time required to update the data warehouse which impacts an organization's overall ability to report material changes within 48 hours. It is typical for most organizations to have a one-day delay in the update of their data warehouse which would reduce the available time to analyze and report material changes. For systems which process data which contains material changes in batch mode, the job streams of these critical jobs need to be re-evaluated and streamlines to provide data results in a timelier manner. The preferred approach is to establish these triggers within the system which feeds the data warehouse to allow for an earlier detection process of material changes. Unfortunately, many organizations will not be able to establish the triggers in these systems.

The system action of processing an accounting material change is the adjustment of data that was previously reported. Section 404 controls should have been established to ensure that appropriate individuals have the ability to adjust data and audit trails established to allow for their subsequent review.  However, a centralized audit trail is not sufficient for Section 409. These transactions need to be immediately sent to the group responsible for monitoring potential material changes. 

Conclusion

Compliance with Section 409 requires that additional controls be established to reduce and identify material changes. The system design needs to be analyzed to determine changes in order to report material changes in a timelier manner. Most importantly, an infrastructure needs to be established to ensure these changes are identified and escalated to the proper branch the organization responsibility for determining whether a material change requires reporting. Unfortunately, the ultimate reporting of material changes requires information to be passed through many hands within a large organization before an 8K filing is made. Therefore, the design team needs to ensure the processes established actually works by performing a test to ensure that an embedded material changes are identified, escalated and reported. 

For a free proposal to perform an audit of your organization or provide SOX support & testing services, contact Mitchell Levine of Audit Serve at (203) 972-3567 or via e-mail at Levinemh@auditserve.com.

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This article appeared in a past issue of the Audit Vision E-Mail Newsletter.