Mattel reaches into its piggy bank to pay the SEC $3.5 million
Auditor PwC seems to have escaped any blame but one of its audit partners is still subject to significant scrutiny.
I wrote about auditing industry regulator the PCAOB’s strategic plan at the beginning of October. I quoted industry veteran Bob Conway regarding concerns the PCAOB has been focusing too much on inspections of auditor compliance with standards regarding internal control reviews and not enough on poor auditing of issuer compliance with GAAP accounting standards.
There are two types of restatements to correct errors that people in the accounting world follow: “Big R” and “Little r” restatements. There is a third category of restatements we unfortunately know nothing about – material errors that never got corrected. Let’s call them “missed restatements.” There are a number of holes in the system that give rise to missed restatements.
One troubling scenario is that the issuer or auditor is aware of a material error in a prior period, but one or the other decides to do nothing (the “let sleeping dogs lie” scenario). Speaking up about the need to restate is a bit of a self-inflicted wound. For an auditor, it might lead to losing the account or discipline. For a controller or CFO, it might be career limiting to admit a mistake.
Whistleblowers who have the fortitude to step forward have played a key role in drawing attention to material uncorrected errors in prior periods. However, not all potential whistleblowers have the fortitude to blow the whistle. Additionally, the SEC has limited resources, so not every promising whistleblower referral gets the attention it deserves.
I wrote then that there was one big case, Mattel, where both the company and its auditor, PwC, tried very hard to avoid a restatement, allegedly colluding to cover up the need for one.
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There was a report nearly three years ago that the SEC and DOJ were investigating Mattel’s eventual restatement in 2019, and departure of officers including the CFO, but we’d heard crickets since. That’s despite the fact the WSJ published a scathing report about exactly what happened from a second non-anonymous whistleblower.
It appears that the PwC partner took the “let sleeping dogs lie” path, perhaps hoping the need to restate would just blow over. Bob Conway
Mattel executives, auditor PwC and the lead engagement partner, Joshua Abrahams, later settled a shareholder lawsuit regarding the episode, agreeing to pay a total of $98 million.
Finally, there was a convenient news report that the PCAOB was investigating PwC regarding the auditor independence issues that Mattel itself admitted to but that was nearly three years ago and we’ve heard nothing from the PCAOB.
And then, as if all I had to do was whisper in their ears, the SEC announced a settled enforcement action against Mattel on October 21. The SEC’s settled complaint against Mattel is full of new information.
The SEC also announced, on the same day, that it was pursuing an ongoing complaint against former PwC partner Joshua Abrahams, the lead Mattel engagement partner during the period in question — 2017 to 2019.
Who knew — truly who knew — the SEC was still working on this?
The SEC’s “Order Instituting Public Administrative Proceedings” against Joshua Abrahams is full of allegedly bad things Abrahams did, apparently all by himself, according to the SEC:
· As the lead engagement partner for Mattel, Abrahams engaged in improper professional conduct within the meaning of Section 4C of the Exchange Act and Rule 102(e) of the Commission’s Rules of Practice.
· Abrahams failed to comply with multiple PCAOB professional standards, including interim review standards, identifying and assessing risks of material misstatement, audit evidence, audit documentation, and due care in the performance of work.
· The engagement team’s workpapers were devoid of any discussion of the $109 million error, any materiality analysis of the error, and any associated internal control deficiency analysis, and Abrahams failed to inform the audit committee of the error.
· Throughout his time as lead engagement partner, Abrahams failed to
maintain independence from his audit client by engaging in prohibited human resource services for Mattel, such as ranking candidates for management positions.
The SEC’s settled complaint against Mattel and its complaint against Abrahams opens with an anecdote that had not been reported before. Before Mattel made the mistake in the 3rd Quarter of 2017 that was the subject of its later 2019 restatement, it made another mistake that it apparently caught at the last minute.
Prior to Q3 2017, Mattel had never taken a valuation allowance related to its deferred tax assets. A deferred tax asset is an asset that a company can use to reduce or eliminate a future tax liability. If a company does not expect to generate taxable income in the future, the deferred tax assets have no value because there will be no tax liability to offset. As a result, once a company determines that it is not likely to have future taxable income, it must record a valuation allowance against the deferred tax assets and reduce their value. That action also results in a non-cash charge against net income.
Many companies are chronic losers that should have valuation allowances against their deferred tax assets — Tesla and Microstrategy come to mind — but not all of them do. Tesla does and Microstrategy did not bite the bullet until June 30 of 2022, for example.
Tesla: As of December 31, 2021, we had recorded a full valuation allowance on our net U.S. deferred tax assets because we expect that it is more likely than not that our U.S. deferred tax assets will not be realized. Should the actual amounts differ from our estimates, the amount of our valuation allowance could be materially impacted.
Microstrategy: As of June 30, 2022, the Company had a valuation allowance of $391.3 million primarily related to the Company’s deferred tax asset related to the impairment on its bitcoin holdings that, in the Company’s present estimation, more likely than not will not be realized. If the market value of bitcoin continues to decline or the Company is unable to regain profitability in future periods, the Company may be required to increase further the valuation allowance against its deferred tax assets, which could result in a charge that would materially adversely affect net income (loss) in the period in which the charge is incurred. To the extent the market value of bitcoin rises, the Company may decrease the valuation allowance against its deferred tax asset. The Company will continue to regularly assess the realizability of deferred tax assets.
As of March 31, 2022, the Company had a valuation allowance of $1.0 million primarily related to certain foreign tax credit carryforward tax assets that, in the Company’s present estimation, more likely than not will not be realized.
As of Q3 2017, Mattel had suffered three years of cumulative losses and in September 2017, Mattel’s largest customer, Toys R Us, declared bankruptcy. The SEC says that after consulting with its national office, PwC’s engagement team informed Mattel that it would need to take a valuation allowance against its deferred tax assets. (It had not been previously reported that someone in PwC had prompted the uncomfortable discussion about the necessity of a valuation allowance.)
The SEC says that Mattel had no internal control specifically related to calculating a valuation allowance and making sure it was correct. When calculating the valuation allowance, a corporation may reduce the number, and therefore the net income impact, by netting out the value of certain deferred tax liabilities. Under the tax law in Q3 2017, only liabilities classified as definite-lived (i.e., related to assets which are amortized) could be used to lower the valuation allowance.
While calculating the valuation allowance number, the SEC says a PwC tax manager identified a $129 million error because a deferred tax liability related to goodwill — an indefinite-lived asset — had been included in the initial calculation of the valuation allowance. The error in the initial valuation allowance calculation was corrected before Mattel filed its Q3 2017 Form 10-Q.
The SEC says PwC’s Abrahams knew about the $129 million calculation error but did not verify that his team documented the $129 million error or any associated internal control deficiency in its Q3 2017 interim review workpapers. Nor did Abrahams communicate this error or any associated control deficiency to Mattel’s audit committee.
At the end of Mattel’s 2017 third quarter, Mattel recorded its valuation allowance against deferred tax assets. But the worst wasn’t over for Mattel. Behind the scenes, another drama was unfolding related to the discovery of another error related to the calculation of the deferred tax asset calculation allowance in January 2018.
In mid-January 2018, Brett Whitaker, who’d just joined Mattel as its Director of Tax in June 2017, discovered a second error in its calculation of the Q3 2017 valuation allowance. From the SEC’s Mattel’s settled complaint:
In Q3 2017, Mattel’s Thomas the Tank Engine asset was classified as an indefinite-lived asset. However, Mattel’s tax department mistakenly accounted for Thomas as a definite-lived asset and used a deferred tax liability to reduce the amount of the valuation allowance by $109 million. As a result, the reported $561.9 million valuation allowance was understated in Q3 by $109 million.
This Mattel tax director discovered the error on Saturday, January 13, and informed PwC’s tax partners on the engagement. PwC’s senior tax partner on the engagement sent an email to the junior tax partner with three possible options to correct the $109 million error:
1) a tax planning strategy to sell Thomas to a high tax jurisdiction;
2) a reclassification of Thomas from an indefinite-
lived to a definite-lived asset;
3) moving Thomas’ book basis to the UK.
So let me just stop here for a moment.
The client’s Tax Director tells the PwC tax partners working on the audit that everyone involved had missed a material error in how the company had calculated its tax provision, net loss, and net loss per share for the 3rd quarter and 4th quarter of 2017. The tax partner, who is a member of the audit team, responds by suggesting options, two out of three of which are global tax avoidance strategies and a third option which is an arbitrary reclassification of intangible asset. The intangible asset had been classified as unamortizable — that is, indefinite-lived — since its acquisition as part of a bunch of identifiable intangible assets (primarily related to intellectual property rights) in 2011.
It seems Joshua Abrahams wasn’t the only PwC professional engaging in egregious violations of auditor independence rules by giving tax strategy advice in order to avoid the correction of an error that was embarrassing to both parties. There’s more:
A Bloomberg article about a November 2019 WSJ’s Mattel scoop quoted a PwC spokeswoman, Megan DiSciullo, on the revelations:
“We will always strive to do the right thing and we will continue to take the appropriate actions in response to any allegations of misconduct.”
The firm “takes its role as an independent auditor seriously,” she added.
DiSciullo also told Bloomberg that once PwC became aware of the complaint, it “took immediate action.”
DiSciullo told Bloomberg PwC reviewed nearly 45,000 documents and 30 interviews and worked with the company to help with its reporting of the investigation’s results.
That, too, is highly problematic from an auditor independence perspective. The “independent” auditor should only be advised of the progress and results of an independent investigation that includes potential wrongdoing by senior executives and, in this case, the audit firm itself. The auditor is supposed to only consider the impact of the investigation on its audit, not actively participate in conducting the investigation.
The SEC says that Mattel had already decided to evaluate whether Thomas should be reclassified in December 2017, but that seems like a too convenient out for the rest of the PwC engagement team.
The SEC says that as of October 1 (the start of Q4) the Thomas the Tank Engine asset was reclassified, based on the agreement of almost everyone involved — everyone, that is, except Brett Whitaker, who quit Mattel in March of 2018.
Let’s review the timeline.
August 8, 2019
· PwC, Mattel’s outside auditor, received a letter on August 2, 2019, from an anonymous individual alleging certain actions of the PwC engagement team violated the SEC’s auditor independence rules.
· PwC makes Mattel aware of the whistleblower letter on August 6, 2019.
· Mattel disclosed all this in a Form 8-K on August 8, 2019.
· Mattel terminated a pending $250 million senior notes offering.
· Mattel and its audit committee initiated an independent internal investigation with independent counsel from O’Melveny & Myers LLP and forensic accountants from FTI Consulting.
· PwC, Mattel’s outside auditor, conducted its own investigation and informed the Audit Committee that it had shared all relevant information with the Audit Committee.
· Mattel announced that it had completed its investigation and would restate its financial results for Q3 and Q4 2017. Because the Q3 understatement and Q4 overstatement self-corrected the error for the fiscal year ended December 31, 2017, the FYE 2017 financial statements did not need to be restated.
· PwC and the Audit Committee of Mattel conducted separate investigations into the allegations and PwC and the Audit Committee concluded that certain actions by the Company's audit engagement partner Joshua Abrahams were in contravention of Regulation S-X Rule 2-01(c)(4)(vii)(E).
· “The Letter also contains allegations regarding the independence of the lead audit partner of Mattel’s outside auditor. The Audit Committee investigated these allegations, many of which were unfounded. However, the Audit Committee’s investigation and a separate investigation by Mattel’s outside auditor concluded that certain actions in specific HR-related activities by the lead audit partner of Mattel’s outside auditor, namely providing recommendations on candidates for Mattel’s senior finance positions, was in violation of the SEC’s auditor independence rules. He also provided feedback on senior finance employees.”
· Both the Audit Committee and Mattel’s outside auditor separately concluded after evaluating the nature and severity of these matters that Mattel’s outside auditor remains capable of exercising objective and impartial judgement on all issues with respect to pending and relevant past audits. The Audit Committee determined that Mattel’s outside auditor should remain as Mattel’s independent registered public accounting firm.
· PwC, Mattel’s outside auditor replaced Joshua Abrahams, its lead audit engagement partner, and certain other members of its audit team for its audit engagement with Mattel. The Audit Committee and Mattel’s management said it supported this decision.
· After Mattel filed its 2017 10-K but before receiving the Whistleblower Letter, Mattel hired a new Controller and a new Senior Vice President of Tax, and it outsourced Mattel’s internal audit function to a third-party service provider. (This seems to be hard evidence that even before a whistleblower alerted PwC, who in turn alerted Mattel, Mattel senior management knew material mistakes had been made.)
· Mattel also announced a CFO transition plan and began conducting a search for a new CFO, as reflected in a separate press release that can be found on Mattel’s website www.mattel.com.
· While finally fixing material mistakes — forced on Mattel by the whistleblower letter — Mattel decided to look and see if anything else, unrelated to the whistleblower letter, the deferred tax asset valuation issues, or issues already being investigated by the Audit Committee, could be thrown into the cleanup effort. Mattel elected to revise 2019 and prior periods for “certain other immaterial, out-of-period adjustments.”
If you are already doing surgery on the patient for an appendix rupture you might as well go look for the scalpel you left behind when you took his gallbladder out last year.
On November 6, The Wall Street Journal published the further expose featuring Brett Whitaker that said PwC partners, in particular the tax partners, were high-fiving each other over having resolved the issue with the reclassification of the Thomas asset in early 2018.
Mr. Whitaker, who said he isn’t the August whistleblower, said that when Mattel didn’t restate earnings or admit to accounting problems in 2018, he believed it was a coverup.
“My team was dumbfounded by it,” said Mr. Whitaker, a tax professional who began his career at Big Four firm Ernst & Young and has worked for a number of public companies.
PwC was involved in the decision not to disclose the error, which the firm would have had to admit it missed, Mr. Whitaker said. A PwC tax partner was “walking down the hall, high-fiving people, after this decision was made,” Mr. Whitaker said. A PwC spokeswoman denied that this had occurred.
“It was known within Mattel that if we took this approach, at worst we might get a slap on the wrist from the Securities and Exchange Commission. But if the company disclosed a material weakness, a senior executive said to me it would be ‘the kiss of death.’ “ Brett Whitaker
November 12, 2019
· Mattel filed a Form 10-K/A that disclosed that the 2017 Q3 and Q4 financials were materially misstated.
· As a result of the $109 million misstatement, Mattel’s Q3 2017 provision for income taxes was understated by 14%, and net loss and net loss per share were understated by 15%.
· As a result of the $109 million misstatement, Mattel’s Q4 2017 provision for income taxes was overstated by 62%, and net loss and net loss per share were overstated by 63% for that period.
· Mattel’s Form 10-K/A also disclosed two material weaknesses in internal control over financial reporting related to the errors:
a. A failure to design and operate an internal control over the review of the income tax valuation allowance analysis (calculation), which refers to the initial $129 million goodwill-related error corrected before third quarter 2017 results were filed and which Mattel said was remediated by December 31, 2018; and
b. a failure to design and operate internal controls to properly assess and communicate known financial statement errors and internal control deficiencies in a timely manner to those parties responsible for taking corrective action, including, for example, the CEO and board of directors, (which Mattel said was subsequently remediated as of December 31, 2019.)
Mattel disclosed that PwC had restated its report on internal control over financial reporting and issued an adverse opinion.
/s/ PricewaterhouseCoopers LLP
Los Angeles, California
February 22, 2019, except for the effects of the revision discussed in Note 1 to the consolidated financial statements and the matter discussed in the penultimate paragraph of Management’s Report on Internal Control Over Financial Reporting, as to which the date is November 12, 2019
Mattel Inc. agreed to pay $3.5 million to settle the SEC’s charges relating to misstatements in its third and fourth quarter 2017 financial statements. The error did not affect Mattel’s full year financial results, but Mattel’s Q3 and Q4 2017 tax provisions remained understated and overstated, respectively, until August 2019 when a whistleblower sent a letter to PwC, focused primarily on some auditor independence issues related to Joshua Abrahams.
It seems that Whitaker was right. Mattel got barely a tap on the knuckles from the SEC for waiting two years, until a whistleblower forced the issue, to admit it had made a material mistake and had some internal control weaknesses it had already fixed.
The SEC goes out of its way to give Mattel, and everyone at PwC except Joshua Abrahams, kudos for addressing the issues on what it said was a timely basis. One reason for this courtesy may be the ongoing tenure of a PwC alumna as the SEC’s Deputy Chief Accountant focused on professional practice and auditor independence.
The SEC settled complaint says Mattel filed a Form 8-K only two days after being made aware of the whistleblower letter on August 6, 2019 and immediately terminated its senior notes offering. However, this was nearly two years after learning of not one but two material errors and of material weaknesses in internal control that were known long before a whistleblower’s letter in 2019 but not disclosed to the public until then.
The SEC says Mattel’s audit committee “promptly” commenced an independent internal investigation but the investigation was not started not until after the whistleblower letter in August 2019, despite Mattel admitting in November 2019 10-K/A that it already knew it had a material weakness in the controls over valuation allowances and had remediated this weakness prior to Dec 31, 2018.
The SEC says Mattel restated its financials only three months after being made aware of the whistleblower letter but actually more than two years after the events prompting it, that Mattel knew about, and that had prompted it to replace its CFO, Controller, Senior Vice President of Tax, to outsource its internal audit function to a third party service provider, and to force a replacement of its auditor’s lead partner and other engagement members.
The CFO responsible for this weak control structure and who failed to escalate the error to the CEO and board in 2017 and 2018 was not asked to depart until October 2019 and then only after a six month transition period.
Is Joshua Abrahams being thrown under the bus by Mattel and PwC?
Well, Abrahams was no tenderfoot. I wrote about how he is at the nexus of several PwC clients that the SEC should be investigating.
What’s interesting is that may not be the only time Joshua Abrahams played matchmaker between a PwC audit client and executives looking for work.
Abrahams was the lead engagement partner for three PwC audits on the west coast — Mattel, and also Herbalife and Sprouts Farmers Market.
Another recent story in the WSJ about another PwC audit client in accounting trouble, Under Armour, mentions that a criminal investigation of the company’s accounting is also focusing on one of its former CFOs, Chip Molloy.
“Among the issues investigators are examining, according to people familiar with the matter, are Under Armour's results at the end of 2016 and the tenure of former finance chief Chip Molloy, who resigned in January 2017 on the same day the company said sales growth fell below 20%. Under Armour shares tumbled 23% that day.”
In June of 2019 Sprouts appointed Chip Molloy—the guy who only worked at PwC audit client Under Armour a year and left suddenly— to serve as interim CFO until a permanent successor is named. Molloy had been serving as a member of Sprout’s board of directors since 2013 and was the Audit Committee Chair.
Molloy was the guy who was responsible for hiring and retaining PwC and Abrahams every year as auditor, and is now one of the guys, with the CEO, who signs the Sarbanes-Oxley 302 internal control and disclosure certifications.
Molloy previously served as interim chief executive officer of another PwC audit client, Torrid LLC, during 2018.
When asked about a relationship between Abrahams and Molloy and whether Abrahams recommended Molloy for jobs at Under Armour or Torrid that gave Molloy authority over PwC’s audit contracts, PwC spokeswoman Megan DiScullio said I was “connecting dots where there was no connection.”
Finally, Abrahams took on the Herbalife audit after a “human resources or management functions” auditor independence issue caused a slight hiccup in the sudden necessary transition of the account from KPMG to PwC in 2013 after KPMG’s independence because the lead partner, who was the firm’s west coast regional partner, had been charged with insider trading.
I wrote in Forbes at the time:
Herbalife, unwitting victim of KPMG partner Scott London’s inside trader scheme, replaced its former auditor yesterday with PwC. There were, supposedly, too few qualified audit firms to choose from for such a large, global, “specialized” company like Herbalife.
Herbalife’s choice of PwC came with extensive disclosures of PwC’s past consulting and other non-audit work for Herbalife all over the world, including during the periods that must now be re-audited, 2010-2011. The Sarbanes-Oxley Act of 2002 and pre-existing SEC rules prohibit the auditor from also performing certain kinds of engagements that may impair the auditor’s independence, in fact or in appearance. Investor perception is supposed to be as important as specific rule breaking.
Molloy is currently CFO at former Abrahams client Sprouts and told me in an email back in July 2020: “I did NOT receive a Wells Notice [about Under Armour].”
Under Armour was the subject of an SEC enforcement action in May of 2021 for disclosure fraud. There has been no action against auditor PwC or its partners related to the that case.
© Francine McKenna, The Digging Company LLC, 2022
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