UNITED STATES OF AMERICA
SECURITIES EXCHANGE ACT OF 1934
ACCOUNTING AND AUDITING ENFORCEMENT
The Securities and Exchange Commission ("Commission") deems it appropriate that administrative proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against National Steel Corporation ("National Steel" or "Respondent").
In anticipation of the institution of these administrative proceedings, National Steel has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Solely for the purposes of these proceedings, and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings set forth below, except as to the jurisdiction of the Commission over itself and over the subject matter of these proceedings, which it admits, National Steel consents to the entry of this Order Instituting Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease-and-Desist Order ("Order").
The Commission makes the following findings:1
This matter concerns the material over accrual of reserve accounts and other accounting errors at National Steel, and the gradual, improper and undisclosed reduction of those reserves, and simultaneous inflation of income, at the direction of National Steel´s controller and vice president of finance, Carl M. Apel.
Through accounting errors and other negligence National Steel´s finance department allowed numerous liability accrual and asset allowance accounts (the "reserves") to become over accrued by approximately $51 million as of 1997. The build up of the excess reserves dated back many years, in some cases from the 1980s and before. When members of the finance department brought certain over accrued reserves to Apel´s attention in 1995 and 1996, Apel did not adjust the accounts in conformity with Generally Accepted Accounting Principles ("GAAP"). Instead, Apel ordered certain reserve accounts to be reduced gradually -- in even dollar amounts on a monthly basis -- without disclosing these gradual reductions to the public. These gradual reductions were not in conformity with GAAP and had the effect of hiding both the errors which had led to the over accruals and the subsequent adjustment of the accounts. This process of gradually reducing reserve accounts is sometimes referred to as "accreting" or "bleeding" the reserves into income. The undisclosed accretions materially inflated the income that National Steel reported to investors in at least two quarters in 1996 and one quarter in 1997. A subordinate reported the excess reserves and Apel's actions to National Steel´s Audit Committee in August 1997. The Audit Committee initiated an internal investigation and the Company voluntarily restated National Steel´s financial statements from 1992 through the second quarter of 1997.
B. Respondent and Responsible Officer
National Steel is a Delaware corporation headquartered in Mishawaka, Indiana and together with its subsidiaries is the fourth largest integrated steel manufacturer in the United States. As of the end of the third quarter 1997, NKK Corporation, through its subsidiary NKK U.S.A. Corporation, held a 51 percent interest in National Steel, and had a 67.6 percent voting interest, due to its holding weighted voting stock. NKK is the second largest steel company in Japan and the seventh largest in the world as measured by production. National Steel´s common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act, and is listed on the New York Stock Exchange. For the years ended December 31, 1994, 1995 and 1996, before its restatement, National Steel reported net sales of $2.70-billion, $2.95-billion and $2.95-billion respectively, and net income applicable to common stock of $157 million, $100 million and $34 million respectively.
Carl M. Apel was National Steel´s controller from 1992 to April 1997, when he was appointed vice president of finance, the top financial position at National Steel at that time. Because of high turnover in the chief financial officer position at National Steel during the 1990s, as the controller Apel was responsible for all accounting matters at National Steel, including the preparation of financial statements and Commission filings.2 Apel is a certified public accountant, licensed to practice in Pennsylvania, and was formerly employed by a national accounting and auditing firm.
C. Relevant Accounting Principles
GAAP require the establishment and accrual of reserves for expenses, losses and liabilities, even though payment of the expense, or realization of the loss, may be contingent upon future events. Pursuant to Statement of Financial Accounting Standards No. 5 ("FAS 5"), Accounting for Contingencies (March 1975), &8:
8. An estimated loss from a loss contingency . . . shall be accrued by a charge to income if both of the following conditions are met [emphasis in original]:
a. Information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements . . . [and]
b. The amount of loss can be reasonably estimated [footnotes omitted].
If the reasonable estimate of a particular loss contingency is a range, an amount shall be accrued for the loss. When some amount within the range appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range shall be accrued. See FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss (September 1976). If there is at least a reasonable possibility that an additional loss has been incurred, beyond the amount accrued, disclosure of the nature of the contingency and an estimate of the possible loss or range of loss shall be made. See FAS 5, &10.
GAAP specifically forbid the accrual of "general" reserves. See FAS 5, &14:
14. Some enterprises have in the past accrued so-called "reserves for general contingencies." General or unspecified business risks do not meet the conditions for accrual in paragraph 8, and no accrual for loss shall be made . . .
Accounting estimates, including estimates for loss contingencies, may change as new events occur, as more experience is acquired, or as additional information is obtained. A change in an accounting estimate should be accounted for in (a) the period of change if the change affects that period only, or (b) the period of change and future periods if the change affects both. Although not dispositive of an issuer's disclosure obligations under the federal securities laws, if the change in estimate affects several future periods, GAAP require disclosure of the effect on income. If the effect on income is material, disclosure is recommended for changes in estimates made each period in the ordinary course of accounting. Materiality should be considered in relation to both the effects of each change separately and the combined effect of all changes. See APB Opinion No. 20 ("APB 20"), Accounting Changes (July 1971).
A change in estimate made in an interim accounting period should be accounted for in the interim period in which the estimate is changed. The effect on earnings should be reported in the current period and in subsequent interim periods, if the effect of the change is material in relation to any period presented. See APB 28, Interim Financial Reporting (May 1973).
Changes in estimates are distinguishable from the correction of errors in previously issued financial statements. Errors result from mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared. The correction of error, including erroneous estimates related to loss contingencies, should be disclosed in the period in which the error is discovered. The correction is accounted for and reported as a prior period adjustment, that is, by restating the financial statements of the affected prior periods. See FAS 16, Prior Period Adjustments (June 1977) [as partially superseded by FAS 109, Accounting For Income Taxes (February 1992) &288(n)]; APB 20, &&13, 36 and 37; and APB 9, Reporting the Results of Operations (December 1966) &&18 and 26.
As these provisions make clear, GAAP do not allow for the deferral of accounting adjustments arising from a change in estimate or the correction of error. If a change in estimate affects one period only, the change may not be accounted for over two or more periods in order to diminish the effect of the change on income, or for any other purpose. Correction of error may not be accounted for prospectively, or over two or more periods, in order to diminish the effect of the correction on any one period.
D. National Steel Over Accrues Reserves
Under Apel, National Steel's finance department reviewed and analyzed most reserve accounts on a quarterly basis. From the early 1980s through 1996, however, National Steel over accrued reserves or made other accounting errors which caused income to be understated by a total of $62 million. Of this amount, $51 million derived from over accrued reserves. The accounts in question included reserves for bad debts, state and local taxes, post employment and post retirement benefits, and other miscellaneous liabilities. Over half of the excess reserves were accrued prior to 1992, before Apel became controller. These were:
In 1994 and 1996, National Steel over accrued reserves and made other accounting errors totaling $16.8 million and $21 million, respectively. The details are (in 000s):
As the above tables indicate, the over accruals and other accounting errors were spread over several different types of accounts and not concentrated within any specific area of responsibility. As to each account, National Steel´s finance department staff made accounting mistakes or mis-estimates, applied incorrect accounting standards, failed to apply correctly new accounting standards, failed to consult with other departments within National Steel as needed, applied incorrect discounting factors and time periods, and/or neglected to adjust estimates in response to changed facts and circumstances. As time passed, it became known within the finance department that National Steel´s reserves for certain liabilities were excessive, but the issue was neglected until 1996.
EFFECT OF ACCOUNTING ERRORS ON
National Steel's failure to correct its over accrued reserves had the following effect on its balance sheets during the years 1992 through 1996:
EFFECT OF EXCESS RESERVES ON
E. Carl Apel Informed of Excess Reserves
In connection with the 1995 year-end close of National Steel's books, Apel distributed a routine memo to his managers requesting their proposed year-end adjustments. The manager for state taxes responded with a hand written note recommending "favorable adjustments" in the reserves for the Michigan Single Business Tax and the State Income Tax of $1.1 million and $3 million, respectively. The manager wrote further:
I would also like to note that only $1,000,000.00 of the $12,847,462 in account 22999-1000 is specifically earmarked for actual [State] Franchise Tax Liabilities. As you know the rest has been carried on the books since we arrived from Pittsburgh [in 1992].
No one in the finance department took any steps in response to this memo to determine why, how or when such reserves came to be over accrued. The finance department did not adjust the account in conformity with GAAP.
By year end 1996, Apel had received written notice of other potential excess reserves from his staff. In December 1996, a finance department employee analyzed the reserves for State Income Tax and Michigan Single Business Tax and recommended reduction by $2.6 million and $4 million, respectively. In January 1997, the manager for financial-customer service analyzed National Steel's reserves for bad debts and recommended reduction by $2 million as of December 31, 1996. National Steel´s manager of general accounting analyzed National Steel's reserves in connection with the expenses related to the closure of a facility and found they were approximately $2.5 million higher than needed per actuarial estimates.4 And National Steel´s controller for closed coal mines analyzed various shutdown reserves and concluded that several were, in total, $9.1 million higher than needed per actuarial estimates.
F. Carl Apel Orders Gradual Accretion of Excess Reserves to Income
Carl Apel addressed the issue of excess reserves by attempting to reduce gradually the excess balances in certain reserve accounts, without disclosing these accounting adjustments to the public, during 1996 and the first two quarters of 1997. Gradually reducing the excess reserves was not in conformity with GAAP, specifically FAS 5 and APB 20, and had the effect of inflating the income (or reducing the losses) that National Steel reported to the public in 1996 and the first two quarters of 1997. Adjusting the reserve accounts in conformity with GAAP would have required a fully disclosed restatement, as National Steel ultimately concluded was necessary, and would have had no effect on current income.5
In January 1996, Apel directed a finance department employee to prepare a recurring journal entry form to debit the State Franchise Tax reserve by $166,666.67 per month until further notice, thus reducing the account by $500,000.01 per quarter in 1996. Apel gave no further instructions regarding adjustments to this account. The finance department performed no analysis pursuant to FAS 5 or APB 20 to justify this reduction. The facts and circumstances relating to National Steel´s liabilities for state franchise taxes did not change in any quarter in 1996 such as to justify the reduction of the reserve by $500,000. In preparing National Steel´s Forms 10-Q and 10-K for 1996, Apel made no public disclosure of these adjustments.6 During 1996 National Steel continued to use the State Franchise Tax reserve for its intended purpose -- to accrue and pay for that year´s state franchise tax expenses, which amounted to $783,316. By year end, the balance in the account had fallen to $10,748,150.
In 1997, Apel expanded significantly the gradual reduction of National Steel´s excess reserves -- in total dollar amount and in the number of accounts affected. In January 1997, Apel directed finance department employees to prepare recurring journal entry forms to: (i) debit the State Franchise Tax reserve by $166,666.67 per month, continuing the gradual reduction of this account begun the previous year; (ii) debit the State Income Tax reserve by $100,000.00 per month; (iii) debit the General Office reserve by $50,000.00 per month; (iv) debit the allowance for bad debts by $125,000.00 per month; (v) debit the Michigan Single Business Tax reserve by $167,000.00 per month; and (vi) debit certain shutdown reserves by $500,000.00 per month. In April 1997, Apel directed a finance department employee to prepare a recurring journal entry form to debit the reserve for the management incentive compensation plan by $200,000.00 per month. Thus, the accretions to income from these reserves totaled $3,326,000.01 in the first quarter of 1997 and $3,926,000.01 in the second quarter of 1997. National Steel´s finance department performed no analyses to justify these reserve reductions. The facts and circumstances relating to the various liabilities in question had not changed in the first or second quarters of 1997 to justify these reductions in the accruals. In preparing National Steel´s Forms 10-Q for the first and second quarters of 1997, Apel made no public disclosure of these adjustments.
The finance department accounted for the gradual reduction of the reserves as pre-tax adjustments. With the exception of the State Income Tax reserve, they were used to decrease the "Cost of Goods Sold" and the ´selling, General and Administrative Expenses" line items on National Steel´s financial statements. As such, they flowed directly to National Steel's bottom line. The table below illustrates the effect of the gradual reductions on the income (loss) reported by National Steel to the investing public in 1996 and 1997. The table compares (i) the amounts improperly accreted to income on a quarterly and year-to-date basis; with (ii) the income (or loss) that National Steel would have reported but for the accretions. In brackets are the percentages by which the accretions inflated National Steel's profits (or reduced losses).7
EFFECT OF UNDISCLOSED GRADUAL REDUCTION OF EXCESS RESERVES
(* These amounts do not include the adjustments of $300,000 per quarter from the State Income Tax reserve, which were applied to the Income Tax provision line item in National Steel's 10-Qs. These adjustments reduced the 1Q 97 Income Tax provision by 11.3%, and the 2Q 97 provision by 3.2%.)
Although small relative to certain measures, such as National Steel's net sales, the above table demonstrates that, in certain quarters in 1996 and 1997, the gradual reduction of the reserve accounts significantly inflated the quarterly and/or year-to-date income (or reduced the losses) National Steel reported to the public. In other quarters the effects were less significant. For the period 1994 - 1996, the income trend was downward as a result of operations. In 1996, the accretions generally had the additional impact of softening that trend and, in 1997, when income began to grow, they increased the rate of that growth.
F. National Steel's Audit Committee Conducts a Self-Investigation and National Steel Voluntarily Restates Its Financial Statements
In the summer of 1997, a finance department employee reported information to National Steel´s general counsel as to the size and adequacy of National Steel´s reserves and as to the ongoing gradual reduction of those reserves. In August 1997, the general counsel reported these matters to the Audit Committee of National Steel´s board of directors. The Audit Committee promptly retained outside counsel, which engaged an independent accounting consultant and conducted an investigation. The Audit Committee voluntarily advised the Commission staff of the inquiry, reported the results of the investigation to the staff, and made disclosure of the self-investigation in public filings with the Commission. In early 1998, National Steel announced the voluntary restatement of its financial statements for the years 1992 through 1996 and the first two quarters of 1997. National Steel continued to cooperate with the Commission staff following the restatement. Based upon the recommendation of the Audit Committee, National Steel engaged the independent accountants to conduct quarterly reviews of National Steel's financial statements pursuant to Statement on Auditing Standards No. 71. Further, National Steel hired a different independent accounting firm to conduct a review of its internal controls (pursuant to Statements on Standards for Attestation Engagements, AT Section 400) and National Steel implemented all recommendations arising out of that review.
A. National Steel Violated the Reporting Provisions of the Exchange Act
Section 13(a) of the Exchange Act requires that issuers with securities registered pursuant to Section 12 of the Exchange Act file such information and documents as the Commission shall prescribe by its rules and regulations. Rules 13a-1 and 13a-13 require issuers to file annual and quarterly reports, respectively. Rule 12b-20 requires that these periodic reports contain such further information as is necessary to make the required statements, in the light of the circumstances under which they are made, not misleading. The filing of a periodic report containing materially false or misleading information constitutes a violation of these provisions. SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979); SEC v. Kalvex, Inc., 425 F. Supp. 310, 316 (S.D.N.Y. 1975).
National Steel violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder by filing annual reports on Form 10-K for the years ended December 31, 1992, 1993, 1994, 1995 and 1996, and quarterly reports on Form 10-Q up to the first two quarters of 1997, that contained materially false and misleading financial statements. National Steel's balance sheets were materially false and misleading throughout this time because of the over accrued reserves. National Steel's income statements were materially false and misleading in 1994, 1996 and the first two quarters of 1997 because of National Steel's failure to accrue reserves properly and because of National Steel's gradual and undisclosed accretion of those excess reserves to income in a manner not in conformity with GAAP.
B. National Steel Violated the Record Keeping and Internal Control Provisions of the Exchange Act
Section 13(b)(2)(A) of the Exchange Act requires issuers to make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer. National Steel violated Section 13(b)(2)(A) of the Exchange Act by accruing reserves far in excess of its probable and reasonably estimable loss contingencies, and by gradually reducing those reserves in a manner not in conformity with GAAP. This created books, records, and accounts which did not, in reasonable detail, accurately and fairly reflect the loss contingencies or the income of National Steel.
Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP. National Steel violated Section 13(b)(2)(B) of the Exchange Act by failing to devise and maintain a system of internal accounting controls sufficient to prevent the accrual of reserves in excess of its probable and reasonably estimable loss contingencies, and sufficient to prevent the gradual and undisclosed reduction of those excess reserves in a manner not in conformity with GAAP.
Based on the foregoing, the Commission finds that National Steel Corporation violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-1 and 13a-13 promulgated thereunder.
In view of the foregoing, the Commission deems it appropriate to accept National Steel Corporation´s Offer. In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by National Steel and cooperation afforded the Commission staff.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Securities Exchange Act of 1934, that National Steel Corporation cease and desist from committing or causing any violation and any future violation of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934, and Rules 12b-20, 13a-1 and 13a-13 promulgated thereunder.
By the Commission.
1 The findings herein are made pursuant to the Offer and are not binding on any other person or entity in this or any other proceeding.
2 National Steel had six CFOs between 1992 and Apel´s termination in December 1997. For a brief period in August 1996, Apel was not employed by National Steel.
3 Figures for 1996 are net of other adjustments made in the restatement.
4 The manager of general accounting orally advised Apel that the reserves for the closed facility were too high in the previous year, 1995, as well. The manager of general accounting and Apel had also discussed the "General Office" reserve account, which had been established in connection with the "quick close" of National Steel´s books, but which had been unused and unchanged (at exactly $7 million) since 1994.
5 Depending on the facts and circumstances, National Steel may have concluded that adjustments to certain reserve accounts were"changes in estimates" in the current period, as opposed to the correction of error. If so, this would have affected current period income, with disclosure governed by APB 20.
6 Apel was not employed by National Steel on the date it issued its Form 10-Q for the second quarter of 1996.
7 The profits (losses) actually reported by National Steel in its 10-K and 10-Qs may be calculated by adding the accretions back into the profits shown on the table (or subtracting from the losses). The percentages relating to Net Income and Net Income Applicable to Common Stock (after preferred stock dividends of approximately $11-million per year) are not adjusted for any presumptive tax effect; National Steel paid no federal income tax in 1996 or the first two quarters of 1997. The table does not take into account the effect of other adjustments made by National Steel during its restatement.