Archer-Daniels-Midland Co. (ADM) accounting investigation - the errors are immaterial, but SEC and DOJ investigations continue
ADM corrected errors in intersegment sales as an immaterial revision, but SEC and DOJ investigations continue.
Archer-Daniels-Midland Co. (ADM) filed its delayed annual 10-K report on March 12, 2024, providing an update on the previously reported internal investigation into accounting for intersegment sales. The investigation was initiated following June 30, 2023 inquiries from the SEC.
From the 10-K filing:
On June 30, 2023, the Company received a voluntary document request from the SEC relating to intersegment sales between the Company’s Nutrition reporting segment and the Company’s Ag Services and Oilseeds and Carbohydrate Solutions reporting segments. The Company is cooperating with the SEC. Following the Company’s January 21, 2024 announcement of the Investigation, the Company received voluntary document requests from the DOJ focused primarily on the same subject matter, and the DOJ directed grand jury subpoenas to certain current and former Company employees. The Company is cooperating with the DOJ. The Company is unable to predict the final outcome of these investigations with any reasonable degree of certainty.
Regulatory inquiries and the Company’s decision to put the CFO on administrative leave raised concerns that the accounting woes are serious. However, the internal investigation identified only immaterial errors—corrected as a “little r” revision—in the intercompany sales between the Nutrition, Ag Services, Oilseeds, and Carbohydrate Solutions segments.
From the 10-K filing:
Correction of Certain Segment-Specific Historical Financial Information
The Company has historically disclosed in the footnotes to its financial statements that intersegment sales have been recorded at amounts approximating market. In connection with the Investigation, the Company identified certain intersegment sales that occurred between the Company’s Nutrition reporting segment and the Company’s Ag Services and Oilseeds and Carbohydrate Solutions reporting segments that were not recorded at amounts approximating market.
Because each sale to be adjusted occurred between the Company’s reporting segments, the adjustments have no impact on the Company’s consolidated balance sheets and statements of earnings, comprehensive income (loss), or cash flows. The Company determined that the adjustments are not material to the Company’s consolidated financial statements taken as a whole for any period.
The message conveyed by the regulatory investigation and the CFO's leave is misaligned with the mild language describing the accounting errors. While the former raises concerns about potentially serious accounting irregularities, the latter suggests a minor insignificant accounting issue corrected through a footnote disclosure.
SEC’s inquiries were issued on June 30, 2023. The Company disclosed the investigation and put the CFO on leave on January 21, 2024, and filed revised financial statements on March 12, 2024. Did the Company know that the errors were immaterial in January 2024, when the investigation was announced, and still put the CFO on the leave? Or did the Company’s perception change dramatically between January 2024 and March 2024?
Several pieces of 10-K disclosure and the March 14, 2024, earnings call provide additional food for thought.
The materiality of the errors
As I discussed in my previous post, errors that affect segments but do not affect the consolidated results are outliers in terms of materiality assessments. While the corrections reduced Nutrition’s segment operating profit by 9.2% and 8.5% in years 2022 and 2021, respectively, they did not—based on the 10-K disclosure—have a material impact on the financial statements taken as a whole.
The materiality assessment requires an evaluation of quantitative and qualitative factors. Let’s look at an excerpt from FASB’s ASC 250-10-S99-1 that lists qualitative factors that could apply to ADM’s materiality analysis:
Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are:
… whether the misstatement masks a change in earnings or other trends
.…whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.
…whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability.
…whether the misstatement has the effect of increasing management's compensation - for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation.
In my previous post, I noted that one of the performance metrics for the 2020 PSU awards was Average Nutrition operating profit (“OP”) growth over the three-year 2020-2022 performance period.
During the March 14, 2024, conference call, the Company noted that the compensation was unaffected by the revisions:
We also confirmed that these adjustments did not change the achievement levels under our incentive plans. Further detail is included in the Form 10-K we filed this morning.
The analysis below was composed using the original and revised numbers disclosed in the 10-K filing:
Based on the disclosure in ADM’s March 14, 2023, proxy filing, the maximum 200% payout requires Average Nutrition OP growth above 20%. The original growth was 21.4%:
Average Nutrition OP growth was 21.4%, and therefore, the resulting payout factor was 200%.
The revised Average Nutrition OP growth was 20.6%, still above the 20% threshold, albeit by a smaller margin of less than 1%.
Rule 10D-1 of the Securities and Exchange Act of 1934 requires that registrants disclose whether:
… the financial statements of the registrant included in the filing reflect a correction of an error to previously issued financial statements and whether any such corrections are restatements that required a recovery analysis, and to disclose any actions an issuer has taken pursuant to such recovery policy.
Note that while the Company noted on the cover page of the 10-K filing that financial statements were revised, it also indicated that compensation recovery analysis was not required. The way I interpret the rule is that if compensation was based on metrics calculated using information that was subsequently corrected, the analysis should be performed, and the results - in this case, that the compensation is unaffected - should be reported. However, Rule 10D-1 is new, so perhaps we should wait for more interpretative guidance from the SEC.
Unfortunately, the materiality analysis is not public, so it is difficult to say how the Company addressed other qualitative factors listed in ASC 250. For instance, the Nutrition segment is the smallest of the three ADM segments, so the Company could have argued that the segment did not materially affect ADM’s operational results.
However, based on publicly available disclosure, whether the revisions affected any trends or analysts’ expectations is hard to say.
Material Weakness (MW) in Internal Control over Financial Reporting (ICFR)
The Company reported a material weakness in internal control over financial reporting and noted that the material weakness impacted the inputs used for impairment testing:
… the Company did not have adequate controls in place around measurement of certain intersegment sales between the Nutrition reporting segment and the Ag Services and Oilseeds and Carbohydrate Solutions reporting segments. The absence of adequate controls with respect to the reporting of intersegment sales impacted the accuracy of the Company’s segment disclosures and review controls over projected financial information utilized in goodwill and other long-lived asset impairment tests.
The material weakness and the related remediation efforts described in the management’s ICFR report are specific to intersegment accounting. Importantly, there is no language suggesting tone at the top issues, ethical violations, or aggressive behavior by the top executives – such as pressure on the accounting personnel to deliver the numbers. The reported material weakness – which is almost a given after an accounting correction – is an account-specific issue that can be remediated by training the personnel and improving documentation. An entity-wide control weakness related to company-wide ethical problems would be harder to remediate.
While reading through the earnings call transcript, I noticed a disclosure related to ERP implementation:
The implementation of ERP systems over the course of the year led to complications in shipping and producing products, negatively impacting both volumes and manufacturing costs.
This disclosure is noteworthy because, in the past, complications in large-scale ERP implementations led to discoveries of IT-related material weaknesses in internal controls - for example, Francine McKenna reported in the past failed SAP implementations that led to interruptions in shipping.
Please note that I am not saying there is an IT-related material weakness or a significant deficiency in ADM’s internal control. One would need substantially more evidence than a brief public disclosure to reach such a conclusion. But I do believe that ERP implementation hiccups may pose a risk to operations and financial reporting.
Impairments of goodwill and other intangible assets
The Company recorded a goodwill impairment charge of $137 million in Q4 of 2023 in its Animal Nutrition reporting unit and “…$64 million of impairments related to customer list and discontinued Animal Nutrition trademarks”.
The Company cited a higher discount rate, industry conditions, and macroeconomic conditions as a reason for the goodwill impairment:
The decline in the fair value of the Animal Nutrition reporting unit was primarily driven by a higher discount rate due to changes in the underlying business performance and industry conditions as well as the macroeconomic environment, causing a decline in the projected cash flows.
ADM performs impairment testing at least annually on October 1st or more often if there is a triggering event indicating that the reporting unit's carrying value may not be fully recoverable. ASC 350 states that companies should consider a decline in share price and market capitalization a triggering event for impairment testing purposes. ADM’s stock declined more than 15% following the announcement of accounting troubles, which may trigger an out-of-cycle impairment testing.
ADM posted lower-than-expected results in Q4 of 2023 and may face an additional write-down of intangibles if the business outlook deteriorates. As of December 31, 2023, ADM’s Animal Nutrition unit had $900 million of goodwill.
What’s next for ADM
Investors’ confidence is easy to lose and hard to gain back. A recently published academic paper finds that SEC investigations lead to enforcement action in about 25% of the cases and the remaining 75% are closed without finding wrongdoing (Solomon and Soltes, Journal of Empirical Legal Studies, 2021).1 The paper also finds that investors punish companies that disclose SEC investigations by negative returns—even if the SEC closes the investigation without pressing charges.
ADM had a mixed bag of news in the week of March 10, 2024. While the Company said said that the errors were immaterial and the stock recovered some ground, Reuters reported on March 13, 2024, that the DOJ expanded the scope of the investigation to include accounting for ethanol hedges:
ADM this week confirmed Reuters reports that the Justice Department is investigating accounting practices related to ADM's Nutrition unit and that current and former employees had received grand jury subpoenas relating to that probe.
The Chicago-based company said the investigation was "focused primarily" on the Nutrition business. The DOJ probe into ADM's ethanol trading operation was not previously reported.
As Bloomberg reported, citing accounting expert, the ADM’s woes are far from over:
The SEC and DOJ are still investigating, and the company showed signs of stress within the nutrition business unit, McKenna said, pointing to a $137 million goodwill impairment the company recorded this past quarter related to its animal nutrition line.
From an accounting perspective, ADM will likely report significant legal expenses in the next several quarters. Note, however, that contingency reserves related to regulatory investigations are not generally recorded until regulatory fines are finalized, leading to large, unexpected legal charges.
Update: the original version of the post was updated to replace term “restatement” with “revision” and “error correction” to better align with the language used by ADM to describe the error correction.
For questions please contact olga@deepquarry.com
An earlier pre-publication version of “Is 'Not Guilty' the Same as 'Innocent'? Evidence from SEC Financial Fraud Investigations” by Solomon and Soltes is available on SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3507083