At the end of last year, the SEC announced settled charges against Entergy Corporation, a Louisiana-based utility company with shares traded on the NYSE, for failure to maintain internal accounting controls adequate to ensure that its surplus materials and supplies were accurately recorded on its books and financial statements in accordance with GAAP. The case represents yet another example where the charged misconduct related only to ineffective controls, without any associated charges of fraud. According to Sanjay Wadhwa, Acting SEC Enforcement Director, “internal accounting controls serve as a front-line defense in ensuring the accuracy and reliability of financial statements….Investors rely on public companies, such as Entergy, to ensure that adequate internal accounting controls are in place. We allege that Entergy failed to fulfill its obligation in this regard.” Entergy agreed to pay a civil penalty of $12 million. Rumor has it that we’re likely not going to see a lot more of these “controls-only” types of Enforcement actions once the SEC comes under new management.
Background. As described in the complaint, “[u]nder GAAP, materials and supplies are generally initially recognized as assets measured at acquisition cost.” However, GAAP also requires remeasurement of these assets “in certain circumstances to ensure that the assets are not carried at more than their recoverable amount.” In particular, for “materials and supplies not yet consumed, the asset must be evaluated for remeasurement, for example, where evidence indicates the materials and supplies are surplus, no longer have service potential, or if a decision is made to dispose of the asset by sale or other means. An expense is required to be recognized if the carrying value of the asset (e.g., historical cost) exceeds the remeasured amount.”
According to the SEC, Entergy maintained “materials and supplies consist[ing] of tangible goods, equipment, and materials that Entergy purchased for use to construct and maintain its power plants, to transmit and distribute power to customers, and for other general facilities and operational use.” Under the company’s accounting policy, the company “considered materials and supplies that had accumulated in quantities greater than needed for future use to be surplus.” At the end of 2018, Entergy reported $752 million of materials and supplies at average cost on its balance sheet. At March 31, 2024, the value was reported as in excess of $1.49 billion.
During the relevant period, the SEC asserted, “Entergy should have regularly reviewed its materials and supplies to determine if any of it was surplus to its business’ needs and recognized a loss when remeasurement of the materials and supplies was required.” However, the SEC charged, from at least mid-2018 going forward, Entergy “failed to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that surplus materials and supplies were timely identified and properly remeasured in its books and reported in its financial statements in accordance with GAAP.” Instead, Entergy recorded materials and supplies as assets on its balance sheet “at their average cost as an asset on its balance sheet”—even though the company had information indicating that some of these materials and supplies were “slow-moving, aged, and potentially in excess of its business needs, and thus were not being used.”
During the time period, the SEC alleged, Entergy engaged two management consultants to help with the company’s management practices regarding materials and supplies; both consultants identified a large quantity of materials and supplies that either “would, or would potentially, go unused or otherwise lack service potential for the company. The first consultant identified over $177 million in materials and supplies that had not been used in 10 or more years, concluding that the company’s power plants had “‘unlimited years of stock on hand,’ which would not be possible to use over any reasonable time horizon.” The consultant concluded that “Entergy could expect to recover, on average, 15-20% of the reported value through dispositioning.” These findings were shared with personnel in the accounting and supply chain departments. The SEC observed that the “supply chain officer responded, ‘[t]here is of course concern about the magnitude of any eventual [write] off.’” In addition, in August 2019, an “Entergy accounting manager was sent this consultant’s March 2018 report and was told that Entergy’s SOX controls (i.e., internal control over financial reporting) for materials and supplies were not ‘necessarily operating effectively in all cases.’ Nevertheless, Entergy failed to make improvements to its internal accounting controls relating to surplus materials and supplies.”
As alleged, in November 2020, Entergy’s supply chain group advised several accounting managers that they had “identified nuclear materials and supplies reported at over $90 million that had not been used in 20 or more years.” By November 2022, that number grew to $193 million. The complaint also alleged numerous other instances when Entergy employees raised issues concerning the company’s failure to identify and properly account for surplus materials and supplies. For example, employees reported “that ‘sub-optimal controls’ over materials and supplies were ‘a key contributor to asset growth,’ as Entergy employees could purchase materials and supplies when Entergy’s quantity on hand was already over its maximum stocking levels.” At one point, the employees identified “inconsistencies and gaps across functions” in the company’s controls and devised a plan to “improve SOX compliance.” However, the company did not fund that effort nor did it “remeasure any surplus materials and supplies and record any expense in accordance with GAAP” or “adopt accounting controls to address the proper accounting for surplus materials and supplies.”
In mid-2021, Entergy retained a second management consultant. As part of that process, over 130,000 categories of materials and supplies were identified that exceeded the maximum amounts set by the company’s business units, with an aggregate reported average cost of approximately $303 million. The complaint alleged that the company “did not identify which materials and supplies were surplus to its business needs or no longer had service potential or determine if remeasurement was necessary.”
To address the surplus issue, in August 2021, the company established a reserve for anticipated surplus write-downs over a three-year period, but, the SEC charged, these amounts “were not derived from an analysis of the materials and supplies identified by Entergy’s consultants as potential surplus.” Subsequently, Entergy employees also suggested that a “significantly larger reserve fund” was required.
Notwithstanding all of “these documented issues,” the SEC charged, “Entergy still failed to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurance that its accounting for surplus materials and supplies complied with GAAP.” As a result of Entergy’s internal accounting control failures, the complaint charged, “Entergy’s evaluation of its recorded materials and supplies for surplus was inadequate, and it therefore failed to ensure that it accurately and fairly remeasured these assets in accordance with GAAP.”
Violations. According to the SEC, Entergy violated Section 13(b)(2)(A) (books and records) and 13(b)(2)(B) (internal accounting controls) of the Exchange Act. Entergy agreed to pay a civil penalty of $12 million and to engage an independent consultant to assess the company’s internal controls and to follow the consultant’s recommendations.
