LXP Industrial Trust: Form 10-Q for the period ended Sep 30, 2023

CONDITION AND RESULTS OF OPERATIONS

Introduction

Unless stated otherwise or the context otherwise requires, when we use the terms the “Company,” the “Trust,” “LXP,” “we,” “our,” and “us,” we refer collectively to LXP Industrial Trust and its consolidated subsidiaries. All of the Company's interests are held, and all of the property operating activities are conducted through special purposes entities, which we refer to as property owner subsidiaries or lender subsidiaries and are separate and distinct legal entities, but in some instances are consolidated for financial statement purposes and/or disregarded for income tax purposes. References herein to ‘‘this Quarterly Report” are to this Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2023. The results of operations contained herein for the three and nine months ended September 30, 2023 and 2022 are not necessarily indicative of the results that may be expected for a full year.

When we use the term “REIT,” we mean real estate investment trust. All references to 2023 and 2022, refer to the periods ending September 30, 2023 and 2022, respectively and our fiscal year ended December 31, 2022.

When we use the term “GAAP,” we mean United States generally accepted accounting principles in effect from time to time.

When we use the term “common shares,” we mean our shares of beneficial interest par value $0.0001, classified as common stock. When we use the term “Series C Preferred Shares,” we mean our beneficial interest classified as 6.50% Series C Cumulative Convertible Preferred Stock.

When we use the term “base rent,” we mean GAAP rental revenue and ancillary income, excluding billed tenant reimbursements and lease termination income.

When we use “Stabilized Portfolio,” we mean all real estate properties other than acquired or developed properties that have not achieved 90% occupancy within one-year of acquisition or substantial completion. Non-stabilized, substantially completed development projects are classified within investments in real estate under construction.

The following is a discussion and analysis of the unaudited condensed consolidated financial condition and results of operations of LXP Industrial Trust for the three and nine months ended September 30, 2023 and 2022, and significant factors that could affect its prospective financial condition and results of operations. This discussion should be read together with the accompanying unaudited condensed consolidated financial statements of the Company included herein and notes thereto and with the consolidated financial statements and notes thereto included in the Company's most recent Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission, or SEC, on February 16, 2023, which we refer to as the Annual Report. Historical results may not be indicative of future performance.

Forward-Looking Statements. This Quarterly Report, together with other statements and information publicly disseminated by us, contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and include this statement for purposes of complying with these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identifiable by use of the words “believes,” “expects,” “intends,” “anticipates,” “estimates,” “projects,” “may,” “plans,” “predicts,” “will,” “will likely result” or similar expressions. Readers should not rely on forward-looking statements since they involve known and unknown risks, uncertainties and other factors which are, in some cases, beyond our control and which could materially affect actual results, performances or achievements. In particular, among the factors that could cause actual results, performances or achievements to differ materially from current expectations, strategies or plans include, among others, those risks discussed below in “Management's Discussion and Analysis of Financial Condition and Results of Operations,” and under the headings “Risk Factors” in this Quarterly Report and under “Risk Factors” in Part I, Item A and “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Annual Report and other periodic reports filed by the Company with the SEC. Except as required by law, we undertake no obligation to publicly release any revisions to these forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Accordingly, there is no assurance that our expectations will be realized.

Overview

As of September 30, 2023, we had equity ownership interests in approximately 115 consolidated real estate properties, located in 19 states and containing an aggregate of approximately 53.9 million square feet of space, approximately 99.0% of which was leased.

As of September 30, 2023, our portfolio consisted of 110 warehouse/distribution facilities and five other properties. Our warehouse/distribution portfolio is primarily focused in our target markets within the Sunbelt and Midwest. We expect to grow these markets by executing on our development pipeline and opportunistically acquiring facilities in these markets.

Third Quarter 2023 Transaction Summary.

The following summarizes our significant transactions during the three months ended September 30, 2023.

Leasing Activity:

• Entered into new and extended leases encompassing 0.8 million square feet, including leasing one speculative development project containing 0.3 million square feet, located in the Greenville-Spartanburg, South Carolina market. The average fixed rent on the extended lease was $6.19 per square foot compared to the average fixed rent on this lease before extension of $4.90 per square foot. The weighted-average tenant improvements and lease commissions was $1.61 per square foot for new leases.

Investments:

• Completed construction of the core and shell for one warehouse/distribution facility containing 0.1 million square feet in the Central Florida market.
• Invested an aggregate of $36.5 million in development activities, including $23.8 million in six ongoing consolidated development projects.

Capital recycling:

• Disposed of two office properties for an aggregate gross sale price of $48.1 million.

Acquisition/Development Activity:

During the nine months ended September 30, 2023, we acquired or completed and placed in service the following warehouse/distribution assets:

Increased financing costs have slowed transaction activity and development starts in our target markets and the markets where we own properties. Proceeds from our dispositions are expected to be used to fund our development obligations and reduce leverage.

As of September 30, 2023, we had six consolidated development projects in process with an aggregate estimated total cost of $426.0 million. We anticipate our remaining funding obligation to substantially complete the construction and estimated tenant improvements and leasing costs of these six projects, exclusive of our joint venture partners' share, to be approximately $52.6 million. However, the risks associated with development, including supply chain issues, could adversely impact our estimates.

Critical Accounting Estimates

Our critical accounting estimates are included in Part II, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company's Annual Report on Form 10-K for the year ended December 31, 2022. There have been no material changes to these estimates during the nine months ended September 30, 2023.

Liquidity and Capital Resources

Cash Flows. We believe that cash flows from operations will continue to provide adequate capital to fund our operating and administrative expenses, regular debt service obligations and all dividend payments in accordance with applicable REIT requirements in both the short-term and long-term, however, our cash flow from operations may be negatively affected in the near term if we experience tenant defaults as a result of the effects of the current economic conditions. In addition, we anticipate that cash on hand, borrowings under our unsecured revolving credit facility, capital recycling proceeds, issuances of equity, mortgage proceeds and other debt, as well as other available alternatives, will provide the necessary capital required by our business.

At September 30, 2023, our property owner subsidiaries do not have mortgage maturities with balloon payments due until 2031. In addition, certain of our subsidiaries are obligated to fund the construction of our development projects and we sometimes guaranty these obligations. We believe our property owner subsidiaries have sufficient sources of liquidity to meet these obligations through future cash flows from operations, the credit markets and, if determined appropriate by us, a capital contribution from us from either cash on hand ($35.4 million at September 30, 2023), property sale proceeds and borrowing capacity under our unsecured revolving credit facility ($600.0 million at September 30, 2023, subject to covenant compliance).

Cash flows from operations were $153.5 million for the nine months ended September 30, 2023 as compared to $154.1 million for the nine months ended September 30, 2022. The decrease was primarily related to property sales, partially offset by the impact of cash flow generated from acquiring properties and stabilizing development assets. The underlying drivers that impact our working capital, and therefore cash flows from operations, are the timing of collection of rents, including reimbursements from tenants, payment of interest on debt and payment of operating and general and administrative costs. We believe the net-lease structure of the leases encumbering a majority of the properties in which we have an interest mitigates the risks of the timing of cash flows from operations since the payment and timing of operating costs related to the properties are generally borne directly by the tenant. The collection and timing of tenant rents are closely monitored by management as part of our cash management program.

Net cash used in investing activities totaled $46.5 million and $208.2 million during the nine months ended September 30, 2023 and 2022, respectively. Cash used in investing activities in 2023 related primarily to an acquisition, investments in real estate under construction, capital expenditures, lease costs, investments in non-consolidated entities and changes in real estate deposits, net. Cash used in investing activities primarily related to acquisitions and investments in real estate under construction offset by net proceeds received from the disposition of real estate and distributions from non-consolidated entities. During the nine months ended September 30, 2022, cash used in investing activities included additional acquisition and development activity when compared to 2023. Additional property sales in 2022 compared to 2023 generated more proceeds from sales than in 2023.

Net cash used in financing activities totaled $125.9 million and $107.5 million during the nine months ended September 30, 2023 and 2022, respectively. Cash used in financing activities in 2023 was primarily related to dividend and debt service payments, offset by revolving credit facility borrowings. Cash used in financing activities in 2022 was primarily related to the repurchase of common stock, the purchase of a noncontrolling interest and dividend and debt service payments, offset by common stock issuances and revolving credit facility borrowings.

At-The-Market Offering Program. We maintain an At-The-Market offering program ("ATM program") under which we can issue common shares, including through forward sales contracts.

We did not sell shares under the ATM program during the nine months ended September 30, 2023 and September 30, 2022, respectively.

During the nine months ended September 30, 2022, we settled 3.6 million common shares previously sold on a forward basis on the maturity date of the contract and received $38.5 million of net proceeds. No shares were sold on a forward basis during the nine months ended September 30, 2023.

In February 2021, we amended the terms of our ATM program, under which we may, from time to time, sell up to $350.0 million common shares over the term of the program. As of September 30, 2023, common shares with an aggregate value of $295.0 million remain available for issuance under the ATM program.

The volatility in the capital markets primarily resulting from the effects of the current economic conditions may negatively affect our ability to access the capital markets through our ATM program and other offerings.

Share Repurchase Program. During 2022, our Board of Trustees authorized the repurchase of an additional 10.0 million common shares under our share repurchase program with no expiration date. We did not repurchase any common shares during the nine months ended September 30, 2023. During the nine months ended September 30, 2022, we repurchased and retired approximately 11.7 million common shares at an average price of $10.84 per share. Approximately 6.9 million common shares remained available for repurchase under the current authorization as of September 30, 2023. We, in the future, may repurchase our common shares in the context of our overall capital plan and to the extent we believe market volatility offers prudent investment opportunities based on our common share price versus net asset value per share.

Dividends. Dividends paid to our common and preferred shareholders were $114.0 million and $107.9 million in the nine months ended September 30, 2023 and 2022, respectively.

We declared a quarterly dividend of $0.125 per common share during the three months ended September 30, 2023, which is an increase of $0.005 per common share from the $0.12 per common share quarterly dividend declared during the three months ended September 30, 2022.

Operating Partnership. As of September 30, 2023, 0.7 million units of limited partner interests, or OP units, in our operating partnership, LCIF, were outstanding not including OP units held by us. Assuming all outstanding OP units not held by us were redeemed on such date, the estimated fair value of such OP units was $7.3 million based on our closing price of $8.90 per common share as of September 30, 2023 and a redemption factor of approximately 1.13 common shares per OP unit. We expect that LCIF will be merged with and into us as of December 31, 2023 and each outstanding OP unit, not including OP units held by us, will be converted into the right to receive our common shares on a 1 for 1.126 basis.

Financings. The following senior notes were outstanding as of September 30, 2023:

Each series of senior notes is unsecured and requires payment of interest semi-annually in arrears. We may redeem the notes at our option at any time prior to maturity in whole or in part by paying the principal amount of the senior notes being redeemed plus any potential make-whole premium.

A summary of the maturity dates and interest rates of our unsecured credit agreement, as of September 30, 2023, are as follows:

(1) Maturity date of the revolving credit facility can be extended to July 2027 at our option, subject to certain conditions. The interest rate includes a 0.10% adjustment. The interest rate spread ranges from SOFR plus 0.725% to 1.40%. At September 30, 2023, we had no borrowings outstanding and availability of $600.0 million, subject to covenant compliance.

(2) The Term SOFR portion of the interest rate was swapped to obtain a current fixed rate of 2.722%.

As of September 30, 2023, we were compliant with all applicable financial covenants contained in our corporate-level debt agreements.

We also have $129.1 million of outstanding Trust Preferred Securities that are due in 2037. The current interest rate is three-month SOFR plus a 0.26% adjustment plus a spread of 170 basis points.

Development Costs

As of September 30, 2023, we had six ongoing consolidated development projects and expect to incur approximately $23.5 million and $29.1 million of costs during the remainder of 2023 and 2024, respectively, excluding noncontrolling interests' share, to substantially complete the construction of such projects. Etna Park 70, LLC, a joint venture that we have a 90% ownership interest, commenced construction of an industrial facility estimated to cost $29.2 million. During the third quarter, through our wholly-owned subsidiary, we entered into an agreement to fund construction of the property until the land is subdivided and sold to us. As of September 30, 2023, we expect to incur approximately $9.5 million during the remainder of 2023 and 2024, respectively, to complete the development of the facility. As of September 30, 2023, we had three consolidated and two non-consolidated subsidiaries that owned land parcels held for industrial development. We are unable to estimate the timing of any required funding for potential development projects on these parcels.

Results of Operations

Three months ended September 30, 2023 compared with three months ended September 30, 2022. The decrease in net income attributable to common shareholders of $10.7 million was primarily due to the items discussed below.

The increase in total gross revenues of $5.3 million was primarily due to an increase of $3.5 million in base rental revenue and a $2.0 million increase in tenant reimbursement income primarily due to acquisitions, properties placed in service and leasing, partially offset by a decrease in rental revenue due to property sales.

The increase in depreciation and amortization expense of $0.6 million was primarily due to properties acquired and/or completed and placed in service subsequent to September 30, 2022.

The increase in property operating expense of $0.7 million was primarily due to an increase in operating expense responsibilities at certain properties.

The decrease in impairment charges of $0.6 million was primarily related to the timing of impairment charges recognized on certain properties during the third quarter of 2022. There were no impairment charges during the third quarter of 2023.

The decrease in gains on sales of properties of $17.7 million was related to the timing of property dispositions.

The increase in equity in earnings (losses) of non-consolidated entities of $1.3 million was primarily due to recognizing our share of gains on sale of one property from the NNN Office JV L.P. in 2023 in the amount of $1.0 million. Additionally, in 2022, we recognized $0.7 million of losses due to property sales and impairment charges related to NNN Office JV L.P.

Nine months ended September 30, 2023 compared with nine months ended September 30, 2022. The decrease in net income attributable to common shareholders of $59.6 million was primarily due to the items discussed below.

The increase in total gross revenues of $17.4 million was primarily due to an increase of $10.4 million in base rental revenue and a $7.2 million increase in tenant reimbursement income primarily due to acquisitions, properties placed in service and leasing, partially offset by property sales.

The increase in depreciation and amortization expense of $2.7 million was primarily due to properties acquired and/or completed and placed in service subsequent to January 1, 2022.

The increase in property operating expense of $3.4 million was primarily due to an increase in operating expense responsibilities at certain properties.

The decrease of $2.2 million in general and administrative expense is primarily related to a decrease of $2.6 million in costs incurred related to the Board of Trustees' strategic alternatives review and consulting costs related to shareholder activism in 2022. There were no consulting costs incurred related to shareholder activism during the nine months ended September 30, 2023.

The increase in impairment charges of $14.0 million was primarily related to the timing of impairment charges recognized on certain properties. The impairments in 2023 were taken on office assets primarily due to potential sales.

The decrease in gains on sales of properties of $37.9 million was related to the timing of property dispositions.

The decrease in selling profit from sales-type lease of $9.3 million is due to a tenant exercising its purchase option resulting in a change in lease classification from an operating lease to a sales-type lease in 2022 with no comparable transaction in 2023.

The decrease in equity in earnings (losses) of non-consolidated entities of $13.0 million was primarily due to the timing of property sales within our non-consolidated entities.

Same-Store Results

Same-store net operating income, or NOI, which is a non-GAAP measure, represents the NOI for consolidated properties that were owned, included for the entirety of two comparable reporting periods. We define NOI as operating revenues (rental income (less non-cash GAAP rent adjustments, non-cash income related to sales-type leases and lease termination income, net), and other property income) less property operating expenses. As same-store NOI excludes the change in NOI from acquired and disposed of properties, it highlights operating trends such as occupancy levels, rental rates and operating costs on properties. Other REITs may use different methodologies for calculating same-store NOI, and accordingly same-store NOI may not be comparable to other REITs. Management believes that same-store NOI is a useful supplemental measure of our operating performance. However, same-store NOI should not be viewed as an alternative measure of our financial performance since it does not reflect the operations of our entire portfolio, nor does it reflect the impact of general and administrative expenses, acquisition-related expenses, interest expense, depreciation and amortization costs, other nonproperty income and losses, the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties, or trends in development and construction activities which are significant economic costs and activities that could materially impact our results from operations. We believe that net income is the most directly comparable GAAP measure to same-store NOI.

The following presents our consolidated same-store NOI, for the three and nine months ended September 30, 2023 and 2022 ($000's):

Our same-store NOI increased for the three and nine months ended September 30, 2023 compared to three and nine months ended September 30, 2022 by 4.7% and 4.3%, respectively, primarily due to an increase in cash base rents. As of September 30, 2023 and 2022, our same-store properties were 99.2% and 99.3% leased, respectively, for the three months and 99.5% and 99.8% leased, respectively, for the nine months.

Below is a reconciliation of net income to same-store NOI for periods presented ($000's):

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Funds From Operations

We believe that Funds from Operations, or FFO, which is a non-GAAP measure, is a widely recognized and appropriate measure of the performance of an equity REIT. We believe FFO is frequently used by securities analysts, investors and other interested parties in the evaluation of REITs, many of which present FFO when reporting their results. FFO is intended to exclude GAAP historical cost depreciation and amortization of real estate and related assets, which assumes that the value of real estate diminishes ratably over time. Historically, however, real estate values have risen or fallen with market conditions. As a result, FFO provides a performance measure that, when compared year over year, reflects the impact to operations from trends in occupancy rates, rental rates, operating costs, development activities, interest costs and other matters without the inclusion of depreciation and amortization, providing perspective that may not necessarily be apparent from net income.

The National Association of Real Estate Investment Trusts, or NAREIT, defines FFO as “net income (calculated in accordance with GAAP), excluding depreciation and amortization related to real estate, gains and losses from the sales of certain real estate assets, gains and losses from change in control and impairment write-downs of certain real estate assets and investments in entities when the impairment is directly attributable to decreases in the value of depreciable real estate held by the entity. The reconciling items include amounts to adjust earnings from consolidated partially-owned entities and equity in earnings of unconsolidated affiliates to FFO.” FFO does not represent cash generated from operating activities in accordance with GAAP and is not indicative of cash available to fund cash needs.

We present FFO available to common shareholders and unitholders - basic and also present FFO available to all equityholders and unitholders - diluted on a company-wide basis as if all securities that are convertible, at the holder's option, into our common shares, are converted at the beginning of the period. We also present Adjusted Company FFO available to all equityholders and unitholders - diluted which adjusts FFO available to all equityholders and unitholders - diluted for certain items which we believe are not indicative of the operating results of our real estate portfolio. We believe this is an appropriate presentation as it is frequently requested by security analysts, investors and other interested parties. Since others do not calculate these measures in a similar fashion, these measures may not be comparable to similarly titled measures as reported by others. These measures should not be considered as an alternative to net income as an indicator of our operating performance or as an alternative to cash flow as a measure of liquidity.

The following presents a reconciliation of net income attributable to common shareholders to FFO available to common shareholders and unitholders and Adjusted Company FFO available to all equityholders and unitholders for the three and nine months ended September 30, 2023 and 2022 (unaudited and dollars in thousands, except share and per share amounts):

(1) Gain recognized upon exercise of the tenant's purchase option in the lease.

(2) Includes costs related to transactions, strategic alternatives and shareholder activism.

(3) Includes OP units other than OP units held by us.

Off-Balance Sheet Arrangements

As of September 30, 2023, we had investments in various real estate entities with varying structures. The real estate investments owned by our institutional joint ventures are generally financed with non-recourse debt. Non-recourse debt is generally defined as debt whereby the lenders' sole recourse with respect to borrower defaults is limited to the value of the assets collateralized by the debt. The lender generally does not have recourse against any other assets owned by the borrower or any of the members or partners of the borrower, except for certain specified exceptions listed in the particular loan documents. These exceptions generally relate to "bad boy" acts, including fraud, prohibited transfers and breaches of material representations, and environmental matters. We have guaranteed such obligations for certain of our non-consolidated entities with respect to $469.0 million of such non-recourse debt. We believe the likelihood of making any payments under such guaranties is remote and we generally have an agreement from each partner to reimburse us for its proportionate share of any liability related to a guarantee trigger unless such trigger is caused solely by us.

DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk relates primarily to our variable-rate indebtedness not subject to interest rate swaps and our fixed-rate debt. Our consolidated aggregate principal variable-rate indebtedness not subject to interest rate swaps was $129.1 million and $259.1 million, respectively, at September 30, 2023 and 2022, which represented 8.7% and 15.9%, respectively, of our aggregate principal consolidated indebtedness. During the three months ended September 30, 2023 and 2022, our variable-rate indebtedness had a weighted-average interest rate of 7.0% and 3.5%, respectively, and had the weighted-average interest rate been 100 basis points higher, our interest expense for the three months ended September 30, 2023 and 2022 would have increased by $0.4 million and $0.6 million, respectively. During the nine months ended September 30, 2023 and 2022, our variable-rate indebtedness had a weighted-average interest rate of 6.7% and 2.7%, respectively, and had the weighted-average interest rate been 100 basis points higher, our interest expense for the nine months ended September 30, 2023 and 2022 would have increased $1.4 million and $1.5 million, respectively. At each of September 30, 2023 and 2022, our aggregate principal consolidated fixed-rate debt was $1.4 billion, respectively, which represented 91.3% and 84.1%, respectively, of our aggregate principal indebtedness.

For certain of our financial instruments, fair values are not readily available since there are no active trading markets as characterized by current exchanges between willing parties. Accordingly, we derive or estimate fair values using various valuation techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved. However, the determination of estimated cash flows may be subjective and imprecise. Changes in assumptions or estimation methodologies can have a material effect on these estimated fair values, especially given the volatility of the current economic environment. The following fair value was determined using the interest rates that we believe our outstanding fixed-rate indebtedness would warrant as of September 30, 2023. We believe the fair value is indicative of the interest rate environment as of September 30, 2023, but this amount does not take into consideration the effects of subsequent interest rate fluctuations. Accordingly, we estimate that the fair value of our fixed-rate indebtedness was $1.2 billion as of September 30, 2023.

Our interest rate risk objectives are to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we manage our exposure to fluctuations in market interest rates through the use of fixed-rate debt instruments to the extent that reasonably favorable rates are obtainable with such arrangements. We may enter into derivative financial instruments such as interest rate swaps or caps to mitigate our interest rate risk on a related financial instrument or to effectively lock the interest rate on a portion of our variable-rate debt. As of September 30, 2023, we had four interest rate swap agreements (see Note 8 to our unaudited condensed consolidated financial statements contained in this Quarterly Report).

Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report to determine if such controls and procedures were effective to ensure that information required to be disclosed by us in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that information required to be disclosed by us in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management, including each of our Chief Executive Officer and Chief Financial Officer, has concluded that our disclosure controls and procedures were effective as of September 30, 2023.

Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this Quarterly Report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Limitations on the Effectiveness of Controls. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.