Financial Reporting & Accounting

• SEC Enforcement Of Accounting Requirements

• Earnings Management: Swept Away?

• Financial Reporting For International Joint Ventures

M&A

• Applying The New M&A Filing Rules

• How To Succeed In Selling Your Business

Securities Offerings

• What To Do Now That Our Offering Has Aborted

Executive & Directors

• Delaware Cases Affecting Executive Compensation

• Dual Role Of Non-Executive Directors

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Examines cases initiated by the SEC in late 1999 as part of a sweep against financial reporting fraud. Notes that many involve traditional forms of fraud, but the SEC is including a broader set of people in its scrutiny. Reveals that the Commission is beginning to address issues peculiar to the so-called New Economy.

Climate of manipulation. On September 23, 1999, the SEC filed enforcement actions against 15 companies and individuals, charging them with fraud in their accounting and reporting of financial results. These enforcement actions were part of the SEC’s coordinated assault on financial reporting fraud. The sweep came exactly one year after the SEC chairman had publicly raised concerns about an erosion in financial reports’ quality, based on a climate of earnings management. In this climate, company management manipulates results to meet the expectations of Wall Street analysts, who in turn seek guidance from management for their estimates. The chairman had focused on five particular accounting gimmicks: taking a large, one-time restructuring charge; writing off large portions of acquisition costs as in-process research and development; using “cookie-jar” reserves to smooth earnings reports; misusing the concept of materiality to cover financial misstatements; and manipulating revenue recognition.

Old wine in new bottles. The enforcement actions generally attacked traditional financial fraud activities. Covered in the sweep were improper revenue recognition, falsification of assets, or blatantly improper accounting adjustments. The revenue recognition cases involve false shipments and invoices, secret side letters guaranteeing a right of return, conditional sales characterized as final, backdated agreements, and extended reporting periods. Two of the defendant companies had falsified assets by altering aged accounts receivable to make them appear current. One target had falsified inventory accounts and another had altered equipment figures. Two companies carried on their books assets that they did not own or had grossly overvalued. Significantly, in only one case did the SEC allege that the company was motivated by a desire to meet analysts’ expectations. The SEC did, however, bring two actions in 1999 against companies for misusing the concept of materiality to manage earnings.

A personal charge. As part of its effort to foster a cultural change in the financial community, the SEC filed actions against corporate officers personally as part of the sweep. The SEC named the current or former CEO as a defendant in 11 of the 15 actions. For example, as part of its action against KnowledgeWare Inc. for parking inventory with resellers (with a right not to pay), the SEC charged CEO Fran Tarkington with fraud, alleging that he had known about and directed the practice. The SEC is also pursuing persons who are not directly involved in the financial reporting process—spreading its net both wider and deeper into the corporate structure. It brought enforcement actions against three KnowledgeWare vice presidents of sales and a district sales manager, each of whom had granted unconditional rights of return through secret side agreements.

Casting a wider net. In SEC v. Computone Corp., alleging the company had recognized revenue from transactions where the customer had never placed an order or for products never shipped, the SEC charged the CEO, CFO, former CAO, two VPs of sales, sales director, and sales manager. In each instance, it did not allege that the officer had a central role in the financial reporting process, but rather that each had engaged in misconduct, resulting in the fraudulent reporting. The SEC has even brought actions against third parties. In the Model Imperial case, the SEC brought a cease-and-desist action against the company’s vendor, alleging that it had provided false invoices. In Sunrise Medical, the SEC filed against an outside information systems consultant who helped the company to manipulate its accounting software. The SEC’s willingness to examine the reasonably foreseeable effects of an individual’s actions, combined with its recent emphasis on qualitative factors in materiality analysis, will expand the scope of the individuals who may face SEC scrutiny.

Customize for the New Economy. Increasingly, corporate financial value comprises intangibles, such as intellectual capital, intellectual property, software, and websites. These New Economy assets compel companies to use more judgment in accounting and may create more opportunities for fraud. The SEC’s May 2000 case against AOL typifies the difficulty in applying existing accounting principles to new business models. AOL distributed software disks to prospective customers, accounting for the cost as an asset (which it amortized) rather than an immediate expense. The SEC charged that this violates the rule against capitalizing direct response advertising costs unless the company has a history of obtaining customers and net revenue in excess of the costs. Agreeing to take a $385 million charge against earnings, AOL paid a $3.5 million civil penalty. The SEC has asked the FASB to address other accounting practices common to Internet-based companies, particularly accounting for barter transactions and booking revenues for sales of products made through another company’s website. Because the market appears to value dot.com revenues more than profits, the SEC is concerned that these practices may inflate the company’s revenues and seeks to tighten the standards.