This is the third in a series of articles examining the creation of the new Financial Reporting and Audit Task Force along with a Center for Risk and Quantitative Analysis. Today’s article examines select cases concerning improper revenue enhancement techniques used by issuers in actions brought by the Commission in the wake Chairman Levitt’s speech.
Following the Numbers Game speech, and continuing through the market crisis to the time of the reorganization of the enforcement division, the Commission brought a series of financial statement fraud cases. Driven by pressure to meet street expectations, a variety of fraudulent techniques to manipulate the numbers were used. Those ranged from the simple falsification of revenue, to sham transactions to managing income using a variety of improper accounting devices. One group of actions used various devices to improperly enhance revenue.
Falsification of revenue: In some instances the pressure to make the numbers resulted in the fabrication of income. Examples of these cases include:
· SEC v. HealthSouth Corporation, Civil Action CV -03-J-0615 (N.D. Ala. Filed March 19, 2003). The Commission’s complaint alleged that the company systematically overstated its earnings by at least $1.4 billion to meet street expectations beginning as early as 1999. Each quarter the company accounting staff created entries to ensure that the firm met expectations for the period. In many instances these entries took the form of reducing a contra revenue account and/or decreasing expenses and correspondingly increasing assets or decreasing liabilities. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and13(b)(20(B); See Lit. Rel. No. 1804 (March 20, 2003).
· SEC v. Koninkijke Ahold N.V.¸ Civil Action No. 04-1742 (D.D.C. Filed Oct. 13, 2004) is an action against the company and three of its former senior executives centered on an accounting fraud that took place between 2000 and 2002. While the complaint alleged a variety of fraudulent practices, one of the key elements of the scheme was the inflation of revenue. An important source of operating income was vendor payments known as promotional allowances. The company materially inflated those allowances, according to the Commission’s complaint. See also Lit. Rel. No. 18929 (Oct. 13, 2004).
· Other significant cases include: SEC v. The Penn Traffic Company, Civil Action No. 08-CIV. 01035 (N.D.N.Y. Filed Sept. 30, 2008) (alleging a financial fraud which in part involved creating fraudulent entries and/or adjustments to the books of a wholly owned subsidiary to inflate income in 2003); SEC v. VeriFone Holdings, Inc., CV 09-4046 (N.D. Cal. Filed Sept. 1, 2009) (complaint alleging that the company improperly boosted its gross margins and income by 129% in the first three quarters of 2007 by doing manual adjustments at quarter end to ensure that earnings expectations were met); SEC v. Farkas, Civil Action No. 1:10 CV 667 (E.D. Va. Filed June 16, 2010); U.S. v. Farkas, 10-cr-00206 (E.D. Va. Filed June 16, 2010) (civil and criminal actions against the former chairman of collapsed mortgage lender Taylor, Bean and Whitaker who engaged in a massive kiting scheme based on fictitious mortgaged backed loans in an effort to sustain the mortgage loans being originated); SEC v. NurtraCea, Civil Action No. 11-0092 (D. Az. Filed Jan. 13, 2011)(Lit. Rel. No. 21819 Jan. 20, 2011) (in a settled action the SEC complaint alleged that the Arizona company and three former executives engaged in an accounting fraud scheme in which the company recorded false sales, thereby over-stating product sales and revenue by as much as 35% in the second quarter of 2007).
Sham transactions. In some instances issuers structured deals to create the false appearance of a legitimate business transaction that generated revenue. Those transactions frequently recycled company cash or goods through a third party and back to create the appearance of an arm-length transaction. These “round trip” transactions lacked economic substance.
Channel stuffing: Another technique used by a number of issuers in an effort to increase reported revenue is channel stuffing. In the typical scheme the company ships product that may not have been ordered or is not needed by customers prematurely in an effort to record additional revenue. Examples of this type of activity include:
Premature recognition: In a number of cases the issuer prematurely recognized revenue in violation of GAAP in a misguided effort to increase earnings and make street expectations.
· SEC v. System Software Associates, Inc., Civ. No. 00C 4240 (N.D. Ill. Filed July 13, 2000) is an action against the software maker and its former CEO and Chairman and former CFO. The complaint alleged that for the fiscal years 1994 through 1996 the company prematurely recognized revenue on its developmental stage UNIX-language software product in violation of GAAP. The Commission’s complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). See Lit. Rel. No. 1667 (July 14, 2000);
· In the Matter of i2 Technologies, Inc., Adm. Proc. File No. 3-11518 (June 9, 2004) is a proceeding in which the Order alleged that the company misstated about $1 billion of software license revenue, including about $125 million which should never have been recognized. The events took place over five years which ended in 2002. During that period the company, in part, immediately recognized revenue for its software licenses despite the fact that some required lengthy implementation and customization efforts to meet customer needs. This practice was not in accord with GAAP. The action, settled at the time of filings, alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B).
Next: Cases following the Numbers Game Speech – distorting trends and balance sheet items
For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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