In Desperate Times: More Savvy and Cooperation at the SEC - Securities and Exchange Commission investigations

California CPA, Dec, 2001 by Deanna McCrary

"Tempt not a desperate man," wrote Shakespeare in "Romeo and Juliet." In today's dog-eat-dog economy, burdened by daily dot-com failures and the increasing instability of the markets in the aftermath of the terrorist attacks of Sept. 11, temptations and "desperate companies" abound.

By honoring Shakespeare's admonition, the SEC is becoming more savvy at recognizing the fraudulent techniques of financially desperate companies, and at the same time, more understanding of the effects of desperate times, by offering a way out of prison terms and other harsh penalties for those who come clean and cooperate.

TRENDS IN FINANCIAL STATEMENT FRAUD

Charles Niemeier, SEC chief accountant, division of enforcement, speaking at the UC Berkeley Haas School of Business 12th Annual Conference on Financial Reporting, said that today the SEC is investigating more large companies than ever before. This may be due, at least in part, to a correlating increase in the number of informants who have come forward--many of whom are disgruntled, former employees, he says.

The SEC also is experiencing an increase in investigations into companies' operations outside the United States. "We're in a new world today," says Niemeier. "We are finding disturbing situations in which problems arise only in a company's non-U.S. operations."

Niemeier says that the SEC currently has 260 financial statement fraud cases underway. And, perhaps not surprisingly, revenue recognition continues to be the number one offender as companies attempt to recognize revenue before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.

According to Niemeier, other types of fraud that the SEC is uncovering include:

* Constant changes in estimates that are not disclosed. Niemeier says this is the biggest emerging fraud issue today.

* Bill-and-hold transactions stand out as by far the most common form of revenue recognition fraud, says Niemeier. He says 90 percent of bill-and-hold transactions the SEC has come across have not met the criteria for revenue recognition.

* Channel stuffing, in which a company will "stuff the distribution channel" with products, thereby inflating accounts receivable. Channel stuffing may work for awhile, however problems arise when high sales from past quarters are made at the expense of poor sales in another quarter. Niemeier says the SEC is carefully examining companies' cash flow relative to sales to catch such schemes.

* Companies that have become dependent on acquisitions to make sales or earnings targets or to reflect growth.

* Companies that are netting onetime gains into operating results, especially against operating expenses.

"All of the above are attempts to blur the issues," says Niemeier. "Frauds don't start out to be frauds. It use ally starts out as 'smoothing a quarter' and builds from there."

Niemeier says a particularly keen eye is being kept on technology companies with whom the competition is relentlessly fierce to be first-to-market with a new and better product, and the temptation to fraudulently inflate revenue to keep stock prices up is high.

"Companies need to report not only the good, but also the bad," cautions Niemeier. "Sooner or later the bad will come out and a company will lose credibility. And once that happens, it is difficult, if not impossible, to get it back."

John Morrissey, SEC deputy chief accountant, says CFOs should never be afraid to pick up the phone and call the SEC with questions. "We encourage registrants to come to us to deal with difficult issues," he says. "We will coordinate with team leaders to get your questions answered. Sometimes we will even arrange for a face-to-face meeting."

COOPERATION COULD GET YOU OFF THE HOOK

The SEC issued a report in late October explaining its decision not to take enforcement action against a company it had investigated for financial statement irregularities. The report effectively created a framework for the SEC to evaluate cooperation in determining whether and how to charge violations of the federal securities laws.

The report identifies four broad measures of a company's cooperation:

* Self-policing prior to the discovery of the misconduct, including establishing effective compliance procedures and an appropriate tone at the top;

* Self-reporting of misconduct when it is discovered, including conducting a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely and effectively disclosing the misconduct to the public, regulators and self-regulators;

* Remediation, including dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct, and appropriately compensating those adversely affected; and

* Cooperation with law enforcement authorities, including providing SEC staff with all information relevant to the underlying violations and the company's remedial efforts.