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U.S. Securities and Exchange Commission

Initial Decision of an SEC Administrative Law Judge

In the Matter of
Scott E. Edwards, CPA

FILE NO. 3-10220

Before the
Washington, D.C.

In the Matter of




December 12, 2002

APPEARANCES: Frank C. Huntington and Daniel P. Barry for the Division of Enforcement, Securities and Exchange Commission.

S. Peter Mills of Wright & Mills, P.A., for Respondent.

BEFORE: Lillian A. McEwen, Administrative Law Judge.


This Initial Decision concludes that Respondent Scott E. Edwards, CPA (Edwards) violated Rule 102(e) in his 1995 audit of Firstmark Corporation (Firstmark). It prevents Edwards from appearing or practicing before the Securities and Exchange Commission (Commission) as an accountant for one year.


The Commission initiated this proceeding by an Order Instituting Public Administrative Proceedings (OIP) on June 8, 2000. The proceeding was authorized pursuant to Rule 102(e) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e). I held a hearing on October 11 and 12, 2000, in Portland, Maine. The Division of Enforcement (Division) called three witnesses from whom testimony was taken, including Edwards and an expert witness. Edwards called two witnesses, himself and a fact witness. Seventy-two exhibits were admitted into evidence.1

Pursuant to the Administrative Procedure Act, 5 U.S.C. § 557(c), and the Commission's Rules of Practice, 17 C.F.R. § 201.340, the following posthearing pleadings were considered: the Division's Post-Hearing Brief and Proposed Findings of Fact and Conclusions of Law, received December 12, 2000; Edwards's Post-Hearing Brief, received January 18, 2001; and the Division's Post-Hearing Reply Brief, received January 24, 2001.


The OIP alleges that Edwards engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) in connection with his audit of the financial statements of Firstmark for the year ending June 30, 1995. The financial statements and Edwards's unqualified audit report were filed with the Commission. The OIP alleges that the financial statements improperly accounted for the value of two investments, one in HMI Investments Limited (HMI) and the other in Industrial Technologies, Inc. (Intec). The OIP further alleges that Edwards falsely certified that Firstmark's financial statements conformed to generally accepted accounting principles (GAAP), and that Edwards failed to obtain sufficient competent evidence, maintain an attitude of professional skepticism, or exercise due professional care. GAAP are the basic postulates and broad principles of accounting pertaining to business enterprises. These principles establish guidelines for measuring, recording, and classifying the transactions of a business entity. See SEC v. Arthur Young & Co., 590 F.2d 785, 789 n.4 (9th Cir. 1979).

Thus, the OIP alleges that Edwards failed to conduct the audit in conformance with generally accepted auditing standards (GAAS). GAAS are the standards prescribed by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA) for the conduct of auditors in the performance of an examination of management's financial statements. See SEC v. Arthur Young & Co., 590 F.2d at 788 n.2.

The Division requests that Edwards be denied the privilege of appearing or practicing before the Commission with a right to reapply after at least three years. Edwards argues that the June 30, 1995, audit dealt with complex transactions. He contends that his conduct throughout the audit was reasonable and within GAAS, and that since reasonable minds could differ on the results, there is no evidence that he acted recklessly. Edwards requests that the proceeding against him be dismissed.


The findings and conclusions in this Initial Decision are based on the record and the demeanor of the witnesses who testified at the hearing. Preponderance of the evidence was applied as the standard of proof. See Steadman v. SEC, 450 U.S. 91, 97-104 (1981). All arguments, testimony, and proposed findings and conclusions that are inconsistent with this Initial Decision are rejected. Having reviewed the entire record, I find the following facts to be true.


Scott Earl Edwards is a fifty-two year old resident of Bangor, Maine, and a certified public accountant registered in the State of Maine. (Tr. 148, 391; Stip. Nos. 1, 2.) He graduated from the University of Maine in 1969, majoring in mathematics, and from Pennsylvania State University in 1971 with a Master in Accounting. (Tr. 391.) After graduation he worked for Peat Marwick Mitchell & Company for ten years, the last three focused on administration of auditing and accounting practices. (Tr. 392.) He became an internal auditor at Hershey Foods for two years and then an audit manager at Berry Dunn McNeil & Parker for nine years. (Tr. 391-92.) In 1991, he became a partner of Edwards, Faust & Smith (EFS), a public accounting firm located in Bangor, Maine, founded by Edwards, Al Faust (Faust), and Brian Smith. (Tr. 148, 392; Stip. No. 3.) Over his career and as Chairman of the New England Peer Review Board for two years, Edwards has had significant experience auditing public companies and undergoing peer reviews of EFS and other AICPA member audit firms. (Tr. 392-94, 458-59; Ex. 72.) The audit at issue in the instant case survived peer review with no adverse findings. (Tr. 396-97.)

Between June 1994 and March 1998, EFS performed a variety of accounting and other services for Firstmark, including auditing Firstmark's financial statements for the fiscal years ending June 30, 1994, and June 30, 1995, and assisting the audit of Firstmark's financial statements for the fiscal year ending June 30, 1996, performed by Deloitte & Touche (D&T). (Stip. No. 4.) Edwards was the partner at EFS with primary responsibility for the services that it provided to Firstmark, and he was the engagement partner for EFS's audit of Firstmark's financial statements for the fiscal years ending June 30, 1994, and June 30, 1995. (Stip. No. 5.) Faust also worked on the June 30, 1995, audit. (Tr. 479-81.) Firstmark was the only publicly traded company EFS audited. (Tr. 461-62.)

Firstmark Corp.

Firstmark, incorporated in Maine in January 1982, engaged in financial services and real estate and timber operations during the time at issue. (Stip. No. 6.) Its financial services business included insurance consulting and marketing, registered investment advisory services, personal and corporate financial planning, management consulting, and venture capital services. In addition, Firstmark investments for its own account included marketable securities and loans. (Stip. No. 7.) James F. Vigue (Vigue), the president and chief executive officer of Firstmark and its subsidiaries, was also the chairman of Firstmark's board of directors. (Stip. No. 8.) Vigue's wife, Ivy Gilbert (Gilbert), was the secretary, treasurer, and chief financial officer of Firstmark and a member of Firstmark's board of directors. (Stip. No. 9.) Vigue and Gilbert ran Firstmark's operations from an office in Waterville, Maine. (Stip. No. 10.)

Firstmark had several wholly owned subsidiaries, one of which, Firm Investment Corp. (Firm), was registered with the Commission as a broker-dealer until August 1999. Another subsidiary, Firstmark Financial Corp. (Financial), was registered with the Commission as an investment advisor until July 1997. Most of Financial's advisory clients had brokerage accounts with the Firm. (Stip. No. 11.) Firstmark and its subsidiaries had approximately twelve employees and approximately eight full-time financial advisors who represented Firm and/or Financial. (Stip. No. 12.) From the 1980s through 1995, Vigue and the registered representatives of Firm and Financial sold Firstmark common and preferred stocks to many customers and clients of Firm and Financial. (Stip. No. 19.) During the time at issue, Firstmark's stock was registered with the Commission pursuant to Section 12(g) of the Securities Exchange Act of 1934. (Stip. No. 17.) Firstmark's common stock was listed on the NASDAQ Small Cap Market. (Stip. No. 18.) As of June 30, 1995, Firstmark had approximately 650 shareholders. (Stip. No. 20.) On April 27, 1999, Firstmark's common stock was delisted for failure to maintain a $1.00 bid price. (Stip. No. 18.)

The HMI Investment.

Initial Investment - January 1994.

Firstmark began investing in HMI in fiscal year 1994. (Tr. 160-62.) On or about November 11, 1993, Firstmark loaned $300,000 to HMI, a start-up company in the field of television advertising and distribution. (Tr. 160-61; Stip. No. 27.) Firstmark also received 60,000 shares of HMI. (Tr. 160-62.) The total investment was considered "as a single type of venture." (Tr. 161.) When Firstmark obtained the 60,000 shares of HMI, it was valued at $15,000, or $.25 per share. As of June 30, 1994, the total amount of Firstmark's investment in HMI was $315,000. (Stip. No. 28.) The audited financial statements for the fiscal year ending June 30, 1994, valued the HMI investment at cost, or $315,000. (Stip. Nos. 29, 30.)

Wire Transfers - September 1994 to March 1995.

Between September 27, 1994, and March 22, 1995, Firstmark made numerous monetary advances to HMI. The total amount of these advances was $241,568.80. (Stip. No. 35.) At least three of the advances were wires to personal bank accounts of HMI's CEO, Mark Kallan (Kallan), and his wife, Dori Kallan. These included $7,500 on December 29, 1994, $7,500 on January 13, 1995, and $25,000 on March 22, 1995. (Stip. No. 36.) A fourth transfer of $14,000 was also wired on December 9, 1994. (Tr. 165-66; Ex. 60.)

Abigail Mullin (Mullin), who made several of the wire transfers with the approval of Vigue, specifically provided the HMI wire transfers and copies of the facsimiles to Edwards for the June 30, 1995, year-end audit. (Tr. 83-84, 113-14, 176-77.) She knew that Vigue did not want the HMI investment specifically mentioned in the financial statements, but in light of the wire transfers, she believed that the HMI investment was overvalued and possibly worthless and communicated this to Edwards and Faust. (Tr. 73, 83-85, 113-114.) Mullin hoped that whatever problems existed, Edwards would discover them when questioning the value of HMI as an investment. (Tr. 85, 113.) Although Mullin signed off on the management representation letter concerning HMI, she believes Edwards was fully aware of her concerns. (Tr. 109-10; Ex. 49.)

During the time of the wire transfers, Vigue was actively involved in helping HMI make a private placement of HMI stock in order to help raise capital for HMI. (Tr. 169-70.) After a discussion with Vigue, Edwards concluded that the wire transfers were made to the personal accounts of Kallan and Dori Kallan due to IRS problems and also so that Firstmark could invest in other companies with which Kallan was involved. (Tr. 167.) Edwards treated the wire transfers "as an HMI investment." (Tr. 168.)

Compensation for Services - December 1994.

On December 9, 1994, Firstmark recognized $125,000 in fee income due to the receipt of 250,000 shares of HMI stock, which Firstmark valued at $.50 per share, as payment for consulting services Vigue rendered to HMI. (Tr. 163-64; Stip. No. 34.) Edwards derived Firstmark's valuation of the fee income through the application of Accounting Principles Board Opinion (APB) 29, because it was difficult to determine the fair value of the HMI stock or the services provided. (Tr. 171-72; Ex. 15.) Although Firstmark's January 1994 acquisition of 60,000 HMI shares was valued at $.25 per share, Venture One, Firstmark's venture capital partnership, also bought HMI shares in August 1994 at $2.00 per share. (Tr. 170-73.) Edwards decided to use a seventy-five percent discount from the $2.00 per share valuation in August 1994, rather than the $.25 per share valuation in January 1994. (Tr. 174-75.)

Very little, if any, documentation was provided to substantiate the services rendered by Vigue to HMI; however, Edwards was not concerned about the lack of evidence. (Tr. 173, 179.) He believed that the consulting services would not generate "a large amount of documentation." (Tr. 182.) Edwards received no billing hours from Vigue or other internal records concerning services rendered. (Tr. 173, 179.) He only knew that Vigue spent a lot of time on the telephone about HMI matters and that he visited the company. (Tr. 172-73.)

Documentation of HMI Activities.

Before Firstmark acquired HMI stock in December 1994, Vigue wrote letters to HMI, advising HMI on November 3 and 29, 1994, to warn its creditors to agree to a plan and wait for equity to come in rather than declaring bankruptcy on HMI. (Tr. 178-79; Ex. 59.) Vigue also wrote a similar letter in January 1995 to Kallan advising that the creditors should be notified that HMI would cease operations if additional funds were not acquired. (Tr. 179.) Edwards was never shown the letters Vigue sent to HMI concerning possible bankruptcy. (Tr. 173, 483-84; Ex. 59.)

Vigue began negotiating with the principals of HMI in early 1995 about the possibility of exchanging Firstmark's investment in HMI for an interest in another yet-to-be-financed company. (Stip. No. 37.) In fact, Firstmark's unaudited financial statements for the third quarter ending March 31, 1995, were written by Vigue and stated, "[Firstmark] has agreed to exchange its shares of HMI Corp. into shares of Trinity Horizons, a Luxembourg based private company." (Tr. 184-85; Stip. No. 40; Ex. 60 at 5-6.) Charles Stein (Stein) and Kallan also controlled Trinity Horizons. (Tr. 187.) By letter dated August 30, 1995, Vigue indicated to Edwards that Firstmark had a valid exchange offer from a Nevada company, as well as other possible companies working with HMI. (Ex. 46.)

Edwards never called Kallan, Stein, or anyone else at HMI to obtain information or documentation about HMI. (Tr. 201-02, 205, 431.) It was his understanding from Vigue that Kallan and Stein were "people of real substance" and he did not deem it necessary to verify. (Tr. 436.) Edwards learned from an August 3, 1995, discussion with Tom Tate, a broker at Smith Barney, that HMI had not paid several months' rent and that HMI was "out of business." (Tr. 188; Ex. 60 at 6-7.) In fact, the telephone for HMI had been disconnected. (Tr. 189.)

In an August 31, 1995, letter to Vigue, Edwards expressed strong suspicions that Firstmark might not recoup its investment in HMI. (Tr. 192-94; Ex. 47.) He was further concerned about "the overall evaluation of HMI." (Tr. 182.) He doubted HMI's ability to maintain $681,000 in value. (Tr. 475.) Because of his suspicions, Edwards sought documentation from Vigue concerning valuation. (Tr. 194.) Edwards, however, never learned anything more about an "offer from a Nevada company" or a New York company, or a Romanian car company that Vigue alluded to in his August 30, 1995, letter. (Tr. 190-92.) Edwards received no documentation from Vigue in response to his letter by the time he finished the audit of the financial statements. Only after the audit was complete did Edwards receive information that Stein was planning to make a gift to Firstmark of shares of a new company, which would be greater or equal to Firstmark's investment in HMI. (Tr. 195-96; Ex. 59.)

At some point Edwards considered writing off the HMI investment as worthless, due to the cash advances, lack of financial data, and plans to add value by exchanging shares with companies controlled by the same principles. (Tr. 197.) He also contemplated identifying a scope limitation to the audit because there was information about HMI that he did not have access to. (Tr. 201.) After discussion with another auditor, Jim Hines, Edwards determined that the scope of the audit was not being limited, that the negotiations of an exchange were ongoing between Vigue at Firstmark and Kallan at HMI for some type of exchange to make Firstmark's investment in HMI worth something, and that "the ultimate value of HMI" would come out of those negotiations. (Tr. 187, 201, 426-27, 429, 445; Exs. 29, 60.)

Edwards unreasonably decided to address the issue of valuation by placing a footnote in the financial statements that focused on the possible future exchange as providing future value to Firstmark's investment. (Tr. 200, 426-35.) The footnote does not state clearly that Vigue had no contractual right to reimbursement of the $681,000 by HMI or that the value of the investment in HMI was actually zero. (Tr. 212-14.) Ultimately, the HMI stock was exchanged for shares in Euro-Asia. (Tr. 445.)

Vigue believed that these possibilities were sufficient to maintain the valuation of the HMI investment at cost, $681,000 - $300,000 for loan, $15,000 for 60,000 shares at $.25 per share, $241,000 for wire transfers, and $125,000 for 250,000 shares at $.50 per share. (Ex. 46.) Although Firstmark had no contractual right to be made whole by HMI through an exchange of investments, Vigue characterized Firstmark's relationship with Stein and Kallan as a moral obligation, which Vigue believed was sufficient to justify the audit treatment. (Tr. 205-06.)

Edwards unreasonably relied primarily on the word of Vigue for valuation of the HMI investment. (Tr. 431.) Edwards's views were "based on [his] discussion with [Vigue] and based on [] what [Vigue] was telling [him]." (Tr. 435.) Edwards had only the loan agreements, a few stock certificates, and several wire transfers, since Vigue had refused Edwards's request for any other files relating to HMI, stating that there was "nothing to provide." (Tr. 179-81.) Edwards never saw anything in writing to substantiate Vigue's prediction that Firstmark's HMI stock would be exchanged. (Tr. 183-86.) None of the "different" investment opportunities for the HMI investment were ever shown to Edwards. (Tr. 433.) In sum, Edwards had "very little solid information" other than Vigue's belief that the investment would pay off, and he had no proof that an exchange of investment would actually occur. (Tr. 210, 212.)

If the HMI investment had been written off as worthless, Firstmark's assets would have decreased by nearly ten percent in the "Other Investments" category. It would have wiped out almost all the pre-tax net income of $772,000. Instead of rising from $270,000 to $772,000, income would have decreased to nearly zero, a material effect on net income. (Tr. 199-200.) It also would have jeopardized Firstmark's goal of upgrading its NASDAQ listing. (Ex. 46.)

EFS's Audit of Firstmark's 1995 Year End Financial Statements.

Firstmark was required to file with the Commission annual reports on Form 10-KSB and quarterly reports on Form 10-QSB. (Stip. No. 22.) At all relevant times, Firstmark's fiscal year ending on June 30. (Stip. No. 23.) Accordingly, on or about September 27, 1995, Firstmark filed a Form 10-KSB for the fiscal year ending June 30, 1995, which contained financial statements audited by EFS and an "Independent Auditors' Report" by EFS dated September 11, 1995. (Stip. No. 25.)

The "Independent Auditors' Report" by EFS was an unqualified opinion followed by an explanatory paragraph,

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Firstmark Corp. and subsidiaries as of June 30, 1995 and 1994, and the results of their operations and their cash flows for the three years end[ing] June 30, 1995 in conformity with generally accepted accounting principles.

(Tr. 157-58; Stip. No. 47.)

The explanatory paragraph stated,

As discussed in Note 2, [Firstmark] changed its method of reporting investments in debt and equity securities in 1995. In addition, [Firstmark] has an investment as of June 30, 1995 in a marketing company [HMI], the ultimate value of which will depend on the outcome of negotiations currently in progress. Also, a settlement was reached on an outstanding option agreement subsequent to year- end resulting in a gain to be reported in the 1996 fiscal year.

(Stip. No. 48; Ex. 32 at 16.)

EFS, primarily Edwards, spent approximately three days in June 1995 preparing and gathering materials for the year-end audit. (Tr. 400-02.) Throughout Edwards's onsite fieldwork, Mullin, the comptroller responsible for preparing Firstmark's financial statements from April 1994 to December 1995, provided all financial documents in her possession to Edwards. (Tr. 68-70, 83, 149-50.) Mullin prepared monthly balance sheets and year-to-date income statements that were approved by Gilbert and forwarded to Vigue. (Tr. 70-71.) Edwards had to go to Vigue and Gilbert for whatever financial documentation not in Mullin's possession. (Tr. 83.)

Audit Results.

In its audited financial statements for the fiscal year ending June 30, 1995, Firstmark's investment in HMI was valued at cost, or $681,569. (Stip. No. 43.) Note 1 to Firstmark's audited financial statements for the fiscal year ending June 30, 1995, which was entitled "Summary of Significant Accounting Policies," contained a subsection entitled "Other Investments" which stated, "other investments are carried at cost, unless evidence indicates that a loss has been incurred." (Stip. No. 44.)

Note 2, entitled "Investments," listed Firstmark's $681,569 investment in HMI in the category of "Other Investments" and referred to the HMI investment as an "equity based loan to start up television marketing and distribution company." (Stip. No. 45.) Note 2 also stated,

The marketing company [HMI] has transferred certain of its operations to a new company, which is currently being capitalized. Management is negotiating with the principals of the marketing company and believes the Company [Firstmark] will receive shares of stock in the newly formed company at least equal to or greater in value than its investment in the marketing company. Accordingly, the investment continues to be recorded at cost. However, its ultimate value will depend on the outcome of the negotiations currently in process.

(Tr. 209; Stip. No. 46.)

GAAP and GAAS Considerations.

The value of the HMI shares received was based on Edwards's arbitrary assignment of a value that "was unsupported by evidence." (Tr. 271; Exs. 7, 8.) APB 29 indicates that valuation for non-monetary transactions is based on the fair values of the assets or services involved beginning with the value of what was given, or otherwise, the value of what was received.

If Vigue spent his time on the telephone with HMI executives merely inquiring about, or worrying about, or "babysitting his investment in HMI," his efforts did not add value to his investment, since he did not provide a service to HMI. (Tr. 274.) If the time Vigue devoted to HMI consisted of arranging financing in the form of Firstmark's loans to HMI, Vigue would have been entitled to a financing fee. Under GAAP, specifically Financial Accounting Standard Bulletin, Statements of Financial Accounting Standards (SFAS) 91, those fees should have been amortized "over the period of the loan" and not recognized as revenue immediately. (Tr. 274-75.) If $125,000 was payment for Vigue's consulting services performed in several past years, there is no "evidence whatsoever" for the conclusion. (Tr. 275-76.)

Firstmark received 250,000 shares of HMI for "compensation of services." In spite of the wire transfers keeping the business afloat, Edwards accepted the valuation of $.50 per share. (Tr. 273.) The characterization of the $.50 as a "discount" from the $2.00 per share value applied six months prior was not objective marketplace information because "the $2.00 per share was paid by a partnership of which Firstmark was the general partner and had advanced all of the money for the purchase of shares." (Tr. 273.) The transaction was not arm's length. APB 29 states that for non-monetary transactions where fair value of what was given cannot be assessed and where fair value of what was received cannot be assessed, the transaction cannot be recognized. (Tr. 276.) The $125,000 of fee income, itemized on the financial statements, was therefore "fictitious." (Tr. 277.)

The HMI investment had become worthless by June 30, 1995, although it continued to be presented at cost on the financial statements. (Ex. 7 at 6.) Notwithstanding a management representation letter stating that the "carrying value of our investment in HMI will be realizable," the objectively verifiable information clearly indicated severe or total impairment of the investment. (Ex. 7 at 7.) The verifiable information indicated that HMI had ceased operations, that cash infusions had been directed to the owners personally, and that the company no longer had telephone service. There was no basis for the original amount of the investment because it was never the subject of a "formal assessment" by the auditor and there was also no basis for continuing to carry the investment in HMI as an asset at its original cost. (Tr. 285-86, 293; Ex. 7 at 12.)

Edwards's decision not to recognize any impairment due to ongoing negotiations to exchange the HMI investment was unreasonably inconsistent with industry standards. Under SFAS 5, gain contingencies are not to be recorded before they have been realized. As of June 30, 1995, the exchange contemplated had not occurred. The loss in value of the investments in HMI, on the other hand, had occurred and thus had to be recognized in earnings. The loss in value of the HMI investment could not be ignored due to the expectation of a later exchange for valuable assets. (Ex. 7 at 13.)

Edwards never identified Financial Accounting Standard Bulletin (FASB) 114 as one of "the appropriate accounting principles" and thus Edwards was "unable to apply the mechanical tests to see what the extent of the HMI impairment was." (Tr. 281-82; Ex. 12.) Part of the investment was "clearly a loan." The original $300,000 was "documented as a loan whose later interest rates increased." (Tr. 282.) Later advances were deposited in private bank accounts for the Kallans. These loans to individuals "would have been covered by 114." (Tr. 282.)

FASB 114 requires that for a loan, the auditor must "project future cash flows to look at potential impairment." (Tr. 282.) The work papers show no evidence that the principal and interest were considered recoverable. Indeed, there is no evidence that the client collected any interest at all on the original $300,000 loan. There is also no evidence that the loan was waived in exchange for the stock that was received. Because Edwards never considered the questions raised by the circumstances of the loan there was "an audit failure." (Tr. 284-85.)

Because the debtor was facing insolvency on a weekly basis unless it was wired $5,000 immediately, there was "a very high probability of impairment" of the loan that was never the subject of a "formal assessment" by the auditor. Furthermore, the issues raised in FASB 114 were never addressed in any work papers. However, it was obvious that Firstmark was "never going to collect this loan." (Tr. 285-86.)

FASB 115 (Ex. 13) applies to the valuation of HMI equity securities. Firstmark paid cash for stock after loaning HMI $300,000. Firstmark paid $.01 per share for 60,000 shares which it "booked" at $15,000, or $.25 cents per share "for reasons that are not made explicit." (Tr. 287; Ex. 13.) Firstmark booked $15,000 "of revenue for the first stock investment. They later booked $125,000 of fee income for 250,000 shares." Later, Firstmark advanced even more money that was in the form of loans, to the principal and the principal's wife. From an accounting perspective, Edwards should have distinguished between the owner and the company. (Tr. 287-88.)

The test for the accounting of the stock investment in HMI is described in FASB 115. Whether the equity securities were marketable, and whether a fair value can be determined for the securities are the questions posed in FASB 115. As of June 1995, the investment was worthless because pursuant to FASB 115, the impairment was other than temporary in nature. (Tr. 288.) The asset must be written down "to the amount that has not been impaired." (Tr. 289; Ex. 13 at 1552, ¶ 16.) The asset would thus be reduced on the balance sheet to a lower number, and the adjustment must be charged as an expense or a loss on the income statement. Thus, the realized loss is reflected as a write-down in earnings. (Tr. 290.) Of course, the fair value of the HMI stock may be determined by market value if there is a market for the securities. By June 1995, HMI was worthless. Thus, FASB 115 requires that the securities be written down as a "realized loss." (Tr. 290-91.) Thus, even though there was no market for the HMI securities, the appraisal of the securities would be based on "the performance of the company." (Tr. 292.)

Audit work papers generated by Edwards had no data on the performance of HMI as an ongoing business. Thus, there was an audit failure and a permanent impairment. When Firstmark refused to produce documents or material on HMI, a reasonable auditor would have withheld his audit opinion on the financial statements. (Tr. 293.) Although Edwards's work papers demonstrate that he might have concluded that the investment in HMI was at risk, the financial statement did not reflect it. (Tr. 296.) The balance sheet should have shrunk by $681,000. The investment should have been written down from $681,000 to zero. Pre-tax earnings of $771,000 should have been reduced by $681,000. (Tr. 297.) Thus, 88% of reported earnings would be affected. The investors would have seen $90,000 as the accurate earning figure for Firstmark. The $771,000 figure in the false earnings statement overstated the truth by 755% for the reader of the financial statements in the instant case. (Tr. 297.)

Mere oral assurances by Vigue, Kallan, or Stein that other projects would succeed in the future for HMI were not competent audit evidence. (Tr. 302-07; Ex. 24; AU § 326.) Edwards's working papers made no reference to,

documentary material such as checks, invoices, contracts and minutes of meetings, confirmations and other written representations by knowledgeable people, information obtained by the auditor from inquiry, observation, inspection and physical examination and other information developed by or available to the auditor which permits him to reach conclusions through valid reasoning.

(Tr. 307; Ex. 24; AU § 326.) Even if future projects might lead to profits, the present losses should have been realized, and future gains would be a mere "gain contingency" that is disclosed in a footnote. (Tr. 316-20; Ex. 11 at 37.)

As for the July 21 $675,000 settlement, in an unrelated Firstmark, Telephone & Data Systems, Inc. (TDS) stock option matter, Edwards recorded it accurately as a subsequent event. It could not have offset the losses already described. Periodic reporting requires that the settlement proceeds could not have been included in the June 30 fiscal period because the settlement had not occurred yet. (Tr. 321-23.)

No audit evidence supports Edwards's statement in the auditor's report and in note 2 that there were negotiations in progress. (Ex. 32 at 13.) Finally, there is "no audit evidence that HMI had any operations to transfer" to any other company. (Tr. 326-29.) The report refers to a newly formed company that is currently being capitalized whose shares will be exchanged for HMI shares. However, there is no evidence that the new company will even "have stock worth a nickel" to be exchanged. (Tr. 328-29.)

As background for the entire audit process, Vigue told Edwards that the threshold to be reached for pre-tax earnings was $750,000, so that Firstmark could be listed on NASDAQ or AMEX. (Tr. 346-49; Ex. 46.) Edwards ignored other indications of impairment, including the deteriorating condition of HMI from late 1994 to June 1995 - Firstmark's cash advances so that HMI could meet immediate needs, and the sending of the cash advances to the principals personally. Auditors are expected to consider the matter of impairment when any of a range of indicators is present, and in this case, the weekly demand of cash was the most impressive negative indicator. (Ex. 7 at 21.) Edwards understood the circumstances of the HMI investment, and he failed to review financial statements of HMI or even contact its principals to clear up any doubts. (Ex. 7 at 22.) Edwards instead chose to trust management's representations. Edwards unreasonably failed to confirm the valuation assigned to the non-monetary transaction, the exchange of HMI securities for services rendered by Vigue, or Firstmark's representation that HMI had transferred certain of its operations to another company. (Ex. 7 at 23.)

The Intec Investment.

In early 1995, Firstmark implemented SFAS 115, which requires that, upon purchase, a security must be classified as "available for sale," "trading," or "held to maturity." (Stip. Nos. 54, 64.) "Trading" securities are recognized on the income statement according to market prices. (Tr. 215-16.) Equity securities that are "available for sale" are not recognized on the income statement; rather they are identified in the equity section of the balance sheet. (Tr. 215-16.)

In May 1995, Firstmark purchased 192,500 shares of common stock of Intec for $154,000 in a private offering. Firstmark also received certain warrants to purchase additional shares of Intec stock. (Tr. 86; Stip. No. 55.) A new employee, Bob Rice (Rice), "came on board as part of an acquisition of a brokerage firm . . . in Portland" after Firstmark sustained a loss of $85,000 from securities investments in its fiscal year 1994. (Tr. 217-18; Exs. 25, 32 at 19.) Rice, a full-time trader in charge of Firstmark Prime, a subsidiary of Firstmark based in Portland, purchased Intec for Firstmark. (Tr. 100, 103, 114, 232-33, 415.) He typically traded securities classified as "trading" securities for short-term gains. (Tr. 102-03, 114-15, 415.) However, when Firstmark purchased the Intec stock in May 1995, the shares were restricted and could not be sold. (Tr. 220-21; Stip. No. 56; Ex. 63 at 2-4.)

Mullin was responsible for documenting the purchased securities and, consistent with Vigue's instructions, categorized the securities based on SFAS 115 at the end of each month by making "manual entries into the accounting software." (Tr. 95, 466; Ex 55.) Thus, the Intec shares were not immediately categorized when first purchased. (Tr. 95-96.) At the end of May, following a conversation with Vigue, Mullin placed the Intec stock in "the category where the unrealized gains are not reflected in current earnings," or the "available for sale" category. (Tr. 86-89, 93.) During his audit, Edwards did not receive any documentation indicating how the securities were categorized for May 1995. (Tr. 233, 414.) The Portfolio Statement for month end May 31, 1995, was not provided. (Tr. 487.) Edwards, however, believed that the Intec stock was either unclassified or classified as "trading." (Tr. 234, 414, 466; Ex. 65.)

By the end of June, before the June 30, 1995, year-end audit, Mullin moved the Intec stock to the "trading" category, consistent with Vigue's instruction. Mullin thought that Vigue wanted to show at least $750,000 in income, so that the company could be listed on a better exchange. (Tr. 86-89, 93.) Accordingly, at the end of the fiscal year, the Intec shares were categorized as "trading." (Tr. 414.) The Portfolio Statement for month ending June 30, 1995, generated on July 17, 1995, identifies the Intec shares in the "trading" group. (Tr. 234, 410-12, 414, 467, 481, 487; Ex. 65.) This document was part of Edwards's audit papers.

In July, the first month of the new fiscal year, Mullin was instructed "to move it back to available for sale as of July 1." (Tr. 86-89, 110-11.) Documentation for the month ending July 31, 1995, identifies Mullin's handwritten notes indicating the movement of 192,500 Intec shares to "available for sale." (Tr. 90-92; Ex. 55.) The Portfolio Statement for the 1996 fiscal year also identifies the stock in the "available for sale" category, as of July 1, 1995. (Tr. 235, 468-69; Ex. 66.) Edwards believed that this information concerning the category change in the new fiscal year, after June 30, 1995, was not relevant to the 1995 fiscal year audit. (Tr. 422.)

SFAS 115 Treatment.

As a threshold determination, Edwards had to determine whether the Intec stock, although restricted, should receive SFAS 115 treatment. (Tr. 224-26; Ex. 13.) Edwards interpreted SFAS 115 to include restricted equity securities that had a reasonable expectation of qualifying for sale within one year. (Tr. 224-26; Ex. 13.)

Edwards originally thought that the restriction placed on the Intec stock would expire in sixty days, based on a conversation with Vigue, but by August 1995, Edwards realized that the restriction would exist for a much longer period. (Tr. 417-19, 462; Ex. 60.) Edwards sought some documentation from Vigue that the restriction would be removed. (Tr. 220-22; Ex. 63 at 2-4.) In September 1995, Vigue responded with documentation that Intec filed a registration statement, Form S-1, on September 5, 1995, covering the restricted shares. (Tr. 221-23, 420; Stip. No. 57; Ex. 63 at 5.)

Since Intec was a listed company already trading on the NASDAQ Small Cap Market, Edwards had no reason to believe that the registration statement would not become effective. (Tr. 223-26; Ex. 49.) On this basis, he believed that the registration statement provided sufficient evidence to warrant SFAS 115 treatment of the Intec shares. (Tr. 224.) The registration statement became effective in May 1996, approximately eight months after the audit was completed. (Tr. 225.)

The second determination Edwards had to make was whether the Intec shares should be categorized as "trading" or "available for sale." Edwards interpreted SFAS 115 as allowing "management intent" to determine whether the Intec shares should be listed as income for purposes of the financial statement. (Tr. 225, 230, 232.) Accordingly, Edwards examined various indications of Firstmark's intent. (Tr. 232.)

Firstmark's management, namely Vigue, wanted the Intec shares classified as "trading." (Tr. 228.) He represented to Edwards that he intended to sell the stock as soon as the registration statement became effective. (Tr. 224, 230-31.) Vigue thought it would occur during the second quarter of the 1996 fiscal year, October through December 1995. (Tr. 225, 228.) Edwards also found it significant that Rice, who purchased the Intec stock, was a trader who typically bought and sold on a short-term basis. (Tr. 233, 415.) Finally, the formal representations made in management's letter to Edwards identified the Intec stock as "trading" securities. (Tr. 420-21.) The management representation letter from Firstmark to EFS, signed by Vigue, Gilbert, and Mullin, asserted the expectation that "trading" securities, including Intec shares, would be sold within a year, according to Firstmark's trading policies. (Tr. 226, 418-22; Ex. 49.)

These indications (Vigue's representation, Rice's typical purchasing habits, and the management representation letter) were tempered with other information Edwards processed during the audit. First, Edwards knew that Firstmark "couldn't have sold [Intec] shares" because the registration statement had not yet become effective. He, nevertheless, accepted Vigue's indication that Firstmark had already sold some of the shares. (Tr. 230.) Second, Edwards knew that documentation of the Intec shares was inconsistent for May, June, and July. For May, Edwards had no documentation but thought the shares were unclassified or classified as "trading" when they were classified as "available for sale." (Tr. 234, 414, 466.) For June, Edwards had documentation showing the shares classified as "trading." (Tr. 235, 466; Ex. 65.) For July, Edwards had documentation showing the shares classified as "available for sale." (Tr. 235, 468-69; Ex. 66.) Third, Edwards was aware that Vigue wanted Firstmark to have at least a $750,000 pre-tax income, so that Firstmark's NASDAQ Small Cap Market listing could be upgraded. (Tr. 237-39, 442-43; Ex. 46.) In a letter to Edwards, dated August 30, 1995, Vigue wrote, "the one hurdle we are going to have to overcome is pre[-]tax income. We need $750,000 of pre-tax income before we can move to a national NMS." (Tr. 238-39, 245-47, 442; Ex. 46.)

On the basis of information collected for the audit, and notwithstanding the tempering facts above, Edwards unreasonably "believed" that the stock was appropriately categorized as "trading" and appropriately recognized as income. He also determined that it was not necessary to discuss, in the auditor's report or the footnotes to the financial statements, his doubts as to the value or categorization of the Intec shares. (Tr. 231.) If the Intec shares had been classified as "available for sale" instead of "trading," pre-tax income for Firstmark would have been reduced by $146,000, the amount of unrealized gains on Intec, a difference of about twenty percent. (Tr. 226-27.) For Firstmark, the difference would have been material. (Tr. 227.) The pre-tax income on marketable securities would have been reduced, from $443,000 to below $300,000. (Tr. 228.)

Audit Results.

Accordingly, in its audited financial statements for the fiscal year ending June 30, 1995 (which were contained in the Form 10-KSB filed on or about September 27, 1995), Firstmark reported total assets of $7,328,113, and pre-tax earnings of $771,895. (Stip. No. 58.) For its fiscal year 1995, Firstmark showed a gain of about $443,000 from securities investments. (Tr. 218; Ex. 32 at 19.) Of that amount, Firstmark reported $225,000 of the gains from actual sales of securities. The remainder, $187,000 resulted from unrealized gains. (Tr. 219; Ex. 32 at 25.) Of that figure, $146,781 was generated from unrealized gains assigned to Intec stock. (Tr. 219-20; Stip. No. 59.)

Note 1 to Firstmark's audited financial statements for the fiscal year ending June 30, 1995, which was entitled "Summary of Significant Accounting Policies," contained a subsection entitled "Debt and Equity Securities" which stated,

Beginning in 1995, all marketable securities held for trading or available for sale are stated at the market value at the balance sheet date. . . . Securities are classified as trading, held for sale, or held to maturity based on management's intent at the time they are purchased . . . . [U]nrealized gains or losses on trading securities . . . are reflected in income.

(Stip. No. 60.)

In a subsection entitled "Impact of Recently Issued Accounting Standards," Note 1 also stated, "The Financial Accounting Standards Board has recently issued . . . [SFAS] 115 on accounting for investments in debt and equity securities . . . . The Company [Firstmark] implemented the statement on . . . investments in securities in 1995. The effect of . . . the investments statement is disclosed in Note 2." (Stip. No. 61.)

Note 2, entitled "Investments," contained a subsection entitled "Marketable Securities," which stated, "In 1995, the Company [Firstmark] implemented [SFAS] 115 on accounting for investments in debt and equity securities. Accordingly, all investments in securities held for trading and available for sale are carried at market, and securities held to maturity are carried at cost." (Stip. No. 62.)

GAAP and GAAS Considerations.

The Intec investment, as a restricted security, would not have been classified by a reasonable auditor as a "trading" security and its reclassification from "available for sale" to "trading" was improper. (Ex. 7 at 15.) Firstmark was not in a position to take advantage of short-term movements in the market. (Tr. 339.) SFAS 115 defines "trading" securities as those which are "bought and held principally for the purpose of selling . . . in the near term, and generally reflect active and frequent buying and selling," indicating that the stock is intended to be held for hours or days. (Tr. 345, 356-60, 382.) The initial classification of "available for sale" was amended only after two months. The almost immediate transfer back to the "available for sale" classification further exacerbated this questionable activity after year end. (Ex. 7 at 15.)

Edwards's use of SFAS 115 to conclude that the Intec investment was "marketable equity securities" was unreasonable. "Trading" securities can be sold at any time based on management's intent. In the instant case, the Intec investment was restricted, and although the registration statement was submitted, it was not effective. The intent of management was therefore not dispositive. A lack of registration would have made it impossible to sell the shares. Only when the registration statement for the securities became effective, would Firstmark have the capability to sell Intec. (Ex. 7 at 16.) The presentation of the Intec investment would have been maintained by a reasonable auditor as an "available for sale" security, with any fair value change reflected only in income, and not in earnings. (Ex. 7 at 16.) Thus, the unrealized gain on the Intec stock was not properly described in the audit report, and the figures for income were inaccurate by twenty-five to thirty-five percent. (Tr. 345, 356-60, 382.) This error materially distorted earnings by $146,000. (Tr. 345; Ex. 32.)

Two major auditing failures occurred. First, there was no documentary evidence for the increase in value of the Intec investment, although the financial statement indicated a nineteen percent increase in a two-month period. Neither the original cost nor the market value was verified. Second, Edwards unreasonably failed to understand, and did not adequately review, SFAS 115, concerning the classification of Intec stock. The work papers indicate only that a registration statement had been filed with the Commission, but there is no indication that the statement would become effective in a short period of time. (Ex. 7 at 25.)


The OIP alleges that Edwards recklessly failed to conduct the audit of Firstmark's financial statement for the fiscal year ending June 30, 1995, in accordance with GAAS, in violation of Rule 102(e). Rule 102(e)(1)(ii) provides for sanctions against accountants who "have engaged in . . . improper professional conduct," which includes "intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards." 17 C.F.R. §§ 201.102(e)(1)(ii), (iv)(A).

The Commission defines recklessness for purposes of Rule 102(e) proceedings as the recklessness under the antifraud provisions. Amendment to Rule 102(e) of the Commission's Rules of Practice, 68 SEC Docket 707, 710; 63 Fed. Reg. 57164, 57167 (Oct. 26, 1998); see also Russell Ponce, 73 SEC Docket 442, 465 n.52 (Aug. 31, 2000), appeal pending, No. 00-71398 (9th Cir. 2000) (holding that the amendment of subsection (iv)(A) to Rule 102(e) merely codified the Commission's longstanding recklessness standard). Thus, recklessness is an extreme departure from the standard of ordinary care which presents a danger of misleading buyers or sellers that is either known to the actor or is so obvious that the actor must have been aware of it. See SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044-45 (7th Cir. 1977).

For auditors, this means that the accounting practices of the independent auditor must be so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. See SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992). If the independent auditor shows that his accounting decisions were reasonable, the scienter requirement is not met. See World of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994).

GAAP and GAAS violations, by themselves, do not constitute circumstantial evidence of recklessness. See Chill v. General Elec., 101 F.3d 263, 270 (2d Cir. 1996); Software Toolworks Inc., 50 F.3d 615, 627 (9th Cir. 1994); see also Danis v. USN Comm., Inc., 73 F. Supp. 2d 923, 941 (N.D. Ill. 1999). The courts have found the requisite scienter when GAAP and GAAS violations are combined with other circumstantial evidence of recklessness, such as when an auditor ignores multiple red flags that should have heightened one's professional skepticism. See Danis, 73 F. Supp. 2d at 941-42; Miller v. Material Sci. Corp., 9 F. Supp. 2d 925, 928-29 (N.D. Ill. 1998).

Edwards Improperly Issued an Unqualified Audit Report.

An audit report is required to state whether the financial statements are presented in accordance with GAAP. See AU § 150.02. An auditor may issue an "unqualified" report only when the financial statements present fairly, in all material respects, an entity's financial position, results of operations, and cash flows in conformity with GAAP. See AU § 508.10. When financial statements contain a departure from GAAP or there is a lack of sufficient competent evidential matter, the auditor should express a qualified or adverse opinion or should disclaim an opinion. See AU § 508.38. Accordingly, issuing an unqualified audit report for financial statements containing a material departure from GAAP constitutes a failure to comply with GAAS. A fact is material if there is a substantial likelihood that a reasonable investor would consider it to significantly alter the total mix of information made available in making an investment decision. See Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

EFS issued an unqualified audit report for Firstmark's June 30, 1995, year-end financial statements. (Stip. Nos. 23, 25.) However, the financial statements departed from GAAP in at least three material ways. These departures resulted in a departure from ordinary care that was so extreme that investors would have been misled. First, the HMI shares received as compensation by Firstmark in exchange for alleged consulting services were not accounted for properly according to GAAP. APB 29 provided Firstmark with the ability to account for the transaction based on the fair value of the services rendered by Firstmark or the fair value of the HMI stock received. Firstmark failed to do either. It was impossible for Firstmark to determine the fair value of the services rendered. Firstmark was not in the business of providing consulting services and kept no records. The evidence established only that Mullin observed Vigue on the phone with HMI principals. Furthermore, the valuation of the HMI stock at $125,000 had no basis. The $.50 per share value placed on the shares received was based on a discounted $2.00 per share price obtained six months earlier in an informal transaction without consideration of HMI's dire financial situation.

Second, Firstmark compounded the problems of accounting for the HMI stock, by not writing-down the HMI investment. Under SFAS 115, worthless investments must be written off to expense in the period in which the loss of value occurs. As of the date of the balance sheet, June 30, 1995, the total investment in HMI totaled $681,569, without any adjustment for impairment. The information at the time of audit indicated that HMI had ceased operations, cash infusions had been directed to the owners personally, and the company no longer had telephone service. Clearly, the investment was impaired to the extent that the HMI investment should have been written off. Edwards's argument that negotiations to exchange the HMI shares justified unimpaired valuation of HMI stock is rejected. A contingent gain cannot be recorded before it has been realized.

Third, the financial statements inappropriately recognized the Intec investment as a "trading" security, in violation of GAAP. According to SFAS 115, "trading" securities are defined as those that are bought and held principally for the purpose of selling them in the near term, and generally reflect active and frequent buying and selling. Firstmark was not in a position to take advantage of short-term movements in the market, regardless of the alleged intent of Firstmark. The Intec investment should not have been categorized as "trading."

These departures from GAAP were material. With an appropriate write-off of the HMI investment, pre-tax income would have decreased to zero. With appropriate classification of the Intec investment, pre-tax income would have decreased another $146,000. Edwards's argument that the TDS investment offsets the HMI investment does not eliminate the misleading nature of the GAAP violations. Edwards violated GAAS when he issued an unqualified audit report for financial statements that contained material departures from GAAP.

Edwards Failed to Obtain Sufficient Competent Evidence.

GAAS requires independent auditors to obtain sufficient competent evidential matter through inspection, observation, inquiries and confirmations, to afford a reasonable basis for an opinion regarding the financial statements under audit. See AU §§ 150.02, 326.01. The auditor's objective is to obtain sufficient competent evidential matter to provide a reasonable basis for forming an opinion. See AU § 326.20. If the auditor remains in substantial doubt about any assertion of material significance, the auditor must refrain from forming an opinion until obtaining sufficient competent evidential matter to remove such substantial doubt, or must express a qualified opinion or a disclaimer of opinion. See AU § 326.23. Furthermore, when evidential matter can be obtained from independent sources outside an entity, it provides greater assurance of reliability for the purpose of an independent audit than that secured solely within the entity. See AU § 326.19.

The record clearly indicates that Edwards lacked sufficient competent evidential matter to support Firstmark's financial statements. His primary source for evidence to support Firstmark's financial statements was its president, Vigue. Edwards failed to further test or corroborate the financial statements for HMI or Intec. For example, Edwards never saw anything in writing to substantiate Vigue's prediction that Firstmark's HMI stock would be exchanged. Edwards did not receive or gather any supporting documentation from HMI, Kallan, or Stein in relation to HMI's solvency. Edwards never called Kallan, Stein, or anyone else at HMI to obtain information or documentation about HMI. Very little, if any, documentation was provided to substantiate the services rendered by Vigue to HMI. Edwards received no billing hours from Vigue or other internal records. He knew only that Vigue spent a lot of time on the telephone with HMI matters and that Vigue visited the company.

Even with suspicions, Edwards gathered no documentation as to appropriate valuation. In the face of conflicting evidence as to the classification of the Intec investment, Edwards did not gather competent evidence to support Vigue's representation that the Intec investment was a "trading" security, nor was Edwards able to corroborate Vigue's assertion that Firstmark had already traded the security. Edwards violated GAAS by failing to obtaining sufficient competent evidential matter to provide a reasonable basis for forming his audit opinions about HMI and Intec.

Edwards Failed to Exercise Due Care and Consider the Potential for Audit Risk.

An auditor has a duty to exercise due professional care in the performance of the audit and the preparation of the audit report. See AU §§ 150.02, 230.01. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated. See AU § 312.02. Audit risk is affected when management's operating and financing decisions are dominated by a single person, management's attitude towards financial reporting is unduly aggressive, and when management places undue emphasis on meeting earnings projections. See AU § 316.10. An auditor should have increased skepticism and should consider whether material misstatements exist, and should not place undue reliance on management's representations. See AU §§ 316.16, .21.

Edwards does not dispute Epstein's conclusions. He contends that the two investments presented complex issues and that a review of the accounting literature indicates that his approach to the accounting is also fully acceptable. He sought after and gathered what documentation was provided and accepted the representations of Firstmark's management. He then examined the accounting literature, sought guidance from others, and determined to accept the accounting of Firstmark's financials. However, because he had doubts, he also provided footnotes for clarity.

Edwards maintains that Epstein simply took a different view, limiting his analysis to the initial investment in HMI and not beyond at the possible exchange. (Tr. 437.) He understands Epstein's position but argues that his treatment of the investment is also valid. (Tr. 437.) As Edwards explained, "If I have an investment that is sitting here and I own it, if someone is willing to give me in exchange for that asset another asset that has value, then those shares in that other company provide value against which this investment can be measured." (Tr. 439.)

Furthermore, Edwards believed that TDS was an offsetting factor to the HMI investment. (Tr. 438.) Firstmark had settled an investment dispute with TDS that would provide a gain of approximately $675,000, which was recognized as a subsequent event in the financial statements. (Tr. 450.) Under the accounting literature, Edwards claims that the TDS settlement could have been recognized in fiscal 1995 because Firstmark knew during that fiscal year that some income would eventually result from the settlement. Edwards also claims that the TDS settlement could have been treated as a contingent gain and Firstmark could have waited until the following year to recognize the income. The TDS settlement was finalized in the following fiscal year on July 21, 1995. (Tr. 453.)

Finally, Edwards argues that Epstein has a different perspective on the categorization of the Intec investment. Even though it was restricted, Edwards had no reason not to believe that the registration statement for the Intec securities would become effective within a reasonable period of time. With Firstmark's management representing the intent to sell in the second quarter of 1996, Edwards concludes that this was consistent with the near-term requirement of the accounting literature. (Tr. 418-19.) No more analysis was required.

In sum, Edwards's position is that the 1995 financial statements fairly presented the condition of Firstmark:

When you looked at HMI, which even if it was totally written off, you could have recorded TDS income in its place, that when you looked at that and when you looked at the issue with respect to Intec in terms of it being a trading security and their intent at the time, those financial statements on an overall basis were okay, that they did present fairly and in accordance with GAAP.

(Tr. 454-55.)

The record clearly indicates a lack of "increased skepticism" by Edwards throughout the auditing process. Edwards accepted a "moral obligation" which Vigue maintained was sufficient to justify HMI's valuation. He did not resolve inconsistencies between HMI's declining financial condition and Firstmark's wire transfers, and Firstmark's valuation of the HMI investment at cost. Vigue also refused to provide documentation that Edwards requested. Edwards did not question Vigue's statements about trading Intec stock, even though he knew that it was a restricted security. Most glaring, however, is Edwards's failure to seek further documentation on these investments in light of Vigue's definitive statement that Firstmark needed to achieve $750,000 in pre-tax income. In sum, Edwards placed undue reliance on management's representation and failed to modify appropriately his audit opinion in face of undue emphasis on meeting earnings projections and the domination of Vigue in management's operations. Edwards violated GAAS by failing to exercise due care and by failing to consider the potential for audit risk in conducting the audit of Firstmark's financial statements.

Edwards Acted Recklessly in His Failure to Comply with GAAS.

Having concluded that Edwards violated GAAS in his June 30, 1995, audit of Firstmark, I must determine whether Edwards acted recklessly in committing the GAAS violations in the context of "improper professional conduct" under Rule 102(e).

The communication of the NASDAQ earnings goal was a "red flag" that should have indicated to Edwards that the earnings on the financial statements were not accurate. The entire audit process should have been more rigorous in light of a clear indication that Vigue wanted a specific pre-tax outcome of $750,000. The knowledge that Firstmark was very anxious to report $750,000 in pre-tax earnings, should have caused closer attention and examination, not unquestioning acceptance. (Ex. 7 at 24.)

It is clear that Edwards disregarded and otherwise ignored several "red flags" in conducting his audit of Firstmark. Vigue told Edwards that the threshold to be reached for pre-tax earnings was $750,000 so that Firstmark's NASDAQ Small Cap Market listing could be upgraded. Mullin reported to Edwards that she believed the HMI investment was overvalued and possibly worthless. When asked, Vigue refused to provide any documentation. These circumstances were all "red flags" that should have indicated to Edwards that the earnings on the financial statements were not accurate. However, Edwards ignored the questionable existence of HMI and did not take any action to investigate whether HMI continued to exist, blindly accepting the representations of Vigue as to HMI and Intec.

Edwards's conduct was reckless in that he refused to see the obvious, or to investigate the doubtful. No reasonable accountant would have made the same decisions if confronted with the same facts. Epstein testified on behalf of the Division and was accepted as an expert witness in the areas of accounting and auditing matters. (Tr. 266; Ex. 7.) The Initial Decision incorporates many of his expert opinions. Epstein has been a certified public accountant for thirty-three years. (Tr. 259.) For fifteen years, in his position as the chief technical officer of two different CPA firms, he has been responsible for reviewing and participating in the planning of all audit engagements. (Tr. 260.) Epstein is presently a partner in the CPA firm, Gleeson, Sklar, Sawyers & Compata, in the litigation services group, providing expertise on accounting and auditing issues. (Tr. 258.) He is also a well-published author on accounting and auditing matters. Notably, he is co-author and lead author of GAAP Interpretation and Application, 16th Edition, a book he has co-authored for sixteen years. (Tr. 261.)

Edwards's conduct was an extreme departure from the standard of ordinary care required in conducting an audit under GAAP and GAAS. Accordingly, Edwards engaged in improper professional conduct under Rule 102(e).


Pursuant to Rule 102(e)(1)(ii), the Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it to any person who is found to have engaged in improper professional conduct. The Division argues that Edwards should be denied the privilege of appearing or practicing before the Commission as an accountant for three years.

Although the Commission has not formally authorized the use of the Steadman factors in determining an appropriate sanction under Rule 102(e), Administrative Law Judges have done so. See Barry C. Scutillo, CPA, and Mark F. Jensen, CPA, 74 SEC Docket 2497, 2555 (May 3, 2001); Combellick, Reynolds & Russell, Inc., 49 SEC Docket 244, 260 (June 19, 1991). These factors include, among others, the egregiousness of the respondent's actions, the isolated or recurrent nature of the infraction, and the likelihood that the respondent's occupation will present opportunities for future violations. See Steadman v. SEC, 603 F.2d at 1140 (quoting SEC v. Blatt, 583 F.2d 1325, 1334 n.29 (5th Cir. 1978)).

Edwards's conduct, as described above, was egregious. He ignored clear warnings and allowed Firstmark to use the auditing process to bolster misleading financial statements. His acceptance of management's representations without investigation or documentation occurred throughout the entire auditing process. Furthermore, as a partner of EFS, Edwards has the opportunity to continue to audit public companies. On the other hand, Edwards has no history of infractions, and he did not intentionally place investor funds at risk. The instant case also is his first audit of a public company.

Taking into consideration these public interest factors, I conclude that Edwards's failures in conducting the audit constituted improper professional conduct and warrant a one-year suspension from the privilege of appearing and practicing before the Commission as an accountant.


Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on March 21, 2001.


Based on the findings and conclusions set forth above, and pursuant to Rule 102(e)(1) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e), IT IS ORDERED that Scott E. Edwards be, and he hereby is, DENIED the privilege of appearing and practicing before the Commission as an accountant for one year.

This Order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this Initial Decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the Initial Decision upon him, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this Initial Decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the Initial Decision shall not become final as to that party.

Lillian A. McEwen
Administrative Law Judge

1 Citations to the hearing transcript will be noted as "(Tr. __.)." All exhibits were jointly offered by the Division and Respondent, and will be noted as "(Ex. __.)." Exhibit One consists of sixty-four stipulations, which will be identified throughout as "(Stip. No. __.)." Citations to GAAS will be made to the Codification of Statements on Auditing Standards, issued by the Auditing Standards Board of the AICPA, as "(AU § ___.)."


Modified: 12/12/2002