UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934, Release No. 39194 / October 3, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 975 / October 3, 1997 ADMINISTRATIVE PROCEEDING File No. 3-9473 ______________________________ : In the Matter of : ORDER INSTITUTING PROCEEDING : PURSUANT TO SECTION 21C OF THE PINNACLE MICRO, INC., : SECURITIES EXCHANGE ACT OF 1934, SCOTT A. BLUM, and : MAKING FINDINGS AND CEASE AND LILIA CRAIG : DESIST ORDER : Respondents. : ______________________________: I. The Securities and Exchange Commission deems it appropriate to institute an administrative proceeding pursuant to Section 21C of the Securities Exchange Act of 1934 (Exchange Act) against: A. Pinnacle Micro, Inc. (Pinnacle), to determine whether Pinnacle violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder; B. Scott A. Blum (Blum), to determine whether Blum caused violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder and whether Blum violated Exchange Act Rule 13b2-2; and C. Lilia Craig (Craig), to determine whether Craig violated Exchange Act Rule 13b2-2. II. In anticipation of the institution of this proceeding, Pinnacle, Blum, and Craig have submitted Offers of Settlement which the Commission has determined to accept. In determining to accept the Offers, the Commission considered remedial acts undertaken by Pinnacle and the cooperation ======END OF PAGE 1====== Respondents afforded the Commission staff. Solely for the purpose of this proceeding and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R.  201.100 et seq., and without admitting or denying the facts and findings set forth herein, except as to the jurisdiction of the Commission over them, which each admits, Pinnacle, Blum, and Craig each consent to the entry of this Order Instituting Public Administrative Proceeding Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Cease and Desist Order of the Commission, as set forth below. III. Based on the foregoing, the Commission finds:<(1)> A. FACTS 1. Summary Following the initial public offering of Pinnacle common stock in 1993, various Pinnacle officers and employees engaged in a variety of improper accounting practices that violated generally accepted accounting principles (GAAP). Those practices included: (a) improperly recording revenue from products shipped after the close of certain of Pinnacle's financial reporting periods (post-period shipments) and (b) inconsistently accounting for the sales of certain electronic chips. These improper accounting practices caused Pinnacle to overstate materially sales and earnings reported in financial statements contained in annual and quarterly reports filed with the Commission. On April 18, 1995, Pinnacle announced that it was restating its financial statements for fiscal 1993. The company disclosed that previously reported net income for the year, $2.6 million, was overstated by approximately $1 million, or 38.5 percent. The company also disclosed that it was restating net income for the fourth quarter of fiscal 1993, from $652,000 to a loss of ($804,000). These material overstatements were due to the improper recognition of revenue from post-period shipments. Pinnacle also disclosed that it could not determine the exact amount of any overstatements or understatements for quarters prior to the fourth quarter of 1993, because it lacked accurately dated shipping documents to establish the date of shipment for certain sales. As a result of this inability to establish the date of shipment for certain sales, Pinnacle's auditor for fiscal 1993 and prior periods withdrew its opinions on Pinnacle's financial statements for the year ended December 31, 1993 and all prior periods, <(1)> The findings herein are made pursuant to respondents Offers of Settlement and are not binding on any other person or entity named as a respondent in this or any other proceeding. ======END OF PAGE 2====== except for its opinion on Pinnacle's balance sheet as of December 31, 1993.<(2)> As a result of the improper accounting practices described above,<(3)> Pinnacle violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder. These violations were caused by, among others, Blum, Pinnacle's former Executive Vice President of Sales and Marketing. In addition, Blum violated Exchange Act Rule 13b2-2 in making materially false or misleading statements to Pinnacle's independent auditors concerning Pinnacle's inconsistent accounting for the sales of certain electronic chips. Craig, a former Vice-President of Finance, violated Exchange Act Rule 13b2-2 in making materially false or misleading statements to Pinnacle's independent auditors concerning post-period shipments. 2. The Respondents a. Pinnacle is a Delaware corporation with its principal place of business in Irvine, California. It designs and manufactures optical storage systems for personal computer and workstation operating systems. In July 1993, Pinnacle conducted an initial public offering of 2 million shares of common stock at $10.50 per share. Pinnacle's common stock is, and was at all times relevant, quoted on the NASDAQ stock market, and is registered with the Commission pursuant to Section 12(g) of the Exchange Act. Pinnacle files periodic reports with the Commission pursuant to Section 13(a) of the Exchange Act which are publicly disseminated. b. Blum, age 31, served as Vice President of Sales and Marketing from October 1987 to July 1992. From July 1992 until June 1996, Blum was Pinnacle's Executive Vice President of Sales and Marketing. From July 1996 until October 1, 1996, Blum was Vice President of Marketing. From June 1988 until he resigned in December 1996, he was a member of the Board of Directors. Together Blum and his father, the Chief Executive Officer of Pinnacle, beneficially own approximately 22 percent of the outstanding common stock of the company. c. Craig, age 44 and a resident of California, was Pinnacle's <(2)> On March 30, 1995, Pinnacle's original independent auditor resigned as a result of former senior management's response to the auditor's discovery of post-period shipments at Pinnacle. See also Pinnacle Micro, Inc. Form 8-K, dated March 30, 1995. <(3)> More recently, Pinnacle capitalized certain non-recurring engineering expenditures that were later determined should have been charged to income. On April 12, 1996, Pinnacle restated its financial statements for the quarter ended September 30, 1995 to reflect adjustments for the capitalized non-recurring engineering expenditures. Third quarter 1995 income was restated from $222,000 to $24,000, a reduction of $198,000. See also Pinnacle Micro, Inc. Form 8-K, dated February 20, 1996. ======END OF PAGE 3====== Corporate Controller from November 1993 until March 1994. From April 1994 until she resigned in November 1994, Craig was Pinnacle's Vice President of Finance. Craig acted as Pinnacle's Principal Financial and Principal Accounting Officer from April 1994 until August 1994. Prior to joining Pinnacle, Craig had worked for several privately held companies. She is not a certified public accountant. 3. Other Relevant Person James G. Hanley, age 34, joined Pinnacle in April 1989 and served as the Chief Financial Officer of Pinnacle until August 1992. From August 1992 until May 1995, Hanley served as Vice President of Operations. From May 1995 until December 1995, Hanley was Senior Vice President of Corporate Development. Currently, Hanley is General Manager, Strategic Products Group. Hanley was also a director of the company from April 1993 until September 1995. He is not a certified public accountant.<(4)> 4. Post-period Shipments From its initial public offering in July 1993 until June 1994, Pinnacle consistently reported increased sales along with record earnings both in its annual and quarterly reports filed with the Commission and in press releases. To achieve such steady growth, Pinnacle's management, including Blum, established ambitious sales targets. At times, in order to meet its sales and earning targets, Pinnacle improperly recognized revenue by recognizing revenue in a quarter from shipments made after the end of that quarter (the cut-off date) of Pinnacle's financial reporting periods. Generally accepted accounting principles (GAAP), however, require that revenue be recognized in financial statements when it is both (1) realized or realizable and (2) earned. Statement of Financial Accounting Concepts No. 5 (SFAC No. 5). In general, under this principle, revenue from the sale of a product is recognized at the date of sale, usually the date of shipment to the customer. See, e.g., In the Matter of Matthew Grant and Robert Goldstein, AAER No. 410 [1991-1995 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) 73,869, at 63,118 (August 24, 1992). At the end of a quarter, if the orders processed by the shipping department were not sufficient to meet the sales goal, the shipping department was told to continue shipping until the sales goal was met. In order for Pinnacle to recognize revenue from shipments made after the end of that quarter, Pinnacle employees predated packing lists, shipping records, and invoices to conceal that orders had not been shipped until after the end of the period. For example, the shipping department, which used United Parcel Service of America, Inc. (UPS) shipping records as part of Pinnacle's shipping log, would not advance the date on the UPS computer. This allowed Pinnacle to date UPS airbills and Pinnacle's shipping log as <(4)> In a related action, the Commission has filed a civil action against Hanley seeking injunctive and other relief. Securities and Exchange Commission v. James G. Hanley, United States District Court for the District of Columbia. ======END OF PAGE 4====== if the shipments had been shipped prior to the end of a period when, in fact, Pinnacle made the shipments after the end of the period. The shipping department would also pre-date or back-date packing lists provided for the preparation of invoices to coincide with the last day of the period. The order processing department would also back-date invoices to reflect the last day of the period. As a result, Pinnacle recorded sales as of the last day of the quarter and not on the actual shipment dates. On several occasions, when there was not enough product available to fill orders needed to meet the sales goals, manufacturing continued after the end of a period. In order to conceal the fact that the order was manufactured and shipped after the end of the period, the shipping department prepared packing lists, shipping records, and invoices in advance of receiving the product from manufacturing. Moreover, when manufacturing and shipping continued after the end of the period, Pinnacle delayed its physical inventory count, which would otherwise have required the company to freeze the movement of product in the shipping and manufacturing departments on the day after the end of the reporting period. Blum was aware of Pinnacle's practice of recording revenue from post- period shipments when the company was privately held. He and other members of management failed, however, to take steps to terminate the practice after Pinnacle's initial public offering in July 1993. Indeed, Blum was aware that the shipping department engaged in post-period shipments in order to make shipments in time to meet the sales goals that he established. In addition, Blum signed Pinnacle's Form 10-K for the fiscal year-ended December 31, 1993, which contained materially false information concerning sales and net income, resulting from Pinnacle's post-period shipments. Shortly before the end of the second quarter 1994, management, including Blum, learned that it would not be able to make shipments in time to meet sales projections for that quarter unless revenue was recognized from post-period shipments. In the presence of Blum, Pinnacle's director of manufacturing was instructed to take as long as he needed to complete manufacturing and shipping of booked sales to meet the sales projections for the quarter. Accordingly, orders shipped on July 1 and July 2, the first two days after the end of the quarter, were recorded as sales as of June 30. Pinnacle's newly-hired controller learned that Pinnacle planned to continue shipping after the end of the June 30 quarter and recognize revenue from those sales in that quarter. The controller told Craig that such an action was improper financial reporting and requested that Craig discuss the matter with Blum and Pinnacle's Chief Executive Officer. Craig, under continuing pressure from the company's then senior management to record additional sales in the second quarter, indicated that the controller should not get involved. Nevertheless, the controller subsequently contacted both the chairman of Pinnacle's audit committee and Pinnacle's independent auditor and advised them of the post-period shipments. ======END OF PAGE 5====== Consequently, the independent auditor, at the direction of Pinnacle's audit committee, conducted a preliminary investigation and verified that some of the shipments that Pinnacle's shipping log indicated had been shipped on June 30, in fact, had been shipped after that date. Thereafter, the independent auditor informed Blum and Pinnacle's Chief Executive Officer that the auditor had reasons to suspect that Pinnacle had improperly recorded revenue on post-period shipments during the second quarter of 1994. After consulting with Blum, Pinnacle's Chief Executive Officer immediately sent termination letters to Pinnacle's independent auditor. The termination was rescinded, however, after Blum and Pinnacle's Chief Executive Officer learned that the termination of its independent auditor would trigger a reporting obligation with the Commission and National Association of Securities Dealers. Subsequently, Pinnacle decided to have its independent auditor conduct a special review to determine the extent to which Pinnacle had recorded post-period shipments. As a result, on July 18, 1994, the independent auditor met with Pinnacle's Chief Executive Officer, Hanley, Craig, and counsel for Pinnacle to discuss the special review procedures. At the meeting and in the presence of Pinnacle's Chief Executive Officer and Hanley, the independent auditor asked Craig whether there were any sales recorded through June 30, 1994 that were not shipped as of June 30, 1994. Craig replied no. As set forth above, however, Craig knew that certain shipments which were made in July were improperly recorded as sales in the previous quarter ended June 30, 1994. On August 8, Pinnacle publicly announced that it was not releasing second quarter results because it intended to restate its financial results for the quarter and year ended December 31, 1993, and the first quarter of 1994. Thereafter, on April 18, 1995, Pinnacle filed an amended Form 10-K, which restated its financial statements for the quarter and year ended December 31, 1993. Pinnacle restated fourth quarter net income from $652,000 to a loss of ($804,000) and year-end net income from $2.6 million to $1.6 million or 38.5 percent of net income.<(5)> Pinnacle did not need to restate its financial statements in its Form 10-Q for the quarter ended June 30, 1994, because of the discovery of Pinnacle's practice of improper revenue recognition prior to Pinnacle's filing financial statements for that period. In its amended Form 10-K for the year-ended December 31, 1993, Pinnacle also disclosed that it could not determine the exact amount of any overstatements or understatements for quarters prior to the fourth quarter of 1993, because it lacked accurately dated shipping documents to establish the date of shipment for certain sales. As a result of this inability to establish the date of shipment for certain sales, Pinnacle's auditor for <(5)> In its quarterly report on Form 10-Q for the quarter ended March 31, 1994, Pinnacle understated sales by approximately $2.4 million or 18.5% because it prematurely recognized those sales in the fourth quarter of 1993. Accordingly, Pinnacle restated its first quarter net income from $679,000 to $1,255,000 or 84.4%. ======END OF PAGE 6====== fiscal 1993 and prior periods withdrew its opinions on Pinnacle's financial statements for the year ended December 31, 1993 and all prior periods, except for its opinion on Pinnacle's balance sheet as of December 31, 1993. 5. Failure to Disclose the Re-classification ofChange in the Method of Accounting for Electronic Chip Sales In addition to recording revenue from post-period shipments, Pinnacle also engaged in other improper accounting practices to meet sales goals. In 1993, Pinnacle learned that it had a surplus inventory of electronic chips used in its optical drives and decided to sell the surplus. Because these sales were short lived and were out-of-the ordinary-course of business, Pinnacle determined in the second quarter of 1993 to record the electronic chip sales as miscellaneous income. In accounting for the electronic chip sales as miscellaneous income, Pinnacle netted the revenues from these sales against the associated cost of goods sold, and included that amount in miscellaneous income. In the third quarter of 1993, however, Blum suggested to the company's Chief Financial Officer that the electronic chip revenue be recorded as sales. The company reported a portion of the electronic chip revenue as sales, and the remaining portion was reported as miscellaneous income. This change was made so that Pinnacle could meet its previously disclosed sales target of approximately $10 million for that quarter. Pinnacle reported approximately $444,000 of the $851,000 from the electronic chip sales as revenue for that quarter. In management's monthly financial reviews, Pinnacle's chief financial officer informed Pinnacle's Chief Executive Officer, Blum, and Hanley, of the amount of electronic chips revenue that had been recorded as sales. Under GAAP, there is a presumption that, in preparation of financial statements, an accounting principle once adopted should not be changed in accounting for events and transactions of a similar type. Accounting Principles Board (APB) Opinion No. 20, Accounting Changes, 15 (1971). Consistent use of accounting principles from one period to another enhances the utility of financial statements to users by facilitating analysis and understanding of comparative accounting data. Id. If an entity makes a change in accounting principle, it must disclose that change and justify the use of an alternative acceptable accounting principle as preferable. Id. at 16; APB Opinion No. 28, Interim Financial Reporting, 23 (1973). While this manipulation of electronic chip sales did not affect Pinnacle's earnings, Pinnacle in its Form 10-Q for its quarter ended September 30, 1993, did not disclose that electronic chip sales had been inconsistently reported in order to meet Pinnacle's sales targetthe change in the method of accounting for electronic chip sales. On January 13, 1995, Pinnacle's independent auditor separately interviewed Blum and other Pinnacle officers to make inquiries and obtain verbal representations concerning its special review of Pinnacle's financial statements for the fiscal year ended December 31, 1993. The independent auditor asked Blum, among other things, whether there were any ======END OF PAGE 7====== financial statement issues, other than post-period shipments, about which it should be concerned. Blum replied that there were not. As set forth above, Blum, however, knew that Pinnacle recorded a portion of the electronic chip revenue as sales. 6. Erroneous Capitalization of Non-Recurring Engineering Expenditures During 1995, Pinnacle incurred the majority of its non-recurring engineering expenditures from the design and development of application specific integrated circuits (ASICs) for use in APEX, Pinnacle's new optical disk drive. In the first three quarters of 1995, Pinnacle capitalized certain of the non-recurring engineering expenditures related to APEX in the expectation that the costs would be matched with revenue when APEX shipped. During the year-end audit, Pinnacle reevaluated the nature of these expenditures and determined that they should in fact be considered as research and development and expensed. As a result of its capitalization of ASICs non-recurring engineering expenditures, Pinnacle overstated its third quarter net income reported in its Form 10-Q for the quarter ended September 30, 1995, by approximately $198,000. On April 12, 1996, Pinnacle restated its financial statements for the quarter ended September 30, 1995. Third quarter net income was restated from $222,000 to $24,000. The financial statements for the quarters ending April 1, 1995, and July 1, 1995 were not restated as the change was not material. B. APPLICABLE LAW 1. Pinnacle's Reporting Violations: Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of securities registered pursuant to Section 12 of the Exchange Act, such as Pinnacle, to file with the Commission annual reports on Form 10-K and quarterly reports on Form 10-Q. Pursuant to instructions applicable to Form 10-K and Form 10-Q, the financial statements contained in these periodic reports must conform with Regulation S-X, which requires conformity with GAAP. 17 C.F.R.  210.4-01(a)(1). An issuer violates these provisions if it files a report on Form 10-K or Form 10-Q that contains materially false or misleading information. SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). In addition, Exchange Act Rule 12b-20 requires that periodic reports filed with the Commission contain all information necessary to ensure that the statements made are not materially misleading. Pinnacle violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder by disseminating to the public and filing with the Commission annual and quarterly reports for at least four periods, the quarter and year ended December 31, 1993 and the quarters ended September ======END OF PAGE 8====== 30, 1993 and September 30, 1995 that contained materially inaccurate financial statements. Pinnacle improperly recognized revenue on sales prior to the time of shipment. Pinnacle also failed to disclose iIn its Form 10-Q for the quarter ended September 30, 1993, thatPinnacle manipulated electronic chip sales had been manipulated in order to meet Pinnacle'its sales targets. Blum, among others, caused these violations. Pinnacle also materially understated expenses and overstated profits in its Form 10-Q for the quarter ended September 30, 1995 as a result of the capitalization of non-recurring engineering expenditures. 2. Pinnacle's Record Keeping Violations: Section 13(b)(2)(A) of the Exchange Act Section 13(b)(2)(A) of the Exchange Act requires issuers such as Pinnacle to make and keep books, records, and accounts that accurately and fairly reflect the issuer's transactions. Pinnacle's practice of recording revenue from post-period shipments involved the preparation of, among other things, inaccurately dated invoices. The invoices were integral to Pinnacle's ability to prepare its financial statements. The practice of deliberately creating improperly dated invoices was in itself a violation of Section 13(b)(2)(A), and also resulted in Pinnacle improperly maintaining books and records which included revenue from sales that had been recognized in contravention of GAAP. Pinnacle's failure to account properly for electronic chip sales also violated Section 13(b)(2)(A). Blum, among others, caused these violations. 3. Pinnacle's Internal Control Violations: Section 13(b)(2)(B) of the Exchange Act Section 13(b)(2)(B) requires issuers such as Pinnacle to "devise and maintain a system of internal accounting controls" sufficient to provide reasonable assurances that, among other things, transactions are executed in accordance with management's general or specific authorization and are recorded as necessary to permit preparation of financial statements in conformity with GAAP. Pinnacle lacked internal accounting controls sufficient to ensure the preparation of accurate and complete consolidated financial statements in compliance with GAAP. Among other things, Pinnacle did not have internal controls in place to test the validity of the dates of shipments. Pinnacle also had inadequate internal controls to assure that it correctly accounted for electronic chip sales. See, e.g., In the Matter of Valley Systems Inc., AAER No. 707, (Sept. 14, 1995). Blum, among others, caused these violations. 4. Blum and Craig's Misrepresentations to Accountants in Connection with the Preparation of Required Reports: Exchange Act Rule ======END OF PAGE 9====== 13b2-2 Exchange Act Rule 13b2-2 prohibits any officer or director of an issuer from making materially false or misleading statements or omitting to state any material fact to an accountant in connection with any required audit of the issuer's financial statements or the preparation of a report required to be filed with the Commission. In the July 18, 1994 meeting, described above, Pinnacle's independent auditor specifically questioned Craig in the presence of Pinnacle's Chief Executive Officer and Hanley about whether any post-period shipments had occurred. Although she knew that post-period shipments had been recorded as revenue in the quarter ended June 30, 1994, Craig stated that there were none. Accordingly, Craig violated Rule 13b2-2 when she failed to tell Pinnacle's auditors that the company had recognized revenue from post-period shipments. Blum also violated Rule 13b2-2. In the January 13, 1995 meeting described above, Pinnacle's independent auditor questioned Blum about whether there was anything improper with the electronic chip sales. Although he knew electronic chip sales had been reported inconsistently in the third quarter ended September 30, 1993, Blum stated that there was nothing improper about these sales. IV. FINDINGS Based on the foregoing, the Commission finds that: A. Pinnacle violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a- 13 thereunder; and B. Blum caused violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a- 13 thereunder, and violated Exchange Act Rule 13b2-2; and C. Lilia Craig violated Exchange Act Rule 13b2-2. V. ORDER Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that: A. Pinnacle cease and desist from committing or causing any violations and any future violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder. B. Blum cease and desist from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) ======END OF PAGE 10====== of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder, and cease and desist from committing or causing any violation and any future violation of Rule 13b2-2 under the Exchange Act. C. Craig cease and desist from committing or causing any violation and any future violation of Rule 13b2-2. By the Commission. Jonathan G. Katz Secretary ======END OF PAGE 11======