UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION Securities Exchange Act of 1934 Release No. 41284 \ April 14, 1999 Accounting and Auditing Enforcement Release No. 1125 \ April 14, 1999 Administrative Proceeding File No. 3-9873 In the Matter of : : MICHAEL, ADEST & : BLUMENKRANTZ, P.C., : ORDER INSTITUTING PROCEEDINGS DAVID MICHAEL, CPA, AND : PURSUANT TO RULE 102(e) OF THE PAUL ADEST, CPA, : COMMISSION’S RULES OF PRACTICE, : MAKING FINDINGS AND IMPOSING : REMEDIAL SANCTIONS Respondents. : : I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted, pursuant to Rule 102(e)(1)(ii)[1] of the Commission’s Rules of Practice against Michael, Adest & Blumenkrantz, P.C. ("MA&B"), David Michael ("Michael"), and Paul Adest ("Adest"). II. In anticipation of the institution of these proceedings, MA&B, Michael and Adest (collectively the "Respondents"), have each submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purpose of these proceedings, and any other proceedings brought by or on behalf of the Commission, or in which the Commission is a party, without admitting or denying the findings set forth herein, except as to the jurisdiction of the Commission over them and over the subject matter of these proceedings, which each Respondent admits, the Respondents consent to the entry of the findings and the imposition of the remedial sanctions set forth below. III. FACTS The Commission makes the following findings:[2] A. Summary Respondents engaged in improper professional conduct in connection with their audit of the financial statements of Power Phone, Inc. ("Power Phone") for the fiscal year ended June 30, 1995. Power Phone included those financial statements in an Annual Report on Form 10-K that was filed with the Commission on October 26, 1995, and a registration statement on Form 10 that was filed with the Commission on June 4, 1996. Respondents issued an audit report containing an unqualified opinion on Power Phone’s financial statements for June 30, 1995, and stating that their audit was conducted in accordance with generally accepted auditing standards ("GAAS") and that the financial statements were presented in conformity with generally accepted accounting principles ("GAAP"). In fact, Respondents did not comply with GAAS in their audit of Power Phone’s financial statements, and Power Phone did not present its financial statements in conformity with GAAP. B. Respondents 1. Michael, Adest & Blumenkrantz, P.C., is a New York professional corporation through which Michael and Adest have practiced public accounting. At all relevant times, Michael and Adest were owners of the firm. MA&B served as Power Phone’s independent accountants for the fiscal year ended June 30, 1995. 2. David Michael, 61 years old and a resident of Bellmore, New York, is a certified public accountant licensed in the state of New York. Michael is a partner atshareholder of MA&B and was the engagement partner on the audit of Power Phone’s financial statements for the fiscal year ended June 30, 1995. 3. Paul Adest, 45 years old and a resident of Staten Island, New York, is a certified public accountant licensed in the state of New York. Adest is a partner atshareholder of MA&B and was the concurring partner on the audit of Power Phone’s financial statements for the fiscal year ended June 30, 1995. Adest directly participated in determining how Power Phone’s assets should be reflected in the financial statements. C. Issuer Power Phone, Inc., during all relevant times, was a New York corporation headquartered in Brooklyn, New York. From June 1995 through February 1998, Power Phone’s common stock was registered with the Commission pursuant to Section 12(g) of the Securities Exchange Act of 1934, and traded in the over-the-counter market. On October 8, 1996, the company changed its name to TMC Agroworld Corporation, and on August 14, 1997, the company changed its name to the Dominican Cigar Corporation. D. Power Phone’s Financial Statements Failed to Comply with GAAP Power Phone’s financial statements for its fiscal year ended June 30, 1995, were not presented in conformity with generally accepted accounting principles ("GAAP"). These financial statements were included in an Annual Report on Form 10-K filed with the Commission on October 26, 1995, and a registration statement on Form 10 that was filed with the Commission on June 4, 1996. Among other things, Power Phone’s financial statements for the period ended June 30, 1995 improperly accounted for the following two assets, which comprised 95% of Power Phone’s total assets: (i) certain artwork held for resale, with a purported value of $2 million; and (ii) a software program known as "ASAP," also with a purported value of $2 million. Significantly, Power Phone did not own either the artwork or the ASAP software as of June 30, 1995. Power Phone never owned the ASAP software because the entity that purportedly sold the software to Power Phone did not own it and thus was in no position to transfer title of the software to Power Phone. Indeed, Power Phone never acquired the "source code" or underlying master key to the operation of the software program. Moreover, the evidence indicates that Power Phone simply acquired a license to use the software rather than outright ownership. Similarly, Power Phone could not claim that it owned the artwork as of June 30, 1995, because as of that date, Power Phone’s contract with the purported vendor of the artwork reflected a consignment of the artwork to Power Phone rather than an outright sale to Power Phone. After Power Phone’s fiscal year end, Power Phone executed a contract with the vendor of the artwork which reflected a sale rather than a consignment. Notably, Power Phone backdated that contract to June 21, 1995, in a blatant effort to make it appear that Power Phone owned the artwork prior to the end of the company’s 1995 fiscal year. Irrespective of whether Power Phone actually owned the artwork and the software, Power Phone materially overstated the value of these assets. Power Phone issued 80,000 shares of preferred stock to the purported vendor of the artwork and 80,000 shares of preferred stock to the purported vendor of the software. In each instance, the preferred stock was stated to be redeemable by Power Phone at any time at a redemption price of $25 per share and was convertible into ten common shares for each preferred share. Power Phone recorded the artwork on its balance sheet at $2 million based on the stated redemption value of the preferred shares (i.e., 80,000 shares x $25). Power Phone used the exact same calculation to arrive at a $2 million value for the software. No other independent or credible evidence supported the $2 million valuations of the artwork or the software. Moreover, there was no evidence to support the $25 per share value for the preferred stock, which apparently was established arbitrarily by Power Phone’s management. At the time of these transactions, no market existed for the preferred stock, and Power Phone did not have other assets available which could have been used to redeem the preferred shares. E. Respondents Engaged in Improper Professional Conduct In July 1995, Power Phone engaged MA&B to audit Power Phone’s financial statements for the fiscal year ended June 30, 1995. MA&B, Michael and Adest were reckless in performing their audit of Power Phone’s financial statements and thus engaged in improper professional conduct. Specifically, Respondents did not comply with GAAS in their audit of Power Phone’s financial statements because they failed to obtain sufficient, competent evidential matter to afford a reasonable basis for their opinion that the artwork and software had a total value of $4 million and were actually owned by Power Phone.[3] Respondents also failed to exercise due professional care and a proper degree of professional skepticism when evaluating documentation and representations related to these assets. As a result of their improper professional conduct, Respondents issued an unqualified audit report on Power Phone’s financial statements for the fiscal year ended June 30, 1995, which falsely stated that the financial statements were prepared in conformity with GAAP. 1. Valuation of Assets The Respondents failed to obtain any independent evidence to support the $4 million valuation of the artwork and ASAP software; instead they relied entirely on the $4 million stated redemption value of the preferred shares exchanged to acquire the assets. Under GAAP, assets received by a corporation in return for stock issued by the corporation are recorded at fair value, which value becomes the corporation’s cost. That fair value may be determined by reference either to the value of the assets received or the stock issued, whichever is more clearly evident. If neither the fair value of the assets received nor the value of the stock issued is reliably determinable, the corporation should assign a nominal value to the assets received and the stock issued. See Accounting Principles Board Opinion No. ("APB") 16, para. 67. Michael and Adest did not attempt to make such a determination and instead relied solely on the stated redemption value of the preferred stock. Michael and Adest did not attempt to determine whether the preferred stock itself had any value. Indeed, at the time of the sales transactions, there was no market for and no recent cash sales of the preferred stock. [4] Also, Power Phone did not have any significant assets -- other than the artwork or the ASAP software, which it did not own -- which could have been used to pay the total $4 million to the sellers. Placing reliance on the stated redemption value of the preferred stock to value the assets -- which was set by the management of Power Phone -- without obtaining corroborating evidence, was improper. 2. Ownership of Assets During the course of their audit work, Michael and Adest recognized that, based on the terms of the original artwork contract provided to them, Power Phone could not legitimately claim that it owned the artwork because the contract represented a consignment of artwork, rather than a purchase by Power Phone. Instead of auditing the contract as written, the auditors permitted Power Phone to revise the contract, after the fiscal year had ended, to reflect a purchase rather than a consignment, thereby enabling Power Phone to erroneously record the transaction as if it had occurred prior to June 30, 1995. [5] Respondents relied solely on management’s representation that both parties to the artwork contract intended that ownership of the artwork pass to Power Phone prior to the June 30, 1995 fiscal year end. Respondents failed to obtain any evidence to corroborate management’s representations or authenticate the transaction. Had the Respondents communicated with the purported seller of the artwork, they would have learned that as late as July 31, 1995, it was still his intention that the transaction be structured as a consignment. Had the Respondents obtained stock transfer records, they would have learned that Power Phone had not issued the preferred stock (i.e., paid) for the artwork as of June 30, 1995. Placing reliance solely on Power Phone management’s representations without any corroborating evidence, particularly in light of contradicting statements in the original artwork contract, was improper. Also, permitting Power Phone to reflect the transaction for the artwork as an asset even though the deal was not completed until after the fiscal year end is not merely a misapplication of accounting principles, but an extreme departure from due professional care. Further, Respondents performed no audit steps to determine whether the artwork actually existed as of June 30, 1995.[6] With respect to the ASAP software, Respondents made no inquiries of the purported software vendor to determine what, if any, rights it had to the software as well as what rights were being given to Power Phone. Respondents also made no inquiries into whether there were any copyrights associated with the ASAP software. Adest maintained that the auditors obtained an appraisal of the ASAP software as evidence that the ASAP software existed.[7] Beyond this, however, the auditors did nothing to ascertain physical existence of the software. Adest also indicated that they did not see the software or a demonstration of the product. The auditors also failed to obtain any evidence to support the footnote to the financial statements which stated that the software was "salable in the over-the-counter consumer software market." Had Michael and Adest taken the audit steps outlined above, they would have learned that the purported software vendor did not own any property rights to the software, that the developer of the software intended to grant Power Phone only a license to use the software, and that no copyright existed for the software. IV. LEGAL DISCUSSION The Respondents’ audit of Power Phone’s 1995 financial statements did not meet applicable GAAS standards, nor did the financial statements reflect the proper application of GAAP.[8] Respondents failed to obtain sufficient competent evidential matter through inspection, observation, inquiries, and confirmations to afford a reasonable basis for their opinion regarding the financial statements of the company. AU §150.02. Rather than execute audit procedures with the professional skepticism necessary to obtain more persuasive evidence sufficient to support Power Phone’s reported assets, Respondents based their audit report principally on the unreasonable and uncorroborated representations of Power Phone’s management regarding the value of Power Phone’s preferred stock, which in turn was used to establish the value of the ASAP software and artwork. Oral or written representations from management are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion on the financial statements. AU §333A.02. By issuing an unqualified audit report without having formed their opinion on the basis of an audit conducted in accordance with GAAS, AU §508.17, Respondents engaged in improper professional conduct within the meaning of Section 102(e)(1)(ii) of the Commission’s Rules of Practice with respect to the audit of Power Phone’s financial statements for the fiscal year ended June 30, 1995, and were reckless in doing so pursuant to Section 102(e)(1)(iv)(A) of the Rules of Practice. V. Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the Offers of Settlement submitted by the Respondents and impose the sanctions specified therein. Accordingly, IT IS HEREBY ORDERED, effective immediately, that Respondents Michael, Adest & Blumenkrantz, P.C., David Michael and Paul Adest are denied the privilege of appearing or practicing before the Commission as accountants. By the Commission. Jonathan G. Katz Secretary **FOOTNOTES** [1]: Rule 102(e)(1) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e), provides in pertinent part that: The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter . . . (ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct. . . . [2]: The findings herein are made pursuant to the Respondents’ Offers of Settlement and are not binding on any other person or entity in this or any other proceeding. [3]: Auditors must obtain sufficient competent evidence to afford a basis for an opinion regarding the financial statements under audit. Codification of Statements on Auditing Standards ("AU") § 326.01. Evidence obtained from an independent source outside the entity which is being audited provides greater assurance of reliability than evidence obtained from the entity being audited. AU §326.19.a. The validity and sufficiency of required evidence depends on the circumstances and the auditors' judgment. AU §326.19-20. With respect to such judgment, an auditor must maintain an attitude of professional skepticism and assess the risk that errors and irregularities may cause the financial statements to contain a material misstatement. AU §§316.05 & .21. An assessment of higher risk may cause the auditor to expand the extent of procedures applied or modify the nature of procedures to obtain more persuasive evidence. [4]: Similarly in June 1995, aside from some sporadic trading by company insiders and their relatives, there was virtually no market for Power Phone’s common stock. [5]: According to Michael, as long as the details of the contract were worked out by the date of their audit opinion, August 18, 1995, the artwork transaction could be considered as a completed transaction as of June 30, 1995. This is not in conformity with GAAP, nor is Michael’s view in accordance with GAAS, because no transaction had been consummated as of year end. [6]: In September 1995, after the audit report had been issued, Respondents learned that more than fifty percent of the artwork that was supposed to be included in Power Phone’s inventory was still in progress. Although this information was inconsistent with the inclusion of the artwork on Power Phone’s financial statements as of June 30, 1995, the auditors took no further action. [7]: Adest stated that they did not rely on the appraisal for purposes of assessing the value of the software and, as such, performed no testing of the appraisal. [8]: Michael, as the engagement partner, had the primary responsibility for ensuring that the audit was conducted in accordance with GAAS. Adest, as concurring partner, had the responsibility to conduct his participation in the audit in accordance with the requirements of GAAS. Adest directly participated in determining how Power Phone’s assets should be reflected in the financial statements and accordingly, his concurrence that the assets were properly valued at $4 million when he knew or was reckless in not knowing that (1) Power Phone did not own the assets and (2) the $4 million value was not supported, demonstrated his failure to exercise due care.