UNITED STATES OF AMERICA Before The SECURITIES AND EXCHANGE COMMISSION Securities Exchange Act of 1934 Release No. 37194 / May 10, 1996 Accounting and Auditing Enforcement Release No. 782 / May 10, 1996 Administrative Proceeding File No. 3-9000 ------------------------------ ) In the Matter of ) ORDER INSTITUTING PROCEEDINGS ) AND OPINION AND ORDER M. SUSAN SOLTIS, CPA and ) PURSUANT TO RULE 102(e) OF THE STEVEN T. HIRATSUKA, CPA ) COMMISSION'S RULES OF PRACTICE ) ) ------------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest to institute public administrative proceedings against M. Susan Soltis ("Soltis") and Steven T. Hiratsuka ("Hiratsuka"), both certified public accountants, pursuant to Rule 102(e)(1)(ii) -[1]- of the Commission's Rules of Practice [17 C.F.R. 201.102(e)]. In anticipation of the institution of these proceedings, Soltis and Hiratsuka have each submitted an Offer of Settlement ("Offer"), 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, and without admitting or denying any of the findings herein, except that they admit the Commission's jurisdiction over them and the subject matter of these proceedings, Soltis and Hiratsuka have consented to the issuance of this Order Instituting Proceedings and Opinion and Order Pursuant to Rule 102(e) of the Commission's Rules of Practice ("Order"). ---------FOOTNOTES---------- -[1]- Rule 102(e)(1) provides in relevant part: The Commission may 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 of and opportunity for hearing ... (ii) ... to have engaged in improper professional conduct. ==========================================START OF PAGE 2====== Accordingly, IT IS ORDERED that proceedings pursuant to Rule 102(e) of the Commission's Rules of Practice be, and hereby are, instituted. II. On the basis of this Opinion and Order and the Offers, the Commission makes the following findings -[2]-: A. Soltis, age 31, is a CPA in Colorado and was, until November 1994, an audit manager in the CPA firm of Lehman Butterwick & Company, P.C. ("Lehman firm") where she began employment in January 1989. She specialized in auditing, which was virtually 100% of her work, and participated in the audits of four SEC clients during her employment at the Lehman firm. Soltis is currently employed as an accountant at a public company in Longmont, Colorado. B. Hiratsuka, age 41, is a CPA licensed to practice in Colorado, Wyoming and Oklahoma and was, until November 1995, a partner/shareholder with the CPA firm of Lehman Butterwick & Company, P.C. ("Lehman firm") where he began employment in 1982 as a supervisor and became an audit partner in 1990. About 95% of his professional time is spent on auditing related matters. He has participated in audits of at least ten SEC clients. Hiratsuka is currently a partner in another public accounting firm in Denver. C. KLH Engineering Group, Inc. ("KLH"), a Delaware corporation domiciled in Colorado, was, until 1994, a holding company engaged in acquiring small civil engineering firms in the western United States. Its stock was traded on the OTC Bulletin Board until August 14, 1992 when it became listed on the Nasdaq Small-Cap Market. D. FACTUAL BACKGROUND 1. The Lehman firm audited the financial statements of KLH for the fiscal year ended December 31, 1992 and issued an audit report thereon that included an unqualified opinion with an explanatory paragraph expressing substantial doubt about KLH's ability to continue as a going concern. Soltis was the audit manager and Hiratsuka was the partner-in-charge of the KLH audit engagement. The Lehman firm's unqualified audit report ---------FOOTNOTES---------- -[2]- Any findings herein are made pursuant to Soltis' and Hiratsuka's Offer and solely for the purposes of these proceedings and are not binding for any other person or entity named as a respondent in this or any other proceeding. ==========================================START OF PAGE 3====== was included in a Form 10-KSB filed with the Commission on April 23, 1993. The audit was deficient in that it allowed KLH to materially overstate the value of its assets due to the overstatement of the values of certain acquired entities. 2. KLH materially overstated the value of two entities it acquired as subsidiaries on March 1, 1992; Bryan and Murphy Associates, Inc. ("Bryan Murphy") and Hefner Engineering and Management, Inc. ("Hefner"). KLH valued the Bryan Murphy and Hefner acquisitions at about $1,926,000, of which approximately $1,356,000 was recognized as goodwill. This goodwill represented 21% of KLH's total assets and 67% of its net assets (stockholders equity) after the acquisitions. 3. Specifically, Soltis and Hiratsuka failed to properly audit the value of the Bryan Murphy and Hefner stock- for-stock acquisition transactions. Contrary to representations in the audit report, the audit of KLH for the fiscal year ended December 31, 1992 was not performed in accordance with Generally Accepted Auditing Standards ("GAAS") and Hiratsuka caused the Lehman firm to incorrectly opine in its audit report that KLH's financial statements were prepared in conformity with Generally Accepted Accounting Principles ("GAAP"). Audit Failures That Contributed to the Misstated KLH Financial Statements Filed with the Commission 4. Soltis and Hiratsuka knew about the financial condition of KLH throughout 1992 and early 1993 because they had been involved in the Lehman firm's audit of KLH's 1989 and 1990 fiscal years in late 1991 and its audit of the 1991 fiscal year in April/May 1992. Soltis and Hiratsuka had also provided substantial review of the financial and accounting matters included in the S-4 registration statement that went effective on February 11, 1992 and an S-1 Registration Statement filed by KLH on September 17, 1992 that never went effective. 5. Soltis and Hiratsuka did not evaluate the Bryan Murphy and Hefner acquisitions based on the stock that KLH issued to acquire them but rather based the evaluation on an assessment of the companies acquired. Consequently, during the audit of the December 31, 1992 financial statements in March/April 1993, Soltis and Hiratsuka did not consider the substantial negative information (continuing losses, large deficit, small net asset position, small book value per share, default on a large loan) available concerning KLH. The ==========================================START OF PAGE 4====== decision to value the acquisitions in this manner was not documented in the audit working papers. 6. Soltis and Hiratsuka did not assess the correctness of the $3.75 per share value used in the acquisitions of Bryan Murphy and Hefner. However, one of the few items documented in the audit working papers regarding the acquisitions, which Soltis wrote, stated that the $3.75 per share price used in the acquisitions appeared reasonable since these shares were registered. According to Soltis, any amount between $1.00 and $5.00 would have appeared reasonable. 7. Since Soltis and Hiratsuka evaluated KLH's acquisitions of Bryan Murphy and Hefner based on an assessment of the consideration KLH received, they deemed unimportant the fact that KLH shares were sold in a private placement for $1.75 per share at about the same time shares were issued to acquire Bryan Murphy and Hefner and valued at $3.75 per share. During the audit, Soltis and Hiratsuka dismissed the per share offering price inconsistency by stating there was no assurance that the demand registration rights of the private placement would be honored. 8. KLH prepared a worksheet for the auditors to use in performing the 1989 and 1990 audits in late 1991 that showed how the values were determined for the 12 acquisitions prior to Bryan Murphy and Hefner. All 12 of these acquisitions were valued using the same mathematical formula.-[3]- This worksheet was also used for the 1991 audit performed in 1992. Soltis and Hiratsuka agreed with this methodology even though the individual results varied widely based on the value received for the KLH shares issued. This worksheet was made a part of the working papers for the 1992 audit. 9. Soltis and Hiratsuka determined not to apply the methodology used in the worksheet when analyzing the values used by KLH for the Bryan Murphy and Hefner acquisitions. According to Soltis and Hiratsuka, KLH was a more established company in 1992 and that Bryan Murphy and Hefner were better engineering companies than the first 12 and could be recorded at a higher value. No one on the audit engagement team made the mathematical calculation at the time of the audit to ---------FOOTNOTES---------- -[3]- The 12 prior acquisitions were each valued by taking 12% of revenues from its immediately prior fiscal year and adding that amount to the net book value at acquisition. ==========================================START OF PAGE 5====== see what the Bryan Murphy and Hefner acquisitions would have been valued at under the formula previously used. 10. In their assessment of the acquisition values of Bryan Murphy and Hefner, Soltis and Hiratsuka gave foremost consideration to revenues earned. Only minimal consideration was given to other financial factors. Soltis based her assessment, in part, on a 10-minute telephone conversation a year earlier with a man who acted as a consultant and broker in the sale of engineering firms. This consultant had been used by KLH to help it value its first 12 acquisitions, some of which he had brought to KLH. The consultant told Soltis that the main criteria in valuing engineering firms should be revenue stream. Soltis' assessment was also based on Hiratsuka's opinion that engineering firms and CPA firms were very similar because both were service oriented and that CPA firms were generally valued on the basis of gross revenues. None of this information was documented in the audit working papers. The only reference to gross revenue valuations in the audit working papers is a sentence, written by Soltis, stating that the valuation of Bryan Murphy and Hefner appears within reason since it came to about 50% of the companies' average annual revenues. 11. The shareholders of both Bryan Murphy and Hefner had Stock Exchange Agreements with KLH which specified the number of shares of KLH stock that would be issued in exchange for all the issued and outstanding stock of Bryan Murphy and Hefner. Each of these Stock Exchange Agreements had terms where the number of KLH shares to be issued in the exchanges would be reduced if the net worth of the company being acquired was below a certain level. Even though the net worth of both Bryan Murphy and Hefner were substantially below these levels, KLH did not reduce the number of shares to be issued in accordance with the agreements. Soltis and Hiratsuka were aware of the share reduction terms in the Stock Exchange Agreements but did not use this information in the assessment of the value placed on the Bryan Murphy and Hefner acquisitions. There is no reference to the terms of the Stock Exchange Agreements in the Lehman firm's audit working papers. 12. Shortly after KLH acquired Bryan Murphy and Hefner, it applied to Nasdaq to become listed in their Small-Cap Market. KLH was able to apply for a Nasdaq listing only because the acquisition values assigned to Bryan Murphy and Hefner provided it with the net assets (capital and surplus) needed to qualify. Even though Hiratsuka provided KLH with a copy of the Nasdaq ==========================================START OF PAGE 6====== listing criteria prior to the acquisitions of Bryan Murphy and Hefner, Soltis and Hiratsuka never questioned KLH concerning whether the method used to value these acquisitions was necessary to meet all the financial criteria for a Nasdaq listing. 13. Soltis evaluated all of KLH's goodwill at the end of the 1992 and determined that there was no impairment and no adjustment to the useful life was required. There was virtually no documentation in the audit working papers of her goodwill evaluation. It was Soltis' position that fluctuation of a subsidiary's operations for a couple of years does not indicate a permanent impairment of goodwill. She was unaware whether KLH had assessed goodwill at the end of 1992. In the spring of 1994, less than one year after the KLH audit report was issued for the 1992 fiscal year, Bryan Murphy was sold by KLH for $160,000 and the Hefner operation was closed. E. DEPARTURES FROM GAAP APB Opinion No. 16, paragraphs 67,75,87 1. Under the Purchase Method of accounting for business combinations, the acquiring corporation should value the acquired company at the fair value of the consideration given (stock issued) or the fair value of the consideration received (net assets including goodwill), whichever is more clearly evident. The values used by KLH to record the acquisitions of Bryan Murphy and Hefner were not supportable on the basis of fair value. 2. KLH did not use the fair value of the KLH stock issued (given up) in the acquisitions since, by definition, fair value is the cash or cash equivalent value in a sale or exchange between a willing buyer and a willing seller. The cash value of newly issued KLH shares was established at the time of the Bryan Murphy and Hefner acquisitions by the concurrent sale of KLH shares in a private placement at $1.75 per share. 3. KLH did not use the fair value of the Bryan Murphy and Hefner entities received in the acquisitions. Both companies had large net losses during the 1991 fiscal year, their net asset positions were small and their retained earnings were either very small or a negative amount. The revenue and income trends for both companies was downward. No independent appraisal was obtained by KLH for either Bryan Murphy or Hefner to support the values recorded in the acquisitions. ==========================================START OF PAGE 7====== APB Opinion No. 17, paragraph 31 4. Continual evaluation of goodwill is required to determine if estimated life should be revised or if an impairment of the intangible asset has occurred. 5. KLH did not evaluate total goodwill at the end of its 1992 fiscal year even though it represented over 26% of total assets and almost 95% of net assets. About half of the goodwill pertained to the acquisition of Bryan Murphy early in the fiscal year. Bryan Murphy's revenue decreased 32% from 1991 and it had a net loss of about $204,000. Its total assets also decreased by 32% and its stockholders' equity was a negative $26,000. Goodwill was evaluated by Soltis at the end of 1992. She determined there was no impairment even though Bryan Murphy's financial situation had deteriorated substantially. F. DEPARTURES FROM GAAS Failure to Adequately Plan the Audit and Consider Audit Risk 1. The first standard of field work of GAAS requires that the audit work be adequately planned and properly supervised. This includes the development of an audit program in sufficient detail to document the audit procedures that the auditor believes are necessary to accomplish the objectives of the audit [Codification of Statements on Auditing Standards ("AU") 311]. Soltis, as audit manager, and Hiratsuka, as engagement partner, should have supplemented the audit program to include specific audit procedures with respect to the Bryan Murphy and Hefner acquisitions since the goodwill recognized in these acquisitions represented 17% of KLH's total assets and almost 62% of its net assets in the December 31, 1992 balance sheet. The audit working papers contained only three pages of documentation concerning the Bryan Murphy and Hefner acquisitions and the valuation of these stock-for-stock exchanges. 2. GAAS requires that an auditor consider audit risk when planning and performing an audit. "Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated." (AU 312.02) "Financial statements are materially misstated when they contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects, in conformity with GAAP. ==========================================START OF PAGE 8====== Misstatements result from misapplication of GAAP, departures from fact, or omissions of necessary information." (AU 312.04) 3. The planning memorandum in the audit working papers did not document the acquisition of Bryan Murphy and Hefner as being considered high risk although Soltis stated that she did in fact consider these acquisitions to be high risk. Based on the lack of documentation in the audit working papers, these acquisitions appear not to have been tested as a high risk area. Soltis and Hiratsuka failed to properly consider the high audit risk resulting from two acquisitions that recognized a very large amount of goodwill representing 21% of the company's assets immediately after the acquisitions occurred. Soltis and Hiratsuka also failed to recognize the substantial audit risk inherent in a transaction involving the issuance of a relatively large amount of new KLH restricted stock to acquire two companies that did not appear financially sound. Failure to Obtain Sufficient Competent Evidential Matter 4. GAAS prescribes that: "Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. (AU 326.01) 5. "During an audit, management makes many representations to the auditor, both oral and written, in response to specific inquiries or through the financial statements. Such representations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those procedures necessary to afford a reasonable basis for his opinion on the financial statements." (AU 333.02) 6. "When evidential matter can be obtained from independent sources outside an entity, it provides greater assurance of reliability for the purposes of an independent audit than that secured solely within the entity." (AU 326.19a) 7. Soltis and Hiratsuka failed to assure that sufficient competent evidential matter was obtained during the audit in that all of the underlying accounting and financial data was provided by KLH management. Based on the lack of documentation in the audit working papers, the Lehman firm's audit engagement team obtained no corroborating evidential matter from third ==========================================START OF PAGE 9====== parties except the verbal opinion of acquistion values given over the telephone by a consulting engineer whose name was provided by KLH management. 8. Soltis and Hiratsuka disregarded negative information about KLH, Bryan Murphy and Hefner during the Lehman firm's audit of the value assigned by KLH in the acquisitions of Bryan Murphy and Hefner. They also disregarded, or failed to obtain, information that indicated that these acquisitions were overvalued. All the documentation in the audit working papers on the Bryan Murphy and Hefner acquisitions consisted of three pages. Failure to Act With Due Professional Care 9. GAAS requires that an auditor perform his/her work with due professional care in the performance of the audit and the preparation of the report. Due care imposes a responsibility upon the auditor to observe the standards (GAAS) of field work and reporting (AU 230.01-.02). Soltis and Hiratsuka failed to exercise due professional care by: (a) failing to properly plan the audit and to recognize the extent of audit risk and potential for material misstatements, particularly in light of the fact that a material amount of the balance sheet assets was derived from the acquisition of two subsidiaries in a stock-for-stock exchange; (b) failing to obtain sufficient competent evidential matter to support the assertions in the financial statements by, among other things, substituting representations from management for the application of auditing procedures necessary to afford a reasonable basis for the opinion on the financial statements, in violation of AU 333.02; and (c) failing to maintain an attitude of professional skepticism about the motives of management and the correctness and thoroughness of their acquisition valuations. Failure to Maintain an Attitude of Professional Skepticism 10. "An audit of financial statements in accordance with generally accepted auditing standards should be planned and performed with an attitude of professional skepticism. The auditor neither assumes that ==========================================START OF PAGE 10====== management is dishonest nor assumes unquestioned honesty. Rather, the auditor recognizes that conditions observed and evidential matter obtained, including information from prior audits, need to be objectively evaluated to determine whether the financial statements are free of material misstatement." (AU 316.16) 11. In Soltis' and Hiratsuka's audit of a difficult to substantiate assertion by KLH management (value of the Bryan Murphy and Hefner acquisitions), they failed to adequately consider the increased risk of material misstatement in the financial statements. In addition, they failed to sufficiently evaluate the information obtained in prior KLH audits with respect to acquisition valuations. They should have obtained independent evidence to support management representations and assertions concerning asset valuations. Failure to Qualify an Opinion 12. "In developing his opinion, the auditor should give consideration to relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements. To the extent the auditor remains in substantial doubt about any assertion of material significance, he must refrain from forming an opinion until he has obtained sufficient competent evidential matter to remove such substantial doubt, or he must express a qualified opinion or a disclaimer of opinion." (AU 326.23) 13. An auditor's standard report, which contains an unqualified opinion, may state that the financial statements are presented in conformity with GAAP only when the auditor has formed such an opinion on the basis of an audit performed in accordance with GAAS. (AU 508.07) 14. Soltis and Hiratsuka did not obtain sufficient competent evidential matter to support management's assertions about the Bryan Murphy and Hefner acquisitions to enable the Lehman firm to form an opinion on whether the financial statements taken as a whole were presented fairly in conformity with GAAP. (AU 508.40 &.41) CONCLUSION Based on the foregoing, the Commission finds that Soltis and Hiratsuka engaged in improper professional conduct within the ==========================================START OF PAGE 11====== meaning of Rule 102(e)(1)(ii) of the Commission's Rules of Practice with respect to the audit of KLH's financial statements for its fiscal year ended December 31, 1992. The financial statements opined on were not prepared in conformity with GAAP and the audit was not conducted in accordance with GAAS, as described above. III. ORDER Based on the foregoing, the Commission finds it appropriate and in the public interest to accept the Offer of Soltis and the Offer of Hiratsuka and impose the sanctions consented to therein. Accordingly, IT IS HEREBY ORDERED that: A. Soltis is denied the privilege of appearing or practicing before the Commission as an accountant. After twelve (12) months from the date of the Order, Soltis may apply to resume appearing or practicing before the Commission as: 1. A preparer or reviewer, or a person responsible for the preparation or review, of financial statements or other information required to be filed with the Commission provided that, in Soltis' practice before the Commission, her work will be reviewed by the independent audit committee of the company or in some other manner acceptable to the staff of the Commission; or 2. An independent accountant upon submission of an application to the Office of the Chief Accountant of the Commission containing a showing satisfactory to the Commission that: a. Soltis, or any firm with which she is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of CPA's Division for CPA Firms ("SEC Practice Section") as long as she appears or practices before the Commission as an independent accountant; b. Soltis, or any firm with which she is or becomes associated in any capacity, has received an unqualified report relating to her or the firm's most recent peer review conducted in accordance with the guidelines adopted by the SEC Practice Section; and ==========================================START OF PAGE 12====== c. Soltis will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as she appears or practices before the Commission as an independent accountant. B. Hiratsuka is denied the privilege of appearing or practicing before the Commission as an accountant. After twelve (12) months from the date of the Order, Hiratsuka may apply to resume appearing or practicing before the Commission as: 1. A preparer or reviewer, or a person responsible for the preparation or review of financial statements required to be filed with the Commission provided that, in Hiratsuka's practice before the Commission, his work will be reviewed by the independent audit committee of the company or in some other manner acceptable to the staff of the Commission; or 2. An independent accountant upon submission of an application to the Office of the Chief Accountant of the Commission containing a showing satisfactory to the Commission that: a. Hiratsuka, or any firm with which he is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of CPA's Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent accountant; b. Hiratsuka, or any firm with which he is or becomes associated in any capacity, has received an unqualified report relating to his or the firm's most recent peer review conducted in accordance with the guidelines adopted by the SEC Practice Section; and c. Hiratsuka will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he appears or practices before the Commission as an independent accountant. C. The Commission's review of either Soltis' or Hiratsuka's application to resume appearing or practicing before the Commission may include consideration of, in addition to the ==========================================START OF PAGE 13====== matters referred to in section III. above, any other matters relating to Soltis' and Hiratsuka's character, integrity, professional conduct, or qualifications to appear or practice before the Commission. By the Commission. Jonathan G. Katz Secretary