==========================================START OF PAGE 1====== UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 37847 / October 22, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 846 / October 22, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9172 ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDING In the Matter of: PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT MIDISOFT CORPORATION, OF 1934, MAKING FINDINGS, AND IMPOSING A CEASE-AND- Respondent. DESIST ORDER I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that a public administrative and cease-and-desist proceeding be, and hereby is, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Midisoft Corporation ("Midisoft" or the "Company" or "Respondent") violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. II. In anticipation of the institution of this proceeding, Midisoft has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of this proceeding 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 the findings contained herein, except that Respondent admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Midisoft consents to the issuance of this Order Instituting Public Administrative Proceeding Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order ("Order") and to the entry of the findings and the imposition of the relief set forth below. ==========================================START OF PAGE 2====== III. On the basis of this Order and Respondent's Offer, the Commission finds the following:-[1]- A. RESPONDENT Midisoft, founded in 1986, is a Washington state corporation with its principal place of business in Issaquah, Washington. Midisoft develops and markets interactive, audio-based software applications for the Microsoft Windows and multimedia applications market. The Company's common stock has been registered with the Commission pursuant to Section 12(g) of the Exchange Act since July 1993 and is quoted on The NASDAQ Stock Market. For the most recent fiscal year, ended December 31, 1995, the Company posted revenues of $5,420,000, a net loss of $12,132,000 and a net loss per share of $2.60. As of March 16, 1996, with 4,662,988 shares outstanding and a closing price per share of $3.00, Midisoft had an aggregate market value of $13,988,964. B. CONDUCT LEADING TO MIDISOFT'S MATERIALLY MISLEADING FORM 10- K FOR FISCAL 1994. Midisoft's original Form 10-K for the year ended December 31, 1994 overstated the Company's revenues by $811,000. Compared to Midisoft's restated revenues for the year of $4,898,000, this amounted to an overstatement of 16.8%. Moreover, when compared to Midisoft's restated revenues for the fourth quarter of 1994 of $685,297, Midisoft's original Form 10-K overstated the Company's revenues by 123.2%. This overstatement was primarily the result of two types of conduct. First, the Company recognized revenues on goods that it did not ship to a customer prior to the end of fiscal 1994. This resulted in a revenue overstatement of $292,000. Second, the Company recognized revenue on transactions for which products were timely-shipped, but for which, at the time of shipment, Midisoft had no reasonable expectation that the customer would accept and pay for the products. Midisoft accepted most of these products back as sales returns during the first three months of 1995, prior to the time the Company issued its original Form 10-K for fiscal 1994. In total, as a result of this conduct, Midisoft's original Form 10-K overstated the Company's revenues -[1]- The findings herein are made pursuant to Respondent's Offer and are not binding on any other person or entity in this or any other proceeding. ==========================================START OF PAGE 3====== by $458,000.-[2]- 1. Midisoft Improperly Recognized Revenue on Goods That Did Not Ship to a Customer Prior to The End of Fiscal 1994. In late December 1994, Midisoft sales personnel obtained purchase orders from certain Midisoft customers based on the understanding that Midisoft would not deliver the products ordered unless and until the Company received further instructions from the respective customers. Midisoft's internal accounting policy, as set forth in the Company's original Form 10-K for fiscal 1994, stated that the Company recognized revenue on sales to distributors, resellers and other end-users only when products were shipped to those customers. Nevertheless, despite the contingent nature of the December 1994 orders, certain Midisoft officers and employees determined that Midisoft would recognize revenues on these transactions during the fiscal year ending December 31, 1994. To do this, they determined, would require that Midisoft: (1) prepare the goods for shipment prior to the end of the fiscal year; and then (2) hold the goods at an off-site location until the Company received further instructions from its customers. Accordingly, Midisoft proceeded to store a total of $292,000 in goods relating to the contingent purchase orders at a freight forwarding company. Midisoft then obtained phony shipping documents from the freight forwarder that made it appear that all of the goods had been shipped to Midisoft customers on or prior to December 31, 1994. In fact, during the first three months of 1995 Midisoft shipped to its customers only approximately $76,000 of the total of $292,000 in goods stored at the freight forwarder. 2. Midisoft Failed to Reserve Adequately for Sales Returns and, Subsequently, Misled Its Auditors Regarding Such Returns. Midisoft maintains written distribution agreements with its distributors. These agreements generally allow the distributor wide latitude to return product to Midisoft for credit whenever the product is, in the distributor's opinion, damaged, obsolete, or otherwise unsalable. Given these broad rights of return, in -[2]- A third cause of the overstatement was the recognition of revenues on an Original Equipment Manufacturer contract for which Midisoft had failed to fulfill its contractual obligations prior to the end of fiscal 1994. This conduct resulted in an overstatement of revenue of $61,000. ==========================================START OF PAGE 4====== order to recognize revenues on sales to its distributor customers, Midisoft must be able to estimate reasonably the likelihood of future product returns and must make an allowance for such returns against its recorded revenues.-[3]- In preparing Midisoft's financial statements for fiscal 1994, Midisoft accounting personnel submitted a proposed allowance for future product returns of $105,000. This figure was unreasonably low in light of the large levels of returns Midisoft received in the first several months of 1995, which were known to various officers and employees in Midisoft's Accounting and Sales Departments prior to the end of March 1995, the time Midisoft's independent auditors finished their field work on the Company's 1994 audit. For example, in January 1995, Midisoft received from five of its largest distributors returns of $197,532; of this total, more than $163,000 was the result of one credit memo issued. In February 1995, Midisoft received additional returns from these same five distributors of $123,051. Had Midisoft revised the allowance for sales returns to reflect this information, the Company would have had to reduce accordingly the amount of net revenue Midisoft could report for fiscal 1994. Instead, several Midisoft officers and employees acted to prevent Midisoft's auditors from discovering the higher levels of returns. As part of this scheme, certain Midisoft employees were instructed to prevent the auditors from touring that portion of the Midisoft headquarters where the returned goods were stored. In addition, Midisoft accounting personnel altered records contained in Macola, the Company's computer accounting system, to falsely reduce the level of returns reflected in that system. When Midisoft's auditors subsequently asked for copies of certain credit memos, Midisoft accounting personnel provided the auditors with a forged "cut-and-paste" memo which matched the alterations made to the Macola system. In fact, in 1995 Midisoft received a total of $458,000 in returns relating to fiscal 1994 sales in excess of the $105,000 the Company had provided for this purpose. Of this amount, Midisoft received returns of approximately $344,500 in the first quarter of 1995 alone, prior to the time the Company issued its original Form 10-K for fiscal 1994. -[3]- See Financial Accounting Standards Board, Accounting Standards R75.107. ==========================================START OF PAGE 5====== C. LEGAL ANALYSIS A. Midisoft's Violations Related to Its Periodic Reports; Books and Records; and Internal Accounting Controls 1. Reporting Violations: Section 13(a) and Rules 12b-20 and 13a-1 Section 13(a) of the Exchange Act and Rule 13a-1 thereunder require that issuers whose securities are registered with the Commission pursuant to Section 12 of the Exchange Act file with the Commission accurate annual reports. Exchange Act Rule 12b-20 requires that such reports contain any additional information necessary to ensure that the required statements in the reports are not, under the circumstances, materially misleading. Thus, the filing of a periodic report that contains materially false and misleading statements or omissions constitutes a violation of the reporting provisions of the Exchange Act. Violations of the reporting provisions do not require a showing of scienter. SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1166-67 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Financial statements incorporated in Commission filings must comply with Regulation S-X, which in turn requires conformity with Generally Accepted Accounting Principles ("GAAP"). Statement of Financial Accounting Concepts No. 5 ("CON5"), entitled "Recognition and Measurement in Financial Statements of Business Enterprises," states that revenue should be recognized when it is both realized (or realizable) and earned. Paragraph 83 of CON5 states that revenue is realizable when a product is "exchanged for cash or claims to cash" and revenue is earned "when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues." In addition, Midisoft's own revenue recognition policy, as set forth in its original 1994 Form 10-K, required that it recognize revenue only after it shipped products to its customers. Midisoft violated Section 13(a) and Rules 12b-20 and 13a-1 when it filed a materially misleading Form 10-K for the year ended December 31, 1994. This report was misleading because it included revenues on goods that Midisoft: (1) had not yet shipped to customers; and (2) had either received or reasonably expected it would receive as returns from its customers. By including these revenues in its original Form 10-K, Midisoft violated both its own revenue recognition policies and GAAP. When compared with its restated 1994 Form 10-K, Midisoft's original 1994 Form 10-K overstated the Company's revenues by 16.8%. This misstatement was material. See Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (fact is material if there is substantial likelihood reasonable investor would consider it important in making investment decision); see also In re Gupta Corporation Securities Litigation, 900 F. Supp. 1217, 1231 (N.D. ==========================================START OF PAGE 6====== Cal. 1994) (materiality of overstatement of revenues greater than 5% "is beyond question"). 2. Books and Records and Internal Accounting Controls Violations: Sections 13(b)(2)(A) and 13(b)(2)(B) Section 13(b)(2)(A) provides that every issuer of securities registered with the Commission shall make and keep books, records and accounts that accurately and fairly reflect the issuer's transactions and dispositions of assets. Section 13(b)(2)(B) further requires each such issuer to devise and maintain internal accounting controls sufficient to reasonably assure the integrity of its books, records and accounts. Midisoft violated Section 13(b)(2)(A) in numerous ways. First, Company personnel prepared records that reflected the sale during fiscal 1994 of assets that were part of the Company's fourth quarter ship-and-hold scheme. In fact, such assets were not sold during fiscal 1994, but were being held off-site by Midisoft and, thus, should have been reflected as inventory in Midisoft's books and records for the period. Second, Company personnel prepared records that reflected revenue from purported sales in the fourth quarter of fiscal 1994, despite the fact that such goods were received as sales returns by Midisoft in early 1995, prior to the time it issued its Form 10-K for fiscal 1994. Third, Midisoft personnel falsified the Company's books, records and accounts relating both to goods held off-site and to goods received as sales returns. Midisoft violated Section 13(b)(2)(B) by failing to maintain a system of internal accounting controls reasonably sufficient to allow the preparation of financial statements in accordance with GAAP and maintain accountability for the assets of the Company. During the period in question, Midisoft's Accounting Department repeatedly recognized revenues on transactions which the Company should have been able to identify as improper. These included revenue on: (1) transactions for which no product was shipped during the fiscal period; and (2) transactions for which the Company received a return and issued a credit memo prior to the issuance of its financial statements for the fiscal period. IV. On the basis of this Order and the Offer submitted by Respondent, the Commission finds that Midisoft violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20 and 13a-1 thereunder. ==========================================START OF PAGE 7====== V. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Midisoft cease and desist from committing or causing any violation and any future violation of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20 and 13a-1 thereunder. By the Commission. Jonathan G. Katz Secretary