UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Securities and Exchange Act of 1934 Release No. 38239 / February 5, 1997 Accounting and Auditing Enforcement Release No. 876 / February 5, 1997 Administrative Proceeding File No. 3-9236 ------------------------------ : In the Matter of : ORDER INSTITUTING PUBLIC : ADMINISTRATIVE PROCEEDINGS : AND OPINION AND ORDER PURSUANT FREDERICK R. GRANT, C.P.A. : TO RULE 102(e)(1)(ii) OF THE : COMMISSION'S RULES OF PRACTICE : ------------------------------- I. The Commission deems it appropriate and in the public interest to institute administrative proceedings against Frederick R. Grant, C.P.A. ("Grant"), pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice.-[1]- Accordingly, IT IS HEREBY ORDERED that said proceedings be, and hereby are, instituted. II. In anticipation of the institution of these proceedings, Grant has submitted an Offer of Settlement ("Offer") 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. In his Offer, which the Commission has determined to accept, Grant consents, without admitting or denying the findings contained herein, except as to the jurisdiction of the Commission over him and over the subject ---------FOOTNOTES---------- -[1]- Rule 102(e)(1)(ii), 17 C.F.R.  201.102(e)(1)(ii), of the Commission's Rules of Practice provides in relevant part: 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 . . . . ==========================================START OF PAGE 2====== matter of this proceeding and as to the findings contained in Section III. paragraph A.1. below, which are admitted, to the entry of this Order Instituting Public Administrative Proceedings and Opinion and Order Pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice ("Order"). III. On the basis of this Order and the Respondent's Offer, the Commission finds that: A. Background 1. Frederick R. Grant, C.P.A. Frederick R. Grant, age 58, is a certified public accountant in the State of Florida who audited Microterra, Inc.'s ("Microterra") financial statements for the year ended December 31, 1991. Grant currently is a sole practitioner based in Boca Raton, Florida. 2. Microterra, Inc. Microterra evolved from a company formerly known as Myo-Tech Corp. ("Myo-Tech"), a manufacturer of medical equipment, which was publicly held and listed on NASDAQ, having filed its Form S-1 with the Commission for an initial public offering in 1988. On June 17, 1991 Myo-Tech acquired a privately-owned Florida corporation named Microterra, Inc. ("Microterra Florida") in a reverse merger resulting in Microterra Florida's shareholders assumption of control. On February 11, 1992, Myo-Tech changed its name to Microterra, Inc. On March 23, 1992, Microterra Florida was merged into Microterra and changed its state of incorporation to Delaware. In late 1994, Microterra changed its name to Atlantis Group, Inc. B. Overstatement of Microterra's Assets 1. The LSU Licensing Agreement Microterra's financial statements included in its Form 10-K for 1991 and its Form 10-Q for the third quarter of 1991 included a "licensing agreement" acquired from Louisiana State University ("LSU") on August 23, 1991 in exchange for 1,400,000 shares of restricted Microterra common stock. The company valued the licensing agreement at $1,400,000 on its balance sheet, representing the supposed market value of the 1,400,000 shares of restricted Microterra stock tendered in payment for the license based on a value of $1.00 per share (1,400,000 shares at $1.00 a share). However, in assigning a value of $1.00 to each restricted share, Microterra used the NASDAQ price for Microterra's publicly traded common stock on the day of the ==========================================START OF PAGE 3====== transaction instead of the contemporaneous price of its restricted stock. The method by which Microterra valued the license was not in conformity with generally accepted accounting principals ("GAAP"). Pursuant to APB 16 paragraph 67, the acquired asset should have been valued at either the fair value of the consideration given or the fair value of the asset acquired, whichever was more clearly evident.-[2]- Between late June 1991 and August 1991, Microterra sold 2,000,000 shares of common stock in a private placement at $0.25 per share. Given this, Microterra should have valued the licensing agreement at no more than $350,000 (1,400,000 shares at $0.25 a share); instead, the licensing agreement was overvalued by $1,050,000, resulting in the overstatement of the value of the company's total assets by 10% at December 31, 1991, based on the improper valuation of this one asset alone. 2. The Thagard Fluid Wall Reactor Microterra's financial statements included in its Form 10-K for 1991, and its Forms 10-Q for the second and third quarters of 1991, included equipment -- a "Thagard Fluid Wall Reactor" -- acquired from Vulcan Resources, Ltd. ("Vulcan") in May 1991 in exchange for 214,100 shares of preferred Microterra stock.-[3]- This reactor is a machine used to destroy toxic wastes by heating them to their temperatures of disassociation. Microterra valued the reactor at $2,141,000 on its balance sheet, which represented 21% of Microterra's total assets at December 31, 1991. Microterra recorded the purchase of the reactor based upon its depreciated value on Vulcan's books. Vulcan's original purchase price was $5,000,000 of which only $500,000 was paid in cash. The $4,500,000 balance was supported by promissory notes which were later cancelled, thus calling into question the recorded value on Vulcan's books. Pursuant to APB 16 paragraph 67, the acquired asset should have been valued at either the fair ---------FOOTNOTES---------- -[2]- Pursuant to APB 17 paragraph 25, intangible assets acquired should be recorded at cost at date of acquisition. "Cost" for this transaction is measured by the fair value of consideration received for stock issued as described in paragraph 67 of APB 16. Since the fair value of the licensing agreement cannot be determined, the fair value of the restricted common stock should be used to measure "cost." -[3]- The preferred stock issued in exchange for the equipment was convertible to four shares of Microterra common stock and carried a dividend calculated at 25% of the net operating revenues from the reactor. ==========================================START OF PAGE 4====== value of the consideration given or the fair value of the asset acquired, whichever was more clearly evident. Based on all available information, the fair value of both the equipment and the preferred stock was difficult to determine.-[4]- Microterra, however, did not have available the funds necessary to place the reactor in operation. The reactor had never been used before it was acquired by Microterra. Rather, it had been in storage for several years and required a significant amount of technical modifications, repairs, refittings and parts. Microterra obtained an estimate of approximately $500,000 to place the reactor back into operational status which it could not afford to pay, and the company did not have the financial strength to borrow funds to put the reactor in operation. As a result, the reactor was never placed in operation and never generated any revenues for the company, and Microterra therefore also never paid a dividend on the preferred stock issued in exchange for the reactor. Notwithstanding these problems, Microterra continued to value the reactor at $2,141,000 in periodic reports filed with the Commission from May 1991, the date of its acquisition, through at least April 1992. The continued valuation of the reactor at this amount was improper. According to GAAP, assets are probable future economic benefits obtained or controlled by an entity as a result of a transaction or event.-[5]- An essential characteristic of an asset is that "it embodies a probable future benefit that involves a capacity ... to contribute directly or indirectly to future net cash inflows."-[6]- The reactor had no future economic benefit to Microterra since it remained non-operational, and because Microterra had few if any prospects of ever placing it in operation based on the reactor's state of disrepair and the company's distressed financial condition. If not immediately evident, this fact should have been realized by no later than the end of 1991 at which time the asset should have been written-off or, at the least, substantially written-down. 3. The Digital Myograph Machine Patent ---------FOOTNOTES---------- -[4]- While the reactor could arguably have been valued based on the price of the common stock into which the preferred shares could be converted, and because of the uncertainty of the stock value at the time of the transaction, the Commission makes no finding that Microterra's initial valuation was incorrect. The Commission finds, however, as discussed below, that the continued valuation of the reactor at that amount was improper. -[5]- FASB Statement of Concepts No. 6, 25. -[6]- FASB Statement of Concepts No. 6, 26. ==========================================START OF PAGE 5====== Microterra's audited financial statements included in its Form 10-K for 1991 included a patent valued at $2,068,000, which represented 20% of the company's total assets at December 31, 1991. The company also valued the same patent at amounts ranging from $1,999,000 to $2,400,000 in its Forms 10-Q for the first three quarters of 1991 and the first quarter of 1992. The patent was for a "digital myograph machine," which tests the strength of muscle groups. This valuation was based on the carrying or book value of the patent by its previous owner. One of the primary reasons Myo-Tech went public in 1988 was to raise capital to manufacture and market the digital myograph machine. However, the company was entirely unsuccessful in these efforts such that by 1990 the company was reporting a going concern problem due to significant operating losses. The company's Form 10-K for the fiscal year ended December 31, 1990 reported that uncertainty of continuing operations had led management "to change the line of business the company is currently in ... and acquire a company in a different industry." This eventually led to the acquisition of Microterra. Despite these failures relating to the digital myograph machine, the company attempted one last effort to generate sales of the machine under the patent. In early 1991, the company entered into a sublicense agreement with a private company, Robert Norman Industries ("RNI"), under which RNI was granted the exclusive right to sell the digital myograph machine worldwide. However, RNI was not any more successful than Microterra in generating sales as it too failed to sell even one machine for the term of the sublicense agreement. By failing to effect any sales, RNI breached a minimum sales clause and defaulted on royalty payments under the sublicense agreement. During this period, RNI also failed to make any payments on an additional $100,000 debt to Microterra which had to be subsequently written- off by the company. The inability of Microterra to effect any sales of the digital myograph machine either independently or through RNI throughout this period confirmed what Myo-Tech had already determined as far back as 1990 -- the patent had little if any future economic benefit to the company. Also, by as early as February 1991 Microterra's management knew that the patent was worthless, and that a meaningful revenue stream would never be derived from sales of the machine. Notwithstanding these facts, Microterra continued to value the patent at or about $2,000,000 in five periodic reports filed with the Commission from March 1991 until the second quarter of 1992, when the company again determined not to commit further time or capital to marketing the machine and expensed the remaining value of the patent. According to GAAP, an asset continues as an asset of an ==========================================START OF PAGE 6====== entity until a circumstance destroys its future benefit,-[7]- at which point "[a]n expense or loss is recognized if it becomes evident that previously recognized future economic benefits of an asset have been reduced or eliminated." -[8]- In this instance, Microterra continued to value the patent at approximately $2,000,000 after it became clear that the company would be unable to successfully market or sell even one digital myograph machine and that the patent had little or no economic benefit to the company. At the time these reports were filed with the Commission, the company should have recognized and accounted for this impairment to the value of the patent. C. Grant's Audit of Microterra For Fiscal 1991 Grant audited Microterra's financial statements for fiscal year end December 31, 1991 and issued an unqualified audit report on those statements. The report represented that Grant had audited the financial statements in accordance with generally accepted auditing standards ("GAAS") and that the financial statements were presented in conformity with GAAP. Contrary to Grant's representations, the financial statements contained in Microterra's filings with the Commission were not presented in conformity with GAAP because they materially overstated assets and were not audited in accordance with GAAS because: (1) Grant lacked sufficient competent evidence to afford a reasonable basis for his opinion regarding the financial statements; (2) Grant failed to sufficiently understand Microterra's internal control structure; (3) Grant did not exercise due professional care in performing the audit; and (4) Grant's audit opinion falsely stated that the financial statements were presented in conformity with GAAP and that the audit was performed in accordance with GAAS. 1. Failure to Obtain Sufficient Competent Evidential Matter The third GAAS standard of field work provides that "[s]ufficient 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." (Codification of Statements on Auditing Standards ("AU")  150.02.) AU  326.14, defines "evidential matter" supporting the financial statements as the underlying accounting data and all ---------FOOTNOTES---------- -[7]- FASB Statement of Concepts No. 6, 33. -[8]- FASB Statement of Concepts No. 5, 87. ==========================================START OF PAGE 7====== corroborating information available to the auditor. By itself, however, accounting data, such as Microterra's general ledgers, cannot be considered sufficient support for financial statements. (AU  326.15.) Therefore, Grant was required to obtain corroborating evidential matter, including evidential matter from sources other than Microterra, that would support the information provided by Microterra. a. Audit of the LSU Licensing Agreement Grant testified that he did not consult GAAP for rules related to the valuation of an asset acquired for consideration other than cash. Grant also did not determine the fair value of the Microterra restricted common stock exchanged for the LSU licensing agreement even though information relating to sales of such stock through private placements was readily available to him. In addition, Grant obtained no corroborating evidential matter relating to the LSU licensing agreement, and instead accepted Microterra's valuation without question. b. Audit of the Thagard Fluid Wall Reactor Grant testified that he was unaware that the Thagard Fluid Wall Reactor was inoperable at the time of his audit. He testified that he did not physically observe the machine nor did he see any pictures of it. Grant also obtained no corroborating evidential matter relating to the reactor including the $500,000 repair estimate. He also did not consider or research the market value of the shares of preferred stock given in exchange for the reactor. Grant agreed with Microterra's valuation based on a range of values provided by a memo for an operable machine and a bill of sale from Vulcan for the reactor in exchange for the preferred stock. Grant conducted no further investigation of the underlying value of the asset. c. Audit of the Digital Myograph Machine Patent Grant relied on the predecessor auditor's valuation of the digital myograph machine patent, and accepted the valuation without further audit testing. Grant did not review the predecessor auditor's workpapers relating to the patent. If Grant had reviewed such workpapers he would have seen a memo from the auditor concerning the possible impairment of the patent. Grant also failed to obtain any corroborating evidential matter relating to the patent and he made no inquiry as to any subsequent events that may have materially affected the patent valuation. Further, he did not request any projections or other information from RNI even though RNI had a sublicense agreement under the patent and was four months in default on payments under the agreement. 2. Failure To Sufficiently Understand ==========================================START OF PAGE 8====== Microterra's Internal Control Structure The second GAAS standard of fieldwork provides that "sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed."-[9]- In the course of his audit, Grant failed to gain an understanding of Microterra's internal control structure and control risk. Grant's workpapers do not contain any documentation with respect to his assessment of control risk, his understanding of Microterra's internal control structure or the procedures that he needed to employ to gain such an understanding. Grant testified that he did not document any procedures or findings relating to internal control. As a result of his failure to sufficiently understand Microterra's internal control structure and control risk, Grant failed to adequately determine the nature, timing and extent of audit tests required to be performed to afford him reasonable assurance that the financial statements were free of material misstatements. 3. Failure To Exercise Due Professional Care GAAS provides that "[d]ue professional care is to be exercised in the performance of the audit and the preparation of the report."-[10]- Due care imposes a responsibility upon the auditor to observe the standards of field work and reporting prescribed by GAAS.-[11]- As shown above, Grant did not observe "due professional care" in his audit. His departure from this standard included his failure to obtain sufficient competent evidential matter and his failure to document in his workpapers support for the unqualified opinion that he issued. Grant was required to but did not document in his workpapers that the audit evidence obtained, auditing procedures applied, and testing performed provided sufficient competent evidential matter to afford a reasonable basis for his opinion.-[12]- In sum, the workpapers do not show a reasonable basis for Grant's unqualified opinion. 4. Improper Audit Report Grant issued an audit report which falsely stated that the ---------FOOTNOTES---------- -[9]- AU  150.02. -[10]- AU  230.01. -[11]- AU  230.02. -[12]- AU  339.05c. ==========================================START OF PAGE 9====== financial statements were presented in conformity with GAAP and that the audit was performed in accordance with GAAS. D. Conclusion Based on the foregoing, the Commission finds that Grant has engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii). IV. IT IS HEREBY ORDERED, effective immediately, that: A. Grant is denied the privilege of appearing or practicing before the Commission as an accountant. B. After three years from the date of this Order, Grant may apply to the Commission by submitting an application to the Office of the Chief Accountant which requests that he be permitted 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 of a public company to be filed with the Commission upon submission of an application satisfactory to the Commission in which Grant undertakes that, in his practice before the Commission, his work will be reviewed by the independent audit committee of the company for which he works or in some other manner acceptable to the Commission; 2. an independent accountant upon submission of an application containing a showing satisfactory to the Commission that: a. Grant, or any firm in 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 Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent accountant; b. Grant or the firm 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. Grant will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, ==========================================START OF PAGE 10====== as long as he appears or practices before the Commission as an independent accountant. 3. The Commission's review of any request or application by Grant to resume appearing or practicing before the Commission may include consideration of, in addition to ==========================================START OF PAGE 11====== the matters referenced above, any other matters relating to Grant's character, integrity, professional conduct, or qualifications to appear or practice before the Commission. By the Commission. Jonathan G. Katz Secretary