UNITED STATES OF AMERICA
In the Matter of
BARBARA HORVATH, CPA,
|ORDER INSTITUTING PUBLIC ADMINSTRATIVE PROCEEDINGS PURSUANT TO RULE 102(e) OF THE COMMISSION'S RULES OF PRACTICE AND FINDINGS AND ORDER OF THE COMMISSION|
The Securities and Exchange Commission ("Commission") deems it that public administrative proceedings be and hereby are instituted against Barbara Horvath, CPA ("Respondent") pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice1 to determine whether Horvath engaged in improper professional conduct.
In anticipation of the institution of this administrative proceeding, the Respondent has submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purposes of this proceeding and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the Commission's findings contained herein, except that she admits the jurisdiction of the Commission over her and over the subject matter of this proceeding, Respondent consents to the entry of this Order and the findings and imposition of remedial sanctions set forth below.
On the basis of this Order and the Respondent's Offer of Settlement, the Commission makes the following findings:2
Barbara Horvath is a certified public accountant licensed in New York and Pennsylvania, employed at all relevant times by Deloitte & Touche ("Deloitte"). She was assigned in 1996 to be the senior manager on the engagement for Fine Host's initial public offering. She also served as the senior manager on the 1996 year-end audit. Promoted to partner at Deloitte in 1997, Horvath was assigned to be the engagement partner for the never-completed audit of Fine Host's 1997 financial statements.3
Fine Host Corporation is a Connecticut-based company that, at all times relevant to this Order, provided food and beverage concession, catering and other services to approximately 400 facilities in 38 states. Fine Host conducted an initial public offering in June 1996, and a secondary offering in February 1997. Its stock was registered with the Commission under Section 12(g) of the Exchange Act and listed for trading on the Nasdaq National Market System. On January 7, 1999, subsequent to the extensive restatement of its financial statements, Fine Host entered a proceeding under Chapter 11 of the U.S. Bankruptcy Code. Pursuant to its plan of reorganization, Fine Host has now become a private entity.
Fine Host Corporation engaged in an extensive financial fraud that, when detected, resulted in the collapse of its stock price and, eventually, the end of its existence as a public company. The scheme predated Fine Host's June 1996 initial public offering by several years and continued through the third quarter of the fiscal year ended December 31, 1997. It involved, as its primary mechanism, the improper capitalization of millions of dollars in Company expenses as assets. Fine Host also manipulated acquisition reserve accounts, income from vendor rebates, and other items for the purpose of managing reported earnings.
Based on an internal investigation, Fine Host issued a restatement of its financial statements in February 1998, reflecting that from 1992 through the third quarter of fiscal year 1997, Fine Host had overstated its pretax income by over $49 million. For fiscal years 1994, 1995 and 1996, Fine Host had overstated pretax income by 149%, 213%, and 197%, respectively.
Horvath, as a senior member of the Deloitte audit team, failed to conduct appropriate audit procedures, in many instances improperly relying on representations of Company management as the principal source of audit evidence. This failure to exercise due professional care; to obtain sufficient competent evidential matter; and to maintain an attitude of professional skepticism, constituted improper professional conduct for purposes of Commission Rule of Practice 102(e).
Fine Host's Fraudulent Accounting Practices
Fine Host's improper accounting for "contract rights"
Fine Host's operations were based on securing contracts to provide food and beverage services to sports arenas, schools, convention centers, and other facilities. Beginning when Fine Host was a private company, its accounting practice was to aggregate certain costs associated with the pursuit of those contracts in an "acquisition costs" account. When a contract was signed, the costs attributed to it were then transferred to the "contract rights" account and were treated as capitalized costs to be amortized over the term of the contract.4
This practice was permissible under generally accepted accounting principles ("GAAP") only to the extent these costs were directly related to the acquisition of assets with a future economic benefit to Fine Host. In practice, however, Fine Host routinely and improperly allocated a pool of general and administrative ("G&A") expenses to the contract rights account, without any documentary support for this practice, rather than properly recognizing these overhead costs as period expenses. Each quarter, Fine Host assigned a certain (arbitrarily determined) percentage of total costs to each facility. Fine Host then allocated costs to specific facilities by multiplying the total costs for the quarter by the facility's assigned percentage.
Fine Host's Improper Accounting for Acquisition Reserves
Fine Host frequently acquired other companies in the food services industry. These acquisitions provided another vehicle to manipulate Fine Host's earnings. For each acquisition, Fine Host would set up goodwill and an acquisition reserve. These reserves were then used as a "cookie jar" to offset losses on a discretionary basis, sometimes two or three years after the acquisition.
In many instances, Fine Host did not discontinue any activity in connection with these acquisitions, or incur costs related to these acquisitions, such as those for terminated employees, which were the basis for establishing such reserves under GAAP. Typically, little (if any) documentation supported the amount taken as a reserve. Indeed, as Fine Host's report of internal investigation later concluded: "[o]ften the only available documentation consisted of the journal entry used."
Fine Host's Improper Accounting for Vendor Rebates
Fine Host received rebates and signing bonuses from various vendors throughout the relevant period. Its practice was to estimate, at the beginning of each year, the amount of rebates and signing bonuses it expected to receive throughout the year, then recognize income monthly on a pro rata basis. As was later acknowledged by both Fine Host and Deloitte, Fine Host did not substantiate that it would realize the rebate receivable balance that it had recorded. Separately, Fine Host also immediately and improperly recorded as income the entire amount of signing bonuses received from vendors (or expected to be received), even when such signing bonuses related to multiple-year contracts.
The Fine Host IPO
The registration statement for the Fine Host IPO was filed on March 29, 1996. In its Form S-1, Fine Host reported results of operations for the fiscal years 1993-95. Horvath served as the Deloitte audit senior manager during the IPO process.
The staff of the Commission's Division of Corporation Finance reviewed the registration statement and questioned Fine Host's accounting policy for contract rights. In response, Fine Host represented that, for all periods after year-end 1995, it would capitalize only two categories of costs associated with contract acquisitions: direct payments made to clients to acquire the contracts and the direct costs of obtaining licenses and permits to operate its contract locations. Fine Host specifically represented that it would no longer capitalize commissions and proposal costs. Finally, Fine Host represented that it had not amended its financial statements for the years covered by the registration statement to conform with this policy "since the impact of this adjustment would not be material for any year presented." In fact, the misstatement of Fine Host's financial results due to improper capitalization of contract rights was material for each fiscal year 1993 through 1995.
Horvath was aware of Fine Host's representation that certain categories of costs it had previously capitalized would be treated as period expenses subsequent to year-end 1995. She was also aware that Fine Host management had represented to the Commission staff that Fine Host did not restate its financial results for the periods covered by the registration statement because the costs it had improperly capitalized as contract rights were not material to any period. This representation was inaccurate but Horvath accepted it without inquiry.
The Form S-1 went effective on June 19, 1996. Net proceeds to the Company from the offering were approximately $32 million.
The Fiscal Year Ended December 25, 1996
Following the IPO, Fine Host improperly continued to spread G&A expenses among its capitalized "contract rights." The aggregate "contract rights" balance increased every quarter in fiscal year 1996.5 In fiscal year 1996, additions to contract rights totaled $12.2 million, while the additions to the fixtures and equipment account approximated $16.5 million.
The items capitalized went well beyond both the two cost categories Fine Host had represented to the Commission staff it would capitalize in the future and the capitalized cost categories it disclosed in its 1996 Form 10-K. In Fine Host's restatement, $6.3 million of capitalized 1996 contract acquisition costs were reversed as improper. This represented approximately 98% of Fine Host's pretax income for that year.
During 1996, Fine Host also became increasingly aggressive in misusing acquisition reserves and rebates to conceal its deepening financial problems. Fine Host improperly lowered its expenses by offsetting $2.65 million in operating expenses against previously recorded acquisition reserves. This inflated Fine Host's pretax income by 41%. Income from rebates was overstated by approximately $800,000 for 1996.
Audit failures in 1996
In 1996, Fine Host added $12.2 million in additional "contract rights" to its balance sheet. Nevertheless, Deloitte auditors, under the supervision of Horvath and others, did inadequate testing of this area.
Even the limited procedures performed by the auditors, however, provided indications of problems that warranted further inquiry. Deloitte auditors, including Horvath, knew that Fine Host capitalized employee sales commissions during 1996, and that it had told Commission staff that it would not follow that practice. Horvath should have known that this practice did not conform with GAAP.
During 1996, Fine Host partially shifted its fraudulent capitalization of period expenses from the contract rights account to the fixtures and equipment accounts. A schedule provided by management to Deloitte disclosed that 1996 additions to the fixtures and equipment accounts approximated $16.5 million. These significant additions should have caused the Deloitte auditors, including Horvath, to conduct a more detailed examination of this area. They did not, however, request a detailed list of these additions, or supporting documents such as vendor invoices. The Deloitte team, under the supervision of Horvath and others, examined a sample of only eight property additions during the 1996 audit, totaling $213,628 or approximately 1.3% of total property additions.
Similarly, Deloitte auditors, under the supervision of Horvath and others, failed to provide any meaningful review of Fine Host's accounting for acquisition reserves and vendor rebates. In 1996, reserves were established for four acquisitions, totaling more than $4.9 million. Horvath accepted the representations of Company management concerning the appropriateness of these additions, without conducting a detailed analysis of these acquisition reserves or obtaining evidential matter to test the reserves for compliance with GAAP requirements. With respect to vendor rebates, the auditors did not address the issue in any significant way.
On February 7, 1997, Fine Host conducted a secondary offering of 2,689,000 shares of its common stock, with net proceeds to Fine Host of approximately $59 million. The registration materials contained financial information for fiscal years 1994 and 1995 and for the nine-month period ended September 25, 1996, that as noted above, was materially false and misleading. Horvath supervised a review of the working papers and performed other procedures in connection with this registration statement.
On October 27, 1997, Fine Host issued $175 million of convertible subordinated notes in a private placement under Rule 144A of the Securities Act of 1933. This offering document contained financial information for fiscal years 1994, 1995, and 1996 and for the six-month period ended June 25, 1997, that was materially false and misleading. Horvath, now the engagement partner for Fine Host, signed Deloitte's reissued audit report, containing an unqualified opinion, on Fine Host's financial statements for fiscal years 1994, 1995 and 1996.
By the autumn of 1997, amortization of Fine Host's growing contract rights balance was eating into reported earnings, and Fine Host was experiencing increasing difficulty in meeting analysts' expectations. Alerted by a member of management that certain of the Company's accounting practices were questionable, the independent directors initiated an internal investigation. In February 1998, at the conclusion of this investigation, Fine Host announced that it had overstated its pretax income by $49 million, from approximately 1992 through the third quarter of 1997.
In Fine Host's restatement, eighteen categories of material accounting errors were identified, with improperly capitalized contract rights of $21.7 million being the largest. Acquisition reserves totaling $8.4 million were written off because (i) they were costs that should have been expensed as incurred, (ii) the Company lacked documentation linking them to a particular acquisition or (iii) the reserve, when properly decreased, already had been exhausted. In addition, Fine Host wrote off purported rebates receivable in the amount of $5.5 million, because they were supported by little if any documentation.
On January 7, 1999, Fine Host entered a proceeding under Chapter 11 of the U.S. Bankruptcy Code. Pursuant to its plan of reorganization, Fine Host has now become a private entity.
Horvath Engaged in Improper Professional Conduct for Purposes of Commission Rule of Practice 102(e)
Horvath failed to obtain sufficient competent evidential matter
In conducting an audit, an auditor must obtain sufficient competent evidential matter through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. AICPA Codification of Statements on Auditing Standards ("AU") § 326.01.
Based on the foregoing, in connection with Fine Host's 1996 and 1997 registration statements and Fine Host's year-end 1996 financial statements, Horvath failed to obtain sufficient competent evidence in support of Fine Host's accounting for: (1) capitalized "contract rights;"(2) capitalized "fixtures and equipment;" (3) vendor rebates; and (4) acquisition reserves.
Horvath failed to maintain an attitude of professional skepticism
An auditor is required to exercise professional skepticism when performing audit procedures and gathering and analyzing audit evidence. AU § 230.07.
Based on the foregoing, in connection with Fine Host's 1996 and 1997 registration statements and Fine Host's year-end 1996 financial statements, Horvath failed to maintain an attitude of professional skepticism concerning Fine Host's accounting for: (1) capitalized "contract rights;"(2) capitalized "fixtures and equipment;" (3) vendor rebates; and (4) acquisition reserves. Specifically, Horvath accepted uncorroborated representations of Fine Host's management in lieu of performing appropriate audit procedures, in contravention of AU § 333. "[R]epresentations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit." AU § 333.02.
Horvath failed to exercise due professional care
Auditors must exercise due professional care in performing the audit and preparing the audit report. AU § 230.01.
Based on the foregoing, in connection with Fine Host's 1996 and 1997 registration statements and Fine Host's year-end 1996 financial statements, Horvath failed to exercise due professional care by failing to perform audit procedures necessary to afford a reasonable basis for the audit opinions.
Based upon the foregoing, the Commission finds that, in connection with the audits of the financial statements of Fine Host Corporation, Barbara Horvath engaged in improper professional conduct for purposes of Rule 102(e) of the Commission's Rules of Practice. Specifically, Horvath was responsible for repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards.
IT IS HEREBY ORDERED, effective immediately, that:
Barbara Horvath is censured pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice for the conduct described herein and undertakes that:
1. She, 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 Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as she appears or practices before the Commission as an independent accountant, and
2. She 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.
By the Commission.
Jonathan G. Katz
|1|| Rule 102(e)(1) of the Commission's Rules of Practice 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 have engaged in ... improper professional conduct. Improper professional conduct includes repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission.
|2||The findings herein are made pursuant to the respondent's Offer of Settlement and are not binding on any other person or entity in this or in any other proceeding.|
|3||Concurrent with the settlement of this matter by Horvath, the Commission issued an Order Instituting Public Administrative Proceedings in the matter of Jeffrey Bacsik, the Deloitte engagement partner at all relevant times.|
|4||In addition, substantial amounts of these costs were improperly capitalized in "fixtures and equipment" accounts, particularly in 1996 and 1997.|
|5||Deloitte conducted reviews of Fine Host's quarterly financial statements throughout the relevant period.|
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