UNITED STATES OF AMERICA
In the Matter of
SCB Computer Technology, Inc.,
|ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS AND IMPOSING A CEASE-AND-DESIST ORDER|
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be, and hereby are, instituted against SCB Computer Technology, Inc. ("SCB") pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act").
In anticipation of the institution of these administrative proceedings, SCB has submitted an Offer of Settlement that the Commission has determined to accept. Solely for purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and prior to a hearing and without admitting or denying the findings set forth herein, except as to jurisdiction over it, and over the subject matter of these proceedings, which it admits, SCB consents to the entry of this Order Instituting Public Administrative Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease-and-Desist Order ("Order"). The Commission has determined that it is appropriate to accept the Offer of Settlement from SCB, and accordingly is issuing this Order.
Based on the respondent's offer and this order, the Commission finds the following:1
A. RESPONDENT AND OTHER RELEVANT ENTITY
SCB Computer Technology, Inc. is a Tennessee corporation with principal offices in Memphis, Tennessee. SCB provides information technology related consulting, outsourcing and staffing services, and has averaged approximately $135 million in revenue over fiscal years 1998, 1999 and 2000.2 SCB's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and was quoted on the NASDAQ National Market System until it failed to meet certain NASDAQ listing requirements. SCB's common stock is now quoted on the Over the Counter Bulletin Board.
The Partners Group was an Arizona partnership acquired in 1997 by SCB. Prior to being acquired by SCB, The Partners Group provided mainframe data processing and support services and leased and remarketed computer equipment to other companies. After the acquisition, The Partners Group grew to provide other computer related services, including enterprise resource planning and information technology consulting.
After the acquisition, The Partners Group operated as a stand-alone division within SCB ("SCB/Partners"). SCB hired a co-founder of The Partners Group as SCB/Partners' Chief Operating Officer and President ("SCB/Partners COO"). SCB/Partners COO was responsible for the day-to-day operations of SCB/Partners, including overseeing the accounting and finance functions of SCB/Partners. SCB contracted with the former Senior Vice President of Finance and Administration of The Partners Group, a CPA, to provide accounting and finance services to SCB/Partners via his outsourcing accounting firm ("SCB/Partners Accountant"). SCB/Partners Accountant was responsible for daily accounting and finance functions of SCB/Partners.
SCB was formed in 1976 to provide information technology services, including consulting, outsourcing and staffing. In 1996, the company became a publicly traded company and expanded its lines of businesses when it acquired The Partners Group. The acquisition of The Partners Group required SCB to implement an accounting system that would ensure that SCB/Partners' books and records were accurate, and that SCB/Partners' financial results, as included in the reported performance of SCB, were in conformity with GAAP. As described in this Order, SCB failed to adopt such a system and instead allowed its own reported financial results to be rendered inaccurate through the improper accounting of SCB/Partners.
SCB/Partners' accounting and finance functions were separate from SCB's. At period end, SCB/Partners COO and SCB/Partners Accountant provided monthly financial statements to SCB that ostensibly reflected the financial performance of SCB/Partners. SCB, through its CFO, uncritically accepted the contribution that SCB/Partners made to SCB's bottom-line. SCB's CFO simply incorporated SCB/Partners' results into the reported results of SCB without taking adequate steps to ensure the validity of the financial information being supplied by SCB/Partners to SCB. In recording the transactions of SCB/Partners, SCB/Partners COO and SCB/Partners Accountant repeatedly disregarded basic principles of GAAP in the areas of revenue recognition, lease accounting, and expense accruals. In addition, there were inadequate controls at SCB to prevent or detect the GAAP violations perpetrated by SCB/Partners. As a result, the books and records of SCB did not accurately reflect the results of SCB's operations.
SCB's periodic reports for fiscal years 1998, 1999, and the 1st quarter of fiscal year 2000, contained financial statements that overstated SCB's pre-tax net income by 10% to 53%. As such, SCB violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder.
1 IMPROPER REVENUE RECOGNITION
1. Improper Recognition of Excess Capacity Revenue
In 1995, The Partners Group entered into an outsourcing contract whereby The Partners Group agreed to provide another company with, among other services, information technology consulting and computer mainframe capacity. The agreement stipulated the company would compensate The Partners Group for any use of the mainframe above and beyond a predetermined level. By April 1998, the company had incurred $1,257,466 in excess capacity charges that remained unpaid to SCB/Partners.
In April 1998, SCB/Partners and the company amended their existing agreement. The amended agreement, among other things, relieved the company's obligation to pay the $1,257,466 in excess capacity charges. Nonetheless, in the 4th quarter of fiscal year 1998, SCB recorded $1,257,466 in revenue related to the excess capacity charges. As a result, SCB overstated its pre-tax income by 10% for fiscal year 1998.
2. Improper Recognition of Revenue from Backdated Contracts
In two instances in fiscal year 1999, SCB recognized revenue on transactions for which no signed contract existed prior to the close of the quarter. During the 3rd quarter of fiscal year 1999, SCB/Partners and a company formed by a co-founder of The Partners Group, began negotiating SCB/Partners' sale of certain schedules relating to computer hardware leases. The contracts relating to the above mentioned proposed transactions were not created or signed by both parties until the 1st quarter of fiscal year 2000. Nevertheless, SCB recognized gains on these sales of approximately $1,550,000 and $1,000,000 in SCB's 3rd and 4th quarters of fiscal year 1999, respectively.
As part of their year-end audit, SCB's independent auditor ("the Auditor") requested that SCB provide it with signed copies of the contracts. Subsequently, SCB/Partners COO created and executed backdated contracts as of the 3rd and 4th quarters of fiscal year 1999 -- the quarters for which SCB/Partners Accountant recorded the revenue. SCB provided the backdated contracts to the Auditor. As a result, SCB overstated its pre-tax income by 43% and 34% for its 3rd quarter 1999 and its fiscal year 1999, respectively.
3. Improper Recognition of Revenue Associated with a Contract Termination Clause
SCB improperly recorded $300,000 in revenue associated with the early termination of an outsourcing contract with an SCB/Partners' client during the 4th quarter of fiscal year 1999. A termination clause in the contract stipulated that if the client terminated the contract, SCB/Partners would nonetheless be paid any outstanding fees. GAAP permits a company to recognize revenue pursuant to an early termination provision provided a company is not obligated to and does not perform any services related to the remaining fee revenue. Sometime after the end of fiscal year 1999, and as part of the year-end audit for fiscal year 1999, SCB represented to the Auditor that the contract had been terminated. To the contrary, SCB/Partners continued to provide services and receive payments from the client under the contract through at least the 1st quarter of fiscal year 2000. The parties did not reach a termination agreement until the 2nd quarter of fiscal year 2000. As a result, SCB overstated its pre-tax income by an additional 4% for fiscal year 1999.
4. Improper Recognition of Revenue from the Sale of Residual Lease Interest
SCB/Partners owned a 100% interest in a lease of computer hardware. In the 4th quarter of fiscal year 1999, SCB sold for $100,000 a 15% interest in the future residual value of the computer equipment covered by the lease. At the time of the sale, SCB/Partners' interest in the residual value of the lease was approximately $587,512.
GAAP permits a company to record a gain equal to the difference between the purchase price and proportional amount of the lease sold. Based on the sale of a 15% interest, the gain SCB should have recorded was approximately $12,000. However, SCB/Partners Accountant and SCB's CFO recorded a gain based on the sale of a 100% interest -- approximately $208,000. The Auditor objected to SCB's accounting treatment during their 1999 audit and posted a related $180,000 adjustment to its statement of audit differences. Despite the Auditor's objection, SCB did not record this adjustment in its financial statements for fiscal year 1999 on grounds of immateriality. As a result, SCB overstated its pre-tax income by an additional 2% for fiscal year 1999.
5. Improper Recognition of Revenue from Correction of an Accounting Error
During the 1st quarter of fiscal year 2000, SCB/Partners mistakenly double-booked $637,691 in revenue related to a consulting contract with one of its clients. GAAP requires that correction of accounting errors be recorded as prior period adjustments. SCB/Partners discovered the mistake during the 2nd quarter, after the issuance of its 1st quarter Form 10-Q. SCB/Partners Accountant did not make a retroactive adjustment as required by GAAP, but rather improperly recorded offsetting expenses in the 2nd and 3rd quarters sufficient to offset the amount of the error. As a result, SCB overstated its pre-tax income by 10% for 1st quarter of 2000.
D. IMPROPER LEASE ACCOUNTING
1. Improper Lease Write-Off
SCB/Partners owned a 100% interest in a lease of computer hardware. SCB/Partners Accountant improperly recorded $217,143 in revenue in the 3rd quarter of fiscal year 1998 by writing-off the lease from SCB's books and recording as revenue the remaining lease payments. The result was to accelerate the recognition of revenue on the lease. GAAP prohibited SCB from writing-off the lease from the books, as no changes to the lease had occurred to justify this accounting change. SCB/Partners Accountant knew that this accounting treatment was not recorded in compliance with GAAP. As a result, SCB overstated its pre-tax income by 7% for 3rd quarter 1998.
2. Improper Lease Accounting Treatment of Unearned Income and Improper Increase in the Lease's Residual Value
SCB/Partners owned a 100% interest in a lease of computer hardware. In fiscal year 1999, SCB/Partners amended the lease of computer equipment and in two separate instances, improperly recorded revenue associated with the amendment. First, in the 1st quarter, SCB/Partners Accountant improperly recognized $709,354 in revenue representing the balance of unearned income that was reflected in SCB/Partners' books before the lease was amended. Under GAAP, when the lease was amended, the remaining unearned income should have been combined with the new lease as unearned income and not immediately recorded as revenue. At the time, SCB/Partners Accountant knew that this accounting treatment was not recorded in compliance with GAAP.
During the 2nd quarter of fiscal year 1999, SCB recognized $200,000 in revenue associated with the lease by increasing the residual value on the amended lease. GAAP prohibits a company from increasing the residual value of leased assets. At the time, SCB/Partners Accountant knew that he was improperly recording the $200,000.
As a result, SCB overstated its pre-tax income by 32% and 8% for its 1st quarter of fiscal year 1999 and its fiscal year 1999, respectively.
E. IMPROPER ACCOUNTING TREATMENT OF ACCRUED BONUSES
At the end of SCB's 1999 fiscal year, SCB owed certain employee bonuses totaling $380,000. SCB paid the bonuses in the 1st quarter of fiscal year 2000. Consistent with GAAP, SCB should have expensed the bonuses in the period in which they were earned, which was fiscal year 1999. Instead, SCB improperly capitalized these bonuses as prepaid commissions associated with a 44-month contract awarded to SCB/Partners in the first quarter of fiscal year 2000.
SCB's CFO and SCB/Partners Accountant did not properly record these bonuses as expenses in 1999 in order to avoid the negative impact the employee bonuses had on SCB's earnings for the fiscal year 1999. By amortizing the bonuses over the term of this 44-month contract, SCB improperly spread out the earnings impact of the bonus payment over future periods. As a result, SCB overstated its pre-tax income by an additional 5% for fiscal year 1999.
F. SCB'S RESTATEMENT
On April 14, 2000, SCB announced the formation of a special committee to investigate potential financial irregularities, and the resignation of its independent auditor. On July 3, 2000, SCB announced that it would be restating its consolidated financial statements for the fiscal years 1998 and 1999 and the first three quarters of fiscal year 2000. SCB's proposed restatement included corrections for the accounting irregularities described above, as well as other accounting corrections and adjustments for these periods.3
As a result of its improper accounting, SCB filed materially false and misleading financial statements and disclosures for fiscal years 1998 and 1999 and the 1st quarter of fiscal year 2000. For fiscal year 1998, SCB overstated its pre-tax income by 11%. For fiscal year 1999, SCB overstated its pre-tax income by 53%. In addition, for the 1st quarter of fiscal year 2000, SCB overstated its pre-tax income by 10%.
G. LEGAL DISCUSSION
1. SCB Violated the Periodic Reporting Provisions of the Exchange Act
Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers to file annual and quarterly reports with the Commission containing current financial information and disclosure. Forms 10-K and 10-Q require that financial statements included in the periodic reports be prepared consistent with Regulation S-X, which requires that the financial statements be presented in accordance with GAAP. No showing of scienter is necessary to establish a violation of Section 13(a). SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1167 (D.C. Cir. 1978), cert. denied 440 U.S. 913 (1979). Rule 12b-20 of the Exchange Act requires that all reports filed pursuant to Section 13 contain all information necessary to ensure that the statements made are not materially misleading.
SCB reported materially inaccurate financial statements in periodic reports filed with the Commission for the fiscal periods from 1998 through the 1st quarter of 2000. SCB overstated pre-tax income by 11% for its fiscal year 1998 and by 53% for its fiscal year 1999. SCB overstated pre-tax income by 10% for its 1st quarter of fiscal year 2000. These overstatements were due to improper accounting for the transactions discussed above and were material to the financial statements in which they were reported. Accordingly, SCB violated Sections 13(a) and Rules 12b-20, 13a-1 and 13a-13 thereunder.
2. SCB Violated the Record-Keeping and Internal Control Provisions of the Exchange Act
Section 13(b)(2)(A) of the Exchange Act requires reporting companies to make and keep books, records and accounts which accurately and fairly reflect their transactions and dispositions of assets. Section 13(b)(2)(B) requires reporting companies to devise and maintain a system of internal controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP.
SCB failed to maintain adequate internal accounting controls and accurate books and records. SCB failed to maintain adequate internal accounting controls to ensure the validity of financial information supplied by SCB/Partners. SCB/Partners COO and SCB/Partners Accountant caused SCB/Partners to record improper accounting entries as discussed above. All of these errors were incorporated in the books and records and into the consolidated financial statements of SCB and caused them to be materially inaccurate. Accordingly, SCB violated Sections 13(b)(2)(A) & 13(b)(2)(B) of the Exchange Act.
In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff.
The Commission finds that SCB Computer Technology, Inc. violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that SCB Computer Technology, Inc.:
Cease-and-desist from committing or causing any violation of, and committing or causing any future violation of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder.
By the Commission.
Jonathan G. Katz
|1||The findings herein are made pursuant to SCB's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding by the Commission.|
|2||SCB's fiscal year ends on April 30th each calendar year.|
|3|| The effect of SCB's entire restatement on its pre-tax income is summarized in this chart:
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