UNITED STATES OF AMERICA
In the Matter of
| ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS PURSUANT TO RULE 102(e) OF THE COMMISSION'S RULES OF PRACTICE, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS|
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be, and hereby are, instituted against Michael Sullivan, CPA ("Respondent" or "Sullivan") pursuant Rule 102(e)(1)(ii) of the Commission's Rules of Practice.1
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "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 to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over him and the subject matter of these proceedings, Respondent consents to the entry of this Order Instituting Public Administrative Proceedings Pursuant to Rule 102(e) of the Commission's Rules of Practice, Making Findings, and Imposing Remedial Sanctions ("Order"), as set forth below.
On the basis of this Order and Respondent's Offer, the Commission finds2 that:
1. Sullivan, age 54, was the engagement partner on the audits and quarterly reviews of the consolidated financial statements of Golden Bear Golf, Inc. ("Golden Bear" or "the Company") for fiscal years 1996 and 1997. Sullivan has been employed by Arthur Andersen, L.L.P. ("Andersen") since 1970 and became a partner in 1984. Sullivan is a certified public accountant.
2. Golden Bear is an international golf services company. It was spun off in an August 1996 initial public offering of stock from Golden Bear International, Inc. ("GBI"), a private company. Golden Bear's common stock was, until the Company completed a going private transaction on June 20, 2000, registered with the Commission pursuant to Section 12(g) of the Exhange Act. Golden Bear's common stock traded in the National Market System of the Nasdaq Stock Market, Inc.
3. Paragon Construction International, Inc. ("Paragon") was a wholly owned subsidiary of Golden Bear that provided golf course construction services. Paragon's financial statements were a material component of Golden Bear's consolidated financial statements.
4. Golden Bear's initial business plan called for it to focus primarily on acquiring and operating golf centers, though it also intended to engage in a number of other golf-related activities, including golf course construction services.3 The Company's golf centers, however, incurred significant losses and failed to provide the revenues and profits Golden Bear expected and needed to grow its golf center business. As a result, in 1997 Golden Bear increasingly looked to Paragon for revenues and profits.
5. In 1997 and 1998, Golden Bear recognized revenue in a manner that was not in conformity with generally accepted accounting principles ("GAAP") as a result of improper financial accounting and reporting practices at Paragon.4 From at least the second quarter of 1997, through the first quarter of 1998, Paragon engaged in a scheme to artificially inflate and accelerate its revenue and gross margin recognition by misrepresenting the true status of its construction contracts. Paragon overstated contract profitability or failed to record expected losses by (i) understating estimated construction costs, (ii) accelerating revenue and income recognition by overstating progress on construction projects, (iii) overstating estimated construction revenues and (iv) recording revenue and gross margin in connection with non-existent project agreements. These artificially inflated and accelerated results were incorporated into Golden Bear's financial statements.
6. Paragon continued these practices until April 1998 when Golden Bear dismissed Paragon management. On May 5, 1998, Golden Bear announced an internal review of Paragon's operations and said it might need to record losses in connection with some Paragon construction projects. On July 28, 1998, Golden Bear announced that it would restate its results for the periods ended December 31, 1997 and March 31, 1998.
7. On October 19, 1998, Golden Bear restated its financial statements for the year ended December 31, 1997 and quarter ended March 31, 1998 (the "Restatements"). Relevant terms of the Restatements are set out below (all amounts in $000):
|Year Ended 12/31/97||3-mo. ended 3/31/98|
|Net operating profit/(loss)||(3,198)||(15,500)||(12,302)||(547)||(5,244)||(4,697)|
|Income tax benefit/(provision)||1,372||(288)||(1,660)||308||(49)||(357)|
|Gain/(loss) from discontinued ops.5||0||(8,429)||(8,429)||0||(1,649)||(1,649)|
8. As a result of Paragon's improper financial accounting and reporting practices, Golden Bear's financial statements for the periods ended June 30, 1997 through March 31, 1998 were not stated in conformity with GAAP or the requirements of federal securities laws and regulations and materially misrepresented the financial condition and results of operations of Golden Bear.
9. In addition, in 1996, 1997 and 1998, Golden Bear omitted material information from its financial statements and other public filings with the Commission. Golden Bear failed to disclose (i) a change in the way that Paragon recognized its revenue and the fact that the change resulted in a material increase to the Company's reported revenue and gross margin; and (ii) certain material terms of an otherwise disclosed related-party transaction.
10. As a result of Golden Bear's not disclosing the change in the way it recognized revenue and certain material terms of a related-party transaction, Golden Bear's filings with the Commission from the period ended October 31, 1996 through the period ended December 31, 1998 did not conform to disclosure requirements set forth in the regulations of the Commission.
11. Paragon measured its income earned on its golf course construction contracts pursuant to the percentage-of-completion method of contract accounting, which permits the proportionate recognition of total revenue, cost and gross margin based on the percentage of work estimated complete under a contract. Through the first quarter of 1997, Paragon developed its percentage-of-completion estimates under the cost method, determining them solely with reference to costs incurred-to-date as a percentage of the project's estimated total costs.
12. In the second quarter of 1997, Paragon changed the way it recognized revenue on construction contracts from the cost method to, what the Company called, the "earned value" method. Under the "earned value" method, Paragon based its percentage-of-completion estimates on management's subjective estimates as to its progress instead of solely on the basis of objective criteria, such as costs incurred.6 As a result of the change in method for estimating percentage-of-completion, the Company experienced a material increase in revenue and gross margin for each reporting period from the second quarter of 1997 through the first quarter of 1998.
13. Paragon's change of its percentage-of-completion estimation method in the second quarter of 1997 resulted in two conditions that called into question the reasonableness of Paragon's revenue recognition under the "earned value" method. There was a material increase in Paragon's recorded (i) unbilled portion of the revenues, and (ii) revenue and gross margin under the "earned value" method as compared to what it would have recorded under the cost method.
14. When the Company proposed to change its method for estimating percentage-of-completion for the second quarter of 1997, Sullivan told the Company that he expected Paragon's results under the "earned value" method, which, for Paragon and the audit team, was new and untested, to not differ materially from its results under the cost method, which was a method Sullivan knew conformed with GAAP.
15. Sullivan monitored Paragon's implementation of the "earned value" method, and how it compared to the cost method by requiring that Golden Bear provide detailed schedules showing Paragon's project-by-project results under both methods for each reporting period from the second quarter of 1997 through the first quarter of 1998. According to these schedules, Paragon recorded materially higher revenue and gross margin under the "earned value" method than it would have reported under the cost method for the same period, precisely the outcome that Sullivan cautioned the Company against.7
16. By the third quarter of 1997, Paragon had reported approximately $1.4 million more in cumulative gross margin under the "earned value" method than it would have reported under the cost method. This amount was material to Golden Bear's financial statements.
17. In connection with the third quarter of 1997, Paragon claimed in response to quarterly review inquiries by Sullivan, that the gap between the gross margin recognized under the two methods was not as great as the analysis suggested and attributed the difference between the two methods to its failure to accrue all of its construction costs. In effect, Paragon said that since percentage-of-completion estimates under the cost method were determined solely with reference to costs incurred-to-date as a percentage of the project's estimated total costs, its failure to accrue all of its construction costs artificially suppressed the amount of revenue and gross margin it would have been able to recognize under the cost method.
18. Sullivan did not request documentation supporting this explanation or quantifying the effect that accruing the costs would have had on the comparative gross margin. Nor did he or his staff perform procedures to verify the accuracy of management's representations. Sullivan told Paragon management that he expected the gap to close to an immaterial amount by year-end.
19. In actuality, the gap between the revenues generated by the cost method and the "earned value" method was a result of Paragon's scheme to artificially inflate its results. To reduce the gap, Paragon booked $4 million in uninvoiced fictitious costs after year-end but posted them as of year-end. These uninvoiced fictitious costs made it appear that the Company had incurred more costs, and thereby performed more work than had, in fact, been the case. By artificially increasing job costs, Paragon increased the percentage-of-completion estimates generated by the cost method and closed the gap between the revenue and gross margin estimates generated by the cost method and the "earned value" method. At year-end 1997 this manipulation reduced the gap from approximately $1.2 million to $209,000, an amount which was still material.
20. Sullivan knew that Paragon booked costs for which no invoices had been received and which were not reflected in the Company's account's payable system, and that recording these uninvoiced costs would have substantially reduced the gap between the results produced by the two estimation methods. Because of the significance of these cost accruals, the audit team discussed them with Paragon's president, vice president for operations and controller, but the audit team too readily relied on management's oral representations that the uninvoiced job cost accruals were for work which had been performed. While procedures with respect to invoiced and paid costs were performed, Sullivan did not employ any procedures to determine whether the uninvoiced costs had actually been incurred as of year-end. As a result, Sullivan recklessly failed to respond to the risk of a material overstatement of earnings.
21. Another condition caused by the Company's scheme to overstate revenues was a dramatic increase of unbilled net revenues after Paragon changed to the "earned value" method in the second quarter of 1997. Unbilled revenue is revenue which had been recognized but which had not been billed to Paragon's customers. By year-end 1997, the unbilled portion of net revenues increased to $11.5 million or 29% of total reported construction revenue. This increase was a dramatic rise from $3.1 million in the second quarter of 1997, when Paragon made the change, and from $6.6 million in the third quarter.
22. Paragon had represented to the audit team, at the time it adopted the "earned value" method of estimating revenues, that it would apply the same methodology to calculate billings to customers as it applied to revenue recognition. Using the same methodology for estimating revenues and billings should ensure that there was little gap between revenue and billings. Customer acceptance of such bills serves as a check, at least in part, on the accuracy of the revenue recognition process.
23. Thus, at year-end Sullivan knew of, and failed to follow up on red flags that suggested that the Company was improperly recognizing revenue. He knew that the "earned value" method accelerated revenue recognition by material amounts. He knew that the difference between revenue recognized by the subjective "earned value" method and the objective cost method narrowed only because the Company booked the $4 million in purported costs for which the Company had not been invoiced. He knew that unbilled revenue had unexpectedly and substantially increased to 29% of total reported construction revenue by year-end, another sign that costs were not being incurred at the same rate as revenue was being recognized. Sullivan knew or was reckless in not knowing that Golden Bear's revenue recognition practices at Paragon did not conform to GAAP.
24. Sullivan was sufficiently concerned about, among other things, the "earned value" method's tendency to accelerate revenue recognition that he designated the audit as "high-risk". Among the factors Sullivan noted in developing Andersen's high risk assessment were the subjective nature of the "earned value" method and its demonstrated tendency to accelerate revenue recognition, Paragon's materially large unbilled revenue balance, Golden Bear management's aggressive revenue recognition and financial reporting practices in response to the Company's lack of profitability, and Paragon's cost accounting system's history of providing unreliable job status information.
25. Sullivan also decided that Andersen would not rely on Paragon's internal controls in connection with its audit, but would instead undertake a high level of substantive testing. In accordance with generally accepted auditing standards ("GAAS"), the less reliance an auditor places on the entity's internal controls, the higher the level of substantive testing of transactions the auditor is required to perform in obtaining sufficient competent audit evidence to support the auditor's opinion on the financial statements. This higher level of substantive testing should include audit procedures such as contacting independent parties and testing sufficiently large samples. Moreover, Sullivan's high-risk audit designation indicated a need for an even greater level of substantive testing.
26. In determining not to rely on the internal controls relating to Paragon's construction costs, revenues, and percentage-of-completion estimates, Sullivan, in effect, decided that obtaining sufficient competent audit evidence required Andersen to test Paragon's construction costs, revenues, and percentage of completion estimates, on significant numbers of transactions involving Paragon's construction jobs in order to determine whether such estimates and transactions accounted for in Paragon's financial statements were reasonably accurate and in conformity with GAAP.
27. Nevertheless, the audit team under Sullivan's direction and supervision i) failed to include numerous audit procedures required by GAAS, ii) excessively relied on Paragon's internal controls, and iii) excessively relied on management representations about key estimates rather than develop sufficient competent evidential matter supporting these key estimates as required by GAAS. More specifically, the audit team under Sullivan's direction failed to adequately test Paragon's costs, revenues and percentage-of-completion estimates including the failure to (i) adequately test uninvoiced job cost accruals, (ii) adequately test unbilled revenues, (iii) include job site visits and discussions with project managers and other on-site operating personnel in its audit, (iv) adequately test estimated total costs, and (v) adequately test estimated total revenues.
28. As noted above, the apparent difference between Paragon's results under the "earned value" method as compared to the cost method was substantially reduced as a result of Paragon booking after year-end (but posting as of year-end) approximately $4 million in uninvoiced, and in fact, fictitious, accrued construction costs. This was an unusually large accrual. Without the accrual, the difference in gross margin would have been approximately $1 million greater under the "earned value" method as compared to the cost method.
29. Sullivan knew that Paragon's year-end accruals were critical to Andersen's ongoing evaluation of Paragon's implementation of the "earned value" method, yet he failed to test directly any of the year-end uninvoiced job cost accruals. Instead, Sullivan relied excessively on oral representations from Paragon management that such costs had actually been incurred and on other procedures that did not specifically address the risk that the uninvoiced cost accruals were for costs that, in fact, had not been incurred. As a result, Sullivan had no sufficient basis to conclude, based on the untested accruals, that the gap between Paragon's results under the "earned value" method as compared to the cost method had narrowed sufficiently to allay his concerns about Paragon's implementation of the "earned value" method and its improper acceleration of revenue recognition.
30. As noted above, Paragon's net unbilled revenues as of December 31, 1997 totaled $11.5 million. A significant unbilled revenue balance requires adequate testing to determine the reason that the company is not billing for the work it reports as complete and whether unbilled amounts are properly recognized as revenue. In response, Sullivan relied excessively on oral representations from Paragon management as to the reason for unbilled balances on three projects and did not adequately test these, or any other unbilled receivable balances.
31. For example, the unbilled balance on one of the three projects the audit team inquired about, the Golf Club at Mansion Ridge ("Mansion Ridge"), totaled approximately $2 million at December 31, 1997. This amount was material to the Company's year-end financial statements. Paragon told the audit team that Mansion Ridge's owners frequently disputed whether Paragon had actually completed the work for which it was billing. Despite this significant evidence that a third-party with knowledge of the project's status disputed Paragon's estimated percentage-of-completion under the contract, the audit team did not properly further investigate this project or otherwise expand Andersen's scope of testing of Paragon's unbilled revenue balances.
32. Sullivan treated the unbilled revenue amount as a "business issue" when he was reckless in not knowing that it represented significant audit evidence that Paragon's revenue recognition practices did not conform to GAAP.
33. The American Institute of Certified Public Accountant's ("AICPA") Audit and Accounting Guide - Construction Contractors ("Audit Guide") provides authoritative guidance on GAAP and GAAS in connection with construction contracts. The Audit Guide recommends job site visits and discussions with project managers, on-site personnel, and other appropriate individuals, including, if possible, the independent architect, regarding the status of the contract and any significant problems and to assess the "representations of management (for example, representations about the stage of completion and estimated costs to complete)" and the testing of estimated costs to complete.
34. Sullivan knew or was reckless in not knowing that Paragon's project managers directed the daily operations of its projects, including estimating, budgeting, and personnel issues. Sullivan also knew that project managers, some of whom were based at Paragon's headquarters, initially prepared Paragon's percentage-of-completion estimates, which Sullivan had identified as a high-risk area of the audit.
35. Notwithstanding the Audit Guide, Sullivan did not include discussions with project managers or job site visits in any phase of the audit nor did Sullivan document why the audit did not include such discussions or site visits. Sullivan limited audit discussions to Paragon's president, vice-president for operations, and controller. And even though the audit team had visited several Paragon job sites in connection with the 1996 audit, they did not visit any job sites in connection with the 1997 audit. Failing to discuss project status, including percentage-of-completion estimates, with project managers and other on-site operating personnel was, under the circumstances, a reckless departure from GAAS.
36. GAAS required that the audit team test significant projects to determine whether Paragon's estimated cost to complete was reasonable and accurate. Notwithstanding the significance of these estimates to Paragon and Golden Bear's financial reporting and Paragon's history of unreliable cost estimates, the audit team failed to adequately test Paragon's construction cost estimates in connection with the year-end audit. Instead, Sullivan was reckless when he relied excessively on Paragon's internal controls and management's representations to support Paragon's cost estimates.
37. During the year-end audit, the audit team tested Paragon's reported estimated total revenue amounts by attempting to trace them to documented contract and/or change order amounts for thirteen projects. The audit team was unable to document the reported estimated revenue amount in connection with eleven of the thirteen projects tested. In each instance, Paragon's estimated total revenue amount was higher than the amount reflected in the contract documents Paragon provided to Andersen. Paragon management told Sullivan that most of these amounts related to unsigned change orders, but management could not produce any documents supporting these oral representations.
38. In each instance, Sullivan failed to properly follow-up on a single undocumented amount; instead, Sullivan relied solely on Paragon management's oral representations that the estimated revenue amounts accurately reflected the economic status of the jobs. As a result, Sullivan recklessly approved the recognition of revenue in connection with these projects without objective and verifiable evidence supporting the amounts.
39. As stated, after Paragon changed to the "earned value" method beginning in the second quarter of 1997, Paragon recorded materially higher revenues and profits under the "earned value" method than for the same periods under the cost method. In fact, the adoption of the "earned value" method moved the Company from a net loss to a net income position in the second quarter of 1997.
40. No financial statement disclosure was made for the change in the accounting methodology in the Company's 1997 interim or annual financial statements. GAAP requires disclosure of the nature and effect of this type of change on the financial statements for accounting changes that have material effects.8 Sullivan was reckless in not knowing that such nondisclosure violated GAAP.
41. Golden Bear also failed to disclose certain material terms of related party transactions it had with GBI and with GBI's owner personally. Among other things, the Company failed to disclose that in October 1996, GBI guaranteed an amount owed to Paragon by the owner of a specific golf course construction project ("Project A") that Paragon was building. The Company also failed to disclose that at December 31, 1997, Project A's owners defaulted on the debt, leaving a balance of $500,000 due from GBI pursuant to the guarantee. Golden Bear also failed to disclose its July 1998 forgiveness of GBI's $500,000 guarantee in connection with GBI's participation in the Company's settlement of claims relating to a separate project.
42. Without disclosure to the contrary, there is a general presumption that transactions reflected in financial statements have been consummated on an arm's-length basis between independent parties. However, that presumption is not justified when related party transactions exist because the requisite conditions of competitive, free-market dealings may not exist. As a result, GAAP requires the full disclosure of all material terms of related party transactions; this requires the disclosure of all information that may be necessary to insure that it validly represents the underlying events and conditions.
43. Sullivan was reckless in not knowing that Golden Bear had failed to disclose these material terms of the related party transactions and that as a result, the financial statements did not comply with GAAP.
44. Based on the foregoing, the Commission finds that, in connection with the audits of the 1996, 1997 and 1998 financial statements of Golden Bear, Michael Sullivan engaged in improper professional conduct for purposes of Rule 102(e)(1)(ii) of the Commission's Rules of Practice.
Accordingly, the Commission hereby accepts Sullivan's Offer and hereby ORDERS, effective immediately, that:
|(a)||Respondent, or the firm with which he is associated, is a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") or an organization providing equivalent oversight and quality control functions ("equivalent organization");|
|(b)||Respondent, 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 or equivalent organization; and|
|(c)||As long as Respondent appears or practices before the Commission as an independent accountant he will remain either a member of, or associated with a member firm of, the SEC Practice Section or equivalent organization, and will comply with all applicable SEC Practice Section or equivalent organization requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education.|
By the Commission.
Jonathan G. Katz
|1||Rule 102(e)(1)(ii) provides, in relevant part, that:|
The Commission may deny, temporarily or permanently, the privilege of appearing or practicing before it by any person who is found to have engaged in improper professional conduct.
|2||The findings herein are made pursuant to Respondent's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding.|
|3||Golf centers are golf practice facilities that sometimes include miniature golf and golf shops that sell golf clothing and equipment.|
|4||The Commission has brought two separate actions against three former Paragon officers in connection with the Paragon fraud, and one action against three former Golden Bear officers in connection with Golden Bear's reporting violations. SEC v. John R. Boyd, and Christopher Curbello, Civil Action No. 02-80726CIV, (S.D.Fla., Hurley). In the Matter of David Friend, CPA, Rels. 34-46290, AAER-1603, File No. 3-10856. In the Matter of Richard P Bellinger, Jack P. Bates, and Stephen S. Winslett, Rels. 34- 46291, AAER-1604, File No.3-10857.|
|5||The golf centers division was treated as a discontinued operation on Golden Bear's restated financial statements.|
|6||For example, in a case where Paragon management's earned value percentage-of-completion estimate was 50% complete, Paragon would recognize for financial statement purposes 50% of the project's estimated total revenue, cost and gross margin, even if the project had incurred substantially lower than 50% of the project's estimated total costs.|
|7||This includes higher cumulative profits of approximately $800,000 at June 30, 1997, $1.4 million at September 30, 1997, $209,000 at year-end 1997 and $1 million at March 31, 1998.|
|8||Regardless of whether the adoption of the "earned value" method was considered a change in accounting principle or a change in accounting estimate, disclosure by the Company in its second quarter 1997 interim financial statements and its 1997 annual financial statements was required to comply with GAAP.|
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