UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 38494 / April 10, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 904 / April 10, 1997 ADMINISTRATIVE PROCEEDING File No. 3-9292 ----------------------------------- : In the Matter of : ORDER INSTITUTING : PROCEEDINGS AND OPINION PHILIP S. PRESENT II, CPA and : AND ORDER PURSUANT TO WILLIAM J. SCANLON, CPA, : RULE 102(e) OF THE : COMMISSION'S RULES OF Respondents. : PRACTICE : : ----------------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted against Philip S. Present II, CPA and William J. Scanlon, CPA pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice.1 II. In anticipation of the institution of these administrative proceedings, each respondent has submitted an Offer of Settlement for the purpose of disposing of the issues raised in these proceedings. 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 prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. 201.1 et seq., the respondents, without admitting or denying the findings set 1 Rule 102(e)(1)(ii) of the Commission's Rules of Practice, 17 C.F.R.  201.102(e), provides in pertinent 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 have engaged in ... improper professional conduct." ==========================================START OF PAGE 2====== forth herein, except that they admit to the jurisdiction of the Commission over them and over the subject matter of these proceedings, consent to the entry of the findings and to the imposition of the sanctions set forth below. III. FINDINGS On the basis of this Order Instituting Proceedings and Opinion and Order Pursuant to Rule 102(e) of the Commission's Rules of Practice ("Order") and the Respondents' Offers of Settlement, the Commission finds the following:2 A. RESPONDENTS AND OTHER RELATED PARTIES 1. Respondents Philip S. Present II, 46, a certified public accountant in the State of Ohio, was an audit partner with KPMG Peat Marwick LLP from 1983 until April 1995. He was the engagement partner for the audit of Structural Dynamics Research Corporation's 1993 financial statements. William J. Scanlon, 49, a certified public accountant in the State of Ohio, was an audit partner with KPMG Peat Marwick LLP from 1979 until June 1995. He was the concurring review partner for the audit of Structural Dynamics Research Corporation's 1993 financial statements. 2. Other Related Parties KPMG Peat Marwick LLP ("KPMG"), is a national public accounting firm with its headquarters in New York. KPMG was SDRC's independent auditor from the early 1980's until its resignation in October 1994. Structural Dynamics Research Corporation ("SDRC"), an Ohio corporation with its principal place of business in Milford, Ohio, is an international supplier of mechanical design automation software and engineering services to automotive, aerospace and industrial manufacturers. SDRC, which was founded as an engineering consulting firm in 1967, went public in September 1987. At all relevant times, the Company's common stock was registered pursuant to 12(g) of the Exchange Act and traded on the NASDAQ National Market System. 2 The findings herein are made pursuant to the Offers of Settlement submitted by Present and Scanlon and are not binding on any other person or entity named as a respondent in this or any other proceeding. ==========================================START OF PAGE 3====== B. SUMMARY This order and opinion relates to KPMG's audit of SDRC's financial statements for the year ended December 31, 1993. In connection with the 1993 audit, KPMG issued an unqualified audit opinion on SDRC's 1993 financial statements stating that the audit was conducted in accordance with Generally Accepted Auditing Standards ("GAAS") and that the financial statements were fairly presented in conformity with Generally Accepted Accounting Principles ("GAAP"). In fact, SDRC's financial statements were not in conformity with GAAP and the auditors failed to conduct the 1993 audit in accordance with GAAS. Beginning in 1992 and continuing through September 14, 1994, when SDRC initially disclosed accounting irregularities, SDRC inflated revenues and earnings by recognizing both premature and fictitious revenue.3 This fraudulent revenue recognition scheme was carried out by certain SDRC senior executives, some of whom made false or misleading statements, or failed to disclose material facts, to the auditors. A material amount of the improperly recognized revenue was based on purchase orders containing conditional language ("conditional purchase orders") from SDRC's Far East Operations.4 On January 17, 1995, SDRC restated its financial statements in order to, among other things, correct for the improper recognition of revenue, which resulted in material decreases to revenue and net income for 1991 through the second quarter of 1994. For 1993, revenue was restated from $186.3 million to $147.6 million, a decrease of $38.7 million or 21%. Net income for 1993 was restated from $14.3 million to a loss of $11.7 million, a decrease of $26 million or 182%. Philip S. Present, II ("Present") was the engagement partner for the 1993 audit of SDRC and continued in that role until KPMG's resignation in October 1994. William J. Scanlon ("Scanlon") was the concurring review partner for the 1993 audit of SDRC. Present and Scanlon were both aware of red flags that should have caused the audit team to perform additional procedures in order to determine whether SDRC's financial statements were prepared in conformity with GAAP. Present was aware that certain revenue was recorded by SDRC based on purchase orders containing conditional language. Present and Scanlon were 3 See SEC v. Structural Dynamics Research Corporation, et al., Litigation Release No. 15325. 4 Many of the purchase orders were clearly conditional. For example, purchase orders were actually titled "Conditional Purchase Order," specified that product was not to be shipped until further notice from the customer or, in some instances, stated that there was no obligation to pay. ==========================================START OF PAGE 4====== aware that material amounts of receivables were outstanding for long periods of time and then ultimately written off when the related revenue was reversed by SDRC. Present and Scanlon were also aware that audit differences, representing 22% of the net income originally reported by SDRC for 1993, were not reflected in SDRC's 1993 financial statements. As described below, Present engaged in improper professional conduct within the meaning of Rule 102(e) in that he failed to conduct the 1993 audit of SDRC in accordance with GAAS. Present failed to exercise due professional care and maintain an attitude of professional skepticism in the performance of the audit and failed to obtain sufficient competent evidential matter to afford a reasonable basis for KPMG's opinion on SDRC's 1993 financial statements, as required by GAAS. Scanlon also engaged in improper professional conduct within the meaning of Rule 102(e) in that he failed to exercise due professional care and to maintain an attitude of professional skepticism in connection with his role as concurring review partner. C. THE 1993 AUDIT At the time of the 1993 audit, Present and Scanlon were aware that there were various risk factors associated with SDRC that increased the risk of financial statement errors. For example, they were aware that SDRC management engaged in aggressive revenue recognition practices. Present and Scanlon were also aware that, in prior audits, concerns had been raised by KPMG about the propriety of revenue recognition on certain types of transactions and about the subsequent reversal of such revenue. In addition, Present prepared a document listing certain "weaknesses" of SDRC including "aggressive earnings history," "an abnormal focus on stock price, strong CEO," "Far East accounting/financial reporting/operational issues," and "very ineffective Audit Committee, CFO is weak." 1. CONDITIONAL PURCHASE ORDERS During the 1993 audit, the engagement team spent considerable time auditing accounts receivable, a critical area of the audit. Particular emphasis was placed on auditing accounts receivable in SDRC's Far East Operations ("FEO") which represented approximately 50% of consolidated accounts receivable at year-end 1993. FEO also accounted for approximately 35% of the revenue recorded by SDRC in 1993. The audit team incorrectly concluded that certain revenue relating to these accounts receivable had been properly recognized and focused their attention on evaluating collectibility. Present was aware that SDRC recorded certain revenue based on conditional purchase orders. While auditing FEO's accounts receivable, the engagement team identified sales supported by ==========================================START OF PAGE 5====== conditional purchase orders. The conditional language noted on the purchase orders should have precluded revenue recognition under GAAP. The audit staff prepared, and Present reviewed, a memo included in the workpapers which stated that certain purchase orders were contingent upon receipt of end-user purchase orders and thus were conditional purchase orders. The memo further indicated that the purchase orders were subject to amendments and cancellation. The memo specifically described conditional purchase orders received from Far East Computers ("FEC"), one of SDRC's sales representatives in the Far East. The workpapers also contain the SDRC controller's explanation to the audit team about these conditional purchase orders, that is, that FEC included this language in certain purchase orders because FEC wanted to be assured via written documentation that it could substitute software modules or end-users. This explanation did not address the fact that these orders were contingent and subject to cancellation, nor did it address whether the revenue recognized by SDRC was in conformity with GAAP. Workpapers reviewed by Present show that the account receivable balance from FEC at year-end 1993 was approximately $4.5 million and that revenue from sales to FEC had increased from $2.9 million in 1992 to $6.6 million in 1993. FEC's account receivable balance alone represented 13% of FEO's accounts receivable and 7% of the company's consolidated accounts receivable at year-end 1993. Sales to FEC represented approximately 10% of the revenue recorded by FEO and approximately 4% of the company's total revenue in 1993. According to a workpaper reviewed by Present, 32% of FEC's account receivable balance at the end of 1992 was either written- off during 1993 or remained unpaid at the end of 1993. Despite the fact that the language in FEC purchase orders clearly stated the orders were conditional and subject to cancellation, the auditors accepted the controller's explanation and did not take exception to the recognition of revenue on these orders. This undue reliance on management's representations constitutes insufficient professional skepticism by Present. Moreover, Present failed to corroborate management's representations regarding conditional purchase orders with sufficient additional evidence that these sales were properly recorded. 2. SIGNIFICANT WRITE-OFFS OF ACCOUNTS RECEIVABLE AND REVENUE REVERSALS In 1993, SDRC wrote off approximately $29 million of accounts receivable, of which approximately $20 million related ==========================================START OF PAGE 6====== to FEO.5 Of the total 1993 write-offs, approximately $21 million related to the write-off of receivables from year-end 1992. In assessing the collectibility of accounts receivable during the 1993 audit, the auditors considered these write-offs in developing their estimate of the appropriate allowance for doubtful accounts. However, they failed to verify adequately the underlying cause of the write-offs and related revenue reversals. Further, they failed to consider adequately whether the write- offs and revenue reversals were an indication that revenue had been improperly recorded in the first place. Present was aware that SDRC had substantial write-offs and reversals in 1993 and that they had increased significantly from 1992 to 1993, especially in FEO. The audit workpapers, reviewed by Present, show that 51% of the FEO accounts receivable outstanding at year-end 1992 were written off in 1993 and that an additional 11% of the 1992 FEO accounts receivable balance had not been collected by year-end 1993. Scanlon was aware, through discussions with Present and the engagement team, that write-offs had increased significantly in 1993 and that a significant amount of 1992 revenue was reversed in 1993. SDRC management represented to the auditors that there were specific, non-recurring reasons for the significant increase in write-offs and reversals in 1993. For example, management represented to the auditors that certain publicly disclosed problems with the company's new software contributed significantly to the increased write-offs and reversals in 1993. In fact, the write-offs and reversals primarily related to revenue that was premature or fictitious; the majority of 1993 write-offs and reversals related to sales that had been recorded in 1992 which were reversed in 1993 because they remained unpaid. The significant level of write-offs and reversals, in and of itself, should have caused Present to question more seriously whether SDRC was recognizing revenue in conformity with GAAP. Present failed to maintain an appropriate level of professional skepticism concerning the write-offs and reversals. He also placed undue reliance on management's representations concerning the write-offs and reversals and thus failed to obtain sufficient competent evidential matter concerning the underlying cause of 5 SDRC had a policy requiring the write-off of receivables that remained unpaid after a certain length of time. Over 90% of the 1993 write-offs were recorded as decreases to revenue in 1993, as opposed to being written off against the allowance for doubtful accounts or charged to bad debt expense. Further, the 1993 write-offs of year-end 1992 accounts receivable were far in excess of the allowance for doubtful accounts at year-end 1992. the write-offs and reversals and the propriety of the revenue recognized by SDRC. Scanlon also failed to maintain an appropriate level of professional skepticism concerning the significant write-offs and reversals. 3. THE PASSED AUDIT DIFFERENCE Based in large part on the percentage of year-end 1992 receivables that were written off in 1993, the audit staff calculated a $5.8 million proposed audit adjustment to increase the allowance for doubtful accounts for FEO receivables. In the aggregate, the audit differences considered by the auditors totalled approximately $3.1 million, which represented approximately 22% of the net income originally reported by SDRC. Present concluded, and Scanlon concurred, that the $3.1 million net audit difference was not material to SDRC's financial statements. In reaching that conclusion, they relied in substantial part on management's representations that the rate of write-offs and reversals in 1993 was based on factors that management did not expect to recur in 1994, and that the $5.8 million audit difference calculated by the staff was, therefore, excessive. Thus, the auditors "passed" on the audit difference and did not require SDRC to adjust its financial statements. Present and Scanlon both placed undue reliance on management's representations and failed to exercise due care in connection with assessing the materiality of the passed audit difference. 4. CONCLUSION The engagement partner has the primary responsibility for ensuring that the audit is conducted in accordance with GAAS. GAAS requires the independent auditor to exercise due professional care and to maintain an attitude of professional skepticism in the performance of an audit. (AU 230.02 and AU 316.16)6 Present failed to demonstrate an appropriate level of professional skepticism with respect to the conditional purchase orders, the significant write-offs of accounts receivable and the material audit difference. Further, Present failed to consider adequately whether these factors were an indication that the financial statements were materially misstated. GAAS also requires an auditor to obtain sufficient competent evidential matter to support the opinion rendered on the financial statements. (AU 326.01) Present failed to corroborate adequately management's representations by obtaining sufficient competent evidential matter regarding the revenue recognized by SDRC. Overall, Present failed to exercise due professional care in the performance of the 1993 audit. 6 GAAS citations are to the American Institute of Certified Public Accountants, Codification of Statements on Auditing Standards (1993). ==========================================START OF PAGE 7====== The review conducted by a concurring review partner provides additional assurance that the financial statements are in conformity with GAAP and that the audit was conducted in accordance with GAAS. As set forth under GAAS, "The independent auditor is responsible for compliance with generally accepted auditing standards in an audit engagement." (AU 161.01) Thus each member participating in an audit engagement, including the concurring review partner, has a responsibility to conduct that professional's role in the audit in accordance with the requirements of GAAS. Scanlon failed to maintain an appropriate level of professional skepticism concerning the significant write-offs, and failed to consider adequately whether these write-offs coupled with the passed audit difference, were an indication that the financial statements were materially misstated. Scanlon's concurrence that the passed audit difference was immaterial demonstrates his failure to exercise due care in his role as concurring review partner for the 1993 audit. IV. ORDER IMPOSING SANCTIONS Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the Offers of Settlement submitted by the respondents and accordingly, IT IS HEREBY ORDERED, effective immediately, that: A. Present is denied the privilege of appearing or practicing before the Commission as an accountant. B. Two and one-half years from the date of this Order, Present 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 person acting as an accountant who prepares, reviews or is 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 Present 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) Present, or any firm with which he is or ==========================================START OF PAGE 8====== 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) Present 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) Present 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 he appears or practices before the Commission as an independent accountant. 3. The Commission's review of any request or application by Present to resume appearing or practicing before the Commission may include consideration of, in addition to the matters referenced above, any other matters relating to Present's character, integrity, professional conduct, or qualifications to appear or practice before the Commission. C. Scanlon is censured for the conduct described herein and undertakes that: 1. Scanlon, or any firm with 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, and 2. Scanlon 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 he appears or practices before the Commission as an independent accountant. By the Commission. Jonathan G. Katz Secretary ==========================================START OF PAGE 9======