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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Enforcement Issues: Good News, Bad News, Brillo Pads, Miracle-Gro, and Roundup

Remarks by

Walter P. Schuetze

Chief Accountant, Division of Enforcement,
U.S. Securities and Exchange Commission

1998 Twenty-Sixth Annual AICPA National Conference on SEC Developments
Grand Hyatt Hotel, Washington, DC

December 8, 1998

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any publication or statement by its employees. The views expressed herein are those of Mr. Schuetze and do not necessarily reflect the views of the Commission or the other staff of the Commission.

There is nothing new under the sun on the accounting side at the Division of Enforcement. Over the years, I have heard every Chief Accountant of the Division speak at forums like this one, and they all said the same things. I have been the Chief Accountant of the Enforcement Division since November 1997, and I have seen nothing new. There are only so many ways to cook the books. I, too, am going to sound like a broken record.

I bring both good news and bad news. I will start with what should be good news. From my perspective as the Chief Accountant of the Enforcement Division, looking only at our statistics, financial accounting and reporting would appear to be in good shape. I say this based on the number of financial accounting and reporting cases that the Commission completes every year. These are the cases involving accounting issues, financial statement disclosure issues, MD&A disclosure issues, auditing issues, and auditor independence issues. These cases do not involve insider trading, stock price manipulations, yield burning, or supervision of registered representatives.

Our statistics show that the Commission completes about 100 accounting cases a year. If I divide 100 cases by 16,000 commercial and industrial public companies who file documents with the Commission, the result is about 0.6%. A very small percentage. To be sure, the percentage is not Six Sigma, but nonetheless it is very small. What that statistic taken in isolation says to me is that, by and large, the issuer-participants in our vast public marketplace are conforming to the rules.

The percentage of 0.6% would be cut about in half were I to include broker/dealers and investment companies in the statistics. In addition to the 16,000 public company issuer/registrants that file financial statements and audit reports with the SEC, there are about 7,000 broker/dealers and about 7,000 investment companies that also file financial statements and audit reports with the SEC. So, if I add 7,000 broker/dealers and 7,000 investment companies to the 16,000 issuer/registrants, the total is about 30,000. Then, 100 cases divided by 30,000 opportunities equals 0.3%. Over the years, we have had only a limited number of accounting cases involving broker/dealers and mutual funds. I think that it is instructive to observe why that is. I think that there are not many cases involving broker/dealers and investment companies because those companies mark their assets to market. Many of our accounting cases not related to broker/dealers and investment companies involve the accounting for various kinds of deferred costs. One cannot mark to market a cost. One can mark to market only something that has value in the marketplace.

While the above should be good news and welcome news, I have bad news. Bad news that makes me suspect that the inferences I draw from the numbers above are incorrect. In the July 13, 1998 issue of Business Week, there is a Special Advertising Section reporting on BW's Seventh Annual Forum of Chief Financial Officers. The 160 delegates at the Forum were polled electronically and anonymously on 27 questions. Question 10 reads as follows:

"As CFO, I have had to fight off other executives' requests that I misrepresent results:

  1. Yes, it has happened, but I said 'no' and fought them off.
  2. I yielded to the requests.
  3. No such pleas ever received by me."

Sixty-five of the 160 CFOs responded to that question. Listen now to the response. Only twenty-one CFOs, or one third of those 65 respondents, said they had not been asked to "misrepresent results." But, 44 of the 65, or 67% of those who responded, said they had been asked to "misrepresent results." Thirty-six of those 44 CFOs fought off the requests, but eight of the 44 respondents, which is 12% of the 65 or 18% of the 44, said they had yielded to the requests to "misrepresent results." I repeat: 67% of the CFOs had been asked to "misrepresent results" and 18% of those who were asked did. Those statistics are staggering. Given that we have about 16,000 commercial and industrial companies as issuer/registrants, and assuming that the responses of the 65 respondents are representative of the entire population, this means that in almost 11,000 cases (16,000 x .67) CFOs were asked to "misrepresent results," and in almost 2000 cases (11,000 x .18) the CFOs yielded to the request to "misrepresent results." Those statistics boggle my mind.

Let me raise with you another troublesome development regarding financial accounting and reporting. While I have not counted the cases, I see, just by reading the newspapers, that some issuer registrants are turning not to their regular auditors but to "forensic" auditors from other firms when questions are raised about the issuer's financial statements. The scenario is as follows: The issuer says in a press release that it has uncovered facts that indicate previously issued financial statements may be wrong. The issuer's Audit Committee then retains counsel to investigate. Counsel retains "forensic" auditors to help in the investigation. The forensic auditors are a different firm than the issuer's regular auditors. The forensic auditors then take their Brillo pads and scrub the issuer's balance sheet until it looks like a newly minted copper penny, and the restatements to assets, liabilities, equity, and income are the size of an elephant. The question is: Which firm did the real audit? Which firm's partners and staff did not have their objectivity clouded or enveloped by relationships developed at picnics or golf outings or at sports events with their clients? Which firm's partners and staff did not have their skepticism dulled by the fact that a former partner of the audit engagement partner is now the client's CFO? That the audit partner and the CFO also are doubles partners at the tennis club on Saturday morning?

Which brings me to the issue of fraternization between auditors and their clients. It appears to me that some auditors and their families, through social contacts, are getting so close to and so involved with their clients and their clients' families that a disinterested observer would question whether the auditor's objectivity had not been clouded or perhaps even enveloped. Let me give you two examples. In Business Week, February 23, 1998, there is an article that talks about auditors and their families having social contacts with their clients and their clients' families through such joint activities as picnics and baseball games.

The Enforcement Division recently came across an Audit Planning Memorandum of a Big Five firm wherein social events between the auditor and client are explicitly set forth. I quote from that Audit Planning Memorandum. (I have not used the names of sports teams actually used in the memorandum. I have substituted other names.)

"Summer and Other Social Events

  • Golf
  • The University of Texas football games (Oklahoma, Texas
    A&M, and Arkansas)
  • NCAA Basketball final four tickets
  • San Antonio Spurs tickets
  • Houston Astros tickets
  • Shopping"

I wonder what "shopping" means. Alpaca sweaters? Golf clubs? Bally's leather jackets?

I wonder how investors or potential investors would react if they were aware of these facts. Would investors believe that the auditor's objectivity is not affected when the auditor and his or her family are engaged in periodic baseball games and picnics with the client and the client's families? Would investors believe that the auditor's objectivity is not affected if the auditor and client personnel regularly attend sporting events together? Go shopping together? Whether paid for by the auditor or paid for by the client? Would investors perceive that gift giving, whether from auditor to client or client to auditor, can go on for very long without compromising the auditor's objectivity? How would an underwriter who is about to underwrite an offering of $500 million of stock of that company react to these facts? A mutual fund investment manager who is about to invest $100 million in the stock of that company? Query: Should auditors have to follow the same rules with respect to their public company audit clients that I as an employee of the US Federal Government have to follow with respect to regulated entities or persons? Would there be fewer restatements if there were not such fraternizations?

Let me now turn to the kind of problems that we accountants in the Enforcement Division actually work on. In the year that I have had to look at the problems, I see that we do not deal much with esoteric accounting problems such as foreign currency translation or the ins and outs of pension accounting or post-retirement benefits other than pensions. We deal with more pedestrian issues.

For example, on the auditor independence issue, we have one case where the outside auditors of a company wanting to raise money went around to their other clients and promoted the stock of the issuer, passed out the subscriptions for the issuer's stock, and then took the checks that their clients wrote for the shares of the issuer's stock and delivered the checks to the issuer. The SEC has a rule that says that the external auditor may not be a broker for his or her client and remain independent. So does the AICPA.

Another independence case that we have is the one involving KPMG Peat Marwick, which the Commission filed in December of 1997 and which has been well publicized. This case has several moving parts which I will not recite here. KPMG has responded by denying the Commission's assertions about KPMG's lack of independence. The matter recently was heard by an Administrative Law Judge. The Judge's opinion will follow in due course.

We also have other independence cases in the works involving ownership by audit and tax partners and staff of securities issued by audit clients and ownership of audit-client-issued securities held indirectly by a trust where a partner in the CPA audit firm is also a co-trustee of the trust. These cases are not yet resolved.

Let me move on to some of the accounting issues with which we are dealing. The Enforcement Division was formed in the 1970s. As I said earlier, over the years, I have heard every one of the Division's Chief Accountants give speeches wherein they described their cases. Well, nothing has changed. Registrants are still doing the same things.

Premature revenue recognition appears to be the recipe of choice for cooking the books. Recognizing revenue when an undisclosed right of return exists. Recognizing consigned inventory as sold inventory. Shipping product to company warehouses or employees' homes and recognizing sales revenue. Recognizing revenue in advance of the customer's acceptance of the product. Keeping the sales journal open after the end of the quarter or year but back-dating sales invoices. The following is quoted from the Commission's AAER 1020 dated March 25, 1998 In re Sensormatic Electronics Corporation:

"The Commission Order finds, among other things, that from at least the start of its 1994 fiscal year through July 10, 1995, Sensormatic manipulated its quarterly revenue and earnings in order to reach its budgeted earnings goals and thereby meet analysts' quarterly earnings projections. During the relevant period, Sensormatic consistently met, within one cent, the analysts' forecasts of quarterly earnings per share, even for the third quarters which were Sensormatic's seasonally weaker quarter.

"Sensormatic carried out this fraudulent scheme by improperly recognizing revenue through several different practices. The conduct, which occurred over a number of years and involved employees throughout the organization, primarily involved recognizing and recording revenue in one quarter from product shipped in the next quarter. At the end of each quarter Sensormatic turned back its computer clock that recorded and dated shipments so that out-of-period shipments, and consequently revenue, would be recorded in the prior quarter. According to the Order, revenue also was recognized through the following improper practices: recognizing revenue in one quarter, when products were shipped to warehouses leased by Sensormatic, instead of in the next quarter, when the products were shipped to the customers; slow shipments, whereby revenue was recognized on shipments which were made during the last days of a quarter but which were not scheduled to arrive at the customers' location until well into the next quarter; and recognizing revenue on goods at the time that they were shipped to customers even though the customers' contracts with Sensormatic contained an FOB destination provision. The amount of out-of-period revenue that Sensormatic recognized in quarters ranged from $4.6 million to $30.2 million."

Sensormatic's income statement should have been headed up as follows: "Year ended June 35, 1994."

Deferral in the balance sheet of costs that should have been reported in income as operating expenses. Assigning inflated, often outrageously inflated, dollar values to exchanges of nonmonetary assets, particularly with related parties. Assigning inflated, often outrageously inflated, dollar values to nonmonetary assets contributed to the corporation in exchange for debt or stock of the corporation. Not disclosing the existence of related parties and transactions with related parties. Recognizing officers' salaries as receivables. Recognizing cash taken from the corporation by officers as cash in bank or as a direct reduction of stockholders' equity instead of as a charge to expense. Including brass bars that look like gold bars in an inventory of gold.

Bleeding into income, without disclosure, "reserves" established in business combinations or in so-called restructurings. In several recent cases, the bleeding turned into a hemorrhage from a severed carotid artery. How I dislike that word "reserve." It is terribly misleading. Most nonaccountants, including lawyers, judges, and journalists, think that "reserves" have green money in them. For example, The New York Times of November 16, in an article by Melody Petersen, says Federal banking regulators often worry that banks have not set aside enough MONEY to cover expected loan losses. The Wall Street Journal of November 17, in an article by Elizabeth MacDonald, also equates "reserves" to MONEY. Even the Times and the Journal think that reserves are vessels containing money.

I thought that the "reserve" issue had been resolved in 1975 when the FASB issued Statement 5 on "Accounting for Contingencies." But, nowadays general reserves are like crab grass. They are everywhere. Tax liability cushions. Deferred tax asset cushions. Inventory reserves. Bad debt reserves. Merger reserves. Restructuring reserves. They are like dirt. They are everywhere. Some companies keep a 55-gallon drum of Miracle-Gro in the garage, and they irrigate their crab grass general reserve accounts with a garden hose hooked up to the 55-gallon Miracle-Gro drum. Then, along comes the Division of Corporation Finance, in its reviews of filings by issuers, and squirts Roundup from a spritzen bottle on issuers' balance sheets, but the crab grass general reserves keep re-emerging. (For you apartment dwellers, Roundup is a herbicide that is supposed to kill weeds.) And, the reserves are being used to manipulate earnings. Need a penny a share to meet Wall Street's expectations? Need two pennies? A nickel? A dime? Two bits? Dip into the chocolate chip cookie jar reserve. The mere existence of reserves is a chocolate chip cookie jar that management finds hard to resist when the earnings need a sugar high.

Let me read to you from the transcript of a September telephone call between an issuer/registrant and Wall Street analysts:

"Q: Analyst: A couple of questions for you Jack. [Jack is the issuer's CEO.] One on the conservative accounting. Actually it surprises me that people have any doubts about the accounting. All the work we've done shows it's really conservative. Let me ask you about a couple aspects of the conservatism. One, it looks like you're probably over-reserving for indirect sales and that's one aspect of the conservatism. If you want to give any clarity on that, that's terrific. And two, it looks like your deferred revenues shot up a lot in the last quarter so it looks like you were holding back revenue recognition, so if you want to offer anything on that.

"A: by Jack: Well you're absolutely right on both counts. We've been extremely conservative and that's how you build little honeypots that you can go to, because when you make these acquisitions in our business planning, we always project a sequential decline in the revenue of the acquired company, and we have to go back to our core businesses to get faster growth to cover up the potential 10-15% decline in revenue. And that's where you see the releasing of backlog, and that kind of thing, you can only do that if you've created those acorns out there."

Honeypots! Acorns! We need another pass at "reserves." We need a Year 2000 version of FASB Statement 5.

How about treasury stock carried as an asset in the balance sheet at market, with gains on sale of treasury stock credited to income. (I'm not making this up.) Counting on-hand but consigned inventory as owned inventory. How about increasing fixed assets and crediting cost of sales. Not booking all of the accounts payable; just put the invoices from suppliers into a desk drawer. Not writing down or writing off uncollectible receivables. Booking barter trade credits as if they represented bona fide US dollars. Such is the grist of our accounting mill. Not very esoteric stuff. If I draw an analogy to police work, what we see is stolen automobiles with finger prints on the door handles, not murders where there are no clues except for dogs that did not bark.

On the audit side, I now have seen several nonaudits since I came on board last year. Auditors accepting, with little or no evidential support, values ascribed to both monetary and nonmonetary assets. Art work by unknown artists booked as assets at huge amounts but without any support for the assigned value and no inquiry by the auditor about independent valuation of the art work. (One registrant did get an opinion about the value of art work it had acquired from an artist through the issuance of stock. The registrant asked the artist the value of the artwork and the artist, without modesty, gave his opinion.) Receivables acquired from collection agencies for pennies but booked at dollars without any documentation and no auditor inquiry as to the basis for the value. Auditors not doing substantive audit work but relying on so-called analytical procedures where the evidence, or lack thereof, cries out for substantive audit work. In one case, the physical inventory test counts showed a large shortfall from the inventory amount in the general ledger. Rather than requiring a complete physical count of the inventory or qualifying the audit opinion, the auditor relied on so-called "analytical procedures" which led to acceptance of an erroneous book amount for the inventory. Auditors not doing cut-off work for sales and purchases, with the result that sales of the next period are booked in this period with a corresponding increase in receivables from customers, and accounts payable for purchases of inventory of this period not booked until next period with the inventory recognized in the balance sheet resulting in understated costs of sales and overstated margins. And, of course, we see cases where the auditors were lied to or were not given all of the documentation that they should have been given. But, sometimes I wonder whether the auditors asked the right questions.

I realize that what I have talked about today is the dark side of financial accounting and reporting, the side that is not nice to look at. And that the dark side is very small in relation to the universe. But, when we see a steady stream of restatements by all manner and kind of registrants, not just microcaps, and when we see a steady stream of articles in business journals entitled "hocus-pocus earnings," "abacadraba accounting," "pick a number, any number," we regulators take notice. Investors also take notice. While the numerical count of enforcement cases is small, 100 or so a year, one has to ask how much cyanide will poison a well. Will it take long before investors bid down the prices of securities in our markets to factor in the uncertainty arising from possible bad numbers and inadequate disclosures? Perhaps the bidding-down process is already silently taking place. Will investors stop drinking from the well called audits by "independent certified public accountants" and sample the water in other wells. You may say that there are no other comparable wells. Not so. When investors begin to believe that their interests are not being protected by external auditors, those investors will find an alternative to protect their interests, in ways other than an audit by independent certified public accountants.